When taking a bath one of the better ways to circulate newly added hot water is to swirl the water in the tub. One hand paddles backwards, the other goes forward and a giant wave soon circles the tub. At any given moment there is a limited volume of water in the tub. The goal is to circulate the water around to each point in the tub equally.
Our friend Sushil Kedia has posited that the Indian market leads the US market. Perhaps this is an application of the bathtub theory. To test this we might wish to look at simple correlations between INP, the Indian ETF, and SPY, the S&P 500 ETF. If in fact the Indian market leads we would expect that there wold be significant correlations at some lag. Following are the recent correlations of the INP with SPY at various lags:
Notably, five of six are strongly negative and the sixth is insignificant at 1.2%. So it would seem that the globe is a giant bathtub and that water does slosh around it in a non random manner. But if there is correlation then we know that a predictive regression model can be developed.
Using only lags 1, 3, 4, 5 & 6, our regression model has an overall correlation of 24.9%. All of the coefficients are negative, mostly in the neighborhood of -.04. The regression constant is -.001, reflecting the recent weak market behavior. Effectively what this says is that when money flows out of the Indian market it tends to go into the US market over the next six days or so. The converse is valid as well, in that if money goes into the Indian market it will come out of the US in the next six days. In any event the bathtub theory works reasonably well for the Indian - US markets, with India leading.
Friday, February 29, 2008
Thursday, February 28, 2008
Home Price Index
The sharp decline in the Case Schiller Home Price Index of 5.4% for
Q4-2007 has caused many to think that improved affordability is signaling the bottom of the new home market, and has fuelled an across-the-board jump in home-builder stocks. However, a close inspection of aggregate housing-industry data shows that virtually all signs are still bearish, and this "here comes the bottom" view is premature. Also, a careful analysis of builders' financials suggests that weaker companies may be headed for bankruptcy or stock-diluting workouts before the housing market does improve.
As the numbers suggest, the bullish effect of increased affordability is being swamped by other forces depressing the new home market, including: buyers' fears of continued price declines and recession; growing inventories that are already at record levels; increasing mortgage payment defaults and foreclosures; limited mortgage availability and unfavorable mortgage pricing.
Prospective buyers' fears of further price declines -- and the problems that price drops bring to mortgaged home-ownership investments -- are justified. The current decline in median home prices of 8.8% in Q4-2007 confirms the continuing downward thrust of the Case Schiller index, and the fact that house price drops are accelerating.
The end of the current house price decline is nowhere in sight.
Goldman Sachs estimates that home prices will fall 20-25% from their
2006 peak, and they have only fallen 10.2% to date. Bank of America's
Chief Economist (Mickey Levy) predicts that home prices will fall for at least another half year. Neither prospective home owners nor mortgage bankers are keen to establish a large mortgage debt on an asset whose value is quickly dropping.
Demand for new homes is also being depressed by high mortgage rates and low mortgage availability. The average interest rate for prime, conforming 30 year fixed mortgages has increased by 19 BPS (basis points) to 5.68% in the past three months, while the average rate for prime, non-conforming loans (mortgages of more than $417,000) has risen 32 BPS to 6.51%. This has occurred even as the Fed has aggressively cut short term rates. One reason that fixed mortgage rates have not followed Fed rates lower is because mortgage rates are tied to long term interest rates and inflation expectations. During the past three months the yield on the 10-year Treasury Note has increased by 3BPS to 3.87%, while inflation expectations (measured by the Cleveland Fed's Adjusted Tips calculation) have increased 38 BPS to 3.15%.
Since last August, mortgage availability has been sharply curtailed by the collapse of the CDO market, lenders' flight to relatively-safe prime, conforming loans, and the inability of large mortgage banks and money-center banks to take new loans onto their balance sheets. These problems will not be reversed in the foreseeable future, which will in turn keep mortgage availability low and will help keep mortgage prices high for some time.
Other forces thwarting homebuyer demand include waning consumer confidence and fear of recession. Yesterday's consumer confidence reading of 75 is down from 87.9 last month. On February 25th, the National Association for Business Economics reported that the number of US business economists who forecast a US recession has doubled in the past three months, to 45%.
Housing market supply indicators are as uniformly bearish as their demand counterparts. Virtually all supply data is weak and continuing to deteriorate. For example, January's 9.9 month supply of new homes will help depress house prices for quite a while. This record supply represents an increase of 38% over January 2007, and is six month's above the 'normal' supply of about four months.
Housing supply will be further enlarged and prices will remain under pressure due to increasing mortgage foreclosures. January 2008's 233,000 foreclosures are up 4.2% from October's numbers, and foreclosures have increased by a stunning 57% in the past year. These bearish trends are paralleled by the increase in mortgage delinquencies through September 2007 (Q4 delinquency data has not yet been published).
The high risk of the weakest builders
While housing industry bulls look beyond the foreseeable future toward the promised land of market recovery, the weakest builders may not get there with them. Irrespective of how their stocks move, homebuilders' viability is dependent on market conditions, and current market trends (as outlined above) strongly suggest that poorly capitalized companies with will not survive – at least not without a dilutive infusion of equity capital.
Beazer Homes (BZH), Hovnanian (HOV) and Standard Pacific (SPF) top our list of most-likely-to-expire homebuilders. A quick look at Standard Pacific's situation, for example, shows why. SPF breached its tangible net worth bank-debt covenant just one quarter after negotiating relaxed covenants with its bankers. It has until March 30th to again renegotiate its indentures. Meanwhile, the company's leverage ratio (debt to equity ratio, reported as 1.69 in SPF's just-released 10K) is deteriorating, and we believe it will rise above its current limit of 1.75 this year. On July 1 SPF's current indentures reduce the limit to 1.65.
In the next two quarters, SPF's leverage ratio will be increased by poor gross margins (currently reported at 2.5% by SPF), negative free cash flow, increased inventory write downs and further deferred tax asset write-offs. As new home prices continue to plunge, SPF's revenues will decline, which will further reduce its gross margins, probably to negative levels. During SPF's latest conference call, management reported its expectation of negative cash flow in Q1-2008, which will further erode its balance sheet.
SPF has written off a portion of its inventory every quarter since the second quarter of 2006 (Q2-2006). These write-offs have been well correlated to decreases in the Case-Schiller home price index and to reductions in median new-home prices. As neither of these indexes show any signs of bottoming, our model predicts further significant inventory write downs for SPF.
Finally, SPF's balance sheet may be damaged this year by further deferred tax asset write downs. Auditors require that this asset be written down in accordance with market conditions and company health as they currently exist, not based on "over the horizon" possibilities. With SPF's foreseeable-future operations looking unprofitable, SPF's auditor (Ernst and Young) can be expected to insist on further write downs, beyond the 53% of this asset that SPF wrote off last year.
SPF has been fighting off its financial troubles by hiring Miller Buckfire – a well known advisor to companies fending off bankruptcy or working through a Chapter 11 restructuring, and by laying the groundwork for an equity/preferred stock infusion. The company has recently doubled its authorized share count from 100MM to 200MM, and registered a mixed shelf filing for up to $600MM of preferred stock or bonds. Given that a bond issuance would further weaken the company's balance sheet, the company can be expected to try issuing preferred stock or common stock. Either option will be difficult unless SPF's stock price holds up strongly, and both options stand to dilute existing shareholders (even in the case of a rights offering for holders who chose not to add to their positions).
West End Advisors is not alone in recommending that investors avoid the weakest homebuilders. Lehman brothers, for example, today assessed Hovnanian's stock as "Underweight," even as it was awarding "overweight" ratings to Toll and DR Horton.
Conclusion
For the foreseeable future, a wealth of data and economic projections show that the benefits of increased housing affordability will be overwhelmed by bearish forces, including buyers' lack of confidence, record-level and still-growing inventories, increasing mortgage defaults and foreclosures, limited mortgage availability and unfavorable mortgage pricing. Before the housing market does recover, some financially weak builders, such as Beazer, Hovnanian and Standard Pacific, are likely to file for bankruptcy or execute other dilutive restructurings.
Q4-2007 has caused many to think that improved affordability is signaling the bottom of the new home market, and has fuelled an across-the-board jump in home-builder stocks. However, a close inspection of aggregate housing-industry data shows that virtually all signs are still bearish, and this "here comes the bottom" view is premature. Also, a careful analysis of builders' financials suggests that weaker companies may be headed for bankruptcy or stock-diluting workouts before the housing market does improve.
As the numbers suggest, the bullish effect of increased affordability is being swamped by other forces depressing the new home market, including: buyers' fears of continued price declines and recession; growing inventories that are already at record levels; increasing mortgage payment defaults and foreclosures; limited mortgage availability and unfavorable mortgage pricing.
Prospective buyers' fears of further price declines -- and the problems that price drops bring to mortgaged home-ownership investments -- are justified. The current decline in median home prices of 8.8% in Q4-2007 confirms the continuing downward thrust of the Case Schiller index, and the fact that house price drops are accelerating.
The end of the current house price decline is nowhere in sight.
Goldman Sachs estimates that home prices will fall 20-25% from their
2006 peak, and they have only fallen 10.2% to date. Bank of America's
Chief Economist (Mickey Levy) predicts that home prices will fall for at least another half year. Neither prospective home owners nor mortgage bankers are keen to establish a large mortgage debt on an asset whose value is quickly dropping.
Demand for new homes is also being depressed by high mortgage rates and low mortgage availability. The average interest rate for prime, conforming 30 year fixed mortgages has increased by 19 BPS (basis points) to 5.68% in the past three months, while the average rate for prime, non-conforming loans (mortgages of more than $417,000) has risen 32 BPS to 6.51%. This has occurred even as the Fed has aggressively cut short term rates. One reason that fixed mortgage rates have not followed Fed rates lower is because mortgage rates are tied to long term interest rates and inflation expectations. During the past three months the yield on the 10-year Treasury Note has increased by 3BPS to 3.87%, while inflation expectations (measured by the Cleveland Fed's Adjusted Tips calculation) have increased 38 BPS to 3.15%.
Since last August, mortgage availability has been sharply curtailed by the collapse of the CDO market, lenders' flight to relatively-safe prime, conforming loans, and the inability of large mortgage banks and money-center banks to take new loans onto their balance sheets. These problems will not be reversed in the foreseeable future, which will in turn keep mortgage availability low and will help keep mortgage prices high for some time.
Other forces thwarting homebuyer demand include waning consumer confidence and fear of recession. Yesterday's consumer confidence reading of 75 is down from 87.9 last month. On February 25th, the National Association for Business Economics reported that the number of US business economists who forecast a US recession has doubled in the past three months, to 45%.
Housing market supply indicators are as uniformly bearish as their demand counterparts. Virtually all supply data is weak and continuing to deteriorate. For example, January's 9.9 month supply of new homes will help depress house prices for quite a while. This record supply represents an increase of 38% over January 2007, and is six month's above the 'normal' supply of about four months.
Housing supply will be further enlarged and prices will remain under pressure due to increasing mortgage foreclosures. January 2008's 233,000 foreclosures are up 4.2% from October's numbers, and foreclosures have increased by a stunning 57% in the past year. These bearish trends are paralleled by the increase in mortgage delinquencies through September 2007 (Q4 delinquency data has not yet been published).
The high risk of the weakest builders
While housing industry bulls look beyond the foreseeable future toward the promised land of market recovery, the weakest builders may not get there with them. Irrespective of how their stocks move, homebuilders' viability is dependent on market conditions, and current market trends (as outlined above) strongly suggest that poorly capitalized companies with will not survive – at least not without a dilutive infusion of equity capital.
Beazer Homes (BZH), Hovnanian (HOV) and Standard Pacific (SPF) top our list of most-likely-to-expire homebuilders. A quick look at Standard Pacific's situation, for example, shows why. SPF breached its tangible net worth bank-debt covenant just one quarter after negotiating relaxed covenants with its bankers. It has until March 30th to again renegotiate its indentures. Meanwhile, the company's leverage ratio (debt to equity ratio, reported as 1.69 in SPF's just-released 10K) is deteriorating, and we believe it will rise above its current limit of 1.75 this year. On July 1 SPF's current indentures reduce the limit to 1.65.
In the next two quarters, SPF's leverage ratio will be increased by poor gross margins (currently reported at 2.5% by SPF), negative free cash flow, increased inventory write downs and further deferred tax asset write-offs. As new home prices continue to plunge, SPF's revenues will decline, which will further reduce its gross margins, probably to negative levels. During SPF's latest conference call, management reported its expectation of negative cash flow in Q1-2008, which will further erode its balance sheet.
SPF has written off a portion of its inventory every quarter since the second quarter of 2006 (Q2-2006). These write-offs have been well correlated to decreases in the Case-Schiller home price index and to reductions in median new-home prices. As neither of these indexes show any signs of bottoming, our model predicts further significant inventory write downs for SPF.
Finally, SPF's balance sheet may be damaged this year by further deferred tax asset write downs. Auditors require that this asset be written down in accordance with market conditions and company health as they currently exist, not based on "over the horizon" possibilities. With SPF's foreseeable-future operations looking unprofitable, SPF's auditor (Ernst and Young) can be expected to insist on further write downs, beyond the 53% of this asset that SPF wrote off last year.
SPF has been fighting off its financial troubles by hiring Miller Buckfire – a well known advisor to companies fending off bankruptcy or working through a Chapter 11 restructuring, and by laying the groundwork for an equity/preferred stock infusion. The company has recently doubled its authorized share count from 100MM to 200MM, and registered a mixed shelf filing for up to $600MM of preferred stock or bonds. Given that a bond issuance would further weaken the company's balance sheet, the company can be expected to try issuing preferred stock or common stock. Either option will be difficult unless SPF's stock price holds up strongly, and both options stand to dilute existing shareholders (even in the case of a rights offering for holders who chose not to add to their positions).
West End Advisors is not alone in recommending that investors avoid the weakest homebuilders. Lehman brothers, for example, today assessed Hovnanian's stock as "Underweight," even as it was awarding "overweight" ratings to Toll and DR Horton.
