June 14, 2010
"Big banks that took on high risks and generated unsustainable losses received a public benefit: TBTF ["too big to fail"] support. As a result, more conservative banks were denied the market share that would have been theirs if mismanaged big banks had been allowed to go out of business. In essence, conservative banks faced publicly backed competition."—Dallas Fed President Richard Fisher
Weekly percentage performance for the major indices
Based on last Friday’s official settlement...
Almost on queue the S&P 500 corrected from its mid-April high of just over 1200, correcting back to support around 1050. The index has bounced off that level twice, and closed this past week at 1091. In prior notes we have focused on these levels as trading points, and will continue to do so in the near term as the markets continue to consolidate. There are two questions in our minds. First, will the market break through the mid 1000 support level? If so, then we could see the S&P correct back to the 950-980 range. Second, will the trading range continue to widen with increasing volatility, or will it tighten up?
There has been quite a bit of discussion over the past few weeks about a double dip recession coming in 2011. If you recall from our beginning of the year note, we assigned a 20% probability to a double dip. Today we would suggest the economy has three possible scenarios. First, a meandering, slow growth recovery, which we would say is the most likely scenario with a 60-70% probability. Second is the double dip scenario, which we still think has a 20-30% probability. Finally, we think a rapidly growing recovery is the outlier, with a less than 10% probability yet the scenario that isn’t priced into many models today.
David Rosenberg of Gluskin Sheff, produced the chart below. We have written about business cycle investing many times in the past, and have shown similar graphics. David’s chart below suggests that, based upon the recent slowdown in the growth rate of the ECRI Weekly Leading Economic Indictor, we are now in Phase III-slowdown. If he is correct, and we believe he is, then its time to focus investments on late cycle stocks while underweighting early cycle stocks. Additionally, this type of environment is poor for higher risk assets such as high yield credits and small caps.
Actual Consensus Prior
Consumer Credit $1.0 bil -$2.0 bil -$5.4 bil
Wholesale Inventories 0.4% 0.5% 0.7%
Initial Claims 456K 450K 459K
Continuing Claims 4462K 4600K 4717K
Trade Balance -$40.3 bil -$41.3 bil -$40.0 bil
Retail Sales -1.2% 0.2% 0.6%
Retail ex-auto -1.1% 0.1% 0.6%
Michigan Consumer Sentiment 75.5 74.5 73.6
Business Inventories 0.4% 0.5% 0.7%
The chart below, courtesy of the NY Times, shows unemployment since the beginning of each recession going back to the 1970’s. The chart demonstrates that unemployment in this recession is worse than any of the others, and has taken longer to begin showing improvements in hiring. The second chart, courtesy of shadowstats.com, shows the official unemployment rate (red line), the BLS U-6 rate (gray line), and the SGS alternative measure (blue line). The differences are that the U-6 includes short-term discouraged workers and those working part-time because they can’t obtain full time work. The SGS alternative includes long-term discourage workers, who were eliminated from the official measures in 1994.
The Best Investment of All
We’ve shown these hats many times since this note began, and have commented what a great investment they were in 1998 when the Dow first topped 10K. With the Dow criss-crossing this much ballyhooed level again, it seemed an appropriate time to break out these well worn, fully amortized chapeaus (before I get pummeled by my more critical readers, I do realize this hat isn’t a true chapeau).
The Bank of Canada became the first Group of Seven country to raise rates since last year’s recession, and said further moves will be “weighed carefully” against future growth in Canada and elsewhere. Canadian GDP grew at twice the rate of the US last quarter, 6.1%.
“Given the considerable uncertainty surrounding the outlook, any further reduction of monetary stimulus would have to be weighed carefully against domestic and global economic developments,” the Ottawa-based central bank said in a statement.
Finally Some Reality
Federal Reserve Chairman Ben Bernanke told the House Budget Committee that the U.S. isn't creating enough jobs to pay for all of the people who will retire during the next 20 years. He urged Congress to take decisive action to reduce the structural deficit because spending cuts and tax reform alone can't close the gap. "Unless we demonstrate a strong commitment to fiscal sustainability in the longer term, we will have neither financial stability nor healthy economic growth," Bernanke said.
Why does it take people in power so long to state the obvious?
A Return to Smoot-Hawley
Treasury Secretary Timothy Geithner said he is considering trade restrictions on Chinese products in response to China's failure to allow the value of its currency to rise. "The distortions caused by China's exchange rate spread far beyond China's borders and are an impediment to the global rebalancing we need," he told the Senate Finance Committee.
Are we doomed to repeat every mistake of the Great Depression?
Leading by Example
Germany announced its biggest spending cuts since World War II, saying Europe's largest economy must set an example. The austerity plan aims to reduce spending by $95.7 billion by 2014. German Chancellor Angela Merkel said the move is a "unique show of strength" that demonstrates Germany's commitment to dealing with Europe's debt crisis.
