I hope you are well

October 19, 2008



Lot’s of crazy stuff going on during the past week. Following on the heels of the worst week in most of our lifetimes, this past week provided some relief as Monday opened with an upward explosion, the biggest up day in the market since the great depression (up 12%). There were quite a few possible catalysts, however, in my view the most important event was the government bailout plan getting the “tweak” I had been saying was needed for quite some time. Investing $250 billion along side the banks will provide up to $2.5 trillion in additional lending capacity, without requiring the banks to rely on each other. In my view this is going to help thaw the credit markets much faster than a nebulous plan to buy bad loans from the banks.



We are certainly not out of the woods, especially given the economic backdrop, which continues to deteriorate. The market apparently agrees because following Monday’s amazing performance, we also saw the market drop 9% on Wednesday, the biggest one day drop since October 1987. Even Ben Bernanke and Treasury Secretary Paulson now agree we are entering a recession! It must be nice to live in an ivory tower and not have to worry about sky-rocketing living costs, exploding unemployment, 401(K)’s turning into 101 (K)’s, a rapidly rising tax bill (for those still drawing paychecks), and all around economic malaise. Tell your kids to go to work for the government, evidently life there is always great no matter what is happening in the real world. I was a bit amazed to see that according to Merrill Lynch, 80% (+) of money managers now believe we are in recession versus about 25% in June. I understand the government types either missing or glossing over the economy, but these managers should be ashamed of themselves. The signs of recession have been in place since early/mid 2006. Maybe now that they are all getting negative we should start putting money back to work in the market (see Buffet comments below)?



Back here on earth there are some disturbing macro items I want to highlight. The first is the University of Michigan Survey of Consumer Confidence (chart below), which just slipped to a 30 year low last seen in early 1980. This measure appears to have peaked most recently at the end of 2006. This measure is typically tied to the employment outlook, but I think it is worth noting that during two prior lows (1990 and 2002) it only took an invasion of Iraq to turn this measure around. Would an attack of Iran suffice? How about Seattle? I’d say Sacramento, but a certain action hero occupies that town and I’m afraid we might get terminated.









From late 2005 to the middle of this year the Baltic Dry Index (chart below) went from one of those measures very few people followed to a momentum investor’s dream. This index measures the carriage rates of various sizes of ships, and during the great commodity and grain bull market this index spiked to all time records. As with most commodity goods and services, pricing has rolled over significantly as demand has ebbed in the global economic slowdown. Obviously this rapid decline in demand is taking its toll on the BDI, right in front of record ship deliveries (amazing how that tends to happen), the orders of which were placed while capacity utilization was at an all time high. Wonder if we’ll start seeing cancellations? I recently attended a dinner where a very young portfolio manager (see Merrill survey referenced above) was postulating about a certain ship building company who should be a great investment because of the large backlog of ships on their books. Hmm.













Look at the ISM below (or look out below)! The ISM has collapsed into recession territory, and based on prior drops it looks like it has quite a way to go. The ISM is a monthly measure of changes in production versus the prior month, and is one of the longest series of economic data in existence (since 1948). Tomorrow the Leading Economic Indicators are release (7:00 AM PST), and the street is looking for a decline of 0.1%. I’d be surprised if that was the extent of the decline coming on the heels of a 0.5% decline in August and a 0.7% decline in July.













Housing starts and building permits have collapsed since peaking near the end of 2005. If you haven’t looked at this yet, it’s obvious that while Congress, the Fed, the Administration, and many others never saw the housing downturn coming, someone must have seen it. Look at how the permits drop like a rock, from 2.3mil in September 2005 to 780K last month-almost in line with January 1991. If you remember much about that housing shock, we didn’t see the housing market begin to show real life until almost five years later. I’d argue this bubble was much bigger than that of the late 80’s and housing has quite a ways to go before it hits bottom, and even longer before it makes any meaningful upward movement again.











I showed this chart last week, but thought it was worth including again. This is the S&P 500 going back to 1928. The bottom chart is a bit more expanded than the last one I sent, and shows the monthly values of the RSI. Last Friday the RSI bottom out around 23, slightly below the lows of 1932 and 2002, but slightly above the low of 1974. Could this be a bottom indicator?









As I mentioned last week, after such a dramatic market collapse, we are probably due for a pretty healthy rally. Given the shaky economy, I would use the rally as an opportunity to take money off the table. Under any circumstance I’d be focused on upgrading the quality of my holdings. Stable, defensive companies with solid balance sheets, sustained margins being helped by collapsing commodity prices, and rock solid dividends make sense in this environment. High quality has outperformed low quality all year, and should continue to do so until we get closer to the end of the tunnel. Buffet is buying, citing the fear on the street as a sign it’s time to buy. I don’t like to try and outguess the Great One, but I still believe we’ll be seeing these market levels a couple more times before we finally say goodbye to the S&P in triple digits.



As I finish this note, the Nikkei is up 1.6% and the Hang Seng up 2.9%.



Have a great week. As always, if you’d like to be removed from this list, let me know.



Ned