Sep 20, 2009

Small Caps Continue to Lead

Small Caps Continue to Lead

September 21, 2009

“Extensive participation in the impersonal, transaction-oriented capital market does not seem to me an intrinsic part of commercial banking.”-Paul Volcker

Weekly percentage performance for the major indices
Based on last Friday’s official settlement...

INDU: 2.2%
SPX: 2.5%
COMPQ: 2.5%
RUT: 4.1%

The market continued its torrid upward pace, rising once again as the momentum in the market outweighed lingering and justifiable fears about the economy. Much has been made about whether this is a bear market rally (we fall into this camp) or a bona fide new bull. Many ask how the market can continue to go up and ignore the weak economy. One plausible answer we have laid out in prior notes is that while the economy isn’t yet on sound footing, it is showing some signs of improvement, which when combined with better than expected corporate earnings, is enough of a positive to bounce the market from an oversold low. The question we have been struggling with since June is how far will this market bounce? So far the market has moved up for much longer than we anticipated, and is now once again outside our beginning of the year estimated trading range of 840-1020 (S&P 500 1068)

In a speech this week Fed Chairman Ben Bernanke stated that the recession was probably over. The cynic in me wants to remember the underestimation Mr. Bernanke has made at every stage of the financial crisis and cringe when I hear pronouncements such as this. Technically, he may be correct. We certainly could see positive economic growth this quarter, however, the level of economic activity is far from the most recent peak, and this is why the early part of the recovery doesn’t feel good. A proxy for how far things have fallen is the drop in S&P 500 earnings, which can be seen in the chart below courtesy of While they have bounced slightly, they still have a long way to go to achieve their prior peak. Employment, economic activity, housing, and consumer balance sheets face a similar hurdle.

Regarding Mr. Bernanke, Barry Ritholtz commented
“Recall it was Mr. Bernanke who described the sub-prime situation as “Contained;” it was he who believed Housing would not spill over to the broader economy; and it was he who somehow thought the Bear Stearns situation was a one-off.

Even now, the Federal Reserve Chairman said the recession was “very likely over” as consumers showed some of the first tangible signs of spending again. Never mind that all this retail activity has been driven by government subsidies.

Now, as an investor, you do want to be mindful of the Fed Chief’s economic views, particularly how they pertain to his interest rate policies. The Fed has made it clear rates are staying low for the foreseeable future, so this becomes a non-issue in this context.

But his economic forecasts? Don’t bother.

Note that I have not been a particularly harsh critic of the Fed Chair. While he may not be Paul Volcker, he is also (thankfully) not Alan Greenspan. And we could have done much worse than having a student of the Great Depression, who is also an out-of-the-box thinker as Fed Chief.

But as a prognosticator? He is no better than his predecessor.”

The charts below, courtesy of Bespoke Investment Group, show a potential overbought condition in the financial, industrial and materials space. Note the oversold condition of all three groups in March 2009, and also the overbought condition near the end of last year. Investors have run these groups hard into the bear market rallies we have experienced so far. More recently the retail and technology stocks have also been strong, but haven’t entered the overbought area suggested in these charts.


Actual Consensus Prior
Core PPI 02.$ 0.1% -0.1%
PPI 1.7% 0.8% -0.9%
Retail Sales 2.7% 1.9% -0.2%
Retail Sales ex-auto 1.1% 0.4% -0.5%
Core CPI 0.1% 0.1% 0.1%
CPI 0.4% 0.3% 0.1%
Capacity Utilization 69.6% 69.0% 69.0%
Building Permits 579K 583K 564K
Housing Starts 598K 298K 589K
Initial Claims 545K 557K 557K
Continuing Claims 6230K 6100K 6101K
Philadelphia Fed 14.1 8.0 4.2

From Peter Boockvar:
Aug Retail Sales were much better than expected. Including clunkers, sales were up 2.7% vs. expectations of a gain of 1.9%. Ex clunkers, sales were up 1.1%, .7% more than expected and ex clunkers and gasoline stations, sales were up .6% vs. the estimates of flat. Sales for auto/parts were up 10.6% and gasoline station sales rose 5.1%. There were also gains seen in clothing, sporting goods, electronics, dept stores, on line retailing and restaurant/bars. Furniture and Building Materials were the only 2 categories that saw declines. Bottom line, the report is a pleasant surprise ex auto sales as there was a fear that the clunker plan would steal sales from other categories. There were tax holidays and the Labor Day calendar shift that helped to boost sales and the same store sales data for Aug seen 2 weeks ago were better than expected. With the clunker plan now over, we’ll see what impact overall it will have in the Sept data next month.