Conclusion
For the foreseeable future, a wealth of data and economic projections show that the benefits of increased housing affordability will be overwhelmed by bearish forces, including buyers' lack of confidence, record-level and still-growing inventories, increasing mortgage defaults and foreclosures, limited mortgage availability and unfavorable mortgage pricing. Before the housing market does recover, some financially weak builders, such as Beazer, Hovnanian and Standard Pacific, are likely to file for bankruptcy or execute other dilutive restructurings.
Wednesday, February 27, 2008
Affordable Homes in Every State
In Greenwich, Conn., Boston, and many parts of California, a four-bedroom house can easily set you back more than $1 million, while in parts of Texas and in the Midwest, a similar house can be had for just over $100,000.
But you knew that already. It's no secret that homes in ritzy Beverly Hills cost 10 times more than comparable houses in the military community of Killeen, Tex. The question is: How much do you really need to pay for the lifestyle you want? It might be less than you originally thought.
According to Coldwell Banker's 2007 Home Price Comparison Index (HPCI), Beverly Hills is the most expensive housing market in the nation for the second year in a row, with the average price of a home sold through July, 2007, at $2.21 million. In Killeen the most affordable market in the U.S., according to the HPCI study—a similar home sells for $136,725.
Killeen is a city of about 100,000 located directly next to the Fort Hood army base, with a military-dependent economy. You won't find anything akin to Rodeo Drive here—but you will find community events such as fairs, concerts, and high school football games; outdoor recreation like fishing and hunting; and a pervasive sense of patriotism.
A Different Sensibility "When you drive through town, all the local establishments have got the stickers saying 'we support our troops' in the window," says Tom DeAngio, a Realtor and Killeen resident whose son will soon be deployed for his second tour of duty in Iraq. For nightlife, DeAngio says Henderson's Family Restaurant on East Avenue A is a popular choice.
The Coldwell Banker HPCI survey evaluates average selling prices in 317 U.S. markets for single-family houses of approximately 2,220 square feet with four bedrooms, two-and-a-half baths, a family room, and a two-car garage. The cumulative average sales price of these subject homes is $422,343 (higher than the National Association of Realtors' median home price of $218,200 for all existing homes sold in the U.S.).
Beverly Hills; Greenwich, Conn.; the California markets of La Jolla, Santa Monica, Palo Alto, Newport Beach, Santa Barbara, San Mateo, and San Francisco; and Boston comprise the top 10 most expensive markets in the country, all with average home prices of $1.38 million and up. In addition to Killeen, Minot, N.D.; Arlington and Fort Worth, Tex.; Canton, Ohio; Muncie, Ind.; Topeka and Wichita, Kan.; Tulsa, Okla.; and Grayling, Mich., make up the list of the most affordable housing markets.
Million-Dollar Differences But affordable markets exist in just about every state—even in California. The average 2007 sales price in Sacramento for one of Coldwell Banker's subject homes was just $380,625, making it the most affordable market in the state. In Connecticut, a home in West Hartford sells for an average of $365,000, and in Worcester, Mass., you can buy a four-bedroom home for around $286,000.
California, Connecticut, and Massachusetts have the widest price variance between high- and low-end housing markets, with an over $1 million difference between the average home price in their most expensive and most affordable markets. But some states are affordable no matter where you look. In Idaho, the difference in sales price between the most expensive (Boise) and most affordable (Coeur d'Alene) markets was a mere $30.
Real Estate's a Local Business Thinking about relocating? An area's affordability is important to consider when buying a home. Unaffordable areas may indicate that prices are too high to be supported by the local economy, while affordable prices ensure that demand will continue to fuel the housing market. Affordable areas can be good hunting ground for real estate deals (BusinessWeek, 7/18/07).
"The real estate market has certainly changed over the last year," says Jim Gillespie, chief executive officer of Coldwell Banker. "I continue to point out that we cannot make national blanket statements about appreciation and inventory. Real estate is a local business, with each market having its own story to tell."
See BusinessWeek's slide show for a look at the most affordable and most expensive housing markets by state.
But you knew that already. It's no secret that homes in ritzy Beverly Hills cost 10 times more than comparable houses in the military community of Killeen, Tex. The question is: How much do you really need to pay for the lifestyle you want? It might be less than you originally thought.
According to Coldwell Banker's 2007 Home Price Comparison Index (HPCI), Beverly Hills is the most expensive housing market in the nation for the second year in a row, with the average price of a home sold through July, 2007, at $2.21 million. In Killeen the most affordable market in the U.S., according to the HPCI study—a similar home sells for $136,725.
Killeen is a city of about 100,000 located directly next to the Fort Hood army base, with a military-dependent economy. You won't find anything akin to Rodeo Drive here—but you will find community events such as fairs, concerts, and high school football games; outdoor recreation like fishing and hunting; and a pervasive sense of patriotism.
A Different Sensibility "When you drive through town, all the local establishments have got the stickers saying 'we support our troops' in the window," says Tom DeAngio, a Realtor and Killeen resident whose son will soon be deployed for his second tour of duty in Iraq. For nightlife, DeAngio says Henderson's Family Restaurant on East Avenue A is a popular choice.
The Coldwell Banker HPCI survey evaluates average selling prices in 317 U.S. markets for single-family houses of approximately 2,220 square feet with four bedrooms, two-and-a-half baths, a family room, and a two-car garage. The cumulative average sales price of these subject homes is $422,343 (higher than the National Association of Realtors' median home price of $218,200 for all existing homes sold in the U.S.).
Beverly Hills; Greenwich, Conn.; the California markets of La Jolla, Santa Monica, Palo Alto, Newport Beach, Santa Barbara, San Mateo, and San Francisco; and Boston comprise the top 10 most expensive markets in the country, all with average home prices of $1.38 million and up. In addition to Killeen, Minot, N.D.; Arlington and Fort Worth, Tex.; Canton, Ohio; Muncie, Ind.; Topeka and Wichita, Kan.; Tulsa, Okla.; and Grayling, Mich., make up the list of the most affordable housing markets.
Million-Dollar Differences But affordable markets exist in just about every state—even in California. The average 2007 sales price in Sacramento for one of Coldwell Banker's subject homes was just $380,625, making it the most affordable market in the state. In Connecticut, a home in West Hartford sells for an average of $365,000, and in Worcester, Mass., you can buy a four-bedroom home for around $286,000.
California, Connecticut, and Massachusetts have the widest price variance between high- and low-end housing markets, with an over $1 million difference between the average home price in their most expensive and most affordable markets. But some states are affordable no matter where you look. In Idaho, the difference in sales price between the most expensive (Boise) and most affordable (Coeur d'Alene) markets was a mere $30.
Real Estate's a Local Business Thinking about relocating? An area's affordability is important to consider when buying a home. Unaffordable areas may indicate that prices are too high to be supported by the local economy, while affordable prices ensure that demand will continue to fuel the housing market. Affordable areas can be good hunting ground for real estate deals (BusinessWeek, 7/18/07).
"The real estate market has certainly changed over the last year," says Jim Gillespie, chief executive officer of Coldwell Banker. "I continue to point out that we cannot make national blanket statements about appreciation and inventory. Real estate is a local business, with each market having its own story to tell."
See BusinessWeek's slide show for a look at the most affordable and most expensive housing markets by state.
Tuesday, February 26, 2008
The Anatomy of a Bear Market
I'm not going to pretend to know how to pick a bottom for stocks, but if we dissect the anatomy of a bear market we might understand why stocks markets eventually recover.
Anatole Kaletsky, a columnist at The Times, wrote a brilliant piece on bear markets in a recent publication. "When we look back through history - or think about the underlying economics of business cycles - we realize that every financial crisis and bear market in the past has been a buying opportunity because we can see, with hindsight, that the world never did come to an end," he says. Kaletsky makes an important observation: "If everyone in the market knew that previous financial crises and bear markets always created buying opportunities, then a new bear market could never occur." Overly simplistic? Logically correct?
But why do we still go through bear markets when everyone knows past bear markets offered buying opportunities? Another important observation: We can only go into a bear market if potential buyers believe that the latest financial crisis was somehow different - and worse - than any that had gone before. "If people believed that this was just an average sort of crisis, they would now be buying instead of selling, and there would be no crisis," adds Kaletsky.
In other words, a bear market is only possible if there is a consensus that a financial crisis is significantly worse than ever before. And that is why we are currently in a bear market. A few examples of this psychology:
- George Soros, who said that this is "the worst market crisis in 60 years". George Soros also reacted to Black Monday in 1987 with a single chilling sentence: "This is 1929"
- David Rosenberg at Merrill Lynch, who said "we confess that we have been in the business for 25 years and have never - and repeat never - seen a cycle like this one."
- Alan Greenspan described LTCM in 1998 as the worst crisis in his 60-year working lifetime.
- Nouriel Roubini of New York University's Stern School of Business, who said that this is "the worst housing recession in U.S. history"
- Legg Mason's CEO, Chip Mason, said that credit markets are in the "worst state he has seen in his 47 yrs in the business"
- etc.
This psychological trap will probably always be with us. The most experienced investors and bankers have careers that last about 30 years, a blink in economic history. "It is hardly surprising, therefore, that people are constantly amazed by each new cycle that comes along - and find it difficult to see it in historic proportion," says Kaletsky.
The near-term question: If bond insurers are bailed out, will credit markets recover? If credit markets recover, will investors then come to the realization that this is just an average crisis? If that is the case, a bottom for stocks might be around the corner.
The long-term question: If each successive crisis really is worse than the one before, a necessary condition for bear markets to occur, are we involved in a cumulative process that may one day approach an apocalyptic climax? That idea seems a bit far-fetched...
Anatole Kaletsky, a columnist at The Times, wrote a brilliant piece on bear markets in a recent publication. "When we look back through history - or think about the underlying economics of business cycles - we realize that every financial crisis and bear market in the past has been a buying opportunity because we can see, with hindsight, that the world never did come to an end," he says. Kaletsky makes an important observation: "If everyone in the market knew that previous financial crises and bear markets always created buying opportunities, then a new bear market could never occur." Overly simplistic? Logically correct?
But why do we still go through bear markets when everyone knows past bear markets offered buying opportunities? Another important observation: We can only go into a bear market if potential buyers believe that the latest financial crisis was somehow different - and worse - than any that had gone before. "If people believed that this was just an average sort of crisis, they would now be buying instead of selling, and there would be no crisis," adds Kaletsky.
In other words, a bear market is only possible if there is a consensus that a financial crisis is significantly worse than ever before. And that is why we are currently in a bear market. A few examples of this psychology:
- George Soros, who said that this is "the worst market crisis in 60 years". George Soros also reacted to Black Monday in 1987 with a single chilling sentence: "This is 1929"
- David Rosenberg at Merrill Lynch, who said "we confess that we have been in the business for 25 years and have never - and repeat never - seen a cycle like this one."
- Alan Greenspan described LTCM in 1998 as the worst crisis in his 60-year working lifetime.
- Nouriel Roubini of New York University's Stern School of Business, who said that this is "the worst housing recession in U.S. history"
- Legg Mason's CEO, Chip Mason, said that credit markets are in the "worst state he has seen in his 47 yrs in the business"
- etc.
This psychological trap will probably always be with us. The most experienced investors and bankers have careers that last about 30 years, a blink in economic history. "It is hardly surprising, therefore, that people are constantly amazed by each new cycle that comes along - and find it difficult to see it in historic proportion," says Kaletsky.
The near-term question: If bond insurers are bailed out, will credit markets recover? If credit markets recover, will investors then come to the realization that this is just an average crisis? If that is the case, a bottom for stocks might be around the corner.
The long-term question: If each successive crisis really is worse than the one before, a necessary condition for bear markets to occur, are we involved in a cumulative process that may one day approach an apocalyptic climax? That idea seems a bit far-fetched...
Monday, February 25, 2008
Small-Cap Stocks Could Have Further to Fall
AFTER SLUMPING INTO bear-market territory in January, small stocks remain 19% below their last peak. They've also dipped below their long-term averages by several price gauges, making it tempting to start buying again. But are they cheap enough yet to truly start loading up on?
One way of deciding is to compare the recent drop with those in past downturns. By this measure, a bottom looks near but not quite here. The crux is whether the downturn is just beginning, almost over or yet to come, particularly as inflation pressures build.
The Russell 2000 index, the benchmark for small stocks, has in the past declined an average 32% from peak to trough in bad times, according to Citigroup's small-cap and midcap equity strategist Lori Calvasina. By contrast, the lowest the Russell has gotten so far is 24% below its recent peak — an indication there could be more downside to come.
Small caps also look overpriced compared to large stocks. Large stocks are trading at about 16 times earnings from the last four quarters, whereas small stocks are trading at 23 times earnings, according to the Russell benchmarks. Small growth stocks, trading at 30 times earnings, are the most expensive, while large value stocks (which includes beaten-down banks) are the cheapest at 15 times earnings.
"Small caps still look pricey to us," says David Joy, chief market strategist at money manager RiverSource Investments. "They've begun to correct but have by no means corrected the extended outperformance cycle enjoyed over the past six years."
MORE ON STOCKS FROM SMARTMONEY.COM
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Amazon Profits a Worry Despite Sales Growth
Contrary to other economic forecasters, Joy says a real recession is more likely to come in the second half of 2009 rather than this year because the Federal Reserve's interest rate cuts and government stimulus plan will work through the system in the coming months. So, small caps might get a temporary boost in the near term. But looking into next year, "We think inflation is going to be an increasingly difficult problem that the Fed will have to address with higher interest rates and that will push us into recession," Joy says.
Sam Stovall, chief investment strategist for Standard & Poor's, points out that earnings growth is oddly expected to be a strong 18% this year for all the size groups — the large S&P 500, mid S&P 400 and small S&P 600. Some of this is because earnings were weak last year, led by a 6% decline in earnings for small caps, Stovall says. The other factors at play are the Fed's rate cuts, and companies continuing to buy back stock, which boosts earnings per share. So it comes down to price. The S&P 500 is trading at about 14 times expected 2008 earnings, while the S&P 600 is at 16 times 2008 earnings, Stovall says.
Another factor hurting small caps is the tighter credit markets. Small companies rely on credit more than large companies, but in this market banks may be loathe to lend money to less-established companies.
