Nov 8, 2010

Two Out of Three Ain’t Bad

Two Out of Three Ain’t Bad

November 7, 2010

“Republicans want to go back and live in the 1950’s. Democrats want to go back and work there.”—Amity Shlaes

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

INDU: 2.93%
SPX: 3.60%
COMPQ: 2.85%
RUT: 4.73%


Please excuse my plagiarism of the old Meatloaf song for my title, but it seemed appropriate given the events this past week. A historic election, a Fed announcement and a positive employment report provided the catalyst for a continuation of this rally. Why two out of three? Since all three of these events are only partially positive, I’m saying that combined they were two up, one down. The election was just a repudiation of more failed policy from another Administration; the Fed’s prolifigate printing of dollars is designed to break the dollar; and the employment data was manipulated. It’s up to you to decide which, if any of the three, weren’t bad.

The GOP won across the country by a combined 17 million votes, resulting in what many are hoping will be total gridlock in DC. Normally gridlock is good for the markets, however, the most recent Congress and Administration have put in place such harmful polices that we actually need cooperation and a herculean effort beyond the abilities of most elected officials to overcome. This may be one of those rare occasions where gridlock isn’t good, and doing nothing in DC is actually worse than doing something.


Actual Consensus Prior
Personal Income -0.1% 0.2% 0.4%
Personal Spending 0.2% 0.4% 0.5%
PCE Core Prices 0.0% 0.0% 0.1%
ISM Index 56.9 54.0 54.4
ISM Services 54.3 53.4 53.2
Factory Orders 2.1% 1.7% 0.0%
Nonfarm Payrolls 151K 60K -41K
Nonfarm Payrolls-Private 159K 60K 107K

Non-farm payrolls showed an increase of 151K vs. an expected gain of 60K, the first increase in four months. The unemployment rate remained unchanged at 9.6%, however, I would expect that to start declining as huge swaths of unemployed begin losing their benefits and fall off the rolls. Payroll data was “seasonally adjusted” upwards by 200K by the BLS, according to John Williams at (see chart below), suggesting a weaker than reported jobs picture.

The chart below shows the nonfarm payroll month over month change since 1958. The periods circled are the largest declines over this window.

The ISM measures (manufacturing and services) were both well within the positive growth range, and both came in ahead of expectations. Remember that these are diffusion indices, and anything above 50 indicates expansion.


The Fed’s primary argument for QE-2 is that lack of inflation, based upon the core CPI. In the real world, inflation is starting to appear in a variety of places. The CRB index has risen to its highest level in 2 years, Starbucks has been forced to raise prices over the past month because of higher coffee prices, McDonalds has reported overall higher food commodity prices, General Mills is struggling and had to raise prices due to higher grain prices, Goodyear and Cooper Tire recently raised prices because of higher rubber prices, Kimberly Clark on their earnings call said that they just experienced the highest cost inflation increase in Q3 that they’ve ever seen, mostly from fiber but also from polymer resin and other oil based materials. Cotton is at a 145 year high and copper is at a 27 month high. In spite of all this, the Fed wants higher inflation. All will be OK as long as you don’t drive, eat, drink, wear cotton based clothes, use copper wire for any type of construction, blow your nose, diaper a kid or wipe your behind.

I go back to my earlier opinion of Helicopter Ben: He’s never seen an economic problem that couldn’t be solved with easier money.

Mandate or no-mandate?

The question coming out of the election is whether the Republicans have been given a mandate to enact their agenda, which, as far as I can tell consists of repealing the health care act and extending the Bush tax cuts. According to most of the media, their overwhelming victory isn’t a mandate to govern, but instead a reflection of a poor economy.

I find it interesting that no one questioned the mandate to govern two years ago when the new sheriff rode into town and hi-jacked health care, the auto industry, and the banking industry.

The French

"Going to war without France is like going deer hunting without your accordion." —Norman Schwartzkopf

California-The Lindsay Lohan of States

I could fill a book with the stupidity running rampant in California, which ironically is the only place in the country where not only was there not a revolution, we actually voted for more of the same. Now, Meg Whitman wasn’t exactly anyone’s idea of an ideal leader, however, we elected a re-tread governor whose sole accomplishment the last time he was in office was unsuccessfully fighting against Prop 13 (unless you count dating Linda Ronstadt as an accomplishment).

Amazingly, the same people who re-elected Governor Moonbeam couldn’t agree to legalize pot. What were they smoking?

More California
Remember I said I could fill a book with the stupidly in California? Well here’s another gem. It seems that the city of San Francisco has decided to approve an ordinance that would limit toy giveaways in fast food children's meals that have excessive calories, sodium and fat. It also requires servings of fruits or vegetables with each meal.

McDonald's says the law would take the joy out of the Happy Meal. The company also said the law threatens business and restricts parents' ability to make choices for their children.

Scott Rodrick, an owner and operator of 10 McDonald's restaurants in the city, said none of his current menu items would be allowed under the nutritional guidelines in the ordinance. Those standards have been criticized by the company, who said proponents lack the evidence to support the claim that they would help reduce obesity.

Rodrick also pointed out that anyone could circumvent the law easily: "Someone doesn't have to travel very far — a mile outside San Francisco — to get the traditional McDonald's Happy Meals experience."

Even More California

From Jeff Miller: -
Some 2.3 million Californians are without jobs, for a 12.4% unemployment rate — one of the highest in the country. From 2001 to 2010, factory jobs plummeted from 1.87 million to 1.23 million — a loss of 34% of the state's industrial base. Ask any company, and it'll tell you the same thing: It's now almost impossible to build a big factory in California. With just 12% of the U.S. population, California has almost a third of the nation's welfare recipients. Some joke the state motto should be changed from "The Golden State" to "The Welfare State." Meanwhile, 15.3% of all Californians live in poverty. The state budget gap for 2009-10 was $45.5 billion, or 53% of total state spending — the largest in any state's history. The state's sales tax is the nation's highest, and its income tax the third-highest, the Web site recently noted. Meanwhile, the Tax Foundation's "State Business Tax Climate Index" ranks California 48th. In a ranking by corporate relocation expert Ronald Pollina of the 50 states based on 31 factors for job creation, California finished dead last. In another ranking, this one by the Beacon Hill Institute on state competitiveness, California came in 32nd — down seven spots in just one year. California is home to 25% of America's 12 million to 20 million illegal immigrants. A 2004 study estimated that illegals cost the state's citizens $10.5 billion a year — roughly $1,200 per family. Unfunded pension liabilities for California's state and public employees may be as much as $500 billion — roughly 17% of the nations total $3 trillion at the state and local level.

The Fed’s Impact

Jim Bianco noted that Since August 27, the Federal Reserve bought Treasuries via POMO on 20 different days. Cumulatively the 10-year Treasury’s total return was 1.03% during these days. Conversely, since August 27 the Federal Reserve has not conducted POMO on 24 different days. Cumulatively the 10-year Treasury’s total return was -0.68% during these days.

Since August 27, the Federal Reserve bought Treasuries via POMO on 20 different days. Cumulatively the S&P 500 was up 10.5% during these days on a total return basis. Conversely, since August 27 there have been 24 different days in which the Federal Reserve did not conduct POMO. Cumulatively the S&P 500′s total return during these days was 0.91%.


Quarter to date 46% of S&P 500 companies have reported and 70% beat on EPS, 62% beat on sales, and 49% beat on both EPS and sales (most others in line). The consensus estimate for the quarter has climbed to $21.27 from $20.64. For companies that have reported, sales grew by 1.7% from Q2, an annualized rate of 6.8%.

Approximately 30% of earnings will be reported this week, dominated by Energy and Utilities.


Disney announced they have come to an agreement with China to open a new theme park in the country. The new park will cost a whopping $3.6 billion.


The market has been moving straight up since the Fed’s original QE-2 announcement, without a pause. The most painful move is still to the upside as hedge funds and long only managers both remain underexposed to US equity long positions. As I have mentioned often, the market tends to move whichever direction causes the greatest amount of investor distress.

Have a great week.


PJ O’Rourke-“I vote Republican because they have fewer ideas. We had government by idiot under Bush, and are now realizing it was better than government by genius.”

Nov 7, 2010

Two Out of Three Ain't Bad

I am having some technical issues and won't have this note up until Monday evening. I apologize for the delay.


Oct 17, 2010

A Dangerous Game of Chicken

October 17, 2010

A Dangerous Game of Chicken

“Bottoms in the investment world don't end with four-year lows; they end with 10- or 15-year lows.”—Jimmy Rogers, Investment Biker

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

INDU: 0.51%
SPX: 0.95%
COMPQ: 2.78%
RUT: 1.35%


Against the backdrop of the Fed pushing hard for another round of easing, aka QE-2, equity markets advanced this week along with commodities, while bonds had one of their worst weeks of the year. The dollar, which Chairman Bernanke has been treating with as much respect as Bill Clinton gave to the infamous blue dress, is likely to be the victim of QE-2, along with 200 million plus US consumers. A bout of low rates (for now), accelerating inflation, a weak dollar, and weak economic activity reminds us of 1970’s stagflation, and if we return to that type of environment the comparisons of Helicopter Ben to Arthur Burns (Fed chair from 1970-1978) will echo throughout the land. How we long for the fortitude of Paul Volcker.

