Apr 18, 2010

Government Sachs in Trouble

Government Sachs in Trouble

April 19, 2010

"Injustice anywhere is a threat to justice everywhere." -- Martin Luther King, Jr.

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

INDU: 0.19%
SPX: -0.19%
COMPQ: 1.11%
RUT: 1.66%

On Friday the market suffered its first 1% pullback in almost 40 trading days, which according to Barron’s is the longest such run since 1994. While I don’t typically emphasize a single event or single day’s activity as significant, the Goldman Sachs news (see below) combined with some less than desirable economic data certainly triggered the sell-off. There have been comparisons made between Goldman Sachs and the Bear Stearns saga (and the ensuing collapse of that firm), however, I think that’s probably over-kill. Either way, stocks and commodities both fell Friday, with gold dropping $25.

There have been a number of articles over the past few weeks questioning the market’s current valuation. At just under 1200, and with an EPS estimate of roughly $80 for 2010, the S&P 500 is now trading at 15 times, high but not ridiculously expensive in today’s low rate environment. Much of the valuation commentary has revolved around trailing earnings, which were $80 in 2005 (the last time the market hit 1200), yet only $50 or so in the most recent trailing twelve months. On a trailing PE basis, this places the market’s PE around 24 times, definitely expensive, but not really relevant. The market always looks expensive on a trailing basis when the economy is improving. On the flip side, it typically looks cheap near market tops. The net-net is that while the market has run a long way, and the economy has some definite potholes to maneuver around, valuation shouldn’t be a catalyst for a market correction.

The bigger question is rates and how long the Fed will remain accommodative? While the Fed may raise rates in the back half of the year, it is still our view that they will error on the side of remaining overly accommodative versus taking away the punch bowl too early. The Fed is justifying their continued accommodative stance based upon “slack” in the economy created by excess manufacturing and labor capacity. Reflating incomes and asset values continues to be the Fed’s goal. Remember that inflated wages and asset values leads to higher tax revenues without tax rate increases and a cheaper dollar to pay down foreign debt.


Actual Consensus Prior
Treasury Budget -$65.4 bil -$62.0 bil -$191.6 bil
Trade Balance -$39.7 bil -$38.5 bil -$37.3 bil
CPI 0.1% 0.1% 0.0%
Core CPI 0.0% 0.1% 0.1%
Retail Sales 1.6% 1.2% 0.5%
Retail Sales-ex-autos 0.6% 0.5% 1.0%
Business Inventories 0.5% 0.4% 0.2%
Continuing Claims 4639K 4580K 4566K
Initial Claims 484K 440k 460k
Capacity Utilization 73.2% 73.3% 73.0%
Industrial Production 0.1% 0.7% 0.3%
Philadelphia Fed 20.3 20.0 18.9
Building Permits 685K 625K 637K
Housing Starts 626K 610K 616K
Michigan Consumer Sent 69.5 75.0 73.6

While much was made of the Goldman Sachs impact on Friday’s market action, the weakness in the Michigan Consumer Sentiment index seems to have perplexed traders a bit. Retail sales earlier in the week were ahead of consensus, yet the consumer sentiment measure fell to its lowest level in six months.

The news from the real estate front was somewhat positive. Builders broke ground on more U.S. homes in March than anticipated and took out permits at the fastest pace in more than a year, a sign of growing confidence that sales will stabilize. Housing starts climbed to an annual rate of 626K last month, up 1.6% from February’s level. Building permits, a sign of future construction, climbed to the highest level since October 2008.

Defaults remain a concern. Foreclosure filings in the U.S. rose 16% in the first quarter. Higher foreclosures combined with higher inventories from the increased build activity may continue to drive down prices. Additionally, the tax credit for first time buyers expires April 30th, which may dampen demand.

Business inventories continued to rise as manufacturers respond to increasing end market demand. The chart below shows the rapid rise (blue line) in sales and the burgeoning recovery in inventories (yellow line). Inventory replenishment has been helping fuel the nascent recovery.

Government Sachs
Keeping with the populist strategy now being employed by our government the SEC charged Goldman Sachs, apparently no longer considered a sacrosanct member of the government, with fraud by the SEC. Not missing a beat, and a chance to line their coffers, the English and Germans have also opened probes. The fraud is related to the packaging and selling of collateralized debt obligations (CDOs) linked to subprime mortgages.

The charges suggest that Goldman allowed one client, who planned to be short the mortgage pool in question, to assist in selecting the mortgages being included in the pool. According to the suit, the plaintiff firms were unaware of this relationship.

I have long felt Goldman trades its own book ahead of its clients, however, if it is shown that they placed the needs of one client, presumably a higher paying client, ahead of another, then they may face some serious sanctions.

