Jan 31, 2010

Risk Trade Unwinding

Risk Trade Unwinding

February 1, 2010

“Even if TARP saved our financial system from driving off a cliff back in 2008, absent meaningful reform, we are still driving on the same winding mountain road, but this time in a faster car.”—Neil Barofsky, TARP investigator

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

INDU: -1.0%
SPX: -1.6%
COMPQ: -2.6%
RUT: -2.4%

For the third consecutive January the market closed down, with the S&P 500 declining by 3.7% for the month and the NASDAQ down 5.4%. Will the January Barometer kick in or is it just another indicator which has lost its predictive ability? The barometer says that if the market is up in January, the market will be up for the year, and vice versa. The indicator has been wrong only six times in the past 60 years, including a horrific miss in 2009.

The market broke through the technical support level of 1085 this week, and now technicians are now looking at 1030-1035 for the next level of support, down another 5%. Based upon the internal action in the market, the real question is whether the outperformance of late cycle and defensive stocks (healthcare, consumer staples, etc) and the underperformance of early cyclicals is because the market is anticipating a peak in economic growth or if investors are just getting conservative in coordination with the market correction. After a huge run by cyclical stocks in 2009, the recent action could also just be a valuation re-adjustment favoring the defensive stocks.

The common theme amongst investment performance during this correction has been an unwinding of the risk trade. Risky assets-technology, emerging markets, small cap, and cyclicals-have traded off while traditional “safe” assets-treasuries, defensive stocks, and the dollar-have held up better. The VIX has spiked from a recent low of 17.6 to 24.7, an increase of 40%. While still well below the all time high of 81 achieved in November 2008, the recent increase comes as investor confidence wanes and stocks falter. Portfolio insurance costs have been rising along with the increase in the VIX as option prices increase with higher volatility.


Actual Consensus Prior
Existing Home Sales 5.45mil 5.90mil 6.54mil
Case-Shiller Home Price Index -5.3% -5.0% -7.3%
Consumer Confidence 55.9 53.5 53.6
New Home Sales 342K 366K 370K
Initial Claims 470K 450K 478K
Continuing Claims 4602K 4593K 4659K
Durable Orders 0.3% 2.0% -0.4%
GDP-Advance 5.7% 4.7% 2.2%
Chain Deflator 0.6% 1.3% 0.4%
UofM Sentiment 74.4 73.0 72.8

The big economic news during the week was the preliminary GDP report, coming in at 5.7% versus the consensus of 4.7%. The market rose initially on the report, then reversed and continued its downturn. A majority of the increase was due to an increase in inventories, which added roughly 3.4% to the measure. Remember this is a preliminary release and the preliminary GDP results for the past few quarters have been revised down significantly in subsequent revisions.

Durable goods orders missed consensus, coming in at 0.3% versus the consensus of 2.0%. The data was all over the board as non-defense aircraft orders declined almost 40% in December after a similar fall in November. Overall orders were up 1.3% excluding the non-defense aircraft orders after a 3% rise in November.

New single-family home sales in December missed the consensus, falling 7.6% to a 342K. Consensus had expected them to increase 3.0% to 366K. Cold weather hindered sales in the Midwest as they fell 41.1%.

On a positive housing note, the inventory of unsold new homes fell again, down 1.7% in December. This equates to a 34.0% y/y decline and represents an 8.1 month supply, excluding the much publicized shadow inventory. New home prices rose 5.2% not seasonally adjusted and 3.2% seasonally adjusted.

A sharp drop in the sale of existing homes during December fueled fear that the housing recovery is faltering. From November to December, seasonally adjusted sales plummeted 16.7%, the National Association of Realtors said. It marked the biggest decline since the group started collecting the data 42 years ago. Mark Zandi, chief economist at Moody's Economy.com, said the statistic highlights the point that "the housing market is on government life support.”

Credit Conditions

The yield on one month Treasury bills turned negative for the first time since March 2009. As the risk trade unwinds during this correction, the negative yield is an outgrowth of a flight to quality.

Sovereign Debt Issues Spread to Japan

According to the Wall Street Journal, investors have been questioning the sustainability of Japan's debt for months, but Standard & Poor's issued its first formal declaration of concern Tuesday. The credit rating agency threatened to downgrade the debt of Japan unless authorities can bolster the economy while curtailing public spending. "It's a warning shot across the bows of the Japanese government. They may or may not pay attention; what is clear is that they can't spend money at will," said John Vail, chief global strategist at Nikko Asset Management.

You would think that S&P would have learned its lessons during the credit crisis when they missed the opportunity to downgrade a myriad of investments before they imploded. Unfortunately they continue to be late to the party, and investors continue to mistakenly rely upon the credit rating agencies.

As the great sportswriter Blackie Sherrod once said “history must repeat itself because we pay such little attention to it the first time.”

Bye-Bye Timmy
The witch hunt continued for Tim Geithner (my apologies to any witches out there insulted by the comparison to Tim Geithner), who continues to say he played no role in the AIG disclosure decisions. He made these claims yet continued to defend the decision to give over $180 billion to the company. The level of detail he was able to recall in describing the bailout makes it highly unlikely he wasn’t involved in the questionable portions of the company’s bailout.

Amazingly, when the illegal decisions were made, he claims he was suddenly not involved. To me (and most observers), it seems highly unlikely he wasn’t involved in every detail. Remember, this is someone whose ego is so big that he felt he wasn’t obligated to pay taxes despite holding a government position.

Relating to payments made to Societe Generale, Graham Fisher’s Josh Rosner, whom we have quoted quite often, said “It appears officials at the New York Fed deceived or even lied to the inspector general regarding the French regulator’s position.”

The New York Times is reporting that according to documents they have obtained, in the weeks that followed the U.S. government's bailout of AIG, two Federal Reserve governors thought allowing the insurer's trading partners to keep $30 billion they had received from AIG would amount to a "gift" to the banks. Despite the concern, the Fed allowed AIG's trading partners, including Goldman Sachs and Societe Generale, to keep the money.

Let’s face it, Tim Geithner is a proven tax cheat, probably a liar, marginally competent, and is certainly compromised. He will be the first to go when the Obama administration takes steps to distance itself once again from the financial crisis.

Toyota Motor told its approximately 1,200 dealers in the U.S. to stop selling eight models covered by a recall for a defective gas pedal. The instruction includes certain Corolla and Camry vehicles, which are top sellers for the company. Toyota said production lines in the U.S. and Canada that make the cars will be shut down Monday.

Helicopter Ben Retains his Wings

Last week I discussed the pending vote to approve the reappointment of Federal Reserve Chairman Bernanke. While I haven’t supported Mr. Bernanke, I stated it would be prudent to re-elect him without a well vetted replacement ready to go. Mr. Bernanke was approved by the Senate 70-30, which was the lowest percentage approval of any Federal Reserve Chairman.

The U.S. Senate may have backed Mr. Bernanke, but he continues to face significant challenges. Bernanke's political standing has taken a beating during the past several weeks, which might make it more difficult for him to defend the central bank and maintain its independence. Fed officials "are going to be fighting a rear-guard action against congressional encroachment and interference," said Martin Barnes, managing editor of BCA Research.

If the Fed loses its independence, look out! Interest rates will soar and Congressmen will be licking their chops to push the Fed into doing their dirty work.

We really need Paul Volker right now. Let’s hope his rekindled influence is far-reaching.

