The Song Remains the Same

"Feeling good, Winthorp!" ~ Billy Ray Brown, "Trading Places"

Last week, I seriously thought that TRB might be going the way of the dodo (bad sushi = bad times), but I'm back with a spring in my step and a twinkle in my eye as I look towards the 80 degree weather that's in store for us up here.  The good news?  Golf is in the air.  The bad news?  My lawn is in terrible shape.  It's absolutely embarrassing.  If there was any doubt to my neighbors that I'm a city boy, this should do the trick!  Hopefully I'll be able to tackle both my swing and my lawn this weekend as both are in similar disrepair. 

Anyway, on to the markets.  Honestly, I wish I had something brand spanking new to say here, but I'm afraid I'm going to sound like a broken record.  The equity market, on the surface, has been acting well for the past couple of months.  This week it fell for the first week in the past 7, and not by very much when all was said and done.  In my opinion, while the first 4 weeks of the rally were very well supported by fundamentals and market internals, I think that the quality of the upward thrust of the past couple of weeks has been somewhat suspect.  I'm going to go out on a limb and say this: the old trader's adage "sell in May and go away" will be prescient this year.  

It seems as if the bank "stress test" is what completely dominated the market psyche this week, which when you really look at it, is kind of stupid if you asked me.  On Monday, equities really took it on the chin when a report suggested that of the 19 banks undergoing the test, 16 would be shown as being "insolvent" under stressed conditions.  Then the market got a boost the next day when Treasury Secretary Geithner said that the majority of the banks had more than enough capital.  On Friday, the press cited the release of the RULES of the stress test (and earnings, which I'll get to in a sec) as the reasons for the rally. 

Regarding Monday, the assumption that 16 of the 19 banks would be insolvent seems REALLY aggressive (although, I guess we can't rule anything out these days).  Regarding Geithner's comments, the question really lies with what set of banks to which he was really referring. Was he saying that most of the banks in the USA (the vast majority of which are small community banks) are more than well capitalized, or was he referring to the majority of the 19 banks undergoing the stress test?  I'm going to go with the former here, which, if true is a tad misleading.  Regarding today, all I can say is, "Really???"  You have to be kidding me.  

The crux of the issue here is that ALL of this is pure economic/political theatre.  It means absolutely nothing regarding fundamentals.  The Government has made it all too clear that, even if a bank fails the test, it will not let the bank go under.  In these cases, the Government will probably have to convert preferred shares into common and "quasi nationalize" a few more banks, but at the end of the day, those who are holding their breath expecting the resolution of the stress tests to result in more lending better have good lungs.  

You see, what seems completely lost on the powers that be is that excessive lending is exactly what got the banks in trouble in the first place.  Regulators SAYING that banks have sufficient capital should absolutely NOT change anything regarding the current reluctance of the banks to rev up lending.  The banks (supposedly) know their business, and to think that managements are going to go back to the willy-nilly lending practices that dominated the past decade is plain ignorance.  In fact, given what the economy looks like at the moment, it would be absolutely natural and rational for bank lending to retrench anyway.  So not only should banks be lending less, but given the artificial and irrational level of lending that we saw coming into this, banks should naturally be lending a LOT less when compared to a year or 2 back.  This would be (GASP!) a sound business decision for a freaking change, and while it will more than likely mean that economic activity is less than robust for a while as the banks reset, it will also mean that the banking system comes out of this period in much better shape.

What may happen however, and what would be a BAD business decision, is that the Government quasi-nationalizes a few banks and begins to forcefully push an agenda of them making more, potentially unsound, loans.  Folks, we need a sound, rational, functioning banking system, and while a push for more lending might be good for a short-term pop in the economy, all this would do would be to push out the resolution of the problem and the real, lasting economic recovery along with it. The point is that a true recovery is going to entail stabilization before recovery, and true stabilization is going to require time.  Patience is not a strong suit for either the American people or the Government, and I think that the risks here are: 1) either the pace of recovery will disappoint (which we can deal with); or 2) the Government tries to FORCE a recovery in lending, which would lead to an extension of the problems and a prolonged period of difficult times. Let's hope with all of our might that risk number 1 is all we have to tackle.

