Nov 8, 2009

Don't Fight the Fed

Don’t Fight the Fed!

November 9, 2009

“How are you going to regulate systematic risk when you are the systematic risk?”—Senator Jim Bunning questioning Ben Bernanke

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

INDU: 3.2%
SPX: 3.2%
COMPQ: 3.3%
RUT: 3.1%

The success of the Fed’s plan to encourage investors to increase their risk and buy securities was made very clear to me this week during a conversation with a reader, who commented that he “needed to buy some stocks since his 5% CD’s were rolling over, and 1% just wasn’t that enticing.” I’m still baffled how leverage, risk, excessive liquidity and easy credit are the cure for a problem caused by leverage, risk, excessive liquidity and easy credit. As the title suggests, don’t fight the Fed, at least in the short term!

The market closed the week with strong gains, although volume was stronger on the down days than the up days during the week. Almost right on cue following our comments over the past two weeks that the transports could be signaling further downside in the markets, Wonderful Warren (aka the Oracle of Omaha), announced his intention to acquire Burlington Northern in his biggest acquisition ever, $44 billion, helping to spark a 6%+ increase in the transports for the week. Rolfe Winkler posted a chart this week (below) which shows Buffet’s recent investments have received quite a bit of support from the Fed, almost $134 billion worth. Is it possible that Buffet’s endorsement of recent government bailouts and his “buy America” pronouncement were procured in exchange for continued government support of his investment positions? The Burlington announcement makes this an interesting quid pro quo.

Earnings estimates have been rising steadily since the early summer months. Jeremy Grantham asserts that “earnings estimates in particular merely follow the market up, not the other way around as one would hope. So it is a law of nature that strong estimates will abound after a major market rally.” Expect to see earnings estimates continue rising into year end and early 2010, but eventually revenue growth will need to return to support the earnings. A reader wrote in last week asking what percentage of companies were beating earnings and revenue estimates. The answer, courtesy of Bank of America Merrill Lynch, shows that 80% of companies beat earnings estimates this quarter while 53% also beat revenue estimates.

Speaking of the Fed, for some reason they bothered to hold a meeting this week at which they unsurprisingly decided to leave rates unchanged. While the Fed rarely specifically spells out their plans for rates, translating the comments after this meeting leads us to believe that the Fed doesn’t plan to raise rates until the next bubble (i.e. financial asset values) is so big that when it pops the collective ear drums of the world will pop.

Don’t fight the Fed.


Actual Consensus Prior
Construction Spending 0.8% -0.2% -0.1%
ISM Index 55.7 53.0 52.6
Factory Orders 0.9% 0.8% -0.8%
ISM Services 50.6 51.5 50.9
Productivity-preliminary 9.5% 6.5% 6.6%
Initial Claims 512K 522K 532K
Continuing Claims 5749K 5750K 5817K
Nonfarm Payrolls -190K -175K -219K
Unemployment Rate 10.2% 9.9% 9.8%
Average Workweek 33.0 33.1 33.0
Hourly Earnings 0.3% 0.1% 0.1%
Consumer Credit -$14.8 bil -$10.0 bil -$9.9 bil

First time unemployment topped 10% for the first time since 1983 (see chart below courtesy, well above the Administration’s peak estimate of 8.5% they projected in February. Temporary employment, typically a leading indicator of hiring, rose for the third straight month, increasing 33.7K in October. Without that increase the employment picture would have been significantly weaker. Unofficial estimates of the “underemployed”, i.e. those wishing to be employed full time but unable to obtain employment, rose 1% to 17.5%. The second chart below, courtesy of Barry Ritholtz, shows the number of unemployed longer than 27 weeks, dating back to 1948. Even if the economy stabilizes and hiring moves back into a 150K-200K per month range, it could take 3-5 years to achieve prior levels of employment.

This is a Test
According to Bloomberg, some of the largest central banks, including the European Central Bank and the Bank of Japan, are starting to exit from stimulus measures implemented to tackle the financial crisis. ECB President Jean-Claude Trichet said the central bank will start to withdraw liquidity initiatives. "There are all kinds of risks," said Jim O'Neill, London-based chief global economist at Goldman Sachs. "We don't know how much of the improvement in markets is due to central banks' largesse, and neither do they. They're pretty nervous, but they've got to get out of it at some stage."