Gold, long a barometer of investor concern about inflation, has been ripping for half a decade or so in response to Mr. Bernanke’s irreverence towards our currency. The recent action in gold, which smells of an intermediate term top, has been relentless in its rise (see chart below of the GLD ETF courtesy of The deflationary crowd has been somewhat quiet lately given the rise in gold, corn, wheat, oil, and any other commodity priced in dollars. While the economy could easily shift back into recession mode, we prefer to focus on the old axiom “don’t fight the Fed”. In that case, it makes sense to position for inflation, because both the Fed’s actions and words suggest they won’t stop their easing until we see the white’s of inflation’s eyes. The problem with their strategy is that it doesn’t address what ails the economy-jobs and incomes.

A stagflationary environment is bad for most asset classes, except commodities, gold and possibly agriculture. Savers get penalized because the income on their savings doesn’t offset the rise in the cost of goods. Pensioners are hurt because the returns on their portfolios pale in comparison to inflation as both stocks and bonds suffer. Social security beneficiaries are already being penalized by the artificially low rates as it was announced they wouldn’t be receiving a COLA increase for next year. In other words, it’s not good.

M&A activity has been strong lately, and many a market prognosticator has referred to this increase in activity as a bullish sign. Unfortunately, history doesn’t support this position as the level of M&A activity has had a mixed record as a bullish market signal. Corporate chieftains and buyout firms have been poor at picking market tops and bottoms.

Rising corporate cash levels have also been cited over the past three years as bullish, however, the chart below shows that corporate cash levels have been rising since the early 1980’s (chart courtesy It is estimated that up to 2/3 of the cash presently residing on corporate balance sheets is sitting overseas as non-repatriated foreign profits. It would make sense for the Obama administration to temporarily, or permanently, lower the rates on foreign profits to allow corporations to bring that capital back to the US. Then, instead of investing that capital overseas, a lower tax rate would help make that capital available for job creating domestic investments. A tax rate of 5% would also generate roughly $330 billion for the treasury, not chump change when we are running trillion dollar deficits.


Actual Estimate Previous
Initial claims 462K 450K 449K
Continuing Claims 4399K 4450K 4511K
PPI 0.4% 0.2% 0.4%
Core PPI 0.1% 0.1% 0.1%
CPI 0.1% 0.2% 0.3%
Core CPI 0.0% 0.1% 0.0%
Retail Sales 0.6% 0.4% 0.7%
Retail Sales ex-auto 0.4% 0.4% 1.0%
Michigan Consumer Sentiment 67.9 68.5 68.2
Business Inventories 0.6% 0.5% 1.1%

Economic activity appears to have stabilized for the time being after an extremely scary set of numbers from July and August. While the economy is anything but robust, it appears that a below normal recovery is in the cards. Any systematic shock could knock this economy back into recession (yes, we officially exited the recession).

The Fed is relying upon irrelevant core CPI and PPI measures of inflation. We have discussed the issues with these measures multiple times in the past, so we won’t reiterate the argument again. Suffice to say that the actual cost of living for most consumers is rising at a much greater rate than the Fed acknowledges, either because it is anathema to their deflationary dogma or because they like to be seen as needed.

The chart below, courtesy, shows the impact on retail sales of the most recent recession. Note that sales haven’t come back to pre-recession levels yet, and are 8% below where trend line sales would have been, which is probably why it doesn’t feel like this recession has ended yet.

Criminals, Politicians and Bankers-What a Mess

As if the mortgage crisis wasn’t enough to tilt this country off its axis, more mortgage problems are coming to light at the back end of the process. First, the banks lent to obviously unqualified borrowers at ridiculously low rates on overvalued and overleveraged properties, now it appears that when they securitized those mortgages they failed to properly file the required paperwork. This “oversight” has created questions as to the legality of foreclosure activity. At an extreme, each foreclosure proceeding could actually be considered breaking and entering.

The politicians are stuck between a rock and a hard place. They can’t allow the banks to fail and certainly can’t reward deadbeat borrowers, yet they don’t want to be perceived as giving even more handouts to the banks at the expense of homeowner’s right before an election. What’s a spineless politician to do?

How big could the problem be? The cost to buy back the mortgages which were improperly originated could be up to $10 billion. Last week JP Morgan increased their mortgages repurchase reserve from $2bil to $3bil. The problems at Bank of America could be larger.

That Explains It
“When Stephan says in an affidavit that he has personal knowledge of the facts stated in his affidavits, he doesn’t. When he says that he has custody and control of the loan documents, he doesn’t. When he says that he is attaching ‘a true and accurate’ copy of a note or a mortgage, he has no idea if that is so, because he does not look at the exhibits. When he makes any other statement of fact, he has no idea if it is true. When the notary says that Stephan appeared before him or her, he didn’t.”—Thomas Cox, a lawyer describing GMAC’s foreclosure process and the work of Jeffrey Stephan, its signing officer.

In spite of the banks holding back on foreclosures, filings were reported on 930,437 properties in the third quarter, a nearly 4%increase from the previous quarter but a 1% decrease from the third quarter of 2009.

Dow Theory
Dow Theory suggests that it is bullish for the market when the transport and the industrial indices are both strong. Today both are moderately strong, however, Richard Russell, the esteemed caretaker of the Dow Theory, has expressed his concerns about the market, valuation, and low dividend yields.

I am finding a lot of stocks trading at low multiples with good growth prospects, a great recipe for long term gains. I don’t think we’re in for a sustainable up market for quite some time, however, with the Fed printing money like crazy and an economy that doesn’t seem to have a need for liquidity, it would certainly seem that the equity market could be a short term beneficiary. If the market were to continue its upward velocity, I would be a better seller than buyer of equities.

As I mentioned in my last communiqué, I am hoping to get back to writing a couple of times a month. Thank you for the hundreds of requests to stay on my distribution list. If you would like to be dropped, please let me know.

Have a great week.


"We do not inherit the Earth from our parents; we borrow it from our children." - Antoine de Saint-Exupery

Oct 3, 2010

Hi Everyone

Thank you for all the emails over the past couple of months. I apologize for just dropping off the map. My plan was to take a month off from writing, which has stretched a bit longer.

If there is still interest, I am planning to get back to publishing around the 17th of October on a bi-monthly schedule. Please let me know if you still wish to be included.

I hope you are well.


Jun 27, 2010

Housing on Life Support

Housing on Life Support

June 28, 2010

“We have market forces that are deflationary and policy response that is inflationary. The next bubble – and this is the lesson of what this Greek drama was all about – is sovereign debt. The government’s official stance is that these deficits are just temporary. And the Fed says we have an exit strategy to reduce the liquidity of the U.S.’s balance sheet. If the notion becomes widespread that this is permanent and that they have to do even more in terms of more of this bad medicine, that’s the kind of thing that could lead gold to go up dramatically from here.”-John Hathaway, Tocqueville Gold Fund

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

INDU: 2.9%
SPX: 3.7%
COMPQ: 3.7%
RUT: 3.3%


All 10 industry groups in the S&P 500 fell last week as macro concerns over-whelmed the psyche of the market. The biggest drop in housing starts since March 2009 and ongoing sovereign debt concerns overshadowed better-than-estimated growth in industrial production, in line employment data, and a revaluation of the Yuan to drag the market lower. In Europe the debt problems in Spain have moved to center stage, allowing Spain to replace Greece as the Spruce Goose of Europe.

Among the negative factors pressuring the market, a series of weak real estate releases seemed to create the highest level of concern. We have been contending that residential housing prices should experience a second leg down, somewhere in the 10-20% range, and it finally looks as though this second correction may be coming. As the government’s residential real estate stimulus programs wane, demand appears to be waning as well. We think this is healthy for this market and feel the Feds should have allowed the real estate market to find a bottom on its own. Now we’ve spent trillions trying to prop up housing and it looks as though the only impact is a delay in finding the ultimate bottom, and an expensive delay at that.

The financial services stocks staged a rally on Friday when the details of the new financial reform package were announced. We’ll discuss more of the details later, however, it seems that the extensive lobbying efforts by the big commercial and investment banks was money well spent as the reform not only is without teeth, the bill wouldn’t have even slowed down the prior financial crisis. What will happen when the next crisis occurs?

This appears to be a great time to begin fundamental research and find those quality stocks becoming oversold. As the market’s focus has turned more to macro concerns (think housing, sovereign debt, double dip recession, etc), company fundamentals have taken a backseat and good companies are being penalized along with companies whose fundamentals are deteriorating. This weekend’s Barron’s noted that the correlation amongst stocks has increased to its highest level since the financial panic in 2008. In prior periods with higher correlations than normal, great opportunities have arisen for individual stock selection. Do your homework, look for entry points!

Actual Consensus Prior

Existing Home Sales 5.66 mil 6.10 mil 5.79 mil
New Home Sales 300K 430K 446K
Housing Starts 593K 655K 659K
Durable Orders -1.1% -1.3% 3.0%
Durable Orders ex Transports 0.9% 1.3% -0.8%
Initial Claims 457K 460K 476K
Continuing Claims 4648K 4580K 4693K
GDP-third estimate 2.7% 3.0% 3.0%
GDP Deflator 1.1% 1.0% 1.0%
U of Michigan Consumer Sentiment 76.0 75.5 75.5

May new home sales were a disaster as the first time home buyer’s tax credit expired. The measure came in 27% below estimates. Even April sales, which included the credit, were revised down by 58k. The May sales level of 300k is the lowest on record since at least 1963! Inventory for sale jumped from 5.8 to 8.5 months due to the lower sales volume. Sales in the West fell 53% from April and foreclosures continue to flood the market. Median home prices also fell 9.6% from a year ago and 1% from April.