Now, regarding 1Q earnings folks seem to making a big deal that results have come in generally better than expected.  On the surface, this is true as upside earnings surprises have nicely outpaced negative ones.  However, along with the upside surprises on the bottom line (earnings) have come frequent doses of NEGATIVE surprises on the top line (revenues).  So what does this tell us?  It tells us that companies are doing a bang up job in the cost cutting department (for which they should be congratulated), but sales are not so hot.  For more evidence of this, if one looks at daily corporate tax receipts, the downward trend has not changed and this doesn't bode well for revenues.  Finally, a lot was made about how "good" some of the banks' results have been, but when one takes a closer look, one finds that the majority of these earnings gains came from trading (notoriously volatile) and interesting (albeit legal) accounting.

So taking all of this into account, while one can't argue with the earnings results (and we should be grateful that they're coming in better than the vastly reduced guestimates of research analysts), one can take a bit of a wary look at their sustainability and quality.  For me to dub an quarterly release "strong", I need to see at least a couple of things: 1) strong revenues; 2) strong margins; 3) strong earnings.  We're only seeing one of these in general now.  Just as the saying goes, "you can't spend your way out of recession", and you can't cost cut your way out of one either.  At some point you run out of cost cutting ammo and you NEED revenues to kick in. This is likely to take a while and I'm concerned about the impatience of the market.  To end on a high note though, companies are running lean and mean, so when revenues do begin to improve we should see a nice earnings pop along with them.  This leaves me increasingly optimistic regarding '10.

Finally, looking at market internals, I'm still concerned about the lack of volume accompanying the recent rallies.  While Friday's volume was decent, the above average volume has been coming on the down days, not the rallies, which gives me pause.  Additionally, we've seen a big jump in insider selling of late, with corporate insiders selling 8X more stock than they're buying.  The last time I saw the selling to buying ratio hit this level was at the top of the market in 2007, and again, this makes me a bit nervous.  

Net/net, it's been a good run.  There are pockets of improvement showing up.  I think we've seen the cycle bottom.  I believe that the S&P 500 is likely to hit 1000 by mid 2010.  However, I also believe that the pace of economic recovery is likely to disappoint as we move into the summer and the new issues are likely to gain brain space (commercial & industrial loans, credit cards, non-residential construction) even though they're lagging indicators.  My guesstimate? The S&P bottoms somewhere between 750 and 800 this summer, before setting up for the run to 1000 in the Fall and into 2010.  My advice?  Have some "dry powder" and a wish list of companies you want to own so that when the time comes, you can take advantage.

Cheers!!!  It's Southside weather!

TRB 

  

Ooooof

Due to what can only be described as a cross between dengue fever and the hantavirus, I didn't get around to the blog this week.  I'll be posting next week.

TRB

Ball of Confusion

Lots going on at the home front and the Masters is stealing my brain-space, so we're going to keep things short and sweet this week.

I must admit that I'm the type of person who generally tends to have an opinion on just about anything.  However the recent action in the equity market has left me scratching my head a bit. Just when I think I've got it figured out and we can move on, the market turns and I'm left saying "huh"?  So this week, I wanted to simply pull a little list together of tid-bits received over the past week or so to think about for no other real reason than clear my mind.  

1) The State of the U.S. Consumer

Investors made a lot about the weekly jobless claims number holding in at around 650K, and it's certainly nice to see the number not getting a lot worse, so I'll chalk this up as a small positive (less bad data continues).  However, the continuing claims number and the 4 week moving average (which tends to smooth out the more volatile weekly data) continues to inch higher. Additionally, the January job loss data has now been revised 3X from 598K to 741K. February's numbers haven't been revised yet, but they will be, and we'll once again be headed in the wrong direction in this respect. Given that employment trends are the laggiest of lagging indicators, I don't want to put too much weight on this, but let's chalk that up to a negative, all else being equal.

On the housing front, numbers were released that showed 7% of all homeowners as being 30 days late on mortgage payments, up 50% year over year, and 40 % of subprime borrowers 30 days late, up a whopping 73%.  So while it looks like the housing market itself is trying to find a bottom, current borrowers are still under a large degree of pressure, and the trends (remember, we're looking for changes in trends here) are still going in the wrong direction.   

At the same time, the ABC consumer confidence survey is showing some signs of trouble after inching up for a bit and causing optimism.  Investors who have been playing the rally (as the "cyclical playbook" might suggest) via consumer cyclical names (i.e. retailers) might want to take a second look here.  The most recent survey came in at -50, the lowest level in weeks and close to its worst levels of -54.  

