The weak dollar carry trade has finally made its way to the mainstream financial media in recent weeks as the plunging dollar continues to drive equities higher. Commentators have finally eluded to this relationship absent any other explanations for the market's continued run-up. In a strange twist of fate, Wall Street continues to cheer adverse economic data as the weak economy keeps the Fed from raising interest rates. So the toxic brew of low rates and cheap money that led to the first collapse will somehow cure all of the structural deficiencies currently plaguing our economy.
It's no accident that the S&P hit its year high on the same day the dollar index hit a 15 month low on the back of bearish comments coming out of the G20 meeting this weekend. Apparently, the G20 has concluded that the US dollar is still overvalued and will most likely post further declines in the coming months. These comments coupled with the group's stance to keep economic stimulus measures in place helped drive the S&P up 2.2% today on top of the 3% gain sported last week. Oil and gasoline prices also rose over 2% alone today as a barrel of oil straddles the $80 mark. Gold also hit a new nominal high at over $1,100/oz. As much as I like gold as a long term investment, I would not touch it at these levels. It has benefited from the excess liquidity and leverage in the system. Once interest rates increase and the aforementioned carry trade reverses, gold will post precipitous declines. The gold trade is crowded and once the retail investor decides that they want to own some gold, it's probably a good idea to go ahead and unload it on to them.
The truest measure of unemployment as measured by the Bureau of Labor Statistics has risen to 17.5%. Contrary to what Keynsian economists may lead you to believe, unemployment statistics are not a lagging indicator. The jobs lost today will not be coming back, they have permanently disappeared.
The unemployment rate has more than doubled since the start of the recession in December 2007, yet US equities have only dropped 26% over their record close in October 2007. Although the weak dollar helps explain part of this discrepancy, low interest rates can only take stocks so far. Incidentally, equities peaked two months before the official onset of the recession, directly challenging market forecasters who claim that the market always prices assets out six to nine months into the future.
Both commodities and equities are in bubble territory. Specifically, oil and gasoline are grossly overvalued based on fundamentals. Eventually, not even the weak dollar will serve as support because the coming collapse in demand will result in a severe and sharp price drop. Oil is at least 50% overvalued at these levels.
On the equities side, technology, retail, and financial stocks are just ridiculously overvalued. I made the same call in June and it's obvious that I was early in my call to short these stocks, but I'm confident that when the bubble bursts, and it will burst, these stocks will see 50%+ haircuts. My top equity shorts based on valuation are 1)Baidu, Inc (BIDU, $425.87) 2)Amazon (AMZN, $126.67), 3) Sears Holdings (SHLD $70.51). Additionally, tech bell weathers such as Google ($562.51) and Apple ($201.46) have approached or eclipsed their all time highs. Although these valuations are more reasonable, consumer and advertising spending will not support these share prices over the next several years. I have put my money where my mouth is with respect to my short positions, but I am prepared to wait until 2010 to see any significant pullback in equities.
The current administration continues to pursue easy money policies favorable to financial markets but detrimental to the country's long term economic health. The average American's standard of living along with saving rates declined during the 20 year stock market bull run from 1987-2007. These measures will result in extreme economic turmoil and the emergence of legitimate political third parties to offset the disastrous policies enacted by both Democrats and Republicans over the past five decades.
Monday, November 9, 2009
Thursday, October 22, 2009
Ignorance Is Bliss (A Peter Schiff Commentary)
The economic commentary article below authored by Peter Schiff perfectly summarizes why we are far from recovery.
While all the talk at present is about economic corners turned and markets charging ahead, no one is paying much notice to an American economy deteriorating before our eyes. These myopic commentators seem to be simply moving past the now almost-universally held conclusion that before the crash of 2008, our economy was on an unsustainable course. If these imbalances had been corrected, then perhaps I too would be joining in the euphoria. But evidence abounds that we have not veered at all from that dangerous path.
Last week, the Bureau of Economic Analysis reported that consumer spending as a percentage of U.S. GDP has risen to 71%, a post-World War II record. This level is notably higher than other wealthy industrialized countries, and vastly higher than the levels sustained by China and other emerging economies. At the same time, our industrial output is contracting, our trade deficit is expanding once again (after contracting earlier in the year), and our savings rate is plummeting (after an early year surge).
The data confirms that government stimuli are worsening the structural imbalances underlying our economy. The recent ‘rebound’ in GDP is not resulting from increased economic output, but merely from the fact that we are borrowing more than ever. That is precisely how we got ourselves into this mess. An economy cannot grow indefinitely by borrowing more than it produces. Not only is such a course untenable, but the added debt ensures a deeper recession when the bills come due.
This soon-to-be-called depression will not end until the pendulum of consumer spending habits swings violently in the other direction. This will be a jarring change, but it is the splash of cold water that we need to return our economy to viability. I believe that consumer spending as a share of GDP will need to temporarily contract to roughly 50% of GDP, before eventually moving toward its historic mean of 65%. Such a move would indicate a restoration of our personal savings, a decline in borrowing and trade deficits, and an increased industrial output. That would be a real recovery.
In the meantime, the higher the spending percentage climbs, the more painful the ultimate decline becomes.
Consumers and governments must spend less so their savings can be made available to businesses for capital investments. Businesses, in turn, will produce more products and employ more people – increasing domestic prosperity. However, rather than allowing a painful cure to return our economy to health, the government prefers to numb the voting public with a toxic saline-drip of deficit spending and cheap money.
The primary factor that enables our government to peddle economic snake oil is the dollar’s unique role as the world’s reserve currency, and our creditors’ willingness to preserve its status. By buying up dollars and loaning them back to us through Treasury debt, productive countries give American politicians carte blanche to play Santa Claus.
Ironically, as foreign governments finance our spending spree, they are simultaneously scolding us for our low savings rate. At the recent G20 meeting in Pittsburgh, all agreed – including President Obama – that resolving the global economic imbalances was a top priority. By definition, this would require Americans to spend less and save more. However, with foreign central banks continuing to buy our debt, the President has shown no political will to encourage this change.
Normally, if politicians run up the government deficit, voters soon suffer the unpleasant consequences of higher inflation and rising interest rates. Yet, if foreign central banks keep supplying the funds, these consequences are indefinitely postponed. As a result, there is no need for American politicians to ever make the tough choices required to solve our problems.
Instead, the burden may fall squarely on the citizens of those governments doing all the lending. The conflict is that within the creditor states, a vocal minority actually benefits from this subsidy (owners of Chinese exporters, for example) while the overwhelming majority fails to make the connection. Thus, foreign politicians have the same incentives as ours to keep playing the game.
The bottom line is that foreign governments can lecture us all they want about the need for prudence but if they keep lending, we’ll keep spending. Any parent knows that if you give your child a curfew yet never impose any penalties when it’s violated, it will not be respected. My gut feeling is that foreign governments are tiring of our conduct and on the verge of finally imposing some discipline. That means the dollar’s days as the world’s reserve currency are numbered, and the days of American austerity are about to begin.
While all the talk at present is about economic corners turned and markets charging ahead, no one is paying much notice to an American economy deteriorating before our eyes. These myopic commentators seem to be simply moving past the now almost-universally held conclusion that before the crash of 2008, our economy was on an unsustainable course. If these imbalances had been corrected, then perhaps I too would be joining in the euphoria. But evidence abounds that we have not veered at all from that dangerous path.
Last week, the Bureau of Economic Analysis reported that consumer spending as a percentage of U.S. GDP has risen to 71%, a post-World War II record. This level is notably higher than other wealthy industrialized countries, and vastly higher than the levels sustained by China and other emerging economies. At the same time, our industrial output is contracting, our trade deficit is expanding once again (after contracting earlier in the year), and our savings rate is plummeting (after an early year surge).
The data confirms that government stimuli are worsening the structural imbalances underlying our economy. The recent ‘rebound’ in GDP is not resulting from increased economic output, but merely from the fact that we are borrowing more than ever. That is precisely how we got ourselves into this mess. An economy cannot grow indefinitely by borrowing more than it produces. Not only is such a course untenable, but the added debt ensures a deeper recession when the bills come due.
This soon-to-be-called depression will not end until the pendulum of consumer spending habits swings violently in the other direction. This will be a jarring change, but it is the splash of cold water that we need to return our economy to viability. I believe that consumer spending as a share of GDP will need to temporarily contract to roughly 50% of GDP, before eventually moving toward its historic mean of 65%. Such a move would indicate a restoration of our personal savings, a decline in borrowing and trade deficits, and an increased industrial output. That would be a real recovery.
In the meantime, the higher the spending percentage climbs, the more painful the ultimate decline becomes.
Consumers and governments must spend less so their savings can be made available to businesses for capital investments. Businesses, in turn, will produce more products and employ more people – increasing domestic prosperity. However, rather than allowing a painful cure to return our economy to health, the government prefers to numb the voting public with a toxic saline-drip of deficit spending and cheap money.
The primary factor that enables our government to peddle economic snake oil is the dollar’s unique role as the world’s reserve currency, and our creditors’ willingness to preserve its status. By buying up dollars and loaning them back to us through Treasury debt, productive countries give American politicians carte blanche to play Santa Claus.
Ironically, as foreign governments finance our spending spree, they are simultaneously scolding us for our low savings rate. At the recent G20 meeting in Pittsburgh, all agreed – including President Obama – that resolving the global economic imbalances was a top priority. By definition, this would require Americans to spend less and save more. However, with foreign central banks continuing to buy our debt, the President has shown no political will to encourage this change.
Normally, if politicians run up the government deficit, voters soon suffer the unpleasant consequences of higher inflation and rising interest rates. Yet, if foreign central banks keep supplying the funds, these consequences are indefinitely postponed. As a result, there is no need for American politicians to ever make the tough choices required to solve our problems.
Instead, the burden may fall squarely on the citizens of those governments doing all the lending. The conflict is that within the creditor states, a vocal minority actually benefits from this subsidy (owners of Chinese exporters, for example) while the overwhelming majority fails to make the connection. Thus, foreign politicians have the same incentives as ours to keep playing the game.
The bottom line is that foreign governments can lecture us all they want about the need for prudence but if they keep lending, we’ll keep spending. Any parent knows that if you give your child a curfew yet never impose any penalties when it’s violated, it will not be respected. My gut feeling is that foreign governments are tiring of our conduct and on the verge of finally imposing some discipline. That means the dollar’s days as the world’s reserve currency are numbered, and the days of American austerity are about to begin.
Thursday, October 1, 2009
The Eye of the Hurricane
Putting today's pullback aside, equity markets have continued their tear over the past several months with the S&P sitting comfortably above 1,000. The dollar index has fallen another 2% since my June post, providing additional support for equities. Although the rally extended further than I originally anticipated, as I was early calling for investors to short cyclical stocks, my original premise remains intact. The fundamentals have only gotten worse over the past quarter, and it's only a matter of time before equities begin to price in the actual economic state, not projected recoveries or wishful thinking. Below are the main drivers underlying the recent stock market run-up as I see them:
Government Capital Market Manipulation
The mainstream media has the general public convinced that equities are simply reflecting the improved economic state and inevitable rebound that is destined to take place over the next several quarters. The reality, however, is a little more sinister. Market observers agree that trading volume has been anemic over the past six months, so the rally is not as broad based as they would lead you to believe. Low volume makes the conditions ripe for government manipulation of the market. This is accomplished through open purchases of futures contracts in the open market with the assistance of large investment banks.
The chart below perfectly illustrates my point. This represents an S&P e-minis futures daily one minute chart for Friday, May 29. It was a sleepy Friday with no news released and very low trading volume throughout the day as depicted by the volume bars below the main line graph. In the last few minutes of trading, enormous buy orders hit the market with over 200,000 contracts purchased right before the market close. This volume spike immediately pushed the S&P up roughly 10 points for no valid reason. I am not a conspiracy theorist by nature, and I'm well aware of the program trading that often takes place near the end of the trading day, but this pattern has continuously repeated itself over the past several months. Downside volatility has disappeared while the major indices often closed right at the highs of the day. Even during the market meltdown in late 2008 and early 2009, equities experienced vicious upside volatility through short covering and government bailouts.
