Oct 11, 2009

Market Finds Support

Market Finds Support

October 12, 2009

“There are no secrets to success. Don’t waste your time looking for them. Success is the result of perfection, hard work, learning from failure, loyalty to those for whom you work, and persistence.”—Colin Powell

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

INDU: 4.0%
SPX: 4.5%
COMPQ: 4.4%
RUT: 6.0%

The markets ripped upwards this week, bouncing off their 50 day moving averages (see chart below courtesy Bespoke), reaching new one year highs. Much has been made about these new highs in the market; however we must point out that one year ago the market was in the midst of a plummet from higher levels. In fact, the S&P 500’s all time peak of 1565 was reached October 9, 2007. Since then the index is down over 30%. According to Bespoke Investment Group, analysts are now the most bullish they have been since their extreme bullishness two years ago. Our contrarian nature keeps us focused on moving away from this crowd, which collectively tends to be the most bullish near peaks and the most bearish near market troughs.

Earnings season will kick off in full force this week as companies discuss third quarter results and their outlook for the fourth quarter and the all important Christmas selling season. Earnings expectations remain somewhat modest and easy to exceed, although at some point companies will have to begin delivering on revenue estimates to sustain their most recent rise. Last quarter was characterized by companies beating earnings estimates on lower cost structures yet missing revenue estimates. As investors have discovered through both expansions and contractions, companies posting strong EPS without commensurate increases in revenue eventually falter. Coca Cola was the perfect example of this in the 90’s, posting high teens EPS growth on mid single digit revenue growth for years, until they finally faltered as they couldn’t cut expenses enough to offset their lack of revenue growth.


GDP Q2-Final -0.7% -1.2% -1.0%
Consumer Conf 53.1 57.0 54.5
Case-Shiller Housing Price Index -13.3% -14.2% -15.4%
ISM Services 50.9 50.0 48.4
Consumer Credit -$12.0 bil -$9.5 bil -$21.6 bil
Initial Jobless Claims 521K 540K 554K
Continuing Claims 6040K 6105K 6112K
Wholesale Inventories -1.3% -1.0% -1.6%

The biggest economic story this week was the massive $12 billion decline in outstanding consumer debt in August (see chart below courtesy Gluskin Sheff). The consensus was looking for an $8 billion contraction. This was the seventh month in a row of debt retrenchment. In other words, the tidal wave of the credit collapse continues unabated. Keep in mind that the $12 billion (5.8% annualized decline) reduction took hold during the peak for cash-for-clunker auto sales in August. This held the contraction in non-revolving credit to $2.1 billion. According to David Rosenberg, the total decline outside of the auto subsidy would have exceeded $20 billion during the month.

The Sept ISM services index hit 50.9, up from 48.4 and above 50 for the first time in a year. Remember that a measure above 50 signifies expansion in the non manufacturing sector. Business Activity rose 55.1, the highest level in two years, but the other components were mixed as just 5 of 18 industries reported growth. New Orders rose to 54.2 from 49.9 and backlog rose 11 pts to 51.5. Employment remained sluggish, rising to 44.3. Export orders fell back below 50 to 48.5 from 55.0. Prices paid fell to 48.8 from 63.1. The ISM said “even with the overall month over month growth reflected in the report, respondents’ comments vary by industry and remain mixed about business conditions and the overall economy.”

The National Retail Federation is expecting a drop of 1% in retail sales during holiday season. This report is typically overly optimistic, so plan accordingly.

Jobless claims came in at 521K, less than consensus and down from the prior period. The chart below, courtesy of Briefing.com, shows the 4-week average initial claims since September 2005.

Continuing claims came in slightly less than anticipated, but still exceeded 6 million. The chart below, dating back to 1991, shows the dramatic increase in continuing unemployment claims.

Credit Conditions
Every Friday the Fed releases the assets and liabilities of US commercial banks, a report which shows how much the banks are actually lending. For the week ended Sept 23rd, commercial and industrial loans outstanding fell for a 12th straight week to the lowest level since Nov ’07. What have the banks been doing with their capital? Primarily buying US Treasuries, agency paper and MBS (guaranteed by FNM/FRE) as almost free money from the Fed has created a nice spread.

From the NY Times this week: “The continued disarray in debt-securitization markets, which in recent years were the source of roughly 60% all credit in the United States, is making loans scarce and threatening to slow the economic recovery. Many of these markets are operating only because the government is propping them up.”

