April 19, 2010
"Injustice anywhere is a threat to justice everywhere." -- Martin Luther King, Jr.
Weekly percentage performance for the major indices
Based on last Friday’s official settlement...
INDU: 0.19%
SPX: -0.19%
COMPQ: 1.11%
RUT: 1.66%
Market
On Friday the market suffered its first 1% pullback in almost 40 trading days, which according to Barron’s is the longest such run since 1994. While I don’t typically emphasize a single event or single day’s activity as significant, the Goldman Sachs news (see below) combined with some less than desirable economic data certainly triggered the sell-off. There have been comparisons made between Goldman Sachs and the Bear Stearns saga (and the ensuing collapse of that firm), however, I think that’s probably over-kill. Either way, stocks and commodities both fell Friday, with gold dropping $25.
There have been a number of articles over the past few weeks questioning the market’s current valuation. At just under 1200, and with an EPS estimate of roughly $80 for 2010, the S&P 500 is now trading at 15 times, high but not ridiculously expensive in today’s low rate environment. Much of the valuation commentary has revolved around trailing earnings, which were $80 in 2005 (the last time the market hit 1200), yet only $50 or so in the most recent trailing twelve months. On a trailing PE basis, this places the market’s PE around 24 times, definitely expensive, but not really relevant. The market always looks expensive on a trailing basis when the economy is improving. On the flip side, it typically looks cheap near market tops. The net-net is that while the market has run a long way, and the economy has some definite potholes to maneuver around, valuation shouldn’t be a catalyst for a market correction.
The bigger question is rates and how long the Fed will remain accommodative? While the Fed may raise rates in the back half of the year, it is still our view that they will error on the side of remaining overly accommodative versus taking away the punch bowl too early. The Fed is justifying their continued accommodative stance based upon “slack” in the economy created by excess manufacturing and labor capacity. Reflating incomes and asset values continues to be the Fed’s goal. Remember that inflated wages and asset values leads to higher tax revenues without tax rate increases and a cheaper dollar to pay down foreign debt.
Economy
Actual Consensus Prior
Treasury Budget -$65.4 bil -$62.0 bil -$191.6 bil
Trade Balance -$39.7 bil -$38.5 bil -$37.3 bil
CPI 0.1% 0.1% 0.0%
Core CPI 0.0% 0.1% 0.1%
Retail Sales 1.6% 1.2% 0.5%
Retail Sales-ex-autos 0.6% 0.5% 1.0%
Business Inventories 0.5% 0.4% 0.2%
Continuing Claims 4639K 4580K 4566K
Initial Claims 484K 440k 460k
Capacity Utilization 73.2% 73.3% 73.0%
Industrial Production 0.1% 0.7% 0.3%
Philadelphia Fed 20.3 20.0 18.9
Building Permits 685K 625K 637K
Housing Starts 626K 610K 616K
Michigan Consumer Sent 69.5 75.0 73.6
While much was made of the Goldman Sachs impact on Friday’s market action, the weakness in the Michigan Consumer Sentiment index seems to have perplexed traders a bit. Retail sales earlier in the week were ahead of consensus, yet the consumer sentiment measure fell to its lowest level in six months.
The news from the real estate front was somewhat positive. Builders broke ground on more U.S. homes in March than anticipated and took out permits at the fastest pace in more than a year, a sign of growing confidence that sales will stabilize. Housing starts climbed to an annual rate of 626K last month, up 1.6% from February’s level. Building permits, a sign of future construction, climbed to the highest level since October 2008.
Defaults remain a concern. Foreclosure filings in the U.S. rose 16% in the first quarter. Higher foreclosures combined with higher inventories from the increased build activity may continue to drive down prices. Additionally, the tax credit for first time buyers expires April 30th, which may dampen demand.
Business inventories continued to rise as manufacturers respond to increasing end market demand. The chart below shows the rapid rise (blue line) in sales and the burgeoning recovery in inventories (yellow line). Inventory replenishment has been helping fuel the nascent recovery.
Government Sachs
Keeping with the populist strategy now being employed by our government the SEC charged Goldman Sachs, apparently no longer considered a sacrosanct member of the government, with fraud by the SEC. Not missing a beat, and a chance to line their coffers, the English and Germans have also opened probes. The fraud is related to the packaging and selling of collateralized debt obligations (CDOs) linked to subprime mortgages.
The charges suggest that Goldman allowed one client, who planned to be short the mortgage pool in question, to assist in selecting the mortgages being included in the pool. According to the suit, the plaintiff firms were unaware of this relationship.
I have long felt Goldman trades its own book ahead of its clients, however, if it is shown that they placed the needs of one client, presumably a higher paying client, ahead of another, then they may face some serious sanctions.
Personally I feel there is a lot of political showboating surrounding these charges. Typically firms are charged with a pattern of illegal behavior, not fraud on a single transaction. While a fraud charge and conviction is nothing to sneeze at, the reality is that if the government can’t identify a pattern of similar transactions, the current charge will probably result in a fine, the employee being fired, and possibly some minor operating restrictions and/or adjustments.
Global Asset Allocation
Global investors have been moving money away from developed nations (UK, US, Europe, and Japan), in favor of emerging markets. “There’s a global reallocation going on,” said Kenneth Akintewe, a Singapore-based portfolio manager at Aberdeen Asset Management. Given the choice between “debt-ridden countries” like the U.K., the U.S. and Japan, and “emerging-market economies with substantially good fundamentals, then you expect to see that global reallocation taking place.”
