December 21, 2008

Merry Christmas

Weekly percentage performance for the major stock averages
Based on last Friday's official settlement...

INDU: -.59%
SPX: +.93%
NDX: +.87%
COMPQ: +1.53%
RUT: +3.81%

Volatility seems to be finally coming down, and now resides at levels we would have historically called very high, with the VIX closing just under 45 after peaking above 89 in October. Market volatility certainly feels more normal, especially when compared to the 5% daily movements we were experiencing during the past few months. I don’t know if this means we are returning to a more “normal” market period or not, but I do know that the pause in the volatility roller coaster ride is a welcome relief and almost enjoyable.

The Not So Big Three
GM and Chrysler received approval for $13.4 billion (or $17 billion, depending upon which version you read) in loans, enough to keep both of these teetering entities operating through March. As I mentioned last week, the resolute President Bush decided to rollover and play like a house Dem, pushing for funds from the TARP after he had taken a hard-line stance against using TARP funds initially. Why did he cave? There are a couple of theories out there, with the most likely being he didn’t want to be blamed for any more debacles under his watch, so he decided to push it off to the new administration. A sharp, if somewhat cynical investment banker friend posited that by backing down, Bush took one for the team and allowed the Senate Republicans to claim victory with their constituents when they blocked the original bill. If you recall those philanthropic fellows at Cerberus mentioned they would forgo any profits on their Chrysler acquisition if they received government funding. Now that they have received this funding, the obviously overburdened folks at Cerberus felt it was time for a public relations email, in which they said “concessions by all relevant constituencies” are needed to restructure Chrysler. We’ll see what the UAW, and more importantly their pensioners have to say about giving concessions.

Oil & The Dollar
I was actually preparing to write a piece on the firming of oil prices in the face of the dollar’s recent weakness, until the commodity took a $12 hit during the week, closing Friday at $33.87. As shown in the chart below, the relationship between the dollar and oil has been very strong (i.e. weak dollar leads to stronger oil prices) historically, however, with supply continuing to swamp global energy demand; it appears that the dollar is taking a backseat for the time being in determining the level of black gold. Since peaking at $1.60 per Euro in the middle of July, the Euro fell 23% by Halloween before a recent 13% bounce brought it back to almost $1.40.




Why has oil not kept up with the Euro? Demand for oil has fallen significantly, and in spite of significant announced production cuts by OPEC, supply continues to swamp demand. The chart below shows the number of active oil rigs since 1988. Even with the recent pullback you can see that global rig counts are still near an all time high. My favorite quote of the week came from a Kuwait Oil Minister, who said “we are having trouble finding customers”. This is oil, not Circuit City. Finding customers shouldn’t be a problem, unless the world is in a global recession and awash with oil.




More Money
The Bloomberg Financial Conditions index, an amalgamation of multiple yield spreads and indices in an effort to represent financial conditions in a single, normalized index. As you can see from the chart below, conditions have improved significantly since early October, however, during the last recession this measure bottom around -2.1, but now sits at a paltry -5.9! While it is up significantly from that dreadful bottom, indicating we have seen some thawing of the capital markets since the Lehman bankruptcy, the reality is that things are still tough out there and banks are not yet lending.



Bernanke continued Greenspan’s irresponsible dollar policy as the Fed lowered its target rate to a range of 0 to .25 percent. They are considering buying treasuries, which is quantitative easing and should further weaken the dollar. Earlier this week the dollar fell to a 13 year low versus the Yen on the back of the rate cuts, and has now dropped 21% vs. the Yen this year. Debasing your currency helps exports, helps the price of gold, fuels inflation, and makes paying back our enormous debt level cheaper.

Stephanie Pomboy, the proprietor of a macro economic shop called MacroMavens, commented on the dollar this week by saying “Either we are going to pay for our policy sins via higher interest rates or a weaker dollar. And for an economy that is as levered as the one in the US is, the former choice is not an option. So a weaker dollar is the natural valve.”

