Sep 28, 2009

Reckless Behavior and Unchecked Excess

Reckless Behavior and Unchecked Excess

September 28, 2009

"Where in the world are you going to find these angels for us to arrange society for us?"..."no other system in the world has lifted so many from poverty as capitalism and free trade"..."is political greed somehow more virtuous than economic greed? If so, where are the examples in history?"-Milton Friedman
Weekly percentage performance for the major indices
Based on last Friday’s official settlement...

INDU: -1.6%
SPX: -2.2%
COMPQ: -2.0%
RUT: -3.1%

Not surprisingly, the pullback in the market this week was virtually the mirror image of the run-up as small caps lagged while large cap, defensive stocks held up better. While we have been (overly) cautious for quite some time, the naysayers are out in force, trying to be the first to predict that this may be the long awaited downturn.

I once said that the best investment I have seen over the past 15 years were the hats the hosts on CNBC purchased in the 90’s saying “Dow 10K.” Sure enough, here we are a mere dozen or so years later and those hats have a chance to make yet another appearance on the air as the Dow closed the week at 9665, off from a peak of over 9900 Thursday. The Dow last saw the magic five figures roughly a year ago during its free-fall from just under 12K (after peaking over 14K) to less than 6700 earlier this year. Will the latest surge take it over the magic 10K Mendoza line once again? Possibly, however, we feel that this visit above 10K will be short lived as the market rally appears to be pricing in one of the most amazing economic recoveries in history. Could this be the case? Of course, as even renowned (now former) bear James Grant has finally turned bullish for the first time since the railroads were a growth industry (or so it seems). Jim has been one of the great prognosticators of my Wall Street career, and while he even seems surprised by his newfound bullishness, he would prefer to see a continuation of the deflation we are now seeing as a way to goad consumers back into the spending environment versus the Fed’s prescription of inflation, inflation and inflation.

ISI, which has been on the positive side of the economic and market picture for quite sometime, said this week that “First Call earnings estimates have soared with the rally up almost 56% in the past 13 weeks.”

ISI’s Eric Boucher, an insightful and quick-witted market commentator and marathon junky continued
“How can stocks, bonds, and commodities continue to rise together? My briefest response is ‘money printing’, and a more nuanced version of the same reply describes how risk appetites have been rising due to low interest rates and quantitative easing. Only the most persistent readers are unsatisfied by this explanation. ‘Why?’, or ‘what’s the linkage between the two?’ come the dogged responses, as well as the ever-popular ‘who is doing all the buying?’ In addition to disgruntled shorts and unhappily underweight portfolio managers, the busiest buyers these days are hedge funds and bank proprietary trading desks. They are putting on carry trades, and the latest funding currency of choice is none other than the U.S. dollar”.

Actual Consensus Prior
Leading Indicators 0.6% 0.7% 0.9%
Housing Price Index 0.3% 0.5% 0.1%
Initial Claims 530K 550K 551K
Continuing Claims 6138K 6183K 6261K
Existing Home Sales 5.1m 5.35m 5.24m
Durable Goods Orders -2.4% 0.5% 5.1%
Durables ex-Transports 0.0% 1.0% 1.1%
Michigan Sentiment 73.5 70.5 70.2
New Home Sales 429K 441k 433k

In a surprise to everyone except those who actually watch the housing market, sales of existing homes fell in August. This is the first time sales have fallen in four months, declining 2.7%. The median price declined 12.5% from the prior year period. With the potential of a large number of foreclosures coming onto the market (some are suggesting up to 7 million), combined with the phasing out of the first time buyers’ credit (set to expire in November, but more than likely will be extended), new inventory in the form of increases in building permits, and it would seem the housing market has a chance of heading back towards a bottom. A big issue, of course, is the unavailability of jumbo mortgages.

In a case of “talking up your book” (which we think is bad form for two reasons: 1) you look stupid when you’re wrong and 2) it compromises your reliability to provide an independent viewpoint), Eli Broad, the billionaire home builder, feels that the housing market has bottomed in many areas and its time to start building again. Imagine that-a homebuilder advising its time to start building again?

A handful of people have asked my view on the first time buyers’ tax credit, and believe it or not this is a program I support. Housing prices have dropped dramatically, and while I am not a supporter of the government directing spending, home ownership is one area which I feel carries a significant benefit beyond the financial advantages that occur during a rising housing market. I feel that increased home ownership helps with employment stability, education, reinvigorating the community, and crime reduction.

The index of U.S. leading economic indicators rose for the fifth straight month, and even though it missed consensus, the rise signals a recovery is bubbling along. We recently discussed that the ECRI Leading Index, a much better indicator than the official government measure, has been positive since the spring.

The gains in stock prices, consumer confidence and homebuilding that are buoying the leading index bolster Federal Chairman Bernanke’s comments that the worst recession since the Great Depression has probably ended. At the same time, rising unemployment and tight credit are still drags on a weak recovery that could easily tip back into recession, as early as the middle of 2010.

Our good friend and small cap strategist Jim Furey of Furey Research Partners has conducted an analysis of the LEI. According to Jim, three of ten indicators are positive year-over-year contributors: money supply, 10-yr/Fed Funds spread, unemployment insurance average weekly initial claims and consumer expectations. Money supply and the 10-yr/Fed Funds spread have been positive in 6 of the prior 7 instances that the LEI turned positive, so it is not surprising they are positive now. Consumer expectations, however, are normally still negative, unlike today's situation, offering a positive divergence from historical tendencies.

Seven of ten indicators remain negative contributors year-over-year -- not unprecedented though building permits and stock prices, which are normally positive when the LEI turns positive, remain down -- a negative divergence from historical trend.

Permits rose 2.7 percent to a 579k annual rate in August. The University of Michigan index of consumer expectations six months from now, considered a proxy for future spending climbed to 69.2, according to a preliminary reading.

FOMC Meeting
The Fed met this week, and said they would keep the benchmark lending rate close to zero for “an extended period”. They discussed the economy and the housing market, saying both had stabilized. Key to their discussions is a plan to discontinue purchasing mortgage backed securities over the next few months. We expect this to phase out sometime early in the spring of 2010.

While the Fed is showing confidence in the economy, they aren’t showing enough confidence to remove the stimulus presently in place. That would signal either 1) the recovery is still very tentative, 2) they don’t believe their own hype, 3) they are receiving political pressure, or 4) they need the accolades that will come with creating another bubble.

Stay tuned.

Credit Conditions
We have often discussed concern over the Fed’s actions and the potential for inflation, longer term. While we still feel this could be an issue in 2011 or 2012, today it is a speck on the horizon, which creates an environment which allows the Fed to “prime the pumps.” Remember that the Fed’s main actions have been to increase the reserves of banks. Typically banks would lend that money, increasing the money supply; however, today the banks have been hoarding this low-cost capital to bolster their balance sheets against non-performing loans. The result is a rapid decline in the velocity of money, and until banks begin lending again the Fed has quite a bit of leeway in their actions.

Money supply actually dropped in the most recent three months by 2.2% (annualized), which many believe could lead to a problem. It is difficult to identify this drop as the Fed stopped publishing M3 some time ago.

The take away? Inflation is on the horizon, but the sun certainly isn’t setting yet. A slack economy with excess capacity in capital production and employment will keep inflation at bay, barring the much discussed (at least in this note) collapse of the dollar.

Increasing Pressure on the Dollar

For many years the Yen has been the currency of choice for the “carry trade”. Now the carry trade has seen a resurgence, but there is a new short vehicle: the US Dollar. The weak dollar and the Federal Reserve's intention to keep its key interest rate close to zero are creating an ideal carry trade, much like that involving the Yen over the past 15 years. "The takeaway point from the Fed meeting is that interest rates in the U.S. will remain low into 2010, leaving the dollar as the perfect funding currency for carry trades," said Kathy Lien, director of currency research at Global Forex Trading.

Fed Unwind
The administration ended its $3 billion “cash-for-clunkers” automobile trade-in program on Aug. 24, and predictably auto sales have collapsed from an annual rate of over 14 million to an estimated 8.8 million (according to Additionally, the Fed is starting to wind down its purchases of Treasury debt, which totaled $285.2 billion between March 25, when the initiative began, and Sept. 16. We expect Treasuries to begin backing up as well, resulting in higher treasury rates as we enter 2010.

Loan Losses Worsen
The Financial Times reports that losses on loans at U.S. banks and other lenders rose to $53 billion in the first quarter, almost triple the previous high reached in 2002. Nonbank lenders, particularly hedge funds, hold $1 of every $3 in troubled loans and 47% of all distressed loans. Loans made to media and telecommunications companies were in the worst state. Lending to the financial-services sector was the next worst, followed by loans to property companies.

State Budgets
In response to the state of New York’s $2.1 billion budget deficit, Governor David Paterson has proposed a 2% spending cap on next year’s budget. While this is a step in the right direction, with total federal, state and local government debt now equaling 100% of GDP, wouldn’t it be nice if someone actually rolled back spending? What if a state (or God forbid the Federal government) did what the rest of Americans have been doing-cut back? Why not a 10% cut across the board, or maybe eliminate some of the unnecessary programs that were created during the boom times?

New Improvements in Power Generation
Business Week is reporting that the smart-grid power-distribution system proposed by the Obama administration would have a revolutionary impact on the U.S. economy, possibly bigger than the Internet. The Commerce Department released technical standards for the project to prepare bidders and power companies. Guido Bartels, IBM's general manager for global energy and utilities, said building a smart grid would drive creation of fresh technologies, businesses, industries and jobs.

