Did I Get Bullish?

Did I Get Bullish?

April 12, 2009

“The key to long-term profits on Wall Street is not making big killings, it’s not getting killed.”-Daniel Turov

Weekly percentage performance for the major indices
Based on last Thursday’s official settlement...

INDU: 0.8%
SPX: 1.7%%
NDX: 1.8%
COMPQ: 1.9%
RUT: 2.6%

Market
A big rally Thursday pulled the market into the black for the fifth consecutive week. For the S&P 500, which closed at 856, the move put the index down just over 5% for the year and near the levels of early February. As I posited in my first letter of the year (http://weeklymarketnotes.blogspot.com), and have reiterated throughout the first quarter, I still anticipate a range bound market for the foreseeable future. While there has been improvement on the credit side of the economy (see below), and some indicators have slowed their rate of decline (see Leading Economic Indicators below), the economy is still dropping and I’m not seeing the bottoming signs necessary to sustain a new bull market.

Last week I wrote that the groups moving in the market made me more inclined to believe that this latest rally could have some legs to it. In response to the many emails I received asking if I had suddenly become bullish, the answer is no. Please note, however, that the market deserves to be listened to, and the prior market rallies were screaming ‘bear market rally’ by their constituent leaders, which were the same stocks that led the prior bull. In my studies, it is rare that a new bull is led by the prior bull’s leaders. This recent rally, which has been right on queue with my outlook, has been led by more of the early cyclical groups, which I have maintained would be the leaders coming out of this bear (see More Market below for an argument against that view). My more positive comments last week merely reflected that view, but I still feel the markets will be range bound, potentially for many years. If you recall from my previous notes I expected this rally to peak in the 830-850 range, and we are slightly over that upper level. A continued move to the upside will require an obvious reassessment of those levels, and you’ll be the second to know (right after my trader).

Leading Economic Indicators
The ECRI leading economic indicators are still negative, but less so than at the end of 2008. Remember that at the present level of -20 the measure is still lower than at any time in the 40+ years that the index has been maintained. The prior low was near the end of 1974.



Defense Cuts
Defense Secretary Gates announced major cuts in defense systems which approached $500 billion. The cuts targeted major programs such as the C-17 transport and F-22 fighter. Raytheon, Northrup Grumman, and Lockheed Martin would be directly impacted, potentially impacting over 200K jobs. Gates announced a new focus on less sophisticated enemies and away from these major systems.

Let’s hope that China doesn’t decide to attack us when we devalue their $1 trillion in US dollar holdings, since I doubt they would be considered a “less sophisticated enemy.”

Mortgages
From a reader: “Quietly last week Fannie and Freddie lifted their moratorium on foreclosures and that is not good for housing prices. It is interesting that when they initially announced the moratorium on foreclosures it received a lot of publicity, but this announcement is scarcely receiving any press.”

More from the same reader “A few years ago FHA loans were a small part of most lenders originations but 2009 has brought them to the head of the pack but BIG trouble is coming soon and a government bailout may not be far behind. 20.7% of all FHA loans issued in 2008 are at least 60 days late whereas only 14.1% of subprime loans that were issued in 2007 are 60 days late. This should not be surprising to anyone as a 3.5% down payment is lost almost immediately with home prices falling every month. We are not even close to the end of the housing crises but the government is too busy wrestling with Congress over AIG, the banks and more regulations to see what is so clear to anyone outside of Washington.

The Comptroller of the Currency released a report Friday that showed re-default rates for modified mortgages continued to rise at the end of 2008. 41% of modified loans in the first quarter of 2008 were 60 days or more late by the third quarter and 46% for loans modified in the second quarter. If house prices continue to fall (and they will) every modified loan will be delinquent within months because homeowners won’t make payments on a house loan when the amount due is more than the value of the house. Add a rising unemployment rate and it’s a recipe for many more years of the U.S. recession/depression.”

Corporate Debt
According to Moody’s 35 high yield companies defaulted in March, the highest number in single month since the 1930’s. The default rate jumped from 4.1% to 7% in Q4, and appears poised to move higher in Q1.

Government Debt
According to the CBO, the budget deficit reached nearly $1T during the first half of FY '09 and receipts fell around $160B, or 14% Y/Y. Nearly half the drop was from a fall in corporate income tax receipts, the largest such fall in more than three decades.

