December 7, 2009
"Creditors need to take part of the responsibility for their decision to lend to the companies." --Abdulrahman al-Saleh, director general of the Department of Finance in Dubai.”
Weekly percentage performance for the major indices
Based on last Friday’s official settlement...
INDU: 0.77%
SPX: 1.33%
COMPQ: 2.61%
RUT: 4.43%
Market
The market has continued to rotate into more defensive sectors as telcos, healthcare and utilities have been leading the market over the past month. Although this has been anything but a typical year in the market, a more defensive posture is not unusual given the uncertainty regarding the 2010 outlook and the enormous equity returns of 2009. The market has churned over the past couple of months as a sector rotation has occurred at the expense of the market leaders off the trough.
The dollar soared on the stronger than expected labor report Friday (see Economy section below), and for the third week in a row we saw a preview of what may come when the dollar regains support-an unwinding of the dollar carry trade. The Fed appears uninterested in raising rates or protecting the dollar, however, if the employment reports continue to stabilize, the Fed’s hand will be forced as treasury yields will rise in spite of the Fed’s desire to keep rates low. Over the past 15 years the Fed has primarily allowed itself to be led by the market in its rate decisions-raising after yields have risen, cutting after yields have fallen. Want a clue on when the Fed will raise rates? Watch the treasury market for that clue. Rising rates should help the dollar, which will hurt risky assets (think commodities, equities, emerging markets, etc) in the short run as funds are forced to sell their risky assets and cover the dollar short positions.
Economy
Actual Consensus Prior
Chicago PMI 56.1 53.3 54.2
Construction Spending 0.0% -0.5% -1.6%
ISM 53.6 55.0 55.7
Pending Home Sales 3.7% -1.0% 6.0%
ADP Employment Report -169K -150K -195K
Initial Claims 457K 480K 462K
Continuing Claims 5465K 5400K 5437K
ISM Services 48.7 51.5 50.6
Nonfarm Payrolls -11K -125K -111K
Unemployment Rate 10.0% 10.2% 10.2%
Average Workweek 33.2 33.1 33.0
Factory Orders 0.6% 0.0% 1.6%
Less than 24 hours after the President’s jobs summit where he promised “immediate action” for job creation, the employment report showed an improvement, posting a decline of 11K versus an anticipated decline of 125K. The unemployment rate ticked down to 10.0% from 10.2%. Temporary help, typically a leading indicator of future hiring needs, increased by over 50K in November.
The ISM Index was just below consensus. The index signals a slowdown in the rate of expansion in manufacturing, which also coincides with the lack of job growth in that sector. The ISM Services index came in light for November after positive reports in September and October. The index fell back under 50-the Mendoza line for determining whether the index is growing or contracting.
Inflation and Fed Policy
A key component of the Fed’s comfort with keeping rates so low is their belief that “with substantial resource slack likely to continue to dampen cost pressures and with longer term inflation expectations stable” inflation will remain subdued for some time. The Fed’s Charles Plosser doesn’t fully agree. He believes there is evidence “that finds that economic slack or low resource utilization is not a very reliable predictor of inflation” and “ultimately, inflation is a monetary phenomenon and there is no question that current monetary policy is extraordinarily accommodative.” He said with “competing views of the economic forecast and the underlying structure of the economy driving that forecast” it will be a challenge to “withdraw or restrict the massive amount of liquidity that we have made available to the economy.” Plosser said as the economy grows and real interest rates rise (market rates), “the fed funds rate should be permitted to rise with them.”
What Bubble?
Debt as a percentage of GDP as soared over the past 20 years. It now sits at a record 340% of GDP. This enormous creation of debt is emblematic (and probably the major driver) of the economic growth we experienced over that time period. The last great debt bubble took 10 years to unwind, but paled in comparison to this bubble. The chart below, courtesy of Ned Davis Research, shows total credit as a percentage of GDP.
Bank of America Paying Back TARP
OK, I know I have a tendency to be a bit cynical, but the timing of the Bank of America decision to repay their $45 billion of TARP funds strikes a chord as it comes right before bonus time.
Let me digress a bit and run through a quick summary of this BofA mess (the order of events may be off a touch, but directionally this is accurate). First, they buy a collapsed Countrywide. Then the Fed prods them into taking on Merrill. Then, in an effort to prop up their balance sheet they take on $45 billion (actually this came in a couple of tranches) of TARP funding to offset a combination of failing mortgages and Merrill/Countrywide losses. The value of their loan portfolios continued to drop until miraculously the accounting rules were altered. Prior to this magical day banks were required to accurately report the value of their loans at the going market rate for those loans (aka mark to market). After the magical date the banks were allowed to mark their loans at any value they wanted (aka mark to imagination). Utilizing mark to imagination accounting, Bank of America went from being completely insolvent to reporting positive earnings. Now the bank has been able to raise outside capital based upon these magical, mystical earnings, and is using that money to free itself from the constraints of the government’s policy capping senior executive pay companies relying upon government support. I would anticipate somewhere close to record bonus payments for a company where the only thing that has truly changed is how they report the value of their assets.
Somehow I doubt that as ill-conceived as this whole bailout has been, no one anticipated that banks would be able to create earnings out of thin air to the point that they could pay out huge bonuses, rewarding the guys who almost ran the economy into the ground yet one more time.
There used to be a day when investors could sue a company for issuing false financial statements, especially when those investors relied upon those statements when making their investment decision.
Retail Sales
U.S. retail chains reported a lower sales volume for November, despite a strong turnout on Black Friday. “It was a month that disappointed us and, I think, the industry," said Michael Niemira, chief economist for the International Council of Shopping Centers. Same-store sales dropped 0.3% in November compared with the same month last year, the trade group said.
