Friday, July 31, 2009

Chinese Sentiment Indicator

Well, Newsweek is claiming that the recession is over, and everywhere I turn, I hear debates not about whether the economy will recover in the second half, but rather how strong the recovery will be. Persistent job losses, reduced capital investment and stubborn consumption numbers do not seem to factor into the discussion. "They're lagging indicators," is the common retort to any negative news. Positive news, is, as always forward looking. So goes the sentiment game.

As I've often held, it's not the news that counts, but rather how people interpret it. Depending on the prevailing mood at the time, this morning's GDP report could have been seen as anywhere from terrible to wonderful depending on which components one chose to focus on. Therefore, it is more useful to focus on sentiment rather than data points.

Nowhere is sentiment more apparent than in China. It is taken as a given that Chinese growth is going to lead the world out of recession. Last year, the Chinese Communist Party told all of the banks to lend money immediately. And they did. The money has flown into real estate, stocks and commodities without regard to the borrowers ability to pay it back.

But people are starting to catch on. And they are seeing that China's miraculously resilient growth economy is both a) statistically manipulated and b) a short term oasis. If the masses catch on to this, the theme of an imminent return to global growth disappears as fast as it arrived.

This week, we've heard a number of China "experts" express their concern with how overheated the Chinese story appears to be getting in comparison with the reality on the ground.

Stephen Roach, head of Morgan Stanley's Asia division, wrote yesterday in the Financial Times:

China's Consumers Key to Revival

On the surface, China appears to be leading the world from recession to recovery. After coming to a virtual standstill in late 2008, at least as measured quarter-to-quarter, economic growth accelerated sharply in spring 2009.

A back-of-the envelope calculation suggests China may have accounted for as much as 2 percentage points of annualised growth in inflation-adjusted world output in the second quarter of 2009. With contractions moderating elsewhere, China’s rebound may have been enough in and of itself to allow global gross domestic product to eke out a small positive gain for the first time since last summer.

That’s the good news. The bad news is that China’s recent growth spurt comes at a steep price. Fearful that its recent economic shortfall would deepen, Chinese policymakers have opted for quantity over quality in setting macro-strategy, the centrepiece of which is an enormous surge in infrastructure spending funded by a burst of bank lending.

Sure, developing nations always need more infrastructure. But China has taken this to extremes. Infrastructure expenditure (including Sichuan earthquake reconstruction) accounts for fully 72 per cent of China’s recently enacted Rmb4,000bn ($585bn) stimulus. The government urged the banks to step up and fund the package. And they did. In the first six months of 2009 bank loans totalled Rmb7,400bn – three times the pace in the first half of 2008 and the strongest six-month lending surge on record.

This outsize bank-directed investment stimulus leaves little doubt as to how bad it was in China in late 2008 and early 2009. An unprecedented external demand shock, stemming from rare synchronous recessions in the developed world, devastated the export-led Chinese growth machine. That triggered sackings of more than 20m migrant workers in export-intensive Guangdong province. Long fixated on social stability, Beijing moved quickly with massive firepower to arrest this deterioration. The government was determined to do whatever it took to restore rapid growth.

Yet there can be no avoiding the destabilising consequences of these actions. Surging investment accounted for an unprecedented 88 per cent of Chinese GDP growth in the first half of 2009 – double the average contribution of 43 per cent over the past decade. At the same time, the quality of Chinese bank lending most assuredly suffered from the rash of credit disbursements in the first half of this year – a trend that could sow the seeds for a new wave of non-performing bank loans. Just this week Chinese regulators sounded the alarm – telling banks new loans must be used to bolster the real economy and not for speculation in equities and real estate.

A little over two years ago, premier Wen Jiabao warned of a Chinese economy that was becoming increasingly “unstable, unbalanced, uncoordinated and ultimately unsustainable”. Prescient words. Yet rather than act on those concerns by implementing a pro-consumption rebalancing, growth-hungry China was seduced by the boom in global trade and upped the ante on its most unbalanced sectors. By 2007, investment and exports accounted for about 80 per cent of Chinese GDP. And now, in the face of a severe global recession, China has compounded the very problems the premier warned of: aiming a massive liquidity-driven stimulus at its most unbalanced sector.

This is not a sustainable outcome for any economy – or sustainable support for the world economy. China must redirect economic growth towards internal private consumption. This may require a compromise on the quantity dimension of its growth outcome. But to the extent that leads to improved quality in the Chinese economy, a short-term growth sacrifice is well worth the effort.

Unlike most, I have been a steadfast optimist on China. Yet I am starting to worry. A macro strategy that exacerbates already worrying imbalances is ultimately a recipe for failure. In many respects, that’s what the global crisis and recession of 2008-09 are all about. China will not get special dispensation from the most critical lesson of this post-crisis era.

I agree that China will eventually become more of a consumer driven economy than it is now. But making an adjustment from their current economy to that of the future will take time and a rebalancing of the productive structure. This means that they will have to undergo a recession like any other nation. For China, however, it is possible that any slowdown in the pace of growth leads to such civil strife that the destination gets lost in the political struggle.

Along similar lines, Michael Pettis of Beijing University has been all over the stimulus programs and how they are lopsidedly effecting the economy in a very unsustainable manner. I highly recommend his blog for those interested in the intricacies of the China story.

And in addition to the above concerns about the outcome of these efforts, both Marc Faber and James Galbraith have come out this week contending that China's publicly available numbers are completely forged and not reflective of reality at all.

Courtesy of Ed Harrison of Credit Writedowns:

China’s economy is growing at 2 percent, not the 7.8 percent its government claims, says economist Marc Faber, publisher of the Gloom, Boom and Doom report.

“The Chinese government is one of the few governments in the world that knows its GDP numbers three years in advance,” Faber told CNBC.

“I’d be a bit careful about China.”

A growing number of investors turned bullish on China after its markets began to rise last March, Faber notes, adding that it’s possible Chinese markets will continue to rise for a while.

“If you throw money at the system, lots of things go up in value — but maybe they go up for the wrong reasons. What disturbs me today … is that the lows in March and late last year, sentiment was incredibly bearish about everything.”

Now, Faber observes, “there’s this incredibly bullish sentiment when insiders are actually selling and the technical picture of the market doesn’t look that great.”

Faber believes the market faces headwinds because there’s a huge supply of available shares and a record number of new issues, which dampens share-price increases.

“My sense is that, near term, we could still have disappointments because now the mood is very optimistic. I don’t think we’ll make new market lows in Asia, but I do think we’ll have a meaningful correction.”

On Monday, China’s first initial public offering in nearly a year rose so high and so fast that regulators were forced to halt trading twice, The Washington Post reports. The Hang Seng index rose to double its low point last fall.

And Tyler Durden of Zero Hedge was reporting this morning on James Galbraith's report. He plucked out what he thought was the most applicable data:

It is no secret that China's economic numbers are so cooked and unreliable, that they make the constantly changing and optimistically biased economic data out of the U.S. (especially lately) have the credibility equivalent of a Harvard Ph.D. thesis. University of Texas professor James Galbraith discusses one aspect of China's "booming" economy, specifically the question of China's Trade Surplus, which as he notes has been drastically inflated since 2002 due to Chinese companies over-reporting profits on exports in order to disguise various investments by foreigners into China, so as to beat capital control restrictions.

Galbraith argues the "fake profits" are so large that China may have actually ran a trade deficit in some years, and these figures casts serious doubt on the reported P&L of Chinese companies.

Focal points in the attached presentation:

Slide 5: 2003-2006, 25% to over 100% overstatement of reported exports if you use constant unit values.
Slide 10-13: increase in reported export value is not due to price increases of exports to US, Japan, or EU.
Slide 17: increase in reported export value is not due to wage increases.
Slide 19: increase in reported export value is not due to quality improvements.
Slide 21: capital inflow suggested by drop in spread of 3-mo RMB repo's from 1.59% to (2.41%), and drop in spread of 3-mo CHIBOR vs LIBOR from 1.66% to (2.57%).
Slide 28: capital inflow seems to have gone into investments in PP&E. Slide 29: capital inflow seems to have gone into real estate investment

When the China bubble bursts, so will the hopes for global recovery. Until then...we dance.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Tuesday, July 28, 2009

Underreported and Underestimated Forces

There's a few stories that I believe have fallen under the radar over the past week, and I will attempt to tie them together.

