Oct 18, 2009

Dow 10K, Again

Dow 10K, Again

October 19, 2009

“A government big enough to give you everything you want, is strong enough to take everything you have"--Thomas Jefferson”

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

INDU: 1.3%
SPX: 1.5%
COMPQ: 0.8%
RUT: 0.2%

First the hype. The Dow crossed the 10K mark for the 26th time in the past decade. As I have mentioned in a number of prior notes, one of the best investments ever was made by CNBC when they bought those Dow 10K hats for their anchors. I can’t remember ever buying a commemorative piece of clothing and having the opportunity to wear it more than once or twice, much less 26 times! Smart guys.

Once again the market finished the week in positive territory, but we saw a significant surge in large caps vis-a-vis small caps. Could this be the beginning of a rotation into the larger caps, which have lagged the small caps in this seven-month rally? At the beginning of the rally small caps were markedly less expensive than large caps, a situation that is now reversed. Small caps have typically led rallies off major bottoms, eventually replaced by their larger peers. It’s a trend worth watching closely.

Whether this is the beginning of such a rotation or not, it is definitely a point in the cycle when stock picking will win out over beta picking. Beta picking occurs when markets broadly rally, and typically the smallest stocks with the highest beta outperform, regardless of their fundamentals. Eventually these markets will mature, and investors will begin rotating into companies with stronger fundamentals and picking winners versus losers becomes the primary driver of out-performance.

Companies have cut back expenses significantly, setting the stage for explosive earnings growth when/if revenue growth returns. Reporting companies have been beating EPS expectations at a record pace this quarter, primarily as a result of stabilizing revenues and massive cost cuts. If the economy continues to stabilize, EPS growth should continue to far exceed estimates.

The chart below, courtesy finviz.com, shows that material stocks outperformed significantly this week as a weak dollar and surging demand (primarily from China) for industrial commodities drove the stocks. China is a voracious consumer of basic materials, and they are rapidly converting their excess dollar holdings into the same.


Actual Consensus Prior
Export Prices 0.0% 0.7%
Import Prices 0.6% 0.3%
Retail Sales -1.5% -2.1% 2.2%
Retail Sales ex-auto 0.5% 0.2% 1.0%
Business inventories -1.5% -1.0% -1.1%
Initial Claims 514K 520K 524K
Continuing Claims 5992K 6000K 6067K
Core CPI 0.2% 0.1% 0.1%
CPI 0.2% 0.2% 0.4%
Empire Manufacturing 34.57 17.25 18.88
Philadelphia Fed 11.5 12.0 14.1
Capacity Utilization 70.5% 69.8% 69.9%
Industrial Production 0.7% 0.2% 1.2%
U of Michigan Consumer Sentiment 69.4 73.3 73.5

The economic release calendar was full this past week, with most of the important measures showing slight improvements and, for the most part exceeding consensus. The exceptions to this trend include the University of Michigan Consumer Sentiment index as consumer concerns about inflation resurfaced. The indicator is highly correlated to gasoline prices (which have been rising), unemployment (which has marginally improved), the stock market, and media coverage (which has been spewing about the economic recovery).

Retail sales ex-autos (which were weak after Cash for Clunkers ended) for September were better than expected, posting a 0.5% gain. "It's mildly encouraging," said Paul Dales, U.S. economist at Capital Economics. Furniture stores posted the biggest sales gain, at 1.4%, followed by gasoline stations, with 1.1%, and general-merchandise stores, including discount chains, at 0.9%.

Capacity utilization and industrial production both came in above expectations. The chart below shows both measures over the past 16 years. Industrial production is at its lowest point in this series, as is capacity utilization. Capacity utilization is a key measure to watch as the Fed will also be watching this measure as they consider when to remove their stimulative policy.

I have railed against the To Big To Fail policy of the Fed and Treasury, wondering why we are taking an anti-capitalistic stance by throwing capital to the weaker operators. Recently Paul Merski of the Independent Community Bankers of America (a DC based trade group) testified to congress that community banks make 20% of all small business loans, even though they only represent about 12% of all bank assets. He also stated that roughly ½ of all small business loans under $100K are made by community banks.
Consistent with the recent results of the large banks, Merski notes that “since Glass-Steagall was repealed in 1999, the giant banks have made much of their money in trading assets, securities, derivatives and other speculative bets, the banks’ own paper and securities, and in other money-making activities which have nothing to do with traditional depository functions.”
I’m sure we are all now feeling better knowing that we didn’t just spend nearly a trillion dollars bailing out key lenders, but instead just saved giant hedge funds disguised as banks.