One way of deciding is to compare the recent drop with those in past downturns. By this measure, a bottom looks near but not quite here. The crux is whether the downturn is just beginning, almost over or yet to come, particularly as inflation pressures build.
The Russell 2000 index, the benchmark for small stocks, has in the past declined an average 32% from peak to trough in bad times, according to Citigroup's small-cap and midcap equity strategist Lori Calvasina. By contrast, the lowest the Russell has gotten so far is 24% below its recent peak — an indication there could be more downside to come.
Small caps also look overpriced compared to large stocks. Large stocks are trading at about 16 times earnings from the last four quarters, whereas small stocks are trading at 23 times earnings, according to the Russell benchmarks. Small growth stocks, trading at 30 times earnings, are the most expensive, while large value stocks (which includes beaten-down banks) are the cheapest at 15 times earnings.
"Small caps still look pricey to us," says David Joy, chief market strategist at money manager RiverSource Investments. "They've begun to correct but have by no means corrected the extended outperformance cycle enjoyed over the past six years."
MORE ON STOCKS FROM SMARTMONEY.COM
Outlook for Agriculture Stocks Remains Strong
Wireless Price War Spooks Telecom Investors
Amazon Profits a Worry Despite Sales Growth
Contrary to other economic forecasters, Joy says a real recession is more likely to come in the second half of 2009 rather than this year because the Federal Reserve's interest rate cuts and government stimulus plan will work through the system in the coming months. So, small caps might get a temporary boost in the near term. But looking into next year, "We think inflation is going to be an increasingly difficult problem that the Fed will have to address with higher interest rates and that will push us into recession," Joy says.
Sam Stovall, chief investment strategist for Standard & Poor's, points out that earnings growth is oddly expected to be a strong 18% this year for all the size groups — the large S&P 500, mid S&P 400 and small S&P 600. Some of this is because earnings were weak last year, led by a 6% decline in earnings for small caps, Stovall says. The other factors at play are the Fed's rate cuts, and companies continuing to buy back stock, which boosts earnings per share. So it comes down to price. The S&P 500 is trading at about 14 times expected 2008 earnings, while the S&P 600 is at 16 times 2008 earnings, Stovall says.
Another factor hurting small caps is the tighter credit markets. Small companies rely on credit more than large companies, but in this market banks may be loathe to lend money to less-established companies.
Sunday, February 24, 2008
Notes for Barron's Feb. 23th 2008
Nothing interesting in this week's Barron's, except the gap between treasury bond and corp bond is all time high, I don't quite understand the meaning yet but in a sense it shows how bearish investors are and thus bullish for the Market.
Alan Abelson is bearish as usual, as a matter of fact, I wonder if this guy will ever turn bullish, just like I doubt the forever bull Victor Niederhoffer who would ever turn bearish. Nonetheles they are the most respectable writers in investment world (My opinion). This time around I would stand by Victor to be a bull.
Alan Abelson is bearish as usual, as a matter of fact, I wonder if this guy will ever turn bullish, just like I doubt the forever bull Victor Niederhoffer who would ever turn bearish. Nonetheles they are the most respectable writers in investment world (My opinion). This time around I would stand by Victor to be a bull.
Guaranteed to Happen
What must not be gainsaid is that the rise of 22 points in S&P futures from 3:30pm to 4:00pm on February 22 from 1334 to 1356 was the greatest rise in history. The rise of 24 points from 3:00pm to 4:00pm from 1332 to 1356 was the second greatest in history, failing by only a point to match the Société Générale rally on 01/17. It was beautiful the way the market set up exactly the same way it did the Friday before all the money was made by frontrunning and running stops associated with the $7 billion loss. Also beautiful was the way the move from 1327 to 1357 (low to high) on Friday basically recapitulated in half an hour the entire range of the last two weeks. That's what a classical symphony is supposed to do at the end of the piece, recapitulate all the themes, bring them together and close with a bang. Also of note was the sentinel function of the bonds in the entire mass, staying down nicely even while the market at the two week lows. It was all guaranteed to happen.
Saturday, February 23, 2008
Stovall: A Freefall in Confidence
This market has had a perfect record of ruining holidays and vacations, as the S&P 500 posted sharp declines during summer vacations in 2007, during the New Years-shortened week and on/following this year's Martin Luther King holiday.
Today (Tuesday, Jan. 22), investors are girding for the second day of a global panic sell-off, in my opinion, which will now include the U.S. following its tension-filled day off, as a result of the increasing belief that the U.S. economy will slip into recession, combined with the unwinding of recent beliefs that global economies had decoupled and that a slowdown or recession in the U.S. would not materially impact foreign economies. In other words, many believed that what happens "over here" wouldn't affect what happens "over there."
So much for that emerging tenet.
Now that world equity markets are in freefall, when will it likely end, and could today actually become that often sought after "capitulation day" that technicians use to identify near-to-intermediate-term bottoms? Mark Arbeter, S&P's chief technical strategist, has been on the money with his calls over the past year, in my opinion. Earlier, he identified 1250 as a likely S&P 500 bottom for this decline, due to the convergence of trendlines, moving averages and retracement levels. Over the weekend, I asked him what he would have to see before he felt the need to set an even lower target.
"There is absolutely no way to tell where things will bottom out in these panics until after the fact," he said. "You just have to let them play out."
Arbeter points out that 10 largest one-day losses for the S&P 500 in descending order were: 20.5% on Oct. 19, 1987; 8.3% on Oct. 26, 1987; 6.9% on Oct. 27, 1997; 6.8% Aug. 31, 1998; 6.8% on Jan. 8, 1988; 6.7% on Sept. 3, 1946; 6.7% on May 28, 1962; 6.6% Sept. 26, 1955; 5.8% on Apr. 14, 2000; and 5.4% on June 26, 1950. Except for the decline in 2000, these drops were very close to major market lows in both time and price.
Arbeter concluded by saying "Should the S&P 500 close at least 1% below the 1250 level, however, and remain in place for two straight days, the next zone of chart support that I see is in the 1140 to 1170 range."
One bit of disconcerting historical fundamental data to us is the abnormally low average price-to-earnings ratio recorded by the S&P 500 at the end of market sell-offs in anticipation of recessions. Since 1945, the P/E on trailing 12-month "as reported," or GAAP, EPS averaged 12 times, about 30% below the 16.5 times trailing results of today, based on the S&P 500 trading at 1250 and GAAP earnings of $75.50 that includes our estimates for the fourth quarter of 2007.
More optimistically, however, the S&P 500, at the 1250 level, would be trading at 14.5 times trailing operating EPS, or a 25% discount from the average P/E of 19.4 times since 1988, when S&P started capturing operating EPS results.
On Jan. 9, S&P's Investment Policy Committee reduced its year-end target for the S&P 500 to 1560 from 1650, and embraced a defensive sector posture, in anticipation of additional market declines. On January 16, the IPC reduced its recommended allocation to international equities. Last week, articulating our decision, Alec Young, S&P's International Equity Strategist explained that "even though we continue to recommend U.S. investors maintain a long-term exposure to international equities, we believe that portfolio rebalancing is now appropriate in both our developed and emerging market equity weightings". While international equity markets have significantly outperformed the S&P 500 during the past several years, S&P thinks they have recently stumbled along with domestic markets as a result of the projected slowdown, and possible contraction, of the U.S. economy.
Also, notes Young, while the dollar still remains relatively weak, S&P thinks the dollar's multi-year decline against key foreign currencies will likely slow this year, as foreign central banks begin easing more aggressively to offset slowing growth in their economies. At the same time, S&P expects the mid-year end to the Fed's easing cycle will ultimately make the greenback more attractive.
Finally, David Wyss, S&P's Chief Economist, told me on Jan. 21 that a joint rate cut, or infusion of liquidity, by the U.S. Federal Reserve and the central banks of Europe and England would likely occur and offer support to the equity markets. At 8:20 am on Jan. 22, the Fed cut the Fed funds rate target by 75 basis points to 3.50% in an emergency move. Will that be enough to stem further losses? We still look for a decline in equity prices on Tuesday, and believe the markets will tell us when the worst is over, rather than the other way around.
Today (Tuesday, Jan. 22), investors are girding for the second day of a global panic sell-off, in my opinion, which will now include the U.S. following its tension-filled day off, as a result of the increasing belief that the U.S. economy will slip into recession, combined with the unwinding of recent beliefs that global economies had decoupled and that a slowdown or recession in the U.S. would not materially impact foreign economies. In other words, many believed that what happens "over here" wouldn't affect what happens "over there."
So much for that emerging tenet.
Now that world equity markets are in freefall, when will it likely end, and could today actually become that often sought after "capitulation day" that technicians use to identify near-to-intermediate-term bottoms? Mark Arbeter, S&P's chief technical strategist, has been on the money with his calls over the past year, in my opinion. Earlier, he identified 1250 as a likely S&P 500 bottom for this decline, due to the convergence of trendlines, moving averages and retracement levels. Over the weekend, I asked him what he would have to see before he felt the need to set an even lower target.
"There is absolutely no way to tell where things will bottom out in these panics until after the fact," he said. "You just have to let them play out."
Arbeter points out that 10 largest one-day losses for the S&P 500 in descending order were: 20.5% on Oct. 19, 1987; 8.3% on Oct. 26, 1987; 6.9% on Oct. 27, 1997; 6.8% Aug. 31, 1998; 6.8% on Jan. 8, 1988; 6.7% on Sept. 3, 1946; 6.7% on May 28, 1962; 6.6% Sept. 26, 1955; 5.8% on Apr. 14, 2000; and 5.4% on June 26, 1950. Except for the decline in 2000, these drops were very close to major market lows in both time and price.
Arbeter concluded by saying "Should the S&P 500 close at least 1% below the 1250 level, however, and remain in place for two straight days, the next zone of chart support that I see is in the 1140 to 1170 range."
One bit of disconcerting historical fundamental data to us is the abnormally low average price-to-earnings ratio recorded by the S&P 500 at the end of market sell-offs in anticipation of recessions. Since 1945, the P/E on trailing 12-month "as reported," or GAAP, EPS averaged 12 times, about 30% below the 16.5 times trailing results of today, based on the S&P 500 trading at 1250 and GAAP earnings of $75.50 that includes our estimates for the fourth quarter of 2007.
More optimistically, however, the S&P 500, at the 1250 level, would be trading at 14.5 times trailing operating EPS, or a 25% discount from the average P/E of 19.4 times since 1988, when S&P started capturing operating EPS results.
On Jan. 9, S&P's Investment Policy Committee reduced its year-end target for the S&P 500 to 1560 from 1650, and embraced a defensive sector posture, in anticipation of additional market declines. On January 16, the IPC reduced its recommended allocation to international equities. Last week, articulating our decision, Alec Young, S&P's International Equity Strategist explained that "even though we continue to recommend U.S. investors maintain a long-term exposure to international equities, we believe that portfolio rebalancing is now appropriate in both our developed and emerging market equity weightings". While international equity markets have significantly outperformed the S&P 500 during the past several years, S&P thinks they have recently stumbled along with domestic markets as a result of the projected slowdown, and possible contraction, of the U.S. economy.
Also, notes Young, while the dollar still remains relatively weak, S&P thinks the dollar's multi-year decline against key foreign currencies will likely slow this year, as foreign central banks begin easing more aggressively to offset slowing growth in their economies. At the same time, S&P expects the mid-year end to the Fed's easing cycle will ultimately make the greenback more attractive.
Finally, David Wyss, S&P's Chief Economist, told me on Jan. 21 that a joint rate cut, or infusion of liquidity, by the U.S. Federal Reserve and the central banks of Europe and England would likely occur and offer support to the equity markets. At 8:20 am on Jan. 22, the Fed cut the Fed funds rate target by 75 basis points to 3.50% in an emergency move. Will that be enough to stem further losses? We still look for a decline in equity prices on Tuesday, and believe the markets will tell us when the worst is over, rather than the other way around.
Thursday, February 21, 2008
Fear of Stagflation
Why should a bull be afraid of Stagflation? Somebody bullish on life is someone who is a producer of a net overplus. Being bullish on the markets is a matter of finding the markets that are representing economies producing overpluses.
On one hand markets have been shaking off on fears of an extended form of reflation called recession and yet on another the all knowledgeable squakboxes say markets are afraid of stagflation! Something does not add up if negative is negative and positive too is also negative. This is the tell of the times that everything appears negative and thus the near future is likely to witness the dawn of a new cycle. Why cant a new cycle take over before the imagined troughs of the ongoing cycle are seen?
Inflation in pure and simple commonsense terms is a redistribution of income and or wealth. Those with a net positive wealth / income stand to gain and those with a net negative income and / or wealth lose when inflation persists. However when inflation goes down those with an overplus stop gaining and those with a deficit accelerate their losses. So, the trick is that manageable inflation is what is the vehicle of all progress in the organised economic world.
Today when Hang Seng sold off after a large upgap opening the moment it was announced that Hong Kong banks are not following lock-in-step with the US Fed one sat down wondering if efforts to contain a redistribution of income will not accentuate the redistribution of wealth. Like energy cannot be destroyed but only transformed it is likely that inflation of consumables being contained will transform into a higher inflation of assets. Maintain the rising interest rate differential and prepare to face a wall of cash gushing in. As the wall hits the larger packets of liquidity are grabbed first by hands that have an overplus and thus can afford to invest and speculate. Inflation morphses into expanding the asset pricing, thus.
So if stagflation is similarly in commonsense terms (by the way the word economics originates from Oikon Nomics — The study of household preferences — which cannot be confined to ivory towers and thinktanks alone) an apparent redistribution of wealth it is the perfect background for speculation to be a good business of several others. Then you have the squakboxes labelling that there is a fear of stagflation and we know fear is the aphrodisiac on which bulls will persist further, despite the recent flounder. It suits a speculation even if all / most economies are going to be running on treadmills and be actually reaching nowhere except where they are since it is far better than the talk of death and disease in economies that is near given in most minds now.
At the risk of repetition, I would like to bring to the table the striking mirror image that is what the Capitalistic Communists are doing in China today of what the Communist Capitalists in Russia did in the last century. The Party in Russia kept on selling the commodities down holding the value of its own money higher while the Party in China is driving the commodities higher holding the value of its own money lower. If what Russia did was dangerous it is easy to see that what China is doing is certainly more dangerous. Every accounting Shenanigan in the universe has had fiddled with managing the Income Statement with the Balance Sheet or vice versa.