Treasuries
What gives with treasury bonds? The short end of the curve is yielding nothing, meaning you don’t get paid for lending money to the government, and the long end has come in significantly. The shape of the curve typically gives some indication as to the future of the economy, and while today’s curve is much more bullish than that inverted grotesqueness we experienced in the middle of 2006, it is still far from steep enough to indicate the end of the current economic malaise is within reach. The peaks of 1991 and 2002 preceded great growth markets, but stood at levels much higher than today. Both of those prior recessions were much tamer than the one we are presently experiencing, and I would guess that the curve needs to get one heck of a lot steeper to give us a viable signal that we are close to an economic bottom. Stay tuned!



Misc Corporate Stuff
As I discussed a few weeks ago, shippers are now cancelling ship orders. The Baltic Dry index, a measure of shipping rates for various size ships, is now an astounding 93% below its high in May. While the index has bounced slightly from its December 5th low, it is still exceptionally weak, an indicator that global trade continues to be weak.

On February 17, 2009, full-power TV stations will stop broadcasting in analog and switch to 100% digital broadcasting. This should be a small boon to the cable companies as older analog sets will require digital converters, which the cable companies are happy to provide at a small monthly fee, to broadcast TV signals.

S&P lowered their debt ratings on Goldman Sachs, Deutche Bank, UBS, Morgan Stanley, Royal Bank of Scotland, Barclays, and HSBC. This should serve to raise the cost of capital to each of these firms. While I applaud S&P for making this move, I can’t help but wonder what took them so long. These companies have fallen far from grace, yet S&P just gets around to downgrading their outlook? Wow! This is another job I think I could handle in about 10 minutes per week along with writing this letter and determining when the US enters and exits recessions.

Which stocks worked in the past few weeks’ rally? In general it has been those companies who are being perceived as beneficiaries of President-elect Obama’s proposed stimulus plan. Outside of the $600 billion/$750 billion/$800 billion/$1.5 trillion the President-elect has suggested, there is really very little information to speculate upon. Needless to say, the market is trying to guess ahead of this entire stimulus. Personally, when the time comes to move back into equities, I would follow the basic principal of business cycle investing and move towards the traditional early cycle stocks (consumer, financial and transports).


Too Big To Survive?
We have heard a ton of commentary over the past year about which firms are too big to fail, i.e. which companies deserve a government bailout. The list is growing by the week; however, maybe the list should be zero? This thought comes from an investment banking friend, who wonders if maybe goliaths such as JP Morgan and Citigroup (among many others) shouldn’t be deemed to big to survive. That’s right, too big! Maybe their very existence creates an enormous risk to the system? Our banker friend, who by the way is not some crazed anti-capitalist but instead a true conservative, both fiscally and socially speaking, further wonders if maybe some type of antitrust or other regulatory action might be required to reduce the size of these large institutions in an effort to minimize any impact of their potential collapse. This is certainly food for thought and something the new administration can chew on, or at least address in one of their many press releases.

Cheap Stocks
Wall Street strategists and analysts are marveling at stocks now trading close to cash. Recently we saw a list of stocks trading at less than 2x cash, without any significant debt burdens. While companies trading close to cash, generating positive cash flow, and lacking debt are certainly getting more attractive, I can’t help but remember the fall of 2002, when stocks were trading as low as 30% of the cash balances while generating positive cash flow and carrying no debt. While stocks are certainly getting cheaper, it is very dangerous to try and pick a bottom, especially when that bottom is based upon factors such as multiples of cash, which historically have little correlation to stock price performance.

Credit
While treasuries have been trading in their own bubble, with the short end of the curve yielding 0%, high yield and corporate grade bonds have yet to show significant improvements. In fact, it is my opinion that senior debt represents the greatest return opportunity of any asset class right now. Even high yield, which is carrying a 22% yield according to Merrill, is cheap even if we experience a significantly increased rate of default.

Economic Reports
CPI was down 1.7%, the fastest decline since the great depression. This gives fuel to those who are concerned about deflation. Personally, I think deflation is a temporary phenomenon we will experience before inflation spikes and the dollar falls into an abyss as we come closer to the end of this morass. Despite government efforts to halt the slide in housing, housing starts were down 19%. The Leading Economic Indicators were once again down, this time dropping 0.4%.