I mentioned a few weeks ago the importance of transparency in accounting as primary in not only unravelling the mess we are in, but also in preventing it from happening again. I argue that taking the oversight of this out of bought-and-paid-for regulators and putting it in the hands of the courts is probably the best way of accomplishing this.

In the meantime, however, we are stuck with the FASB (Federal Accounting Standards Board). And their prerogative is now to either make themselves heard or become obsolete. They are not a government organization per se, but rather the role of determining accounting standards has been delegated to them by the SEC. They were criticized heavily in April after succumbing to congressional and lobbyist pressures to suspend "mark-to-market" accounting rules for financial services companies. This criticism has led to a questioning of their independence, and therefore, relevance. So their choice is to grow a pair or be dissolved. It appears they are choosing the former.

Jonothan Weil reports:

July 23 (Bloomberg) -- Turns out America’s accounting poobahs have some fight in them after all.

Call them crazy, or maybe just brave. The Financial Accounting Standards Board is girding for another brawl with the banking industry over mark-to-market accounting. And this time, it’s the FASB that has come out swinging.

It was only last April that the FASB caved to congressional pressure by passing emergency rule changes so that banks and insurance companies could keep long-term losses from crummy debt securities off their income statements.

Now the FASB says it may expand the use of fair-market values on corporate income statements and balance sheets in ways it never has before. Even loans would have to be carried on the balance sheet at fair value, under a preliminary decision reached July 15. The board might decide whether to issue a formal proposal on the matter as soon as next month.

“They know they screwed up, and they took action to correct for it,” says Adam Hurwich, a partner at New York investment manager Jupiter Advisors LLC and a member of the FASB’s Investors Technical Advisory Committee. “The more pushback there’s going to be, the more their credibility is going to be established.”

Broad Consequences

The scope of the FASB’s initiative, which has received almost no attention in the press, is massive. All financial assets would have to be recorded at fair value on the balance sheet each quarter, under the board’s tentative plan.

This would mean an end to asset classifications such as held for investment, held to maturity and held for sale, along with their differing balance-sheet treatments. Most loans, for example, probably would be presented on the balance sheet at cost, with a line item below showing accumulated change in fair value, and then a net fair-value figure below that. For lenders, rule changes could mean faster recognition of loan losses, resulting in lower earnings and book values.

The board said financial instruments on the liabilities side of the balance sheet also would have to be recorded at fair-market values, though there could be exceptions for a company’s own debt or a bank’s customer deposits.

The FASB’s approach is tougher on banks than the path taken by the London-based International Accounting Standards Board, which last week issued a proposal that would let companies continue carrying many financial assets at historical cost, including loans and debt securities. The two boards are scheduled to meet tomorrow in London to discuss their contrasting plans.

Differing Treatment

While balance sheets might be simplified, income statements would acquire new complexities. Some gains and losses would count in net income. These would include changes in the values of all equity securities and almost all derivatives. Interest payments, dividends and credit losses would go in net, too, as would realized gains and losses. So would fluctuations in all debt instruments with derivatives embedded in their structures.

Other items, including fair-value fluctuations on certain loans and debt securities, would get steered to a section called comprehensive income, which would appear for the first time on the face of the income statement, below net income. Comprehensive income now appears on a company’s equity statement.

Another quirk is that the FASB doesn’t intend to require per-share figures for comprehensive income. Only net income would appear on a per-share basis. My guess is that means Wall Street securities analysts would be less likely to publish quarterly earnings estimates using comprehensive income.

Imagining the Impact

Think how the saga at CIT Group Inc. might have unfolded if loans already were being marked at market values. The commercial lender, which is struggling to stay out of bankruptcy, said in a footnote to its last annual report that its loans as of Dec. 31 were worth $8.3 billion less than its balance sheet showed. The difference was greater than CIT’s reported shareholder equity. That tells you the company probably was insolvent months ago, only its book value didn’t show it.

The debate over mark-to-market accounting is an ancient one. Many banks and insurers say market-value estimates often aren’t reliable and create misleading volatility in their numbers. Investors who prefer fair values for financial instruments say they are more useful, especially at providing early warnings of trouble in a company’s business.

‘Religious War’

“It’s been a religious war,” FASB member Marc Siegel said at last week’s board meeting. “And it’s been very, very clear to me that neither side is going to give, in any way.”

So, the board devised a way to let readers of a company’s balance sheet see alternative values for loans and various other financial instruments -- at cost, or fair value -- without having to search through footnotes. At last week’s meeting, FASB member Tom Linsmeier called this a “very useful approach that addresses both sets of those constituents’ concerns.”

This will not satisfy the banking lobby, which doesn’t want any significant expansion of fair-value accounting. “I guess the nicest thing I can say is it’s difficult to find the good in this,” Donna Fisher, the American Bankers Association’s tax and accounting director in Washington, told me.

If the bankers don’t like it, that’s probably a good sign the FASB is doing something right.

The implications of this are massive and not to be understated. Knowing what is actually on the balance sheets of large institutions would be a large step in the direction of liquidating these malinvestments - a necessary precursor to any lasting recovery. This battle is likely to get nasty, so I would keep it on your radar.

In other news, we learn that insiders have continually been selling shares over the past few weeks at the highest levels since October and November of 2007 - the all-time highs.

Courtesy of Mark Hulbert of Marketwatch:

Corporate insiders are a company's officers, directors and largest shareholders. They are required to report to the SEC whenever they buy or sell shares of their companies, and various research firms collect and analyze those transactions.

One is the Vickers Weekly Insider Report, published by Argus Research. In their latest issue, received Monday afternoon, Vickers reported that the ratio of insider selling to insider buying last week was 4.16-to-1, the highest the ratio has been since October 2007.

I don't need to remind you that the 2002-2007 bull market topped out that month.

To be sure, the weekly insider data can be volatile, especially during periods like the summer, in which the overall volume of insider transactions can be quite light. That is one of the reasons why Vickers also calculates an eight-week average of the insider sell-to-buy ratio, and it currently stands at 2.69-to-1. That's the highest that this eight-week ratio has been since November 2007.

To put the insiders' recent selling into context, consider that in late April, the last time I devoted a column to the behavior of insiders (and when the rally that began on March 9 was still only six weeks old), the comparable eight-week sell-to-buy ratio was just 0.72-to-1.

It is true that insider selling is not a perfect leading indicator, as insiders will sell for many different reasons (as this paper outlines quite well). It may just be that with their own property values collapsing and debts coming due, they are needing to sell anything liquid - even their own company's stock. Corporate bigwigs are human as well and no less susceptible to the workings of a credit crunch.

But if the wealthy are now being forced into selling their stock to make good on other commitments, that does not exactly speak too well of their ability to continue spending conspicuously as they have previously - meaning headwinds for the economy in general.

Along similar lines, we are seeing that CFOs are Not on the Recovery Bandwagon Yet. CFOs have a very good predictive record on the economy. Brian Pretti follows them regularly for that reason. And until that record turns sour, so will I. From the article:

As financial markets embrace the idea that economic recovery is drawing near, CFOs are not as infused with optimism — indeed, many are downright skeptical that better times are right around the corner. That sentiment was clearly evident in the first two weeks of operation of the CFO Prediction Market.

The forecasting tool, which uses technology from Redwood City, California-based Crowdcast, aggregates the opinions of anonymous finance executives on important economic indicators and trends.

