April 5, 2009


The problem with socialism is eventually you run out of other peoples’ money.” – Margaret Thatcher

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

INDU: 3.1%
SPX: 3.3%
NDX: 5.2%
COMPQ: 4.9%
RUT: 6.3 %

Market
The market continued its upward march with the S&P 500 moving to 842, slightly above its 100 day moving average (green line on chart below). The index has now moved an impressive 26% off its March 6th bottom, and is just 8 points short of the area where I felt this rebound would get tested. There are certainly valid arguments to be made for the market to continue its upward path, not the least of which is the improvement in the capital markets as evidenced by the positive change in the Bloomberg Financial Conditions Index (second chart below)






G-20
The G-20 meeting resulted in a pledge of $1 trillion in emergency aid, stricter limits on hedge funds, executive pay, credit rating companies, and bank risk-taking. And in what is sure to be another sinkhole for capital, they offered more than $750 billion to the International Monetary Fund (IMF), one of the worst run financial organizations in the world. In summary, bowing to German and French demands, the G-20 has agreed to rewrite the rules of capitalism. Some of the new rules involve limits on excessive leverage- I wonder if the US will qualify?

The end result of these meetings will be a more global regulatory and financial system that de-emphasizes the US. Instead of celebrating this as a victory, we should mourn the loss, or more accurately the give-away of yet one more industry in which we were the global leader. I guess now we can be the global leader in bankruptcy attorneys.

The markets celebrated with a rally on Thursday, but for what? The #1 priority for team Obama was to get hard commitments for stimulus from other countries, yet was blocked by the Germans and French. The $1 trillion pledge was a PR number while the actual commitment was to “do what we can.”

Did you notice?
Did you notice that as the market roared off the G-20 meeting, the movement clearly favored the inflation play (with the exception of gold)? Bonds and the dollar fell while oil and materials rose. In the S&P 500, the groups I have been saying need to lead for a real rally were leading the rally-transports, consumer discretionary, financials, and energy (although that one hasn’t been one of my target groups). Could this rally be for real?

Junk Bounce
Jim Furey of Furey Research Partners feels that “the typical manager is lagging off the March 9th bottom. Why? Low priced (+48%), micro-cap (+43%) and loss making (+45%) R2000 firms are outperforming sharply since the March 9th bottom. Few managers own these shares. These returns compare to the average R2000 stock, which has risen +34% since March 9th. Consumer Discretionary and Financial sector low priced, micro-cap, loss making firms have been the strongest and are likely under owned.”

To me this is reminiscent of the 2003 rally, in which sub $5 and micro caps led a monstrous rally. Small caps were up over 40% that year, staging a rally that began around the Iraq invasion in March 2003.

Unemployment
Much has been made about the rising unemployment rate. According to Liz Sonders at Charles Schwab, unemployment typically peaks near the end of a recession. The chart below seems to confirm this thought, and also confirms employments’ status as a lagging economic indicator.



More Problems from California
From Art Laffer: “the problem is that California has the most “progressive” (ah, what a deceptive term!) income tax code in the country. Tax progressivity exaggerates the normal ups-and-downs of the overall economy, and explains why income tax receipts in California are among the most volatile of all the 50 states. When times are good, California citizens earn more, pushing many of them into a higher tax bracket, thereby giving the state a larger fraction of a bigger pie. But then the opposite holds true during recession. People earn less income in general, thereby shrinking the tax base, as many fall into lower tax brackets and pay a smaller fraction of smaller paychecks. This one-two punch explains why hard times seem to hit California harder than other states.”

These comments follow reports that the state is looking for federal backing for additional borrowing.

Commercial Real Estate
Commercial real estate delinquency rates have jumped. The Real Estate Roundtable, a trade group, estimates that commercial real estate in the U.S. is worth $6.5 trillion and financed by about $3.1 trillion in debt.

Deutsche Bank estimates the default rates on the $700 billion of commercial-mortgage-backed securities outstanding could hit at least 30%, and loss rates, which figure in the amounts recovered by lenders, could reach more than 10%, the peak seen in the early 1990s.

Economy
California reported 80,775 properties with foreclosure filings in February, a 5% increase from the previous month, according to the latest RealtyTrac® U.S. Foreclosure Market Report. The CaseShiller Home price index was down 19% year over year, roughly in line with consensus.

The Chicago Purchasing Manager survey was under the consensus, posting 31.4 vs. the 34.3 expectation and 34.2 in the prior period.

The ISM manufacturing index measured 36.3 vs. a 36.0 consensus and 29.0 in the prior period. The ISM prices paid was 31 vs. the 33 expectation.

Payrolls were inline, with another 663K job losses announced and the unemployment rate up to 8.5% from 8.1%, a new 25 year high. Manufacturing payrolls were down 161K.