With a large percentage of Americans having seen their 401Ks decimated, I am not at all surprised to see the government try to restore confidence in the economy. It is also no accident that consumer confidence has risen with the stock market, but this correlation will prove short lived as unemployment continues to soar.
Massive Government Stimulus Programs
I underestimated the short term impact that the coordinated response of governments around the world would have on equities and economic activity. I am a strong advocate of free market capitalism and tend to analyze such programs from a longer term perspective. Long-term, debt based government spending adds no value and only serves to increase the national deficit. Although in the near term, such policies act as stimulant, akin to an addict getting his fix. The euphoria will wear off leading to a more violent crash once participants realize that despite the government's best efforts, the long term contraction has only been slowed.
The cash for clunkers program is a perfect paradigm for our current economic state. Some analysts have gone as far to suggest that the four year decline in auto sales may have reached a turning point with the success of the program. The government of course allocated billions it doesn't have to fund the program, representing yet another example of taking from the taxpayer (or borrowing from the Chinese in this instance) to artificially create an increase in auto sales. Even with the deep cuts made by the auto manufacturers over the past several years, the sad truth is that there are still too many dealers and too much excess capacity still remaining in the system. As a result, auto sales showed a nice bump over the past several months, but this only shifted future sales to the present.
I've had many people come up to me over the past several weeks pointing to the stock market's recent performance as an indication that the worst has past and we are on the road to recovery. They also point to the housing uptick and question my long term bearish stance on the economy. I have two words for these individuals.....just wait! The FHA is providing mortgage loans with as little as 3.5% equity that has resulted in 50:1 leverage on their books. Although this is better than the 100:1 leverage sported by the Fannie Mae and Freddie Mac, the risk has only been shifted from the private sector to the tax payer.
A brief note on my investment strategy. I do not buy or sell individual stocks but instead sell deep out of the money naked call options on stocks, commodities and broad-based equity ETFs. Through time decay on these options and proper risk management, I have not had one losing trade in 2009. However, it has taken me longer to realize my profits as a result of the market run-up. The early cyclical names that I highlighted in my prior post represent excellent shorting opportunities if you have the patience and the wherewithal to profit from the coming collapse in consumer spending. Consistent with my prior posts, I fully expect the S&P to drop below 500 by the end of 2010 with the only risk to my forecast being a weak dollar that artificially inflates equities.
Ask yourself these two questions: If the equity rally was for real, why is gold trading over $1,000/oz? Second, how in the world is cheap credit and increased personal spending going to lead us out of this "recession" when these were the primary drivers leading to the excesses in the first place?
Government Capital Market Manipulation
The mainstream media has the general public convinced that equities are simply reflecting the improved economic state and inevitable rebound that is destined to take place over the next several quarters. The reality, however, is a little more sinister. Market observers agree that trading volume has been anemic over the past six months, so the rally is not as broad based as they would lead you to believe. Low volume makes the conditions ripe for government manipulation of the market. This is accomplished through open purchases of futures contracts in the open market with the assistance of large investment banks.
The chart below perfectly illustrates my point. This represents an S&P e-minis futures daily one minute chart for Friday, May 29. It was a sleepy Friday with no news released and very low trading volume throughout the day as depicted by the volume bars below the main line graph. In the last few minutes of trading, enormous buy orders hit the market with over 200,000 contracts purchased right before the market close. This volume spike immediately pushed the S&P up roughly 10 points for no valid reason. I am not a conspiracy theorist by nature, and I'm well aware of the program trading that often takes place near the end of the trading day, but this pattern has continuously repeated itself over the past several months. Downside volatility has disappeared while the major indices often closed right at the highs of the day. Even during the market meltdown in late 2008 and early 2009, equities experienced vicious upside volatility through short covering and government bailouts.
With a large percentage of Americans having seen their 401Ks decimated, I am not at all surprised to see the government try to restore confidence in the economy. It is also no accident that consumer confidence has risen with the stock market, but this correlation will prove short lived as unemployment continues to soar.
Massive Government Stimulus Programs
I underestimated the short term impact that the coordinated response of governments around the world would have on equities and economic activity. I am a strong advocate of free market capitalism and tend to analyze such programs from a longer term perspective. Long-term, debt based government spending adds no value and only serves to increase the national deficit. Although in the near term, such policies act as stimulant, akin to an addict getting his fix. The euphoria will wear off leading to a more violent crash once participants realize that despite the government's best efforts, the long term contraction has only been slowed.
The cash for clunkers program is a perfect paradigm for our current economic state. Some analysts have gone as far to suggest that the four year decline in auto sales may have reached a turning point with the success of the program. The government of course allocated billions it doesn't have to fund the program, representing yet another example of taking from the taxpayer (or borrowing from the Chinese in this instance) to artificially create an increase in auto sales. Even with the deep cuts made by the auto manufacturers over the past several years, the sad truth is that there are still too many dealers and too much excess capacity still remaining in the system. As a result, auto sales showed a nice bump over the past several months, but this only shifted future sales to the present.
I've had many people come up to me over the past several weeks pointing to the stock market's recent performance as an indication that the worst has past and we are on the road to recovery. They also point to the housing uptick and question my long term bearish stance on the economy. I have two words for these individuals.....just wait! The FHA is providing mortgage loans with as little as 3.5% equity that has resulted in 50:1 leverage on their books. Although this is better than the 100:1 leverage sported by the Fannie Mae and Freddie Mac, the risk has only been shifted from the private sector to the tax payer.
A brief note on my investment strategy. I do not buy or sell individual stocks but instead sell deep out of the money naked call options on stocks, commodities and broad-based equity ETFs. Through time decay on these options and proper risk management, I have not had one losing trade in 2009. However, it has taken me longer to realize my profits as a result of the market run-up. The early cyclical names that I highlighted in my prior post represent excellent shorting opportunities if you have the patience and the wherewithal to profit from the coming collapse in consumer spending. Consistent with my prior posts, I fully expect the S&P to drop below 500 by the end of 2010 with the only risk to my forecast being a weak dollar that artificially inflates equities.
Ask yourself these two questions: If the equity rally was for real, why is gold trading over $1,000/oz? Second, how in the world is cheap credit and increased personal spending going to lead us out of this "recession" when these were the primary drivers leading to the excesses in the first place?
Tuesday, June 2, 2009
Smoke and Mirrors
Illusion #1: Nominal Returns
With today’s close, the S&P has soared 42% off of its most recent bear market low of 666 set in early March. However, during the same period, the dollar index has plummeted 11.4% from 88.5 on March 6 to 78.4 on June 2. So in real dollar terms, the S&P is up just over 30%. In my prior post, I stated that the S&P could run another 5% to 920 back when it was trading at 877. As of today, the S&P is up 7.7% from its May 1 close, surpassing my target by 2.7%. Should I admit defeat and move on? Not quite as the dollar index has shed 7.2% over the same period, resulting in a real dollar gain from May 1 – June 2 of only .5%. In other words, the S&P must pass 980 holding the dollar index constant at today’s levels to violate my original call. All of the gains enjoyed over the past month are an illusion, only making up for the loss in the dollar’s value.
The devaluation of the dollar artificially improves equity performance given that real returns over the past month were less than 1%. America thinks in nominal terms, and the shrewd policy makers have developed an uncanny ability to pull the wool over the general public’s eyes. The average person watching TV every night sees a continuous stream of positive headlines and concludes that the economy seems to have turned the corner. All the while, national gas prices have soared over 50% in 2009 to a national average of $2.52/gallon on the back of lower refinery production and the weaker greenback. Note that each 1 penny rise in the retail price of gasoline costs American consumers $1B a year. Oil priced in gold will fall sharply once this most recent round of speculation reverses by mid-summer. In general, I believe that commodity prices will crash again as people realize that the anticipated economic recovery will not take place.
Illusion #2: Second Derivative Data
The main driver underlying Monday’s 2.6% rally was the better than expected ISM index of 42.8 against the consensus estimate of 42. Any reading below 50 still represents contraction, although new orders for the month rose above 50 for the first time in 17 months, which is the main data point that equities rallied on during Monday’s session. The Chinese manufacturing survey, also released Monday, showed growth for the third straight month and helped set a positive tone for trading in Europe and the U.S this week. I fully expected this economic uptick because of all the money that has been thrown at economies by governments worldwide. These stimuli coupled with second derivative economic statistics have and will create the illusion of improvement over the next several months.
Second derivative means the change of the change. For example, house prices are often analyzed by the change over the prior year or month. So if home prices fall 20% in May over the prior year, this means the real change from the peak is actually worse (maybe 30% lower than 2006) since home values had already started falling as of May of 2008. Eventually, the rate of decline will slow or show slight improvement because the comparisons will be made against depressed economic data. Markets are fixated on this second derivative data, but it only serves as noise over the long run because the trend will only continue lower. The talk by year end will shift from this change to fears of a double dip recession that will lead to the next leg down in the equity markets.
Illusion #3: The Emerging Market Mirage
The biggest smoke screen that I have seen recently, however, is the emerging market mirage. Many strategists believe that the Asian growth economies are going to lead the global economy out of this recession. As a result, many firms and individuals have emerged advocating full investment in foreign markets in order to shield investors from the low growth developed economies.
Chinese, South Korean, and Indian equities have sharply outperformed their American and European counterparts during the most recent bear market rally. The prevailing thought by money managers blindly throwing money into these markets is that this is where the growth lies during a potential economic rebound. This school of thought is flawed for several reasons:
1) Contrary to popular belief, these economies benefited from much of the fake growth that took place over the past decade fueled by cheap credit. As a result, the deleveraging process that still needs to unwind will impact these markets significantly.
2) These economies remain heavily dependent on exports. Thus, the decoupling theory, or belief that their domestic economies can more than offset the reduced demand in developed economies is ludicrous. Many U.S. equity bears continue to shift funds into emerging markets thinking that those economies have or will soon decouple from the U.S. economy. They point to the outperformance of the Chinese Composite, the Hang Seng index in Hong Kong and the Indian Sensex as these indices have outperformed U.S. equities during the most recent bear market rally. They conveniently exclude the fact that these indices had fallen much more sharply than U.S. indices as of November 2008. These strategists have concluded that China and India, sporting populations well in excess of 1B people each (or roughly 37% of the global population) will easily step in and replace the purchasing power of the U.S. I agree with this school of thought over the long term, however, it took decades for this relationship to develop, and it will not unwind over the course of several months.
At first glance, it is difficult to argue against the potential purchasing power of over 2B people in China and India, but of China’s 1.3B people, 130M live on less than $1 a day. Additionally, 8% of the Chinese population lives below the poverty line. Although Chinese GDP for 2008 amounted to $7.8T, 40% of its GDP was based on exports to the U.S., Japan, South Korea, and Germany. Unlike U.S consumption, which accounts for 67% of the economy, only 36% of the Chinese economy is based on consumption. This does not even begin to address the huge gap between the rich and poor in both China and India as their respective middle classes attempt to establish themselves. People also cannot ignore the practical environmental limitations of having over 2B people try to live an American lifestyle.
Those clamoring to gain emerging market exposure will see their portfolios decimated during the next wave down in the late summer and early fall. Expecting these economies to replace American consumption is akin to asking a high school student to support a family with their part-time mall job after both parents have been laid off. China and India will grow, but not until they have been weaned off the Western economies.
Given my thoughts above, I will highlight several key concepts underlying my current investment strategy:
1) I do not expect equity markets to pull back meaningfully until this fall, but I believe that certain names within the consumer cyclical, technology and financial sectors in the U.S. are now attractive shorts. For example, Goldman Sachs, Amazon, Google, and Apple all have rich valuations and have significant downside risk once investors realize that the economic recovery will not take place nearly as soon as expected.