Take the numbers for second-quarter gross domestic product, due to be released this Friday. On average, forecasters project that economic output will be reported to have shrunk 1.5% in the second quarter, less than the first quarter's 5.5% drop, according to a survey by the Federal Reserve Bank of Philadelphia. But 168 Prediction Market participants think, on average, that the shrinkage is going to be larger — 1.88%. "I don't see a silver lining yet," comments one executive. "Business outlook is still grim and everyone is talking of a recovery only post-December."

Indeed, asked "When will real GDP grow again?" 32% of 168 participants project the fourth quarter of this year. In contrast, forecasters surveyed by the FRB of Philadelphia say the third quarter will be the turning point. Another 27% of the same participants in the Prediction Market peg the first quarter of 2010 as the point at which output rises into positive territory, with 17% saying a rebound won't happen until the second quarter of 2010.

"First quarter is the earliest it will grow," says one. "The drag from continued increases in unemployment and underemployment, as well as the increase in consumer savings will contribute to anemic consumption and lack of growth."

Indeed, the unemployment rate is a statistic that finance executives track closely, according to betting on the Prediction Market. More than 450,000 virtual dollars have been bet on July's outcome. (No real money is bet.) The Prediction Market is a speculative market created for the purpose of forecasting. With each bet placed on a forecast, the odds grow that the consensus "prediction" will prove correct. Prediction markets have proven so accurate that they have been used by top corporations, the U.S. military, and the National Association of Business Economists.

On average, 186 participants think the unemployment rate will hit 9.98% this month, but many think the number could creep even higher, hitting double digits. "I think we are going above 10%," comments one executive. "Revenues have not yet started to rebound and so companies are going to continue to lay people off." Indeed, unemployment has already topped 10% in 15 states, according to data from the Bureau of Labor Statistics. On Monday Verizon announced another 8,000 job cuts.

One area where additional layoffs will play out is in a higher number of applications for unemployment insurance. CFOs are projecting this week's tally of initial applications to be as high as 582,000, which would be a 40,000 increase from last week. (Economists, on average, are forecasting 570,000, according to a Bloomberg News survey.)

Another area that I see being massively underestimated in its influence toward the long-term trend of the economy is the generational/demographic waves that roll through over 20-30 year periods. I don't know why its importance is systematically avoided. Perhaps it is the unalterability and endogenous nature of it that makes most analysts and economists uncomfortable.

I have touched on this subject numerous times in the past. I see the huge wave of baby boomers retiring as a massive deflationary force on the economy as they liquidate assets to cover living expenses. The generation they are supposed to be selling to, myself for example, are seemingly assumed to pick up the slack in not only consumption but in debt accumulation. Add this to the many assumptions going into neoclassical economic models that will not prove wise. Just as anyone had assumed in the 60s that the boomer generation would automatically embrace the social values of their parents - and were dumbfounded at the rejection of such values with the anti-war movement, racial equality, women entering the workforce, careless sexual expression, etc. Such differing generational attributes are common to every generation - yet it is always assumed to be unchanging.

Those who underestimated the influence of the enormous generation entering adulthood in the 70s likely missed the inflationary implications by a mile. Now that the same generation is retiring, the same people are likely to miss its opposite and equal force - deflation.

A recent article in BusinessWeek describes this reality:

When 79 million people—nearly a third of Americans—start spending less and saving more, you know it won't be pretty. According to consulting firm McKinsey, boomers' conversion to thrift could stifle the economy's hoped-for rebound and knock U.S. growth down from the 3.2% it has averaged since 1965 to 2.4% over the next 30 years. "We would have gotten here in 5 or 10 years as boomers retire, but we pushed it up," says Michael Sinoway, managing director of consulting firm AlixPartners. "Now [companies] are scared things won't come back." And that's why everyone from Mercedes to Nordstrom (JWN) to designer Vera Wang are scrambling to remake themselves for the Incredible Shrinking Boomer Economy.

Not so long ago, boomers were never going to die. Filled with a self-confidence born of unprecedented prosperity, many thought rising markets would assure their future. If the economy faltered, well, it would rebound more strongly than ever, as it had so many times before. And so boomers spent—and borrowed—as if there were no tomorrow.

Meet Tim Woodhouse, 56. He owns Hood Sailmakers in Middletown, R.I., a business that helped finance a plush life. Woodhouse owns a boat, five Ducati motorcycles, and every few years treated himself to a new Porsche 911. He figured he'd retire when he felt like it. Then the markets crashed, the economy tanked, and suddenly Woodhouse felt a lot poorer. In April, with business slowing and his real estate holdings leaking value, Woodhouse hit the brakes. "I was scared," he says. "My net worth took a real hit." Woodhouse sold the Porsche and bought a Mini Cooper. The boat spends more time tied up these days than out on the water. He and his wife dine out less often, and they don't entertain at home much either.

Woodhouse and millions of boomers like him are doing what people normally do when they near retirement: They're living more frugally. Companies have long factored in this actuarial reality, gradually tweaking their products and marketing to appeal to the next generation. With boomers, however, many companies became complacent. It wasn't that they ignored younger consumers but that they counted on boomers to keep spending longer. And why not? Until recently boomers typically reached their spending peak at age 54, according to McKinsey. Contrast that with the previous generation—a thriftier bunch whose consumption typically peaked at 47.
Can younger consumers pick up the slack? Consider the demographics. Generation X, Americans born between 1964 and 1980, is generally estimated to be about two-thirds the size of the boomer cohort. And with boomers working longer, especially since the crash wiped out many retirement funds, it may take longer for Xers to move into their prime earning (and spending) years. And what about Generation Y, the 81 million-strong group born between 1981 and 1994? Right now, 14% are unemployed and will have their own hole to claw out of when the economy revives, according to Edward F. Stuart, who teaches economics at Northeastern Illinois University. In other words, companies will need boomers for years to come.

The trick will be finding a way to fulfill the needs and wants of a generation that is used to being catered to—but is now on a budget. Timothy Malefyt, an anthropologist who studies consumer trends for the ad agency BBDO New York (OMC), argues that boomers, having ridden a wave of technological change, are highly adaptable and well versed in problem-solving. (Or at least they see themselves as such.) Already, he says, they are making a virtue of value shopping, once viewed by this group as hopelessly déclassé. For many boomers it's no longer about keeping up with the Joneses, it's about outthinking them. "If you make boomers feel they've failed, you'll lose them," Malefyt says. "They want to feel they've outsmarted the system or their circumstances.

That's why some companies are coalescing around "cheap chic," a marketing conceit that has become synonymous with Target (TGT) but also has been tried by the likes of JetBlue, Ikea, and Mini. The latter is owned by BMW, another classic boomer brand. BMW didn't plan it this way, but the Mini is one solution for a company whose cars are becoming too pricey for many boomers. A fully loaded BMW 3 Series costs $40,000 plus change; a comparably equipped Mini: $25,000. The Mini, while a feat of engineering and retro style, can't compete with a BMW, which the company bills as "the ultimate driving machine." But the Mini possesses cheap chic in spades. In recent months, says BMW, fiftysomethings have been trading in their Bimmers and other luxury brands for Minis.

Expect that trend to continue.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Sunday, July 26, 2009

Technical Update 28.09

The market's parabolic rise continued last week, adding another 4% to the prior week's gains. Speculators were dialing 1-800-Get Me In as optimism rose that the recession is soon to be distant past. Financials and commodities continued to lag behind, leaving a glimmer of hope for the bears.

I continue to watch in amazement at how higher prices begets more optimism - not less. One minute I'll hear on TV that optimism is the cause for the rally and the next minute the rally is cited as cause for further optimism.

I'm doing what I do best. Using popular sentiment as a contrary indicator while respecting that market insanity can perpetuate itself further than usually believed. Below is the MarketPsych Sentiment indicator (ht John at GD). They take the number of "fear" words found in newspapers and use their findings as a contrary indicator. As of this week, the amount of such words found is the lowest in one year, matching levels seen at the October and January highs. Both such readings preceded near immediate turns, resulting in 25-30% losses. (the blue line is the sentiment indicator [lower reading equals higher sentiment] overlaid on the QQQQ ETF).