Earnings continued to come in strong, with 75% of reporting companies beating earnings estimates, and more impressively roughly 65% of companies having exceeded estimated revenues. Leaders include Amazon, Microsoft, and Netflix. A notable miss from Qualcomm rocked that stock during the week.

Asset Allocation

Jeremy Grantham of GMO just issued his 10 year asset class forecast. His forecast for the prior decade was extremely accurate, and given Jeremy’s outstanding track record, his newest 10 year forecast deserves attention. Jeremy utilizes both relative valuation and reversion to the mean, among other factors, in generating his forecasts. The forecast, in order of preference, for the next 10 years:

1. US High Quality
2. International Large Cap Equity
3. International Small Cap
4. Emerging Market Equities
5. Emerging Market Bonds
6. US Equities, Large Cap
7. US Government Bonds
8. Bonds-TIPS
9. US Small Cap
10. International Government Bonds
11. US treasuries (up to 2 years)

Federal Deficit
The U.S. deficit for 2010 is expected to be $1.35 trillion, only slightly less than last year's $1.4 trillion, the Congressional Budget Office said. The CBO projected that next year's deficit will come close to $1 trillion. According to Bloomberg, President Obama is expected to release his budget plan tomorrow, with expectations of a $1.6 trillion deficit this year. His overall budget comes in at a whopping $3.8 trillion.

The President is still committed to cutting the deficit in half, to $650 billion, by the end of his first term.

Across the globe Central Banks and governments are looking at reducing stimulus. President Obama announced his intention to freeze about 20% of government program spending (BTW-that’s a 20% cut on $455 billion of the $3.6 trillion budget). The Bank of Canada and the Canadian government look set to start withdrawing some of their fiscal stimulus in the March federal budget. The ECB is talking about starting to reduce its economic stimulus measures by mid-2010.

“It’s going to be very interesting to see how the global economy performs without the government lifeline that has pumped over $2 trillion of government stimulus into the world economy since 2008”, said David Rosenberg.

Anticipation of this pullback in stimulus could be the main reason defensive stocks have begun outperforming cyclical stocks and may be answering the question of what will happened when the easy money goes away!

FOMC Meeting and Real Estate

The Federal Reserve voted to keep interest rates near zero at its meeting last week, and restated its intention to cease buying mortgage-backed securities in March.

At the same time, “the Committee will continue to evaluate its purchases of securities in light of the evolving economic outlook and conditions in financial markets,” the statement read.

Policy makers are keeping interest rates “exceptionally low” for an “extended period” as they wind down the record amounts of credit they have provided since the bankruptcy of Lehman Brothers in 2008.

Kansas City Fed President Thomas Hoenig dissented, saying “financial conditions had changed sufficiently that the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted.”

The Fed also repeated that it will close four facilities supporting money markets and bond dealers in February, as well as dollar swap programs with central banks in Europe and Asia. The central bank is “prepared to modify these plans if necessary to support financial stability and economic growth,” the statement said. The Fed also said it is winding down the Term Auction Facility and will hold a final auction on March 8.

Bernanke is looking for signs that the return to economic growth is generating jobs and is accompanied by an increase in credit to people and businesses. The U.S. unemployment rate held at 10% in December, while consumer credit dropped a record $17.5 billion in November. “Household spending is expanding at a moderate rate, but remains constrained by a weak labor market, modest income growth, lower housing wealth, and tight credit,” the Fed said in its statement. Businesses “remain reluctant to add to payrolls.”

The upcoming week features more earnings, plus key economic releases including the ISM, personal income, construction spending, and of course unemployment and nonfarm payrolls. The last two are amongst the most important as the government has done all it can to stimulate the economy, with jobs the last and most stubborn to respond. Should hiring begin to kick in, and we’re not talking about just reductions in the unemployment rate due to people ending their job search but actual job creation, then this recovery could sustain itself. Without job growth, watch out for a double dip recession that will have nasty consequences.

Have a great week.


“While one person hesitates because he feels inferior, the other is busy making mistakes and becoming superior.”—Henry Link, Industrial Psychologist

Jan 24, 2010

Bravo, Mr. Obama

Bravo, Mr. Obama!

January 25, 2010

“My choice in life was either to be a piano player in a whorehouse or a politician. And to tell the truth, there’s hardly any difference.”—Harry S. Truman

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

INDU: -4.1%
SPX: -3.9%
COMPQ: -3.6%
RUT: -3.3%

I have been accused of many things since I began writing this note, but I still laugh about the email that criticized me for being a capitalist. Hello, McFly! That’s the point! So why, you may ask, am I using the title of this week’s note to applaud the most anti-capitalist President any of us has seen in our investing lifetimes? Because he’s at least giving lip service to a regulation that actually make sense. I’ve been around the block enough to know that a) this President is a populist and he’ll say anything to the public he feels will help his opinion polls and b) announcing an idea (which wasn’t even his, it belongs to Mr. Paul Volker) is a far cry from enacting legislation. What did the gifted oracle from Illinois say to earn my praise? He spoke this past week of separating banking and other risky behaviors such as proprietary trading, hedge funds, and private equity. I’ve long called for a repeal of the Gramm-Leach Bliley act of 1999, which stupidly repealed the key portions of Glass-Steagall. While the President’s commentary falls short of repealing the handiwork of Senator Phil Gramm (you may remember him as Senator McCain’s crack economic advisor who felt the recession was all in people’s heads), it will be a step in the right direction if they can get it past the TARP funded lobbyists in DC.

After a month of relatively boring market action this past week finally had its share of drama. Coming off the MLK holiday the market suffered steep declines and, lo and behold, the big volume increases that market observers have desired. The President’s comments were credited by a few irresponsible publications with triggering the downturn, however lending related comments from China, mixed to weak economic data, and a market that has bounced some 70% from its March lows were more than likely bigger contributors to the correction. We discussed China last week, but as a reminder they plan to increase their monitoring of banks and have “advised” banks not to exceed loan limits to ensure their economy or housing market don’t overheat. Evidently enough to trip up this market.

The entire carry-trade looks like it began to unwind last week. There was a flight to quality (at least quality as defined before this crisis) as treasuries and the dollar rallied during the week. Losers included commodities, risky assets including US and emerging market stocks, and gold.

A final concern undoubtedly impacting the market is the status of Fed Chairman Ben Bernanke. Theoretically this will be Mr. Bernanke’s last week in office as his term expires January 31. He faces a Senate confirmation vote next week, which has become ever more contentious as politicians have learned that bankers, even central bankers, make easy cannon fodder. A handful of Democrats have announced their opposition to confirming the Chairman for a second term. The Chairman needs 60 votes to retain his position, which means some Republicans will have to throw their support behind Helicopter Ben to keep him in office. Personally I’m not a fan of Mr. Bernanke’s, however; I’d like to see who a viable candidate might be before supporting the decision to block his confirmation. I wonder if Mr. Volcker would consider a return to the role?


Actual Consensus Prior
Building Permits 653K 580K 589K
Housing Starts 557K 572K 580K
Core PPI 0.0% 0.1% 0.5%
PPI 0.2% 0.0% 1.8%
Initial Claims 482K 440K 446K
Continuing Claims 4599K 4598K 4617K
Leading Indicators 1.1% 0.7% 1.0%
Philadelphia Fed 15.2 18.0 22.5

Housing starts came in below consensus while building permits were above consensus. The measures have been bouncing around for the past 7-8 months, possibly attempting to find a bottom. As we have discussed in the past, another leg down seems likely, although it hinges significantly on the Fed’s plans with their MBS program, which expires at the end of March. The weakness in starts was focused in single family starts; however, permits rose to the highest level since September 2008. This is mixed news as inventory is still running high; however, the builds should help GDP.