2) If yields in the treasury market continue to rise, this will have an immediate and sharp impact on stocks. The yield on the 10-year note has already risen to over 3.6%, and that is with the Fed in the market purchasing treasuries. Investors (mainly China) continue to reallocate funds from longer dated notes to short term bills because of inflation concerns. This has resulted in widening spreads between bills and notes although mortgage rates remain artificially suppressed because of government controls and subsidies.
3) Starting in August, I will begin shorting basic materials and related stocks such as Rio Tinto. I decided to delay this strategy because commodities still have room to run as people continue to rotate out of the dollar and into hard assets.
4) I will short emerging markets in late August because they are not the safe haven that everyone assumes.
With today’s close, the S&P has soared 42% off of its most recent bear market low of 666 set in early March. However, during the same period, the dollar index has plummeted 11.4% from 88.5 on March 6 to 78.4 on June 2. So in real dollar terms, the S&P is up just over 30%. In my prior post, I stated that the S&P could run another 5% to 920 back when it was trading at 877. As of today, the S&P is up 7.7% from its May 1 close, surpassing my target by 2.7%. Should I admit defeat and move on? Not quite as the dollar index has shed 7.2% over the same period, resulting in a real dollar gain from May 1 – June 2 of only .5%. In other words, the S&P must pass 980 holding the dollar index constant at today’s levels to violate my original call. All of the gains enjoyed over the past month are an illusion, only making up for the loss in the dollar’s value.
The devaluation of the dollar artificially improves equity performance given that real returns over the past month were less than 1%. America thinks in nominal terms, and the shrewd policy makers have developed an uncanny ability to pull the wool over the general public’s eyes. The average person watching TV every night sees a continuous stream of positive headlines and concludes that the economy seems to have turned the corner. All the while, national gas prices have soared over 50% in 2009 to a national average of $2.52/gallon on the back of lower refinery production and the weaker greenback. Note that each 1 penny rise in the retail price of gasoline costs American consumers $1B a year. Oil priced in gold will fall sharply once this most recent round of speculation reverses by mid-summer. In general, I believe that commodity prices will crash again as people realize that the anticipated economic recovery will not take place.
Illusion #2: Second Derivative Data
The main driver underlying Monday’s 2.6% rally was the better than expected ISM index of 42.8 against the consensus estimate of 42. Any reading below 50 still represents contraction, although new orders for the month rose above 50 for the first time in 17 months, which is the main data point that equities rallied on during Monday’s session. The Chinese manufacturing survey, also released Monday, showed growth for the third straight month and helped set a positive tone for trading in Europe and the U.S this week. I fully expected this economic uptick because of all the money that has been thrown at economies by governments worldwide. These stimuli coupled with second derivative economic statistics have and will create the illusion of improvement over the next several months.
Second derivative means the change of the change. For example, house prices are often analyzed by the change over the prior year or month. So if home prices fall 20% in May over the prior year, this means the real change from the peak is actually worse (maybe 30% lower than 2006) since home values had already started falling as of May of 2008. Eventually, the rate of decline will slow or show slight improvement because the comparisons will be made against depressed economic data. Markets are fixated on this second derivative data, but it only serves as noise over the long run because the trend will only continue lower. The talk by year end will shift from this change to fears of a double dip recession that will lead to the next leg down in the equity markets.
Illusion #3: The Emerging Market Mirage
The biggest smoke screen that I have seen recently, however, is the emerging market mirage. Many strategists believe that the Asian growth economies are going to lead the global economy out of this recession. As a result, many firms and individuals have emerged advocating full investment in foreign markets in order to shield investors from the low growth developed economies.
Chinese, South Korean, and Indian equities have sharply outperformed their American and European counterparts during the most recent bear market rally. The prevailing thought by money managers blindly throwing money into these markets is that this is where the growth lies during a potential economic rebound. This school of thought is flawed for several reasons:
1) Contrary to popular belief, these economies benefited from much of the fake growth that took place over the past decade fueled by cheap credit. As a result, the deleveraging process that still needs to unwind will impact these markets significantly.
2) These economies remain heavily dependent on exports. Thus, the decoupling theory, or belief that their domestic economies can more than offset the reduced demand in developed economies is ludicrous. Many U.S. equity bears continue to shift funds into emerging markets thinking that those economies have or will soon decouple from the U.S. economy. They point to the outperformance of the Chinese Composite, the Hang Seng index in Hong Kong and the Indian Sensex as these indices have outperformed U.S. equities during the most recent bear market rally. They conveniently exclude the fact that these indices had fallen much more sharply than U.S. indices as of November 2008. These strategists have concluded that China and India, sporting populations well in excess of 1B people each (or roughly 37% of the global population) will easily step in and replace the purchasing power of the U.S. I agree with this school of thought over the long term, however, it took decades for this relationship to develop, and it will not unwind over the course of several months.
At first glance, it is difficult to argue against the potential purchasing power of over 2B people in China and India, but of China’s 1.3B people, 130M live on less than $1 a day. Additionally, 8% of the Chinese population lives below the poverty line. Although Chinese GDP for 2008 amounted to $7.8T, 40% of its GDP was based on exports to the U.S., Japan, South Korea, and Germany. Unlike U.S consumption, which accounts for 67% of the economy, only 36% of the Chinese economy is based on consumption. This does not even begin to address the huge gap between the rich and poor in both China and India as their respective middle classes attempt to establish themselves. People also cannot ignore the practical environmental limitations of having over 2B people try to live an American lifestyle.
Those clamoring to gain emerging market exposure will see their portfolios decimated during the next wave down in the late summer and early fall. Expecting these economies to replace American consumption is akin to asking a high school student to support a family with their part-time mall job after both parents have been laid off. China and India will grow, but not until they have been weaned off the Western economies.
Given my thoughts above, I will highlight several key concepts underlying my current investment strategy:
1) I do not expect equity markets to pull back meaningfully until this fall, but I believe that certain names within the consumer cyclical, technology and financial sectors in the U.S. are now attractive shorts. For example, Goldman Sachs, Amazon, Google, and Apple all have rich valuations and have significant downside risk once investors realize that the economic recovery will not take place nearly as soon as expected.
2) If yields in the treasury market continue to rise, this will have an immediate and sharp impact on stocks. The yield on the 10-year note has already risen to over 3.6%, and that is with the Fed in the market purchasing treasuries. Investors (mainly China) continue to reallocate funds from longer dated notes to short term bills because of inflation concerns. This has resulted in widening spreads between bills and notes although mortgage rates remain artificially suppressed because of government controls and subsidies.
3) Starting in August, I will begin shorting basic materials and related stocks such as Rio Tinto. I decided to delay this strategy because commodities still have room to run as people continue to rotate out of the dollar and into hard assets.
4) I will short emerging markets in late August because they are not the safe haven that everyone assumes.
Sunday, May 3, 2009
The Top Is Near
The equity market has continued its impressive rally with the S&P rising nearly 32% off of its March 6th low. About half of the S&P 500 companies have reported earnings, with over 65% beating sharply reduced estimates. On average, operating profits have fallen 30% over the prior year. I stated back in my March 29th post (after the S&P had already rebounded 23%) that the rally could last another 10%. We have almost reached that target as the S&P rose an additional 9% in April. I'm revising my prior projection upward by about 5% from current levels, which will result in a short term S&P target of around 920. Let me reiterate my stance; this rally is completely unjustified from a fundamental perspective and the result of technical oversold conditions. Many stocks that I follow are trading at multiples that are unsustainable given the current and future economic climate.
Treasury yields have soared despite the Fed's treasury purchase program as the 10-year note has risen to 3.15%. Money has flowed from treasuries to equities and corporate bonds as risk appetite and inflation fears return. Foreigners have also scaled back on treasury purchases as China remains a vocal critic of the government's recent policies. On March 25th, I recommended that investors consider TBT, (a double inverse ETF that increases with yields) which has risen 9% in the past five weeks. The equity market has gone from properly pricing in risk to underpricing risk over the past six weeks. Treasury yields will decline as risk aversion re-enters the market and deflation concerns return.
Commodities (and related stocks) have risen sharply on hopes of an economic recovery in the second half this year. Oil settled above $53/barrel on Friday while wholesale gasoline climbed to over $1.51/gallon. This represents nearly a 70% increase over the December gasoline lows of around $.90 as refiners cut back on production to boost profit margins. As a result, retail gasoline prices have risen back to $2.20/gallon throughout most of the nation despite the fact that the economy remains mired in the midst of the worst post-war recession. I would hate to see what happens to oil prices if the dollar actually weakens as the recent run-up has been driven entirely by speculation that the economy will improve within the next six months.
The problems plaguing this economy are structural, not cyclical, so the conventional wisdom applied by money managers in prior downturns will not apply this time around. I am therefore providing a 12-18 month S&P price target of approximately 500, representing a 43% decline from Friday's close. As illustrated by the excel table below (obtained directly from Standard & Poor's), the S&P is currently trading at 15X full year 2009 operating earnings estimates of 58. Valuations even look attractive once 2010 is considered with a forward PE of "only" 11.60 based upon Friday's close. But hold on a second, analysts are forecasting a sharp recovery in 2010 with operating earnings expected to jump 30% over the current year. Even if the pace of economic decline slows over the next 12 months, these projections border on the absurd. With a real unemployment rate of just over 15% and rising, the consumer is only now beginning to feel the impact of the upcoming depression.
Source: http://www2.standardandpoors.com/portal/site/sp/en/us/page.topic/indices_500/2,3,2,2,0,0,0,0,0,0,6,0,0,0,0,0.html
The figures above represent operating results, not reported GAAP earnings that are often lower because of write-downs and other one time adjustments. Over the past several decades, the spread between GAAP and operating earnings have increased, artificially lowering PE ratios. In any event, 2010 earnings estimates will prove overly optimistic and should decline over the next four quarters. S&P operating earnings will not surpass $50 in 2010, well below the current $75 estimate. Accordingly, the PE ratio will contract to below 10 as investors price in a severe multi-year contraction. Historically, bear markets trough in the 6-10 P/E range, well below the current levels. Once we apply a 10 P/E on $50 of earnings, we arrive at an S&P of 500. I will most likely revise this preliminary estimate downwards as I review additional data.
This argument really comes down to one simple question. Do you believe that the worst is over? The bulls will say that the economy is near a bottom while the bears believe that the worst is yet to come. There is one important distinction, however. If you buy the bear's argument, you are buying the facts and prescribing to common sense while the bulls are trying to sell a mystery tonic that promises way more than it could ever deliver. There will be the buying opportunity of a lifetime....just not yet!
Treasury yields have soared despite the Fed's treasury purchase program as the 10-year note has risen to 3.15%. Money has flowed from treasuries to equities and corporate bonds as risk appetite and inflation fears return. Foreigners have also scaled back on treasury purchases as China remains a vocal critic of the government's recent policies. On March 25th, I recommended that investors consider TBT, (a double inverse ETF that increases with yields) which has risen 9% in the past five weeks. The equity market has gone from properly pricing in risk to underpricing risk over the past six weeks. Treasury yields will decline as risk aversion re-enters the market and deflation concerns return.
Commodities (and related stocks) have risen sharply on hopes of an economic recovery in the second half this year. Oil settled above $53/barrel on Friday while wholesale gasoline climbed to over $1.51/gallon. This represents nearly a 70% increase over the December gasoline lows of around $.90 as refiners cut back on production to boost profit margins. As a result, retail gasoline prices have risen back to $2.20/gallon throughout most of the nation despite the fact that the economy remains mired in the midst of the worst post-war recession. I would hate to see what happens to oil prices if the dollar actually weakens as the recent run-up has been driven entirely by speculation that the economy will improve within the next six months.
