Mar 28, 2010

Cyclical Recovery in a Secular Bear Market

Cyclical Recovery in a Secular Bear Market

“Industrial capitalism has generated the greatest productive power in human history. To date, no other socioeconomic system has been able to generate comparable productive power.”—Peter L. Berger

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

INDU: 1.01%
SPX: 0.58%
COMPQ: 0.87%
RUT: 0.75%


Despite what many (including this writer) have chided as irresponsible government policies, the market continues its death defying (OK, that is a bit of hyperbole) rise. Amazingly, the US market has overtaken those of China, India and of other faster growing countries as they begin to battle emerging bubbles while the US is keeping the pedal to the metal. US investors, never ones to sneeze at accommodative Fed policy, continue to support their market with fervor and zest. In a foreign version of ‘don’t’ fight the Fed’, capital has been flowing out of these foreign markets and into the US as the Fed appears willing to keep rates low for much longer than necessary in an effort to kick start housing and re-inflate assets. Unfortunately, recent policy changes such as the new healthcare bill will ensure higher unemployment rates over the long run while the Fed will more than likely be successful in not only re-inflating assets, but fueling another round of inflation, possibly as early as late 2011.

If you believe, as we do, that the US is experiencing a cyclical bull market recovery in a secular bear market, then its time to own mid-cycle stocks and domestic securities over early cycle and foreign securities. Consumer issues, financials, and industrials should benefit from this mid-cycle environment. If employment truly kicks up, then consumer stocks should shine.

Remember this comes with a backdrop that we are still mired in a bear market which began ten years ago, March 2000. Our view is that this bear market, punctuated with powerful bull market rallies, may not end until 2014. Only time will tell, but caution is virtuous when it comes to markets.


Actual Consensus Prior
Existing Home Sales 5.02 mil 5.00 mil 5.05 mil
Durable Goods Orders 0.5% 0.6% 3.9%
Durable Goods ex-Autos 0.9% 0.6% -0.6%
New Home Sales 308K 315K 315K
Continuing Claims 4648K 4562K 4702K
Initial Claims 442K 450K 456K
GDP-3rd Q4 estimate 5.6% 5.9% 5.9%
GDP Deflator-Q4 0.5% 0.4% 0.4%
Michigan Sentiment Indicator 73.6 73.0 72.5

New home sales fell to an all time record low in February, 308K. Existing home sales also came in soft, down 0.6%. The weakness was focused in single family homes while condominium sales rose 5%. Prices continue to be weak, and inventories were up again. The weather in the east was especially bad in February, but these numbers are reminders that despite spending trillions, the problems plaguing the housing industry are not over.

Durable goods orders (see chart below) increased 0.5% vs. the consensus estimate of 0.6% in February after increasing 3.9% in January. Transportation (motor vehicles) was once again weak as orders outperformed the consensus 0.9% to 0.6% excluding autos. Business investment rebounded strongly after being very soft in January. Orders of nondefense capital goods rose 1.1% after falling 3.9% in the previous month.

Government Economics-the New Math

Let’s see if this makes sense. There are reportedly 32 million uninsured Americans, of which 10 million are eligible for Medicaid but haven’t enrolled; another 12 million make $50K or more but choose not to have insurance, which leaves 10 million people (excluding 12-20 million illegal immigrants) who need health care coverage. We are going to spend $1 trillion to cover those 10 million uninsured, which works out to roughly $100,000 per person.

That’s a pretty pricey solution. Nice going Congress!

Treasury Yields Rise
Treasury yields rose on the week, with the TLT (a measure of the 20 year Treasury) falling 2.5%. Why? There are a number of plausible reasons.

First, this could be an indication that the global investors are saturated with low yielding US paper, and will demand higher yields to offset the risk of owning debt in one of the most levered countries in the world. Huge issuance for the week, $120 billion, with the likelihood of another $1.8 trillion in the pipeline, had to have some impact on rates.

Second, investors may be sniffing out higher US economic growth, which could be reflected in higher yields. A few months ago we discussed a rise in yields from a stronger economy which could eventually force the Fed to raise rates.

