Words from the wise for the week that was (Jan 14 – 20, 2008)
The stock market continued its downward trajectory during the past week, experiencing wild swings on the back of a barrage of bad news in the financial sector, and ongoing concerns about the housing and credit markets weighing on investor sentiment.
This prompted Bill King (The King Report) to raise the following questions about Fed chairman Ben Bernanke’s troubled facial expression: “How dreadful has sentiment about the economy and financial system become? If one picture is worth a thousand words, what are two pictures worth?”
Bernanke’s testimony before a congressional committee on Thursday reaffirmed the market’s worries about the health of the economy. He admitted that the tumbling house prices, increased energy costs, falling consumer spending, increasing unemployment and weak stock market performance were more than likely to drag down US economic growth. Bernanke expressed his support for significant fiscal and monetary stimulus as a pre-emptive strike against a US recession. Despite these pronouncements the stock market plummeted by more than 300 points.
On Friday President Bush broadly outlined a plan for roughly $150 billion’s worth of tax breaks, rebates and unemployment benefits to boost the slowing economy and help stave off a recession. This announcement, however, could not prevent stocks from sliding further, especially as concerns mounted that the downgrading of bond insurers dealing in credit default swaps could trigger another wave of huge debt write-downs.
“I hope I’m wrong, but I’m thinking that a large economic storm is building, and it’s aiming to hit hard in the weeks and months ahead,” said Richard Russell, 83-year old author of the Dow Theory Letters.
Before highlighting some thought-provoking news items and quotes from market commentators, let’s briefly review the financial markets’ movements on the basis of economic statistics and a performance chart.
The bulk of the economic statistics reported during the past week, including soft retail sales, falling housing starts and a declining Index of Leading Economic Indicators, reaffirmed the US’s economic woes and the precarious position of consumers. BCA Research summarized the implications for the Fed’s meeting at the end of the month as follows: “While some FOMC members remain concerned about upside inflation risks, this will not prevent further major rate cuts. A stimulative Fed will not lead to an early improvement in the economy, but should cushion the downside.”
WEEK’S ECONOMIC REPORTS
Source: Yahoo Finance, January 18, 2007.
Next week’s economic highlights include Initial Jobless Claims and Existing Home Sales on Thursday.
Source: Wall Street Journal Online, January 20, 2007.
Concerns about a US recession again clouded the financial markets during the past week and the subprime woes continued to unfold as more write-downs and depressed earnings were reported.
The bears made their presence felt and stock markets slumped across the globe with almost panicky selling being encountered. This is evidenced by the steep fall in both the MSCI World Index (-5.1%) and emerging markets (-6.4%). Under the circumstances, the Japanese Nikkei 225 Average did relatively well with a more modest decline of 1.8%.
The losses of the US stock markets are mounting as illustrated by the following year-to-date returns: Dow Jones Industrial Index: -9.5%; S&P 500 Index: -10.4%; Nasdaq Composite Index: -12.5% and Russell 2000 Small Cap Index: -12.8%. The latter has declined by 21.5% since its high in July 2007, thereby now qualifying as being in a bear market as the “official” definition of a 20% decline has been met.
On the currency front, the Japanese yen gained strongly as a result of the reversal of the carry trade, putting pressure on a number of high-yielding currencies. The US Dollar Index found slight gains on hopes that the White House’s stimulus plan will help ease credit market problems. The euro, on the other hand, declined as expectations for the ECB shifted from holding rates steady to perhaps joining the Fed in cutting rates.
Government bond yields fell further around the world as the global economic outlook worsened and investors switched stocks to what is perceived to be a safe-haven asset class. In the US, the real 10-year bond yield traded at its lowest level since the 1970s.
Commodities, in general, came off their highs on the back of the economic slowdown and heavy profit-taking after the recent rallies. Agricultural commodities, however, continued their uptrend and posted a gain of 2.1% for the week.
Now for a few news items and some words (and graphs) from the investment wise that will hopefully assist in guiding us through the stormy waters and making the correct investment decisions during the shortened week ahead.
Source: Jim Sinclair’s Mineset, January 17, 2008.
Asha Bangalore (Northern Trust): Fiscal stimulus package and impact on economic activity
“Questions about the benefits of a fiscal stimulus package made up a major part of the Q&A session in Bernanke’s testimony. As an example, Bernanke answered that the impact of a $100 billion tax rebate to households was expected to result in a $60 billion increase in consumer spending. This has enormous significance. As an exercise, when we plugged in $60 billion spending in our GDP forecasting model, holding other things constant, it resulted in a nearly 2.0% annualized increase in real GDP in the quarter it was spent. The multiplier effect of this spending is a more complex exercise. Our exercise is for illustrative purposes only. Studies have found that the rebate is probably spent over two quarters. By implication, the $140 billion package should have a larger impact than the example cited in the testimony.