While it’s doubtful anyone anticipated strong results post the tax credit, the magnitude of the decline was shocking. It would appear that the tax credit pulled forward sales from future months, the question remains how long until volumes return? We would guess that the tax credit pulled demand from as far forward as September, and that all things being equal we won’t see positive housing data until October, at the earliest.

“Builders still remain very cautious and are aware that several factors could impede the nascent housing recovery, including serious problems in obtaining financing for the production of housing, faulty appraisal practices and competition from short sales and foreclosed properties.”

Part of the pressure on the real estate market continues to be the ongoing rise in defaults, not just from subprime borrowers but also prime borrowers. The chart below, courtesy of Bloomberg, shows the increase in defaults amongst these “superior credits”.

Floating Yuan!
China announced that they would relax the yuan’s fixed peg to the dollar, and the currency posted its largest single day gain in almost two years. Treasuries and the dollar initially fell while global commodities, equities and the yuan rose. An appreciating yuan could be marginally positive for mid-cycle stocks with global exposure such as industrial, energy, and materials producers as their products become more affordable to China. A stronger currency will also help China’s inflation problem, but could add inflationary pressures to the US as profit margins get squeezed for domestic manufacturers reliant upon inexpensive Chinese labor markets. A stronger yuan could also increase pressure on Chinese textile manufacturers who have flourished due to their lower cost of labor and currency advantage.

While these changes may seem dramatic, in reality they will be subtle and occur over the long term. Typically currency impacts do not result in an immediate shift in competitive dynamics or pricing.

Thank You BP

Is anyone else thinking that Congress and the bankers are breathing a sigh of relief and thanking BP for getting the heat off of them for the time being?

Beggar thy Neighbor

According to the Bank for International Settlements, banks in Germany and France are owed more money by European nations that are in financial distress compared with other countries' financial institutions. Greece, Ireland, Portugal and Spain had borrowed nearly $1 trillion from French and German banks by the end of 2009, the BIS said!

That’s a lot of motivation to help the PIIGS.

Credit Demand, Not Credit Availability is the Issue

The National Federation of Independent Businesses (NFIB) surveys a sample of its 300K or so members each month. A recent survey found that only 3% of its members reported financing as their top business problem. A third cited “weak sales” as their top problem while 92% reported all of their credit needs met (or having no desire to borrow). Thirteen percent of regular borrows reported credit “harder to get” than previously.

The First Quantitative Easing

The Federal Reserve Bank of St. Louis just published a 20 page tomb on the quantitative easing that took place in the 1932. It’s a bit dense, but informative.

Thanks to reader Doug.

The Best President for the Environment?
Would you believe Richard Nixon?

The Daily Show With Jon StewartMon - Thurs 11p / 10c
An Energy-Independent Future
Daily Show Full EpisodesPolitical HumorTea Party

Commercial Real Estate

Morningstar writes that the pace of commercial-property acquisition is picking up in a way that might continue for some time. "We believe the large amount of capital that real estate investment trusts, pension funds, and private investment funds have amassed for commercial real estate investment has, to date, overwhelmed the available supply of assets for purchase."

It’s Not California!

A few weeks ago we talked about the fiscal problems in Illinois looking worse than those in California. Last week the state issued $300 million of Build America Bonds at a yield premium over treasuries about 40% higher than two months ago as investors showed concern about the state’s $13 billion budget deficit. The paper priced almost 300bps over treasuries to yield 7.1%. In April the state issued similar term bonds at 210bps above treasuries.
Governor Pat Quinn is pushing to issue an additional $3.7 billion in debt to make pension payments and help with the gaping shortfall. The state presently has unpaid liabilities totaling $4.5 billion. The cost to insure Illinois debt has surpassed that of California, with CDS at 309bps vs. 299bps to insure California debt. Moody’s and Fitch both downgraded the state’s debt this month.

Test Run from the Fed

The U.S. Federal Reserve started testing its tool for credit tightening, selling $1.15 billion through its term deposit facility. Chairman Bernanke plans to use the program to drain funds from the banking system and help policymakers increase interest rates when the Fed begins pulling back on liquidity. In addition to the deposit facility, the Fed also said it will use reverse-repurchase agreements to soak up liquidity. "The use of reverse repos and the deposit facility would together allow the Federal Reserve to drain hundreds of billions of dollars of reserves from the banking system quite quickly, should it choose to do so," Bernanke told lawmakers earlier this year.

From Fox News:

The seven experts who advised President Obama on how to deal with offshore drilling safety after the Deepwater Horizon explosion are accusing his administration of misrepresenting their views to make it appear that they supported a six-month drilling moratorium -- something they actually oppose.
The experts, recommended by the National Academy of Engineering, say Interior Secretary Ken Salazar modified their report last month, after they signed it, to include two paragraphs calling for the moratorium on existing drilling and new permits.
Salazar's report to Obama said a panel of seven experts "peer reviewed" his recommendations, which included a six-month moratorium on permits for new wells being drilled using floating rigs and an immediate halt to drilling operations.
"None of us actually reviewed the memorandum as it is in the report," oil expert Ken Arnold told Fox News. "What was in the report at the time it was reviewed was quite a bit different in its impact to what there is now. So we wanted to distance ourselves from that recommendation."
Salazar apologized to those experts Thursday.
"The experts who are involved in crafting the report gave us their recommendation and their input and I very much appreciate those recommendations," he said. "It was not their decision on the moratorium. It was my decision and the president's decision to move forward."
In a letter the experts sent to Salazar, they said his primary recommendation "misrepresents" their position and that halting the drilling is actually a bad idea.
The oil rig explosion occurred while the well was being shut down, a move that is much more dangerous than continuing ongoing drilling, they said.
They also said that because the floating rigs are scarce and in high demand worldwide, they will not simply sit in the Gulf idle for six months. The rigs will go to the North Sea and West Africa, possibly preventing the U.S. from being able to resume drilling for years.
They also said the best and most advanced rigs will be the first to go, leaving the U.S. with the older and potentially less safe rights operating in the nation's coastal waters.

Oil Spill Positive for Economy?

I mentioned this a few weeks ago, and got a lot of blowback from readers (which of course makes me want to say it again). Bloomberg is now estimating that jobs associated with the cleanup will exceed 15K, more than the estimated 8K workers being displaced by the spill. That excludes the 30K rig workers being displaced by the offshore drilling moratorium.

The Katrina cleanup effort was effective at stimulating the area’s economy after the devastation of the hurricane. The BP cleanup effort could go on for a decade or more, helping to offset the decline in tourism, fishing, and other water related businesses.

The Benefits of War?

Pentagon scientists uncovered a vast array of mineral deposits in Afghanistan that could provide money to rebuild the war-torn economy. According to an internal U.S. government memo, Afghanistan could end up as the "Saudi Arabia of lithium," a mineral essential to the manufacture of batteries for computers and other electronic devices. Geologists estimated that the deposits could be worth nearly $1 trillion.

Opportunistic Brazilians

Sensing an offshore drilling opportunity, Petro Bras has announced plans to invest $224 billion over the next three years in oil exploration and production. The company is looking to increase its development of offshore reserves just off their own, very oil rich coast.

Chinese Liquidity Crunch

We have discussed a possible liquidity crunch in China a number of times in the past. Blogger Tyler Durden noted this week that repo rates between Chinese banks have bee surging recently, a sign the liquidity crunch may be worsening. As the chart below demonstrates, the 30 Day repo surged by 19 bps to a record 4.25%, up from 1.75% six weeks ago. Could the bad loans in China finally be hitting a boiling point?

Financial Non-Reform

Congress announced a deal on reforming financial services and supervision which failed to keep banks from participating in hedge funds or buyout investing, limiting their exposure to 3% of total capital. Derivative trades on interest rates and foreign-exchange rates are also still allowed, although other trading on derivatives is banned.

The net of the bill is that banks are still allowed to continue their investment banking activities, with some minimal limitations.

After all the crowing and posturing coming from the Administration, this bill is effectively a worthless pile of paper that does little to address any potential problems, doesn’t get rid of TBTF, and wouldn’t even stop the most recent crisis much less any crisis that could be looming in the future.

No wonder financial stocks all jumped on the news.


Credit default swap rates on Spanish sovereign debt widened this past week as the market began acknowledging another source of problems in Europe. Remember that Spain’s economy is 4x that of Greece, and a default would have a much greater impact on Europe and the global economy than the sneeze we just experienced from Greece.


The Baltic Dry Index, which tracks international shipping prices, has been highly correlated to commodity prices and economic activity over the past decade plus. The chart below, courtesy of, shows that the index has been range bound since bottoming in December 2009, down 90% from its peak. If the support lines are accurate, it suggests the index may be correcting once again. If that is true, it could be another indicator supporting the double dip recession scenario.

Debt-Yours, Mine and Ours

Alliance Global Investors created the chart below showing the liability per tax payer and citizen of our national debt. The numbers are daunting.


