May 31, 2010
“The problem is the market is not buying this “fix too much debt with more debt” approach. More bailouts are not the answer. Austerity is the answer.”—Jim Bianco,
Weekly percentage performance for the major indices
Based on last Friday’s official settlement...
The S&P has experienced its biggest correction since the March 9, 2009 bottom, declining roughly 13% from its recent high to touch new lows for the year. We mentioned the mid 1000’s for a level to begin coming back to the market, and the S&P bounced on cue from the those very levels as the market touched down just below 1050 before rebounding slightly to close the week at 1089. This is the first 10% correction since the market bottomed in March 2009, which is not unusual except that it occurred in a single month. Typically 10% corrections don’t occur within a single month, but trace out over multiple months. The severity of the downturn has raised investor concerns about whether this is a normal correction in an upward trending market or something a bit more ominous.
Richard Russell of Dow Theory fame feels the markets are signaling weak economic conditions or even something direr on the horizon. Personally I feel there are many macro concerns, primarily debt, taxes, and entitlement related obligations, but I don’t feel this is the end all correction some are expecting. Comparisons are becoming much more difficult, but there is also a bit more economic activity. This activity is requiring capital, which is no longer being thrown recklessly at risky assets. I continue to believe we are in a range bound market, and referred back to the January 4th note for this quote “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).”
Earnings look as though they will come in a bit higher than $67, however, with the uncertainty surrounding the macro environment and concerns about a double dip recession, the 15x multiple seems a bit aggressive, so the fair value of 975-1000 stays intact.
The chart below, courtesy of dshort.com, shows how the Hang Seng (green line) peaked first amongst the major global indexes. The US, Europe, and Japan all rolled over simultaneously after making new post crash highs.
A number of readers have asked how far corporate earnings have bounced. While they haven’t reached the prior peak (2007), the chart below shows that they have bounced to dot.com bubble era levels since bottoming in early 2009. Total corporate profits of the S&P 500 are roughly $50 billion or 18% below the peak. The chart below, courtesy chartoftheday.com, shows inflation adjusted corporate earnings of the S&P 500 since 1935.
Actual Consensus Prior
Existing Home Sales 5.77 mil 5.65 mil 5.36 mil
Case Shiller Home Index 2.4% 3.0% 0.7%
Consumer Confidence 63.3 58.3 57.7
Durable Goods 2.9% 1.5% 0.0%
Durable Goods ex Transports -1.0% 0.7% 4.8%
New Home Sales 504K 425K 439K
GDP-2nd Estimate 3.0% 3.3% 3.2%
GDP Deflator 1.0% 0.9% 0.9%
Initial Claims 4607K 4600K 4656K
Personal Income 0.4% 0.4% 0.4%
Personal Spending 0.0% 0.3% 0.6%
PCE Prices 0.1% 0.1% 0.1%
Chicago PMI 59.7 60.0 63.8
U of Michigan Consumer Sentiment 73.6 73.2 73.3
The Case Shiller home price index posted its sixth consecutive month of soft results in March after peaking in September 2009. The first time home buyers’ credit has expired, meaning the housing market is going to lose another one of its training wheels, the first being the Fed exiting the secondary mortgage market on March 31.
Durable goods orders came in ahead of consensus after a flat March. The core number, ex-transportation, actually declined for the month. Transportation orders for April increased 16.1%, while capital goods increased 7.4% and non-defense orders increased 9.2%. Nondefense/non aircraft capital goods orders declined for the month by 2.4%.
More Trouble for the Rating Agencies
Virtually every bond trader has a Bloomberg terminal on their desktop. Bloomberg has revamped their credit products to include an actual rating system (see chart below). While the credit agencies struggle with fiduciary responsibility concerns, government investigations, and investor skepticism, it appears that they also have a new competitive concern.