“Fiscal policy has a relative advantage compared with monetary policy when considering the timing issues of policies because the impact lag of fiscal policy is smaller in comparison with monetary policy. By contrast, the implementation lag of fiscal policy is longer than monetary policy. Therefore, the emphasis is on enacting the package in a timely manner. If the Fed lowers the Fed funds rate to 3.00%, eventually, matching our forecast, it would be a cumulative ease of 225 basis points. The impact of this large cut in the federal funds rate will be visible only several months ahead unlike the impact of fiscal policy changes.”
Source: Asha Bangalore, Northern Trust – Daily Global Commentary, January 18, 2008.
Bernanke, Paulson, whatever: you financial types all look alike
Source: Paul Kedrosky’s Infectious Greed, January 17, 2008.
BCA Research: Bernanke to markets – we are not asleep
“While some FOMC members remain concerned about upside inflation risks, this will not prevent further major rate cuts. A stimulative Fed will not lead to an early improvement in the economy, but should cushion the downside, and ensure that equities move higher over the course of the year.”
Source: BCA Research, January 15, 2008.
The Wall Street Journal: A quote from 1993
“Too many people have become complacent about deflation. But watch out. Debt has grown too large to be sustained out of cash flow. As soon as the balance sheet is depleted, a deeper crisis of asset liquidation will catch the world by surprise.”
Source: James Dale Davidson, The Wall Street Journal, 1993.
Goldman Sachs: Calling a US recession
“The change to a more negative view was made after analyzing the poor data that has been coming out of the US since the start of this year, particularly the unemployment rate which rose by 0.3% to 5%. Historically, whenever the unemployment rate has risen by 1/3% or more, the US has fallen into a recession.
“The changes have significant impact on our forecasts for a number of asset classes. We now expect the EUR/USD rate to show further USD weakness. We forecast 1.51, 1.51 and 1.40 in 3, 6 and 12 months respectively. USD fixed income will benefit from stronger easing by the Federal Reserve (2.5% interest rates for 2008). Equities will need to be positioned more defensively (overweight pharma, consumer staples, utilities, underweight tech, industrials and financials).
“These changes will also affect the growth forecasts of other regions. We have maintained that other regions such as the Euro zone and Asia would show some resilience unless the US outlook became worse, as we now predict. We have already adjusted the outlook for Japan, where we now also expect a recession in 2008.”
Source: Thomas Stolper, Fiona Lake and Jens Nordvig, Goldman Sachs, January 10, 2008.
Asha Bangalore (Northern Trust): Inflation is a problem, but FOMC should ease monetary policy on January 30
“Conclusion – Bernanke’s comments on January 10 clarified that in the inflation-growth debate the Fed now sees the risk of weakening economic conditions as the predominant risk. He also remarked that the Fed stands ready to take substantive action to jump start a stalling economy. True, the CPI rose 4.1% in the twelve months ended December 2007. At the same time, industrial production fell at an annual rate of 1.0% in the fourth quarter. In addition, the sharp increase in the unemployment rate and a negligible expansion of payrolls in December, the below 50 reading of the ISM manufacturing composite index, soft retail sales in December and the continued decline in equity prices are factors building the case for further easing of monetary policy. Today’s economic reports have not changed our forecast of a 50 bps cut in the federal funds rate on January 30 to 3.75%.”
Source: Asha Bangalore, Northern Trust – Daily Global Commentary, January 16, 2008.
Kiplinger Business Resource Centre: Lasting housing woes paint a grim economic picture
“For now, the housing sector is caught in a sickening downward spiral. New construction is still much too high. At 2.5%, the ratio of vacant unsold homes to total homeownership is 50% greater now than it had been for 20 years. There’s an excess inventory of up to a million homes. To work that off, housing starts must drop by an additional 25%, to about a million a year. But we expect starts of 1.2 million or so this year, down just 11% from last year’s figure of 1.35 million.
“One reason: Too much of builders’ money is tied up in development – the cost of buying finished lots, impact fees and permits, building roads, installing water and sewer lines and so on. To keep cash flowing and minimize losses, they keep building homes and hoping to sell them. Mario Ricchio, housing industry analyst with Zach’s Investment Research, says, ‘If builders could shut down for two years, they would eliminate all the overhang. Of course, that’s not going to happen. They have to generate cash flow.’