The market continues to trade within the ranges we outlined early in the year, and still has support around the 1050 level. As we have discussed more than once, use that level to add to positions, however, if the market breaks significantly below 1050, 950-980 could be the next stop, an additional decline of 7-9%.

If you are interested in receiving daily economic results, subscribe to Twitter via the “Follow Me” link in the upper right hand side of the note. I try to put them out around 10 EST since most reports are released around that time. Also, thank you once again for supporting our advertisers.

Have a great week.


“Ratings firms fear litigation more than they fear regulation because past regulation efforts haven’t “been that draconian.” -Scott McCleskey, a former Moody’s compliance officer who has testified before Congress about the industry.

Jun 13, 2010

Market Follows a Well Worn Path

Market Follows a Well Worn Path

June 14, 2010

"Big banks that took on high risks and generated unsustainable losses received a public benefit: TBTF ["too big to fail"] support. As a result, more conservative banks were denied the market share that would have been theirs if mismanaged big banks had been allowed to go out of business. In essence, conservative banks faced publicly backed competition."—Dallas Fed President Richard Fisher

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

INDU: 2.81%
SPX: 2.51%
COMPQ: 1.10%
RUT: 2.37%

Almost on queue the S&P 500 corrected from its mid-April high of just over 1200, correcting back to support around 1050. The index has bounced off that level twice, and closed this past week at 1091. In prior notes we have focused on these levels as trading points, and will continue to do so in the near term as the markets continue to consolidate. There are two questions in our minds. First, will the market break through the mid 1000 support level? If so, then we could see the S&P correct back to the 950-980 range. Second, will the trading range continue to widen with increasing volatility, or will it tighten up?

There has been quite a bit of discussion over the past few weeks about a double dip recession coming in 2011. If you recall from our beginning of the year note, we assigned a 20% probability to a double dip. Today we would suggest the economy has three possible scenarios. First, a meandering, slow growth recovery, which we would say is the most likely scenario with a 60-70% probability. Second is the double dip scenario, which we still think has a 20-30% probability. Finally, we think a rapidly growing recovery is the outlier, with a less than 10% probability yet the scenario that isn’t priced into many models today.

David Rosenberg of Gluskin Sheff, produced the chart below. We have written about business cycle investing many times in the past, and have shown similar graphics. David’s chart below suggests that, based upon the recent slowdown in the growth rate of the ECRI Weekly Leading Economic Indictor, we are now in Phase III-slowdown. If he is correct, and we believe he is, then its time to focus investments on late cycle stocks while underweighting early cycle stocks. Additionally, this type of environment is poor for higher risk assets such as high yield credits and small caps.


Actual Consensus Prior
Consumer Credit $1.0 bil -$2.0 bil -$5.4 bil
Wholesale Inventories 0.4% 0.5% 0.7%
Initial Claims 456K 450K 459K
Continuing Claims 4462K 4600K 4717K
Trade Balance -$40.3 bil -$41.3 bil -$40.0 bil
Retail Sales -1.2% 0.2% 0.6%
Retail ex-auto -1.1% 0.1% 0.6%
Michigan Consumer Sentiment 75.5 74.5 73.6
Business Inventories 0.4% 0.5% 0.7%

The chart below, courtesy of the NY Times, shows unemployment since the beginning of each recession going back to the 1970’s. The chart demonstrates that unemployment in this recession is worse than any of the others, and has taken longer to begin showing improvements in hiring. The second chart, courtesy of, shows the official unemployment rate (red line), the BLS U-6 rate (gray line), and the SGS alternative measure (blue line). The differences are that the U-6 includes short-term discouraged workers and those working part-time because they can’t obtain full time work. The SGS alternative includes long-term discourage workers, who were eliminated from the official measures in 1994.

The Best Investment of All

We’ve shown these hats many times since this note began, and have commented what a great investment they were in 1998 when the Dow first topped 10K. With the Dow criss-crossing this much ballyhooed level again, it seemed an appropriate time to break out these well worn, fully amortized chapeaus (before I get pummeled by my more critical readers, I do realize this hat isn’t a true chapeau).

Credit Conditions
The Bank of Canada became the first Group of Seven country to raise rates since last year’s recession, and said further moves will be “weighed carefully” against future growth in Canada and elsewhere. Canadian GDP grew at twice the rate of the US last quarter, 6.1%.

“Given the considerable uncertainty surrounding the outlook, any further reduction of monetary stimulus would have to be weighed carefully against domestic and global economic developments,” the Ottawa-based central bank said in a statement.

Finally Some Reality

Federal Reserve Chairman Ben Bernanke told the House Budget Committee that the U.S. isn't creating enough jobs to pay for all of the people who will retire during the next 20 years. He urged Congress to take decisive action to reduce the structural deficit because spending cuts and tax reform alone can't close the gap. "Unless we demonstrate a strong commitment to fiscal sustainability in the longer term, we will have neither financial stability nor healthy economic growth," Bernanke said.

Why does it take people in power so long to state the obvious?

A Return to Smoot-Hawley
Treasury Secretary Timothy Geithner said he is considering trade restrictions on Chinese products in response to China's failure to allow the value of its currency to rise. "The distortions caused by China's exchange rate spread far beyond China's borders and are an impediment to the global rebalancing we need," he told the Senate Finance Committee.

Are we doomed to repeat every mistake of the Great Depression?

Leading by Example

Germany announced its biggest spending cuts since World War II, saying Europe's largest economy must set an example. The austerity plan aims to reduce spending by $95.7 billion by 2014. German Chancellor Angela Merkel said the move is a "unique show of strength" that demonstrates Germany's commitment to dealing with Europe's debt crisis.

Austerity is important and much needed in the US and most of the developed world, but I wonder if eliminating another slug of spending in Europe while the economy falters is the right medicine at this time?

Jobs and the ISM
According to Barry Ritholtz at The Big Picture, the ISM usually does not spend much time above 60. It printed at 60.4 in April and dropped slightly in May to59.7. In the previous 485 readings, it has printed above 60 just 48 times, or 9.9% of the time. As it relates to jobs, the year over year change in payrolls lags ISM by about seven months.

The chart below shows the ISM in blue and non-farm payrolls in red. By lagging payrolls seven months, the correlation rises to 0.73, suggesting we should start seeing an improvement in the jobs picture any month. On the flip side, with the ISM approaching historical peak levels and suggesting we are in the late cycle, yet hiring hasn’t picked up significantly, we could be in for a long employment downturn.

They Call Me Coach

Even though I’m a USC fan, John Wooden had a significant influence on my life. As a boy I read his book “They Call Me Coach”, and had his pyramid of success tacked onto my wall. He was a great coach, teacher, and man whose focus on persistence, loyalty, honesty, hard work and process are timeless lessons that transcend professions. I have included some of his greatest quotes below:

"Things turn out best for the people who make the best of the way things turn out."

"Never mistake activity for achievement."

"Adversity is the state in which man mostly easily becomes acquainted with himself, being especially free of admirers then."

"Be more concerned with your character than your reputation, because your character is what you really are, while your reputation is merely what others think you are."

"Be prepared and be honest."

"Be quick, but don't hurry."

"You can't let praise or criticism get to you. It's a weakness to get caught up in either one."

"You can't live a perfect day without doing something for someone who will never be able to repay you."

"What you are as a person is far more important than what you are as a basketball player."

"Winning takes talent; to repeat takes character."

"A coach is someone who can give correction without causing resentment."

"If you don't have time to do it right, when will you have time to do it over?"

"If you're not making mistakes, then you're not doing anything. I'm positive that a doer makes mistakes."

"It isn't what you do, but how you do it."

"Consider the rights of others before your own feelings and the feelings of others before your own rights."

"Do not let what you cannot do interfere with what you can do."

"Don't measure yourself by what you have accomplished, but by what you should have accomplished with your ability."

"It's not so important who starts the game but who finishes it."

"It's what you learn after you know it all that counts."

"It's the little details that are vital. Little things make big things happen."

"Talent is God-given. Be humble. Fame is man-given. Be grateful. Conceit is self-given. Be careful."

"The main ingredient of stardom is the rest of the team."

"Success comes from knowing that you did your best to become the best that you are capable of becoming."

"Success is never final; failure is never fatal. It's courage that counts."

BP Gets a Tongue Lashing

The President, who for some reason seems to periodically forget he is in the US, continued his verbal attack on BP by saying they shouldn’t market, buy ad time, or pay dividends to its shareholders.

I’m speechless.

Regulatory Reform?
From Barry Ritholtz

“Even for Washington, the revolving door between government and Wall Street spins at a dizzying pace. More than 1,400 former members of Congress, Capitol Hill staffers or federal employees registered as lobbyists on behalf of the financial services sector since the start of 2009, according to an exhaustive new study issued Thursday. The analysis by two nonpartisan groups, Public Citizen and the Center for Responsive Politics, found that the “small army” of financial lobbyists included at least 73 former lawmakers and 148 ex-staffers connected to the House or Senate banking committees. More than 40 former Treasury Department employees also ply their trade as lobbyists for Wall Street firms.”

Alternative Energy
Given the BP oil spill and what appears to be an overriding drive to move us even further away from fossil fuels, I have reproduced a piece I wrote about a year ago (April 19, 2009) on alternative energy. I recently read a study suggesting that we will need to double our energy production between now and 2030, and that the technologies required for that type of capacity increase don’t exist. The only way we can get there is through a combination of carbon based energy and alternatives, not just alternatives.