Third, PIMCO’s Bill Gross noted this week that the present value of the US unfunded social insurance expenditures (Social Security and Medicare) totaled $46 trillion! He feels that is why the 30 year now trades 360bps above the 2 year note. He also asserts that the new health care legislation will add to, not reduce, fiscal deficits. We agree and feel that the new healthcare bill is destined (and designed) to add hundreds of billions to the deficit and will result in higher tax rates, lower employment, and more sluggish economic growth in the future (think Europe).

Finally, China could also have been a cause. China, whose fiscal house is seems to be in better order than that of the US, has had to endure a verbal berating from the Obama Administration over the handling of their currency. The Chinese hold over $1 trillion in US debt and over $2.4 trillion in foreign reserves. They may have been sending a signal this week to the US that we should back off or face a debt issuance future devoid of Chinese participation. Given we will be issuing close to $2 trillion in debt this year and with plans to increase the deficit dramatically with another entitlement program, Mr. Obama would help his cause by catering publicly to our biggest creditor, as opposed to just bowing down to terrorist countries.

As always, watch the bond market as a leading indicator to the stock market. The Clinton’s learned early that the bond market should be heeded.

Top 30 CEOs

This weekend’s Barron’s released their list of the thirty most respected CEOs. I am happy to say that six of the members of this list are readers of this note. While I don’t release the names of readers, given my past areas of coverage it shouldn’t be hard to figure out the six.


Unintended Consequence of Healthcare Reform
From the Sound Off section of

"This is cool. I'm just going to drop my insurance now, pay the $700 yearly fine, and then pick up insurance when I get sick since insurance companies can't deny me." "I'll save a bundle of money every year."

"I suspect this is what most 'smart' Americans will do. And then guess what? Insurance companies will collapse because they'll have no pool of money to pay for the claims that start coming in, and we'll be in a world of hurt again."

Look Who’s Talking Now
Fed Chairman Ben Bernanke said the U.S. government should not be in a position in which it is forced to extend state aid to major financial institutions. "It is unconscionable that the fate of the world economy should be so closely tied to the fortunes of a relatively small number of giant financial firms," Bernanke said. "If we achieve nothing else in the wake of the crisis, we must ensure that we never again face such a situation."

To me this sounds like a call to repeal Graham Leach Bliley.

The chart below, courtesy, show the median price of a single-family home over the past 40 years in the US. Housing prices have dropped 35% from the mid-2005 top, and are now at levels comparable to the peak of the 1980 bubble.


Jim Fickett of ClearOnMoney provided the following chart. “Serious delinquencies continue to rise – in the 64% of the market covered by Mortgage Metrics, there are now about 3.4 million loans either seriously delinquent or in the process of foreclosure. Completed modifications actually declined in each of Q2-Q4 of 2009. Foreclosures have been flat. Thus, as this chart suggests, the various programs amount to little more than window dressing hiding the underlying weakness of the Real Estate market.”

Cost of Healthcare
Farm machinery maker Deere, with headquarters in Moline, Illinois, said in a statement that the new health care law will increase its expenses by $150 million this fiscal year. Caterpillar said it expects to record a charge of about $100 million as a result of the law. AT&T expects to take a $1 billion charge related to the new legislation.

So much for job creation!

More Health Care Hocus Pocus
“Fantasy in, fantasy out,” writes Douglas Holtz-Eakin who held the CBO Chair from 2003–2005. Front-end loaded revenues and back-end loaded expenses promote the fiction that a program that will cost $950 billion over the next 10 years actually reduces the deficit by $138 billion. After all the details are analyzed, Mr. Holtz-Eakin’s numbers affirm a vigilante’s suspicion – it will add $562 billion to the deficit over the next decade. .

Mortgage Fallout
Ambac, created in 1971 to insure debt sold by states and municipalities, announced (again) that it may have to enter bankruptcy on the heels of being taken over by state regulators. The company lost its top credit ratings and 99% of its stock-market value after expanding from its main business into guaranteeing bonds backed by riskier assets and CDOs. The company guarantees $256 billion of the $1.4 trillion in insured municipal issuance, according to Bloomberg.