Emerging-market bond funds received a record $1.8 billion in the past week, as 2010 inflows rose to a record. Where is this capital coming from? How about global equities, which have seen multi-billion dollar withdrawals for the past few weeks?
Currency
The Eurozone came up with an emergency aid package for Greece totaling $61 billion in below market-rate loans. The loans yield 5%, nearly 200bps lower than current market rates.
Morgan Stanley feels that if the Euro is damaged by the bailout, Germany could pull out of the Euro to ensure its borrowing costs remain low.
Pork Roast
It was revealed yesterday that Mississippi Senator Thad Cochran is the king of pork for the third consecutive year, bringing home over $500 million in pork to his state last year for such important items as shrimp research, local museums, and military projects unwanted by the Pentagon. The three year total for Senator Cochran is over $2 billion.
Hawaii is the leader in pork per capita at $251. I guess that’s for luaus.
Financial Reform
Akin to the alcoholic who asks his wife to throw away the liquor after a bender, the Feds are feeling political remorse after allowing banks to become TBTF, then throwing them a massive lifeline. As a result, a new bill that won’t limit TBTF has a good chance of making its way into law so that politicians can claim victory over the financial services evil villains and conveniently just before the elections.
California Budget-Cuts in all the Wrong Places
We all know that the State of California’s budget is a mess. I recently reviewed the line item budget for the past five years, and it isn’t pretty. For the fiscal year ended June 2009, revenues declined by 13.9%, with the biggest decline coming from a category entitled “other tax revenues”, which I am guessing could be capital gains taxes but am not 100% sure.
Expenditures for the fiscal year ended June 2009 declined by 6.44%. The astute (and awake) reader will note that the decline in revenues dwarfed the decline in spending, resulting in a severe budget deficit of $8.4 billion (which will be worse in 2010) and a decline in fund balances of $12 billion. Education, which represents just less than 50% of total spending, suffered the largest cutback in expenditures during FYE 2009, declining $6 billion or 10.0%. Sadly, the cut in Education is equal to the entire decline in expenditures year over year. General government expenses actually increased 22.5% while debt service (both principal and interest) increased by 14%.
Predictably, sales taxes declined for the third consecutive year after peaking at $27.6 billion in FYE 2006.
Earnings
Intel and JP Morgan both reported robust numbers as the first week of earnings season got underway. JPM’s Jamie Dimon, said that the U.S. economy is recovering. "Large companies have got lots of money, lots of liquidity and complete access to markets," he said. "This could be the makings of a good recovery."
State Pension Liabilities Taking Center Stage
Taxpayers across the U.S. owe public school teacher retirement accounts about $933 billion, nearly triple the amount reported by the plans themselves, according to a study by the Center for State and Local Government Excellence. The report, covering 59 plans for 13 million working and retired educators, found that California had the largest unfunded teacher pension liability at almost $100 billion, more than the $42.6 billion reported by the system in January. It’s the third study in less than two months to suggest that pension costs of about $1 trillion threaten to overwhelm state and local budgets already crimped by declining tax revenue.
The two-year-old recession has left two-thirds of U.S. public retirement systems with assets worth less than 80% of future obligations, a level the GAO has said is acceptable. Underfunded pensions were cited by rating agencies in recent months for bond or rating-outlook downgrades in Illinois, Ohio and the City of Los Angeles.
According to former Social Security administrator Andrew Biggs, this estimated pension underfunding of $1 trillion could be as high as $3.5 trillion!
China
Manufacturers in China recently experienced a significant increase in their labor costs. The Chinese government gave manufacturers a 30 day notice to raise the minimum weekly wage by 22%. These manufacturers are already suffering from a labor shortage that has some employers offering workers $1000 (the equivalent of a year’s salary) as they exit trains as an enticement to quit their current job and come to work with the new employer.
This employee shortage should help the country’s robust recovery continue (recent GDP approached 12%) and pull workers from the outlying cities into the larger, coastal manufacturing locations.
Recent Bumper Sticker
Commodities
Miner Rio Tinto said it is running most of its iron-ore facilities worldwide at maximum capacity to keep up with the demand of customers in China. "Chinese demand grew strongly and we saw some recovery in OPEC markets, but we are still cautious about short-term volatility," said CEO Tom Albanese. The company increased its production 39% in the first quarter.
Federal Deficit
According to the Washington Post, the U.S. government is on track to end 2010 with a deficit that is $300 billion less than an estimate made two months ago. For the first six months of this fiscal year, the deficit is 8% less than that of the same period a year earlier, officials said. The bailout of the financial system was less expensive than expected, White House officials said, and tax collection is running higher than projected.
Conclusion
I thought last week’s note was pretty benign, but I obviously hit a chord with a number of readers on both sides of the tax debate. Thanks for the notes, it was very entertaining. I don’t remember many topics generating so much commentary, heated at that, on both sides of the argument. The comments definitely ran about 4:1 supporting my position that everyone with an income should pay some taxes, but I was surprised by the number of readers who felt lower wage earners should shoulder even less of the tax burden.
Speaking of reader notes, over the past nine months or so I have received roughly 300 from readers requesting assistance with asset allocation for their personal investments. In response, I am exploring creating a monthly newsletter specifically focused on using ETFs and low cost funds to create a diversified portfolio with a goal of protecting assets and generating returns, in that order. This monthly letter will be directed towards the investor who prefers to manage his/her own money, or those looking for a tool to help monitor their existing managers’ allocations. Please let me know if you are interested and I will get you more information.
Have a great week.
Ned
“If you destroy a free market you create a black market. If you have ten thousand regulations, you destroy all respect for the law.”—Winston Churchill
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