Here is the text from my note last year:

“US consumers pay average of $.11 per kilowatt-hour (kWh) for power derived from coal, natural gas, nuclear and hydroelectric. The proposed $10 per ton carbon tax would increase the price of coal-fired electricity by $.01 per kWh or 9%. In an effort to help the environment, the new administration is pushing renewable energy sources hard, regardless of the economic impact. Below I have shown some alternative energy sources, their costs, and some of the benefits/drawbacks of each. The pricing estimates are from Scientific American, and are estimates at full deployment (current pricing is much higher).

Solar-Thermal-At a cost of $.20-$.28 per kWh, this technology is expected to cost three times current sources. The advantage is that it may be one of the only renewable sources which allows for the storage of energy to meet peak demand. The drawbacks are the need to locate in deserts, far from existing transmission lines and available water for cooling.

Ocean Wave Power-The price is unknown at this point as the technology is still in its design phase. The advantage is that most of the population is located near the coasts. A major drawback will be designing a building that can withstand 50-75 years of heavy waves.

Geothermal-At a cost of $.062-$.076 per kWh, geothermal is actually cheaper than the existing technology. The advantage is that the supply is very reliable, and can generate to meet daily demand patterns. The downside is the pollution given off by the steam from underground water can be highly toxic and corrosive.

Solar-Photovoltaic-Right now this technology is one of the furthest along in commercial deployment; however, it is heavily subsidized by governments due to its high cost, $.47-$.71 per kWh. The major advantage is the ability to overlay the technology in heavily populated areas to save the cost of new distribution lines. The drawback-cost!

Wind-The US is undergoing a major wind generation deployment program over the next 12 years. The advantages include no cooling water requirements and its low cost of $.06-$.085 per kWh. The disadvantages are location (typically far from population centers) and most generation occurs at night, which doesn’t match the demand requirement patterns. There are also issues with birds and bats flying through the turbines.”

So far BP has lost roughly $95 billion in market cap. The company is self-insured, which means the potential liability from the spill could be limitless unless they qualify for some legal caps. There has been discussion of a possible bankruptcy filing to isolate the company from its spill liabilities, which adds a key question to the discussion on whether the equity is a good investment or not.

The Congressional Oversight Panel has concluded that the Federal Reserve could have acted earlier to find a privately funded solution for New York-based AIG before the September 2008 rescue. The $182.3 billion bailout transformed banks’ financial bets into fully guaranteed obligations, the panel said.

“The government’s actions in rescuing AIG continue to have a poisonous effect on the marketplace,” said the panel, led by Harvard University law professor Elizabeth Warren. “The AIG rescue demonstrated that Treasury and the Federal Reserve would commit taxpayers to pay any price and bear any burden to prevent the collapse of America‘s largest financial institutions and to assure repayment to the creditors doing business with them.’’

European Banks
Jean-Claude Trichet, president of the European Central Bank, said stress tests on major financial institutions across the eurozone are nearly complete and the results should be made public to calm financial markets. The U.S. has been urging Europe to follow its lead with banks' stress tests as a way of restoring investor confidence and encouraging banks to raise capital, if necessary. The Committee of European Banking Supervisors is conducting the tests.

What do you do with $2 trillion in Foreign Reserves?

China is taking a big stake in Greece’s recovery, making investments that eventually could be worth billions of Euros. The modernization and expansion of the Piraeus seaport to become a gateway to Europe and North America for China's exports is one of the first big projects. Shipping giant Cosco took over a major Piraeus container-cargo facility this week and plans to spend $700 million on improvements.

When the first charges against Goldman and their marketing of mortgage backed securities arose we suggested that this would only become a nightmare scenario for the firm if additional securities were identified. The Wall Street Journal reported this week that a second tranche of securities is now being reviewed for similar improprieties.

A second (or more) security could indicate an institutional problem versus just a one off event, which could carry much more severe financial and criminal ramifications.

Fuel for the “Anti-Wall Street” Crowd
According to data from Thomson Reuters, Wall Street investment banks have received more than $670 million in commission and charges from sales of Build America Bonds. The fees are an average of 20% higher than those charged for conventional tax-exempt debt.

Brazil, Ole!

Brazil reported first quarter GDP growth of 9%, the fastest in a decade. The Real gained 1% vs. the dollar, and the Bovespa, the country’s equity index, rose 1.1% YTD.

One Boot on the Brake, One on the Accelerator

China's central bank pumped $24.3 billion into its financial system this past week through the use of repurchase agreements and bill issuance. It marked the third consecutive week of net injections by the central bank.

Meanwhile, China's CPI rose 3.1% last month compared with the same month a year earlier. Over the same period, retail spending on consumer goods soared 18.7%.

The U.S. House recently approved a tax increase on certain compensation paid to investment managers, known as carried interest, but the Senate has watered down the proposal slightly. Carried-interest income is taxed at the capital-gains rate of 15% versus 35% for incomes in the highest federal bracket. The Senate proposal would raise the tax to as much as 33% by 2013. The House's proposal would raise the rate to 35%.

Chinese Trading Becoming More Liberal

The China Securities Regulatory Commission, encouraged by initial results of a trial program, approved a limited expansion of margin trading and short selling. The regulator added five securities firms to the program, which already had six, and relaxed capital requirements to encourage smaller brokerages to participate.

Money Supply
We have discussed the slowdown in growth of M3 over the past two years in spite of the Fed’s massive attempts at increasing the monetary base. As we discussed last month, the main culprit is the lack of velocity caused by banks holding back on lending as they attempt to shore up their balance sheets. The chart below, courtesy of, shows the discontinued measure of M3 in blue (actual measure in red, SGS’s continuation in blue).

Readership has been soaring lately, thank you all for the referrals and as always thank you for supporting our sponsors. If you are reading this via one of the 15+ websites that carries these notes, thank you as well.

Have a great week.


“The collapse of the financial system as we know it is real, and the crisis is far from over,” Soros said today at a conference in Vienna. “Indeed, we have just entered Act II of the drama.”

May 31, 2010

About Face! Offshore Drilling Off the Table!

About Face! Offshore Drilling Off the Table!

May 31, 2010

“The problem is the market is not buying this “fix too much debt with more debt” approach. More bailouts are not the answer. Austerity is the answer.”—Jim Bianco,

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

INDU: -0.56%
SPX: .016%
COMPQ: 1.26%
RUT: 1.90%

The S&P has experienced its biggest correction since the March 9, 2009 bottom, declining roughly 13% from its recent high to touch new lows for the year. We mentioned the mid 1000’s for a level to begin coming back to the market, and the S&P bounced on cue from the those very levels as the market touched down just below 1050 before rebounding slightly to close the week at 1089. This is the first 10% correction since the market bottomed in March 2009, which is not unusual except that it occurred in a single month. Typically 10% corrections don’t occur within a single month, but trace out over multiple months. The severity of the downturn has raised investor concerns about whether this is a normal correction in an upward trending market or something a bit more ominous.

Richard Russell of Dow Theory fame feels the markets are signaling weak economic conditions or even something direr on the horizon. Personally I feel there are many macro concerns, primarily debt, taxes, and entitlement related obligations, but I don’t feel this is the end all correction some are expecting. Comparisons are becoming much more difficult, but there is also a bit more economic activity. This activity is requiring capital, which is no longer being thrown recklessly at risky assets. I continue to believe we are in a range bound market, and referred back to the January 4th note for this quote “For 2010 I expect the market to continue its upward march through the first one-third of the year, with the possibility of a pull-back to consolidate 2009’s gains. A more significant stalling beyond that time frame is highly possible.

Prediction: look for the S&P500 to rise another 8-10% (north of 1200) before settling back in the back 2/3 of the year. Should the Fed be forced (they won’t do it voluntarily) to raise rates, the market could correct back towards fair value, which I peg at 975-1000 (15x $67).”

Earnings look as though they will come in a bit higher than $67, however, with the uncertainty surrounding the macro environment and concerns about a double dip recession, the 15x multiple seems a bit aggressive, so the fair value of 975-1000 stays intact.

The chart below, courtesy of, shows how the Hang Seng (green line) peaked first amongst the major global indexes. The US, Europe, and Japan all rolled over simultaneously after making new post crash highs.

A number of readers have asked how far corporate earnings have bounced. While they haven’t reached the prior peak (2007), the chart below shows that they have bounced to bubble era levels since bottoming in early 2009. Total corporate profits of the S&P 500 are roughly $50 billion or 18% below the peak. The chart below, courtesy, shows inflation adjusted corporate earnings of the S&P 500 since 1935.


Actual Consensus Prior
Existing Home Sales 5.77 mil 5.65 mil 5.36 mil
Case Shiller Home Index 2.4% 3.0% 0.7%
Consumer Confidence 63.3 58.3 57.7
Durable Goods 2.9% 1.5% 0.0%
Durable Goods ex Transports -1.0% 0.7% 4.8%
New Home Sales 504K 425K 439K
GDP-2nd Estimate 3.0% 3.3% 3.2%
GDP Deflator 1.0% 0.9% 0.9%
Initial Claims 4607K 4600K 4656K
Personal Income 0.4% 0.4% 0.4%
Personal Spending 0.0% 0.3% 0.6%
PCE Prices 0.1% 0.1% 0.1%
Chicago PMI 59.7 60.0 63.8
U of Michigan Consumer Sentiment 73.6 73.2 73.3

The Case Shiller home price index posted its sixth consecutive month of soft results in March after peaking in September 2009. The first time home buyers’ credit has expired, meaning the housing market is going to lose another one of its training wheels, the first being the Fed exiting the secondary mortgage market on March 31.