Gluskin Sheff reported that 75% of retailers missed their sales target in November.
Making Hay in the Commercial Real Estate Market
We have often discussed how the shrewder (and stronger) companies have been taking advantage of the commercial real estate crisis by negotiating better deals and rates. Last week Lowe’s secured a $13 million loan to build a 102K square-foot facility on 13 acres in Quincy, MA. The company also finalized its lease agreement and will soon break ground in San Francisco, becoming the first big box DIY retailer in the city. Lowe’s will build a 107K sq. foot store on Bayshore Boulevard, on the same site where Home Depot gained approval for a new unit after battling with community activists and local businesses for more than a decade. The Atlanta retailer then withdrew its plans as part of its new construction cutbacks last May. Lowe’s has agreed to abide by some of the provisions set forth in Home Depot’s agreement with municipal and county authorities: a $75,000 contribution to workforce training for neighborhood residents; a $100,000 contribution to the San Francisco day labor programs; and a promise to hire three-fourths of the store’s retail employees from San Francisco.
Bottom Fishing
Brookfield Asset Management, one of Canada's biggest commercial-property owners, and Simon Property Group, the largest mall owner in the U.S., have been buying the debt of bankrupt General Growth Properties. Brookfield has accumulated nearly $1 billion in unsecured debt, possibly preparing a bid to acquire some or all of General Growth's portfolio. Meanwhile, Simon reportedly hired legal and financial advisers to assist in forming a bid.
Capitalism
If you are a reader of this note you either agree with my basic free market view or you like to be tortured each week by my writing. JP Morgan released an interesting table this week which partially explains why I am constantly in disagreement with the economic policies of the Obama administration. The chart below shows the percentage of cabinet appointments for the last 110 years (19 Presidents) with prior private sector experience. Mr. Obama’s administration is the least experienced of any in the measurement period.
I think this chart helps explain why the administration constantly comes out against capitalism and is so focused on state-sponsored solutions.
Bank Math
If a bank takes in a $50K deposit, then lends $500K on a home mortgage at 10:1 leverage, is it inflationary when they are forced by the Making Homes Affordable program to wipe out a portion of the debt? Since the seller’s purchasing power increased by $500K, and the buyer is only required to pay back some portion of that, say 50%, then isn’t this a backhanded way of increasing the money supply?
Anyone want to comment?
Oh Canada, eh?
Statistics Canada gave the official word that the country emerged from recession during the third quarter, but the 0.4% GDP expansion fell short of what experts were expecting. The growth was driven mostly by a jump in imports, at an annual rate of 36%, suggesting considerable vitality on the part of Canada's consumers.
Why Housing Prices Have Another Leg Down
I have discussed a number of times that the Fed has been the primary (and often only) purchaser of mortgage backed securities. They recently said that their $1.25 trillion buying program should be completed by March 2010. When that program ends, it is more than likely that mortgage rates will rise from today’s record lows. These low rates have allowed affordability to improve and the housing market to stabilize, for now.
Jim Welsh has noted that a significant portion of the recent rise in housing values is due to the increasing number of prime borrowers selling their houses or going into foreclosure due to joblessness. These higher priced homes are skewing the pricing data used by Case-Shiller. With nearly 8 million mortgages late or in foreclosure on top of the 3.5 million homes already for sale, there is a ton of inventory that needs to be moved over the next 12 months, just as rates may start rising.
The FHA is also getting stretched as they are now making roughly ¼ of all loans versus less than 5% historically. FHA only requires a 3.5% down payment, and as Welsh points out a first time buyer can use $7K from their $8K tax credit for the down payment on a $200K house and pocket $1K. Not surprisingly, the default rate on FHA loans is soaring as 14.5% of FHA loans are now delinquent. Additionally, 20% of the FHA loans made in 2007 are now over 90 days delinquent.
In case you’re interested, the FHA is now levered 188:1 versus their Congressional mandate of 50:1.
Europe
The Financial Times is reporting that the European Central Bank is expected to move forward with its exit plan from policies and measures aimed at battling the financial crisis. Although the central bank likely will keep its main interest rate at 1%, it is expected to make policy tweaks that indicate its intention to unwind emergency programs. The ECB will be rejecting the advice of Dominique Strauss-Kahn, managing director of the International Monetary Fund. Strauss-Kahn advised policymakers to err "on the side of caution, as exiting too early is costlier than exiting too late."
India
Bloomberg reported that India’s economy, marking its strongest growth in six quarters, expanded 7.9% in the third quarter compared with the same period last year. Manufacturing grew 9.2%, the strongest showing since June 2007.
Weekly Market Notes Update
Thank you again for all of your great input. I’d say 40-50% of this week’s content came from reader contributions.
Direct email distribution of the note is approaching 2000, and an unknown number are reading the note via various syndicated websites. Please note that due to the sheer size of the distribution list and to avoid boners like the one I made a couple of weeks ago when I accidently emailed out one of my distribution lists, I may start having you notified of the posting to the website and you’ll have to click on the link to view the note. I know that will create problems for some mobile readers and I am trying to figure out a workaround. As always please give me your feedback.
I have had countless requests to provide more actionable information for those who management their own portfolios, and in response to that I am exploring producing a monthly newsletter which would be focused on asset allocation. I would be creating a series of portfolios for various risk profiles, and making recommendations as to the funds to use (primarily ETFs but also some mutual funds) to achieve the desired investment objectives. If I move in this direction I anticipate a modest fee, possibly $200 per year (mama needs new shoes). I’d love to hear your feedback and thoughts on that as well.
Have a great week.
Ned
“The best approach here if at all possible is to use supervisory and regulatory methods to restrain undue risk-taking and to make sure the system is resilient in case an asset price bubble bursts in the future.” --Ben Bernanke, Federal Reserve Chairman
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