The debt-securitization markets finance corporate loans, home mortgages, student loans and more. In good times, they enabled banks to package their loans into securities and resell them to investors. That process, known as securitization, freed banks to lend even more money.

Many investors have lost trust in securitization after losing huge sums on packages of subprime mortgages that had high default rates. The government has since spent more than $1 trillion trying to restore the markets, with mixed success.”

As we have discussed in the past, now that credit risk between banks has been normalized, the next step is repairing investor confidence and freeing the banks to lend. Without this secondary market the velocity of money has ground to a halt.

Ben Bernanke commented Friday that the Federal Reserve would tighten monetary policy once the economy improves. He finally admitted that they must address inflation at “some point.” The dollar strengthened on the comments, showing a rare flash of strength in response to an even rarer comment by a US official on their concern for either the dollar or inflation.

Due Warning
We posted this quote in our March 1, 2009 note from Robert Prechter of Elliot Wave International, who correctly advised massive shorting against the market in July 2007, “is now recommending covering those shorts. The market is compressed. When it finds a bottom and rallies, it will be sharp and scary for anyone who is short. I would rather be early than late.” Mr. Prechter first achieved notoriety by recommending shorting the market two weeks before Black Monday, 1987.

Robert now feels the market is over bought, the dollar over sold, and the economy will sink into deflation. He feels the dollar could rise for the next year or more. He also expects the stock market to break the March 2009 lows before the end of 2010 and bank failures to accelerate.

More from the Not-So-Golden State

This past week California raised the yields on part of a $4.5 billion bond offering after getting a weaker response than at a sale of short-term notes two weeks ago. The deal from California, the largest borrower and the lowest rated among U.S. states, will push new municipal issues this week to a five-month high, according to data compiled by Bloomberg. The state raised preliminary yields by two to four basis points on maturities ranging from 2015 through 2029. Tax-exempt bonds due in 20 years may yield 4.66%, and those due in 2025 might pay 4.42%, according to Dan Solender of Lord Abbott & Co.

Commercial Real Estate
According to Bloomberg there was a stunning omission from the government’s June 30 list of “problem” banks, a list of 416 lenders. One outfit not on the list was Georgian Bank, the second-largest Atlanta-based bank, which supposedly had plenty of capital. It failed last week.

It is estimated that Georgian’s clean-up will be unusually costly. The book value of Georgian’s assets was $2 billion as of July 24, about the same as the bank’s deposit liabilities, according to an FDIC estimate. The FDIC calculates the collapse will cost its insurance fund $892 million, or 45%of the bank’s assets.

The key question that we have been raising for over a year is how many other “healthy” community banks are out there waiting to implode? That’s impossible to know, which is what’s so unsettling about Georgian’s sudden downfall. Just when the conventional wisdom suggests the banking crisis might be under control, along comes a reality check that tells us we have no idea what’s in bank portfolios.

We have often discussed the nature of construction loans and how quickly they go from performing to non-performing. In the case of Georgian, they reported a 12x jump in nonperforming loans to $306.4 million from $24.7 million three months earlier, mostly construction loans. On its March 31 report, the bank said just $79.1 million of its loans were 30 days or more past due. That included the loans it had classified as nonperforming.

Is it any wonder the FDIC keeps increasing its estimates for the losses it’s anticipating from future bank failures? In May, the agency said it was expecting $70 billion of losses through 2013. This week, it bumped that to $100 billion. The agency also said its insurance fund would finish the third quarter with a deficit, meaning liabilities exceed assets.

Monkey off their Back

The Angels won the ALDS this morning (Sunday), coming back from a 5-1 deficit to beat the Red Sox 7-6 at Fenway. As most of you know, I am a long time (40 years) and long suffering Angel fan, and after losing to the Sox in every imaginable way possible in previous playoffs, this was especially sweet. Now it looks as though the Yankees will be the only thing standing in the way of the long awaited Freeway Series versus the Dodgers.

I will be rooting hard for the Angels, however, remember in my January 4 note one of my predictions for 2009 was that the Angels would lose in the ALCS. Let’s hope I’m wrong there.

The price of gold closed at record highs this week, nearly hitting $1050 per ounce. While gold is at record highs in dollar terms, the commodity is still down 10% from its highs when priced in Euros and Yen. As shown in the charts below (courtesy Bespoke and Bianco Research), the price of gold is up considerably over the last five years, but the recent run has only been strong in dollar terms. This suggests that the strength is solely a function of a weaker dollar rather than any real pickup demand.