America, to a neutral observer with a dispassionate view of what you are doing, you are doing fine. Facing the reality and not fiddling. By this count alone, ain't it clear that the Chinese decision makers find the American money more useful than their own, in the longer run?
Fear and greed are the extremes of the emotional pendulum and when observers see the extremes while the pendulum is just in equilibrium (if there is another commonsense meaning of stagflation it perhaps is the solitary variant of inflation with highest relative equilibrium) it is that zen moment which builds the business of speculation further. What has been correcting at a systemic level globally is the underpricing of risk. Risk getting dearer cannot necessarily imply that opportunities will get scarcer. Recent few years' correlation may be an aberration in the larger cycles of progress. If risk and returns are not to be seen as coexsting together on the same Mobius Strip of perceptions then the fortunes that were created by the forefathers at times of war, turbulence, mass immigrations, disease and famine cannot be explained. Don't worry Wall Street you are doing fine too, since stagflation is going to be round soon, speculators will do well. Risk itself is the opportunity, always and very much today.
On one hand markets have been shaking off on fears of an extended form of reflation called recession and yet on another the all knowledgeable squakboxes say markets are afraid of stagflation! Something does not add up if negative is negative and positive too is also negative. This is the tell of the times that everything appears negative and thus the near future is likely to witness the dawn of a new cycle. Why cant a new cycle take over before the imagined troughs of the ongoing cycle are seen?
Inflation in pure and simple commonsense terms is a redistribution of income and or wealth. Those with a net positive wealth / income stand to gain and those with a net negative income and / or wealth lose when inflation persists. However when inflation goes down those with an overplus stop gaining and those with a deficit accelerate their losses. So, the trick is that manageable inflation is what is the vehicle of all progress in the organised economic world.
Today when Hang Seng sold off after a large upgap opening the moment it was announced that Hong Kong banks are not following lock-in-step with the US Fed one sat down wondering if efforts to contain a redistribution of income will not accentuate the redistribution of wealth. Like energy cannot be destroyed but only transformed it is likely that inflation of consumables being contained will transform into a higher inflation of assets. Maintain the rising interest rate differential and prepare to face a wall of cash gushing in. As the wall hits the larger packets of liquidity are grabbed first by hands that have an overplus and thus can afford to invest and speculate. Inflation morphses into expanding the asset pricing, thus.
So if stagflation is similarly in commonsense terms (by the way the word economics originates from Oikon Nomics — The study of household preferences — which cannot be confined to ivory towers and thinktanks alone) an apparent redistribution of wealth it is the perfect background for speculation to be a good business of several others. Then you have the squakboxes labelling that there is a fear of stagflation and we know fear is the aphrodisiac on which bulls will persist further, despite the recent flounder. It suits a speculation even if all / most economies are going to be running on treadmills and be actually reaching nowhere except where they are since it is far better than the talk of death and disease in economies that is near given in most minds now.
At the risk of repetition, I would like to bring to the table the striking mirror image that is what the Capitalistic Communists are doing in China today of what the Communist Capitalists in Russia did in the last century. The Party in Russia kept on selling the commodities down holding the value of its own money higher while the Party in China is driving the commodities higher holding the value of its own money lower. If what Russia did was dangerous it is easy to see that what China is doing is certainly more dangerous. Every accounting Shenanigan in the universe has had fiddled with managing the Income Statement with the Balance Sheet or vice versa.
America, to a neutral observer with a dispassionate view of what you are doing, you are doing fine. Facing the reality and not fiddling. By this count alone, ain't it clear that the Chinese decision makers find the American money more useful than their own, in the longer run?
Fear and greed are the extremes of the emotional pendulum and when observers see the extremes while the pendulum is just in equilibrium (if there is another commonsense meaning of stagflation it perhaps is the solitary variant of inflation with highest relative equilibrium) it is that zen moment which builds the business of speculation further. What has been correcting at a systemic level globally is the underpricing of risk. Risk getting dearer cannot necessarily imply that opportunities will get scarcer. Recent few years' correlation may be an aberration in the larger cycles of progress. If risk and returns are not to be seen as coexsting together on the same Mobius Strip of perceptions then the fortunes that were created by the forefathers at times of war, turbulence, mass immigrations, disease and famine cannot be explained. Don't worry Wall Street you are doing fine too, since stagflation is going to be round soon, speculators will do well. Risk itself is the opportunity, always and very much today.
Wednesday, February 20, 2008
It is too early to celebrate just yet
Last week, the Dow Jones Industrials and the S&P 500 both gained 1.4%. Both indices are well above their January lows and appear to be heading higher. Have the markets put in a bottom (as Jim Cramer happily exclaimed back in late January) and are now merrily on their way up? It is too early to celebrate just yet.
The Federal Reserve rate cut on 22 January, in response to the global market stumble of the previous day, followed by another cut at its regular meeting, has certainly cheered the bulls and led many to mark that day as a market bottom. The Fed, certainly, has given indication that it is ready to intervene and provide liquidity to bolster the markets. At the same time, many seem convinced that the latest wave of write-downs has accounted for all the bad news associated with the subprime meltdown and the credit crunch. It may be a little too early for that, too.
What we are currently experiencing is another bear market rally; financials, consumer discretionaries, and other sectors will likely continue to suffer in the coming months. Due to travels in Asia during these past several weeks, I have not been active in the markets -- this has provided me with an interlude during which to step back from the daily torrent of market news and its associated wild gyrations. As I return, I see little that leads me to believe that we have turned a corner...
It is, perhaps, stylish to be bullish. Over the past several years, the investing public has been conditioned to "buy the dips" as the market continued to rise. Based on the financial news, one would guess that the average investor is bearish. However, it is not so; Barron's quotes David Kostin, a strategist at Goldman Sachs: "Contrary to popular belief, short interest is low and decreasing, not high and rising." The put-call ratio, a contrary sentiment indicator, provides a bullish signal the more put trading exceeds call trading; for the S&P 100 index, the ratio for the week ending 8 February was 0.65, the lowest in many months. Memories are short. Buying the dips is somewhat counter-productive when markets continue to decline.
Certainly, many sectors -- most notably the financials -- have already suffered significant declines and are in bear market territory. So now they must come up, right?
Perhaps being bearish is the true contrary position?
Why do I remain pessimistic? The subprime crisis and the resultant credit crunch are far from over; the worst should actually come this year. RealtyTrac calculates that 1.8 million mortgages are scheduled to reset in 2008 and 2009. At the same time, despite write-downs, companies have been notoriously slow to accept the full extent of losses associated with these developments and other aspects of the credit crunch. Far from being over, the bad news continues -- witness UBS' report of a $13.7 billion write-down this past week. Philip Finch, a UBS analyst, estimates that global banks face $203 billion in further write-downs. With billions of dollars of potential losses still unrealized, the true value of assets on the books of financial institutions remains open to question.
Beyond the financial sector, though many P/E ratios currently seem attractive, much of that depends on the denominator. If earnings disappoint, apparently cheap stocks will become much less so. At the same time, consumer confidence continues to ebb as the US domestic economy slows. Whether we enter a recession or not, domestic growth and corporate profits will slow.
As a result, I remain broadly bearish on the domestic stock market and especially suspicious of the financials.
Where should one look for profits now? Commodities, such as grains and gold, offer opportunities for further appreciation, as do their related stocks. Agnico Eagle Mines (AEM) interests me, though I have yet to purchase any shares. Energy exploration also offers opportunities for long-term appreciation.
At the same time, I continue to maintain my long-term core holdings and to build my "wish list" for beyond this bear market. Some financials have been unfairly punished and will undoubtedly prove good investments; though I think this punishment may yet continue for several months, I am waiting for the opportunity to purchase American International Group (AIG) and additional shares of Lehman Brothers (LEH), as well as some regional banks. Railways, such as Burlington Northern Santa Fe (BNI), are also interesting.
In time, the markets will turn. I cannot predict with any accuracy when that time will come, but I feel it is still too early to begin shopping now. I do not expect to call the bottom, but I am not in a hurry to catch any falling knives, either.
The Federal Reserve rate cut on 22 January, in response to the global market stumble of the previous day, followed by another cut at its regular meeting, has certainly cheered the bulls and led many to mark that day as a market bottom. The Fed, certainly, has given indication that it is ready to intervene and provide liquidity to bolster the markets. At the same time, many seem convinced that the latest wave of write-downs has accounted for all the bad news associated with the subprime meltdown and the credit crunch. It may be a little too early for that, too.
What we are currently experiencing is another bear market rally; financials, consumer discretionaries, and other sectors will likely continue to suffer in the coming months. Due to travels in Asia during these past several weeks, I have not been active in the markets -- this has provided me with an interlude during which to step back from the daily torrent of market news and its associated wild gyrations. As I return, I see little that leads me to believe that we have turned a corner...
It is, perhaps, stylish to be bullish. Over the past several years, the investing public has been conditioned to "buy the dips" as the market continued to rise. Based on the financial news, one would guess that the average investor is bearish. However, it is not so; Barron's quotes David Kostin, a strategist at Goldman Sachs: "Contrary to popular belief, short interest is low and decreasing, not high and rising." The put-call ratio, a contrary sentiment indicator, provides a bullish signal the more put trading exceeds call trading; for the S&P 100 index, the ratio for the week ending 8 February was 0.65, the lowest in many months. Memories are short. Buying the dips is somewhat counter-productive when markets continue to decline.
Certainly, many sectors -- most notably the financials -- have already suffered significant declines and are in bear market territory. So now they must come up, right?
Perhaps being bearish is the true contrary position?
Why do I remain pessimistic? The subprime crisis and the resultant credit crunch are far from over; the worst should actually come this year. RealtyTrac calculates that 1.8 million mortgages are scheduled to reset in 2008 and 2009. At the same time, despite write-downs, companies have been notoriously slow to accept the full extent of losses associated with these developments and other aspects of the credit crunch. Far from being over, the bad news continues -- witness UBS' report of a $13.7 billion write-down this past week. Philip Finch, a UBS analyst, estimates that global banks face $203 billion in further write-downs. With billions of dollars of potential losses still unrealized, the true value of assets on the books of financial institutions remains open to question.
Beyond the financial sector, though many P/E ratios currently seem attractive, much of that depends on the denominator. If earnings disappoint, apparently cheap stocks will become much less so. At the same time, consumer confidence continues to ebb as the US domestic economy slows. Whether we enter a recession or not, domestic growth and corporate profits will slow.
As a result, I remain broadly bearish on the domestic stock market and especially suspicious of the financials.
Where should one look for profits now? Commodities, such as grains and gold, offer opportunities for further appreciation, as do their related stocks. Agnico Eagle Mines (AEM) interests me, though I have yet to purchase any shares. Energy exploration also offers opportunities for long-term appreciation.
At the same time, I continue to maintain my long-term core holdings and to build my "wish list" for beyond this bear market. Some financials have been unfairly punished and will undoubtedly prove good investments; though I think this punishment may yet continue for several months, I am waiting for the opportunity to purchase American International Group (AIG) and additional shares of Lehman Brothers (LEH), as well as some regional banks. Railways, such as Burlington Northern Santa Fe (BNI), are also interesting.
In time, the markets will turn. I cannot predict with any accuracy when that time will come, but I feel it is still too early to begin shopping now. I do not expect to call the bottom, but I am not in a hurry to catch any falling knives, either.
Tuesday, February 19, 2008
Understanding What Recessions Are
One of the misunderstandings about recessions is what actually happens in the real world. A recession is where economic growth stops, and you are left with flat to contracting sales.
Note that economic activity does not grind to a halt -- the year-over-year growth rate merely slips into the negative. This is often misstated, in some variation of "Gee, how can it be a recession -- I was out shopping and the stores were pretty crowded." Whenever you see that, the speaker is either technically misunderstanding what a recession is -- or alternatively, is painfully long and hoping for the best.
Of course, growth may falter, not total economic activity. With the $13 trillion US economy, economic activity certainly won't fall to zero dollars. Everyone is still eating, driving to work, using electricity, phones, buying iPods, etc. If economic activity were to fall to an annual run rate of below $13 trillion dollars for a few quarters, well then there's your mild recession. If it drops much below the $12.75 - 13 trillion dollar range, that's a bit more serious contraction. Indeed, the greater the year over year contraction in economic activity, the deeper the recession.
Consider Housing: Sales don't drop from ~7m homes sold to zero; rather, the number drops significantly (i.e., 4.5m sold). It only seems like nothing after the boom years.
But even if US activity were to drop a huge trillion dollars in a year -- that's still a $12 trillion of economic activity, and that typically involves one or two people still going shopping and out to eat occasionally.
So far, we are only at the point where Real Sales have slipped into negative year-over-year territory. High food and energy prices, as well as health care, are keeping nominal sales positive. Outside of that, we see clothing, autos, homes all negative. Consumer Technology spending and business CapEx spending remain positive.
Indeed, while many aspects of the economy are revealing marked weakness, select areas are still hanging on. We are just as likely to be in a recession -- as not -- as of February 19th, 2008.
Note: We were out and about this past 3 day weekend (it's not all linkfests); one of the things I find interesting is what you can -- and cannot discern -- from anecdotal experiences.
The stores were busy, but not jammed. Discounting was aggressive, reflecting a combination of weak spending and seasonal changeover.
I do not think I could draw the conclusion that we either are definitely in -- or NOT in -- a recession. Too regional, too random.
The most I can conclude is that it seemed a little softer than usual at the outlet center for an off-Summer season, holiday weekend sale.
Note that economic activity does not grind to a halt -- the year-over-year growth rate merely slips into the negative. This is often misstated, in some variation of "Gee, how can it be a recession -- I was out shopping and the stores were pretty crowded." Whenever you see that, the speaker is either technically misunderstanding what a recession is -- or alternatively, is painfully long and hoping for the best.