For those that follow DeMark patterns, I will note that both the Nasdaq and S&P have registered numerous "sell" setups and in order to be perfected, would require a rise past 1000. Regardless, the daily charts will confirm a sell signal with a close below the close of four days prior.

It's probably something readers are getting sick of reading, but the market appears "overbought" based on various momentum and relative strength indicators. As seen on the chart below, the RSI has peeked above the 70 line for the first time in more than a year.

As mentioned, the banks remain weak despite the overall market's attempts to drag it higher. They barely squeezed out a positive performance this week.

Internals are showing negative divergences. The percentage of stocks above their 50day MA is lower now than it was at the June highs, suggesting weakening leadership.

101 NYSE issues managed to hit new 52-week highs on Thursday. Make what you will of that.

Dr. Copper has run into some strong resistance at its 100 and 200 day EMAs. A reaction to this resistance could set up a decent short opportunity.

The US Dollar Index and the Euro are almost mirror images of themselves. But when one of the indices makes a new high or low while the other does not, the non-confirmation typically provides for low risk opportunities to go the other way. As both press their December and June highs, it will be interesting to watch for such a possibility. The typical cause of such a reaction is the Yen's pull on the dollar index, so that might be something to watch.

Have a good week.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Saturday, July 25, 2009

Digging Beyond "Better than Expected" Earnings

We are more than half way through earnings season, and I thought that it would be important to take the pulse of what many of the companies are individually telling us. In all sorts of market environments (bull and bear), it is important to know how a certain company has reached the results it reports. It is not enough to simply see the headline number and draw any conclusions from it. Many of these companies are massive organizations with dozens of different income streams and products. In a way, they are little economies in themselves.

When looking for economic recovery, it is important to know where to look. Many people, the media being the major culprit, make the mistake of labeling anything that looks a return to the conditions present in the prior expansion as a sign of impending recovery. But economies don't work that way.

Economic expansions are led by increases in capital expenditures, investment and the application of theretofore unproductive technologies. The prior contraction is the lead cause of these factors. Wages typically fall as quality employment becomes scarcer, thus making new investment more "productive." Additionally, consumers and businesses have a propensity to save more during economic contractions. These savings provide the capital needed, at a lower rate of interest, to make these investments possible.

As the expansion wears on, the excess profits then derived from the previous gains in productivity are used increasingly for consumption goods. The perceived benefit to making further investments at that time is typically nowhere near where it was years earlier. Wages will be higher, machinery more expensive, interest rates rising, etc. It becomes more "economic" to satisfy one's immediate wants.

The US economy can be seen riding this wave following the early 90's recession into the 2007 top. The blip in between ('01-'02) was the economy making the adjustment between this productivity driven economy to the consumption driven. How central bank and government policies interfere with this process, twisting certain parts, expanding and lengthening others, is not of importance to the bigger picture. What we are trying to determine here is which part of the cycle are we embarking on and thus, how to allocate our investments.

What we are looking for is not a return to the consumption driven economy. Going backward is not feasible. We are looking for signs that the contraction is morphing into a productivity driven expansion. This process is never going to be uniform. Certain sectors of the economy will lead, while others will lag behind. We can ascertain from history that technology and other capital intensive industries will be the first to show signs of making this transition. However, no two recoveries are the same. When not making the mistake of assuming the recovery will look like the previous consumption driven expansion, many make the mistake of assuming the productivity expansion will look the same as the previous one. The previous productivity expansion centered around telecommunications and information technology. It would be safe to say that this expansion will surround something else entirely.

I'll have more on what I think this will look like in a later post. For today, let us focus on some important notes by companies that can be seen as "leading edge" or "investment intensive" for the economy:

Dell Reviewing Alternative Sources of Capital

uly 14 (Bloomberg) -- Dell Inc., after cutting spending, raising money in the debt market and temporarily suspending its share-buyback program, says it is reviewing alternative sources of capital to bolster its unit that provides customer financing.

The world’s second-largest maker of personal computers has had to fund the unit internally and will likely need to provide more capital to the business later in the year, Chief Financial Officer Brian Gladden said today. The unit provides financing to customers who buy Dell products and services.
Dell is also working on a plan to save $4 billion in annual costs by fiscal year 2011. The company is adjusting to a slump in information-technology spending, which Goldman Sachs Group Inc. expects to drop 8 percent this year.

“In 2009, there’s been a deferral of spending -- a pretty significant deferral -- which we think sets up for a pretty large refresh in 2010,” Michael Dell said. “The refresh will come first in storage and servers” and then in PCs.

Intel Trumps Forecast; Bodes Well For PC Sector

SAN FRANCISCO (Reuters) - Intel Corp's quarterly results and outlook blew past Wall Street forecasts on better-than-expected consumer demand for PCs, especially in Asia, setting an auspicious tone for the technology sector.
Intel's strong showing came despite what it described as weak demand from the corporations that traditionally are big buyers of computer equipment, and comments by Intel executives that Microsoft's forthcoming Windows 7 operating system is unlikely to revive corporate spending this year.

"You have an $8 billion quarter with very little enterprise spending taking place," said Broadpoint Amtech analyst Doug Freedman. "The consumer is healthier than we expected."

Cost Cuts Help IBM Earnings Surge 18%

IBM's second-quarter earnings per share surged 18 per cent from a year earlier, exceeding Wall Street expectations of a 3 per cent improvement, as cuts in the workforce and other expenses more than made up for falling revenue.

Although total sales slid a more-than-expected 7 per cent after currency adjustments and hardware revenue dropped 22 per cent, every dollar that IBM did take in contributed more to the bottom line, the company said yesterday.

Cost cuts boosted the pre-tax profit margin more than 4 percentage points to 18.3 per cent, delivering $3.1bn of net income on sales of $23.3bn.
The company said it was still on track to save $2bn this year from "workforce rebalancing" - or cutting out employees in more expensive countries and adding back a smaller number elsewhere.

It previously said it would save a further $1bn by retooling its internal processes and support mechanisms, and Mr Loughridge said yesterday that the company could save another $500m that way.

Google Earnings Top Analysts' Expectations

Google Inc. said Thursday that its net profit for the second quarter hit $1.48 billion US, or $4.66 a share, as the company topped Wall Street's expectations.
Overall revenues grew year-over-year by only three per cent to $5.52 billion. That is the company's lowest growth rate since its stock started trading publicly five years ago. Prior to late 2008, Google's quarterly revenue growth had never fallen below a year-over-year rate of a 30 per cent.
"We remain focused on investing in technical innovation to drive growth in our core and new businesses."

Economy Hits Microsoft Earnings
A tough global economy has impacted technology sales in recent months, weakening Microsoft's (NASDAQ: MSFT) profits in the process.

This week, the company announced that its revenues declined 17 percent in the fourth quarter of 2008, with a total of $13.10 billion in revenues. Earnings per share fell 26 percent to 34 cents, while operating income was down 30 percent and net income was down 29 percent.

"Our business continued to be negatively impacted by weakness in the global PC and server markets. In light of that environment, it was an excellent achievement to deliver over $750 million of operational savings compared to the prior year quarter," said Chris Liddell, Microsoft CFO.

General Electric's Net Earnings Fall 47% Led By Finance Unit

General Electric reported a steep fall in second-quarter earnings on Friday, weighed down by the continuing struggles of its big finance business, falling orders for industrial equipment and declining advertising spending at its NBC television network and local stations.
Given its global reach across product lines as diverse as gas turbines, power plants and aircraft engines, G.E. provides a concentrated glimpse of the health of capital spending in the industrial economy as a whole.

On that score, the G.E. report showed continued weakness. The company’s revenue fell 17 percent, to $39.08 billion. After adjusting for a stronger dollar, which reduces the value of overseas sales, sales were down 12 percent from the previous year. G.E.’s quarterly revenue was about $3 billion less than the Wall Street forecast.