Durable goods orders came in ahead of consensus after a flat March. The core number, ex-transportation, actually declined for the month. Transportation orders for April increased 16.1%, while capital goods increased 7.4% and non-defense orders increased 9.2%. Nondefense/non aircraft capital goods orders declined for the month by 2.4%.

More Trouble for the Rating Agencies
Virtually every bond trader has a Bloomberg terminal on their desktop. Bloomberg has revamped their credit products to include an actual rating system (see chart below). While the credit agencies struggle with fiduciary responsibility concerns, government investigations, and investor skepticism, it appears that they also have a new competitive concern.

Credit Conditions

From LoanConnector:

"With the turmoil in Europe wreaking havoc on the high yield bond market, the week of May 17 saw the second largest spread widening of 2010. Spreads widened 69bp for the week and 33bp on Thursday alone. When Germany unilaterally announced a ban on naked short-selling, a move that could have major ramifications outside of Germany, the markets went wild. The DJIA plummeted 552 points last week, the VIX index, a popular measure of volatility, jumped to 47 Friday morning, and the 10-year Treasury yield dropped to 3.12% at one point last Friday. High yield funds saw an outflow of $378 million, which added onto the previous week's exodus of $1.69 billion, the largest weekly outflow since 2004. Investors are fleeing to safety, and last week saw the lowest weekly high yield bond volume for 2010 to date at $1.30 billion. With spreads on the rise, issuers are waiting for more favorable conditions before testing the markets. Four out of last week's five new issues that priced were LBO deals - transactions that had to close and were therefore not extremely price-sensitive. May has already seen six high yield deals postponed, and this morning's announcement by Allegiant Travel Company upped that number to seven. Many of last week's new issuance traded down, and it is expected that a few more deals will be postponed this week."

California vs. Texas
The Governor of each state was jogging with his dog along a trail. A coyote jumped out and attacked the dog. The respective responses are outlined below.

1. The Governor starts to intervene and then realizes he should stop; the coyote is doing what is natural.
2. Call animal control. Animal control captures coyote and spends $200 testing it for diseases and $500 relocating it.
3. Call Vet. Veterinarian collects dead dog and spends $200 testing it for diseases.
4. Governor goes to hospital and spends $3500 getting checked for diseases from the coyote and getting bite wound bandaged.
5. Running trail gets shut down for 6 months while wildlife services conduct a $100,000 survey to make sure the area is clear of dangerous animals.
6. Governor spends $50,000 and starts a coyote awareness program for people who live in the area.
7. State legislature spends $2 million investigating how to better handle rabies and how to possibly eradicate it.
8. Governors security agent fired for not stopping the attack and letting the Governor try to intervene.
9. Cost $75,000 to train new security agent.
10. PETA protests the relocation of the coyote.

1. The Governor spends $1.23 on a .380 ACP Gold Dot Hollow Point and he and the dog keep jogging.

And we wonder why California is broke?

China’s Inflation Problem
According to the London Telegraph, a rapid expansion of China's money supply strongly suggests that the economy is overheating, said Guo Shuqing, chairman of China Construction Bank, the nation's second-biggest bank. The government's effort to cool off the housing market might be ineffective because property developers are holding so much cash, he said. "Sales are falling but prices are not," Guo said.

Chinese Growth Slowing?
According to Bloomberg, Chinese manufacturing expanded at a slower pace in May, adding to signs that growth may moderate in the world’s third-biggest economy. The Purchasing Managers’ Index fell to 53.9 from 55.7 in April versus a consensus estimate of 54.5.

A government crackdown on property speculation is cooling the economy by damping sales and construction, while Europe’s sovereign-debt crisis could exacerbate a slowdown by cutting demand for exports. China’s policy makers may delay raising benchmark interest rates or letting the Yuan appreciate against the dollar even after the economy grew 11.9% in the first quarter.

India Rocking!
India's gross domestic product increased 8.6% in the first quarter, ahead of consensus and compared to a 6.5% increase in the fourth quarter of 2009.

The Gulf Oil Disaster

The number of times I have been asked about whether British Petroleum (BP) is a good investment at these levels or not is astonishing. The short answer is that I’m not sure, but there are significant unknown factors that need to be examined. The chart below, courtesy of, shows the damage done to the company’s market value since the explosion of the offshore rig.

The questions that need to be answered really center on what is BP’s ultimate liability? There is an obscure drilling law from 1851 that drilling partner Transocean is attempting to use to limit their liability, but it’s applicability may be a reach. Given the current Congress’ willingness to throw anyone under the bus and retroactively change any law they deem to be a roadblock to achieving their goals, I would be a bit wary about placing bets centered on the existing legal limits. An additional question related to the liability is how much BP’s insurance companies are willing or legally obligated to pay? The answer to that one could take years to determine.

The cost of the cleanup will be significant, especially given the leak hasn’t been slowed yet. Additionally, there are unconfirmed estimates that there is a second leak 5-7 miles from the first which is emitting up to 120K barrels of oil per day, well in excess of BP’s estimate of 5K barrels per day. If this is true then the estimates of $10-20 billion will be well short of the actual cleanup costs.

The impact on future drilling will obviously be negative. The Obama administration has already announced they won’t issue any new drilling permits (in spite of new ones actually being issued last week), and many coastal states are rapidly mobilizing to do the same. This will push drillers further offshore into more dangerous and difficult locations.

One question is whether all the environmental concern actually helped cause this disaster. I’m not saying they caused the spill, but instead suggesting that aggressive environmentalist policies have forced oil exploration off of the continental US and into coastal waters, where the drilling environment is much more dangerous and difficult. Had we allowed more on-shore drilling, would it have helped avoid this disaster?

The final point to remember is that access to inexpensive fuel sources, along with superior communication systems dating back to the Revolutionary War, have allowed the US to prosper. Eliminating cheap fuel sources will hamper mobility and transportation, two key components in the success of the US over the past century.

Pension Problems in California

The Wall Street Journal reported this week that for the California Pension system to get fully funded, it will either require massive funding well in excess of the state’s existing tax revenues or the Dow needs to climb to roughly 28,000,000 (from 10.1K as of Friday’s close)!!!

How did we get in this mess? In 1999 then California Governor Gray Davis signed into law a bill that represented the largest issuance of non-voter-approved debt in the state's history. The bill, SB 400, granted billions of dollars in retroactive pension boosts to state employees, allowing retirements as young as age 50 with lifetime pensions of up to 90% of final year salaries. The California Public Employees' Retirement System sold the pension boost to the state legislature by promising that "no increase over current employer contributions is needed for these benefit improvements" and that Calpers would "remain fully funded." They also claimed that enhanced pensions would not cost taxpayers "a dime" because investment bets would cover the expense.

What Calpers failed to disclose, however, was that (1) the state budget was on the hook for shortfalls should actual investment returns fall short of assumed investment returns, (2) those assumed investment returns implicitly projected the Dow Jones would reach roughly 25,000 by 2009 and 28,000,000 by 2099, unrealistic to say the least, (3) shortfalls could turn out to be hundreds of billions of dollars, (4) Calpers's own employees would benefit from the pension increases, and (5) members of Calpers board had received contributions from the public employee unions who would benefit from the legislation. Had such a flagrant case of non-disclosure occurred in the private sector, even a sleepy SEC and US Attorney would have noticed.

Far from being "fully funded" as promised, Calpers has already required $15 billion more from the state budget than projected in 1999 and $3.5 billion is budgeted for this year, a figure that is more than five times the expense projected by the state legislature in its SB 400 analysis. Pensions are crowding out important programs like higher education, parks and health care, and the state will continue to whack away at those programs because the legislature refuses Governor Schwarzenegger's request to repeal SB 400 for new employees!

A recent Stanford University study concluded that California's pension funds are understating liabilities by $400 billion. In response, California's pension funds set up websites and attacked the study as "shoddy" and "faulty."

Cathy Bussewitz of the Associated press reported that “facing massive investment losses, the board of California's giant pension fund voted Tuesday to make the state increase its contributions to employee retirement benefits by $600 million in the coming fiscal year.”

CalPERS, the nation's largest public pension fund, lost $55.2 billion, or a quarter of its value, during the 2008-09 fiscal year.

"The biggest reason why we need increases is the investment losses," said Alan Milligan, interim chief actuary for CalPERS. "Quite frankly, there's more to come.""

Scary stuff indeed!

More Do as I say, Not as I do
Just two days after the WSJ reported that certain members of Congress “made risky bets with their own money that U.S. stocks or bonds would fall during the financial crisis,” it followed up with a story noting that the “Stop Trading on Congressional Knowledge (the ‘STOCK Act’)” continues to languish in Congress. The STOCK Act would prohibit lawmakers from engaging in insider trading based on nonpublic information they learn on the job.

The WSJ’s reminder that Congress currently can’t be held liable for insider trading based on congressional knowledge seemed to come as a surprise to many people. “That’s right! Members of Congress are currently allowed to profit on insider trading!,” Yahoo! Finance reported in an article last week.