Personally I feel there is a lot of political showboating surrounding these charges. Typically firms are charged with a pattern of illegal behavior, not fraud on a single transaction. While a fraud charge and conviction is nothing to sneeze at, the reality is that if the government can’t identify a pattern of similar transactions, the current charge will probably result in a fine, the employee being fired, and possibly some minor operating restrictions and/or adjustments.

Global Asset Allocation
Global investors have been moving money away from developed nations (UK, US, Europe, and Japan), in favor of emerging markets. “There’s a global reallocation going on,” said Kenneth Akintewe, a Singapore-based portfolio manager at Aberdeen Asset Management. Given the choice between “debt-ridden countries” like the U.K., the U.S. and Japan, and “emerging-market economies with substantially good fundamentals, then you expect to see that global reallocation taking place.”

Emerging-market bond funds received a record $1.8 billion in the past week, as 2010 inflows rose to a record. Where is this capital coming from? How about global equities, which have seen multi-billion dollar withdrawals for the past few weeks?

The Eurozone came up with an emergency aid package for Greece totaling $61 billion in below market-rate loans. The loans yield 5%, nearly 200bps lower than current market rates.

Morgan Stanley feels that if the Euro is damaged by the bailout, Germany could pull out of the Euro to ensure its borrowing costs remain low.

Pork Roast

It was revealed yesterday that Mississippi Senator Thad Cochran is the king of pork for the third consecutive year, bringing home over $500 million in pork to his state last year for such important items as shrimp research, local museums, and military projects unwanted by the Pentagon. The three year total for Senator Cochran is over $2 billion.

Hawaii is the leader in pork per capita at $251. I guess that’s for luaus.

Financial Reform
Akin to the alcoholic who asks his wife to throw away the liquor after a bender, the Feds are feeling political remorse after allowing banks to become TBTF, then throwing them a massive lifeline. As a result, a new bill that won’t limit TBTF has a good chance of making its way into law so that politicians can claim victory over the financial services evil villains and conveniently just before the elections.

California Budget-Cuts in all the Wrong Places
We all know that the State of California’s budget is a mess. I recently reviewed the line item budget for the past five years, and it isn’t pretty. For the fiscal year ended June 2009, revenues declined by 13.9%, with the biggest decline coming from a category entitled “other tax revenues”, which I am guessing could be capital gains taxes but am not 100% sure.

Expenditures for the fiscal year ended June 2009 declined by 6.44%. The astute (and awake) reader will note that the decline in revenues dwarfed the decline in spending, resulting in a severe budget deficit of $8.4 billion (which will be worse in 2010) and a decline in fund balances of $12 billion. Education, which represents just less than 50% of total spending, suffered the largest cutback in expenditures during FYE 2009, declining $6 billion or 10.0%. Sadly, the cut in Education is equal to the entire decline in expenditures year over year. General government expenses actually increased 22.5% while debt service (both principal and interest) increased by 14%.

Predictably, sales taxes declined for the third consecutive year after peaking at $27.6 billion in FYE 2006.


Intel and JP Morgan both reported robust numbers as the first week of earnings season got underway. JPM’s Jamie Dimon, said that the U.S. economy is recovering. "Large companies have got lots of money, lots of liquidity and complete access to markets," he said. "This could be the makings of a good recovery."

State Pension Liabilities Taking Center Stage
Taxpayers across the U.S. owe public school teacher retirement accounts about $933 billion, nearly triple the amount reported by the plans themselves, according to a study by the Center for State and Local Government Excellence. The report, covering 59 plans for 13 million working and retired educators, found that California had the largest unfunded teacher pension liability at almost $100 billion, more than the $42.6 billion reported by the system in January. It’s the third study in less than two months to suggest that pension costs of about $1 trillion threaten to overwhelm state and local budgets already crimped by declining tax revenue.

The two-year-old recession has left two-thirds of U.S. public retirement systems with assets worth less than 80% of future obligations, a level the GAO has said is acceptable. Underfunded pensions were cited by rating agencies in recent months for bond or rating-outlook downgrades in Illinois, Ohio and the City of Los Angeles.

According to former Social Security administrator Andrew Biggs, this estimated pension underfunding of $1 trillion could be as high as $3.5 trillion!

Manufacturers in China recently experienced a significant increase in their labor costs. The Chinese government gave manufacturers a 30 day notice to raise the minimum weekly wage by 22%. These manufacturers are already suffering from a labor shortage that has some employers offering workers $1000 (the equivalent of a year’s salary) as they exit trains as an enticement to quit their current job and come to work with the new employer.

This employee shortage should help the country’s robust recovery continue (recent GDP approached 12%) and pull workers from the outlying cities into the larger, coastal manufacturing locations.