Of course, growth may falter, not total economic activity. With the $13 trillion US economy, economic activity certainly won't fall to zero dollars. Everyone is still eating, driving to work, using electricity, phones, buying iPods, etc. If economic activity were to fall to an annual run rate of below $13 trillion dollars for a few quarters, well then there's your mild recession. If it drops much below the $12.75 - 13 trillion dollar range, that's a bit more serious contraction. Indeed, the greater the year over year contraction in economic activity, the deeper the recession.
Consider Housing: Sales don't drop from ~7m homes sold to zero; rather, the number drops significantly (i.e., 4.5m sold). It only seems like nothing after the boom years.
But even if US activity were to drop a huge trillion dollars in a year -- that's still a $12 trillion of economic activity, and that typically involves one or two people still going shopping and out to eat occasionally.
So far, we are only at the point where Real Sales have slipped into negative year-over-year territory. High food and energy prices, as well as health care, are keeping nominal sales positive. Outside of that, we see clothing, autos, homes all negative. Consumer Technology spending and business CapEx spending remain positive.
Indeed, while many aspects of the economy are revealing marked weakness, select areas are still hanging on. We are just as likely to be in a recession -- as not -- as of February 19th, 2008.
Note: We were out and about this past 3 day weekend (it's not all linkfests); one of the things I find interesting is what you can -- and cannot discern -- from anecdotal experiences.
The stores were busy, but not jammed. Discounting was aggressive, reflecting a combination of weak spending and seasonal changeover.
I do not think I could draw the conclusion that we either are definitely in -- or NOT in -- a recession. Too regional, too random.
The most I can conclude is that it seemed a little softer than usual at the outlet center for an off-Summer season, holiday weekend sale.
Monday, February 18, 2008
Market Bears Take a Breather
We had reaffirmed last week that stocks were in a confirmed bear market. We also categorically stated that a pullback rally within the larger downtrend was overdue and should be used solely to lighten up on long-only exposures. Stocks played to script this week notching up modest gains despite heightened volatility that usually accompanies an options expiration week. Stocks gained sharply mid-week following Warren Buffett's bailout plan for the monolines and a narrower-than-expected trade deficit. But comments from Ben Bernanke and a remarkably weak consumer sentiment survey spoiled the party. The front-line indexes closed out the week with a respectable 0.5%-1.5% gain. Most indexes witnessed an 'inside week', that is in keeping with the idea of a consolidation after recent steep losses.
While our call for a rebound in global equities seems to be coming true (Asian equities managed their first weekly gain in 2008), the outlook remains largely unchanged. We view the current rebound as a mere pullback within a longer downtrend. A major sell signal on longer time frames (weekly, monthly and quarterly charts) spread across global indexes and across multiple sectors suggests tougher times ahead for equities. 1400 levels on the S&P 500 will continue to be a formidable resistance in this pullback.
We review the major economic headline this week - a drastic shift in consumer sentiment over the past few weeks that makes a recession now appear increasingly plausible. Although the Fed has dropped is benchmark Fed funds rate by 225 basis points in six months, it has had only limited success in bringing borrowing costs down for consumers and borrowers. Nevertheless, the market believes this failure is the very reason why the Fed will further reduce rates. This negative feedback loop has the Fed pushing on a string in vain. Further, the complete freeze in the relatively obscure auction-rate bond market is the latest shoe to drop in the sub-prime contagion that has now spread world-wide. We finally wrap up with Warren Buffett's keen sense of timing, that could potentially strike gold for Berkshire Hathaway amidst a pile of toxic waste.
The Gloom Is Spreading
The University of Michigan's consumer sentiment index tumbled to 69.6 in its preliminary February reading from 78.4 last month, marking its lowest point since February 1992 when the economy was emerging from a recession. The component of the index that gauges consumers' expectations - a possible sign of their willingness to spend - dropped to to 59.4 from 68.1.
As noted in the chart above, the dip in consumer sentiment is startling. Consumer confidence is now even below the lows seen in 2001-2002 recession and close to its worst levels since the early 1990s, when unemployment rate was up over 7%.
The New York Fed's 'Empire State' index, a widely tracked gauge of manufacturing growth fell for the fourth consecutive month in February to its weakest level since April 2003. The general business conditions index slipped alarmingly to minus 11.72 in February from plus 9.03 the previous month, the first negative reading in almost two years. Readings below zero signal contraction.
These reports are not isolated. Best Buy, the largest U.S. consumer electronics chain, cut its full-year revenue and earnings forecast this week driven by what it termed 'soft domestic customer traffic in January... and weak near-term outlook'. The ABC News/Washington Post Consumer Comfort Index fell to its lowest reading since November 1993. Fewer than half of Americans surveyed rated their own finances positively, again a first since 1993. The Economic Cycle Research Institute [ECRI], a New-York based independent forecasting group, noted that its Weekly Leading Index skidded down to an annualized growth rate of minus 9.1 percent for the week ended February 8, its lowest reading since November 2001.
The evidence favoring a recession is mounting. Economic growth screeched to a 0.6 percent stall in the fourth quarter. A quarterly survey issued by the Philadelphia Federal Reserve suggested a 47 percent probability of contraction in GDP this quarter and a 43 percent chance in the second quarter, levels not seen since the recession in 2001. Economists surveyed by Bloomberg and WSJ earlier this month forecast even odds of a recession. A contracting labor market (payrolls declined for the first time in four years in January) and sharp weakness across the services sector that accounts for 85-90% of the economy (ISM non-manufacturing index fell off a cliff to its lowest since 9/11 ) amplify the chances of the economy turning over into a recession this quarter. The housing slump has only accelerated further over the past few months. Builders broke ground at an annual rate of just over a million homes in December, the fewest since 1991. The National Association of Realtors estimates sales of existing homes fell more than forecast in December, while prices of single-family homes posted the biggest annual drop probably since the Great Depression.
Corporate earnings are also taking a hit. Bloomberg data suggest that the S&P 500 companies that have reported 4Q 2007 earnings thus far posted an average 15 percent decline in earnings. The outlook for the first two quarters of the year is not much better either, with analysts expecting a 1.4 percent and 0.7 percent decline in earnings. The only bastion of hope is the rise in exports, driven by sustained weakness in the dollar and more resilient economic growth abroad. US trade deficit shrunk 6.2 percent to $711.6 billion in 2007 from its record set in 2006, the largest annual percentage drop since 1991 and its first decline in six years. But as global growth falters, partly weighed down by the slowdown in the US, it remains to be seen if there would be enough takers for US exports going forward.
The gloom has spread steadily over the past few months, with the odds of a recession rising as economic data has turned nastier. Former Federal Reserve Chairman Alan Greenspan now believes that the economy is "clearly on the edge", putting the odds of an economic contraction at "50 percent or better", up from his guesstimate of a one-in-three chance just a few months ago. His successor, Ben Bernanke, asserted in a Congressional testimony that policy makers were prepared to lower rates further as the economy hurtles in its downward spiral, vowing to provide "adequate insurance against downside risks." He essentially said, as nearly as a Fed Chairman can, that we were indeed headed towards a recession. The telling statement: "More-expensive and less-available credit seems likely to continue to be a source of restraint on economic growth." This sense of caution, despite the "substantive additional action" of a 125 bps rate cutting blitzkrieg in January - the fastest pace of monetary policy easing in over two decades - will only serve to heighten anxiety in the minds of market participants.
History has taught us that economies do not normally slip gradually into recession; they plunge spectacularly as they turn over. This usually creates glaring discontinuities in the incoming economic data, of the sort clearly on display in the survey reports of the past few weeks. A degree of panic seems to have set in that could possibly tip the scales in a stalling economy, pushing it into a free fall.
Pushing On A String
Let's recall that statement from Bernanke again... "more-expensive or less-available credit seems likely to continue to be a source of restraint on economic growth" We know where this is coming from, with the Fed having cut the Fed funds rate by 225 basis points in six months. But deteriorating credit conditions have undone pretty much most of what the Fed has done. The yield on Baa corporate bonds – a better measure of what drives actual business spending than the Fed funds target rate - has stayed largely constant, widening its spread over the Fed funds rate.
Data compiled by Merrill Lynch suggests that companies are paying more to borrow now than before the aggressive Fed rate cuts in January. Rates on so-called jumbo mortgages – mortgages with a value of over $417,000 and those not guaranteed by Fannie Mae and Freddie Mac - have increased in the past month, according to Bloomberg. Lenders and investors alike are demanding greater compensation for offering credit as losses continue to mount on sub-prime mortgage securities amid concerns of a cut in credit ratings of bond insurers. The increase in credit spreads has contrarily resulted in an effective tightening of financial conditions that the rate cuts were partly meant to address. It is as if the Fed were pushing on a string. The market perceives elevated borrowing costs will force the Fed to make further rate cuts, thereby reinforcing the "negative feedback loop" that has been in vogue all through this crisis. Traders now place a 100% chance of at least a 50 bps rate cut on or before the FOMC meeting on March 18.
A crisis that began with loans made to a small group of home-buyers with shaky credit has disrupted pretty much the entire financial ecosphere. Indeed, small towns in far-flung Norway have lost money due to the sub-prime contagion in the US. It has proved to be much more than a credit crunch... it has become a crisis of confidence.
Crisis Of Confidence
Another shoe dropped this week in this saga with the state of Michigan suspending a major student-loan program led by the sudden collapse of the estimated $300 billion auction-rate securities market. Auction-rate securities are another one of those complicated securities that seemed to offer something in return for nothing. They are long-term securities that unusually behave like short-term bonds. The securities purportedly offered borrowers, typically tax-exempt local governmental or quasi-governmental authorities – a school district, hospital district or a municipality - a method to borrow long term without paying the relatively higher interest rates that investors usually demand to lend long term. This was achieved by the covenants of the bond that required securities to be auctioned every 7, 28 or 35 days. Investors (typically short term money market funds) did not mind this at all because they got an asset that seemed as good as cash - investors wanting to cash out their bonds could sell it back to the investment banks who subsequently sold it to newer investors – and yielded higher than bank deposits.
Because the borrowers bought insurance from monoline insurance companies that then imparted an investment grade rating to the bonds, investors simply looked at the rating and made their decision. In theory, the market was always running the risk of auctions failing for lack of enough willing buyers... but that possibility seemed very remote. Issuers also ran the risk of invoking the covenant penalty clause that compensated the buyer for the lack of liquidity - if an auction failed, the interest rate that the borrower had to pay jumped up. But since the possibility of the market failing seemed so remote, borrowers continued to pile on the market.
Circa credit crunch 2007. What seemed remote is now reality. With the sub-prime genie out of the box, the creditworthiness of monolines is in serious doubt. Ambac (ABK), MBIA (MBI), FGIC and other monolines have been downgraded by rating agencies and face an imminent danger of having their ratings cut. A rating cut would be akin to a death knell for these monolines. Without their ratings, they would have nothing left to sell.
Also, it is a big big problem for those who bought into those ratings. With not enough buyers to take all the paper that was insured by these monoliners, markets are failing. Investment banks are being forced to take that paper that they helped to sell. Investors' confidence in the financial order seems shaken. Investors no longer trust assurances given to them, having already witnessed what happened to those naive enough to believe that their sub-prime filled toxic waste was safe. A loss of faith and confidence can quickly become a self-fulfilling prophecy. New investors will refrain from parking their money in these auction-rate securities knowing very well that they are not as good as cash, making these securities appear to be even worse investments.
In the last few weeks, a series of auctions have failed, leaving investors stuck with illiquid securities and borrowers facing hefty penalty rates. Fathom this. The Port Authority of New Jersey, which had a failed auction of $100 million last week, saw their interest rates leap from around 4% to 20%! Quick back of the envelope math... that's an extra $300,000 per week. The collapse of this market does not reflect any new problem with the borrowers; the Port Authority is as financial sound today as it was a fortnight ago. Instead this reflects the latest shoe to drop in the broader credit contagion. There are many other bonds from solid issuers that are quoting at over a 10-15% yield, up from 4-5% just a few days ago. Less than 1% of tax-exempt bonds actually default. Most of these are good-quality issuers (some even sovereign), yet the interest rates are higher than CCC junk bonds.
This has obviously put pressure on politicians to act. Eliot Spitzer, the Governor of New York, threatened monolines this week, giving them three to five days to find sufficient capital to resolve the crisis. Or else the state steps in and takes charge. It is in this context that Warren Buffett's offer to take over $800 billion worth of municipal bonds from the monolines seems like a masterstroke.
Buffett's Alchemy
This week, Warren Buffett offered to take over $800 billion worth of the tax-exempt insurance business guaranteed by the troubled big three monolines - MBIA, Ambac and FGIC. Buffett's Berkshire Hathaway Inc. would assume the risk of this debt in exchange for a hefty fee. The offer would exclude the bond insurers' sub-prime related obligations that caused over $5 billion in losses last quarter. According to JP Morgan estimates, a total of $2.4 trillion of debt is insured by the bond insurers, with potential losses ballooning up to $41 billion if the value of this debt continues to decline.
The offer seems like a non-starter at first glance. If the monolines were to actually agree to this deal, they would be ceding the book of business where there is value currently - the fattest, most profitable part of their business - giving up all the unearned premiums on the municipal bonds that they have insured. It would leave them with all the toxic waste from the various structured vehicles insured by them.
The looming prospect of major bond insurers losing their AAA credit rating has dominated the attention of the credit markets, as indeed the stock markets. Until this issue is resolved, states and municipalities will find it tougher and more expensive to borrow. In January, states and localities sold barely $20 billion in bonds, the lowest total for a month in two years, as issuers large and small postponed sales until there was more clarity on the insurers' health. Those municipalities that managed to sell debt are paying more to borrow. Since the middle of January, the yield on the Bond Buyer 20 General Obligation Bond Yield Index has climbed almost 20 basis points, from 4.15 percent to 4.33 percent.
It is important to realize that there are other larger issues at stake as well. If Buffett succeeds, investment banks who are counting on the cash flows from the monoline municipal bond business to offset burgeoning toxic waste losses, would likely get nothing at all. They would thus surely look to step in and recapitalize the insurers, which although expensive, would be less than the losses they stand to incur if the monolines fail. UBS estimates that investment banks around the world could have to write off another $203 billion if the monolines go upside down, in addition to the $150 odd billions already lost.