Automotive Debt
Not satisfied at making horrendous loans that have contributed to driving them close to bankruptcy and into the waiting arms of the government, GMAC has announced they will make an additional $5 billion available for dealer and consumer loans. Among some of the perks are guaranteed payments if the borrower loses his job.

Didn’t the housing crisis start with similar poor lending standards?

Another Top of the Market Call
In what has to be a sign the market is topping, Goldman Sachs is preparing to repay their $10 billion TARP loan (remember they announced plans to do so when the government announced they would cap recipients pay at $250K) by issuing new common stock. GS has been very adept at issuance of debt, equity and preferred at very favorable times (ask Warren Buffet).

Earnings
Retail same store sales came in last week slightly better than anticipated, which helped really fuel stocks in the sector. Surprisingly, Wal-Mart stood out as one of the few retailers to miss on their comps. Of course, Wal-Mart was also one of the only retailers posting positive comps last year, so they had a tougher year over year comparison than the others.

According to Liz Sonders at Charles Schwab, “retail March same-store-sales came in mixed, but many consumer-related stocks were higher, as traders viewed the results as stabilizing.”

Economy
Retail sales improved in the April 4 week, up 0.6 percent from the prior week, but remain weak at a year-on-year pace of -0.3 percent. ICSC-Goldman reports some pullback at discount chains but strength at ultra-discount dollar stores. The report expects sales for the full month of March flat to 1 percent lower.

Wholesale inventories dropped 1.5%, the largest decline since 1992 as sales at US wholesalers rose in February for the first time since June, up 0.6%. Additionally, factory inventories dropped 1.2%. Wholesale inventories (25%) and factory inventories (33%) make up approximately 58% of US inventories, with the rest residing at retailers.

These continued inventory declines suggest that, if demand has stabilized, we may experience an increase in manufacturing activity in coming months to replace the depleted wares. Personally, my data points suggest we are already seeing some pickup in manufacturing.

The trade deficit dropped on a huge drop in imports, coming in at a deficit of $26 billion versus expectations of -$36 billion. Lower oil prices and slowing consumer spending contributed heavily to this decline.

The pundits have stopped being shocked over the 600K (+) job losses each week. In an obvious case of becoming numb to the magnitude of the problem, there no longer seems to be shock value attached to over 1 million people losing their jobs every other week. The chart below shows the rate of new claims (gray line) and also the 4 week moving average (red line). I guess that you could say there has been some moderation in the rate of job losses as indicated by the small flattening of the moving average, but that seems like a reach to me. Remember that employment is a lagging indicator.



Toxic Debt
According to the London Times, the International Monetary Fund is forecasting that financial institutions have racked up $4 trillion in troubled debt. In its upcoming assessment of the global economy, the IMF is expected to raise its estimate of the deterioration of assets originated in the U.S. from $2.2 trillion to $3.1 trillion by the end of 2010. Meanwhile, troubled assets originated in Asia and Europe are expected to total $900 billion.

Thank goodness the new proposed regulations from Congress won’t require banks to mark these assets to market.

Welcome Back Mike
Bank analyst Mike Mayo recently left Deutsche Bank to join a Calyon division. His first report was filled with gloomy forecasts, including a prediction that loan losses because of the financial crisis will exceed levels seen during the Great Depression. Of the 11 banks under his coverage, he rated them all either underperform or sell.

More Market
David Rosenberg, the soon-to-be former Economist for Merrill Lynch, had this to say about the recent 25% rally:

“As for this 25% rally in three weeks – the consensus has swung to the view that this is a real inflection point. One warning. We saw this happen in late 2001 and early 2002 too … big, big rally; early cyclicals flew; the markets thought we were in for a V-shaped recovery … it was longer away than many at the time believed and many were burnt as a result. And keep in mind that the ‘second derivative’ on growth began to improve in the fourth quarter of 2001, and the S&P 500 still did not bottom for another year.

Currently, the equity market is priced for $70 on earnings on a going-forward basis, or a 75% rebound. And with retailing stocks up 30%, leisure/accommodation up 35%, and the homebuilders up 40%, the market is priced, amazingly, for a revival that is led by the consumer! (in fact, the only S&P sector that is now trading at P/E multiples that are at post-2001 highs is the consumer cyclical group). If we see that in the next year, we will be the first to hang up our Hewlett Packards. Being up 25% in a year and staying bearish … well, shame. Achieving that in less than a month – come on. Too flashy for our liking.