Finally I'd point out once again that the savings rate currently stands at about 4%.  It was 11% in the early 80's.  It was 16% in '74.  It's simply screaming to me that it's going higher and that does not bode well for the consumer spending outlook.  Couple this with a 3.5% decline in consumer credit in March, and I think that it's pretty tough to argue for a strong consumer-led economic rally anytime soon.  Even if the rally does continue, I can't see the consumer leading us out as it would normally.  This is not a "normal" cycle.     

2) Business Inventories

It looks as if the nation's business managers are doing a very respectable job of managing inventory levels in here, which is a solid positive.  Overall inventories were reported down 1.5% while durables were down 2.5%.  This was in the face of sales actually rising for the first time in 8 months.  While I'm not sure how sustainable the sales rise is, the inventory control is a solid positive for the economy, as it means: a) that further large economy-draining production cuts are not in the cards, at least in the near term; and b) that if I'm wrong and sales are ready to shoot higher, we'll really be in business as factories will have to step up production and hiring to meet demand, which could be the beginning of a virtuous cycle.

3) Commodity Prices

Positive action here of late.  The direction of commodity prices can be seen as a leading economic indicator as the demand for the "stuff" that drives the world obviously moves before construction and the like can begin.  Interestingly, the price of lumber, which has been in a brutal bear market given the state of housing, has rallied over 30% in the past few weeks, and copper, platinum, palladium, and oil have also moved nicely higher.  Now, some of this action is more than likely tied to speculators who are playing what they see as a potential bottoming in the global economy vs. demand for practical purposes, but the move is a positive nonetheless. 

4) Market Technicals

Much more of a mixed bag here.  The VIX (volatility index) has broken lower after holding the 40 level for the longest time, which is solidly positive (less volatility is better for the market and the VIX is generally negatively correlated to the equity market).  So technicians are likely looking at this turn of events as a major one.  

On the other side, however, is the fact that the Dow has been rising on lower and lower volume, which could mean that we're running out of steam.  What you'd want to see is the market rising on increasing volume, suggesting increasing participation and conviction.  With this in mind, it's worth looking at the Lowry data, which measures supply and demand for equities by looking at upside volume going into advances and downside volume going  into declines.  Just as the overall volume market is signaling a tired market, the Lowry data is not yet supportive of an extended rally from here either.  Generally, the start of an extended bull market is marked with a large decline in selling pressure, and we have not seen this.  Rather, selling pressure has only been moving slowly and stubbornly lower, so this is not confirming the advance. 

The market can talk to you and tell you things in the way it moves, not just in the direction it in which it moves.  Unfortunately the make up of the rally, at least of late, doesn't argue for a huge boost from these levels.  While the VIX is a positive that shouldn't be ignored and is something that could well argue for further near term upside, unless the make up of the rally changes it still seems that odds favor that we're at the end of an up-leg vs. the beginning of one.

5) Credit Market

The lack of participation by the credit market in the rally is probably what bothers me the most here.  A view into investor confidence can be gleaned from looking at the CI ratio, made up of the difference between medium grade and high grade bond yields.  Even in the face of the rally in the equity markets last week, the ratio dropped from 60 to 52, which is a big move and is negative.   Additionally credit spreads (between Baa rated bonds and Treasuries) have actually been widening (which is a sign of risk aversion in the credit market) while the equity markets have been rallying, and spreads are now close to their peak.  This, again, is not a good sign at all. 

The fact that the bond market is not confirming the stock market's move should give us pause here as activity in the bond market is generally seen as a leading indicator of the stock market. Yes, some of the positives that I called for a month or so ago have occurred and the market has, justifiably in my mind, risen.  However, a 30% move from the low seems slightly overdone to me given that the economic recovery is likely going to be pretty anemic for a while, and the fact that we're going to have to tackle the issue of the budget deficit and dollar at some point. In addition, expectations, especially regarding the U.S. consumer, seem to be getting ahead of reality.  

Now, the market tends to move more than generally anticipated in both directions, and with the VIX breaking down it would be silly for me to write that this is the absolute top of this wave higher.  However, I'll repeat that the market internals are arguing that we're at least closer to the end of this move than the beginning, and I'm still of the mindset of being hedged and playing a little defense in here on a short term basis.  