In January, U.S. Reps. Louise Slaughter and Brian Baird introduced—for the third time—legislation intended to stop insider trading on Capitol Hill called the “Stop Trading on Congressional Knowledge Act” (the STOCK Act). Slaughter and Baird also introduced similar bills in 2006 and 2007, without success.

Now yet another year has passed, and the STOCK Act has made absolutely no progress. In fact, its minimal support continues to dwindle. As the WSJ notes, when Baird and Slaughter “first proposed the legislation more than four years ago, they were able to persuade just 14 of their colleagues to endorse it. The current version of the bill has fared worse: Only six lawmakers have agreed to support it, and Mr. Baird has announced that he is retiring from Congress at the end of the year.”

Thanks to Al Daniels

More Pension Problems

A Democratic senator is introducing legislation for a bailout of troubled union pension funds. If passed, the bill could put another $165 billion in liabilities on the shoulders of American taxpayers.

The bill, which would put the Pension Benefit Guarantee Corporation behind struggling pensions for union workers, is being introduced by Senator Bob Casey, (D-Pa.), who says it will save jobs and help people.

As FOX Business Network’s Gerri Willis reported Monday, these pensions were in bad shape; as of 2006, well before the market dropped and recession began, only 6% of these funds were doing well.

Although right now taxpayers could possibly be on the hook for $165 billion, the liability could essentially be unlimited because these pensions have to be paid out until the workers die.

It’s hard to say at the moment what the chances are that the bill will pass. A hearing is scheduled Thursday, which will give the public a sense of where political leaders sit on the topic, said Willis.

Just last week President Obama said there would be no more bailouts. Does that include pension funds?

US Lagging in Competitiveness

According to Google and the Associated Press, for the first time since 1993, the U.S. does not hold the top spot in the World Competitiveness Yearbook's rankings. The 2010 yearbook, published by IMD business school, put the U.S. in third place, behind Singapore and Hong Kong.

China IPOs Remain Hot

One area of the market remains hot-Chinese IPOs. China's initial public offerings have seen the best performance in the world this year, according to Bloomberg. During their first month of trading, Chinese IPOs are outperforming the nation's equity indexes by 3300 basis points.

I won’t say that my daily economic notes on Twitter have been an explosive success so far, but I haven’t received any complaints either. I have been consistently sending out the morning economic data via Twitter, and a handful of people have subscribed. I’ll continue doing it unless a better method comes along or people stop caring.

Interestingly, I have found that my weekly notes are being “re-tweeted” by numerous readers. I have to be honest, I’m not sure why someone would re-tweet what another person wrote, but I am curious to find out. If you are one of these “re-tweeters”, please shoot me a note so I can understand the logic and maybe help you in this distribution.

A reader corrected my 1AM typo last week, and it was significant enough I though I’d better include it in this week’s note. When I was discussing the CPI adjustments made in the early 1990’s, I referred to the new pricing method as “hedonistic”, when in fact it is “hedonic”.

Thanks Robert!

Happy Memorial Day to all of our active servicemen and veterans. Thank you for your loyal service which has been instrumental in ensuring we have the freedoms promised to us in our Constitution.

Have a great week.


“Whatever method you use to pick stocks…your ultimate success or failure will depend on our ability to ignore the worries of the world long enough to allow your investments to succeed. It isn’t the head but the stomach that determines the fate of the stockpicker.—Peter Lynch.

May 23, 2010

Credit Crisis Part Deux

Credit Crisis Part Deux

May 24, 2010

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

INDU: -4.0%
SPX: -4.2%
COMPQ: -5.0%
RUT: -6.4%


The Leading Economic Indicators came in at -0.1% versus consensus of 0.2%. Nondefense capital goods orders were up, while the pace of deliveries and building permits were the largest negative contributors to the decline in LEI.

Money Supply

The chart below, courtesy of the National Inflation Association, shows the growth (red and blue lines) and total (green line) money supply in the US. The growth rate, a 13 week moving average, was an astronomical 100% at the peak of the crisis, and has since pulled back to what appears to be a low double digit rate.

Regardless of how the government tries to cover up inflation (see Inflation below), the end result will be the same. The dollar, and potentially all paper currency, is headed towards Armageddon.

Credit Conditions
The European credit crisis is wreaking havoc on the credit markets. As we showed last week, LIBOR is spiking. Additionally, corporate credit issuance has slowed dramatically and credit spreads are rising, all signs of another brewing credit crisis. Credit-default swaps soared in Europe this week after German Chancellor Angela Merkel implemented a curb on using CDS to speculate on sovereign debt. Rising CDS rates signal investor concern about credit quality.
Spreads on corporate bonds rose to 170bps this week, up from 140bps a month ago. Libor, the rate which banks charge each other for borrowing amongst themselves, rose to the highest level in almost a year to just under 50bps. The LIBOR-OIS spread now sits at 25bps, up from 6bps in March. The rising spread indicates a concern about counterparty risk between lenders. According to Merrill Lynch, the rise in the LIBOR-OIS spread simply signifies reluctance among US banks to lend to European banks.


The dollar has been a beneficiary of the recent problems with the Euro. The chart below, courtesy of reader Bob Rezaee, shows the movement in the dollar since the Euro began experiencing its issues near the end of last year.

The National Inflation Association created this video discussing the impact and under-statement of inflation. I think it is well done, although I feel the part which discusses silver is much too long and too much of a propaganda section.

We have commented extensively about the problems in California, but it appears that Illinois is in even worse shape than the Golden State. According to the Illinois Comptroller, they haven’t paid close to $4.5 billion in bills so far this year. In January the state issued $3.5 billion in pension bonds to pay the state’s obligations to the retirement system.

Could Illinois and California be the US version of the PIIGS?

Concerns over demand and oversupply of oil combined with a surging dollar have pushed the price of West Texas Intermediate under $70 per barrel. The chart below, courtesy, is a five year chart on the commodity.

Alternative Energy
Construction is slated to begin later this year on a 49-megawatt geothermal-energy plant in the U.S. after financing for the project was finalized last week. The $399 million project is being developed by EnergySource. The company plans to pursue as many as four additional geothermal projects, with the next one possibly ready as early as 2013.

Remember about a year ago we compared all the alternative sources of energy, and geothermal was the most economically attractive.


I have written extensively about the hedonistic adjustments made to the CPI measure in 1993. produced the chart below showing the official CPI (orange) and their own estimate of CPI without the hedonistic adjustments. According to the National Inflation Association, the underestimation of CPI over the past two decades has resulted in social security beneficiaries receiving approximately 50% of what they would have received had the measure not been altered.

It makes me wonder how reliant Greenspan was on this meausre when he kept rates artificially low during a 10 year period, and also how close to bankruptcy the Social Security program would be without those adjustments?

Real Estate

According to Jim Welsh, Fannie Mae and Freddie Mac have been taken over by the U.S. government, and the taxpayers will have to make good on their combined losses of at least $400 billion. It’s also worth noting that between 1988 and 2007, Fannie and Freddie made almost $200 million in campaign contributions to Congress. The three largest recipients in the Senate were Christopher Dodd, John Kerry, and Barack Obama.

I mentioned last week that 400 point gains on the Dow typically were bad, and the market reacted as expected with a big drop this week. I’ve closed my QID positions (double short NASDAQ). I discussed a correction taking the S&P 500 to the mid-low 1000’s, and while we aren’t quite there yet, I am going to at least stay off the shorts for now. If we get more negative movement in the credit markets, I may go back in on the short side. I have also been adding to my holdings in high quality, more stable large caps with solid dividends.

Have a great week.


May 16, 2010

A Greek Tragedy

A Greek Tragedy

May 17, 2010

“If healthy economic systems require taxing the responsible and debasing the currency to bail out the profligate, the EU’s rescue package should be a raging success.” --Kevin Duffy

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

INDU: 2.31%
SPX: 2.23%
COMPQ: 3.58%
RUT: 6.28%


Volatility has exploded over the past two weeks (see chart below courtesy of Bloomberg) as the markets reacted to an IMF/EU bailout of the PIIGS. The correction of 2:45, which saw the Dow fall by 1000 points in a matter of minutes due to inconsistencies in the circuit breakers amongst the various exchanges, has investors on edge. Rumors of a trading mistake (isn’t it funny how trading mistakes only seem to occur on down days?) have proven to be false and seemingly unlikely.

The market staged an enormous bounce back Monday after the announcement of the big bailout package (also known as ‘Tarp, Part Deux’). David Rosenberg notes that big bounces (400 Dow points or more) typically have occurred during or near the beginning of bear markets. Personally, I have maintained this market has been a cyclical bull in a secular bear market, and right now we may be experiencing either a normal correction or the beginning of a down phase that could take the S&P down to the low 1000’s.

The Euro also staged a one day rally Monday before continuing its retreat (see chart below courtesy The Euro now stands at a four year low, and seems destined to continue falling over the intermediate time frame. Some traders are expecting a short lived bounce due to the crowded short position in the currency. I would use any strength to add to short positions.

The results have been predictable as US Treasuries and the dollar have both rallied given Europe’s problems and a potential slowdown in China (more below). Commodities have recoiled on the strength in the dollar and concerns about demand coming from both Europe and China. Finally, gold has ripped to a new high amidst concerns about not only the Euro, but also most currencies which have been debased in response to the recent financial crises.