Capital equipment orders for G.E. fell sharply, especially transportation machinery like locomotives and health care equipment like medical-imaging machines. In a conference call with analysts, company executives said they expected industrial equipment orders to be off about 25 percent for the year.

“That’s a pretty significant decline, but it’s not unexpected in this economy,” said Richard Tortoriello, an analyst at Standard & Poor’s.

Still, analysts said, the fall in industrial orders disappointed investors, sending G.E.’s shares down 6.05 percent, to $11.65.
Analysts say two main concerns cloud the outlook for G.E. Its industrial side is a collection of capital-equipment businesses, and many customers will delay large purchases until genuine signs of economic recovery surface, they say.

The worry about the finance unit, analysts say, is the possibility that G.E. may not yet have seen the worst of losses and that it may have to set aside more money to cover them. But for a quarter at least, the trends looked encouraging.

The finance business was the biggest drag on G.E.’s results. Its operating profits fell 80 percent, to $590 million, down from $2.9 billion a year ago. And revenue in the finance unit, which includes home mortgages in Britain and private-label credit cards in the United States, declined 29 percent, to less than $12.8 billion, from nearly $18 billion.

G.E. has moved to strengthen the finance business. It said leverage, or the ratio of borrowings to equity, is down to 5.6 to 1, compared with 7 to 1 a year ago. And borrowing in the short-term commercial paper market is down to $50 billion, from $72 billion a year ago.
The impact of economic stimulus programs has not yet been evident, Mr. Immelt said. “We’ll see benefit from the global stimulus in the second half of the year,” he said.

United Technologies Profit Falls; Sales Forecast Cut

July 21 (Bloomberg) -- United Technologies Corp. posted a 23 percent drop in second-quarter profit as the recession slowed demand for aircraft parts and commercial construction, and said full-year sales will be less than it previously predicted.
Chief Executive Officer Louis Chenevert has been reducing costs to cope with a drop in revenue, which fell 17 percent to $13.2 billion in the quarter. He is cutting 18,000 jobs, or 8 percent of the global workforce, at the maker of Otis elevators, Carrier air conditioners and Pratt & Whitney jet engines by the end of the year. The company still sees profit growth next year.
United Technologies still expects to return to profit growth in 2010 based more on cost-cutting than revenue boosts, Chief Financial Officer Greg Hayes told investors on a conference call. So far, the company has spent more than $460 million of the $750 million targeted to reduce costs this year to cut 12,000 positions.

“We don’t expect to see a significant economic recovery in 2010,” Hayes said. “As we begin developing our detailed 2010 financial plan, business units are developing cost-led plans without much reliance on top-line recovery.”

United Technologies is also tightening costs through reduction in travel, furloughs and paring back expenses such as merit raises. The company doesn’t foresee any economic improvement in 2010 with the possible exception of China, where Otis and Carrier equipment orders declined 18 percent in the second quarter, an improvement over 40 percent in the first.

UPS Earnings Decline 49% As Downturn Saps Demand

United Parcel Service, the world’s largest package delivery company, said on Thursday that its second-quarter earnings fell 49 percent as the recession cut business demand. It forecast that its profit in the third quarter will be lower than analysts’ projections.
Package volume in the United States slid for a sixth consecutive quarter as the recession caused businesses to reduce orders amid the highest unemployment rate in 26 years. The company said shipments would remain “significantly below” those for last year. U.P.S. is considered an economic bellwether because it delivers a wide variety of items, including clothing, auto parts and financial documents.

“A lot of us got excited by those initial signs of stabilization, and now we’re realizing it’s going to be more of a 2010 event before we see real recovery,” said Nathan Brochmann, an analyst at William Blair & Company in Chicago.
“We are cautious, frankly,” the company’s chief financial officer Kurt Kuehn told analysts and investors on a conference call. “We don’t have any confidence that either demand or activity is going to pick up substantially” in the next several months.

Domestic volume fell 4.6 percent in the second quarter, the worst results since the company’s 1999 initial public offering. The measure will probably decline at a similar pace this quarter, Mr. Kuehn said. International volume tumbled 5.5 percent and will not improve this quarter, he said.

The number of hours U.P.S. airplanes were in operation declined 11 percent, saving 14 million gallons of fuel and contributing to a 54 percent drop in the company’s total fuel bill to $539 million as oil prices collapsed from a year earlier.

Burlington Northern's Earnings Up 15%; But Volumes Fall

Burlington Northern Santa Fe Corp.'s (BNI) second-quarter profit grew by 15% amid a prior-year charge, but fuel surcharges and volumes dropped.

The company's results were the latest sign that freight demand hasn't improved after rivals CSX Corp. (CSX) and Union Pacific Corp. (UNP) posted declining profits and volumes for the second quarter.

Still, executives from CSX and Union Pacific said the freight sector appeared to hit a bottom as the economy shows signs of recovery. On Thursday, Burlington Northern said volumes were beginning to stabilize in its more economy-sensitive businesses.
Total freight revenue dropped 26%, as volume, measured by rail car units, fell 19%.

Consumer and industrial products revenue each decreased 34%. Consumer products revenue fell on lower international and domestic intermodal and automotive volumes, while the decline in industrial products revenue was due to lower demand for construction and building products. Automotive revenue, counted in consumer goods, fell 43%.

As can be seen from doing a little digging in these earnings reports, there is little consensus of immediate or near term economic recovery. Many companies are benefiting from inventory buildups which had been decimated in the prior two quarters. Many are also showing increased revenues by cutting costs. Cutting costs, in most cases, refers to laying off workers, spending less on R&D, and sometimes eliminating businesses units altogether that have been losing money. Some are experiencing cost savings on falling fuel prices, which have experienced YoY price reductions.

It is in these sectors that we want to see companies going out and spending their cash reserves buying new units, hiring more workers and otherwise lengthening the productive cycle to add goods and services that increase the ability for others to attain their wants at lower costs than were previously possible.

Some may suggest that I am cherry picking by not focusing on the positive news in the financial space. But I will reiterate my above points. The recovery that eventually follows this period of contraction/liquidation/deleveraging will not be driven by easy credit and consumption. It will come from savings and capital investment. So focusing on either the financial services or consumer discretionary sectors is missing the boat entirely in my opinion.

But I will note that although the financials posted their best quarter in a long time, there is nothing in those results that tells me it was anything other than temporary. The bulk of the gains came from accounting changes and trading gains. To a lesser extent banks were beginning to make money on interest differentials. However, there was an aura of optimism in listening to conference calls - and it does not appear that the banks are taking seriously enough the coming impairments on Option ARM mortgages, commercial real estate loans nor consumer loans. My estimate is that they blew their "allowance" in one quarter, so they can attempt to raise capital at inflated prices. Next quarter, they will again require significant provisioning for loan losses, which will again hurt the bottom line.


Operating earnings are expected to come in (combined actual numbers with estimates for the other half) somewhere around $14.22 for the quarter. This makes for trailing 12-month operating earnings of $40.20. As of Friday's close, this gives a current trailing P/E valuation of 24.35. Analysts are expecting earnings of $15, $16.09, $16.40, and $17.89 for the next 4 quarters respectively for a total of 65.38, giving a forward P/E valuation of 14.97.

There are two things wrong with these numbers in my opinion.

First, they are excessively optimistic. As I mentioned above, much of the improvements are due to more or less one time cost cutting measures that add EPS points. These obviously cannot continue to occur, lest the companies disintegrate entirely. This means that when it comes to meeting the analysts targets, an even larger proportion of earnings are going to be required from actual revenues, expanding profit margins, etc. With that in mind, those targets are lofty at best.

Second, those numbers are "operating" earnings. Unfortunately, a company cannot invest operating earnings. Nor can they be used to pay dividends. For those often overlooked reasons to purchase common stock (ie. growth and/or income), a company must use their "as reported" earnings - which are what counts according to GAAP. As reported earnings were typically the benchmark for determining value. However, in 2008 when financials especially were writing off hundreds of billions per quarter in bad loans and making loan/loss provisions for the future, these numbers went off the charts. Other factors that contribute to "as reported" earnings include:

- legal costs
- goodwill writedowns
- plant and property writedowns (value of office buildings, for example)
- charges incurred to refinance debt and much, much more.