Austerity is important and much needed in the US and most of the developed world, but I wonder if eliminating another slug of spending in Europe while the economy falters is the right medicine at this time?
Jobs and the ISM
According to Barry Ritholtz at The Big Picture, the ISM usually does not spend much time above 60. It printed at 60.4 in April and dropped slightly in May to59.7. In the previous 485 readings, it has printed above 60 just 48 times, or 9.9% of the time. As it relates to jobs, the year over year change in payrolls lags ISM by about seven months.
The chart below shows the ISM in blue and non-farm payrolls in red. By lagging payrolls seven months, the correlation rises to 0.73, suggesting we should start seeing an improvement in the jobs picture any month. On the flip side, with the ISM approaching historical peak levels and suggesting we are in the late cycle, yet hiring hasn’t picked up significantly, we could be in for a long employment downturn.
They Call Me Coach
Even though I’m a USC fan, John Wooden had a significant influence on my life. As a boy I read his book “They Call Me Coach”, and had his pyramid of success tacked onto my wall. He was a great coach, teacher, and man whose focus on persistence, loyalty, honesty, hard work and process are timeless lessons that transcend professions. I have included some of his greatest quotes below:
"Things turn out best for the people who make the best of the way things turn out."
"Never mistake activity for achievement."
"Adversity is the state in which man mostly easily becomes acquainted with himself, being especially free of admirers then."
"Be more concerned with your character than your reputation, because your character is what you really are, while your reputation is merely what others think you are."
"Be prepared and be honest."
"Be quick, but don't hurry."
"You can't let praise or criticism get to you. It's a weakness to get caught up in either one."
"You can't live a perfect day without doing something for someone who will never be able to repay you."
"What you are as a person is far more important than what you are as a basketball player."
"Winning takes talent; to repeat takes character."
"A coach is someone who can give correction without causing resentment."
"If you don't have time to do it right, when will you have time to do it over?"
"If you're not making mistakes, then you're not doing anything. I'm positive that a doer makes mistakes."
"It isn't what you do, but how you do it."
"Consider the rights of others before your own feelings and the feelings of others before your own rights."
"Do not let what you cannot do interfere with what you can do."
"Don't measure yourself by what you have accomplished, but by what you should have accomplished with your ability."
"It's not so important who starts the game but who finishes it."
"It's what you learn after you know it all that counts."
"It's the little details that are vital. Little things make big things happen."
"Talent is God-given. Be humble. Fame is man-given. Be grateful. Conceit is self-given. Be careful."
"The main ingredient of stardom is the rest of the team."
"Success comes from knowing that you did your best to become the best that you are capable of becoming."
"Success is never final; failure is never fatal. It's courage that counts."
BP Gets a Tongue Lashing
The President, who for some reason seems to periodically forget he is in the US, continued his verbal attack on BP by saying they shouldn’t market, buy ad time, or pay dividends to its shareholders.
From Barry Ritholtz
“Even for Washington, the revolving door between government and Wall Street spins at a dizzying pace. More than 1,400 former members of Congress, Capitol Hill staffers or federal employees registered as lobbyists on behalf of the financial services sector since the start of 2009, according to an exhaustive new study issued Thursday. The analysis by two nonpartisan groups, Public Citizen and the Center for Responsive Politics, found that the “small army” of financial lobbyists included at least 73 former lawmakers and 148 ex-staffers connected to the House or Senate banking committees. More than 40 former Treasury Department employees also ply their trade as lobbyists for Wall Street firms.”
Given the BP oil spill and what appears to be an overriding drive to move us even further away from fossil fuels, I have reproduced a piece I wrote about a year ago (April 19, 2009) on alternative energy. I recently read a study suggesting that we will need to double our energy production between now and 2030, and that the technologies required for that type of capacity increase don’t exist. The only way we can get there is through a combination of carbon based energy and alternatives, not just alternatives.
Here is the text from my note last year:
“US consumers pay average of $.11 per kilowatt-hour (kWh) for power derived from coal, natural gas, nuclear and hydroelectric. The proposed $10 per ton carbon tax would increase the price of coal-fired electricity by $.01 per kWh or 9%. In an effort to help the environment, the new administration is pushing renewable energy sources hard, regardless of the economic impact. Below I have shown some alternative energy sources, their costs, and some of the benefits/drawbacks of each. The pricing estimates are from Scientific American, and are estimates at full deployment (current pricing is much higher).
Solar-Thermal-At a cost of $.20-$.28 per kWh, this technology is expected to cost three times current sources. The advantage is that it may be one of the only renewable sources which allows for the storage of energy to meet peak demand. The drawbacks are the need to locate in deserts, far from existing transmission lines and available water for cooling.
Ocean Wave Power-The price is unknown at this point as the technology is still in its design phase. The advantage is that most of the population is located near the coasts. A major drawback will be designing a building that can withstand 50-75 years of heavy waves.