The Leading Economic Indicators for December came in above consensus, however, much of the rise is being attributed to a one time administrative problem in processing the December jobless claims. Based on the big jump in this week’s number it looks like the data has caught up with reality.

Reported jobs data is continuing to benefit from people giving up looking for work. According to the Orange County Register, the County’s unemployment rate dropped from 9.6% to 9.1% as 11.1K people stopped looking for work versus 600 new hires.

Sixteen states now have unemployment rates exceeding 10%.

41st Republican
Edward Kennedy was the Senator from Massachusetts for longer than I’ve been alive, and most Dems felt the seat actually belonged to the late Senator. During the recently concluded election to replace Senator Kennedy, Democratic candidate Martha Coakley made the mistake of referring to the seat as “Senator Kennedy’s” during a debate, and Republican Candidate Scott Brown pounced on the opening, declaring the “seat belongs to the people of Massachusetts.” Mr. Brown, the former centerfold, is now the 41st Republican Senator, which breaks the Democrats filibuster-proof stranglehold on the Senate.

As I’ve written and proven in the past, gridlock in Washington DC is good for business and the stock market. This upset, in the face of heavy partisan support from both the sitting President and the former President (you know, the one married to a current cabinet member), shows that the people, while generally gullible, recognize that single party control is akin to sleeping with the devil, albeit without the benefits. Hopefully this will provide some sanity in DC and we can say goodbye to this monstrosity known as health-care reform and some of the other ridiculous, anti-business and anti-taxpayer legislation floating around our nation’s capital.

As I mentioned earlier, health care stocks again led the market this week, partially helped by Mr. Brown’s election.

Finally Some Common Sense from DC!!

Earlier we mentioned the President’s proposal to limit proprietary trading, etc, by firms receiving government guarantees. While this is a very populist proposal, and will no doubt lead to more banker bashing as the Dems attempt to reverse their slide in popularity (bankers have a lower public opinion rating than Congress), there could be many unforeseen consequences of any legislation-and these will be the ones that concern us. The financial services industry spends more on lobbyists than any other industry, and, let’s faces it, have outsmarted the guys in DC for decades.

Once again, let’s credit Mr. Volcker and the Group of Thirty with this concept. A year ago, Mr. Volcker issued a report from the Group of Thirty, a panel of former central bankers, finance ministers and academics, calling for separation between commercial banks and businesses that engage in speculative risk-taking such as hedge funds and proprietary trading. “The point is that they present added risk and virtually unmanageable conflicts of interest with more essential customer relationships,” Volcker said.

As a fund manager I favor regulations that restrict those firms with which I do business from also competing against me, all the while benefiting from a cheaper source of capital and a government backstop.

China vs. Hillary
China sharply criticized comments by Secretary of State Hillary Clinton on the issue of Internet freedom, saying they had "harmed U.S.-China relations."

"We urge the U.S. side to respect the facts, and stop using the so-called 'Internet freedom' issue to make groundless charges against China," foreign ministry spokesman Ma Zhaoxu said in a statement posted on the ministry's Web site.

On Thursday, Clinton said in a speech that the U.S. and China "have different views" on the issue of Internet freedom, and that "we intend to address those differences candidly and consistently. Countries that restrict free access to information or violate the basic rights of Internet users risk walling themselves off from the progress of the next century," Clinton said.

So much for the improved image of the US in international communities. Can anyone say “Axis of Evil”?

Keep Spending Like a Drunken Sailor and You Might be Viewed as one

Dow Jones reported that Senate Democrats are seeking an increase to the federal government's borrowing limit by $1.9 trillion, raising the total US debt to $14.3 trillion. The borrowing hike comes fast on the heels of a $290 billion increase to the debt ceiling agreed to by lawmakers at the end of 2009.

Credit Spreads

Credit spreads widened by 6 bps in the later half of the week as investors started moving away from riskier assets. Six bps is actually a very large move on a spread, the largest since late in the fall. Emerging market bonds also fell during the week and credit default swaps (bets that companies will be unable to pay their debt) rose.


Bloomberg reported this week that US banking supervisors haven’t been waiting for new regulations, but instead are using EXISITING AUTHORITY to raise standards for capital, liquidity and risk management. They are contemplating raising capital requirements to offset the risk of trading losses.

As I have maintained since this crisis began, we don’t need a ton of new regulation, just someone with enough political will to enforce the existing regulations.

Stock Focus
I had a lot of calls and emails after last week’s note about positioning given my concerns about a correction. I typically don’t discuss specific positions unless they are ETF’s, long short positioning, or sector calls. On Tuesday I purchased the QID, which is an ETF that is double short the NASDAQ 100. I positioned roughly 20% of my portfolio here as a way to offset a net long position that had grown too large over the past four months.

Earning reports began flying in this week, and while there hasn’t been discernable trend yet, few stocks were able to overcome the market weakness and close up on the week, regardless of their earnings report.

Companies beating numbers included Google, Starbucks, Skyworks, Xilinx, eBay, F-5 Networks, Panera Bread, Seagate Technology, American Express, and General Electric.

Political Spending
Corporations have been restricted for 100 years from directly spending in political campaigns, however, the Supreme Court this week struck down that restriction. Corporations are now able to spend an unlimited amount of capital to help elect or defeat federal candidates. Labor unions may also spend more. Both of these groups will gain political power at the expense of individual voters.

This may have a long term impact on Congress, which during my lifetime has primarily been an “anti-business” political body. Additionally, this ruling could impact the lobbying industry, which relies upon corporate funding. Laura Martin, media analyst at Needham, thinks all ad driven companies will benefit, especially CBS.

President Obama, who obviously was not happy with the decision because it reduces his internet based fundraising advantage, announced that he would work with Congress to enact “a forceful response” to the ruling.

Forceful? Is he going to bomb the Supreme Court?

It’s not Different This Time Because It’s the Same People

According to a report by Professor Emma Coleman Jordan of the Georgetown University Law Center one simple issue might help to explain why change has been so elusive at the bailed out banks: Their people.

Jordan notes that the folks who run the major banks today, the senior executives, directors, managers, etc, are essentially the same people who ran them (into the ground) 5 and 10 years ago:

“The prospects for a robust prudently guided financial sector have been substantially clouded by the fact that both the corporate governance structure and the executive leadership of the financial sector remain largely unchanged—92% of the management and directors of the top 17 recipients of TARP funds are still in office.”

Thanks to the Big Picture for this.

Real Estate and the FHA
The Washington Post is reporting that in an effort to bolster its increasingly shaky financial condition, the FHA plans to require a bigger down payment from some borrowers, increase the fee for mortgage insurance, and restrict the amount sellers can contribute to closing costs. For many buyers, the down payment would continue to be as little as 3.5%, but borrowers with a low credit score would be required to pay at least 10%. The insurance premium paid at closing would rise from 1.75% to 2.25% of the loan value.

It still seems a bit irresponsible to me that the FHA’s mission has been to allow borrowers with the weakest credit, and therefore the highest probability of default, to take on the most leverage.

