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.

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.

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.

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.

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…..