In fact, let’s learn from history. The only times we have ever seen the stock market surge close to this much in such a short time frame were:

* December 1929
* June 1931
* August 1932
* May 1933
* July 1938
* September 1982

Only in September 1982 and in May 1933 was the equity market embarking on a new bull phase. But guess what? By the time the S&P 500 surged 25%, it had already crossed above its 200-day moving average. So call us when the S&P 500 crosses the 1,000 mark – another 20% to go. That is how deeply entrenched this particular bear market has been – that even after this massive rally, the onus is still on the bulls! Consider as well that on 4 of the 6 occasions that the equity market staged such a huge rally over such a short time period, it relapsed. So we are going to wait this out, acknowledging that we could be late to the party. We still feel the downside risks are too high to be involved.”

Thanks David-I’m going to miss your voice of reason.

Volatility
The VIX finally broke below the 40 level, for the first time since spiking through that level in October (see chart below). Could this be indicating the market is finally relaxing somewhat from the frenetic activity over the past six months? Certainly a downward move is bullish, however, the level is still extraordinarily high when compared to virtually any time period except the past six months.



Spring Training and Opening Day
Now that baseball season is back, it seems only appropriate that the Pirates are back in action. Not the Pittsburgh variety, but the Somalian ones. Once again they have been extremely active this past week, probably in an effort to divert media time from their National League East namesakes. Over the course of three days the pirates managed to nab five ships, the most recent a Danish ship with an American crew. In an effort to maintain their neutrality and demonstrate their displeasure with the recent G-20 meetings, they have also hijacked British, French, German and Taiwanese ships in this latest spree.

During 2008 the pirates batted a mere .261, hijacking 43 of the 165 vessels they attacked. After some intensive off-season training, it appears they are on a mission to exceed last season’s tepid results. Although difficult to confirm, rumors are swirling that many of the Pirates are in the last year of their contracts, which would suggest a bumper crop of free-agents this fall. Stay tuned.

Optimism
Ever the optimist, Pulte Homes CEO Richard Dugas feels the February sales jump in housing sales may signal stabilization in the housing market. In a sign of his renewed optimism, Dugas and Pulte agreed to buy Centex Corp for $1.3 billion in an all stock deal. The deal was done at a 38% premium to Centex’s closing price the prior day, which is 87% lower than its peak. Many analysts are hailing this as a transaction that will save both companies in the face of a 75% decline in new home sales. The combined companies now have $3.4 billion in cash and $1.8 billion in debt. Management feels they will save $250 million in overhead and $100 million in debt service per year. There are, of course, opportunities (however unlikely) to pull inventory from the market, which could help ease some of the pressure on the new housing market.

More Earnings
The market appears prepared for a bad spate of Q1 earnings. This is only a small sample, but I noticed that companies which pre-announced in-line to better numbers really sailed, typically up 10-15%. Interestingly, even companies pre-announcing weaker than expected numbers showed some positive returns. While many are talking about the disaster the Q1 earnings reports will be and the negative impact on the market, these early reports would suggest that much of the bad news may already be expected. Could we see an upward bias to the market during earnings? If so, it would be the first time in over a year.

Even More Earnings
According to www.chartoftheday.com the drop in S&P 500 earnings during this recession is greater than the average recession. While this represents the obvious severity of the economic crisis we are facing, in my opinion it also is indicative of two other items. First, earnings of financial stocks were overstated for much of this decade and their downfall has been a significant contributor to the decline in S&P 500 earnings. Second, earnings in general were overstated leading into this recession as corporate profit margins were at record levels, partially due to efficiency improvements, accounting games, and outsourcing to foreign manufacturing, which allowed companies to import deflation from countries with lower labor costs.




Stress Testing the Banks
Is anyone else dubious of the government’s intentions in their stress tests of the banks? It seems to me this is a rubber stamp for bad management teams to remain in place and is designed as cover to protect those banks deemed “too big to fail.” The bank stress tests currently underway are “a complete sham,” says William Black, a former senior bank regulator and S&L prosecutor. I continue to support the alternative view that “too big to fail means to big to survive.” Break up the big guys!