Credit Cycle Improvement

Bank of America, Wells Fargo and other U.S. banks reported fourth-quarter results that show losses on consumer loans are beginning to moderate. Bank executives said they expect the turnaround to continue this year but cautioned that slow economic growth and high unemployment will continue to pressure consumers. "We are encouraged by signs the economy is improving," said Brian Moynihan, CEO of Bank of America. "[But] economic conditions remain fragile, and we expect high unemployment levels to continue."

Word from the Wise
Former Senator and Presidential Candidate Paul Tsongas once said “If anyone believes the words ‘government’ and ‘efficiency’ belong in the same sentence, we have counseling available.”

After proof reading this week’s note I realize that there was a lot of political noise this week. I don’t seek it out; it just seems to find me. I try to only discuss the political issues that impact the market, and of course those which continue to demonstrate the sheer stupidity and corruption of our political system, or should I say those who inhabit it.

Have a great week.


“The baleful reality is that the big banks, the freakish offspring of the Fed’s easy money, are dangerous institutions, deeply embedded in a bull market culture of entitlement and greed.”--David Stockman, former director of OMB.

Last week I published a chart from www.chartoftheday.com, and didn't properly provide the link to their website.

Jan 18, 2010

Intel, Alcoa and China-An Interesting Trio

Intel, Alcoa and China-An Interesting Trio

January 18, 2010

“The crowd is always wrong at market turning points, but often times right once a trend sets in. The reason many market fighters go broke is they believe the crowd is always wrong. There is nothing further from the truth. Unless volatility is extremely low or very high, one should think twice before betting against the crowd.”—Shawn Andrew

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

INDU: -0.1%
SPX: -0.8%
COMPQ: -1.3%
RUT: -1.0%

After slogging along during the early part of the week, the market corrected hard on Friday. The market closed down for the week, the first loss of the New Year. Defensive sectors definitely outperformed as healthcare, utilities and consumer staples were the only groups showing gains on the week. The laggards included telecom, materials and energy.

Alcoa (see Earnings section below) reported weak earnings during the week as did video game maker Electronic Arts and oil and gas giant Chevron. Policy tightening in China (see China section below) created the backdrop for the weaker market performance last week. It’s ironic that China, not the US, is taking the global lead via policies designed to stem inflation.

The chart below, courtesy of Bespoke Investment Group, shows the cumulative breadth of the S&P 500 over the last six months. What is the significance of the A/D line? This measure is used to determine whether stock prices and breadth are moving together. While volume (another indicator of market conviction) has been light during the first few weeks of January and over the holidays, the A/D line still supports the recent rally.


Actual Consensus Prior
Trade Balance -$36.4 bil -$34.6 bil -$33.2 bil
Initial Claims 444K 437K 433K
Continuing Claims 4596K 4750K 4807K
Retail Sales -0.3% 0.5% 1.8%
Retail Sales ex-autos -0.2% 0.3% 1.9%
Core CPI 0.1% 0.1% 0.0%
CPI 0.1% 0.2% 0.4%
Capacity Utilization 72.0% 71.8% 71.5%
Industrial Production 0.6% 0.6% 0.6%
UOM Consumer Sent 72.8 74.0 72.5

The November trade deficit widened to $36.4b, above expectations of $34.6b. Exports rose 0.9%, but imports grew faster at 2.6%. Oil imports rose by 2.3% as the nearly 100% increase in energy prices over the past year begins to have an impact. Exports have now risen for a 7th straight month. According to Peter Boockvar, the higher than expected deficit will lead to a reduction in Q4 GDP estimates of 0.1-0.2%.

CPI for December showed inflation remains benign, with headline price growth slowing to 0.1% from 0.4%. Housing prices, by way of owners’ equivalent rent, continue to create downward pressure on this measure of inflation. An interesting fall out from Cash for Clunkers is the rise in used car pricing of nearly 12% since July, primarily attributable to a lack of supply. Year over year CPI increased by 2.7%, primarily driven by energy costs.

December Retail Sales
Expectations of a 0.5% increase proved to be too optimistic as sales declined by 0.3% in December vs. November, the worst drop on record. November and December combined (the holiday season) were up slightly, 1.1% according to the National Retail Federation. For the full year 2009 sales dropped 6.2%.

As the global population now approaches 7 billion, and is growing by 80 million per year to and estimated 9 billion in 2046, our investing attention should be focused on those areas where shortages of basic products will arise. While its true global penetration of iPhones remains low, we feel that food and water are two areas deserving further focus. Today roughly 70% of available water is being used in food production, and that is rising on a per capita basis as beef consumption rises. At the current pace of consumption there won’t be enough fresh water globally by the end of this decade. Conservation, desalinization, crop enhancement, and more efficient land utilization all represent viable investment opportunities.

An example of a new technology being applied to an existing field was recently announced. Researchers at Adelaide University have been genetically engineering crops to enhance their ability to prevent saline buildup in their leaves. While only being utilized in the lab today, the hope is to soon port this technology over to cereal crops such as wheat and rice. While it is doubtful these crops could grow in salt-water, they have the potential to grow in abandoned lands thought to be fallow, raising overall land utilization.

Opportunities in Health Care
We have discussed extensively the health care bill and its downside, but what about the upside? It appears that the bill, if it passes, will be very watered down from either of the two existing versions. The House and Senate can’t seem to agree on a number of key issues, and with the potential loss of a super-majority in the Senate as the battle for Ted Kennedy’s open seat tightens, healthcare compromise may occur quickly.

The upside is that healthcare stocks, which have lagged the market bounce partially due to the uncertainty surrounding passage of this bill, might actually have some upside if the worst case scenario with health care legislation doesn’t occur.


China unexpectedly raised the proportion of deposits that banks must set aside as reserves to cool their economic growth. Officials fear a developing credit boom threatens to stoke inflation and create asset bubbles.
Beginning today (January 18th) reserve requirements will increase by 50 basis points. The existing level for big banks is 15.5%, 13.5% for smaller, rural banks.

China's government also issued orders to its departments and local governments to slow down rapidly increasing real estate prices. "With the recovery of the real estate market, such problems as excessively rising house prices have recently emerged in some cities, which call for great attention," according to the General Office of the State Council, the Chinese Cabinet. The country will keep a close watch on capital flow to "stop overseas speculative funds from jeopardizing China's property market," the Cabinet said.

Note that the last time China raised its reserve ratio was June 2008 as commodity prices skyrocketed.

U.S. President Barack Obama announced a plan to levy a fee on about 50 financial institutions to raise between $90 and $120 billion. The money would be used to cover the cost of TARP and reduce the federal deficit. The President said the levy is not a punishment but rather a way to prevent excesses. Investment banks would be hit harder than commercial banks because the fee would not be levied on insured deposits as it would on other liabilities.

“Clearly this is designed as a political measure,” said Roberton Williams, an economist for the Tax Policy Center, a Washington-based research group run jointly by the Urban Institute and Brookings Institution.

A weak earnings report from Alcoa started the week and caused weakness in the economically sensitive sectors. Intel posted strong revenue and earnings on better than anticipated PC growth, but inventories and lead times were up, which could signal peaking margins. The stock traded down the day after the call.

Fiscal Imprudence
President Obama will put cutting the budget deficit on the back burner to help Americans get back to work, said Christina Romer, chairwoman of the White House Council of Economic Advisers. "We are talking about actions right now to jump-start job creation," she said. "You don't get your budget deficit under control at a 10% unemployment rate."