The problems plaguing this economy are structural, not cyclical, so the conventional wisdom applied by money managers in prior downturns will not apply this time around. I am therefore providing a 12-18 month S&P price target of approximately 500, representing a 43% decline from Friday's close. As illustrated by the excel table below (obtained directly from Standard & Poor's), the S&P is currently trading at 15X full year 2009 operating earnings estimates of 58. Valuations even look attractive once 2010 is considered with a forward PE of "only" 11.60 based upon Friday's close. But hold on a second, analysts are forecasting a sharp recovery in 2010 with operating earnings expected to jump 30% over the current year. Even if the pace of economic decline slows over the next 12 months, these projections border on the absurd. With a real unemployment rate of just over 15% and rising, the consumer is only now beginning to feel the impact of the upcoming depression.
Source: http://www2.standardandpoors.com/portal/site/sp/en/us/page.topic/indices_500/2,3,2,2,0,0,0,0,0,0,6,0,0,0,0,0.html
The figures above represent operating results, not reported GAAP earnings that are often lower because of write-downs and other one time adjustments. Over the past several decades, the spread between GAAP and operating earnings have increased, artificially lowering PE ratios. In any event, 2010 earnings estimates will prove overly optimistic and should decline over the next four quarters. S&P operating earnings will not surpass $50 in 2010, well below the current $75 estimate. Accordingly, the PE ratio will contract to below 10 as investors price in a severe multi-year contraction. Historically, bear markets trough in the 6-10 P/E range, well below the current levels. Once we apply a 10 P/E on $50 of earnings, we arrive at an S&P of 500. I will most likely revise this preliminary estimate downwards as I review additional data.
This argument really comes down to one simple question. Do you believe that the worst is over? The bulls will say that the economy is near a bottom while the bears believe that the worst is yet to come. There is one important distinction, however. If you buy the bear's argument, you are buying the facts and prescribing to common sense while the bulls are trying to sell a mystery tonic that promises way more than it could ever deliver. There will be the buying opportunity of a lifetime....just not yet!
Thursday, April 16, 2009
US Prices Drop For First Time Since 1955
This was the title for an April 15th Financial Times article following the March Consumer Price Index (CPI) report showing a .4% year-over-year decline. Think about the significance of this statement for a moment. Prices have risen for 53 consecutive years.....53! And you probably thought that Joe DiMaggio's 56 game hitting streak was impressive. However, anyone that has taken an introductory economics course learned that cyclical patterns will lead to either rising or falling prices as the economy expands and contracts. Every basic textbook reminds us that rapidly expanding economies lead to full capacity utilization driving prices upward. The opposite should also hold true as economies slow and these pressures ebb, theoretically pushing prices down. Oddly, this basic free market principle does not seem to apply given inflation's impressive 53-year winning streak.
How is it that prices have continually risen despite the recessions and economic shocks of the past half century? Enter the Central Bank, affectionately dubbed the Federal Reserve, although it is neither Federal nor does it maintain any significant reserves. The Fed, run by a consortium of private bankers, has designed a debt-based system that requires ever-expanding prices to fuel the repayment of all outstanding loans. Although this may sound confusing, bare with me for a moment. If you could call a timeout and pause all economic activity while simultaneously requiring the immediate repayment of any outstanding debt, the global economic system would collapse. More simply, the amount of debt in circulation far exceeds the amount of cash currently in the system, and the ability of debtors to repay their obligations. This makes complete sense when examined from the perspective of an average middle class household. It may have modest savings, but a huge mortgage and credit card debt, which is reliant upon future income to repay, eclipses whatever savings accumulated. These future earnings will not exist without a continuously expanding money supply. Inflation represents the Fed's best and only tool to ensure that enough money is circulating through the system to repay these future obligations.
So the Fed's 1%-2% targeted annual inflation rate is beginning to make a little more sense. The bankers have convinced the general public that our economy cannot achieve sustainable growth without modest inflation, which is a complete a lie. Deflation, per the Fed's mandate, should be fought with all the tools available at its disposal. In a true deflationary environment, income streams will contract, inhibiting businesses and individuals alike from repaying their respective debts. This results in skyrocketing defaults and the failure of every major bank that is reliant on future inflationary earnings for their debtors to repay current obligations.
Deflation is best compared to a forest fire, painful and destructive in the near-term, but instrumental for building a solid foundation for future growth. Other than serving as a pricing mechanism, it encourages saving (through increased purchasing power) and proper capital formation supported by these savings, rather than debt. However, given the current system's complete over reliance on debt, any prolonged period of deflation will also lead to a complete collapse of the system. To further simplify, the current monetary system is structurally flawed and bound to collapse because it violates the most basic economic covenant; that prices must rise and fall with the cycles.
This brings me to my final question. Is the foundation of modern finance built on a flawed theory "that a dollar today is always going to be worth more than a dollar tomorrow?" After all, in a true free market, shouldn't bank lending models at least factor in for the possibility of a deflationary environment? Economic principles and common sense tell us that nothing happens 100% of the time, not even inflation. The most recent monthly CPI report proves this fact.
I realize that this post may seem overly theoretical, but I believe that these questions are essential to understanding the issues that plague our economy and declining standard of living. Make no mistake about the future of this topic, however, as people begin questioning the viability of the current monetary system.
How is it that prices have continually risen despite the recessions and economic shocks of the past half century? Enter the Central Bank, affectionately dubbed the Federal Reserve, although it is neither Federal nor does it maintain any significant reserves. The Fed, run by a consortium of private bankers, has designed a debt-based system that requires ever-expanding prices to fuel the repayment of all outstanding loans. Although this may sound confusing, bare with me for a moment. If you could call a timeout and pause all economic activity while simultaneously requiring the immediate repayment of any outstanding debt, the global economic system would collapse. More simply, the amount of debt in circulation far exceeds the amount of cash currently in the system, and the ability of debtors to repay their obligations. This makes complete sense when examined from the perspective of an average middle class household. It may have modest savings, but a huge mortgage and credit card debt, which is reliant upon future income to repay, eclipses whatever savings accumulated. These future earnings will not exist without a continuously expanding money supply. Inflation represents the Fed's best and only tool to ensure that enough money is circulating through the system to repay these future obligations.
So the Fed's 1%-2% targeted annual inflation rate is beginning to make a little more sense. The bankers have convinced the general public that our economy cannot achieve sustainable growth without modest inflation, which is a complete a lie. Deflation, per the Fed's mandate, should be fought with all the tools available at its disposal. In a true deflationary environment, income streams will contract, inhibiting businesses and individuals alike from repaying their respective debts. This results in skyrocketing defaults and the failure of every major bank that is reliant on future inflationary earnings for their debtors to repay current obligations.
Deflation is best compared to a forest fire, painful and destructive in the near-term, but instrumental for building a solid foundation for future growth. Other than serving as a pricing mechanism, it encourages saving (through increased purchasing power) and proper capital formation supported by these savings, rather than debt. However, given the current system's complete over reliance on debt, any prolonged period of deflation will also lead to a complete collapse of the system. To further simplify, the current monetary system is structurally flawed and bound to collapse because it violates the most basic economic covenant; that prices must rise and fall with the cycles.
This brings me to my final question. Is the foundation of modern finance built on a flawed theory "that a dollar today is always going to be worth more than a dollar tomorrow?" After all, in a true free market, shouldn't bank lending models at least factor in for the possibility of a deflationary environment? Economic principles and common sense tell us that nothing happens 100% of the time, not even inflation. The most recent monthly CPI report proves this fact.
I realize that this post may seem overly theoretical, but I believe that these questions are essential to understanding the issues that plague our economy and declining standard of living. Make no mistake about the future of this topic, however, as people begin questioning the viability of the current monetary system.
Saturday, April 11, 2009
Financial Earnings Do Not Equal Solvency
Wells Fargo reported record profits, nearly doubling analyst estimates despite the worst recession in the post-war era. The Fed designed its aggressive policy to slash interest rates over the past year to yield the maximum benefit for banks just as the economy fell of a cliff. The major banks are sitting on a pile of free cash as depositors earn less than 1% on their savings. This steepening of the yield curve has made it impossible for even bankers to lose money. So the Fed's actions have punished savers yet again and transferred a significant amount of wealth from the saving public to the banks. These actions continue to discourage saving while simultaneously encouraging excessive risk taking by lenders and debtors. However, an economy needs a solid savings base in order to encourage sustainable capital investment that is not based purely on debt. This begs the question; why do oil companies reporting record profits infuriate the general public while banks are applauded for producing record quarters? After all, don't both these industries generate their profits at the expense of the general public?
This upcoming week will see financial heavyweights Goldman Sachs, JP Morgan Chase, Bank of America and Citibank all report first quarter results. These companies are all expected to post solid numbers as they will benefit from the same operating environment that Wells Fargo exploited during the quarter. However, the market has priced in a solid earnings season for these banks following the Wells Fargo pre-announcement on Thursday and significant run-up in bank shares over the past four weeks. Do not expect the banks reporting this week to "blow out" the numbers because Wells Fargo achieved its results by under-reserving for future losses. I advised investors to avoid shorting financial stocks ahead of the mark-to-market rule change several weeks ago, and they have rallied sharply since that point.
Let me be as clear as possible. Although the financial sector will produce positive operating cash flow aided by free money, it remains insolvent, sitting atop a pile of bad assets. While bank share prices no longer reflect this reality, it is only a matter of time before the market prices these bank stocks accordingly. With additional capital raises looming and loan defaults accelerating, some excellent long term shorting opportunities are emerging within the sector following this earnings season. No other industry employs the amount of leverage that financials utilize. Even at a 10:1 leverage ratio, banks use $1 in equity to fund $10 in lending. So a small change in the value of the underlying assets can wipe out a large amount of equity. This is exactly what has plagued the sector for the past 18 months. The banks' tangible equity pales in comparison to the size of their actual balance sheets. After all, what is a couple billion dollars in quarterly profit when banks maintain balance sheets in the hundreds of billions? Further, these balance sheets will continue to deteriorate as the economy contracts.
This upcoming week will see financial heavyweights Goldman Sachs, JP Morgan Chase, Bank of America and Citibank all report first quarter results. These companies are all expected to post solid numbers as they will benefit from the same operating environment that Wells Fargo exploited during the quarter. However, the market has priced in a solid earnings season for these banks following the Wells Fargo pre-announcement on Thursday and significant run-up in bank shares over the past four weeks. Do not expect the banks reporting this week to "blow out" the numbers because Wells Fargo achieved its results by under-reserving for future losses. I advised investors to avoid shorting financial stocks ahead of the mark-to-market rule change several weeks ago, and they have rallied sharply since that point.
Let me be as clear as possible. Although the financial sector will produce positive operating cash flow aided by free money, it remains insolvent, sitting atop a pile of bad assets. While bank share prices no longer reflect this reality, it is only a matter of time before the market prices these bank stocks accordingly. With additional capital raises looming and loan defaults accelerating, some excellent long term shorting opportunities are emerging within the sector following this earnings season. No other industry employs the amount of leverage that financials utilize. Even at a 10:1 leverage ratio, banks use $1 in equity to fund $10 in lending. So a small change in the value of the underlying assets can wipe out a large amount of equity. This is exactly what has plagued the sector for the past 18 months. The banks' tangible equity pales in comparison to the size of their actual balance sheets. After all, what is a couple billion dollars in quarterly profit when banks maintain balance sheets in the hundreds of billions? Further, these balance sheets will continue to deteriorate as the economy contracts.
Friday, April 3, 2009
The Service Based Economic Model Has Failed
The once popular rhetoric of the past decade has turned to a whisper as cracks in our service based economy continue to widen. The dinner bill is due and everyone is trying to pass the check off to the next person as they scramble for the exits. Unfortunately, the years of binging are much more expensive than anyone could have imagined as the sticker shock sets in.