"With the turmoil in Europe wreaking havoc on the high yield bond market, the week of May 17 saw the second largest spread widening of 2010. Spreads widened 69bp for the week and 33bp on Thursday alone. When Germany unilaterally announced a ban on naked short-selling, a move that could have major ramifications outside of Germany, the markets went wild. The DJIA plummeted 552 points last week, the VIX index, a popular measure of volatility, jumped to 47 Friday morning, and the 10-year Treasury yield dropped to 3.12% at one point last Friday. High yield funds saw an outflow of $378 million, which added onto the previous week's exodus of $1.69 billion, the largest weekly outflow since 2004. Investors are fleeing to safety, and last week saw the lowest weekly high yield bond volume for 2010 to date at $1.30 billion. With spreads on the rise, issuers are waiting for more favorable conditions before testing the markets. Four out of last week's five new issues that priced were LBO deals - transactions that had to close and were therefore not extremely price-sensitive. May has already seen six high yield deals postponed, and this morning's announcement by Allegiant Travel Company upped that number to seven. Many of last week's new issuance traded down, and it is expected that a few more deals will be postponed this week."
California vs. Texas
The Governor of each state was jogging with his dog along a trail. A coyote jumped out and attacked the dog. The respective responses are outlined below.
1. The Governor starts to intervene and then realizes he should stop; the coyote is doing what is natural.
2. Call animal control. Animal control captures coyote and spends $200 testing it for diseases and $500 relocating it.
3. Call Vet. Veterinarian collects dead dog and spends $200 testing it for diseases.
4. Governor goes to hospital and spends $3500 getting checked for diseases from the coyote and getting bite wound bandaged.
5. Running trail gets shut down for 6 months while wildlife services conduct a $100,000 survey to make sure the area is clear of dangerous animals.
6. Governor spends $50,000 and starts a coyote awareness program for people who live in the area.
7. State legislature spends $2 million investigating how to better handle rabies and how to possibly eradicate it.
8. Governors security agent fired for not stopping the attack and letting the Governor try to intervene.
9. Cost $75,000 to train new security agent.
10. PETA protests the relocation of the coyote.
1. The Governor spends $1.23 on a .380 ACP Gold Dot Hollow Point and he and the dog keep jogging.
And we wonder why California is broke?
China’s Inflation Problem
According to the London Telegraph, a rapid expansion of China's money supply strongly suggests that the economy is overheating, said Guo Shuqing, chairman of China Construction Bank, the nation's second-biggest bank. The government's effort to cool off the housing market might be ineffective because property developers are holding so much cash, he said. "Sales are falling but prices are not," Guo said.
Chinese Growth Slowing?
According to Bloomberg, Chinese manufacturing expanded at a slower pace in May, adding to signs that growth may moderate in the world’s third-biggest economy. The Purchasing Managers’ Index fell to 53.9 from 55.7 in April versus a consensus estimate of 54.5.
A government crackdown on property speculation is cooling the economy by damping sales and construction, while Europe’s sovereign-debt crisis could exacerbate a slowdown by cutting demand for exports. China’s policy makers may delay raising benchmark interest rates or letting the Yuan appreciate against the dollar even after the economy grew 11.9% in the first quarter.
India's gross domestic product increased 8.6% in the first quarter, ahead of consensus and compared to a 6.5% increase in the fourth quarter of 2009.
The Gulf Oil Disaster
The number of times I have been asked about whether British Petroleum (BP) is a good investment at these levels or not is astonishing. The short answer is that I’m not sure, but there are significant unknown factors that need to be examined. The chart below, courtesy of stockcharts.com, shows the damage done to the company’s market value since the explosion of the offshore rig.
The questions that need to be answered really center on what is BP’s ultimate liability? There is an obscure drilling law from 1851 that drilling partner Transocean is attempting to use to limit their liability, but it’s applicability may be a reach. Given the current Congress’ willingness to throw anyone under the bus and retroactively change any law they deem to be a roadblock to achieving their goals, I would be a bit wary about placing bets centered on the existing legal limits. An additional question related to the liability is how much BP’s insurance companies are willing or legally obligated to pay? The answer to that one could take years to determine.