There are other proposed alternatives. One idea is to break up the monolines into two parts - the good part that holds the tax-exempt insurance business cash cow, and the bad part that gets dumped with all the sub-prime and structured vehicle nonsense. FGIC apparently plans to do just that, having requested the New York state insurance regulators for a license to create a standalone municipal company. The other is for the insurers to raise some capital on their own, albeit a difficult task in partially frozen credit markets. Some even suggest that the government should get involved in order to prevent a major systemic crisis.
In this context, Buffett's proposal would be a win-win situation for Berkshire Hathaway as well as municipal bondholders... though certainly not for the bond insurers and possibly even the investment banks. Having said that, the regulators and the politicians would love to see this happen. Berkshire is one of the few companies with an impeccable AAA rating and it can easily take on the mantle of insuring the pile of debt, allowing issuers to lower their borrowing costs. At the very least, this move could potentially remove some of the systemic risk ("solve the crisis in one stroke of a pen" - Buffett). To us, it seems like a brilliant move in a developing end-game that could checkmate the monolines into giving up the attractive municipal insurance business ("high return, low risk" - Buffett) that Buffett covets so much. He would probably do a much better job of running it in any case. For Berkshire Hathaway and its share-holders, Buffett could just be the alchemist who managed to turn toxic waste laden garbage into gold!
While our call for a rebound in global equities seems to be coming true (Asian equities managed their first weekly gain in 2008), the outlook remains largely unchanged. We view the current rebound as a mere pullback within a longer downtrend. A major sell signal on longer time frames (weekly, monthly and quarterly charts) spread across global indexes and across multiple sectors suggests tougher times ahead for equities. 1400 levels on the S&P 500 will continue to be a formidable resistance in this pullback.
We review the major economic headline this week - a drastic shift in consumer sentiment over the past few weeks that makes a recession now appear increasingly plausible. Although the Fed has dropped is benchmark Fed funds rate by 225 basis points in six months, it has had only limited success in bringing borrowing costs down for consumers and borrowers. Nevertheless, the market believes this failure is the very reason why the Fed will further reduce rates. This negative feedback loop has the Fed pushing on a string in vain. Further, the complete freeze in the relatively obscure auction-rate bond market is the latest shoe to drop in the sub-prime contagion that has now spread world-wide. We finally wrap up with Warren Buffett's keen sense of timing, that could potentially strike gold for Berkshire Hathaway amidst a pile of toxic waste.
The Gloom Is Spreading
The University of Michigan's consumer sentiment index tumbled to 69.6 in its preliminary February reading from 78.4 last month, marking its lowest point since February 1992 when the economy was emerging from a recession. The component of the index that gauges consumers' expectations - a possible sign of their willingness to spend - dropped to to 59.4 from 68.1.
As noted in the chart above, the dip in consumer sentiment is startling. Consumer confidence is now even below the lows seen in 2001-2002 recession and close to its worst levels since the early 1990s, when unemployment rate was up over 7%.
The New York Fed's 'Empire State' index, a widely tracked gauge of manufacturing growth fell for the fourth consecutive month in February to its weakest level since April 2003. The general business conditions index slipped alarmingly to minus 11.72 in February from plus 9.03 the previous month, the first negative reading in almost two years. Readings below zero signal contraction.
These reports are not isolated. Best Buy, the largest U.S. consumer electronics chain, cut its full-year revenue and earnings forecast this week driven by what it termed 'soft domestic customer traffic in January... and weak near-term outlook'. The ABC News/Washington Post Consumer Comfort Index fell to its lowest reading since November 1993. Fewer than half of Americans surveyed rated their own finances positively, again a first since 1993. The Economic Cycle Research Institute [ECRI], a New-York based independent forecasting group, noted that its Weekly Leading Index skidded down to an annualized growth rate of minus 9.1 percent for the week ended February 8, its lowest reading since November 2001.
The evidence favoring a recession is mounting. Economic growth screeched to a 0.6 percent stall in the fourth quarter. A quarterly survey issued by the Philadelphia Federal Reserve suggested a 47 percent probability of contraction in GDP this quarter and a 43 percent chance in the second quarter, levels not seen since the recession in 2001. Economists surveyed by Bloomberg and WSJ earlier this month forecast even odds of a recession. A contracting labor market (payrolls declined for the first time in four years in January) and sharp weakness across the services sector that accounts for 85-90% of the economy (ISM non-manufacturing index fell off a cliff to its lowest since 9/11 ) amplify the chances of the economy turning over into a recession this quarter. The housing slump has only accelerated further over the past few months. Builders broke ground at an annual rate of just over a million homes in December, the fewest since 1991. The National Association of Realtors estimates sales of existing homes fell more than forecast in December, while prices of single-family homes posted the biggest annual drop probably since the Great Depression.
Corporate earnings are also taking a hit. Bloomberg data suggest that the S&P 500 companies that have reported 4Q 2007 earnings thus far posted an average 15 percent decline in earnings. The outlook for the first two quarters of the year is not much better either, with analysts expecting a 1.4 percent and 0.7 percent decline in earnings. The only bastion of hope is the rise in exports, driven by sustained weakness in the dollar and more resilient economic growth abroad. US trade deficit shrunk 6.2 percent to $711.6 billion in 2007 from its record set in 2006, the largest annual percentage drop since 1991 and its first decline in six years. But as global growth falters, partly weighed down by the slowdown in the US, it remains to be seen if there would be enough takers for US exports going forward.
The gloom has spread steadily over the past few months, with the odds of a recession rising as economic data has turned nastier. Former Federal Reserve Chairman Alan Greenspan now believes that the economy is "clearly on the edge", putting the odds of an economic contraction at "50 percent or better", up from his guesstimate of a one-in-three chance just a few months ago. His successor, Ben Bernanke, asserted in a Congressional testimony that policy makers were prepared to lower rates further as the economy hurtles in its downward spiral, vowing to provide "adequate insurance against downside risks." He essentially said, as nearly as a Fed Chairman can, that we were indeed headed towards a recession. The telling statement: "More-expensive and less-available credit seems likely to continue to be a source of restraint on economic growth." This sense of caution, despite the "substantive additional action" of a 125 bps rate cutting blitzkrieg in January - the fastest pace of monetary policy easing in over two decades - will only serve to heighten anxiety in the minds of market participants.
History has taught us that economies do not normally slip gradually into recession; they plunge spectacularly as they turn over. This usually creates glaring discontinuities in the incoming economic data, of the sort clearly on display in the survey reports of the past few weeks. A degree of panic seems to have set in that could possibly tip the scales in a stalling economy, pushing it into a free fall.
Pushing On A String
Let's recall that statement from Bernanke again... "more-expensive or less-available credit seems likely to continue to be a source of restraint on economic growth" We know where this is coming from, with the Fed having cut the Fed funds rate by 225 basis points in six months. But deteriorating credit conditions have undone pretty much most of what the Fed has done. The yield on Baa corporate bonds – a better measure of what drives actual business spending than the Fed funds target rate - has stayed largely constant, widening its spread over the Fed funds rate.
Data compiled by Merrill Lynch suggests that companies are paying more to borrow now than before the aggressive Fed rate cuts in January. Rates on so-called jumbo mortgages – mortgages with a value of over $417,000 and those not guaranteed by Fannie Mae and Freddie Mac - have increased in the past month, according to Bloomberg. Lenders and investors alike are demanding greater compensation for offering credit as losses continue to mount on sub-prime mortgage securities amid concerns of a cut in credit ratings of bond insurers. The increase in credit spreads has contrarily resulted in an effective tightening of financial conditions that the rate cuts were partly meant to address. It is as if the Fed were pushing on a string. The market perceives elevated borrowing costs will force the Fed to make further rate cuts, thereby reinforcing the "negative feedback loop" that has been in vogue all through this crisis. Traders now place a 100% chance of at least a 50 bps rate cut on or before the FOMC meeting on March 18.
A crisis that began with loans made to a small group of home-buyers with shaky credit has disrupted pretty much the entire financial ecosphere. Indeed, small towns in far-flung Norway have lost money due to the sub-prime contagion in the US. It has proved to be much more than a credit crunch... it has become a crisis of confidence.
Crisis Of Confidence
Another shoe dropped this week in this saga with the state of Michigan suspending a major student-loan program led by the sudden collapse of the estimated $300 billion auction-rate securities market. Auction-rate securities are another one of those complicated securities that seemed to offer something in return for nothing. They are long-term securities that unusually behave like short-term bonds. The securities purportedly offered borrowers, typically tax-exempt local governmental or quasi-governmental authorities – a school district, hospital district or a municipality - a method to borrow long term without paying the relatively higher interest rates that investors usually demand to lend long term. This was achieved by the covenants of the bond that required securities to be auctioned every 7, 28 or 35 days. Investors (typically short term money market funds) did not mind this at all because they got an asset that seemed as good as cash - investors wanting to cash out their bonds could sell it back to the investment banks who subsequently sold it to newer investors – and yielded higher than bank deposits.
Because the borrowers bought insurance from monoline insurance companies that then imparted an investment grade rating to the bonds, investors simply looked at the rating and made their decision. In theory, the market was always running the risk of auctions failing for lack of enough willing buyers... but that possibility seemed very remote. Issuers also ran the risk of invoking the covenant penalty clause that compensated the buyer for the lack of liquidity - if an auction failed, the interest rate that the borrower had to pay jumped up. But since the possibility of the market failing seemed so remote, borrowers continued to pile on the market.
Circa credit crunch 2007. What seemed remote is now reality. With the sub-prime genie out of the box, the creditworthiness of monolines is in serious doubt. Ambac (ABK), MBIA (MBI), FGIC and other monolines have been downgraded by rating agencies and face an imminent danger of having their ratings cut. A rating cut would be akin to a death knell for these monolines. Without their ratings, they would have nothing left to sell.
Also, it is a big big problem for those who bought into those ratings. With not enough buyers to take all the paper that was insured by these monoliners, markets are failing. Investment banks are being forced to take that paper that they helped to sell. Investors' confidence in the financial order seems shaken. Investors no longer trust assurances given to them, having already witnessed what happened to those naive enough to believe that their sub-prime filled toxic waste was safe. A loss of faith and confidence can quickly become a self-fulfilling prophecy. New investors will refrain from parking their money in these auction-rate securities knowing very well that they are not as good as cash, making these securities appear to be even worse investments.
In the last few weeks, a series of auctions have failed, leaving investors stuck with illiquid securities and borrowers facing hefty penalty rates. Fathom this. The Port Authority of New Jersey, which had a failed auction of $100 million last week, saw their interest rates leap from around 4% to 20%! Quick back of the envelope math... that's an extra $300,000 per week. The collapse of this market does not reflect any new problem with the borrowers; the Port Authority is as financial sound today as it was a fortnight ago. Instead this reflects the latest shoe to drop in the broader credit contagion. There are many other bonds from solid issuers that are quoting at over a 10-15% yield, up from 4-5% just a few days ago. Less than 1% of tax-exempt bonds actually default. Most of these are good-quality issuers (some even sovereign), yet the interest rates are higher than CCC junk bonds.
This has obviously put pressure on politicians to act. Eliot Spitzer, the Governor of New York, threatened monolines this week, giving them three to five days to find sufficient capital to resolve the crisis. Or else the state steps in and takes charge. It is in this context that Warren Buffett's offer to take over $800 billion worth of municipal bonds from the monolines seems like a masterstroke.
Buffett's Alchemy
This week, Warren Buffett offered to take over $800 billion worth of the tax-exempt insurance business guaranteed by the troubled big three monolines - MBIA, Ambac and FGIC. Buffett's Berkshire Hathaway Inc. would assume the risk of this debt in exchange for a hefty fee. The offer would exclude the bond insurers' sub-prime related obligations that caused over $5 billion in losses last quarter. According to JP Morgan estimates, a total of $2.4 trillion of debt is insured by the bond insurers, with potential losses ballooning up to $41 billion if the value of this debt continues to decline.
The offer seems like a non-starter at first glance. If the monolines were to actually agree to this deal, they would be ceding the book of business where there is value currently - the fattest, most profitable part of their business - giving up all the unearned premiums on the municipal bonds that they have insured. It would leave them with all the toxic waste from the various structured vehicles insured by them.
The looming prospect of major bond insurers losing their AAA credit rating has dominated the attention of the credit markets, as indeed the stock markets. Until this issue is resolved, states and municipalities will find it tougher and more expensive to borrow. In January, states and localities sold barely $20 billion in bonds, the lowest total for a month in two years, as issuers large and small postponed sales until there was more clarity on the insurers' health. Those municipalities that managed to sell debt are paying more to borrow. Since the middle of January, the yield on the Bond Buyer 20 General Obligation Bond Yield Index has climbed almost 20 basis points, from 4.15 percent to 4.33 percent.
It is important to realize that there are other larger issues at stake as well. If Buffett succeeds, investment banks who are counting on the cash flows from the monoline municipal bond business to offset burgeoning toxic waste losses, would likely get nothing at all. They would thus surely look to step in and recapitalize the insurers, which although expensive, would be less than the losses they stand to incur if the monolines fail. UBS estimates that investment banks around the world could have to write off another $203 billion if the monolines go upside down, in addition to the $150 odd billions already lost.
There are other proposed alternatives. One idea is to break up the monolines into two parts - the good part that holds the tax-exempt insurance business cash cow, and the bad part that gets dumped with all the sub-prime and structured vehicle nonsense. FGIC apparently plans to do just that, having requested the New York state insurance regulators for a license to create a standalone municipal company. The other is for the insurers to raise some capital on their own, albeit a difficult task in partially frozen credit markets. Some even suggest that the government should get involved in order to prevent a major systemic crisis.
In this context, Buffett's proposal would be a win-win situation for Berkshire Hathaway as well as municipal bondholders... though certainly not for the bond insurers and possibly even the investment banks. Having said that, the regulators and the politicians would love to see this happen. Berkshire is one of the few companies with an impeccable AAA rating and it can easily take on the mantle of insuring the pile of debt, allowing issuers to lower their borrowing costs. At the very least, this move could potentially remove some of the systemic risk ("solve the crisis in one stroke of a pen" - Buffett). To us, it seems like a brilliant move in a developing end-game that could checkmate the monolines into giving up the attractive municipal insurance business ("high return, low risk" - Buffett) that Buffett covets so much. He would probably do a much better job of running it in any case. For Berkshire Hathaway and its share-holders, Buffett could just be the alchemist who managed to turn toxic waste laden garbage into gold!