Geothermal-At a cost of $.062-$.076 per kWh, geothermal is actually cheaper than the existing technology. The advantage is that the supply is very reliable, and can generate to meet daily demand patterns. The downside is the pollution given off by the steam from underground water can be highly toxic and corrosive.
Solar-Photovoltaic-Right now this technology is one of the furthest along in commercial deployment; however, it is heavily subsidized by governments due to its high cost, $.47-$.71 per kWh. The major advantage is the ability to overlay the technology in heavily populated areas to save the cost of new distribution lines. The drawback-cost!
Wind-The US is undergoing a major wind generation deployment program over the next 12 years. The advantages include no cooling water requirements and its low cost of $.06-$.085 per kWh. The disadvantages are location (typically far from population centers) and most generation occurs at night, which doesn’t match the demand requirement patterns. There are also issues with birds and bats flying through the turbines.”
So far BP has lost roughly $95 billion in market cap. The company is self-insured, which means the potential liability from the spill could be limitless unless they qualify for some legal caps. There has been discussion of a possible bankruptcy filing to isolate the company from its spill liabilities, which adds a key question to the discussion on whether the equity is a good investment or not.
The Congressional Oversight Panel has concluded that the Federal Reserve could have acted earlier to find a privately funded solution for New York-based AIG before the September 2008 rescue. The $182.3 billion bailout transformed banks’ financial bets into fully guaranteed obligations, the panel said.
“The government’s actions in rescuing AIG continue to have a poisonous effect on the marketplace,” said the panel, led by Harvard University law professor Elizabeth Warren. “The AIG rescue demonstrated that Treasury and the Federal Reserve would commit taxpayers to pay any price and bear any burden to prevent the collapse of America‘s largest financial institutions and to assure repayment to the creditors doing business with them.’’
Jean-Claude Trichet, president of the European Central Bank, said stress tests on major financial institutions across the eurozone are nearly complete and the results should be made public to calm financial markets. The U.S. has been urging Europe to follow its lead with banks' stress tests as a way of restoring investor confidence and encouraging banks to raise capital, if necessary. The Committee of European Banking Supervisors is conducting the tests.
What do you do with $2 trillion in Foreign Reserves?
China is taking a big stake in Greece’s recovery, making investments that eventually could be worth billions of Euros. The modernization and expansion of the Piraeus seaport to become a gateway to Europe and North America for China's exports is one of the first big projects. Shipping giant Cosco took over a major Piraeus container-cargo facility this week and plans to spend $700 million on improvements.
When the first charges against Goldman and their marketing of mortgage backed securities arose we suggested that this would only become a nightmare scenario for the firm if additional securities were identified. The Wall Street Journal reported this week that a second tranche of securities is now being reviewed for similar improprieties.
A second (or more) security could indicate an institutional problem versus just a one off event, which could carry much more severe financial and criminal ramifications.
Fuel for the “Anti-Wall Street” Crowd
According to data from Thomson Reuters, Wall Street investment banks have received more than $670 million in commission and charges from sales of Build America Bonds. The fees are an average of 20% higher than those charged for conventional tax-exempt debt.
Brazil reported first quarter GDP growth of 9%, the fastest in a decade. The Real gained 1% vs. the dollar, and the Bovespa, the country’s equity index, rose 1.1% YTD.
One Boot on the Brake, One on the Accelerator
China's central bank pumped $24.3 billion into its financial system this past week through the use of repurchase agreements and bill issuance. It marked the third consecutive week of net injections by the central bank.
Meanwhile, China's CPI rose 3.1% last month compared with the same month a year earlier. Over the same period, retail spending on consumer goods soared 18.7%.
The U.S. House recently approved a tax increase on certain compensation paid to investment managers, known as carried interest, but the Senate has watered down the proposal slightly. Carried-interest income is taxed at the capital-gains rate of 15% versus 35% for incomes in the highest federal bracket. The Senate proposal would raise the tax to as much as 33% by 2013. The House's proposal would raise the rate to 35%.
Chinese Trading Becoming More Liberal
The China Securities Regulatory Commission, encouraged by initial results of a trial program, approved a limited expansion of margin trading and short selling. The regulator added five securities firms to the program, which already had six, and relaxed capital requirements to encourage smaller brokerages to participate.
We have discussed the slowdown in growth of M3 over the past two years in spite of the Fed’s massive attempts at increasing the monetary base. As we discussed last month, the main culprit is the lack of velocity caused by banks holding back on lending as they attempt to shore up their balance sheets. The chart below, courtesy of shadowstats.com, shows the discontinued measure of M3 in blue (actual measure in red, SGS’s continuation in blue).
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Have a great week.
“The collapse of the financial system as we know it is real, and the crisis is far from over,” Soros said today at a conference in Vienna. “Indeed, we have just entered Act II of the drama.”