My guess is that there will never be the “right time” to get your budget deficit in order while this Administration is in power. Of course, the last two administrations are guilty of the same sin.

Finding a Way to Make a Buck

Hedge funds are loaning record amounts of money to unprofitable and bankrupt companies, according to HedgeFund.net. Banks have been avoiding financing companies in distress, creating an opening for hedge funds.

Some hedge funds and other nonbank lenders charge interest rates as high as 19% in this mostly unregulated corner of the debt market, according to a survey by Pepperdine University’s Graziadio School of Business and Management. Firms also layer on fees, including costs as high as 12% of the loan for monitoring the value of a borrower’s collateral assets, according to the survey. Some lenders demand closing charges of up to 4%.

Funds exclusively devoted to lending reaped returns that outpaced the hedge fund industry index for six of the eight years from 2001 to 2008, according to HedgeFund.net. .

Do as I say, not as I do

The SEC filed another lawsuit against Bank of America, saying shareholders were kept in the dark about huge losses at Merrill Lynch when the bank took over the firm. The SEC sued again after a judge refused to let it add charges to an existing lawsuit against the bank.

Remember, this is the same SEC which allowed AIG to skirt securities laws regarding disclosure and avoid reporting how $100 billion or so in government aid was used.

I’ve said it before, but people in glass houses just shouldn’t.

The Not-So-Golden State

S&P lowered its rating on California's $64 billion in general-obligation debt from A to A-minus and assigned it a "negative" outlook. The firm said it is worried that the state will run out of cash if California's "revenue and spending trajectories continue."

According to the CME Group, California is now ranked in the Top 10 of sovereign debtors likely to default. Greece is #9.

Real Estate

According to RealtyTrac, A total of 2,824,674 U.S. properties received a foreclosure filing in 2009, a 21% increase in total properties from 2008 and a 120% increase in total properties from 2007.

According to The Big Picture, from September 5, 2008 forward (the day the GSEs were put into conservatorship) the U.S. Government is likely to spend more money bailing out Fannie Mae (FNM) and Freddie Mac (FRE) than they have on the Iraq and Afghanistan Wars combined!

Earnings season is here, and will be a key to maintaining the torrid rise of the market. The market is anticipating strong EPS growth throughout 2010, without which we could experience a serious correction. In spite of the much anticipated “correction”, it is certainly beginning to feel as though the “pain” in the market is now to the downside.

Have a great week.


“Mann traoch, Gott Lauch” which means “Man plans, God laughs.”-- Old Yiddish expression

Jan 11, 2010

2010: One Week Down, 51 to Go

2010: One Week Down, 51 to Go

January 11, 2010

"We have the most potentially inflationary policy I have ever observed in a developed country," said Alan Meltzer, Fed historian.

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

INDU: 1.8%
SPX: 2.7%
COMPQ: 2.1%
RUT: 3.1%

The markets started the year with a robust opening rally, albeit on light volume. Sentiment is at an extreme (see AAII chart below), the highest level since October 2007 when the S&P 500 peaked. Extremes in sentiment seem to typically precede corrections, although I haven’t seen any statistical analysis showing that there is a strong correlation between the two. My concern with waiting for a correction is that apparently the consensus is also looking for a correction. Remember what Bob Farrell from Merrill once said “When all the experts and forecasts agree – something else is going to happen.”

Market action was tilted towards economically sensitive groups as basic materials, energy, industrials and financials led the S&P 500. The lagging groups were telecommunications, utilities, and technology. Earnings reports won’t begin in earnest for a few weeks, with the exception of pre-announcements. In the meantime, barring any unusual events (think terrorist attacks, Treasury Secretary resignations, etc) speculation about the economy, trade shows and investment conferences will dominate the market news.


Actual Consensus Prior
ISM Index 55.9 55.3 53.6
Factor Orders 1.1% 0.5% 0.8%
Construction Spending -0.6% -0.5% -0.5%
ISM Services 50.1 50.5 48.7
Initial Claims 434K 439K 433K
Continuing Claims 4802K 4975K 4981K
Average Workweek 33.2 33.2 33.2
Nonfarm Payrolls -85K 0K 4K
Unemployment Rate 10.0% 10.0% 10.0%
Wholesale Inventories 1.5% -0.3% 0.6%
Consumer Credit -$17.5bil -$5.0bil -$4.2bil

The U.S. unexpectedly lost 85,000 jobs in December, supporting Federal Reserve forecasts that a labor market recovery will take time. Payrolls fell last month after a revision showed a gain of 4,000 in November, the first gain in almost two years. Payrolls in construction dropped almost twice as much in December as a month earlier. Manufacturing shed the fewest jobs last month since December 2007.

Wholesale inventories rose in November. This is important because inventories are a key in measuring the recovery. Inventories in November rose 1.5% vs. expectations of a decline of .3%; October was revised up from 0.3% to 0.6%. Unless final demand picks up in a sustainable way, an inventory led recovery will just be temporary.

Consumer credit fell by a greater than expected $17.5 billion in November vs. an expected decline of $5 billion and follows a revised $4.2 billion decline in October. It is the 13th month of the last 14 that has seen a reduction and is the biggest monthly drop ever! Total consumer credit outstanding now stands at $2.464 trillion, the lowest since July ‘07 and has fallen $117 billion from the record high in July ‘08. As the consumer continues to de-lever, the government continues to lever in an effort to ease the landing.

Discussions are shifting in the healthcare debate as the House and Senate attempt to hammer out the variations in their two bills. How to pay for the 10-year legislation, whose price tag topped $1 trillion in the House, may be the biggest fight. Either way, despite the assurances of everyone involved, this plan is going to be expensive. The Senate plan calls for a 40% tax on the high-end, employer-provided insurance plans. The House wants a 5.4% surtax on couples earning at least $1 million. Unions are against the Senate plan since their generous plans typically would trigger the tax.


Last week Gluskin Sheff put out the chart below looking at employment in a different manner. The chart shows the percentage of people employed versus the total population going back to 1984. For the first time the measure has fallen below 60%, to 58%. This comes at a time when population growth has slowed.

The enlightened must be happy that we are looking more and more like a European country every day.

More Employment
We all know how poor this decade has been for job creation. The chart below, courtesy of chartoftheday.com, shows just how bad the Zeroes were for job creation, the first decade on record where job growth was less than 20%. I’m sure the 30’s were just as bad, if not worse, but unfortunately reliable (I know, please no jokes) economic records don’t exist for that time period.

Retail Sales
According to research firm ShopperTrak, foot traffic in retail stores fell slightly and total spending rose a healthy 8.8% during Christmas week in the U.S. The increase came in spite of a severe storm in the Northeast which led to disappointing sales the Saturday before Christmas. "As expected, pent-up demand following the snowstorm on Super Saturday pushed consumers to spend heavily last week," said Bill Martin, co-founder of ShopperTrak.

According to CommScore, a 5% increase in online spending during the holidays brings with it a mixed message. Between Nov. 1 and Christmas Eve, U.S. consumers spent $27.1 billion on the internet, compared with $26.8 billion in the same period last year. But the amount in 2008 was down 3% from that of 2007. In addition, this year's per-person spending was less than last year's. "Online sales growth this year was driven by a continued increase in the number of people buying online," said Gian Fulgoni, ComScore's chairman.

According to Barron’s, 75% of retailers beat estimates during the holiday selling season. We won’t get all of the details until the companies report in late February. Most retailers keep a fiscal year end of January 31st.

Munis Galore
According to Thomson Reuters, in 2009 U.S. municipalities sold $409 billion in debt, the second-heaviest year ever. Several factors contributed to the sales, including investors' willingness to own bonds with some risk of default and lack of liquidity. The Federal Reserve's policy of low interest rates also likely drove investors into bonds as they yielded more than bank deposits and money-market funds. However, the Build America Bonds program is seen as the biggest contributor to the surge.

Corporate Issuance
Municipal issuers aren’t the only ones actively issuing debt. After a record 2009 for bond issuance, US corporations issued over $50 billion in new debt just last week.

I guess they’re trying to get deals done before the Fed comes to auction this week.

Commercial Real Estate

According to Trepp, commercial mortgages delinquent 30 days or more shot up to 6.1% last month, the highest rate since commercial mortgage-backed securities were first marketed. The rate for November was 5.7%. By the end of 2010, the rate of delinquent commercial mortgages likely will be in the range of 9% to 14%, according to Jefferies.

More Commercial Real Estate
Echoing what we have been saying in this note for the past 15 months, U.S. bank examiners concluded that losses on commercial real estate loans pose the biggest risk to U.S. banks this year, impacting smaller lenders more significantly. According to Bloomberg, regional banks are almost four times more concentrated in commercial property loans than the nation’s biggest lenders.

The failure of loans backing malls, hotels and apartments may impede the U.S. recovery as small- and medium-sized banks reduce lending and conserve capital to absorb losses. Tight credit could slow the cycle of investment and hiring required for sustained economic growth.

The default rate on commercial mortgages held by U.S. banks more than doubled to 3.4% in the third quarter, according to Real Estate Econometrics. Default rates in the first three quarters of 2009 have been the highest since 1993.

Interior Secretary Ken Salazar is expected to announce that his agency will require oil and natural-gas companies to clear more regulatory hurdles before they are allowed to drill on federal lands. Mr. Salazar's action is likely to make it more difficult for the U.S. Bureau of Land Management to fast-track the permitting of oil and gas projects on federal land.

According to the AP, the BLM manages more than 260 million acres of federal land, which represents a significant chunk of U.S. energy supplies. Domestic production from federal onshore oil and gas wells accounts for 11% of U.S. natural-gas supplies and 5% of the nation's oil.

In a letter to Mr. Salazar last week, the Industrial Energy Consumers of America, a lobbying group that represents manufacturers, credited the 2005 law easing drilling restrictions with reducing drilling-permit backlogs and boosting natural-gas production. "At a time when we should be working to enhance our energy supplies here at home, we believe it would be a mistake to pursue policies that would make it more expensive or difficult to access critical natural-gas resources," the group said.

Spokesmen for the Interior Department declined to comment Tuesday, except to say that Mr. Salazar would hold a teleconference Wednesday to announce "several initiatives to reform the onshore oil and gas leasing program" administered by the BLM.

Compare this to China, which is dramatically ramping up its domestic refining capacity to eliminate reliance on foreign refining. Their goal is to create a surplus in capacity so that they can export to refining constrained countries such as the US.

Meanwhile here in California we are paying over $3 per gallon and the average gallon of gasoline in the US is $2.70, the highest level in 15 months. The all time record was $4.11 in the summer of 2008. I have seen estimates that an additional $.10 in gasoline prices hits the American consumer by $14 billion.

More on M3
Two weeks ago I showed a re-creation of the US M3, which estimated that annualized M3 growth had declined to zero. Now we see a similar trend in the Eurozone as their M3 surprisingly slipped in November. The European Central Bank said growth of the money supply in the Eurozone reversed course last month and turned negative, marking the first contraction on an annual basis. The M3 money supply declined 0.2% compared with November 2008. Many economists had expected a 0.4% increase.

Rosie-82 vs. 10
David Rosenberg, who has been and continues to be quite bearish, put out a table this week comparing August 1982 with 2009, arguing that 2009 isn’t the beginning of a new secular bull market but instead just another bear market rally. Here are some of the highlights.

1. Fed funds rate 18% and only one way to go (down) vs. 0% and only one way to go, up.
2. 10-year bond yield 15% and falling vs. 3.8% and rising
3. Monetary base $170 billion and rising vs. $2.2 trillion and stable to falling
4. Budget deficit-to-GDP ratio -3% and moving towards a surplus vs. -10% and steady or falling from here
5. Household debt-to-personal disposable income ratio 62% and rising vs. 123% and falling
6. Inflation rate 10% and falling vs. 0% and rising
7. Misery index at 16 and falling vs. 12 and rising
8. Labor force participation rate 64% and rising vs. 65% and falling
9. Tax rates (highest marginal) 69% and falling vs. 35% and rising
10. Union share of the job market 20% and falling vs. 12% and rising
11. Profit margins (room for expansion?) 6.0% vs. 10.0%
12. S&P 500 P/E ratio (1-year trailing) 8.0x vs. 20.0x
13. P/E ratio (10-year normalized in real terms) 7.0x vs. 23.0x
14. S&P 500 price-to-book ratio 1.0x vs. 2.2x
15. S&P 500 dividend yield 6.0% vs. 2.0%
16. Investor sentiment 10% bullish vs. 88% bullish
17. Baby boomer population Median age is 25, peak spending and investing years ahead (capital gains) vs. Median age is 52, retirement focus ahead (capital preservation)

The Usual Suspects
Recognize any of the suspects below? They’re being charged with mismanaging the economy, amongst other crimes.

The Fed’s Keeping the Pedal to the Metal

From Scott Lanman at Bloomberg:
“Federal Reserve officials last month debated increasing and extending asset purchases should the economy weaken, with a few favoring the move and one seeking a reduction, minutes of their last meeting showed. Policy makers also differed over whether risks are greater that inflation will speed up or slow down too much, the Fed’s Open Market Committee said. Some officials said “quite elevated” slack in the economy would damp prices, while others saw a risk of faster inflation from the Fed’s “extraordinary” stimulus. “

“To keep inflation expectations anchored, all participants agreed that monetary policy would need to be responsive to any significant improvement or worsening in the economic outlook and that the Federal Reserve would need to continue to clearly communicate its ability and intent to begin withdrawing monetary policy accommodation at the appropriate time and place,” the minutes said.

Policy makers in the Dec. 16 statement following their meeting said the labor market is stabilizing, while keeping a pledge to keep interest rates “exceptionally low” for an “extended period.” The Fed said most lending programs would expire as scheduled on Feb. 1 because of “improvements in the functioning of financial markets.”

One member said the Fed could reduce planned asset purchases because of improvement in financial markets and the economy, and “that it might become appropriate” to start reducing asset holdings “if the recovery gains strength over time,” according to the report. The Fed is buying $1.25 trillion of mortgage-backed securities issued by housing-finance companies Fannie Mae, Freddie Mac and federal agency Ginnie Mae.

Some officials said there was a risk that the end of Fed purchases and federal homebuyer tax credits may “undercut” improvements in the housing market. Under Bernanke, the Fed has cut interest rates almost to zero and pumped more than $1 trillion into the financial system to battle the worst recession since World War II.

Officials “generally thought the most likely outcome” was for economic growth to “gradually strengthen over the next two years,” helping reduce joblessness and slack. Still, the “weakness in labor markets continued to be an important concern,” the Fed said.

At the same time, Fed officials “noted that any tendency for dollar depreciation to put significant upward pressure on inflation would bear close watching,” the central bank said.

This week should give us a better view of investor appetite. Volume should begin picking up again as vacations end, bonuses are paid, and people reallocate for 2010.

Have a great week.


“One determined person can make a significant difference; a small group of determined people can change the course of history.”—Sonia Johnson,

Jan 5, 2010

2010-Goodbye to the Naughties

2010-Goodbye to the Naughties

January 4th, 2010

“If you could kick the person in the pants responsible for most of your trouble, you wouldn't sit for a month.”—Teddy Roosevelt

2010 percentage performance for the major indices
Based on last Friday’s official settlement...

INDU: 18.8%
SPX: 23.5%
COMPQ: 43.9%

I hope you had a wonderful holiday season. Ours was terrific, although I’m not sure having three kids home for 18 days is exactly my wife’s definition of a vacation. Thank goodness for sports camps!

After ten years of what can be viewed as a lost decade (think jobs, stock markets, GDP, housing, etc), someone finally coined a name for the decade that makes sense-The Naughties. What were some of the biggest events of the decade? How about two recessions, two burst bubbles, a near collapse in the financial markets, hanging chads, rolling blackouts, a war, social networking, a democratic takeover of Washington, bird and swine flu, reality TV, The Sopranos, blogging, privatized gains/socialized losses,
Tiger Woods, texting (and in Tiger’s case, sexting), steroids in baseball, and the iPod? By far the biggest event will remain September 11, 2001 when 3000 of our fellow citizens were cut down by terrorists. It certainly hasn’t been a boring decade.

Well, goodbye and good riddance to the Naughties, hello….Teens.

This week I’ll be departing a bit from the weekly norm to review my predictions for 2009 and discuss 2010.

Review of 2009 Predictions

In the January 4, 2009 note (http://weeklymarketnotes.blogspot.com) I laid out 12 predictions for 2009. Some turned out to be a bit weak, but nonetheless I am reviewing each of them below. You can go to the website to review them in their entirety.

1. Stock Market-I was looking for a range bound market for 2009, this was obviously incorrect. I had the first two breaks of the year correct, was accurate with adding to equities under 750 and going net long (the S&P bottomed at 666), but never got bullish enough as the market never looked back after hitting that low in March. I still think the market will resemble that of the 1970’s over the next couple of years, marked by powerful rallies and powerful declines. For now: wrong

2. Economy-I said the economy will be weak all year, but it will improve slightly. After posting negative GDP from Q308 until Q209, we had a slightly positive Q309, up 2.3%. Correct

3. Corporate Earnings-I missed here also, but need to add a disclaimer. I never anticipated that the accounting rules for financial services companies would change from mark-to-market to mark-to-imagination. This change resulted in a major surge in corporate earnings versus consensus, but will provide a challenge in 2010 in the guise of tougher comps during the back half of the year. I’m calling this a tie due to the accounting change.

4. Sports Predictions-
I hit two of the three on the screws. I picked the Lakers to win the NBA and the Angels to lose in the ALCS, both of which were correct. My miss was on USC, which for once wasn’t ripped off by the BCS. Correct

5. Inflation-I discussed inflation as a potential issue in 2010 and 2011, but stated that “for 2009 inflation will remain tame.” Correct

6. Dollar-I was very bearish on the dollar, especially after it had a big run in the back half of 2008. I suggested gold as a hedge against the declining dollar. For the year the dollar was down double digits (see chart below), while gold rose 26%. Correct

7. Commercial Real Estate-
I said that CRE loans would be the bane of regional banks, and this is starting to take hold. The process has been slower than I would have anticipated, almost like watching a slow speed car crash. However, the number of banks being taken over by the FDIC continues to rise, and commercial lending is increasingly becoming the cause of these disasters. Correct

8. Obamanomics-I said that Congress would agree to the massive spending being pushed by the incoming Administration, but not without adding billions in pork. Predicting Congress would vote to spend money was too easy, I’m not taking a “correct” on this one.

9. Credit-I said that credit, as measured by Libor and the TED Spread, would improve over the year, giving us a shot at recovery in 2010. The chart below is a 5 year view of the TED Spread, which has certainly moved back to historically “normal” levels. Correct

10. Housing-I said we would see a bottoming process lasting 3-5 years, the jury is still out on this one.

11. More Credit-I recommended moving away from treasuries and high grade corporate to high yield paper. High yield returned 58%, investment grade 19%, and 30 year treasuries had the worst year in history, declining 24%. The chart below shows the yield increase (which corresponds to a price decrease) of the 10 year treasury. Correct

12. Oil-I said oil would rise for the year, but was thinking $60, not $80. Given my inability to capitalize all year long on the rise in oil, wrong! The chart below is the 5-year chart on the WTI.

Net-net I was 7 right, 2 wrong, 1 tie and 2 no scores, a bit better than 2008, although I think my economic and market calls for 2008 were much better, much more difficult, and more significant. The final score: 75% accurate versus last year’s 65%.

2010 Outlook
This is the part where I get to throw some darts, open myself up to a significant amount of ridicule, and be wrong once again. After the past two years the market should act much more along the “normal” lines, although this might make forecasting a bit more difficult as there aren’t as many obvious, yet to be discovered issues as the prior two years. Believe it or not, when you can identify big outlier events, whether positive or negative, it makes forecasting much easier. I feel that 2010 won’t have the significant number of outliers as 2008 or 2009.

1. Market
The market has roared off the bottom, the only surprise being there really wasn’t a significant correction during the bounce. What fueled this resurgence, and will it continue? The fuel was provided by the Fed, pushing massive liquidity into an economy which wasn’t or isn’t ready to absorb it. This excess capital has moved into the riskiest assets-equities, high yield bonds, and commodities, and should remain there until the economy starts absorbing the capital.

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).

2. Earnings
Earnings for the first quarter should be quite robust as the comps are very easy. Earnings comps should become much more difficult during Q2-Q4 as we anniversary the accounting shift in the financials (from mark-to-market over to mark-to-imagination). The banks are not yet lending and are still contending with write downs in spite of the fantasy accounting treatment of some loans on their books, so earnings growth for the market in the back half of the year may be difficult without a contribution from the financials.

Prediction: Look for strong first half earnings growth followed by weak second half growth, overall up 20% (consensus is for a 34% increase).

3. Economy
The economic numbers suggest we have passed the depths of the downturn, for now. I’d say we have a 20% chance of a double-dip recession in 2011. As far as the market is concerned, we may be in a new world where good economic news becomes bad news for the market as we inch ever closer to the Fed pulling back on its quantitative easing. The market is enjoying a giant carry trade being fueled by a weak dollar and a viewpoint that the Fed is afraid to pull back on its stimulus programs. Strong economic numbers may spook investors concerned about the Fed taking away the stimulus.

The ISM (see chart below) has been above 50 for the past five months, indicating manufacturing expansion. The tricky question will be whether this is sustainable without the stimulus.

Prediction: Watch for GDP to continue meandering and substandard growth rates through the year while employment stabilizes below 10%. David Rosenberg says that typically the first quarter of GDP growth post recession averages 7.3% versus Q309, which was 2.3%, 90% of which came from government stimulus.

4. Inflation
2010 is the year where my inflation concerns may arise. As I have stated, this won’t be a supply constraint or demand driven inflation, but instead due to currency weakness. Prediction: Watch inflation pick up in the back half of the year as the dollar wanes again. The caveat here will be if the Fed is forced to pull back on their stimulus as a result of better economic results and/or an increase in money velocity. Watch bank lending to get a handle on money velocity.

5. Real Estate
Mortgage rates and foreclosures will both be up in 2010. If 10-year treasury rates rise again, and mortgage rates don’t budge, we could actually witness mortgage rates lower than treasuries. Does this suggest that the American homebuyer is a better credit than the US government? Probably not. It would simply be a result of more aggressive MBS purchases by our boys in Washington.

Prediction: The residential housing market will ebb and flow in a bottoming process over the next 2-4 years, and I fully expect another drop in this market during 2010 (10%+).

6. 2010 Election
The Dems will lose seats in both chambers, that’s my call. The question is will they lose enough to balance out Washington and save us all from single party rule. Remember, I don’t really care who is in charge, I just prefer gridlock because I believe that no action from Washington is superior to any action.

Watch job growth because incumbents benefit from job growth, challengers from job weakness.

Prediction: I don’t think we will get significant job growth in 2010, therefore the Dems will lose seats, but won’t lose their majorities.

7. Oil
Here we go again. The fundamentals on oil are still very weak, and I am expecting a pullback from this $80 level. I know and understand that this is counter to my view that the dollar will be weak, and I have been living with that dichotomy for a while (not very profitably, by the way). Oil will be range bound in 2010, being pulled down by weaker fundamentals but pushed up by a weak dollar. If the dollar strengthens during the year, oil will take a significant tumble as both the fundamentals and the carry trade work against it.

Prediction: Fair value is probably $60-$65, a that number is as good a guess as any for the year.

8. The Fed
I’ve mentioned the Fed in a number of these predictions, and I feel they are one of the key variables in determining what occurs in 2010. Based upon Mr. Bernanke’s recent comments that low rates didn’t cause the housing bubble, I’d say the Fed chief won’t be in any hurry to raise rates. In fact, he is likely to lead us directly into another bubble, which politically is easier to swallow than another recession. The hope in Washington will be that everyone will be termed out by the time the next bubble bursts. This chairman would rather stoke inflation and devalue the dollar than manage through another recession. Don’t think that all the carping going on in the Senate about not reconfirming Mr. Bernanke is anything more than a warning to the chairman that should he raise rates too soon, his independence will be on the line in the form of increased Congressional and Treasury oversight.

If the economy suddenly becomes robust, then the Fed may be forced to raise rates and pull back on their QE programs. This is the “good economic news is bad for the market” view. If the banks start lending again and money velocity increases, the Fed may be forced once again to pull back the reins. If inflation kicks up, the dollar becomes dramatically weaker, or treasury rates continue rising, the Fed may be forced to pull back.

My prediction is that the Fed will pull back on some programs (think MBS), yet will continue to hold rates well below that of the market, therefore spreads over Fed Funds will keep rising.

Prediction: Look for a single rate increase near the end of 2010.

9. Healthcare Reform
The train is out of the station, the horse is out of the barn, the mustard is on the sandwich, the beer is on the floor. This is a done deal. It will pass. It will be bad. It will cost 10x more than anyone admits. Rationing will occur. Taxes will go up. Quality of care will go down. Corporate costs will go up. Reimbursements rates will go down. Regulatory costs will explode. Illegal aliens will be covered.

Need I say more?

Prediction: It passes.

10. Kalifornia
This state is a mess that keeps getting worse. Until the state redistricts in a manner which isn’t skewed by partisan politics, the state will continue to be mired in red ink. California will only come back when the real estate market returns, and then only if the ridiculous FHA lending standards remain in place that allow a person with lower credit to take on more leverage than someone with higher credit when buying a house.

Can you say “Governor Whitman”? See my comment on employment above and the impact on elections.

Prediction: She’s in.

BTW-I still remember meeting with Ms. Whitman in the early EBay days and making the comment “so, you’re basically a swap-meet online?” She handled it gracefully and zinged me a year later when she was on the cover of Forbes after becoming a billionaire.

11. Bank Lending
Prediction: Bank lending will improve in 2010. I apologize for not having the appropriate chart in here to provide a relevant measurement, but will include one in one of the next couple of notes. In general bank balance sheets are still a mess, but many banks are maxed out on the amount of treasuries they own and are continuing to borrow to shore up their book. At some point they will begin lending to generate a return on their borrowed capital. An interesting data point from The Big Picture showed that 92% of the senior executives who “led” the big banks through the past few financial crises’ are still in place.

Banking is survival of the un-fittest at its finest.

12. Glass Steagall
I was against the repeal of this fine law that kept everyone doing their jobs, minimizing the risk in financial services. I’d love to say we are going to see this law come back, however, the big 5 financial firms pad too many pockets in DC to lose this one.

One more for the banks, one less for taxpayers. Again, privatizing the gains, socializing the losses.

Prediction: No repeal.

13. Treasuries

The rates on treasuries rose as much in 2009 as any year I can remember. The consensus is looking for a continued rise as issuance to cover the record deficits and anticipation of future inflation dominate the thoughts of investors. While I agree that rates will continue rising, I don’t feel it will be a straight line, and I question predictions of rate Armageddon being made in some shops.

Prediction: At roughly 3.85% for the 10 year Treasury today, look for the 10 year to end 2010 in the mid-high 4% range (4.5-4.9%).

14. Sports
OK, here is my early stab at picking some winners (and losers) in sports. I’m taking Alabama for the BCS championship. I’m picking the Lakers to repeat. I admit I have no idea in the NFL except to say that Sir Brett and the Vikings will NOT win. Tim Tebow will get drafted in the 3rd round, and eventually get a shot a playing QB in the NFL. My beloved Angels will miss the playoffs, finishing second to the Mariners in the West. The Trojans will struggle with another weak defense in 2010, but should finish 9-3 and play in the Holiday Bowl.

15. General Investing Philosophy
Whether in stocks, bonds, or other asset classes, 2009 was a year to focus on riskier investments. I expect the first portion (say first 1/3) of the year to again favor the riskier assets. From that point I anticipate a rotation towards higher quality across all assets. Consider high grade corporate bonds over high yield, defensive large caps over cyclical small caps, etc.

I wouldn’t get too cute on the timing, but instead would begin systematically rebalancing towards quality over the next few months.

Stocks don’t need a great economy to work, we’ve seen that repeatedly. The economy has many issues, and any missteps by the Fed could result in either catastrophic inflation or a double dip recession. The politicians understand the relationship between jobs and re-election, and are desperately trying to get the former moving before September, when most voters will have made up their minds.

Thanks to Byron Hector at Bloomberg and countless others for providing charts for this note and previous notes during the past year. You know people are truly your friends when they take time away from their busy days to help you with your non-paying writing hobby, which reminds me of my first quote of 2009: “Try to surround yourself with people who can give you a little happiness, because you can only pass through this life once, Jack. You don’t come back for an encore.” -Elvis Presley

I’m always open to suggestions, appreciate everyone’s great input and information from their various businesses, and even enjoy the weekly criticism.

Have a great week, and good luck in 2010.


“Behind the ostensible government sits enthroned an invisible government owing no allegiance and acknowledging no responsibility to the people.”—Teddy Roosevelt