ISM lows and the Market
From Deutsche Bank: A very interesting chart on the ISM, which hit the low 30's in '49, '74 and '80 and snapped back above 50 within 7months, 7months, and 4months respectively.

February of '49 Low at 32 on the ISM - the market declined another 5.5% by May. However, that was the low - from there the market rallied 30% by Feb of 50. Also, that represented the beginning of a 10 year Bull Market as the market was up 3-fold during the 50's.

December of '74 at 31 on the ISM - the market rallied roughly 30% from end of Dec 74 to March 75. The market was up roughly 40% by Dec of 75. Sept 74 was the low - Dec 74 was a retest, but we never broke that Sept 74 low. From there we did not experience a raging bull market, but we were up over 70% by the end of the 70's from the 74 low.

May of '80 at 30 on the ISM - the market rallied roughly 12% from May 80 to Aug 80. The low in the market had already formed in March of 80 and by May of 81 the market was up about 18%. The 80's represented another good bull market - the market was up over 200% by the end of '89 from the May of 80 level.



The Fed
From Bloomberg: Bernanke noted that "credit spreads are much wider and credit market more dysfunctional in the United States today than was the case during the Japanese experiment with quantitative easing." Because the U.S. financial system has seized up more than the Japanese financial system did during its crisis, the Federal Reserve has chosen to tackle the U.S. financial crisis in a different way. Rather than simply expanding the quantity of banks' excess reserves as the Bank of Japan did, with the hope of boosting bank lending, Bernanke indicated that the Fed has chosen instead to "focus its policies on reducing [key credit] spreads and improving the functioning of private credit markets more generally."

GM Conspiracy
President Obama, who has no business experience whatsoever, has determined in his inestimable wisdom that GM needs to go through a prepackaged bankruptcy. Personally, I don’t disagree with the President, but think it’s tantamount to Richard Nixon announcing that Charles Manson was guilty during the Tate-LaBianca murder trials.

Some of my more cynical readers (I swear it’s not me) are suggesting that Obama’s attempt at taking over GM is solely to promote the production of smart cars. The President has often indicated he is looking towards a US future with no carbon emissions, so their suggestions certainly have some validity.

Japan
It appears Japan will be hitting their economy with another enormous stimulus package. I don’t have an exact count, but I believe that this is their 5th or 6th attempt at big stimulus packages, all of which have been funded by printing paper. Japan’s total debt is close to 2x their GDP, and yet the economy hasn’t rebounded at all. Maybe the people crafting our stimulus packages should take note that printing money to foster consumer spending and lending has never succeeded.

EU
The ECB cut rates by 25bps, sparking a rally as investors had anticipated a cut of 100bps. In a refreshing piece of common sense from a Central Bank, the ECB feels that easy money won’t cure a hangover from a period of easy money. Comments were also made that the economy didn’t “need to stimulus” right now.

Mark to Imagination
Changes to FASB 157 will allow banks to mark the loans in their portfolios to some imaginary value. So let me get this straight-the banker who made a bad loan that is now worth 40% of face value has the leeway to mark this same loan back to 80%, 90%, or 100% because he feels it has more value than the free market ascribes to that loan? If nothing else, this should boost bank earnings by the second half of the year and once and for all kill any need for banks to participate in the PPIP.

Things are getting more bizarre by the day! Next thing you know the Czar of the United States will start firing the CEOs of major corporations.

Recessions
Courtesy of Chart of the Day, the length of US recessions is shown below.



Blog
On April 3rd I published a short and somewhat entertaining note which walks through the steps of creating a derivative security. Click on http://weeklymarketnotes.blogspot.com and look in the right hand column under “the old stuff”, 2009, April, Derivatives Explained to view this quick read.

Dollar
I have discussed the potential fall of the US dollar many times due to reckless stewardship and the resultant loss of desire to hold our currency by foreign trading partners. The chart below shows what appears to be the first drop in dollar holdings in the past decade. Should this trend continue, then hello inflation and goodbye dollar.



Oil
The chart below shows the massive drop in US rig counts since late 2008, from over 2000 to just over 1000. Global rig counts have taken a similar plunge, falling from 3500 to 2700 since September. While oil inventories have been rising, it would appear that any increase in demand could quickly bump the price of oil.



Conclusion
This week should give us a sense as to whether this bounce will continue or lose steam. The market is approaching levels that suggest it should hit some resistance, however, if it moves through these levels it is certainly feasible that the S&P 500 could move well above the 900 level. Stay tuned.

Please have a wonderful week and a Happy Easter.

Ned


"The market can stay irrational longer than you can stay solvent." - John Maynard Keynes