From a stock standpoint we have been suggesting staying focused on mid-cycle stocks since the beginning of the year. Doug Cliggott, strategist at CSFB and a very astute market observer, suggested moving to late cycle stocks this week. Doug may be a tad early, but given weakening demand coming from Europe (20% of US exports); the potential for a rate increase in China; and tougher earnings comps in the back half of the year, the burgeoning economic recovery may be peaking this quarter. As a side note, Doug was right on the mark with his market calls heading into the 2000 peak and eventual bear market.

One major area of concern may be liquidity in Europe. The chart below shows the jump in one month LIBOR rates over the past year. Banks across Europe are significant holders of Greek, Portuguese, and Spanish debt. You may recall that spiking LIBOR rates in the middle of 2008 were an outgrowth of the financial crisis, and contributed significantly to the bank liquidity problems at that time.


Actual Consensus Prior
Wholesales Inventories 0.4% 0.5% 0.6%
Continuing Claims 4627K 4570K 4615K
Initial Claims 444K 440K 448K
Export Prices ex-ag 1.4% 0.7%
Import Prices ex-oil 0.5% 0.2%
Retail Sales 0.4% 0.2% 2.1%
Retail Sales ex-Auto 0.4% 0.5% 1.2%
Capacity Utilization 73.7% 73.9% 73.1%
Industrial Production 0.8% 0.8% 0.2%
Michigan Sentiment 73.3 73.5 72.2
Business Inventories 0.4% 0.4% 0.4%

The IMF said this week that this is the first time Asia has led a global recovery while the US and Europe lag. Europe may have destined itself to another decade of slow growth with their most recent bailout package, joining the US as underperforming economies over the next decade due to overly leveraged balance sheets.

Employment rose the most in 4 years last week, but the unemployment rate jumped as more people began looking for jobs. Job gains are still needed to sustain the recovery. Employers increased payrolls by 200,000 workers in April. ISI estimates 750K jobs were created last month, 550K from the government hiring census workers and 200K from the private sector.

March Business Inventories rose by 0.4%, in line with expectations and up for the 5th month in the past 6 after 13 months in a row of declines. Because sales rose 2.3%, the inventory to sales ratio fell to 1.24 months, matching the lowest level on record dating back to 1980. The historically lean inventories is a reflection of business caution to the still uncertain economic environment but also provides a great backdrop for a pick up in production if confidence in the outlook grows and end demand improvements become longer lasting

Oil Spill Good for the Economy

Outside of the obvious environmental disaster, should we be looking at the BP oil spill as a boon to the regional economy? Remember that the rebuilding of the south after Hurricane Katrina was a major boon to the area’s economy.

More on Taxation without Representation

Last week we discussed the UK usuriously taking bonus money while an unnamed US based bank clipped employee bonuses by 7% globally to pay the tax. This week both BofA and Citi announced they would pay $465 million and $400 million respectively due to the UK tax. The UK government had hoped to raise 500 million pounds via the tax, however, it appear that figure may be closer to 2 billion pounds.

I just want to clarify this one. BofA and Citi, among others, operate their businesses so poorly that they require the financial assistance of the American taxpayer, helping to push the country into a recession. Then, after some favorable accounting changes, they begin to pay bonuses again. The UK decides to zing them for their “profitability” for 2 billion pounds.

So the net is that the US taxpayer just subsidized the UK by 2 billion pounds!

Am I missing something here? Don’t they still owe us for helping them a few decades ago when it was apparent they’d be speaking German and doing the goose step?

Demonstrations have been rampant in Greece as the citizenry, primarily government unions, are showing their unhappiness with the plan to cut back on government expenditures in exchange for IMF funding. The protest is aimed at Prime Minster Georgios Papandreou, who was elected in October based on promises to raise wages for public workers and increase stimulus spending. The budget deficit of 14% of GDP is twice the estimate of the prior government and more than 4 times the limit of the EU, tying the Prime Minster’s hands on doling out the goodies.
The surge in the budget gap as the economy contracted fueled investor concern about Greece’s ability to finance the deficit and sent borrowing costs to the highest level since before the start of the Euro in 1999. Papandreou has pledged to lower the shortfall to within the EU limit of 3% of GDP in 2014. With reductions in wages and increases in taxes, the Greek economy is forecast to shrink 4% this year and 2.6% in 2011. Unemployment has risen to 11.3%, a six- year high.

Europe’s Debt Problems

The chart below, courtesy of the NY Times, shows the breadth of the problems facing Europe. In addition to the PIIGS, Britain, Hungary, France and Belgium all have debt levels exceeding EU limits. It’s ironic that the Eastern Block countries, historically unable to issue debt, are now more fiscally sound than their Western neighbors. I’m wondering how much of this Western European debt problem can be traced back to the cost of integration and support of Eastern Europe after the fall of the Berlin Wall?

Identity Theft Gold Mine

Every digital copier since 2002 has been shipped with a hard drive. This means that every document that has been copied on those machines is stored inside. A used machine could have up to 300K stored copies on it. Check out this link to CBS news:

If you have any concern for your financial privacy, this will scare you.

Marge Simpson and Europe

Enough said?

Thanks to the Big Picture.

China’s property market is a bubble looking more and more like the one that preceded it in the US. An estimated 60% of GDP in China comes from construction related activities. James Chanos (who is short Chinese developers and building related materials suppliers) said China is “Dubai times a thousand. They can’t afford to get off this heroin of property development. It’s the only thing keeping the economic growth numbers going.” “China is on a treadmill to hell.”

Property prices in China rose at the fastest pace in almost two years in February even after officials this year re-imposed a tax on homes sold within five years of their purchase to curb speculation and ordered banks to set aside more funds as reserves to cool lending. The boom in China’s real estate has fueled concern that China may face a collapse like that in the US and Dubai.

China’s Reserves
Chanos was also negative on China’s enormous foreign currency reserves, $2.4 trillion, of which nearly $900 billion are US government debt. China’s foreign currency reserves will be “one asset” that can be used to fund a cleanup of the banking system, he said. If that were to occur it could be the end of the 30 year bull market in US Treasuries.

China Part 3

The Chinese market is now down 20%, which qualifies for a bear market. The market has been pressured by concerns about the government raising rates to slow the economy and cool the housing market, rising inflation, and an increase in bank reserve ratios.

Andy Xie on the US Recovery
“I think the current recovery is merely based on government stimulus and low-base effect. And given the amount of stimulus spending, this is not a strong recovery. More importantly, structural problems exposed by the financial crisis were merely covered up, not resolved, by stimulus spending. This is why the recovery is not sustainable.

Since stimulus will eventually lead to inflation, interest rates will have to be raised. That will lead to another dip in the global economy. I expect this second dip in 2012, which means we are en route to a W-shaped economic phenomenon, not a V-shaped recovery.”

People in Glass Houses Just Shouldn’t
An unlikely advisor to Europe regarding their debt problems has emerged- Barack Obama.

I have nothing more to say.

The International Energy Agency scaled back its forecast for growth in global oil demand this year. The revision cut the forecast by 50K barrels a day to 1.62 million. Analysts said the reduction reflects a shaky world economy.

Inflation in Afghanistan?

Bloomberg is reporting that up to one-third of Afghanistan’s poppy harvest this spring has been destroyed by a mysterious disease, according to estimates revealed by the UN, which could hinder the American military offensives this summer in the country’s opium-producing heartland. It seems the Taliban’s public relations strategy against the offensive includes trying to convince local residents that Western troops will destroy their poppy crops, and in recent weeks Afghan farmers have started blaming the American and NATO militaries for spreading the disease. In many places, the blight has wiped out more than half of individual poppy fields.

Besides fueling the propaganda war, the blight might also help the insurgency by forcing prices up. Reduced production is causing prices for fresh opium to soar as much as 60%. The price increase is also raising by hundreds of millions of dollars the value of opium stockpiles held by traffickers and insurgents. The opium trade is believed to provide the Taliban with a large portion of their budget.

Real Estate
Data from the National Association of Realtors indicate that the housing rebound is losing steam and that housing prices in the U.S. might slip into the second part of a double-dip downturn. Core-Logic, a real estate analytics firm, forecast that prices will be 4.2% lower by February. Economists said the next downturn likely would be less severe, in line with our outlook for another 10-15% decline.


With the dollar rising 6% this month and the Euro falling 5% this week, commodities have been hurt while gold and treasuries have risen. The charts below, courtesy of, show the moves in gold, west Texas crude, and the dollar.

As a reminder I am now sending out the morning economic data via Twitter. I’m not saying I won’t forget some mornings, but if you are interested in receiving them, just click on the “Follow Me on Twitter” button on the upper right of the website. It’s easy to join (just requires an email and password), and more importantly it’s easy to unsubscribe.

The market has some tough sledding in front of it. We are advocating a defensive posture, and would use the market weakness to move into stronger, higher quality holdings and away from higher risk, lower quality holdings. There seems to be very few values in the bond market after a 14 month run, and would use any strength or liquidity in that market to take profits.

Have a great week.


“You have the great problem of a potential disintegration of the euro. The essential element of discipline in economic policy and in fiscal policy that was hoped for has so far not been rewarded in some countries.”-Paul Volcker