February 21, 2010
“Real knowledge is to know the extent of one’s ignorance”—Confucius
Weekly percentage performance for the major indices
Based on last Friday’s official settlement...
INDU: 3.0%
SPX: 3.1%
COMPQ: 2.8%
RUT: 3.4%
Market
We just finished the best week of the year, and in a bullish twist no one seems to be happy about it. Among other issues, there seems to be concern about the low volume rally, which really shouldn’t be surprising as rolling or range bound markets typically signify little conviction in either direction. Volume is typically lower and volatility wanes, much as we’ve seen since the beginning of the year. The market bounced smartly beginning late the week prior, just above significant support levels, and just shy of the 10% correction which has long eluded this market. The chart below, courtesy The Big Picture, shows the S&P 500 since 2004.
The Fed made a symbolic gesture this week by raising the discount rate by 25bps, the first increase since the middle of 2006. There was no change in the more important Fed Funds rate as the spread between the two measures of 50bps is now closer to the historical “normal” range of 50-100bps. The Fed commented that the move will encourage financial institutions to rely more on money markets rather than the central bank for short-term loans. The move only impacts banks utilizing the Fed’s discount window, an unusual tactic during normal times as banks typically borrow at Fed Funds, away from the window. The problem still hampering the Fed and their ability to stimulate the economy is that banks are not lending and money velocity is so low that monetary growth has stalled.
When the Fed does decide to reduce liquidity, they plan to use different approaches to dry up excess liquidity and not rely entirely on interest rates. "We're in a different situation than ever before, and the tools we are using are entirely new," said former Fed Governor Lyle Gramley. Stay tuned.
Economy
Actual Consensus Prior
Wholesale Inventories -0.8% 0.5% 1.6%
Trade Balance -$40.2 bil -$35.8 bil -$36.4 bil
Initial Claims 473K 438K 442K
Continuing Claims 4563K 4500K 4563K
Retail Sales 0.5% 0.3% -0.1%
Retail sales ex-auto 0.6% 0.5% -0.2%
Michigan Sentiment 73.7 75.0 74.4
Business Inventories -0.2% 0.2% 0.5%
Housing Starts 24.91 18.00 15.92
Building Permits 621K 620K 653K
Industrial Production 0.9% 0.7% 0.7%
Capacity Utilization 72.6% 72.6% 71.9%
PPI 1.4% 0.8% 0.4%
Core PPI 0.3% 0.1% 0.0%
Leading Indicators 0.3% 0.5% 1.2%
CPI 0.2% 0.3% 0.2%
Core CPI -0.1% 0.1% 0.1%
The past two weeks have been another mixed bag for economic releases, with a bias to weaker than expected results. Consumer expectations (yellow line in chart below courtesy of briefing.com) appear to have peaked, but are still up significantly from a year ago. PPI was higher than expected, but the overly manipulated core-CPI measure actually showed a decline for the first time in decades.
According to the Commerce Department, in spite of additional exports, the U.S. trade deficit increased in December to $40.2bil, the highest level in a year. Exports increased 3.3%, but imports of crude oil went up 9.2%. So much for a weak dollar policy.
According to Xinhuanet.com, China's exports, measured in U.S. dollars, increased 21% last month compared with January 2009. At the same time, the trade surplus narrowed because of additional imports.
The Leading Economic Indicators (see chart below courtesy ECRI) was still up, but missed consensus as the money supply component of the measure grew less than anticipated and less than in prior months. This is partially explained by the lack of credit creation as bank borrowing remains soft and the consumer (see Consumer below) continues to de-lever. One regional bank commented this week that they aren’t lending, but instead holding their cash in the form of treasuries to ensure they have adequate capital available to meet the needs of existing customers.
The Consumer Comes Out of His Shell
This week’s title reflects a trip I took to my local retail center this afternoon. Today it was cold here. I know that it’s Southern California, but I actually had to put on a sweatshirt (and later had jeans and a jacket on at my son’s baseball game this evening). I went out around mid-day to grab a Starbucks’ decaf, and the center near my home was absolutely packed. Target, Bed Bath & Beyond, GNC, Jamba Juice, Rubios, and Starbucks were among those which appeared full. I don’t know that this signals a recovery, but I think it’s apparent the consumer has at least come out of hiding.
A year ago I discussed this same retail center as being completely empty a number of times. One difference is that it was obvious these consumers weren’t spending as aggressively as two years ago. Based upon recent retail reports and observations, the average retail ticket size is down significantly as foot traffic begins to increase. The rub is that in general consumers are not using their credit cards as aggressively, and in fact are deleveraging.
Toyota Issues Not All Bad
We have all heard the conspiracy theories about the government squeezing Toyota to help out their investment in GM and Chrysler. First, to the conspiracy theorists, I must say GET REAL! This government couldn’t coordinate brunch much less a synchronized attack on a foreign corporation requiring the interaction and cooperation of multiple three letter agencies.
While Toyota may suffer a temporary public relations black eye from the recall, the reality is that this is big business for the dealers. I had breakfast last week with a friend who advises the owner of one of the biggest Toyota dealers in California, and he said his client’s dealership had scheduled over 20K vehicles to come in for inspection or repair. Maintenance is the most profitable business for the dealers and they benefit from the OEM-paid warranty work, are able to cross-sell additional maintenance and service, and get unbelievable foot traffic to look at their new and used car inventory.