The Sept Empire Fed manufacturing survey was 18.9, almost 4 points more than expected, up from 12.1 in Aug and it reached its highest level since Nov ‘07 when it was at 25. New Orders rose to 19.8, up almost 6.5 points from Aug. Shipments though moderated by 9 points after jumps in July and Aug. Backlogs remained negative still but rose almost 5 points. Employment stayed sluggish, falling about 1 point to -8.3 but Aug saw a big improvement from July. Prices Paid rose almost 7 points and Prices Received, while still negative, rose 9 points and both are at Nov ‘08 highs. For those looking for a boost in inventories didn’t get it as it fell almost 3 points and this category will be a key focus as we look at all the manufacturing surveys. The 6 month outlook rose 4 points to the highest since Nov ‘04. Net-net, manufacturing is a key component of the 2nd half recovery theme and today’s number confirms that improvement in the NY metro area.

Aug PPI rose 1.7%, .9% more than expected while the core rate was up .2%, .1% more than estimates. The y/o/y headline decline of 4.3% was the smallest since April as we begin to cycle thru the big drops in commodity prices and start to capture the bounce back. An 8% rise in energy prices was the main catalyst for the headline upside surprise. Food prices rose .4%. Helping to boost the core was a .7% price gain in passenger cars and an .8% rise in light trucks. The lack of supply and clunker demand gave auto makers pricing power. Inflation in the pipeline, as measured by intermediate goods, rose smartly, up 1.8% headline and .6% ex f&f and rose 3.8% headline and 6% at the core in the first stage of production, thus adding evidence that the disinflation trends over the past year has run its course.

Unemployment rose in 27 states in August, with California and Nevada reaching record levels of unemployment at 12.3% and 13.2% respectively. Michigan continues to have the highest unemployment rate at 15.2%. It is interesting to note that over 50% of the job creation came from the state of Texas, which claims to be the freest market state in the union.

ECRI reports that
“a weekly gauge of future U.S. economic growth hit a year-high in the latest week, sending its yearly growth rate to an all-time high that points to a more vigorous recovery than consensus has shown.”

"The rise in WLI growth to a record high reinforces our earlier forecast that at least the early stage of the current economic recovery will be more vigorous than the last two," said ECRI Managing Director Lakshman Achuthan.

Retail Sales
Retail sales jumped in August by 2.7%, the biggest jump in three years. As expected, auto sales showed the biggest jump in eight years, rising 11% on the Cash for Clunkers program. The real bright spot in the report was that 11 of 13 categories showed increases. Excluding autos the gain was the biggest in six months.

David Rosenberg of Gluskin Sheff also notes that seasonal factors used by Commerce were the most aggressive in five years and helped give the data bit of a boost — in fact, one-quarter of that 2.7% gain came just from the more generous-than-usual seasonal factor.

According to the Financial Time the Japanese yen rose to a seven-month high against the U.S. dollar after Japanese Finance Minister Hirohisa Fujii assured markets that the government will not intervene to slow the currency's rise. The yen was at 90.16 against the dollar, its strongest level since early February. Fujii said the government, led by the Democratic Party of Japan, opposes currency intervention as a policy.

Commercial Real Estate

From Bridgewater Associates:
“At the headline level, there are $3.5 trillion in commercial real estate loans outstanding, with more than $1.0 trillion coming due in the next three years. The average loan outstanding has a loan-to-value of 100% versus 65-70% at origination, and our expected losses on those loans are about $700 billion (including construction & development loans) through the cycle. The three big holders of these loans are banks with 52% (two-thirds of which are held by regional or small banks), CMBS & other securitized products with 21%, and insurance companies with 10%. We have just begun to experience the problems. This month Colonial Bank and Guaranty Bank, with a combined $40 billion in assets, failed largely due to their commercial real estate exposure.”

Household Net Worth Increasing

Household wealth in the U.S. increased by $2 trillion in the second quarter, bringing an end to the biggest slump on record. Net worth for households and non-profit groups climbed to $53.1 trillion from $51.1 trillion in the first quarter, marking the first gain since the third quarter of 2007, according to the Federal Reserve’s Flow of Funds report. The government began keeping quarterly records in 1952.

The advance reflected the biggest quarterly jump in stock prices since 1998 and the first increase in home values in more than two years. Together with increased savings and less debt, the gain in wealth is part of the mending process consumers will undergo in coming years before spending can gain speed.