“More foreclosures will worsen the problem in the short term. Two million homeowners face a reset of adjustable mortgages both this year and next.”
Source: Jerome Idaszak, Kiplinger Business Research Centre, January 2008.
Asha Bangalore (Northern Trust): Housing starts record severe weakness
Source: Asha Bangalore, Northern Trust – Daily Global Commentary, January 17, 2008.
Asha Bangalore (Northern Trust): US Index of Leading Economic Indicators offers support for recession forecast
“The quarterly average of the LEI is down 0.6% from a year ago. Historically, negative year-to-year changes in the quarterly LEI are associated with recessions with the exception of the drop in 1967 when the economy was weak. Larger declines will be necessary to confirm that a recession is underway. However, the fact that the LEI has now declined in two out of last three quarters on a year-to-year basis is a strong signal that should be watched.”
Source: Asha Bangalore, Northern Trust – Daily Global Commentary, January 18, 2008.
Asha Bangalore (Northern Trust): CEO Confidence Index lowest in current cycle
Source: Asha Bangalore, Northern Trust – Daily Global Commentary, January 15, 2008.
John Mauldin (Thoughts from the Frontline): Credit default swaps – the continuing crisis
“The real problem is the ‘monoline insurers’ like ACA, Ambac, and MBIA. Here’s a quick primer on how they work. Let’s say you are a small municipality and want to borrow $10 million for a bond offering to build a road or a water treatment plant. If you went to the market with your credit rating, it would be a low rating and the cost of the money would be high. But if you get one of the seven monoline insurers to guarantee your bond, then you get whatever their credit rating is. The fees for such insurance are lower than the savings you get on the bond, so everyone wins.
“But over the years, most of the monocline insurers went from boring municipal bonds and jumped into the mortgage-backed security markets, selling credit default swaps that significantly juiced up their earnings. But it also added a lot of risk that they clearly, in hindsight, did not understand.
“ACA has already seen its rating go from A to CCC, which is basically junk. This puts it out of business, as no one will pay to be rated as junk. Merrill wrote down almost $2 billion in bonds that were insured by ACA. They will not be alone.
“Today, Fitch downgraded Ambac Financial Group two notches from AAA to AA. That doesn’t seem like a lot, until you realize that 74% of their revenue comes from that AAA rating that covers $556 billion in municipal and structured finance debt. Moody’s says it is going to review MBIA.
“If you are a bank or regulated entity, and you have mortgage-backed securities that have been written by a AAA monocline company, you can carry that debt on your books as AAA. But as the companies get downgraded, you have to write down the potential loss.
“If you have Ambac or MBIA insurance, as a bank you have not yet written down any debt they insured. They are still rated AAA. But that re-rating is coming. And what about the monster CDS business in the hedge fund world? There are going to be more losses in the biggest banks, and even bigger investments by Sovereign Wealth Funds. Count on it.”
Source: John Mauldin, Thoughts from the Frontline, January 18, 2008.
The Wall Street Journal: Citi makes an enticing offer
“The bank is set to issue $2 billion worth of so-called convertible preferred stock to the public. The prospectus hasn’t been issued yet, but the terms should be similar to those offered to a handful of very rich investors in a just-concluded $12.5 billion private placement. Those investors include the bank’s former chairman, Sandy Weill, and Prince Alwaleed bin Talal. So if you buy into the convertible preferreds, you’ll be in good company.
“The stock will have a 7% yield. These are ‘preferred’ stocks, which means they’re a little like bonds. The dividends won’t rise: But they are pretty secure, as they should get paid in full before common shareholders get a penny. On the other hand, the dividends should get the same privileged tax treatment as payouts on shares. Oh, and investors will have the ability to swap their preferreds into ordinary shares if the price of the latter recovers 20% from its current depressed situation. In other words, you get a great yield, some pretty good security, and almost all the upside if things improve.”
Source: Brett Arends, The Wall Street Journal, January 15, 2008.
Ambrose Evans-Pritchard (Telegraph): Anna Schwartz blames Fed for subprime crisis
“The high priestess of US monetarism – a revered figure at the Fed – says the central bank is itself the chief cause of the credit bubble, and now seems stunned as the consequences of its own actions engulf the financial system. ‘The new group at the Fed is not equal to the problem that faces it,’ she says, daring to utter a thought that fellow critics mostly utter sotto voce.
“‘They need to speak frankly to the market and acknowledge how bad the problems are, and acknowledge their own failures in letting this happen. This is what is needed to restore confidence,’ she told The Sunday Telegraph. ‘There never would have been a subprime mortgage crisis if the Fed had been alert. This is something Alan Greenspan must answer for,’ she says.