The Wisconsin insurance commissioner on Wednesday ordered Ambac’s main operating subsidiary, Ambac Assurance Corp., which is based in that state, to set up a segregated account for policies related to risky structured finance transactions.

The Ever Shrinking Euro
The euro traded near a 10-month low versus the dollar after European Central Bank President Jean- Claude Trichet said that aid for a euro-area nation from any outside group such as the International Monetary Fund is “very, very bad.” Leaders of the euro region met in Brussels to debate a French-German contingency plan for a mix of IMF and bilateral loans to help Greece deal with its budget deficit.

The market doesn’t care that “France and Germany are saying they have the framework to a plan to support Greece including the IMF,” said John Curran, a Toronto-based senior vice president at Canadian Forex. “It’s like ‘Yeah, OK, great, I have a plan for winning the lottery, too.’ Show us something that works.”

The Death Panels are Gone, But Look at This!

Tucked inside the 2400 page health care bill is a 43-page measure that may have a far greater effect on medical care than any other portion of the bill. The overhaul creates an institute, funded with $500 million or more annually, to spur studies of which drugs, devices and medical procedures work best. The boost for comparative-effectiveness research will increase scrutiny on treatments used by millions of Americans.

“The findings may add scientific rigor to doctors’ decisions sometimes influenced more by marketing,” said Jeffrey Lerner of the ECRI Institute, a nonprofit that conducts such research.

According to UniCredit SpA, oil prices will jump almost 20% this year, driven by demand from China and emerging markets. The chart below, courtesy Bloomberg, shows Chinese crude oil imports, in blue, have surged 66% since 2004 and that oil prices, in red, have more than doubled over the same period. Prices may rise to $95 a barrel in the fourth quarter and $115 by the end of 2011 from $81 today, said Jochen Hitzfeld, an analyst at UniCredit in Munich.

Demand from emerging markets, which accounts for 56% of global crude oil consumption, “continues to be underestimated,” Hitzfeld said. “China adds an incredibly large share in terms of energy demand. That’s one reason why crude oil prices will trend towards $100 a barrel in the second half of the year.”

Why Did Health Care Stocks Rally?

Many predicted that health care stocks would fall if the bill was passed. We have written that the stocks would react positively over the short and medium term. Why? Because, as the bill is written today, the negatives (think higher taxes and fees) being charged to health care companies are already known and priced into the stocks. More negatives will only come as Congress rewrites the bill over the next couple of years.

What are some of the positives? Think Big Pharma, which rolled over when they calculated the bill had a chance of passing. Instead of fighting it, they helped craft the legislation to their benefit. Certainly they have to pay a large fee ($80 billion, I believe), however, they were successful in keeping generic competition out of biologics. Biologics are the next wave of drugs coming to market, carrying price tags which often exceed $100K per year per patient.

Big Pharma’s profits on biologics will eventually surpass their profits from their existing portfolio of drugs.

Social Security-The Next Big Problem

The Congressional Budget Office said Social Security payments will outstrip money paid into the program this year. Until recently, contributions were expected to cover the payout until at least 2016. Stephen Goss, chief actuary of the U.S. Social Security Administration, said the CBO's projection is probably correct.

Wow! It doesn’t seem like a good time to be adding another entitlement program when the most popular one goes cash flow negative.


The most important event in the market this week will be Friday’s unemployment report. The stock market will be closed that day for Good Friday, so only the bond market will be able to react to the release. The estimate calls for job growth of 190K (thank you Census). The timing of a positive number would be ironic given the recently announced jobs bill.

Have a great Easter. I will not be publishing on Easter Sunday, see you in two weeks.


“The same people who transferred the too big to fail firms toxic liabilities onto the taxpayers’ balance sheet are now going to write legislation so that firms can't be too big to fail....yet they are now the principles of the largest levered financial services firm in the world, i.e. the US Government, and think they’re too big to fail...throw all these bums out!”—an anonymous reader

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