The cost of the cleanup will be significant, especially given the leak hasn’t been slowed yet. Additionally, there are unconfirmed estimates that there is a second leak 5-7 miles from the first which is emitting up to 120K barrels of oil per day, well in excess of BP’s estimate of 5K barrels per day. If this is true then the estimates of $10-20 billion will be well short of the actual cleanup costs.
The impact on future drilling will obviously be negative. The Obama administration has already announced they won’t issue any new drilling permits (in spite of new ones actually being issued last week), and many coastal states are rapidly mobilizing to do the same. This will push drillers further offshore into more dangerous and difficult locations.
One question is whether all the environmental concern actually helped cause this disaster. I’m not saying they caused the spill, but instead suggesting that aggressive environmentalist policies have forced oil exploration off of the continental US and into coastal waters, where the drilling environment is much more dangerous and difficult. Had we allowed more on-shore drilling, would it have helped avoid this disaster?
The final point to remember is that access to inexpensive fuel sources, along with superior communication systems dating back to the Revolutionary War, have allowed the US to prosper. Eliminating cheap fuel sources will hamper mobility and transportation, two key components in the success of the US over the past century.
Pension Problems in California
The Wall Street Journal reported this week that for the California Pension system to get fully funded, it will either require massive funding well in excess of the state’s existing tax revenues or the Dow needs to climb to roughly 28,000,000 (from 10.1K as of Friday’s close)!!!
How did we get in this mess? In 1999 then California Governor Gray Davis signed into law a bill that represented the largest issuance of non-voter-approved debt in the state's history. The bill, SB 400, granted billions of dollars in retroactive pension boosts to state employees, allowing retirements as young as age 50 with lifetime pensions of up to 90% of final year salaries. The California Public Employees' Retirement System sold the pension boost to the state legislature by promising that "no increase over current employer contributions is needed for these benefit improvements" and that Calpers would "remain fully funded." They also claimed that enhanced pensions would not cost taxpayers "a dime" because investment bets would cover the expense.
What Calpers failed to disclose, however, was that (1) the state budget was on the hook for shortfalls should actual investment returns fall short of assumed investment returns, (2) those assumed investment returns implicitly projected the Dow Jones would reach roughly 25,000 by 2009 and 28,000,000 by 2099, unrealistic to say the least, (3) shortfalls could turn out to be hundreds of billions of dollars, (4) Calpers's own employees would benefit from the pension increases, and (5) members of Calpers board had received contributions from the public employee unions who would benefit from the legislation. Had such a flagrant case of non-disclosure occurred in the private sector, even a sleepy SEC and US Attorney would have noticed.
Far from being "fully funded" as promised, Calpers has already required $15 billion more from the state budget than projected in 1999 and $3.5 billion is budgeted for this year, a figure that is more than five times the expense projected by the state legislature in its SB 400 analysis. Pensions are crowding out important programs like higher education, parks and health care, and the state will continue to whack away at those programs because the legislature refuses Governor Schwarzenegger's request to repeal SB 400 for new employees!
A recent Stanford University study concluded that California's pension funds are understating liabilities by $400 billion. In response, California's pension funds set up websites and attacked the study as "shoddy" and "faulty."
Cathy Bussewitz of the Associated press reported that “facing massive investment losses, the board of California's giant pension fund voted Tuesday to make the state increase its contributions to employee retirement benefits by $600 million in the coming fiscal year.”
CalPERS, the nation's largest public pension fund, lost $55.2 billion, or a quarter of its value, during the 2008-09 fiscal year.
"The biggest reason why we need increases is the investment losses," said Alan Milligan, interim chief actuary for CalPERS. "Quite frankly, there's more to come.""
Scary stuff indeed!