This is Another Fine Mess you’ve Gotten me into
The problem is, as Don Kohn said last month, they do not understand the monster they have unleashed:

“Our limited knowledge of the determinants of asset prices and their effects on credit has made it more challenging to respond to the crisis and explain our actions to the public. More generally, while most of the literature on the effects of monetary policy assumes that the federal funds rate is the single relevant tool for monetary policy, the financial crisis has shown that a wide array of policy measures, acting on the prices of different assets, may be needed in extreme circumstances. The research literature that could help gauge the potential impact of these measures and the exit from them is disappointingly sparse.”

As we have repeatedly questioned-who is going to buy all the paper on the Fed’s books when it decides to reverse its quantitative easing?

The coming week will mark the first offering of treasuries by the Treasury Department since the Fed completed its commitment to buy $300 billion of the paper. The $81 billion coming this week should reveal whether the markets are ready to support treasuries on its own or a continuation of the program will be required to quell a rise in rates.

Stay tuned.

While I typically don’t discuss specific positions in this note, I have commented often about our long position in gold. This week India helped us out by aggressively buying gold from the IMF- 200 tons. Now, I doubt they are planning to make jewelry with this much of the yellow metal, so it would appear that this is the first significant move by a central bank to diversify away from the Dollar and Euro.

Although I have been very critical of him, I am starting to miss the strong dollar days of Robert Rubin.

Jobs were foremost in voter’s minds this past week as Republicans won gubernatorial races over Democratic incumbents in Virginia and New Jersey. As we mentioned two weeks ago, voters typically vote based upon their wallets, and in New Jersey it was high tax rates undoing Mr. Corzine, the incumbent, while in Virginia it was the mere threat of higher taxes.

Stock Focus
I have mentioned my personal Starbucks indicator (again, full disclosure I have a position in the stock) in prior notes (the length of the line at my local SBUX) has been improving since roughly April, and the stock price has followed, rising from high single digits to just over $21. SBUX was also used as an example of a company negotiating better lease rates with an estimated annual savings of $500 million fueled by lower real estate costs. This past week the company announced solid earnings driven by cost cuts and improving, but still negative same store sales.

Cisco Systems (CSCO) announced order improvements in their quarterly conference call this past week. CEO John Chambers, who has been the canary in the coal mine for recessions and recoveries, was almost giddy during the Q&A session of the call. I sat with John (pre Reg FD) as he pre-announced downside to the quarter and a marked slowdown in capital spending in late 2000, and then listened to his call two years ago as he again lamented about a marked slowdown in orders.

Ford (F), the only U.S. automaker that did not seek bankruptcy protection, surprised analysts with a third-quarter profit of $997 million. Ford benefited from the government's "Cash for Clunkers", rebates, cost-cutting measures and market share gained after General Motors and Chrysler went bankrupt. At the same time, it gained market share faster than Japanese competitors Honda Motor and Toyota Motor even though consumers are favoring foreign makers again (see chart below courtesy BEA).

Alternative Energy
Speaking of autos, the alternative energy push will hurt the continually short sighted domestic auto industry. Barron’s showed that Toyota, Nissan, Hyundai, Honda and Panasonic are the top 5 holders of auto related alternate-power patents.

Where are the domestic auto makers? Most likely spending your tax money on healthcare benefits and political contributions.

I mentioned last week that I would be attending the 39th annual AEA Tech Classic in San Diego. While it isn’t surprising to see conference attendance down in this economic environment, both the number of financial services attendees and presenting companies was down significantly over prior years. I think this was my 14th time attending, so I have a decent perspective on the attendance. There were roughly 80 presenting companies compared to a few hundred in some prior years.

The conference organizers were giving away passes in the last week, which are typically priced near $2000.