Best Buy reported EPS less than consensus on above consensus revenues. The company guided both measures above consensus for the full year. Comps were down 3.9% versus the decline of 6.2% in the prior quarter. As we discussed last week, the company feels that the late back to school season will help September comps. Strength was noted in notebooks, phones and flat panel TVs.

Better revenue on lower gross margins is the prescription we laid out for Best Buy when Circuit City closed up. Best Buy has become the walk-in electronics store of choice, however, price discovery has become so efficient because of information availability on the internet, and competition has increased from Wal-Mart and the club stores to the point that Best Buy has been unable to raise prices in spite of the Circuit City closure.

Are you kidding me?

According to Bloomberg, former Federal Reserve Chairman Alan Greenspan warned that Congress might slow the Fed's attempts to exit from supporting the economy with stimulus measures. "It's the politics in the United States that worries me, whether the Congress will basically feel comfortable" with the Fed ending stimulus measures, Greenspan said. The U.S. must reduce its debt and take measures against inflation, Greenspan said.

What about that comment about US politics bothering him? I thought the Fed was supposed to be independent?

Who’s Buying Stocks?

From David Rosenberg:
“While some pundits will boil it down to abundant liquidity, a term they can seldom adequately define. If it’s a case of an endless stream of cheap money, we are reminded of Japan where rates were microscopic for years and the Nikkei certainly did enjoy no fewer than four 50% rallies and over 420,000 rally points in a market that is still more than 70% lower today than it was two decades ago. Liquidity and technicals can certainly touch off whippy tradable rallies, but they don’t take you all the way to a sustainable bull market. Only positive economic and balance sheet fundamentals can do that.”

A survey by the Boston Consulting Group found that the rapid loss of wealth in North America through the economic crisis pushed Europe to the top of the list as the world's richest region. The consulting firm said the wealth of North Americans, according to assets under management, plummeted 21.8%, the most severe drop anywhere during the downturn. At the same time, the value of Europeans' assets declined only 5.8%, the company said.

I wonder how the Administration will pay for all these new spending priorities without the wealth of the American taxpayer to kick around?

It should be no surprise that newspapers’ share of US advertising dollars has been dropping significantly since peaking at 37% in 1949. First television, then direct mail, and now the internet have all taken a bite out of the papers. Help wanted and classified ad sales have plummeted along with readership over recent years as online options (think EBay, Craig’s List,, and blogs) have chipped away at the share of traditional media (see chart below courtesy Pali Research). Now social media threatens to blow the lid off of online ad spending. Social networks such as Facebook (an estimated 100 million users) are growing exponentially, and users are recommending products, sharing ideas, and most importantly spending hours a day on the sites. The companies themselves are attempting to increase the utility of the sites to encourage users to be online all day long, without barraging them with advertising and other revenue generating techniques. The success of social media entering the advertising space could drive the final nail into the coffin of the newspapers.

Protectionism 101

In past notes we have discussed the risk of protectionism and how the Smoot Hartley tariff act prolonged the Great Depression. In response to a recent WTO ruling, the Obama administration announced a 35% tariff on the $1.8 billion of automobile tires being imported from China. The Chinese responded by saying they will begin dumping tires and will probe subsidies on chicken and autos from the US. The US had the option to not act on this ruling, however, since the complaint was filed by the United Steelworkers union, a major Obama financial backer, the administration was stuck between a rock and a hard place.

More Bank Closures

Corus Bank, heavily laden with commercial real estate loans, failed last week, bringing the total number of banks that have been closed this year to 94, the most bank failures in the last 15 years combined.

National Debt

From Jon Fisher (
“The annual interest on the current public debt is ~$329B, which was the total debt circa 1970. That’s the annual profits generated by the top ~75 Fortune 500 companies (combined) assuming a zero versus negative contribution by the ones losing money. The President of the United States should not be called a liar on television but maybe the President of the United States should also pass on borrowing another trillion dollars this week.”

According to ISI the total government debt, the Feds and the locals as a percentage of GDP, hit a record 68% in the 2nd Q.


The economic calendar is light this week as the quarter enters its last two weeks. News flow should be fairly light with the exception of the typical slew of investment conferences and field trips. Companies are generally in their quiet period, so outside of mergers & acquisitions and pre-announcements, there should be very little corporate news flow impacting the markets.

Have a great week.


“If bullsh… was currency,” he said straight-faced, “Joe Biden would be a billionaire.” Everyone in the room burst out laughing.—George Bush, as related by former speech writer Matt Latimer

Ned W. Brines
O (562) 430-3232

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