I'll repeat what I wrote last week (and about 2% lower): those more prone to trading, it's time to hedge/take profits.  For investors, I think you've been given an opportunity to upgrade portfolios.  Take advantage by selling the lesser quality names you have left and scale into better names over time at better prices.  I think we've found bottom, at least on an intermediate term basis, but we ain't going up in a straight line.  

Have a wonderful holiday and enjoy the company of your families!  Go Kenny Perry!!!

TRB

Slow Down, You Move Too Fast..........

The US equity markets continue to stretch higher, closing the week with their 4th consecutive weekly increase.  The recent action was spurred by a few specific catalysts (a couple of which were probably valid, and a couple of which left me scratching my head), as well as more than a few prognosticators declaring that we're off to the races.  While I wish I agreed with them, I'm going to have to invoke the Simon and Garfunkel line above. 

Valid Points Vs. Head Scratchers

First, let's take a look at the VALID reasons to be more optimistic going forward that we received this week.  We continue to get "less bad" news out of housing, and while I agree with the bears that the housing market is not going to look anywhere close to good anytime soon, it seems to me that we're in the process of putting a bottom in here (see the last few posts for the details).  As I've written before, you have to start the recovery process somewhere, and that somewhere is a pickup in foreclosed home sales.  This week, we got another piece of relatively positive housing info in the form of pending home sales, which added to, dare I say, a string of "less bad" housing data.  So the hits keep on coming in housing, and it's hard for me to argue with folks taking at least a little heart in this.  

The second, and more important, piece of positive news this week was the FASB's decision to change the mark to market accounting rules.  Again, I've written a bit on this in the past, so I won't dive into gory details, but until now, banks have had to mark the "value" of their holdings of assets like mortgage backed securities on their balance sheets to current market prices.  The problem with this is that, in many cases, the market for these assets has completely dried up. There is no market.  Therefore, banks have had to mark the value of assets, many of which probably carry substantial value if held to maturity (remember that prime default rates are around 3% and subprime are at about 16-17%, implying that most borrowers are current, even if default rates rise further), to fire sale prices, bringing along with the markdowns the need to raise substantial amounts of capital in order to keep their capital cushions where they need to be and thus substantially hampering the ability to lend. 

What the FASB has done is to give banks that are pledging to hold these assets to maturity substantially more leeway in valuing them, based not on "market value" but rather on an analysis of the actual cash flows and delinquency rates of, for instance, the underlying mortgages that make up the securities in question.  Now, to be sure, some of the toxic stuff that the banks hold and has been marked down substantially is worthless or close to worthless, but some of it surely is not. So this change should help in terms of actually freeing up capital in the banking system as certain assets are marked back up, hopefully helping to get the credit markets going again by spurring (hopefully more responsible) lending.  

In my humble opinion, this was a logical thing to do.  My question is what in the world took them so long?  It's a trifle maddening that we probably wouldn't have gone so far down the slippery slope as we did had the FASB simply stepped back and thought about this last Fall. Nonetheless, we'll chalk the move up to a very nice positive, however late.  

So we indeed had a couple of positive arrows in our quiver this week, and the market responded by rising (I can't begrudge it for doing so, and I'll certainly take it).  However, I can't shake the sneaking suspicion that we may be setting ourselves up for near term disappointment in here.  The sigh of relief is simply getting too loud, and it just seems to me that too many talking heads are a little too quick in declaring the end of the recession.  Remember, these were the same loudmouths that just a few weeks back were calling for Dow 5000.  There also seems to be a whole lot of "stretching" going on.  What I mean by this is that these new bulls seem very quick to now take datapoints or news stories and spin them more positively than warranted.  

A quick case in point: the G-20 summit.  President Obama heralded the summit as an "historical turning point" in the global recovery and the press ate it up.  I'm sorry, but you can't be serious.  Someone please explain to me how ending tax havens, regulating hedge funds, and providing $550bln to the IMF is going to change the game substantially here.  Do I think that hedge funds should be regulated?  Yes I do.  Do I think that the IMF should have enough moolah to help emerging economies out?  Sure.  Will this help the Eastern European situation from getting worse and spinning out of control?  I sure hope so.  The fact that these leaders actually got something done should be seen as a major victory, as most of these things are nothing more than a complete waste of money and time.  However, while the leaders were veering to the left, they seemed to forget why they were really there and didn't accomplish much in terms of really stimulating the global economy.  Even the ECB's rate cut left a lot to be desired as it, once again, is showing how laughably out of touch it is with reality.  