More Madoff
As if there weren’t already a crisis of confidence on Wall Street, Bernie Madoff decides to abscond with approximately $50 billion. This had to be a very elaborate scam, and I find it highly unlikely that he acted alone in this caper. Outside of the great tabloid fodder, my guess is that the end result will be significantly more transparency from hedge funds. Legitimate funds should have no qualms about opening up their books to profession investors or customers.

Commodity Odds and Ends
Intrepid Potash (IPI) announced this week that they anticipate production volumes of potash and langbeinite for the full year to be far below the previous guidance range and anticipates that its corresponding annual cost of goods sold for both potash and langbeinite will be higher than previous guidance. The higher cost per ton numbers are a function of the company strengthening its workforce and continuing infrastructure improvements while at the same time producing fewer tons in response to declining demand. In order to manage some variable cost elements, the Company has recently elected to reduce its contract labor in Carlsbad, New Mexico through the end of 2008 and into 2009 as long as the current market conditions exist.
As a result of entering 2009 with relatively higher than historical inventory levels, and in an effort to manage the supply demand balance, the Company currently anticipates that 2009 potash production will be below 800,000 tons.
IPI’s Chief Executive Officer, Bob Jornayvaz, states “We are evaluating the market in a real-time fashion and taking the appropriate actions to navigate the Company through this period of general market uncertainty. We will continue to actively monitor sales and production rates to manage inventory levels against the near-term market demand profile while at the same time being thoughtful about long-term fundamentals. We firmly believe that the macro potash trends of world population growth, improved diets and farmers investing for yield remain unchanged.”
I can only say “I told you so”.

January Effect
Traders Almanac says that the January effect now happens in December. Satya Pradhuman of Cirrus Research says that consumer services, telecom, consumer discretionary, tech and health care will benefit from a January effect since they are off over 30% from their peak and have the most companies trading under 2 times cash. Other factors Satya is looking for include positive cash flow, Forward P/E, Cash Adj. Debt Due in 2 Yrs, Analyst Est. Chg, Net Debt/Total Cap and YoY EBITDA change. I still believe we are seeing a bear market rally, however, as I mentioned earlier in this note I agree with Satya’s position on the various sectors as his recommendations are effectively the traditional early cycle groups.

Mortgage Rates
Mortgage rates have dropped significantly, nearing 5% in most parts of the country for conforming loans. Interestingly, most of the new mortgage activity has come in the way of refinancing as individuals are taking advantage of the lower rates to reset their mortgages. The goal, of course, of lower mortgage rates is to help the sagging housing market by encouraging affordable borrowing. Although credit is still tight, the problem isn’t financing, but in fact people’s sullen outlook for housing in general. Additionally, the stimulus has resulted in the housing market finding a short term bottom; however, it still isn’t low enough for the typical first time buyers who will be instrumental in repairing this market.

Miscellaneous
Recently a resort offered rooms for rent and was accepting as payment the stock of financial firms who’s stock had fallen significantly. A novel approach to bottom fishing on these stocks.

This unsubstantiated rumor about Citigroup, who evidently took money out of people’s checking accounts instead of automatically depositing funds into them. This is a very novel way to raise capital for a bank, but undoubtedly very low cost funds.

Conclusion
Tonight I discussed a lot of data points, but the summary is that I still think we have some upside risk to the market in the short run. Longer term, I see the market staying roughly between 800 and 950 (closed Friday at 887).

Final Point
I have joined the world of new media and have launched a blog site to house all the historical notes I have published. The site is almost fully operational, and once it is I will send you the link to the site. I have loaded all the old notes, and just need to spend some time putting together all the old charts and graphs and getting them to display properly. Any of you who are tech heads and want to give me a hand, feel free to call. The subscription link on the site should allow people to sign-up for the weekly notes directly from the site. Let me know what you think.

I wish you all a very Merry Christmas and a Happy New Year. Next week’s note will probably be a bit light; however, I expect to have a full year wrap up in the following week’s note.

As I write this note, the NIKKEI is up 1.2% while the Hang Seng is down 1.7%. Crude is up slightly at $43 after bottoming below $34 on Friday.


Ned

Ned W. Brines
nbrines@gmail.com
(562) 430-3232