The official March U-3 unemployment rate rose to 8.5% as the U.S. shed another 663,000 jobs in March, roughly in line with estimates. Even more concerning was the large January adjustment, pushing total job losses to 740,000 for the month. It's odd how the current month figures came in so close to estimates while there was such a significant adjustment to the January report. Originally, the BLS estimated that the U.S. "only" lost 598K jobs in its original January release. That's nearly a 24% margin of error from the most recent revision. Would the BLS ever consider transferring job losses to prior months in order to cushion the impact on the markets? I will let you decide for yourself, but I fail to see the point behind releasing a draft report that could include a 24% margin of error. The U-6 unemployment rate, which is far more reflective of reality, soared to 15.6%. As I previously stated, this figure factors in underemployed and marginally attached workers.
http://www.bls.gov/news.release/empsit.t12.htm
Treasury prices fell last week and yields rose to 2.9% on the 10-year note as the market anticipated the U.S. will sell an anticipated $59B in notes this week. Interest rates have climbed back to the levels prior to the Fed's announcement of its treasury purchase program in March. Yields would have risen to well over 3% had it not been for these note purchases. The Treasury has several auctions scheduled for next week, and investors will keep a close eye on the auction results, although the Fed will no doubt provide support in the face of waning foreign demand. Note that the CDS spreads on government issued debt has risen steadily over the past six months as risk is transferred from the private sector to the government with all the bailouts.
I want to take a step back and discuss where I think the general economy is headed over the next several years. Putting the recent equity market rally aside, I have long-term concerns on the U.S. economy. This stance is a matter of common sense and based on the following factors:
1) Slightly less than 70% of the U.S. economy is based on consumer spending. This debt-fueled spending has also supported 25% of the world economy, buoying export countries like China, Japan, and Taiwan. As American consumption increased, productive capacity declined, forcing the government and households to take on more debt to maintain their standard of living. There are more than $5T in outstanding credit lines and $500B was pulled in Q4. Prominent banking analyst, Meredith Whitney, believes that banks could pull more than $2.7T by the end of 2010. With rising unemployment and lower credit availability, it does not take a genius to see where consumer spending is headed over the next year....down.
2) The American standard of living has steadily declined over the past several decades. There are currently 32M people on food stamps in this country, representing over 10% of the population. This is an astonishing number for the largest economy in the world and indicative of a failed system. It was possible in the 1950’s and 1960’s for a factory worker to comfortably support his family on one income alone. Today, that quality manufacturing job has disappeared, while it often takes dual incomes to maintain a similar standard of living. In short, families have to work longer and harder for lower wages as the cost of living skyrockets. This often goes unreported in most media outlets because these fundamental shifts are easy to overlook.
3) Neither the government nor the private sector has come up with a long-term structural solution to resolve the growing trade deficit. The approach has been to throw more debt at the problem just as the economy tries to deleverage. There is a significant difference between this downturn and those in prior cycles. America had a stronger savings rate and manufacturing base to fall back on during the prior postwar recessions. Unfortunately, the spending programs outlined in the stimulus consists of too many one time handouts that add little long-term value to kick start the economy. In other words, this country must make a fundamental shift from over consumption to production, but no administration over the past 20 years has been willing to tackle these serious issues.
4) Putting the credit crisis aside for a moment, the economy was due for a significant correction based on the demographics of the U.S. population. The baby boomers have just surpassed their peak spending years at roughly 48 years of age. This will result in a severe spending slowdown that will dramatically reduce GDP growth for the better part of the next decade. It will not be until the echo boomers reach their peak spending years that you will see a meaningful rebound within the domestic economy.
The questions that bullish money managers and analysts cannot answer should also be the simplest. What will bring the quality jobs back? What catalyst will provide the foundation for a sustained economic recovery as consumers reign in their spending to reduce their debt levels? These are the fundamental questions that bullish analysts continue to dodge. Until these issues are resolved, the economic contraction will not see the bottom.
The official March U-3 unemployment rate rose to 8.5% as the U.S. shed another 663,000 jobs in March, roughly in line with estimates. Even more concerning was the large January adjustment, pushing total job losses to 740,000 for the month. It's odd how the current month figures came in so close to estimates while there was such a significant adjustment to the January report. Originally, the BLS estimated that the U.S. "only" lost 598K jobs in its original January release. That's nearly a 24% margin of error from the most recent revision. Would the BLS ever consider transferring job losses to prior months in order to cushion the impact on the markets? I will let you decide for yourself, but I fail to see the point behind releasing a draft report that could include a 24% margin of error. The U-6 unemployment rate, which is far more reflective of reality, soared to 15.6%. As I previously stated, this figure factors in underemployed and marginally attached workers.
http://www.bls.gov/news.release/empsit.t12.htm
Treasury prices fell last week and yields rose to 2.9% on the 10-year note as the market anticipated the U.S. will sell an anticipated $59B in notes this week. Interest rates have climbed back to the levels prior to the Fed's announcement of its treasury purchase program in March. Yields would have risen to well over 3% had it not been for these note purchases. The Treasury has several auctions scheduled for next week, and investors will keep a close eye on the auction results, although the Fed will no doubt provide support in the face of waning foreign demand. Note that the CDS spreads on government issued debt has risen steadily over the past six months as risk is transferred from the private sector to the government with all the bailouts.
I want to take a step back and discuss where I think the general economy is headed over the next several years. Putting the recent equity market rally aside, I have long-term concerns on the U.S. economy. This stance is a matter of common sense and based on the following factors:
1) Slightly less than 70% of the U.S. economy is based on consumer spending. This debt-fueled spending has also supported 25% of the world economy, buoying export countries like China, Japan, and Taiwan. As American consumption increased, productive capacity declined, forcing the government and households to take on more debt to maintain their standard of living. There are more than $5T in outstanding credit lines and $500B was pulled in Q4. Prominent banking analyst, Meredith Whitney, believes that banks could pull more than $2.7T by the end of 2010. With rising unemployment and lower credit availability, it does not take a genius to see where consumer spending is headed over the next year....down.
2) The American standard of living has steadily declined over the past several decades. There are currently 32M people on food stamps in this country, representing over 10% of the population. This is an astonishing number for the largest economy in the world and indicative of a failed system. It was possible in the 1950’s and 1960’s for a factory worker to comfortably support his family on one income alone. Today, that quality manufacturing job has disappeared, while it often takes dual incomes to maintain a similar standard of living. In short, families have to work longer and harder for lower wages as the cost of living skyrockets. This often goes unreported in most media outlets because these fundamental shifts are easy to overlook.
3) Neither the government nor the private sector has come up with a long-term structural solution to resolve the growing trade deficit. The approach has been to throw more debt at the problem just as the economy tries to deleverage. There is a significant difference between this downturn and those in prior cycles. America had a stronger savings rate and manufacturing base to fall back on during the prior postwar recessions. Unfortunately, the spending programs outlined in the stimulus consists of too many one time handouts that add little long-term value to kick start the economy. In other words, this country must make a fundamental shift from over consumption to production, but no administration over the past 20 years has been willing to tackle these serious issues.
4) Putting the credit crisis aside for a moment, the economy was due for a significant correction based on the demographics of the U.S. population. The baby boomers have just surpassed their peak spending years at roughly 48 years of age. This will result in a severe spending slowdown that will dramatically reduce GDP growth for the better part of the next decade. It will not be until the echo boomers reach their peak spending years that you will see a meaningful rebound within the domestic economy.
The questions that bullish money managers and analysts cannot answer should also be the simplest. What will bring the quality jobs back? What catalyst will provide the foundation for a sustained economic recovery as consumers reign in their spending to reduce their debt levels? These are the fundamental questions that bullish analysts continue to dodge. Until these issues are resolved, the economic contraction will not see the bottom.
Thursday, April 2, 2009
Market Wrap (4/2) & What's on Tap for Friday
The verdict is in. I said Wednesday that equities would see limited up side ahead of the Friday jobs report with the mark-to-market rule change providing the only possible exception as an upward catalyst. Once the FASB caved in and approved the measure, markets extended their gains with financials rising over 3%. The S&P closed up 23 points or 2.9%, well off the session highs as stocks pulled back late in the day ahead of tomorrow's employment report. The financial sector underperformed cyclicals, basic materials, and transportation today. The G20 are also increasing the International Monetary Fund's lending power to $750B. The dollar index slipped nearly 1.4% as the European Central Bank cut interest rates by 25 basis points to 1.25%, less than the 50 expected by most observers. Rhetoric coming from the G20 leaders did contribute to the positive sentiment in the market.
The consumer cyclical and transportation sectors drove the market's gains today rising 7% and 6% respectively. The G20's actions coupled with the possible easing of credit conditions fueled investor optimism that the economy will improve sooner than originally anticipated. This also prompted oil to rise 8% to over $52 a barrel. I am particularly confused by the strength exhibited in the retail sector as many of these stocks have soared over the past several weeks in the face of increasing unemployment and rising gas prices. Many of these stocks are no longer pricing in the severe strains that consumers will begin to endure over the next year.
Treasuries declined as investors fled from the safety of government bonds to equities in search of better returns. The yield on the 10-year increased to 2.76% and would have risen further had it not been for the Fed purchasing over $7B of notes in today's session. The Fed will most likely increase its treasury purchase program from $300B to over $600B in the next six months. Given the Fed's current treasury purchase pace, it will most likely surpass its original $300B limit within four months.
I want to hit on a brief point regarding the US dollar fluctuations and impact on equity markets. Investors can attribute about 1% of today's equity market gain to the weaker dollar. If the S&P rises 1% while the dollar falls 1%, then the U.S. market value has not risen from a real dollar perspective. Take today as an example. If you are money manager based out of the Euro-Zone and own a broad based S&P ETF, you are excited that it closed up 3.5%. However, since you will have to convert those gains back into your currency eventually, your real gains from a Euro perspective are only 1.4% (2.9% market gain minus 1.5% daily Euro gain). I just wanted to point this fact out since most people do not consider how currency fluctuations can impact their real returns. So if the S&P doubles from here, but the dollar index loses 50% of its value, then you have a 0% real rate of return.
The DOW is currently hovering near 8,000 after it closed at 11,500 on 12/31/99, meaning that it has lost 3,500 points or 30% this decade. However, once we review the DOW’s performance in terms of gold, which factors in the dollar's declining value, the market’s drop has been even more precipitous. Gold traded at roughly $300/oz when we ushered in this decade, but today, it has soared to over $900/oz, more than tripling its value over the past eight years. Once you apply the DOW/Gold ratio, the market’s drop is stunning. The ratio dropped from 38 (11,500/$300oz) in 2000 to 9 (8,000/$900oz) in 2009. So when you price the index in gold and compare the prices over the same time period, it has dropped by 76% (38-9/38)! This drop follows significant cuts in the capital gain tax rates to 15% and a favorable interest rate environment for the better part of the last decade. These are the types of measurements that main stream commentators and financial networks rarely discuss.
The BLS releases the March employment report tomorrow with economists forecasting 650,000 in job losses for the month. Traders have decided that poor employment numbers no longer matter since it is already baked in to the market. I am not a market timer nor do I aim to become one, but people continue to underestimate the true state of the job market and the longer term impact on the economy.
Company Spotlight
Sears Holdings (SHLD)completely defies all logic closing up over 8% to $52.13 today. Operating cash flows continue to deteriorate as it loses market share to competitors. Consensus analyst estimates for the current and next fiscal year is $.16 and $.58 respectively. Sears real estate holdings continue to decline in value yet the market has assigned this stock a crazy premium trading at over 300 times this year's estimates. It is even expensive when analyzed using enterprise value metrics. Needless to say, if you have the patience and can find the shares to short, you will be rewarded because the stock has no business trading over $20.