Attention Mr. Bernanke

The Reserve Bank of Australia’s decision to boost the overnight cash rate target to 3.25% from a 49-year low of 3% followed the first expansion this year in U.S. service industries (ISM). Manufacturing in emerging markets increased the most in the past three months since the second quarter of 2008, according to the HSBC Emerging Markets Index of data from purchasing managers.

Gold and material stocks jumped on the news.

Private Equity & VC
Bloomberg is reporting that Stanford University is reportedly offering stakes in funds run by Silicon Valley neighbors Sequoia Capital and Kleiner Perkins in an asset sale that may raise $1 billion. The university’s endowment is seeking bids on portions of $6 billion in holdings of venture capital, buyout, real estate and energy funds, said people close to the deal, who declined to be named because the plan is private. Those stakes also carry $5 billion in future investment commitments to the fund managers.

Stanford began shopping the fund stakes about a month ago, according to a fourth person with knowledge of the matter. Its goals are to determine pricing and shift the mix of endowment assets, not raise cash. Stanford won’t sell more than 20 percent of its holdings in a single fund, and may decide against any dispositions, the person said.

Downward Pressure on CPI
According to Eric Boucher at ISI, bond bulls are enjoying an unprecedented inflation backdrop. "Apartment Glut Deepens" is the title of a WSJ story about falling rents (housing has about 40% of the weight in US CPI.). Near term it is likely the low CPI run will continue and with it the bond bull market.

Real Estate
Home values in 20 U.S. cities climbed in July by the most in almost four years, helping stem the record plunge in household wealth that’s depressed spending.

The S&P/Case-Shiller home-price index rose 1.2% in July from the prior month, the biggest gain since October 2005. Home values are firming as low borrowing costs and government tax credits lift home sales.

How the Public Option Really Works
The Federal Housing Administration (FHA) provides home loan insurance for mortgages with low down payments. Their volumes have quadrupled since 2006 as the private lenders and insurers pulled back from the market. During a House committee meeting this week, a former Fannie Mae executive testified that the FHA may require a US bailout because of $54 billion MORE in losses than it can withstand.

House legislation has been introduced that would require an increase in the FHA’s minimum down payment from 3.5% to 5%. Presently 17.5% of FHA loans are delinquent or in foreclosure, well above the national average of 13%.

This serves as another example of the private sector understanding the market better than the government. Let me repeat this one more time: Government isn’t the solution, it’s the problem.

Retail Sales
Same store sales grew 0.6% in September, feeble but welcome growth for an industry which hadn’t seen a positive comp in over a year. Analysts had expected a 1% drop. "Let the retail recovery begin!" the International Council of Shopping Centers said.

That seems a bit too optimistic for us, but we are certainly happy to see some improvement for the retail sector.

That’s a lot of Tamales
The Congressional Budget Office released its final estimate for the US budget deficit before the official figure is announced for the year that ended Sept. 30, estimating a record $1.4 trillion. The deficit for the 2008 fiscal year was $459 billion.

The Son of Hawley-Smoot Tariff Act

The U.S. Commerce Department is investigating China's dumping of steel in the U.S. market. The move was instigated by a petition from U.S. Steel last month regarding carbon and alloy steel pipes. The government already slapped tariffs on tubular and steel pipes from China used in oil drilling and on certain low-priced tires.

We may not see a full tariff act, which occurred in the 1930’s and helped to lengthen the Depression; however, a series of tariffs over time could have a negative impact on this fledgling recovery.

President Obama has been looking for some bipartisan support outside of D.C., seeking public endorsement of his health care overhaul because he has been unable to get support from Republicans on Capitol Hill. The White House distributed a statement from California Gov. Arnold Schwarzenegger saying he supports many of Obama's goals. Other public statements came from New York City Mayor Michael Bloomberg and former Wisconsin Gov. Tommy Thompson.

For the President’s sake let’s hope he can find better Republican support than the Governator, who technically isn’t even a Republican.

Earnings begin in earnest this week, with releases from industry bellwethers such as Johnson & Johnson, Intel, Abbott Labs, JP Morgan, Landstar, Citigroup, Goldman Sachs, Harley-Davidson, Safeway, Google, IBM, General Electric, Halliburton, Mattel, and Bank of America featured this week. Mixed in will be the periodic preannouncement (both positive and negative) to keep the markets hopping. The economic calendar is light this week.

Have a great week.


“Most people can stay excited for two or three months. A few people can stay excited for two or three years. But a winner will stay excited for 20 to 30 years-or as long as it takes to win.” – A.L. Williams

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