Sunday, February 17, 2008
Notes for Barron's Feb. 16th 2008
1.Short interests are very low, which indicates more down side
2.New site for investing: Marketswiki, checked out, very interesting
3.Phases of the Bear
a.The leaders narrows
b.The leaders turns down dramatically, while the broad market stabilizes
c.Everyone gets hurt, it doesn’t end until there is blood in the streets
2.New site for investing: Marketswiki, checked out, very interesting
3.Phases of the Bear
a.The leaders narrows
b.The leaders turns down dramatically, while the broad market stabilizes
c.Everyone gets hurt, it doesn’t end until there is blood in the streets
Friday, February 15, 2008
Online Money Managment Site
To Track your money
Moneycenter.yodlee.com
mint.com
expensr.com
To Exchange Ideas
savingadvice.com
To improve bottom line
comsumerismcommentary.com
getrichslowly.org
Moneycenter.yodlee.com
mint.com
expensr.com
To Exchange Ideas
savingadvice.com
To improve bottom line
comsumerismcommentary.com
getrichslowly.org
Analyze Today's Yield Curve
There are many things that are unusual about the current Treasury yield curve. I've built a moderately-sized model to analyze the shape of the curve, and what it might tell us about the state of the economy, and perhaps, future movements of the yield curve. My model uses the smoothed data from the Federal Reserve H15 series, which dates as far back as 1962, though some series, like the 30-year, date back to 1977, and have an interruption from 2002-2005, after the 30-year ceased to be issued for a time. So, what's unusual about the current yield curve? The slope of six months to three months (19 bp) is very inverted — a first percentile phenomenon. The slope of two years to three months (38 bp) is very inverted — a third percentile phenomenon. The slope of seven years to ten years is steep (57 bp - 5 bp away from the record wide) — a 100th percentile phenomenon. The slope of five years to thirty years is steep (186 bp - 30 bp away from the record wide) — a 100th percentile phenomenon. The slope of two years to thirty years is steep (274 bp - 97 bp away from the record wide) — a 97th percentile phenomenon. The slope of ten years to thirty years is steep (82 bp - 29 bp away from the record wide) — a 98th percentile phenomenon. The butterfly of three months to two years to thirty years is at the record wide (312 bp). (Sum of #5 and #2. Buy 3 months and 30-years, and double sell 2-years? Lots of positive carry, but the 30-year yield could steepen further versus the rest of the curve, and its price volatility is much higher than the shorter bonds.) What prior yield curves is the current yield curve shaped like? 9/7/1993 — after the end of the 1990-1992 easing cycle to rescue the banks from their commercial real estate loans. 2/15/1996 — after the end of a minor easing cycle, recovering from the 1994 "annus horribilis" for bonds. 9/14/2001 — 60% through the massive easing cycle where Greenspan overshot Fed policy in an effort to reliquefy the economy, particularly industrial companies that were in trouble. Also days after 9/11, when the Fed promised whatever liquidity the market might need to stave off the crisis.
Okay, I've set the stage. What conclusions might we draw from the current shape of the yield curve? The curve is forecasting a 2% Fed funds rate in 2008. Fed policy is adequate at present to reliquefy the economy; the Fed doesn't need to ease more, but it will anyway. Political pressure will make that inevitable. (If we really want an independent central bank, let's eliminate the pressure oversight that Congress has over the Fed.
Better, let's go back to a gold standard; a truly private monetary policy. Oh, wait. I'm behind the times. We don't want an independent central bank. Dos that mean we can now blame Congress for monetary policy errors?)
We could see a record slope for the yield curve (in the post Bretton Woods era) if the Fed persists in its easing policies. One can sell sevens and buy tens, dollar-duration-weighted and have positive carry. Assuming one can hold onto the position, it would be hard to lose at these levels, if the last thirty years of history is an adequate guide to the full range of possibilities. The Fed is planting the seeds of its next tightening cycle now. Every cut from here will make the tightening cycle that much more intense. The curve can get steeper from here, but it is getting close to the boundaries where strange things begin to happen. The Fed is not omnipotent, and the steepening curve is evidence of that. As I have said before, recently, the US Dollar is no longer a "sell" for now. The anticipation of Fed funds cuts is already factored in, and even if we get down to 2%, I suspect that we can't go much lower because of negative real interest rates and rising inflation. That's where I stand for now. The Fed is trying to rescue the economy from asset deflation, much like 1990-1992, but will run into the buzzsaw of price inflation, and tighten a la 1994. Conditions in the real economy are not as weak today as they were in 2001, but the banks are in worse shape. That will drive further loosening by the Fed, until inflation is intolerable.
Okay, I've set the stage. What conclusions might we draw from the current shape of the yield curve? The curve is forecasting a 2% Fed funds rate in 2008. Fed policy is adequate at present to reliquefy the economy; the Fed doesn't need to ease more, but it will anyway. Political pressure will make that inevitable. (If we really want an independent central bank, let's eliminate the pressure oversight that Congress has over the Fed.
Better, let's go back to a gold standard; a truly private monetary policy. Oh, wait. I'm behind the times. We don't want an independent central bank. Dos that mean we can now blame Congress for monetary policy errors?)
We could see a record slope for the yield curve (in the post Bretton Woods era) if the Fed persists in its easing policies. One can sell sevens and buy tens, dollar-duration-weighted and have positive carry. Assuming one can hold onto the position, it would be hard to lose at these levels, if the last thirty years of history is an adequate guide to the full range of possibilities. The Fed is planting the seeds of its next tightening cycle now. Every cut from here will make the tightening cycle that much more intense. The curve can get steeper from here, but it is getting close to the boundaries where strange things begin to happen. The Fed is not omnipotent, and the steepening curve is evidence of that. As I have said before, recently, the US Dollar is no longer a "sell" for now. The anticipation of Fed funds cuts is already factored in, and even if we get down to 2%, I suspect that we can't go much lower because of negative real interest rates and rising inflation. That's where I stand for now. The Fed is trying to rescue the economy from asset deflation, much like 1990-1992, but will run into the buzzsaw of price inflation, and tighten a la 1994. Conditions in the real economy are not as weak today as they were in 2001, but the banks are in worse shape. That will drive further loosening by the Fed, until inflation is intolerable.
Wednesday, February 13, 2008
Some Trading Tips
• Tighten stops. If other stocks in the same industry begin trending down, then tighten the stop in the stock you own in that industry. If your stock shoots up several points in a few days, then tighten the stop because price may reverse and retrace much of the gain.
• Trade with the trend. If the market and industry are moving up, select stocks with upward breakouts. Avoid counter-trend trades - the market or the industry is going down and your stock is moving up. The rise will be less than you expect unless the market or industry reverses. If you buy a stock even though the market is trending lower, that’s fine providing you expect the market to reverse shortly. Just hope that you don’t get stopped out while waiting.
• Trade on the intraday scale. Switch to the intraday scale or the next shorter period to place the trade. The shorter time scale will zoom into the price action and highlight support and resistance zones. I use the one- and five-minute scales to time my entry.
• Raise that stop as price rises. Check the volatility and place the stop no closer than 1.5 times the current price volatility.
• Never lower a stop. If you feel a desire to lower a stop, sell the stock. Fall in love, just never with a stock.
• Follow the same stocks each day. Become familiar with them. Don’t invest in unfamiliar stocks. Over time, you’ll know when the stock is expensive and when it’s cheap. That voice will tell you when to buy and sell.
• Trading takes work. You have to believe the system you trade or you’ll ignore the signals. Explore new techniques that add value to your system and prune the deadwood as it becomes less effective.
• Check commodities. I follow oil, copper, and natural gas because so many of the industries I track rely on them. If the price of oil is shooting up, the airlines, truckers, and chemicals may suffer but oil service companies, refiners, and drillers should prosper.
• Tune your system. The markets change over time and so should your system and your trading style. When the markets are choppy, directionless, I make short-term trades. When the market is trending, I relax and my hold time increases.
• Ignore chat room chatter. Some of the worst trades I’ve made come from scenario trading. I’d read that the price of oil was predicted to rise because of a production shortage. Then I’d buy a refiner and get cleaned out when the price of oil dropped instead. Don’t restrict this advice to the Internet chat room. Apply it to newspaper articles and television news as well. Don’t trade scenarios. Buy-and-hold investors may do well with scenarios, but they can wait years.
• If you have to ask, you’re making a mistake. If you have doubts about a trade, such that you feel compelled to ask someone’s opinion about it, then skip the trade. Don’t let others spend your money.
• Set price targets. With experience, you’ll be able to tell when price is about to turn. Use the measure rule for the chart pattern (usually the pattern’s height added to the breakout price) to predict a price target. For more conservative targets, use half the formation height projected upward. If the target and overhead resistance are nearly the same, then you’ve struck gold. Place a sell order to dump the stock just below the resistance zone. You may be early, but you never go broke taking a profit.
• Watch for a throwback or pullback. Prices turn postbreakout in an average of 3 days and return to the breakout usually in 10 or 11 days, so watch for that. Have faith that prices will resume the original breakout direction-they do-86% of the time.
• Don’t short a stock. If you can’t make money on the long side, you won’t make it on the short side either. Try it on paper first.
• Prices drop faster than they rise. I found this out when I reviewed the statistics measuring the time from the breakout to the ultimate high or low. Price trends after downward breakouts were quicker and steeper than their upward counterparts. This emphasizes the need to use stops to get out. If you can’t sell, your losses will grow quickly.
• Price reverses one month after the breakout in a bear market. This is also true in a bull market, but less often. The one-month benchmark also varies from pattern to pattern. It’s rarely shorter, but often longer-five to seven weeks after the breakout. I found a slight rise in the number of patterns reaching the ultimate low a month after the breakout, so don’t expect price to turn on a dime every time.
• Price moves most in the first week after a breakout. I discovered this when looking at failure rates. This emphasizes the need to get in early after a breakout. The best way is to have a buy order positioned a penny above the breakout price. That will get you in early and you won’t have to worry as much about throwbacks taking you out.
• Trade with the trend. If the market and industry are moving up, select stocks with upward breakouts. Avoid counter-trend trades - the market or the industry is going down and your stock is moving up. The rise will be less than you expect unless the market or industry reverses. If you buy a stock even though the market is trending lower, that’s fine providing you expect the market to reverse shortly. Just hope that you don’t get stopped out while waiting.
• Trade on the intraday scale. Switch to the intraday scale or the next shorter period to place the trade. The shorter time scale will zoom into the price action and highlight support and resistance zones. I use the one- and five-minute scales to time my entry.
• Raise that stop as price rises. Check the volatility and place the stop no closer than 1.5 times the current price volatility.
• Never lower a stop. If you feel a desire to lower a stop, sell the stock. Fall in love, just never with a stock.
• Follow the same stocks each day. Become familiar with them. Don’t invest in unfamiliar stocks. Over time, you’ll know when the stock is expensive and when it’s cheap. That voice will tell you when to buy and sell.
• Trading takes work. You have to believe the system you trade or you’ll ignore the signals. Explore new techniques that add value to your system and prune the deadwood as it becomes less effective.
• Check commodities. I follow oil, copper, and natural gas because so many of the industries I track rely on them. If the price of oil is shooting up, the airlines, truckers, and chemicals may suffer but oil service companies, refiners, and drillers should prosper.
• Tune your system. The markets change over time and so should your system and your trading style. When the markets are choppy, directionless, I make short-term trades. When the market is trending, I relax and my hold time increases.
• Ignore chat room chatter. Some of the worst trades I’ve made come from scenario trading. I’d read that the price of oil was predicted to rise because of a production shortage. Then I’d buy a refiner and get cleaned out when the price of oil dropped instead. Don’t restrict this advice to the Internet chat room. Apply it to newspaper articles and television news as well. Don’t trade scenarios. Buy-and-hold investors may do well with scenarios, but they can wait years.
• If you have to ask, you’re making a mistake. If you have doubts about a trade, such that you feel compelled to ask someone’s opinion about it, then skip the trade. Don’t let others spend your money.
• Set price targets. With experience, you’ll be able to tell when price is about to turn. Use the measure rule for the chart pattern (usually the pattern’s height added to the breakout price) to predict a price target. For more conservative targets, use half the formation height projected upward. If the target and overhead resistance are nearly the same, then you’ve struck gold. Place a sell order to dump the stock just below the resistance zone. You may be early, but you never go broke taking a profit.
• Watch for a throwback or pullback. Prices turn postbreakout in an average of 3 days and return to the breakout usually in 10 or 11 days, so watch for that. Have faith that prices will resume the original breakout direction-they do-86% of the time.
• Don’t short a stock. If you can’t make money on the long side, you won’t make it on the short side either. Try it on paper first.
• Prices drop faster than they rise. I found this out when I reviewed the statistics measuring the time from the breakout to the ultimate high or low. Price trends after downward breakouts were quicker and steeper than their upward counterparts. This emphasizes the need to use stops to get out. If you can’t sell, your losses will grow quickly.
• Price reverses one month after the breakout in a bear market. This is also true in a bull market, but less often. The one-month benchmark also varies from pattern to pattern. It’s rarely shorter, but often longer-five to seven weeks after the breakout. I found a slight rise in the number of patterns reaching the ultimate low a month after the breakout, so don’t expect price to turn on a dime every time.
• Price moves most in the first week after a breakout. I discovered this when looking at failure rates. This emphasizes the need to get in early after a breakout. The best way is to have a buy order positioned a penny above the breakout price. That will get you in early and you won’t have to worry as much about throwbacks taking you out.
Tuesday, February 12, 2008
Should we rely on history?
The proper questions to ask are: How are things changing, and how does the trading strategy need to evolve to adapt. A dogmatic approach will not lead to good analysis and will lead to mistakes. Things are changing from the 2003-06 regime.
1. Volatility is up.2. Global influences are greater3. Governmental influences are increasing.4. The industry is consolidating and shifting to electronic.