The consumer cyclical and transportation sectors drove the market's gains today rising 7% and 6% respectively. The G20's actions coupled with the possible easing of credit conditions fueled investor optimism that the economy will improve sooner than originally anticipated. This also prompted oil to rise 8% to over $52 a barrel. I am particularly confused by the strength exhibited in the retail sector as many of these stocks have soared over the past several weeks in the face of increasing unemployment and rising gas prices. Many of these stocks are no longer pricing in the severe strains that consumers will begin to endure over the next year.
Treasuries declined as investors fled from the safety of government bonds to equities in search of better returns. The yield on the 10-year increased to 2.76% and would have risen further had it not been for the Fed purchasing over $7B of notes in today's session. The Fed will most likely increase its treasury purchase program from $300B to over $600B in the next six months. Given the Fed's current treasury purchase pace, it will most likely surpass its original $300B limit within four months.
I want to hit on a brief point regarding the US dollar fluctuations and impact on equity markets. Investors can attribute about 1% of today's equity market gain to the weaker dollar. If the S&P rises 1% while the dollar falls 1%, then the U.S. market value has not risen from a real dollar perspective. Take today as an example. If you are money manager based out of the Euro-Zone and own a broad based S&P ETF, you are excited that it closed up 3.5%. However, since you will have to convert those gains back into your currency eventually, your real gains from a Euro perspective are only 1.4% (2.9% market gain minus 1.5% daily Euro gain). I just wanted to point this fact out since most people do not consider how currency fluctuations can impact their real returns. So if the S&P doubles from here, but the dollar index loses 50% of its value, then you have a 0% real rate of return.
The DOW is currently hovering near 8,000 after it closed at 11,500 on 12/31/99, meaning that it has lost 3,500 points or 30% this decade. However, once we review the DOW’s performance in terms of gold, which factors in the dollar's declining value, the market’s drop has been even more precipitous. Gold traded at roughly $300/oz when we ushered in this decade, but today, it has soared to over $900/oz, more than tripling its value over the past eight years. Once you apply the DOW/Gold ratio, the market’s drop is stunning. The ratio dropped from 38 (11,500/$300oz) in 2000 to 9 (8,000/$900oz) in 2009. So when you price the index in gold and compare the prices over the same time period, it has dropped by 76% (38-9/38)! This drop follows significant cuts in the capital gain tax rates to 15% and a favorable interest rate environment for the better part of the last decade. These are the types of measurements that main stream commentators and financial networks rarely discuss.
The BLS releases the March employment report tomorrow with economists forecasting 650,000 in job losses for the month. Traders have decided that poor employment numbers no longer matter since it is already baked in to the market. I am not a market timer nor do I aim to become one, but people continue to underestimate the true state of the job market and the longer term impact on the economy.
Company Spotlight
Sears Holdings (SHLD)completely defies all logic closing up over 8% to $52.13 today. Operating cash flows continue to deteriorate as it loses market share to competitors. Consensus analyst estimates for the current and next fiscal year is $.16 and $.58 respectively. Sears real estate holdings continue to decline in value yet the market has assigned this stock a crazy premium trading at over 300 times this year's estimates. It is even expensive when analyzed using enterprise value metrics. Needless to say, if you have the patience and can find the shares to short, you will be rewarded because the stock has no business trading over $20.
Wednesday, April 1, 2009
Market Wrap (4/1) & What's on Tap for Thursday
Today's economic data came in roughly in line with expectations as the National ISM numbers showed a slight improvement over the prior month's 35.8 reading with a 36.3. Employment and new orders improved while production held steady over the prior month. This number still indicates significant contraction, but stocks greeted the release with optimism paring their morning losses to close up 1.6%. The data diverged from the Chicago PMI survey released yesterday, which came in below estimates.
Consistent with my forecast yesterday, pending home sales ticked up 2.1% over February as lower mortgage rates and foreclosure sales prompted buyers to enter the market. The West continues to deteriorate as pending sales fell 13% showing that the the general economy is standing in the way of a more sustained housing recovery. All other regions enjoyed pending home sale increases over the prior month. I am interested to see next month's sales data as we enter the home buying season and mortgage rates remain near record lows. The housing situation is actually worse than the data suggests given the shadow inventory held by lenders. Official statistics report that there are 3.8M existing homes currently on the market, equal to about 9.7 months supply. However, lenders are holding over 600,000 residential properties that are not listed on the multiple listings service.
Vehicle sales, although terrible, came in slightly above expectations adding to the market's gains midday. The year-over-year declines will level out over the next six months as the auto manufacturers begin to compare their figures to weak sales months in 2008. The General Motors CEO stated that vehicle sales are finally bottoming out, but I urge him not to get ahead of himself as consumers continue to deleverage their balance sheets.
As expected, the market continues to ignore the poor economic reports as most of this information has already been "discounted" into the market. After all, the bulls contend that the market is a forward looking mechanism, pricing securities nine months out into the future. If this is truly the case; how was it that the major indices hit their all time highs in October of 2007, less than two months before the official onset of the current recession? The fundamentals do not support a significant market rally from these levels. I will dig deeper into this over the next week, but needless to say, I believe that the market is getting ahead of itself at the moment. However, equities could easily trade up another 10%-15% before turning back down.
Tomorrow is light on the economic front with initial jobless claims due out in the morning with a consensus estimate of 655,000 new filings. Aside from the initial market reaction, this report poses limited downside risk for equities with any better-than-expected figures used as an excuse to rally the markets. The FASB will also vote on the final mark-to-market rule tomorrow, which supported financial shares in today's trading. Banks will apply this rule change retroactively, meaning that it will be applicable for Q1 earnings. What a loss for transparency, and as a non-practicing CPA, I am personally disgusted that this was even considered. Mark to model is best compared to a homeowner valuing their house at twice the market value because they think "that is what it should be worth."
Consistent with my forecast yesterday, pending home sales ticked up 2.1% over February as lower mortgage rates and foreclosure sales prompted buyers to enter the market. The West continues to deteriorate as pending sales fell 13% showing that the the general economy is standing in the way of a more sustained housing recovery. All other regions enjoyed pending home sale increases over the prior month. I am interested to see next month's sales data as we enter the home buying season and mortgage rates remain near record lows. The housing situation is actually worse than the data suggests given the shadow inventory held by lenders. Official statistics report that there are 3.8M existing homes currently on the market, equal to about 9.7 months supply. However, lenders are holding over 600,000 residential properties that are not listed on the multiple listings service.
Vehicle sales, although terrible, came in slightly above expectations adding to the market's gains midday. The year-over-year declines will level out over the next six months as the auto manufacturers begin to compare their figures to weak sales months in 2008. The General Motors CEO stated that vehicle sales are finally bottoming out, but I urge him not to get ahead of himself as consumers continue to deleverage their balance sheets.
As expected, the market continues to ignore the poor economic reports as most of this information has already been "discounted" into the market. After all, the bulls contend that the market is a forward looking mechanism, pricing securities nine months out into the future. If this is truly the case; how was it that the major indices hit their all time highs in October of 2007, less than two months before the official onset of the current recession? The fundamentals do not support a significant market rally from these levels. I will dig deeper into this over the next week, but needless to say, I believe that the market is getting ahead of itself at the moment. However, equities could easily trade up another 10%-15% before turning back down.
Tomorrow is light on the economic front with initial jobless claims due out in the morning with a consensus estimate of 655,000 new filings. Aside from the initial market reaction, this report poses limited downside risk for equities with any better-than-expected figures used as an excuse to rally the markets. The FASB will also vote on the final mark-to-market rule tomorrow, which supported financial shares in today's trading. Banks will apply this rule change retroactively, meaning that it will be applicable for Q1 earnings. What a loss for transparency, and as a non-practicing CPA, I am personally disgusted that this was even considered. Mark to model is best compared to a homeowner valuing their house at twice the market value because they think "that is what it should be worth."
Tuesday, March 31, 2009
Market Wrap (3/31) & What's on Tap for Wednesday
Now that's what I call quarter-end window dressing at its finest. The S&P closed the day up 1.3% with the Nasdaq outperforming once again to end the session 1.8% higher. Financials led the way with a 3.5% gain as positive news from Barclays in Europe set a positive tone for the rest of the sector. The London-based bank declined to take part in the British Asset Protection Plan, fueling optimism that the sector's operating environment may start to improve. Additionally, Microsoft, a major Nasdaq component, closed 5% higher following an upgrade citing increased PC demand in the U.S. and China.
Stocks closed well off of their session highs as the DOW shed nearly 100 points in the final hour of trading. All three economic reports (the Case-Shiller Composite, Chicago PMI, and Consumer Confidence) released today came in below forecasts. House prices fell 2.8% over the prior month and 19% over the prior year to settle at $146.4K in January. Incidentally, the average price came in just below my $147K estimate documented in my Sunday post. More recent new and existing home sale data show no let up in the contraction during February. Chicago PMI also came in well below estimates at 31.4 against the 35.0 consensus. This number indicates continued and severe contraction in the manufacturing sector. I expected the survey number to improve slightly over the prior month, so this came in below my estimate as well. I now expect the ISM number scheduled for release tomorrow to decline over the prior month mirroring the data released within the Chicago PMI.
Four key reports are scheduled for release tomorrow morning:
1) ADP employment report (Monthly)
Economists utilize this report to gauge private sector job activity to fine-tune their BLS employment report forecasts scheduled for release on Friday. As mentioned in my Sunday post, I expect over 650K jobs lost this month and a rise in unemployment to 8.5%. The official U3 unemployment rate will surpass 10% over the next year. I am not concerned with the exact month-to-month figures given the tendency for large prior month revisions.
2) ISM manufacturing Index (Monthly)
The results should come in below the 36.0 consensus estimate given the data released within the Chicago PMI survey today. I would estimate somewhere around 33, but the point is that the figure will continue to show severe contraction on a nationwide basis. It would take a pretty horrible number to significantly impact the markets given that investors are well aware of the current manufacturing environment.
3) Pending Home Sales (Monthly)
This represents a sale in which a contract is signed, but not yet closed. February pending home sales will likely show a slight improvement over the prior month record low of 80.4. However, any improvement will be attributable to higher foreclosure related sales and unseasonably warm weather. Home sales will remain near record lows and should set new lows in the coming months in response to rising unemployment.
4) Motor Vehicle Sales (Monthly)
The major manufacturers will release their sales totals throughout the day, and I expect to see no improvement in the numbers for March.
Traders should avoid shorting the financial sector ahead of the FASB meeting scheduled for Thursday. Although a probable rule change surrounding mark-to-market accounting has been in the news for several weeks now, the sector may see a rally once the rule change is confirmed. It is difficult to gauge exactly what the market has already priced in, but a confirmed change may lift bank shares in the near-term. Putting this possible rule change aside, there is no significant upside to the market ahead of the Friday BLS Employment Report.
Stocks closed well off of their session highs as the DOW shed nearly 100 points in the final hour of trading. All three economic reports (the Case-Shiller Composite, Chicago PMI, and Consumer Confidence) released today came in below forecasts. House prices fell 2.8% over the prior month and 19% over the prior year to settle at $146.4K in January. Incidentally, the average price came in just below my $147K estimate documented in my Sunday post. More recent new and existing home sale data show no let up in the contraction during February. Chicago PMI also came in well below estimates at 31.4 against the 35.0 consensus. This number indicates continued and severe contraction in the manufacturing sector. I expected the survey number to improve slightly over the prior month, so this came in below my estimate as well. I now expect the ISM number scheduled for release tomorrow to decline over the prior month mirroring the data released within the Chicago PMI.
Four key reports are scheduled for release tomorrow morning:
1) ADP employment report (Monthly)
Economists utilize this report to gauge private sector job activity to fine-tune their BLS employment report forecasts scheduled for release on Friday. As mentioned in my Sunday post, I expect over 650K jobs lost this month and a rise in unemployment to 8.5%. The official U3 unemployment rate will surpass 10% over the next year. I am not concerned with the exact month-to-month figures given the tendency for large prior month revisions.