More Do as I say, Not as I do
Just two days after the WSJ reported that certain members of Congress “made risky bets with their own money that U.S. stocks or bonds would fall during the financial crisis,” it followed up with a story noting that the “Stop Trading on Congressional Knowledge (the ‘STOCK Act’)” continues to languish in Congress. The STOCK Act would prohibit lawmakers from engaging in insider trading based on nonpublic information they learn on the job.
The WSJ’s reminder that Congress currently can’t be held liable for insider trading based on congressional knowledge seemed to come as a surprise to many people. “That’s right! Members of Congress are currently allowed to profit on insider trading!,” Yahoo! Finance reported in an article last week.
In January, U.S. Reps. Louise Slaughter and Brian Baird introduced—for the third time—legislation intended to stop insider trading on Capitol Hill called the “Stop Trading on Congressional Knowledge Act” (the STOCK Act). Slaughter and Baird also introduced similar bills in 2006 and 2007, without success.
Now yet another year has passed, and the STOCK Act has made absolutely no progress. In fact, its minimal support continues to dwindle. As the WSJ notes, when Baird and Slaughter “first proposed the legislation more than four years ago, they were able to persuade just 14 of their colleagues to endorse it. The current version of the bill has fared worse: Only six lawmakers have agreed to support it, and Mr. Baird has announced that he is retiring from Congress at the end of the year.”
Thanks to Al Daniels
More Pension Problems
A Democratic senator is introducing legislation for a bailout of troubled union pension funds. If passed, the bill could put another $165 billion in liabilities on the shoulders of American taxpayers.
The bill, which would put the Pension Benefit Guarantee Corporation behind struggling pensions for union workers, is being introduced by Senator Bob Casey, (D-Pa.), who says it will save jobs and help people.
As FOX Business Network’s Gerri Willis reported Monday, these pensions were in bad shape; as of 2006, well before the market dropped and recession began, only 6% of these funds were doing well.
Although right now taxpayers could possibly be on the hook for $165 billion, the liability could essentially be unlimited because these pensions have to be paid out until the workers die.
It’s hard to say at the moment what the chances are that the bill will pass. A hearing is scheduled Thursday, which will give the public a sense of where political leaders sit on the topic, said Willis.
Just last week President Obama said there would be no more bailouts. Does that include pension funds?
US Lagging in Competitiveness
According to Google and the Associated Press, for the first time since 1993, the U.S. does not hold the top spot in the World Competitiveness Yearbook's rankings. The 2010 yearbook, published by IMD business school, put the U.S. in third place, behind Singapore and Hong Kong.
China IPOs Remain Hot
One area of the market remains hot-Chinese IPOs. China's initial public offerings have seen the best performance in the world this year, according to Bloomberg. During their first month of trading, Chinese IPOs are outperforming the nation's equity indexes by 3300 basis points.
I won’t say that my daily economic notes on Twitter have been an explosive success so far, but I haven’t received any complaints either. I have been consistently sending out the morning economic data via Twitter, and a handful of people have subscribed. I’ll continue doing it unless a better method comes along or people stop caring.
Interestingly, I have found that my weekly notes are being “re-tweeted” by numerous readers. I have to be honest, I’m not sure why someone would re-tweet what another person wrote, but I am curious to find out. If you are one of these “re-tweeters”, please shoot me a note so I can understand the logic and maybe help you in this distribution.
A reader corrected my 1AM typo last week, and it was significant enough I though I’d better include it in this week’s note. When I was discussing the CPI adjustments made in the early 1990’s, I referred to the new pricing method as “hedonistic”, when in fact it is “hedonic”.
Happy Memorial Day to all of our active servicemen and veterans. Thank you for your loyal service which has been instrumental in ensuring we have the freedoms promised to us in our Constitution.
Have a great week.
“Whatever method you use to pick stocks…your ultimate success or failure will depend on our ability to ignore the worries of the world long enough to allow your investments to succeed. It isn’t the head but the stomach that determines the fate of the stockpicker.—Peter Lynch.