Bank of America
Continuing to defy the odds, Bank of America somehow remains in business despite crapping all over their customers and running their bank like a bunch of morons. This past week I was notified they intended to raise the rate on my Visa card from 8.5% to 14.9% on purchases and 25.99% on other transactions. I have been a customer for years without incident or change in my credit rating. Meanwhile, these imbeciles have seen their cost of capital drop as a result of MY TAX DOLLARS bailing out their lack of lending standards. Additionally, their credit rating has declined, not mine, yet for some reason they feel they want to gouge me for an additional 650bps on a card we barely use. I’ve also had friends attempt to draw on committed home equity lines of credit, only to be blocked by this same institution.

I’m changing banks, and if anyone has any suggestions for a decent bank catering to small businesses and individuals, please let me know. Note to Ken Lewis-I hope you gag on Countrywide and Merrill. What makes you think you can operate those businesses when you have ZERO idea how to operate the business you grew up in?

OK, I’m done ranting.

TED spread chart
Earlier I mentioned the credit situation has improved slightly. The chart below shows the TED spread, which has improved from its death defying heights of the fall, but is still stubbornly hanging around the 100bps level. I’d like to see it cut in half to really get things moving.




Short Selling and the Uptick Rule
Repeal of the uptick rule has been broadly condemned as causing the market downturn. According to Peter Boockvar, “short sellers didn’t get people to buy homes with no money down, didn’t convince people to buy homes with teaser rates, didn’t encourage people to lie about their income on mortgage applications, didn’t tell banks and brokers to lever up to huge levels, didn’t tell Greespan to cut rates to 1% and leave it there, didn’t invent Freddie Mac and Fannie Mae, didn’t tell the OTS, OCC, FDIC, Fed, SEC, FFIEC, FTC, FHFA, and all the state regulators to twiddle their thumbs all day, didn’t tell the rating agencies to rate AAA on anything that moved, didn’t tell banks to lend to commercial real estate investors on a property where the rent didn’t cover the mortgage payment, and didn’t tell the average consumer to spend more money than they make and borrow the difference.”

And you thought I was ranting?

In my view what the SEC needs to do is enforce the law against naked short selling, which is illegal. Naked short selling (not as fun as it sounds since its rarely done without clothes) occurs when a short seller sells a stock short but hasn’t borrowed the shares. This effectively allows short sellers to pile onto stocks even when the supply doesn’t exist to borrow. Congress and the SEC messing around with the uptick rule only diverts attention from their long-standing failure to adequately enforce existing naked short selling laws.

Bull vs. Bear Market
From Barry Ritholtz: “The smart investor’s playbook is very different in bear markets than bull markets. In a Bull Market, you buy the dips. Lower prices are an opportunity to buy into equities at cheaper valuations. Most sales are disappointing, as prices eventually go higher. Buy & hold is the simplest, most cost effective investment strategy.

Bear markets call for a very different set of plays: You sell the rallies; higher prices are opportunities to sell equities at premium valuations. Most buys are disappointing, as prices eventually go lower. Buy & hold is a losing strategy – trading what the market presents to you is the best risk management strategy.

The goal during bull markets is to grow your capital; the goal during bear markets is to protect your capital.”

Asia
Asian stocks continued their run after Japanese Prime Minister Taro Aso more than doubled his intended stimulus spending package. The announcement, which came on April 10, was the third plan since he took office and will total 57 trillion yen ($566 billion).

In China lending activity rose by a record to 1.9 trillion Yuan ($277 billion), as their M2 rose almost 26%. The People’s Bank of China “will implement moderately loose monetary policy and maintain the continuity and stability of policy” while pledging “ample liquidity” to ensure loan growth and money supply remain sufficient. In a warning that sounds eerily similar to those describing the US situation a couple of years ago, Jian Zhenghua, the former vice chairman of China’s parliamentary committee said “the biggest of these hidden dangers is the degree of bad loans in China.”

Angel Baseball
God Bless N.A.

Conclusion
I have heard from many of you, and appreciate your continued support and hopefully enjoyment of these letters. I encourage you to visit the website (http://weeklymarketnotes.blogspot.com) as eventually I hope to move the distribution over to the site directly. Feel free to support my advertisers by visiting those that present interesting ads on the site.

Have a great week and good luck as earnings season begins.

Ned

“The best minds are not in government. If any were, business would hire them away.”-Ronald Reagan