Interest Rates
From ISI: Historically, the fourth quarter is a good quarter for stocks. The two year note normally rising in this environment is suppressed in part because banks are not lending, choosing to lend to Uncle Sam before making loans. This helps explain why rates are low with the balance sheet of banks still reflecting fear. Loans as a percentage of balance sheet assets are the lowest since 1983. Add no inflation, institutional investors are bearish on bonds, and huge retail demand, the Chinese still managing their peg, and you have recipe for stubbornly low rates.

Another Skeptic
From Josh Rosner, “We haven’t fixed either the banks or the credit markets. Fixing would actually be a fundamental repair-not a patch like we have now. We’ve merely put up scaffolding to make sure when bricks fall off the buildings they do not hit people below.”

We have quoted Josh a number of times, and his predictions have been right on!

Long Short Equity Weightings
I have been receiving a lot of questions recently about our positioning. While I try not to “talk up the book”, much as we’ve discussed over the past few months we have moved to a net neutral position since the S&P 500 has moved over the 1050 mark, which was our target level for that benchmark to begin moving neutral or even net negative. While three months isn’t a long time in the real world, in the market it can sometimes feel like an eternity, especially when the market is surging and you’re somewhat bearish (or vice versa). In addition to the net neutral position, we have recently added a long position in the QID, which is effectively a short on the NASDAQ.

The Banks are Lending, but to Whom?
BBT reports that bank regulators are seriously considering a plan to have healthy banks lend billions of dollars to the FDIC's bank insurance fund, which is rapidly running out of cash amid a wave of bank failures. The plan appeals to banks, because it would forestall yet another across-the-board emergency assessment on them, which could erode $5-10B of their profits. And it appeals to FDIC head Sheila Bair, who bankers say "would take bamboo shoots under her nails" before turning to the Treasury to tap the FDIC's $100B emergency credit line.


Real Estate
The Wall Street Journal reported this week that slow foreclosure processing is creating a pool of homes that will come on the market and drive housing prices down. As of July, mortgage companies had not begun the foreclosure process on 1.2 million loans, according to LPS Applied Analytics. Also, 1.5 million seriously delinquent loans were still caught up in the foreclosure process. Should these homes come on the market in a flood, recovery of the housing market could be hurt severely, analysts said.

Housing Prices
The median price of a single-family home dropped 2.3% in August. The chart below, courtesy, illustrates the US median price of a single-family home over the past 39 years. Not only did housing prices increase at a rapid rate from 1991 to 2005, the rate at which housing prices increased accelerated. Current prices are 30% off their 2005 highs, resulting in home appreciation since 1970 of 4%.

Note that Fed Funds rates fell to 1% in 2003 (thanks Mr. Greenspan), leading to another Greenspan led bubble!

Health Care Reform
CBS news reports that 59% of Americans are confused by the health care reform proposals, slightly less than the percentage of Congress who is also confused by the issue. Approximately 45% approve of the plan, up from 39% last week, after the President put on his full court press of public relations supporting, but not explaining his plan. Ironically, less than 1/3 of respondents feel each party has taken a stance on the reforms because of the good it will do for the country.

Amazingly, 55% of respondents feel the President is puffing up the results of his health care plan, which makes us question President Lincoln’s comment that you can only fool some of the people some of the time…

Health Care Reform and Ted Kennedy
Paul Kirk Jr., a long time Kennedy associate, was named to replace the Senator until an interim election can be scheduled in January. While the placement of Mr. Kirk (seems like there should be a guy named Spock as well) is controversial, the reality is this could give President Obama his best chance of passing health care reform. I would anticipate a major push by the White House for this reform to come to vote before the January election.

Clean it up!!
We usually try to keep the commentary very clean in this note, and even edited a quote from President Bush last week. However, this quote from Barry Ritholtz was accurate, even though it’s a bit blunt. Sorry to those who are offended:

“If the Fed is Wall Street’s bitch, then Congress is the Street’s whore.”

I don’t anticipate publishing next week as we (my wife and I) will be in Napa next weekend for an annual get away. Although some of you have informed me of the potential brain cell loss associated with too much wine consumption, I must, of course, remind you of the philosophical (and scientific) viewpoint of one of our favorite commentators on life, Cliff Clavin. As you may recall, Cliff has been credited (erroneously), with the following quote:

"A herd of buffalo can only move as fast as the slowest buffalo. When the herd is hunted, the slow and weak at the back are killed first. The speed and health of the herd keeps improving by the regular killing of the weakest members. In the same way, the human brain can only operate as fast as its slowest brain cells. Excessive intake of alcohol, as we know, kills brain cells. Naturally, it attacks the slowest and weakest brain cells first. In this way, regular consumption of beer eliminates the weaker brain cells, making the brain a faster and more efficient machine. That's why you always feel smarter after a few beers."

So even though I’ll miss next week, I should be smarter when I return.

Have a great week. Cheers.


“There’s going to be a flood of bank-owned homes listed for sale at some point.”-John Burns, real-estate consultant

Ned W. Brines
O (562) 430-3232

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