2) ISM manufacturing Index (Monthly)
The results should come in below the 36.0 consensus estimate given the data released within the Chicago PMI survey today. I would estimate somewhere around 33, but the point is that the figure will continue to show severe contraction on a nationwide basis. It would take a pretty horrible number to significantly impact the markets given that investors are well aware of the current manufacturing environment.
3) Pending Home Sales (Monthly)
This represents a sale in which a contract is signed, but not yet closed. February pending home sales will likely show a slight improvement over the prior month record low of 80.4. However, any improvement will be attributable to higher foreclosure related sales and unseasonably warm weather. Home sales will remain near record lows and should set new lows in the coming months in response to rising unemployment.
4) Motor Vehicle Sales (Monthly)
The major manufacturers will release their sales totals throughout the day, and I expect to see no improvement in the numbers for March.
Traders should avoid shorting the financial sector ahead of the FASB meeting scheduled for Thursday. Although a probable rule change surrounding mark-to-market accounting has been in the news for several weeks now, the sector may see a rally once the rule change is confirmed. It is difficult to gauge exactly what the market has already priced in, but a confirmed change may lift bank shares in the near-term. Putting this possible rule change aside, there is no significant upside to the market ahead of the Friday BLS Employment Report.
Monday, March 30, 2009
Market Wrap (3/30)
The S&P closed down 3.5% as the Obama Administration advocated Chapter 11 bankruptcy to best restructure GM and Chrysler. As I mentioned in yesterday's post, the market was due to consolidate this week following its recent 25% run-up off the March 6th lows. Financials and basic materials were the worst performing sectors, declining by roughly 5.6% and 4.6% respectively. Chatter centered on banks needing to raise additional capital coupled with general profit taking accounted for a majority of the decline in bank shares today. Most of the major banks closed down more than 10% ending the session near their lows. Investors should continue to steer clear of bank stocks and just allow the speculators to whip these shares around. I do not believe that any financial deserves to trade above tangible book value, and I am sure that market will agree with me in due time.
Basic materials traded down with commodities and oil on the back of a stronger dollar and renewed concerns over energy demand. Light sweet crude and gasoline futures each closed down 7%, but remain at trading levels well above their 3-month moving averages. Commodities have traded in correlation with equity markets over the past several months, and I expect this pattern to continue in the near-term. Note that a stronger dollar is generally bearish for commodity and equity markets in the near-term.
The Nasdaq outperformed the broader market, declining by only 2.8%. The technology sector is only down 5% on the year buoyed by Google, Amazon, and Apple. This strength is unjustified given that the weakness in the general economy is only now beginning to filter down to the consumer. With first quarter earnings just around the corner, I do not consider this sector a buy at these levels.
Three key releases are due out tomorrow morning with Consumer Confidence, the S&P Case-Shiller Home Price Index, and Chicago PMI kicking off the weekly economic calendar. I provided a preview of these releases in yesterday's post. Tomorrow is the last day of the quarter for fund managers, so I expect the market to trade in a range as funds close their books with the aforementioned economic releases setting the tone for the day.
Basic materials traded down with commodities and oil on the back of a stronger dollar and renewed concerns over energy demand. Light sweet crude and gasoline futures each closed down 7%, but remain at trading levels well above their 3-month moving averages. Commodities have traded in correlation with equity markets over the past several months, and I expect this pattern to continue in the near-term. Note that a stronger dollar is generally bearish for commodity and equity markets in the near-term.
The Nasdaq outperformed the broader market, declining by only 2.8%. The technology sector is only down 5% on the year buoyed by Google, Amazon, and Apple. This strength is unjustified given that the weakness in the general economy is only now beginning to filter down to the consumer. With first quarter earnings just around the corner, I do not consider this sector a buy at these levels.
Three key releases are due out tomorrow morning with Consumer Confidence, the S&P Case-Shiller Home Price Index, and Chicago PMI kicking off the weekly economic calendar. I provided a preview of these releases in yesterday's post. Tomorrow is the last day of the quarter for fund managers, so I expect the market to trade in a range as funds close their books with the aforementioned economic releases setting the tone for the day.
Sunday, March 29, 2009
The Week Ahead - March 30th Edition
We have a full slate of economic data scheduled for release this week, capped off by the employment report on Friday. Below is the summary of key market moving releases and my brief commentary over several of the key reports:
Week of 3/30/09
Day Description Time (ET)
31-Mar Consumer Confidence 9:00 AM
31-Mar S&P Case-Shiller Home Price Index 9:00 AM
31-Mar Chicago PMI 9:45 AM
1-Apr ADP Employment Report 8:15 AM
1-Apr ISM Index 10:00 AM
1-Apr Construction Spending 10:00 AM
1-Apr Pending Home Sales 10:00 AM
1-Apr Auto Sales 1:00 PM
1-Apr Crude Inventories 10:35 AM
2-Apr Initial Claims 8:30 AM
2-Apr Factory Orders 10:00 AM
3-Apr Employment Report 8:30 AM
3-Apr ISM Services 10:00 AM
Although consumer confidence is likely to improve slightly over the prior month, the survey will remain near its record low in the high 20s. Note that this report is based off of a monthly survey of 5,000 households with expectations constituting 60% of the index while current conditions account for the remainder.
The S&P Case-Shiller Home Price Index operates on a two month lag, so the information published this week represents the January data. Last month, the 20 city composite fell to a seasonally adjusted price of $150K, resulting in a near 17% decline over the prior year and 30th straight month-over-month price decline. I expect prices to continue on their downward trend for January and come in around $147K.
As illustrated by the chart below, national home prices have receded down to late 2003 levels, giving back five years worth of illusionary gains. In total, prices, as measured by the 20-city composite, have fallen 27% below their 2006 highs. However, home price will likely fall another 15% to $125K over the next year bringing prices down to 2002 levels. Record low mortgage rates may provide some relief, but rising unemployment and the general lack of affordability will continue to pressure home values. These forecasts assume that the U.S. dollar remains stable around current levels because a significant devaluation will artificially inflate home values. It is entirely possible for prices to fall below 2000 levels because housing inventories have risen at a faster rate than the U.S. population.
Chicago Purchasing Managers Index (PMI), a regional manufacturing survey of purchasing managers gauges activity on new orders, production, employment, and prices paid. A reading of 50 or above indicates expansion while readings below 50 show contraction. The readings over the past five months have leveled off in the mid 30s, but I expect the current month to rebound slightly into the high 30s. The Chicago PMI is a great indicator of the National ISM index released the next day as there is a high historical correlation (over 90%) between the results of the two surveys. Again, I expect the ISM results to improve slightly over the prior month as companies slowly begin to rebuild drawn inventories. Aside from the initial knee-jerk reaction by the market, it has largely ignored the manufacturing statistics over the past three months because the slow-down has been largely priced into equities.
Investors have largely ignored the horrible auto sales numbers released over the past several months even as sales came in well below analyst expectations. This is not surprising given that the general state of the auto industry has been well discussed and priced into the market. The reports would have more of a market impact during normal economic times, but you can only beat a dead horse so many times. That being said, if there is an unexpected rise or stabilization in auto sales, the markets would rally on the news. This will not be a problem for the current month, however.
The March employment report will continue to show monthly job losses in excess of 600,000 workers. Economists are forecasting a rise in the employment rate to 8.5% and roughly 650K in job losses. These estimates appear reasonable, but it is hard to forecast accurately because the government’s numbers typically have large prior month revisions. The bulls will tell you that the market has priced in an unemployment rate over 9%, which is probably true in the short-term. Many also view the employment statistics as a lagging indicator, and although this may hold true during a typical recession, I believe that this theory is based on faulty logic in the current climate.
The headline unemployment figures that you read about in the mainstream press dramatically under represent the number of displaced workers. The Bureau of Labor Statistics (BLS) releases alternative measures of unemployment. During the Great Depression, the government calculated unemployment based on statistics akin to the U-6 measure as opposed the U-3 measure currently in use. This rate calculates unemployment by taking the number of unemployed and adding back marginally attached workers and part time workers looking for full time employment. Marginally attached individuals represent people who would like to work but have given up looking for a job because they are discourage and cannot find one. Once these people are added back in to the calculation, the true unemployment rate equals 14.8% based on the February statistics. I have included the BLS table link for your reference. http://www.bls.gov/news.release/empsit.t12.htm
Traders have driven the market down on the day prior to the employment report over the past several months. Then, regardless of the actual job loss number, buyers usually enter the market following the report’s release. I expect to see a similar pattern emerge this week unless the mark-to-market meeting set for Thursday, April 2nd, yields any significant rule changes. From the initial commentary over the topic, it appears that the FASB will adjust the rules and allow banks more flexibility in marking their “toxic” assets to model. Shorts should remain cognizant of this meeting as the bulls could use any news to ignite a significant and baseless rally.
As a side note, I believe that allowing banks to circumvent mark-to-market in certain instances is a horrible idea that is politically driven and destined to fail. This decreases transparency and makes these black boxes (aka banks) even harder to value. How can an investor trust a bank to value their assets to model when their faulty models are what created this mess in the first place? The market will do what it does best after the initial knee-jerk reaction; price financial stocks for this uncertainty, which means lower prices.
The S&P has rallied 23% off of its March 6th low of 666. This bailout driven rally is not supported by broader fundamentals, but government programs that are designed to artificially inflate the book value of banks’ toxic assets. This bear market rally could run another 10%, but I have little doubt that the indices have yet to see their bear market lows. For those of you in 401Ks, I would use any possible move in the DOW north of 8,000-9,000 over the next several months to go to cash and protect your remaining capital. For the current week, I would expect to see some consolidation given market’s sharp run-up. I will discuss some of this week’s upcoming earnings reports in tomorrow’s post.
Week of 3/30/09
Day Description Time (ET)
31-Mar Consumer Confidence 9:00 AM
31-Mar S&P Case-Shiller Home Price Index 9:00 AM
31-Mar Chicago PMI 9:45 AM
1-Apr ADP Employment Report 8:15 AM
1-Apr ISM Index 10:00 AM
1-Apr Construction Spending 10:00 AM
1-Apr Pending Home Sales 10:00 AM
1-Apr Auto Sales 1:00 PM
1-Apr Crude Inventories 10:35 AM
2-Apr Initial Claims 8:30 AM
2-Apr Factory Orders 10:00 AM
3-Apr Employment Report 8:30 AM
3-Apr ISM Services 10:00 AM
Although consumer confidence is likely to improve slightly over the prior month, the survey will remain near its record low in the high 20s. Note that this report is based off of a monthly survey of 5,000 households with expectations constituting 60% of the index while current conditions account for the remainder.
The S&P Case-Shiller Home Price Index operates on a two month lag, so the information published this week represents the January data. Last month, the 20 city composite fell to a seasonally adjusted price of $150K, resulting in a near 17% decline over the prior year and 30th straight month-over-month price decline. I expect prices to continue on their downward trend for January and come in around $147K.
As illustrated by the chart below, national home prices have receded down to late 2003 levels, giving back five years worth of illusionary gains. In total, prices, as measured by the 20-city composite, have fallen 27% below their 2006 highs. However, home price will likely fall another 15% to $125K over the next year bringing prices down to 2002 levels. Record low mortgage rates may provide some relief, but rising unemployment and the general lack of affordability will continue to pressure home values. These forecasts assume that the U.S. dollar remains stable around current levels because a significant devaluation will artificially inflate home values. It is entirely possible for prices to fall below 2000 levels because housing inventories have risen at a faster rate than the U.S. population.