“Schwartz remains defiantly lucid at 92. She still works every day at the National Bureau of Economic Research in New York, where she has toiled since 1941.”
Source: Ambrose Evans-Pritchard, Telegraph, January 14, 2008.
Bloomberg: Greenspan’s reputation at risk as recession odds grow
“‘He’s had a bubble reputation that derived from the growth of US household wealth,’ said Edward Chancellor, author of ‘Devil Take the Hindmost: A History of Financial Speculation’. ‘As that goes down, his standing as a superstar will suffer.’
“At stake is not only Greenspan’s legacy but also the future of policies he espoused during 18-1/2 years atop the central bank. Critics blame his aversion to regulation and reluctance to use interest rates to puncture asset bubbles for the boom in mortgage lending and house prices that has since gone bust, threatening to throw the economy into recession.
“In an interview, Greenspan said such criticism ignores limits on what regulation and monetary policy can achieve.
“Fed Chairman Ben S. Bernanke has already moved away from the laissez-faire approach of his predecessor by proposing new restrictions on subprime mortgages.”
Source: Rich Miller, Bloomberg.com, January 10, 2008.
The Wall Street Journal: Trader made billions on subprime
“Now, in another twist in financial history, Mr. Paulson is retaining as an adviser a man some blame for helping feed the housing-market bubble by keeping interest rates so low: former Federal Reserve Chairman Alan Greenspan.
“‘Most people told us house prices never go down on a national level, and that there had never been a default of an investment-grade-rated mortgage bond,’ Mr. Paulson says. ‘Mortgage experts were too caught up’ in the housing boom.
“In several interviews, Mr. Paulson made his first comments on how he made his historic coup. Merely holding a different opinion from the blundering herd wasn’t enough to produce huge profits. He also had to think up a technical way to bet against the housing and mortgage markets, given that, as he notes, ‘you can’t short houses.’
“Also key: Mr. Paulson didn’t turn bearish too early. Some close students of the housing market did just that, investing for a downturn years ago – only to suffer such painful losses waiting for a collapse that they finally unwound their bearish bets. Mr. Paulson, whose investment specialty lay elsewhere, turned his attention to the housing market more recently, and got bearish at just about the right time.
“Mr. Paulson has taken profits on some, but not most, of his bets. He remains a bear on housing, predicting it will take years for home prices to recover. He’s also betting against other parts of the economy, such as credit-card and auto loans. He tells investors ‘it’s still not too late’ to bet on economic troubles.
At the same time, he’s looking to the next turn in the cycle. In a recent investor presentation, he said his firm would at some point ‘start preparing’ for opportunities in troubled debt.”
Source: Gregory Zuckerman, The Wall Street Journal, January 15, 2008.
Richard Russell (Dow Theory Letters): Market shaping up as an angry bear
“At the time, nothing seemed terribly out-of-kilter in the US economy. Sure, housing was a mess, but that had been well-publicized weeks, even months, in advance. And that’s the strange and damnable thing about the stock market. It speaks, it gives its rather rare Dow Theory ‘signals’, but at the time we never know exactly what it is that the market is telling us. But we don’t have to know – all we do have to know is UP from DOWN. At the time I didn’t know how important or how far ‘down’ was. And I’m still not sure about the full meaning of ‘down’ in the current situation.
“But it’s becoming rather clear to me that ‘down’ in this bear market means ‘down and dirty’. It’s ‘Katie bar the door.’ In other words, this bear market is not shaping up as anything vaguely pleasant. No, it’s shaping up as an angry grizzly bear. And this bear has been sinking his claws into the throats of investors, not only in the US, but around the world.”
Source: Richard Russell, Dow Theory Letters, January 16, 2008.
David Fuller (Fullermoney): Where will markets be in 12 months’ time?
“Psychological problems for corporations, consumers and investors are considerable because a year ago very few people had even an inkling of what was about to happen. The outlook seems grim, or has certainly been made to look so by an excited and emotional press. Therefore, for perspective, we should refer to the table by DB Global Markets Research.
“The $400bn of losses forecast is insignificant compared to items in the table, not least DB’s calculation of $149.1trn for total world financial markets. However, the ongoing and more serious problem that has yet to be checked concerns confidence. The setback in stock market valuations since the sub-prime related problems broke is vastly greater than $400bn.
“Needless to say, governments and their central banks have a big vested interest in stopping the rot. This requires leadership, which has not exactly instilled confidence to date. However governments are crisis oriented and I assume that leadership in monetary, fiscal and psychological terms will improve over the next few months. This does not require a miracle – just common sense.