In sum here, what really gives me pause is not that little on the stimulus front was accomplished at the G-20 (my expectations couldn't have been lower).  Rather it's how quick investors were willing to buy into the BS that something substantial WAS accomplished.  This to me points to over-optimism.

Data = Not So Hot

Turning to economic datapoints, there was little signs of change in trend this week.  Bulls were quick to jump on the fact that the ISM manufacturing index came in above expectations (rising month over month for the first time in many months, although still well below breakeven) with new orders rising 1.8%.  However, last month's new order number was revised substantially lower, from -1.8% to -3.5%, so it seems very, very premature to break out the party hats here (One point of reference: it pays to watch the direction of revisions, sometimes even more so than the actual numbers themselves in order to discern a true change in trend.  So far, no good).  

Sticking with the ISM, the services index was released this afternoon and it showed no bright spots, declining for the 6th consecutive month.  Importantly, new orders also continue to decline (dropping from 40.7 to 38.8, with 50 indicating break-even).  New orders presage hiring, and with ~75% of American workers employed by the services sector, this doesn't augur well for any change in the employment trend we've seen of late, which was reinforced with the March payroll number this morning.  The 663K March payroll decline and 8.5% unemployment rate were as bad as advertised, but the real attention grabber was the revision (again, watch 'em!) to January's payroll decline number to a whopping 741K from the mid 600K's.  3rd worst reading on record and the other 2 were due to the end of WWII and a couple of massive strikes in '49.  OUCH!!!

Now, I have and will continue to pound home the fact that unemployment is a notorious lagging indicator, and I have no reason to believe that this is not going to be the case this time around.  However, I would point out that a couple of the "less bad" data points that got this rally going centered on consumer spending and confidence.  In fact, it looks as if overall consumer spending actually ROSE quarter/quarter in the 1Q, even in the face of the continued deterioration in the employment situation.  While I wish it were the case, I do not expect this to continue given the state of the labor market at the moment.  I don't see how it's possible.  To drive this home, according to Gartman this morning, an important industrial shipping measure fell 22% for March, which is counter to the usual seasonal trend (generally March shipments are up as companies prepare for the summer selling season).  Therefore, this grabs my attention as well, and as one puts the puzzle pieces together, it seems logical that the optimism on the consumer front that we've run into over the past few weeks may easily give way to a new bout of pessimism before too long.

Perge Sed Caute (Proceed With Caution) 

Soooooo, I'll conclude thusly: severe bear markets do not historically end with sharp reversals to the upside.  They tend to end as selling is exhausted and the market limps sideways for a bit before heading higher. Bear market rallies, however, are generally sharp, much like what we've seen lately, so I'm wary here.   

Can the upside continue?  Absolutely!  We are seeing progress on a number of fronts, and I will once again note that, in my opinion the intermediate low has been put in.  However, I also think that investor optimism may have begun to run ahead of reality.  The economic recovery is not likely to be sharp, and the numbers are very likely to bear this out as we move through the next few weeks (it's all about puts and takes for a while folks and I think we've had our share of takes over the past few weeks).  We've had positive actions out of the Fed and Treasury which should help the economy out in due time, but in the meantime, we have to deal with a likely reversal (at least for a while) in the direction of consumer data, the release of the results of the banks' "stress tests" (I'll eat my hat, which I wear a lot these days, if a couple of banks aren't shown as inadequately capitalized, lest the test be seen as a total farce), and the 1Q earnings "confession season".  

So in sum, traders, I think it's time to take profits and/or hedge long positions.  As for investors, I'd consider this:  if you've been waiting for an opportunity to re-tool your portfolio by getting rid of the weaker sisters, now may be the time to do so.  While I don't want you out of the market, you might have a chance here to upgrade the quality of your portfolio.  Use the recent bounce to rid yourself of the names who's time has passed and use what I see as the potential for near term market weakness to initiate positions in names with better prospects. Have those wish lists handy and act!

Have a super weekend and pass the word!!!

TRB