Chicago Purchasing Managers Index (PMI), a regional manufacturing survey of purchasing managers gauges activity on new orders, production, employment, and prices paid. A reading of 50 or above indicates expansion while readings below 50 show contraction. The readings over the past five months have leveled off in the mid 30s, but I expect the current month to rebound slightly into the high 30s. The Chicago PMI is a great indicator of the National ISM index released the next day as there is a high historical correlation (over 90%) between the results of the two surveys. Again, I expect the ISM results to improve slightly over the prior month as companies slowly begin to rebuild drawn inventories. Aside from the initial knee-jerk reaction by the market, it has largely ignored the manufacturing statistics over the past three months because the slow-down has been largely priced into equities.
Investors have largely ignored the horrible auto sales numbers released over the past several months even as sales came in well below analyst expectations. This is not surprising given that the general state of the auto industry has been well discussed and priced into the market. The reports would have more of a market impact during normal economic times, but you can only beat a dead horse so many times. That being said, if there is an unexpected rise or stabilization in auto sales, the markets would rally on the news. This will not be a problem for the current month, however.
The March employment report will continue to show monthly job losses in excess of 600,000 workers. Economists are forecasting a rise in the employment rate to 8.5% and roughly 650K in job losses. These estimates appear reasonable, but it is hard to forecast accurately because the government’s numbers typically have large prior month revisions. The bulls will tell you that the market has priced in an unemployment rate over 9%, which is probably true in the short-term. Many also view the employment statistics as a lagging indicator, and although this may hold true during a typical recession, I believe that this theory is based on faulty logic in the current climate.
The headline unemployment figures that you read about in the mainstream press dramatically under represent the number of displaced workers. The Bureau of Labor Statistics (BLS) releases alternative measures of unemployment. During the Great Depression, the government calculated unemployment based on statistics akin to the U-6 measure as opposed the U-3 measure currently in use. This rate calculates unemployment by taking the number of unemployed and adding back marginally attached workers and part time workers looking for full time employment. Marginally attached individuals represent people who would like to work but have given up looking for a job because they are discourage and cannot find one. Once these people are added back in to the calculation, the true unemployment rate equals 14.8% based on the February statistics. I have included the BLS table link for your reference. http://www.bls.gov/news.release/empsit.t12.htm
Traders have driven the market down on the day prior to the employment report over the past several months. Then, regardless of the actual job loss number, buyers usually enter the market following the report’s release. I expect to see a similar pattern emerge this week unless the mark-to-market meeting set for Thursday, April 2nd, yields any significant rule changes. From the initial commentary over the topic, it appears that the FASB will adjust the rules and allow banks more flexibility in marking their “toxic” assets to model. Shorts should remain cognizant of this meeting as the bulls could use any news to ignite a significant and baseless rally.
As a side note, I believe that allowing banks to circumvent mark-to-market in certain instances is a horrible idea that is politically driven and destined to fail. This decreases transparency and makes these black boxes (aka banks) even harder to value. How can an investor trust a bank to value their assets to model when their faulty models are what created this mess in the first place? The market will do what it does best after the initial knee-jerk reaction; price financial stocks for this uncertainty, which means lower prices.
The S&P has rallied 23% off of its March 6th low of 666. This bailout driven rally is not supported by broader fundamentals, but government programs that are designed to artificially inflate the book value of banks’ toxic assets. This bear market rally could run another 10%, but I have little doubt that the indices have yet to see their bear market lows. For those of you in 401Ks, I would use any possible move in the DOW north of 8,000-9,000 over the next several months to go to cash and protect your remaining capital. For the current week, I would expect to see some consolidation given market’s sharp run-up. I will discuss some of this week’s upcoming earnings reports in tomorrow’s post.
Wednesday, March 25, 2009
Treasuries Flashing Red but Will Equities Take Notice?
Wednesday's Treasury auction went poorly following lower-than-expected demand on the $34B five-year note issuance. The auction pushed the yield on these notes up to 1.85%, roughly five basis points higher than forecast. The 10-year note also rose eight basis points as the Treasury plans to sell a record of $98B in notes this week alone.
News of the auction sent equity markets tumbling mid-day as the DOW shed 300 points off of its morning high before rebounding in the last hour to close up 90 points. Putting the market's roller coaster ride aside, Wednesday's auction is significant because the days of cheap borrowing by the government may be nearing an end. As Treasury supply continues to flood the market, investors will demand higher yields to compensate for potential inflation and increased risk. The panic over the past six months has buoyed the Treasury market as investors fled to the perceived safety of government bonds. This trade will unwind as risk appetite returns, significantly increasing yields. Now I'm not saying that Treasuries are going to collapse overnight, but yields will not remain at these low levels indefinitely.
The US Dollar Index is up 25% over the past year and 3% year-to-date despite the most recent sell-off. This trend is not at all surprising given the weakness that is spreading throughout the Euro-Zone and Great Britain, two regions that are in worse shape than the U.S. The European banks are even more levered than their American counterparts, making the U.S. more stable at this time. However, gold has remained solidly over $900/oz as investors shun paper currencies for the safety of gold. The point, keep a close eye on gold and commodity prices to accurately gauge the strength of the dollar. Reviewing the dollar index trends is akin to comparing bad apples to more bad apples and will not really tell you much.
In order to profit from rising yields, please consider TBT, a double inverse exchange trade fund that moves in the opposite direction of Treasury prices. Normally, I like to stay away from levered ETFs because of a natural time decay, but there are plenty of instruments available to protect investors against rising yields. Current Treasury prices continue to price in a deflationary environment over the next several years. However, the near-term risk is hyper-inflation and much higher yields given the devaluation of the dollar.
News of the auction sent equity markets tumbling mid-day as the DOW shed 300 points off of its morning high before rebounding in the last hour to close up 90 points. Putting the market's roller coaster ride aside, Wednesday's auction is significant because the days of cheap borrowing by the government may be nearing an end. As Treasury supply continues to flood the market, investors will demand higher yields to compensate for potential inflation and increased risk. The panic over the past six months has buoyed the Treasury market as investors fled to the perceived safety of government bonds. This trade will unwind as risk appetite returns, significantly increasing yields. Now I'm not saying that Treasuries are going to collapse overnight, but yields will not remain at these low levels indefinitely.
The US Dollar Index is up 25% over the past year and 3% year-to-date despite the most recent sell-off. This trend is not at all surprising given the weakness that is spreading throughout the Euro-Zone and Great Britain, two regions that are in worse shape than the U.S. The European banks are even more levered than their American counterparts, making the U.S. more stable at this time. However, gold has remained solidly over $900/oz as investors shun paper currencies for the safety of gold. The point, keep a close eye on gold and commodity prices to accurately gauge the strength of the dollar. Reviewing the dollar index trends is akin to comparing bad apples to more bad apples and will not really tell you much.
In order to profit from rising yields, please consider TBT, a double inverse exchange trade fund that moves in the opposite direction of Treasury prices. Normally, I like to stay away from levered ETFs because of a natural time decay, but there are plenty of instruments available to protect investors against rising yields. Current Treasury prices continue to price in a deflationary environment over the next several years. However, the near-term risk is hyper-inflation and much higher yields given the devaluation of the dollar.
Tuesday, March 24, 2009
What Are They Thinking?
The Fed’s announcement last week that it will purchase $300B on long-dated Treasuries over the next six months sent T-Bill prices soaring and yields plummeting as mortgage rates receded to near historic lows at 4.75%. However, mortgage rates were never the real problem as the housing bubble collapsed in a low interest rate environment. The Fed did not stop there as it expanded its mortgage-backed securities purchase program to the tune of $750B. In effect, Bernanke has decided that the printing press and devaluation of the dollar is the best course of action to combat the dreaded “deflationary” spiral. But this begs another question that the pundits have not really discussed. If there was robust foreign demand for American debt, the Fed would have no need to purchase treasuries. I'll get back to this in a moment.
Not to be outdone, our newly minted Treasury Secretary unveiled a massive bank bailout program on Monday that masquerades as a Public-Private partnership to purchase toxic assets from these "vital" institutions. Mr. Geithner decided that he would commit another $1T in taxpayer money to "unclog" the credit markets by purchasing so called "legacy" assets and troubled loans. I've included a brief summary of the plan below from Sunday's edition of the Washington Post:
"To deal with the troubled loans, the administration would combine resources from the FDIC and the Public Investment Corp. to create several investment funds that could ultimately buy $500 billion to $750 billion worth of loans.Here's how the program could work: If a lender wants to dispose of about $10 million worth of residential mortgages, it would approach the FDIC, which would run an auction for interested private investors. If the winning bid ended up fetching an $8 million price tag, the FDIC would provide most of the financing and guarantee losses for as much as $6 million. The Treasury would contribute as much as 80 percent of the rest of the cost of the pool of loans. Private investors would contribute only the remaining amount, yet would be in charge of managing the portfolio of loans. Government officials said they would maintain strict oversight on who will run the funds and how the funds will be managed.
To deal with toxic securities, the government has developed two separate initiatives.
One would expand an existing Fed program, known as the Term Asset-Backed Securities Loan Facility, or TALF, that is aimed at reviving non-traditional lending markets. These markets, which some call the "shadow banking system," provide nearly half of all U.S. consumer loans. The program would be expanded to buy some residential and commercial mortgage-backed securities that have high credit ratings using money from the Public Investment Corp. Although details have not been worked out, the plan would require the Fed to offer loans to private investors for a much longer period than the central bank does under TALF, possibly as long as seven years, sources said.
The administration will also launch public-private investment funds to buy toxic assets that back mortgages and other troubled loans. In this case, the Treasury would provide financing that would match, dollar-for-dollar, money from private investors who participate. In addition, the department would provide a loan to increase the newly formed investment funds' purchasing power. "
http://www.washingtonpost.com/wp-dyn/content/article/2009/03/21/AR2009032102246_2.html
So when all is said and done, the private side of this supposed partnership is contributing well less than 10% of the total equity in the transaction with the loans received from the FDIC completely guaranteed against losses. It comes as no surprise that the government selected fund managers like Blackrock and Pimco are really excited about these prospects. They have virtually no risk of loss as it has been transferred to the taxpayer with all these loan guarantees. Financial shares rallied sharply on the news pushing the broader indices up over 6% on Monday. Could the bank share rally be attributable to the generous auction prices that they are sure to receive as a result of all these government guarantees? In other words, the government is employing leverage to artificially inflate these asset prices. Kind of ironic considering that this practice is what got us into this mess in the first place. Please click on the diagram below for a great example of how this program would work.
*Exhibit obtained from zero hedge.
As a result of these dollar killing actions, there is a growing chorus of countries openly questioning the dollar's status as the world's reserve currency. With China taking the lead as the most vocal critic of Washington's latest round of bailouts, its desire to diversify away from its dollar holdings is worth noting. This course of action has sealed the short term fate of the economy. Massive inflation will inhibit any potential rebound that economists have been anticipating for 2010. We have already seen the first signs of a potential commodity explosion as oil and wholesale gasoline prices jumped 10% on the weaker dollar in the past week alone. Gold continues to trade above $900/oz. In addition, the CPI rose .4% last month, resulting in an annualized inflation rate of nearly 5% despite the severe economic contraction.
The Bernanke Boys have not yet developed a mechanism to unwind and reduce the size of Fed's balance sheet when/if the economy does improve. The housing bubble was created by keeping interest rates too low for far too long. So how does creating the same environment that led to the bubble in the first place make any sense for combating the current crisis? The Fed has not been able to provide a logical response to this simple question because it has none.
The Fed’s actions continue to defy free market principles by artificially inflating asset prices while real wages continue to decline. Deflation is the market’s way of bringing prices back down to equilibrium levels. If the economy is not allowed to run its natural course, prices will continually rise while killing the standard of living for most Americans. This is exactly what has taken place over the past three decades with a perpetual growth policy that interferes with the normal market cycles. The government raised taxes on the American people this past week, but few even took notice. How unfortunate…..
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