Clearly, these are all issues that affect a company's ability to operate - even though they are not considered to be "operating" issues. It is quite normal for reported earnings to be marginally lower than operating earnings (anywhere from 5-15%) during times of expansion, and substantially lower (usually 40% or so) during recessions. However, there is something notably amiss in the analysts expectations for this "recovery" that they are all pricing into operating earnings: They are not forecasting reported earnings to recover much at all for the next four quarters. Even in comparison with the "top down" operating numbers, analysts are forecasting reported earnings to stay 30-40% below operating earnings over the next year. They are obviously forecasting a continuation in writedowns of various sorts.

So I would beware of the "mass consumption" valuation numbers being thrown around by the financial media. The analysts making these forecasts appear to be hedging their bets by talking down reported earnings. Below is a table of various metrics of P/E valuation applied to whatever multiple you choose. "Trough earnings" for bear markets consistently fall between 6-8x, while "peak earnings" for bull markets typically get as high as 24.

One of these forces will win out. They are currently miles apart. My money is on reported earnings, as that is what is tangible and what affects a company's ability to invest in projects for the future. It is now a waiting game. I think we will eventually start to see the evidence for these future impairments in credit delinquency reports. Knowing that this will cause another bout of deleveraging will create a similar atmosphere seen last autumn, where individuals begin to turn pessimistic on their job prospects and run for cover. There is, of course, room on the upside for the opposing force to continue its reign, but I believe the optimism trade is close to running its course.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Friday, July 24, 2009

Bottom Fishing Revisited

Back in early March, I managed to do something I didn't realize I was doing at the time. I called the bottom in equity markets almost to the day. But I wasn't actually expecting that to mark the bottom for the spring. That, I was convinced, wouldn't happen for at least 2 weeks thereafter. At the time I was riding a pretty unreal streak of calling tops and bottoms in the market. So confidence, was, to say the least, of little issue. I suppose it serves me right that I wouldn't participate in a monster rally (not much anyway). The market has a way of keeping one humble.

However, I did manage to do a pretty good job in picking which sectors would yield the best returns based on both fundamentals and technicals. In my March 3rd article, "on bottom fishing", I posted the following table:

The price data in the table above is from the close of March 2nd. The bottom would eventually come later that week. The rally in many of the names to date has been fairly impressive. Below are the returns (as of the close July 23):

INTC 58%, VMW 61%, MSFT 62%, CSCO 53%, GOOG 33%, AAPL 79%, BRCM 87%, QCOM 44%, JNPR 96%, ISRG 152%, ABB 56%, FLR 73%, PCU 102%, LO 30%, EBS (20%)

The average return of the above was 64.4%, handily outpacing the S&P 500, which from it's Mar 2 close at 700 has returned 39.5% in comparison. I see this as further justification for my method of choosing high quality companies without the burden of excessive debt and those which have been outperforming the overall market during selloffs.

My main hint for those stocks was that they, and the Nasdaq index in general, had not gone on to surpass their November lows while the large cap indices (Dow and S&P) had. Nothing fancy. Positive divergence.

One could argue, though, that buying financials or other distressed companies at the time would have done better. Yes, perhaps. The first few weeks of the rally, especially, would have been profitable. In fact, the only trade I made was taking a double on some JPM calls. The immediate upside is always greater on securities that have been under panic selling. But the increased upside also comes with increased risk. What if your upside trading vehicle was CIT, KEY or RF? It is a hit or miss strategy. Not to mention the fact that finding a bottom on something falling like a stone is no easy task and provides no common sense levels for putting out stop-loss orders.

So what now? After an enormous 18 week rally, perhaps longs would be wise to learn from my mistakes in March. In other words, don't look a gift horse in the mouth. The S&P has touched 980 as of yesterday. Everybody and their dog is looking for "round number resistance" at 1000. It very well may be time to take the trade and wait for better opportunities. Even if one is of the persuasion that "the bottom is in," after experiencing gains that most would be happy to see in 4 years, cutting loose should be fairly easy for now.

Picking up dimes in front of bulldozers is only profitable to a point.

For those of the opposite persuasion, there may be opportunities on the other side. With the major averages above their early January highs, finding relative weakness in various sectors may prove profitable. Financials, utilities, and REITs are all showing such weakness. It should be of no surprise that these are the most debt dependent sectors. Their weakness is very telling. Credit markets have not completely unfrozen - not for unworthy borrowers. And this suggests that the credit crunch of 2008 is ongoing.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Wednesday, July 22, 2009

Ron Paul Mania!

When Ron Paul began his presidential campaign in the summer of 2007 he was, when not systematically ignored, popularly derided by the media. They would mention his name in passing or as part of a joke. When he set internet fundraising records, far surpassing those of even what Obama or McCain had raised at the time, it was discarded as a mere internet miracle. A one-off stunt by some fanatics who never had a voice in real politics - only the internet. When he did it again, surpassing the previous record, the media started sharpening their attacks. They disallowed him from participating in debates. They labeled his whole movement a bunch of conspiracy theorists. When that didn't work, they called Paul himself a racist and made sure everybody knew about it. That didn't work either. It was patently absurd. When hundreds of Libertarian-minded Republican Party members showed up to state conventions, they were intimidated, accused of treason and disqualified from eligibility for delegation.

It was apparent that the neocons had their minds made up. So Paul took his remaining funds and started The Campaign For Liberty. It would serve as a hub for the continuation of the campaign after Paul withdrew from the presidential race. When the Republican Party held their convention in St. Paul to cement John McCain's inevitable failure, it was to be expected that Dr. Paul would not be invited to speak. So the Campaign For Liberty held their own convention across town, drawing thousands in kind.

The economic crisis validated much of what Paul's platform had warned of. Primarily that the Federal Reserve System was the primary cause of exaggerated business cycles and that inflationism and mounting debt was a guaranteed path to crisis.

Fast forward about one year and America is gaga over Ron Paul. The media can't get enough. His bill HR 1207 now has over 270 cosponsors - far more than the 218 majority necessary. It's sister bill in the Senate S. 604 has 17 cosponsors. And the media is in a frenzy over the once thought of remote possibility that the Federal Reserve's opacity will be challenged.

Yesterday, congressman Paul questioned Fed Chairman Bernanke in the semiannual hearing with the Financial Services Oversight Committee. His rhetoric was some of the most pointed I have seen to date, reflecting the growing clout Paul and his supporters now carry. The two exchanges, the first being a statement and the second being his allotted 5 minutes for Q&A are both below for your viewing enjoyment.

Bernanke and some other prominent monetarist economists have been trying to poke holes in Paul's bill and cause some consternation among populist supporters of the bill. Naturally, the objections fall on deaf ears because they are preposterous. And in Paul's questioning of Bernanke yesterday, he pointed out some of those faulty assertions.

If one were to have the fortitude to sit through an entire session of these hearings, it becomes painfully obvious that there are very few members who have the faintest idea of what is going on. At one moment, Rep. Emmanuel Cleaver said he was asking a "theological" question (obviously meaning "theoretical"). Most simply ask Bernanke of his opinion about the future - as if his predictive record qualifies him for palm reading let alone the timing of public policy initiatives.

But it is this higher understanding of the financial system and the Federal Reserve System in general that seems to have endeared himself to the average folk yearning to make sense out of the jumble of political rhetoric. Paul explains things very simply - from the Austrian perspective. What goes up, must come down. Spending more now, means spending less later. Deficits result in higher taxes. Inflationary policies result in economic distortions. These are things that the average everyday person can relate to. Neoclassical economists often claim the opposite - that while something may be true for the individual, it may not be true for government, bankers or any other special interest group. Paul's ability to convey these basic praxeological truths in layman's terms has made him somewhat of a rockstar. Indeed, "during times of universal deceit, telling the truth becomes a revolutionary act."