Recent Bumper Sticker

Miner Rio Tinto said it is running most of its iron-ore facilities worldwide at maximum capacity to keep up with the demand of customers in China. "Chinese demand grew strongly and we saw some recovery in OPEC markets, but we are still cautious about short-term volatility," said CEO Tom Albanese. The company increased its production 39% in the first quarter.

Federal Deficit
According to the Washington Post, the U.S. government is on track to end 2010 with a deficit that is $300 billion less than an estimate made two months ago. For the first six months of this fiscal year, the deficit is 8% less than that of the same period a year earlier, officials said. The bailout of the financial system was less expensive than expected, White House officials said, and tax collection is running higher than projected.

I thought last week’s note was pretty benign, but I obviously hit a chord with a number of readers on both sides of the tax debate. Thanks for the notes, it was very entertaining. I don’t remember many topics generating so much commentary, heated at that, on both sides of the argument. The comments definitely ran about 4:1 supporting my position that everyone with an income should pay some taxes, but I was surprised by the number of readers who felt lower wage earners should shoulder even less of the tax burden.

Speaking of reader notes, over the past nine months or so I have received roughly 300 from readers requesting assistance with asset allocation for their personal investments. In response, I am exploring creating a monthly newsletter specifically focused on using ETFs and low cost funds to create a diversified portfolio with a goal of protecting assets and generating returns, in that order. This monthly letter will be directed towards the investor who prefers to manage his/her own money, or those looking for a tool to help monitor their existing managers’ allocations. Please let me know if you are interested and I will get you more information.

Have a great week.


“If you destroy a free market you create a black market. If you have ten thousand regulations, you destroy all respect for the law.”—Winston Churchill

Apr 11, 2010



April 12, 2010

“A good manager is a man who isn’t worried about his own career but rather the careers of those who work for him. Take care of those who work for you and you’ll float to greatness on their achievements.”—H.S.M. Burns, former CEO Shell Oil

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

INDU: 0.64%
SPX: 1.38%
COMPQ: 2.14%
RUT: 2.77%


Complacency is the perfect word to describe the world today. Voters are complacent; otherwise they never would have allowed politicians to create yet another unaffordable entitlement plan. Investors are complacent, with the VIX hitting its lowest level in 24 months. The politicians are complacent in spite of record deficits and all-time low approval ratings. Greece is still on the ropes, but concern over default is being replaced with a complacency that assumes the damage will be contained and well-defined. The Fed is complacent about inflation in spite of a world awash with massive liquidity. Why all the complacency? Because compared to a year ago, with the exception of jobs, things are looking pretty good. CEO surveys are turning positive, hiring plans are weak but improving, and for the time being we aren’t in the grips of economic pandemonium. The negatives still abound, but for now the attitude is “don’t speak about what’s wrong, and maybe it will go away.”

The chart below, courtesy of www.chartoftheday.com, shows how lost this decade has been for investors. Since peaking in 2000 above 5,000, the NASDAQ at its low had lost nearly 90% of its value. Now, still down by half, it’s obvious that we are in the grips of a secular bear market, in spite of the recent gains YTD and since bottoming a year ago March. The moderation of the red resistance line could be an indication the market is running out of steam and may meld once again into a range bound market.

April started out strong, albeit on weak volume due to the recent holidays. Seasonally, April is a strong month for market performance, second only to December (as measured by the S&P 500). A few weeks ago we discussed focusing on mid-cycle stocks, especially consumer stocks. Additionally, energy stocks have been lagging the commodities somewhat as oil has surged over $85, driven by both seasonal factors and increased demand from both China and India. Energy tends to be a leading sector into the summer driving season.


Actual Consensus Prior
ISM Services 55.4 54.0 53.0
Pending Home Sales 8.2% 0.0% -7.8%
Consumer Credit -$11.5bil -$0.7bil $10.6bil
Continuing Claims 4550K 4630K 4681k
Initial Claims 460K 435K 442K
Wholesale Inventories 0.6% 0.4% 0.1%

The ISM Services Index (chart below courtesy briefing.com) came in at a robust 55.4, above expectations of 54.0 and the prior reading of 53.0. This reading is the highest since October 2006. According to the ISM “14 of the 18 industries surveyed reported growth with two reporting a contraction and the comments are mostly positive about business conditions and the direction of the economy.”

March same store sales were up 9% versus horrific comps a year ago, the best comps in over 10 years. Big comps were posted by CATO (CATO, +24%), Kohl’s (KSS, up 22.5%), Aeropostale (ARO, up 19.0%), American Eagle (AEOS, up 15.0%), and Limited (LTD, up 15.0%). JC Penney (JCP) and Abercrombie (ANF) were two of a small handful which missed comps. Warm weather and an early Easter helped the March results.

Pending home sales rose 8.2%, the second largest gain since October 2001. The gain was led by the Midwest region and followed by the South and Northeast. The West saw a drop of 4.8%. Growth may be short lived as expiring tax credit and rising mortgage rates may put a cap on this tentative recovery.