More Dow 10K
From Peter Boockvar:

“With the DJIA approaching 10,000 again, let’s reminisce about 1999, the year it first passed that magic level on March 29th. Millennium by the Backstreet Boys was the best selling album, American Beauty won the Academy Award, the Euro was established, SpongeBob SquarePants aired for the first time, Hugo Chavez was elected President of Venezuela, Karl Malone, Pudge, Chipper Jones, Jagr and Kurt Warner won MVP awards and the average price of a gallon of gasoline at the pump was about $1.20. US nominal GDP ended at $9.6b vs $14.1 as of Q2 ‘09. Also, on March 29th 1999, the DXY was at 100.36 (now 75.60), the CRB was at 192.40 (now 269.15), gold was at $280 (now $1,060), oil was $16.44 (now $74.80), corn was $2.32 (now $3.85), copper was $.62 (now $2.83), the 10 yr yield was 5.19% (now 3.38%), and the fed funds rate was at 4.75% (now 0-.25%). Oh, how time flies.”

According to Bloomberg, U.S. stocks and the dollar are moving in the opposite direction more than ever before as a weaker currency boosts the value of sales outside America. The correlation coefficient using 120 days of data between the Dollar Index and the Standard & Poor’s 500 Index is minus 0.43, near the level of minus 0.45 reached on July 7. The reading three months ago was the lowest in the currency gauge’s 42-year history.

“When the dollar drops, that’s good for companies that are making products in the U.S. and selling them abroad,” said Frederic Dickson, who manages $20 billion as chief market strategist at D.A. Davidson & Co. in Lake Oswego, Oregon. “Investors are expecting U.S. multinational companies to have positive earnings surprises as a result of the dropping dollar.”

Companies in the S&P 500 generated 48%of their revenue outside the U.S. in 2008, an increase from 44% in 2006, according to data compiled by S&P. While the S&P has been rising since March, the dollar has fallen 14%, the largest drop over a two quarter period ever.

According to Barclays Capital, central banks are increasingly putting reserves into the euro and the yen, a move that is putting more pressure on the U.S. dollar. Central banks put 63% of new reserves into Euros and yen during the second quarter. "Global central banks are getting more serious about diversification, whereas in the past they used to just talk about it, and it looks like they are really backing away from the dollar” said Steven Englander, chief U.S. currency strategist at Barclays.

The Administration’s proposed healthcare legislation is offset by $404 billion in cost savings over a decade in both the Medicare and Medicaid programs. That includes $117 billion in cuts to Medicare Advantage, a program in which private insurers offer 10 million senior-citizen enrollees benefits such as dental or vision coverage not offered by the government program.

If there are $400 billion in Medicare and Medicaid savings, let’s have the government show us that they can achieve these savings, and then maybe we will give them the opportunity to take on another entitlement program. Until then, stand down!

First Stanford, now Harvard?
According to Bloomberg, Harvard, considered the world’s richest school, paid almost $500 million to investment banks to escape interest-rate swaps that backfired. The data was obtained from the school’s annual report.

Harvard paid $497.6 million during the fiscal year ended June 30 to get out of $1.1 billion of interest-rate swaps intended to hedge variable-rate debt for capital projects, the report said. The university also agreed to pay $425 million over 30 to 40 years to offset an additional $764 million in swaps.

The Oil Conundrum
The price of oil rose to a one-year high Friday, closing at nearly $78 per barrel. The jump came after the U.S. Energy Information Administration released data showing that gasoline inventory unexpectedly decreased by 5.2 million barrels last week. Analysts warned that the rally might not last. "A correction is on the cards. I would expect profit-taking to set in next week and for oil to retreat to the mid- to low-$70s," said Ben Westmore, an analyst at National Australia Bank.

I haven’t discussed oil much the past couple of months as I haven’t been involved on either side of the trade since mid-late August. After being very short through early February, and then slightly short through June, we have no exposure today. A smart PM/reader asked a number of months ago how I could be bearish on the US dollar AND oil. My comment at the time was that short term I was bearish on both because I felt the supply/demand equilibrium favored a short position in oil. Around mid-August it became apparent that global concerns about the dollar were increasing and it was time to abandon the net short position in energy. We are now looking for a pullback and, unless or until evidence of a double dip recession arises, will use the pullback to establish a net long position.