Time series sample selection in data becomes more important since last year. The idea of regimes being helpful in cycle analysis.
1. Volatility is up.2. Global influences are greater3. Governmental influences are increasing.4. The industry is consolidating and shifting to electronic.
Time series sample selection in data becomes more important since last year. The idea of regimes being helpful in cycle analysis.
Monday, February 11, 2008
Here comes a big bull
Dow 15,000: It Will Be Here Sooner Than You Think
I know. I write stuff like this and I get accused of (yes, rampant) drug use. Ironically, I am one of the few people I know who can honestly say that I’ve never indulged.
So right after I pen some craziness, I always say the same thing: Hear me out.
A recent Merrill Lynch report is calling for a 15% drop in housing prices in the coming year. The fed cut this week and will cut again next week. What does all this mean? Simply, that real estate, bonds, and interest bearing accounts will be lousy investments this coming year.
There is a theory (one I subscribe to) that the stock market would have been much higher over the last few years except that housing and commodities were too hot of an investment… so housing and commodities was where the money flows went.
With cooling (not freezing, cooling) housing, cooling jobs, both housing and commodities are beginning to move downward. Certainly, there will not be big returns to be had in either in 2008. So money will be moving to where money can be made: stocks.
Stock valuations are still historically low. We could easily move to 15,000 and still have reasonable market P/E, and stock-price-to-corporate cash valuations that are well within historical ranges. Further, valuations combined with lower interest rates will continue to drive M&A.
So the Dow will easily get to 15,000 by year’s end.
“But what about the economy?” What about it? The stock market and the economy are not the same thing, sometimes they move in lock step, and sometimes they don’t. Remember in 03 and 04 when we had our ‘jobless recovery’? Markets did great and the economy did only pretty good. Look for that again this year.
So what to buy? Right now: Money Center Banks and Brokerages. For two reasons: First, they have been crushed, and the worst is over. These stocks will move up in anticipation of improving valuations, and once valuations improve (think 3Q) the stocks will go up some more. Second, it’s volatile times like these that drive scared, stressed, confused investors into the waiting arms of their broker. Expect record earnings from that part of the business.
Speaking of housing, one pet peeve: Falling housing prices are the headline of the day, and every person I talk to is concerned about it. And I always say the same thing: Are you selling your house this year? No? Then what the hell do you care? This doesn’t affect you.” Stay diversified, even if it’s just a 401k. There will be money to be made in stocks this year and money will be made in housing another year. Over time, everything goes up in value, so relax… and unless you just want to be depressed, turn off the 24 hour depression machine known as cable news.
PS. There will be a ton of volatility in the market between now and election day. Then a 10% move up if a Republican is elected and a smaller, muted move if a Democrat is elected (markets like gridlock and the Dems will continue to hold both chambers of Congress).
I know. I write stuff like this and I get accused of (yes, rampant) drug use. Ironically, I am one of the few people I know who can honestly say that I’ve never indulged.
So right after I pen some craziness, I always say the same thing: Hear me out.
A recent Merrill Lynch report is calling for a 15% drop in housing prices in the coming year. The fed cut this week and will cut again next week. What does all this mean? Simply, that real estate, bonds, and interest bearing accounts will be lousy investments this coming year.
There is a theory (one I subscribe to) that the stock market would have been much higher over the last few years except that housing and commodities were too hot of an investment… so housing and commodities was where the money flows went.
With cooling (not freezing, cooling) housing, cooling jobs, both housing and commodities are beginning to move downward. Certainly, there will not be big returns to be had in either in 2008. So money will be moving to where money can be made: stocks.
Stock valuations are still historically low. We could easily move to 15,000 and still have reasonable market P/E, and stock-price-to-corporate cash valuations that are well within historical ranges. Further, valuations combined with lower interest rates will continue to drive M&A.
So the Dow will easily get to 15,000 by year’s end.
“But what about the economy?” What about it? The stock market and the economy are not the same thing, sometimes they move in lock step, and sometimes they don’t. Remember in 03 and 04 when we had our ‘jobless recovery’? Markets did great and the economy did only pretty good. Look for that again this year.
So what to buy? Right now: Money Center Banks and Brokerages. For two reasons: First, they have been crushed, and the worst is over. These stocks will move up in anticipation of improving valuations, and once valuations improve (think 3Q) the stocks will go up some more. Second, it’s volatile times like these that drive scared, stressed, confused investors into the waiting arms of their broker. Expect record earnings from that part of the business.
Speaking of housing, one pet peeve: Falling housing prices are the headline of the day, and every person I talk to is concerned about it. And I always say the same thing: Are you selling your house this year? No? Then what the hell do you care? This doesn’t affect you.” Stay diversified, even if it’s just a 401k. There will be money to be made in stocks this year and money will be made in housing another year. Over time, everything goes up in value, so relax… and unless you just want to be depressed, turn off the 24 hour depression machine known as cable news.
PS. There will be a ton of volatility in the market between now and election day. Then a 10% move up if a Republican is elected and a smaller, muted move if a Democrat is elected (markets like gridlock and the Dems will continue to hold both chambers of Congress).
Sunday, February 10, 2008
Notes of Barron's Feb. 9, 2008
Jeremy Grantham is bearish and here is his prediction:
SP's trend line should be 1100 in 2010, market will then reach bottom and take off from there.
He is bullish on JPY, Singapore dollar and Swiss Franc.
His position is: 50% long US blue chips, 50% emerging market, and 100% short on Russell 2000.
To mark his words and position, here is the current level of Russell 2000, Emerging market and DOW:
RUT 698
DJ 12182
EEM 132
Personally, I don't think US market is as bad as he think and also EEM won't outperform US market in the next 12 months, so let's mark the post and will come back in Feb. 2009.
SP's trend line should be 1100 in 2010, market will then reach bottom and take off from there.
He is bullish on JPY, Singapore dollar and Swiss Franc.
His position is: 50% long US blue chips, 50% emerging market, and 100% short on Russell 2000.
To mark his words and position, here is the current level of Russell 2000, Emerging market and DOW:
RUT 698
DJ 12182
EEM 132
Personally, I don't think US market is as bad as he think and also EEM won't outperform US market in the next 12 months, so let's mark the post and will come back in Feb. 2009.
Saturday, February 9, 2008
A Brief History of Recession Time
There have been 7 more recessions since 1950. The median decline in real GDP for the 8 slumps has been 1.91%; their average duration has been 10 1/2 months.
Aug.1957 - Apr. 1958 8 months -3.75%
Apr. 1960 - Feb. 1961 10 months -1.64%
Dec. 1969 - Nov. 1970 11 months -0.64%
Nov. 1973 - Mar 1975 16 months -3.10%
Jan 1980 - Jul 1980 6 months -2.18%
Jul 1981 - Nov 1982 16 months -2.87%
Jul 1990 - Mar 1991 8 months -1.26%
Mar 2001 - Nov 2001 8 months -0.17%
It would be nice to have the corresponding Market stats.
Aug.1957 - Apr. 1958 8 months -3.75%
Apr. 1960 - Feb. 1961 10 months -1.64%
Dec. 1969 - Nov. 1970 11 months -0.64%
Nov. 1973 - Mar 1975 16 months -3.10%
Jan 1980 - Jul 1980 6 months -2.18%
Jul 1981 - Nov 1982 16 months -2.87%
Jul 1990 - Mar 1991 8 months -1.26%
Mar 2001 - Nov 2001 8 months -0.17%
It would be nice to have the corresponding Market stats.
Market Technician Calls That I don't agree
RICHARD RHODES: BULL MARKET IS OVER
“The bull market is over; the Dow Industrials broke below its major bull market trendline extending from the 1982 bear market lows through the 2002 bear market lows. Obviously, one cannot take this lightly, as last week’s negative price action was more of a bear market “exclamation point” intended to say that from this point forward - rallies are to be sold and sold hard. However, it would appear the initial decline is coming to an end quite soon; the 30-month moving average crosses at 12,038 and was successfully tested on Friday. Too, the previous highs all-time highs at 11,500 are just below current levels. The 9-month RSI is approaching levels that in the past have coincided with bull market correction bottoms and bear market bottoms. Thus, the risk-reward profile for the Dow is changing in the short-term from bearish to ‘flat’ and will ultimately turn to bullish. But, remembering that the trend is lower… rallies will be short-lived.”
CARL SWENLIN: BEAR MARKET RULES APPLY
“On January 8 the 50-EMA crossed down through the 200-EMA on the S&P 500 daily chart, generating a long-term sell signal and declaring that we are now in a bear market. This was confirmed this week when the weekly 17-EMA crossed down through the 43-EMA. Let me say that these signals are not 100% reliable, but there is a ton of additional supporting evidence, such as the decisive violation of the long-term rising trend line, and the violation of the double top neckline, seen on the chart below.”
“An important point is that this long-term sell signal is not so much an action signal as it is an information signal. What this means is that we need to begin interpreting charts and indicators in the context of a bear market template. For example:
- Oversold conditions should be viewed as extremely dangerous. Whereas in bull markets oversold lows usually present buying opportunities, in bear markets they can often resolve into more heavy selling.
- Overbought conditions in a bear market are most likely to signal that a trading top is at hand.
- While bear market rallies present great profit opportunities, long positions should be managed as short-term only.
The questions remain as to how far down prices will go and how long the bear market will last? In the shorter term we have a minimum downside projection from the double top neckline of about 1160 on the S&P 500 Index. That could mark a medium-term low from which a bear market rally could rise. For the longer-term, let’s look at the 4-Year Cycle chart below. As you can see, the last cycle low was in mid-2006, so the next projected low is in mid-2010. Assuming that the cycle low and bear market low will be the same, we have a long, bloody road ahead. The most obvious downside target is the support at the 2002 lows, about 750 on the S&P 500.”
Let's mark their words and see what happens
“The bull market is over; the Dow Industrials broke below its major bull market trendline extending from the 1982 bear market lows through the 2002 bear market lows. Obviously, one cannot take this lightly, as last week’s negative price action was more of a bear market “exclamation point” intended to say that from this point forward - rallies are to be sold and sold hard. However, it would appear the initial decline is coming to an end quite soon; the 30-month moving average crosses at 12,038 and was successfully tested on Friday. Too, the previous highs all-time highs at 11,500 are just below current levels. The 9-month RSI is approaching levels that in the past have coincided with bull market correction bottoms and bear market bottoms. Thus, the risk-reward profile for the Dow is changing in the short-term from bearish to ‘flat’ and will ultimately turn to bullish. But, remembering that the trend is lower… rallies will be short-lived.”
CARL SWENLIN: BEAR MARKET RULES APPLY
“On January 8 the 50-EMA crossed down through the 200-EMA on the S&P 500 daily chart, generating a long-term sell signal and declaring that we are now in a bear market. This was confirmed this week when the weekly 17-EMA crossed down through the 43-EMA. Let me say that these signals are not 100% reliable, but there is a ton of additional supporting evidence, such as the decisive violation of the long-term rising trend line, and the violation of the double top neckline, seen on the chart below.”
“An important point is that this long-term sell signal is not so much an action signal as it is an information signal. What this means is that we need to begin interpreting charts and indicators in the context of a bear market template. For example:
- Oversold conditions should be viewed as extremely dangerous. Whereas in bull markets oversold lows usually present buying opportunities, in bear markets they can often resolve into more heavy selling.
- Overbought conditions in a bear market are most likely to signal that a trading top is at hand.
- While bear market rallies present great profit opportunities, long positions should be managed as short-term only.
The questions remain as to how far down prices will go and how long the bear market will last? In the shorter term we have a minimum downside projection from the double top neckline of about 1160 on the S&P 500 Index. That could mark a medium-term low from which a bear market rally could rise. For the longer-term, let’s look at the 4-Year Cycle chart below. As you can see, the last cycle low was in mid-2006, so the next projected low is in mid-2010. Assuming that the cycle low and bear market low will be the same, we have a long, bloody road ahead. The most obvious downside target is the support at the 2002 lows, about 750 on the S&P 500.”
Let's mark their words and see what happens
Sunday, February 3, 2008
Bear Market
1. There is no such thing as a bear market, only markets that have gone down a lot from a previous high in a reasonable time frame.
2. The market had its best week in 5 years two weeks after having the worst week in 5 years.
3. When the vol rises to above 30, expect a 1-2% gain in next two days with say a 90% prob.
4. The differential between the discount rate and the 10 year rate is an excellent predictor of short and long term movements in the market.
5. The market likes to set a big minimum at the beginning of the week and all the limits downs have occured on such days.
6. The knowledge of a big forced seller in the market will filter out and effect everything and the market will go to unprecedented low levels until the sales are requited.
7. The Fed chair thanked Milton Friedman for insuring with his research that the Fed would never again cause a depression by tightening the money supply during a time of economic doldrum and we may thank Milton Friedman and the Fed chair, and Mr Kerviel for insuring that no such depression or recession will be induced again by such activity.
8. The market will go back up along the same path that it went down. i.e. Lobagola lives. (Remember Lobagola's story about the elephants).
9. Buy and hold must not be leveraged too high for it to work .
10. The tried and true patterns are the most dangerous during times of crisis. (Beware of patterns with a 90% chance of success).
2. The market had its best week in 5 years two weeks after having the worst week in 5 years.
3. When the vol rises to above 30, expect a 1-2% gain in next two days with say a 90% prob.
4. The differential between the discount rate and the 10 year rate is an excellent predictor of short and long term movements in the market.
5. The market likes to set a big minimum at the beginning of the week and all the limits downs have occured on such days.
6. The knowledge of a big forced seller in the market will filter out and effect everything and the market will go to unprecedented low levels until the sales are requited.
7. The Fed chair thanked Milton Friedman for insuring with his research that the Fed would never again cause a depression by tightening the money supply during a time of economic doldrum and we may thank Milton Friedman and the Fed chair, and Mr Kerviel for insuring that no such depression or recession will be induced again by such activity.
8. The market will go back up along the same path that it went down. i.e. Lobagola lives. (Remember Lobagola's story about the elephants).
9. Buy and hold must not be leveraged too high for it to work .
10. The tried and true patterns are the most dangerous during times of crisis. (Beware of patterns with a 90% chance of success).
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