This may work so well that I wouldn’t be surprised to see GM announce a recall to help out their ailing dealer base. Now THAT would be a conspiracy!
Credit Conditions
Much discussion has been made about future Fed rate increases. Specific concerns have been raised regarding the impact of the Fed Funds Rate on the 30-year mortgage rate. The chart below, from Iacono Research, shows that the Fed Funds rate has had minimal impact on mortgage rates over the past 40 years.
The bigger impact has come from the secondary MBS market, which the Fed has committed $1.25 trillion over the past 18 months. This program ends next month, and while I wouldn’t anticipate an immediate bump in mortgage rates, a steady increase would not surprise me.
Long Bear Markets
During the 20th century the US has experienced long periods of prosperity interspersed with equally long periods of economic despair (or vice versa). One example can be found from the crash of 1929. It took the Dow 25 years, or until 1954, to regain its 1929 high when adjusted for inflation. I have often said we are in a similar economic period, and it may take at least that many years until the NASDAQ touches its peak from March 2000. Despite last year’s gains, the NASDAQ still sits roughly 60% below its all-time peak.
Ratings Agencies Finally Waking Up!
S&P, that much-maligned debt ratings agency, announced last week they were revising their outlook on two of the nation’s largest banks, BofA and Citi. S&P downgraded the credit outlook from stable to negative for both banks on concerns about the banks’ asset quality.
Could it be that S&P is now trying to function in a manner useful to investors? Miracles never cease to amaze me.
China
China’s central bank took its second step in a month to restrain inflation and control asset prices, ordering banks to set aside larger reserves. The reserve requirement will rise 50bps effective Feb. 25. The existing level is 16% for the biggest banks and 14% for smaller ones.
Policy makers are reining in credit growth after banks extended 19% of this year’s 7.5 trillion Yuan ($1.1 trillion) lending target in January and property prices spiked the most in nearly two years.
“Policy makers are becoming more concerned about containing inflationary expectations and managing the risk of asset price bubbles,” said Jing Ulrich, chairwoman of China equities and commodities at JPMorgan Chase & Co. in Hong Kong. “2010 is likely to be characterized by further policy tightening.”
Didn’t I Already Say That?
Repeating what I have been saying for at least 24 months, The Washington Post is reporting that a wave of foreclosures on commercial properties in the U.S. likely will hit community banks especially hard. "There's been an enormous bubble in commercial real estate, and it has to come down," said Elizabeth Warren, chairwoman of the Congressional Oversight Panel. "There will be significant bankruptcies among developers and significant failures among community banks."
It’s always interesting waiting around for that other shoe.
Valuation
According to Bloomberg, investors are coming back to high-yield bonds. The default rate on high-yield securities was 10.2% in December, but bond buyers seem to be expecting that measure to come down at the fastest rate in a decade. The market is pricing high-yield bonds in a way that assumes the default rate will be down to 0.3% by the end of the year, JPMorgan Chase said.
Fed Balance Sheet
After purchasing an additional $53 billion in mortgage-backed securities last week, the Fed's balance sheet now holds over $1 trillion of MBS. This program, which is expected to end next month, is presently capped at $1.25 trillion.
More Real Estate
Real estate foreclosures in the U.S. declined 10% last month from December, but an “increase might be on the way as alternatives to foreclosure are abandoned or fall through,” said RealtyTrac. "If history repeats itself, we will see a surge in the numbers over the next few months as lenders foreclose on delinquent loans where neither the existing loan-modification programs or the new short sale and deed-in-lieu of foreclosure alternatives works," said James Saccacio, the company's CEO.
Foreclosure filings were up 15% year over year to 315K.
Even More Real estate
An investor notified me this week that the big pools of 5/1 residential ARMs are going to start resetting early this year. They said the pools are “pretty big” and could result in more delinquencies, foreclosures and pressure on both real estate prices and lenders.
Let the Bottom Fishing Begin!
Simon Property Group offered nearly $10 billion to buy General Growth Properties, which has been in Chapter 11. The buyout brings almost a third of U.S. malls and one-half of the top performing malls in the country under a single owner. Simon's offer has the support of General Growth's committee of unsecured creditors and consists of $7 billion to pay off debt and nearly $3 billion for shareholders.
As we’ve been discussing since the beginning of this note, secondary assets are going to be where bargains exists for an extended period of time.
Supercycle Winter Until Oct 2014
According to Bob Bronson:
“The S&P 500 index is currently at the same level as it was four to five months ago, 15 months ago and 12 years ago – that is, there are 0% gains over each of those periods, the latter of which especially has caused the 16-year Supercycle Oscillator to be approaching its predictable 0% +/- 2% trough.
We continue to expect the end of the current Supercycle Period (a Supercycle Winter, or deflationary Supercycle Bear Market Period) will be signaled by the Oscillator declining still further from about 5% at present to probably below 1% during the next several years, a forecast supported by our Supercycle fundamental valuation and other indicators in our forecasting models.”
Conclusion
I’m glad to be back after a week off. People have been asking about positioning. I haven’t come back to the gold trade, yet, but expect to do so after what I anticipate will be a near term run-up then a substantial pullback. I also closed the QID trade for a nice short term profit. From an exposure standpoint I’m about 125% long and 100% short. I plan to maintain that position for now.
Have a great week.
Ned
“In this game the market has to keep pitching but you don’t have to swing. You can stand there with the bat on your shoulder for six months until you get a fat pitch.”—Warren Buffet
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