Los Angeles
The city of Los Angeles is running out of cash, fast. The city, a poster child for major cities buried with pension and benefit woes, announced they would run out of cash by early this summer. Mayor Villaraigosa announced closing non-essential services for two days per week in response to the crisis, however, early reports suggest that he doesn’t have the power to follow through on those furloughs. My question is outside of police and fire, what exactly is an essential government service?

Stay tuned, this should get entertaining.

Credit Conditions

An increasing debt burden in the biggest developed economies is becoming a "systemic crisis," said Tim Backshall, chief strategist at Credit Derivatives Research. The company's Government Risk Index rose nearly 40% in the past month. The index is based on credit default swaps on France, Germany, Italy, Japan, Spain, the U.K. and the U.S.

More Hidden Costs in the Health Care Bill

William Blair’s health care team put together an analysis of the recently passed health care bill, and while everyone knows the numbers being bandied about by the Dems are completely made up, Blair’s estimates of the costs are shocking even to me.

First, they note that the Medicare physician fee schedule fix is estimated to cost $280 billion over 10 years and is NOT included in the bill. This cost is roughly twice the amount of the projected $138 billion deficit reduction in the new bill. Further, numerous other timing tricks were played to lower CBOs scoring of the bill. Once fully implemented, the 10-year cost of the bill is estimated at $2.6 trillion. Thus, a cost-containment bill will probably be top priority for whoever is in the White House in 2013.


Earnings Season
Earning reports begin in earnest this week. The numbers should look good compared to last year’s first quarter, but only moderately better on a two year basis. The one year estimated EPS growth for the S&P 500 is 37%.

Tax Week
Taxes are due this week, so I thought I’d provide a few tidbits sure to make your blood boil, or at least 53% of you. It seems that 53% of citizens over 18 pay all the taxes in this country, leaving a whopping 47% who pay zero taxes. This compares to less than 40% non-payers just five years ago. Obviously this is being exacerbated by the increase in unemployment, but that doesn’t account for the entire shift. At this rate of increase, by 2012 the majority of voters won't be tax payers. So much for no taxation without representation!

Other tax facts: The top 5% of wage earners pay 60% of all taxes. The top 10% pays 75% of all taxes. I’d say “the rich” are certainly paying their fair share.

Thanks Jeff.

Banks Just Doing What Banks, and Criminals, Do
According to a recent Wall Street Journal report, data from the Federal Reserve Bank of New York shows that during the past five quarters, big banks in the U.S. cut back their borrowing immediately before it was scheduled to be reported. The Fed found that 18 banks understated their debt used in securities trading by an average of 42%. By timing their borrowing this way, the banks effectively hid debt risk from the public.

Valuing the Market
From Bob Bronson regarding the effectiveness of PE ratios in predicting future stock performance:
“Using future four-quarter earnings, which proxies for perfect forecasts of EPS, did not improve the results. Even if the next four quarter EPS were to be as high as $80, which is extremely unlikely, the current P/E of that future EPS would be down to 14.7, but during the previous 280 previous times, or 17% of the time, that such future-EPS P/E ranged between 15.7 and 13.7, the subsequent median six- and 12-month price-only returns, have been 52% and 104% less, respectively, than the median returns of all those 1,660 monthly periods, which have been +3.0% and 6.2%, respectively. This includes big declines following the periods from mid-1987, late-1972 through early-1973, late-1938, late-1936 and early-1934.

We believe it cannot be reasonably argued that today’s stock market is fairly valued, much less undervalued, based on past or future corporate earnings, or the related P/E ratio, or their relationship to bond yields (interest rates). To the contrary, none of our Supercycle stock market valuation indicators have reached their mean reversion target areas (see the P/E volatility chart below). But even more important, they all show that the stock market is significantly overvalued again.”

Thanks Bob

Mortgage Rates
The Fed has curtailed their $1.25 trillion program targeting the MBS market, and rates on mortgage have begun to rise. A month ago the nationwide median 30 year fixed mortgage was yielding 5.0%. Friday that same mortgage carried a 5.2% rate.

Rising rates will put significant pressure on a struggling housing market.

Every 100 Years?
I know that comparing market performance from various time periods is a poor way to predict future performance, however, sometimes the correlations amaze me. The chart below, courtesy of thechartstore.com, overlays the most recent performance of the Dow (orange line) to that of the 1906-1912 Dow (green line).

If the next few years plays out similar to that older period, it would coincide with our prediction of a flattish market over that time period.

Earnings should grab most of the market headlines this week. Growth year over year should be robust, but make sure to watch the two and three year comparisons to get a better idea of where normalized earnings and revenues actually reside.

Have a great week.