Below are some videos of Paul's TV appearances. All in the last 24 hours:

The Ron Paul Revolution was supposed to end with a whimper. Now, it's being televised.

Periods of economic turmoil are renowned for preceding political upheaval. And nobody would realistically assert that the current paradigm will survive indefinitely. Ross Perot tried to change things in the early 90's. But people weren't angry enough. Eventually, some figure will come along and change everything. When this happens it will have a profound impact on investments of all types. The only question remaining is whether this change will be a force for good or evil.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Monday, July 20, 2009

Mauldin: Europe On The Brink

This has been an ongoing topic of mine for quite some time. And it is good to see that more than just a few primarily North American focused analysts are casting an eye across the pond and chiming in on what they see.

This week, John Mauldin takes out a knife and defines what he sees as a potentially mammoth shoe hanging overhead. His article can be read in its entirety here. I will post some excerpts.

But Europe's banks have been much more aggressive in funding emerging-market expansion than US or Japanese banks. Western European banks have lent $4.5 trillion to various emerging-market countries, businesses, and consumers. Many Eastern European businesses borrowed in low-interest-rate euros. New homeowners in Hungary and the rest of Eastern Europe borrowed in Swiss francs and euros, and as their currencies have collapsed they now find they owe more on their homes than they're worth.

And here's the problem. Europe's banking system is in far worse shape than the US system. The losses may be bigger, and their capital to meet those losses is certainly less. Let's look at some charts. Remove sharp objects or pour another adult beverage.
In the first few years of the G.W. Bush administration, the banking authorities decided it would be OK to allow five banks to increase their leverage from 12:1 up to 30:1. Which five banks, you ask? Bear Stearns, Lehman, Merrill Lynch, JPMorgan, and Goldman Sachs. How did that work out, just five years later? Three are gone and two survived with large dollops of taxpayer money.
Thirty times leverage means that if you lose 3.3%, you wipe out all your capital. And we watched as banks too big to fail were bailed out with taxpayer dollars. Slowly, banks are buying time, writing down assets. Remember, this month is the second anniversary of the onset of the credit crisis. I wrote back then that the strategy would be to stretch this out as long as possible. Time heals a lot of bad debts, especially at a 0% Fed Funds rate.
I am going to give you four charts showing the leverage of banks in the US, the United Kingdom, the Eurozone, and Switzerland. The bottom, blue portion is assets to common and preferred stock; the red is assets to common equity, which can include good will; and the purple is assets to tangible common equity.

Tangible common equity is all the rage, and that is what the recent "stress tests" measured, as opposed to tier 1 capital, which includes preferred stock (which would basically be the blue portion.) TCE only includes common shares. Now, let's start with the US. These graphs show leverage. The average leverage of tier 1 capital of the five largest banks is in the range of 12:1, and is actually down from ten years ago. (By the way, a very good and simple explanation of all this can be found at

While the TCE has obviously been rising and taking total leverage to rather lofty levels in the mid-40s, banks are raising capital, and over time leverage will come back down. It helps if you can borrow money at almost nothing and lend it out at much higher rates...But as the commercial says, "But wait, there's more!" Let's look at the Eurozone.

Leverage is now 35:1 and with TCE is almost 55. How did 35:1 work out for the US? Given the massive credit problems that Eurozone banks have with emerging markets (plus Spain's housing bubble, which is every bit as bad as that of the US), will this not end up in wailing and weeping?

Mauldin also shows UK and Swiss banking systems that are even more grossly overleveraged. I think this elucidates another very important fact. While many may assume that the "excesses" have been worked off as a result of the autumn panic and subsequent clampdown by regulators, reality appears to show otherwise. The banking system has become MORE leveraged, not less. In addition to the growing amount of leverage, the systemic risk that the large institutions pose has increased. JP Morgan is now one with Bear Stearns and Washington Mutual. Wells Fargo joined with Wachovia. Bank of America is now Countrywide and Merrill Lynch all tied up. PNC added National City to its balance sheet. The list goes on. If any one of these was too big to fail back then, what of it now? Back to the article:

And here's the real issue. They have no Paulson and Bernanke. Now some of my Austrian-economist friends will say, "Good, they should all be allowed to die;" but that is a very cavalier attitude when you start talking about actually increasing the unemployment rate to something like 20%. I agree that management should be changed (as well as the regulators: 35:1 to 1 - really? What were they thinking?) and shareholders wiped out, but I do not want the system to collapse. And this is a global risk, not just localized to Ireland or Spain or Austria. Sure, the pain might be worse in the local region, but we will all feel it.

The European Central Bank, at least as of now, cannot step in and start saving individual banks. How do you save a Spanish bank and not an Austrian bank? Austria's banks have made large loans to Eastern Europe, in euros and Swiss francs, and are going to have large losses, far more than 3%, which would wipe out their capital. But bank assets in Austria are 4 times GDP. What we have are banks that are too big to save for relatively small Austria. And for Italy, Spain, Greece, et al. More on this below.

Mauldin is correct when he says the Austrian solution to "let them die" is very cavalier. That doesn't, however, make it wrong. And should it be allowed to happen, the 20% unemployment figure cited will have no reason to prove anything but temporary. The question should be what is morally justifiable, rather than what would cause the least short term pain.

Eurozone banks are already reeling from losses from US subprime-related problems. They are now getting ready to deal with even deeper losses from their own lending portfolios. If the losses were just 5% of the portfolio (an optimistic assumption), it would be 20% of Eurozone GDP. But each country is responsible for its own banks. While it is thought Germany will be able to handle its problems, the prognostication for Austria and Italy is not so sanguine. Italy is already running a massive deficit, and has no central bank to monetize its debt. The same goes for Portugal, Spain, Greece, and Ireland. 5% loan losses in Ireland would be 40% of GDP, the equivalent for my fellow US citizens of about $5 trillion. Where does Europe find a few trillion dollars?

I was writing in late 2006 that the subprime lending market would end in tears. And I think the European banking crisis that is on the horizon has the potential to be every bit as big a problem as subprime loans. The world depended on Europeans banks for much of the lending that allowed for growth and development. Like their counterparts in the US, they are going to have to reduce their loan portfolios. Deleveraging is not fun.

It takes time to build up a banking infrastructure that can raise the capital necessary to make and process loans. A lot of time. Europe is a big customer of the US and Asia. Their businesses are going to be hit hard by the lack of capital, which is of course no good for employment, etc. We are all connected. What happens in Rome no longer stays in Rome.

The entire article is well worth the read. But I think the most important point here is that what appeared to be a temporary "fix-it" for the US financial system last year is not politically possible in Europe because of the complications involved over sovereign borders. Minyan Peter of is a former executive of a large US Bank. His name and the bank remain anonymous, but his insight is always worth the read. And he had a few words of his own to add to Mauldin's article:

If you haven't already read John Mauldin's piece this morning on the challenges facing European banks, I encourage you to do so. In it, he discusses the fact that many European banks are far greater in size than their home country economies.

But to me, there's an even greater significance to his report: For most banks, their vast banking empires extend well beyond their local borders -- for some, the bulk of their assets (both good and bad) are abroad.

Bailing out banks because of their domestic missteps is one thing; asking local taxpayers to bail out a bank's foreign failings is another.

As a consequence, I expect that the long-term price paid by the "empire" banks (largely Swiss, British, Belgian, Dutch and German) will be a far, far smaller foreign footprint. (And, for what it's worth, the Swiss Central Bank has already created a 2-tiered capital requirement system: One level for domestic activities and another, higher, level for foreign business.)

But as necessary as these steps may feel to local politicians and central bankers, to the untrained eye, politically driven retrenchment looks a lot like protectionism.