Health Care-Politics as Usual
Health care reform squeaked through the House Saturday by a 220-215 vote as the threat of working during the Christmas holiday got the House version moving. The plan passed with virtually no discussion as speaker Pelosi squashed any attempts at questioning the bill or virtually any portion of the bill. Democrats must now be especially motivated to get this passed after viewing the results in Virginia and New Jersey, which could be a precursor to the 2010 elections. A loss of even a handful of seats next year could mean this type of bill won’t get passed in the next session.

It was interesting to note that one Republican voted for the bill while 29 Democrats voted against it.

Goodbye Sarbanes Oxley

“That the Democratic Party is the vehicle for overturning the most pro-investor legislation in the past 25 years is deeply disturbing,” said Arthur Levitt, a Democrat who was chairman of the Securities and Exchange Commission under President Bill Clinton. “Anyone who votes for this will bear the investors’ mark of Cain.”

Is anyone in Washington ever held accountable for their votes?

More on Mark to Imagination

From Floyd Norris “This year, a subcommittee of the House Financial Services Committee held a hearing at which legislators sought no facts but instead threatened dire action if the chairman of the financial accounting board did not promptly make it easier for banks to ignore market values of the toxic securities they owned. The board caved in, which may be one reason why banks are reporting fewer losses these days. But the board’s retreat was not enough to satisfy the banks. The American Bankers Association is now pushing Congress to give a new systemic risk regulator — either the Federal Reserve or some panel of regulators — the power to override accounting standards. The view of the bankers is that the financial crisis did not stem from the fact that the banks made lots of bad loans and invested in dubious securities; it was caused by accounting rules that required disclosure when the losses began to mount.”

The superciliousness continues.

Real Estate and Business Health

According to The Wall Street Journal, bankruptcy filings by U.S. businesses increased 7% in October, according to researcher Automated Access to Court Electronic Records. Last month, 7,771 businesses filed for bankruptcy, compared with 7,271 in September. The real estate and retail sectors suffered the most, said Jack Williams, a bankruptcy law professor at Georgia State University. “Almost any financial challenge could cause a business to file for bankruptcy in these difficult times,” Williams said.

Its no wonder vacancy rates for retail and office space are rising.

From Peter Boockvar: “China’s economic bounce has continued so far into Q4 as evidenced by both the October state enterprise and private sector weighted manufacturing indices which rose to the highest level since April ‘08. There will also likely be no change in economic policies for the foreseeable future according to the Minister of Commerce as he believes the global recovery is still fragile. While China cannot single-handedly lift global economic growth, it clearly remains the most important country in the world in terms of driving economic activity which so far has spilled over into many other countries via trade.”

The Cost of Moral Hazard

Asian Strategist Andy Xie wrote this past week
“Today, governments and central banks are celebrating their victorious stabilizing of the global financial system. To achieve the same, they could have saved Lehman with $50 billion. Instead, they have spent trillions of dollars, probably more than $10 trillion, to reach the same objective. Meanwhile, a broader goal to reform the financial system has seen absolutely no progress.”

“Because policy makers mistakenly think stimulus spending can bring back growth, they are pushing too hard. The eventual consequences are inflation and bubbles along the way. These bubbles will be short-lived. The current boom market is a good example.”

Andy has been the king of identifying emerging bubbles over the past 15+ years, his comments deserve respect.

The market will attempt to hold onto last week’s gains during a light week for economic and earnings releases. The upcoming holiday shopping season should be one of the key fundamental drivers of the market through year end. Expectations are low, which could set up for upside surprises and further market returns. Countering the low expectations for the holidays is the fact that earnings growth has been stretched across negligible revenue growth, an unsustainable situation. Either sales will need to improve or earnings growth will falter. Valuations seem extended, but are rarely the singular cause for either a rally or correction. Jeremy Grantham notes that the S&P 500 fair value is now 850, down about 200 points from here. Jeremy is a great investor and wonderful writer, and while quite prescient over the past 24 months, he has also under-valued the S&P 500 since 1998.

Have a great week.


“Practical men who believe themselves to be quite exempt from any intelligent influence are usually the slaves of some defunct economists.”—John Maynard Keynes

1 comment: