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

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