To me, this is where it is going to get very interesting, particularly as governments pressure super-sized financial services firms to shrink. (And here I will digress once more to remind readers that, at the top of AIG's (AIG) divestiture plan, is none other than the firm's foreign operations. Or how about Bank of America's (BAC) sale of its investment in China Construction Bank? Or dare I suggest GM's sale of Opel, its European subsidiary? It will be interesting to watch other financial services firms -- from Citigroup (C) to Wells Fargo (WFC) -- to see if they follow suit.)

I don't pretend to know how this will fully play out. But at this point, the course is set. In an increasingly politically driven global financial system, the priorities are clear; and those priorities are being driven more and more by the voting booth.

And as any politician will tell you, local always wins.

Whether you call it protectionism, political populism or something else, the structure of multinational financial institutions will be receding for the foreseeable future. It is a key reversal in attitudes from those of the last 30 years, where cooperation and compromise ruled the day. Those values have been cast aside. It's gonna be a no-holds-barred scrap for TCE. If that means abandoning foreign liabilities, I highly doubt voters will blame legislators for making those decisions.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Sunday, July 19, 2009

Technical Update 27.09

Everything that I pointed out last week reversed completely. If there was ever a picture perfect justification for the "stop loss" order, it can be found in the chart below. The reversal was breathtaking in its ferocity. The Nasdaq surpassed its highs from early June. Volatility was slammed back into the low 20's. And the circus barkers delighted at the apparent justification for their "the worst is over" claims.

As I mentioned on Wednesday, the function of this entire rally is to convince as many people as possible that the worst is over and "happy" days are here again. Until that function has been satisfactorily fulfilled, the rally can have legs. It is also possible, however, that there is a "light switch" event for social mood somewhere along the way. Where something happens and people immediately, rather than gradually, revert to their Oct/Nov '08 frame of mind. I realize that is fairly ambiguous (ie. the market could go up or down), but such is the nature of countertrend moves in any market. They are notoriously hard to gauge, yet when they end, they end with a bang. Think back to the Currency Crises of the late '90s and how they were quickly brushed off prior to the last years of the bubble.

Looking a bit more short-term, there is a decent amount of evidence supporting a "closing of the gap" open from Monday, which surrounds the 906-911 level. RSI and Stochastics are both overbought on the hourly chart and a selloff to those levels would relieve that condition. However, I've noticed a number of technicians mentioning this possibility, which means it may just not happen. I got a number of e-mails from readers talking about the "head and shoulders" pattern formed from the May-July price action. It was one of those that seemed to fit the bill of, "If it's that obvious, it's obviously wrong." That proved correct. Bear that in mind when looking at any pattern such as the "double top" or various trendline breaks.

While the major averages all seemed to rally in kind last week, we can glean a bit more information from the individual sectors that make up those averages. All sectors are not created equal. And perhaps the most important of those is the banking index. Although posting 8% gains on the week, the index is nowhere near it's highs posted back in early May. This is despite the apparently bullish earnings reports posted for the second quarter and a government green light to commit accounting fraud. The banking sector is still under extreme amounts of pressure, and this, again, is one sector I would want to watch for potential non-confirmations of new market highs.

Oil is one market that has actually been performing as I expected all along in 2009 (trust me they're few and far between). I originally targeted a range between 66 and 74 for this rally, and it pinned the top end perfectly before reversing. The CRB Commodity Index is another sector (of which oil is a part) that I would watch closely for non-confirmations. Virtually nobody is looking for lower oil prices. I am. I see oil trading with a "2" handle by next spring. Additionally, the Elliott Wave pattern on this chart is clear as day and is supportive of my hypothesis.

Another Elliott Wave pattern that appears to be playing out nicely is that of the US Dollar. It appears ready to make a "5th wave" low for this current "wave C" of "Primary wave 2". If you do not understand Elliott Wave that makes absolutely no sense whatsoever. For the layman, it is saying that it wants to dip slightly below it's December low (77.69), before reversing higher in a move that will prove to be greater in magnitude and longer in duration than that seen between July and November '08.

Have a great week!

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Saturday, July 18, 2009

Paulson Forced To Revisit '08 Events

Former Secretary of the Treasury Hank Paulson sat before a congressional panel this week to answer questions about his handling of the events surrounding the Bank of America/Merrill Lynch merger. The inquiry is the third of a series into the matter, the first being of BAC CEO Ken Lewis, and the second being of Fed Chairman Ben Bernanke.

Nearly the entire event, when not tragically repetitive, proved to be quite entertaining and worth watching. Most of the members of the committee, rather than questioning Paulson, took the opportunity to launch into 5 minute tirades against the various inconsistencies and obfuscations not only present in the BAC/MER issue, but in the TARP program, AIG bailouts and Paulson's favourable treatment with his former company, Goldman Sachs.

The hearing in its entirety (3.5 hours) can be watched uninterrupted below:

The meat of the hearing can be found between 43:00 and 1:14:00 where congressmen Kucinich, Jordan, Kanjorski, Burton and Lynch take their turns going over the events of late September and early October. Equally as hostile were questioning by congressmen Chaffetz and Turner as well as congresswomen Speier and Kaptur (2:38:00).

It is interesting to go back to those days and think about what was considered unthinkable at the time. Unemployment figures of 10% were being thrown around like grenades. It happened anyway. Talk of major damage to the stock market was often used as reason for pushing through the bailouts without delay (or even members reading the bills before voting). That ended up happening in November and even further in March anyway. They said banks would fail without action. 55 banks have failed thus far in 2009. And they said that systemically important firms would bring down the entire economy. And the result has been not a reduction in the size of these firms, but rather a massive increase. They also said that large employers would not have access to capital (debt markets) in order to fund their operations without any assistance. As it turns out, these companies (like GM and Chrysler) as well as small business lenders Advanta and CIT Group have ceased operations or entered bankruptcy protection.

Nearly every doomsday justification used to promote this idea of bailing out financial institutions happened anyway. So while the stock market is currently rallying on a media fueled inventory rebuild and trading firms reaping huge profits, essentially everything the bailouts were supposed to do failed miserably. But throughout Paulson's entire testimony he trumpets the terrible things that "would have happened" as justification for the illegal actions taken in Sept/Oct. I suppose that logic can be extended to anything. A doctor whose negligence caused the death of 100 people can say, "hey, good thing I didn't kill a thousand."

The congressmen and women on this panel are not buying the arguments of former Treasury Secretary Paulson. Nor did they buy what Lewis and Bernanke were telling them. And I doubt they will be more civil when questioning former SEC Chairman Chris Cox and FDIC Chairwoman Sheila Bair next fall. Now that they have seen the real world damage take place without regard to the trillions thrown around on Wall Street, they realize how foolish the actions of 2008 seem.

The reason this is important is not necessarily to pin the blame on any one person or group of people, however justified that may seem. It is important because it marks a change in the attitude of lawmakers in the US. Previously, they had been all too willing to go along with any recommendations given to them by Wall Street bankers. There appears to be, now, bipartisan agreement that such an act can not be tolerated again. So when the time comes for the next round of support by the taxpayer, none will be forthcoming. It will be entirely up to the Fed to provide such support. Something they may not be willing or able to do.

It is also important for the psychological impact it will have on future generations of wall street executives. They have now been warned, that if they do something that the average person feels has been wrong, then they are liable to find themselves taking the stand under oath. With such knowledge, they are not likely to simply continue their reckless behaviour as before (GS may be the exception here).

A total backlash against the banking industry is to be expected as a result of this episode. Many people are talking about a potential sequel to the Pecora commission of the early 30's. I believe that will happen once the second leg of this crisis begins to become apparent. It will likely go too far in its attacks on the banking industry, targeting even innocents who were "just following orders." Such is the nature of angry mobs.

The point is, the financial industry will never be the same. And to those who think that a new financial bubble can have any legs under such circumstances will likely prove to be disappointed. It is for this reason, among others, that attempts to expand credit that has worked in every attempt since the recession of the late 50's, will fail this time around. And it is corollary to that, that I believe hyperinflation is an impossibility anytime in the foreseeable future.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

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