ISI’s Ed Hyman sees the orderly decline of the dollar as a positive for the stock market. "Investors outside the U.S. are purchasing companies in the Standard & Poor's 500 Index at the cheapest valuations on record, their buying power boosted by a seven-month decline in the dollar.” ISI’s Eric Boucher writes that the “S&P 500 is priced at 19.9 times earnings, the biggest discount to the MSCI World Index of 23 developed countries since May 2003. For euro-based money managers, currency translations push the cost of U.S. stocks down to 13.6 times profits, the lowest level ever relative to global equities and a discount that dollar-based investors have never enjoyed. Overseas investors that hold almost $2.5 trillion in U.S. equities are getting a bigger slice of corporate America with each euro, yen and pound they spend just as S&P 500 companies from PepsiCo Inc. to General Electric post higher overseas sales. While more losses in the dollar would cut returns, the last time U.S. stocks were this inexpensive, in 2003, the S&P 500 began a four-year, 62 percent advance.”

I have been receiving a lot of emails about where opportunities in technology might be occurring. Presently I feel we are in a scenario where internet bandwidth is temporarily greater than PC CPU power. Historically when this imbalance has occurred, it has paid to be involved in PC related stocks (think Dell, Intel, etc).

I do, however, think that this imbalance will be short lived as consumer devices generating gigabytes of data become ubiquitous. Cisco recently purchased Flip, makers of a flash based, pocket sized video camera, for $350 million. I own a Flip camera, and this weekend alone created 4GB of new video! Cisco plans improvements in picture stabilization as well as a slew of accessories for the device. Their ultimate goal is to make video creation so simple and ubiquitous that bandwidth consumption accelerates, driving sales of their higher margin network equipment. The increase in video content also has the potential to drive a consumer PC upgrade cycle as CPU cycles won’t be able to keep up with the demands of HD video.

More Public Pension Problems
An analysis by PricewaterhouseCoopers concludes that within an average of 15 years, public pension funds will have less than half of the money needed to pay promised benefits. After losses of $1 trillion on investments by U.S. state and local pension funds covering police officers, teachers and other government employees are forcing managers of the retirement plans into a difficult choice. They must either try to boost returns by taking on even riskier investments or start cutting benefits.

I smell tax increases coming.

Real Estate
RealtyTrac spokesman (and reader) Rick Sharga said “during the third quarter, home foreclosures in the U.S. reached a record high. They were the worst three months of all time.” The firm said 938K homeowners received some form of foreclosure notice. The number is 23% higher than that of last year's third quarter and 5% higher than the second quarter.

Amazingly, just 6 states account for 62% of US total foreclosures: California, Florida, Arizona, Nevada, Illinois and Michigan.

Hard to Believe, but more from the Not So Golden State
About half of California’s personal income tax revenue, which finances 50% of the California government’s general fund, comes from 144K taxpayers, or about 1% of the total legal population of the State.

The governor supports a budget overhaul, proposed last month by a bipartisan commission that would reduce personal income taxes as well as eliminate corporate and sales levies. Instead, revenue would be raised through a new business receipts tax that would collect more revenue from companies providing services.

When will this government learn that at some point they need to just say NO to spending programs and get back to providing basic services?

More Bait and Switch
According to USA Today, if the President’s plan for health care overhaul makes its way through Congress and then onto his desk for signature this year, Americans will have to wait several years to enjoy full benefits of the measure. Some cuts in Medicare and tax increases to pay for the plan would take effect immediately. But families with low and medium incomes would not get tax credits to help with insurance premiums until 2013.

Benefits are conveniently “scheduled” to occur just after the next Presidential election. We’ll see.

Telling It like It Isn’t
According to the Financial Times, one of five hedge fund managers is not straightforward with investors about the fund or its performance, according to research by New York University's Stern School of Business. According to researchers' data, a large percentage of managers did not give the right amount of money under management. Managers also exaggerated performance data and did not include some key points in regulatory and legal history. Funds with compliance problems often failed to mention those issues.

Is it any wonder Main Street doesn’t trust Wall Street?

Late to the Party, Again
Former Federal Reserve Chairman Alan Greenspan, once the defender of large financial institutions, and creator of the biggest asset bubbles in US history, said this week that U.S. regulators should consider breaking up large financial institutions considered “too big to fail.” The Bubble Master had plenty of opportunities to address this issue during his 16 or so years running the Fed, but instead chose to ignore ever-concentrating risk to the determinant of this country.

Why won’t he just go away?

Earnings will continue this week with Gannett, BB&T, Hasbro, Apple, Texas Instruments, Blackrock, Caterpillar, Coca-Cola, Microsoft and Wells Fargo among the hundreds of reporting companies.

Have a great week.


“Insured deposits are being used in ways that I don’t like to see.”--Sheila C. Bair, Chairman, Federal Deposit Insurance Corporation

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