“A year from now, and perhaps well before, I believe calm will have returned to stock markets which will be trading above today’s levels … Meanwhile, most stock markets look as if they will move somewhat lower before they trend higher once again.”
Source: David Fuller, Fullermoney, January 15, 2008.
GaveKal: Equity markets approaching a bottom
Source: GaveKal – Checking the Boxes, January 18, 2008.
Mike Lenhoff (Brewin Dolphin Securities): Global equities looking oversold
“‘First, if the rate at which Citigroup has been prepared to make its writedowns is followed by other banks in similar positions … much, if not all, of the bad news relating to the subprime fallout could be flushed away – if not by the end of the first quarter, then by the summer.’
“Second, Mr Lenhoff says, US and UK interest rates will be very much lower by the summer. ‘Our view has been that the Fed funds rate will be down to 3.5 per cent by then and UK base rates down to 4.75 per cent, levels sufficiently low to induce expectations of better times ahead for the US and UK economies and an improving outlook for corporate earnings.’
“Third, valuations will start to look much more appealing when earnings are being upgraded, which Mr Lenhoff expects to happen when interest rates have been lowered.
“He says: ‘The major equity markets are oversold. That’s not much comfort if a bull market is breaking down. But the way I see it, this is a consolidation phase following four years of a bull market, and hence the transition phase to another leg of the bull market.’”
Source: Mike Lenhoff, Brewin Dolphin Securities (via Financial Times), January 16, 2008.
MarketWatch: Credit Suisse, in switch, recommends US stocks
“The strategists on Monday raised their rating on the US to 5% overweight, from benchmark.
“Strategists at HSBC made a similar call, raising their stance on the US to overweight while cutting their views on Europe and emerging markets to neutral.
“The Credit Suisse analysts pointed out the US Federal Reserve is one of the only central banks with a clear growth mandate. ‘Thus, we believe that the Fed will continue to be more balanced in its assessment of inflation risks,’ the strategists said, adding that labor-cost inflation and corporate-sector pricing trends both suggest underlying inflationary pressures are well contained.
“From a current level of 4.25%, the strategists said the Ben Bernanke-led Fed may slice the fed funds rate to as low as 3% by the end of the first half of 2008.
“‘By virtue of the weakening dollar and the Fed’s easing cycle, monetary conditions are now far looser in the US than in Europe,’ they noted. As for the housing market downturn, it said the US is up to two-thirds of the way through the downward adjustment.
“Where the strategists have turned negative is in Continental Europe: they cut the region’s rating to 10% underweight from benchmark. Unlike the Fed, the European Central Bank has an inflation-related mandate, and the hawkish comments made by ECB officials, including President Jean-Claude Trichet last week, suggest the ECB ‘could disappoint’ by keeping rates too high for too long.
“Of other regions, it kept Britain at benchmark, noting that domestic UK sectors are already pricing in something close to a hard landing; it kept its emerging-market overweight at 8%; and it moved its view on Japan to 10% underweight from 15% underweight.
“Credit Suisse bases its positions on the MSCI World Index, which has a 45% US weight, a 20.7% Europe weight, a 10.6% Asia ex-Japan weight, a 9.6% UK weight and an 8.6% Japan weight.
“Japan is now HSBC’s least favored market, because it’s the most cyclical, has least monetary room for cuts and new construction regulations won’t help. It cut Europe and emerging markets to neutral because of cyclical drawbacks.”
Source: Steve Goldstein, MarketWatch, January 14, 2008.
BCA Research: Take profits on long duration bond positions
“First, our valuation models show that US and G7 10-year bond yields are trading near to the threshold of overvaluation. In the US, the real 10-year bond yield is at its lowest level since the 1970s. Moreover, the bond and money markets have already largely discounted a US recession. For example, eurodollars are priced for the fed funds rate to fall almost to zero in the next year. Similarly, investment-grade and junk corporate bond spread indexes are still below their 2002 peaks, but they too appear to be very close to recession territory.”
Source: BCA Research, January 17, 2008.
GaveKal: Remaining bullish on oil is a dangerous strategy
“Current speculative fever centers on crude stock levels being at multi-year lows, and indeed they are. However, if we look at stocks of refined products, the picture is not as dramatic. The difference is accounted for by a slowdown in oil demand in the US – itself a function of price, seasonality and GDP growth. And herein lies the rub: With everyone and his uncle is calling for a recession in the US, official bodies keep lowering their energy demand growth estimates, and the industry is thereby left with little incentive to keep adding to stocks. In turn, low inventory numbers fuel speculation, and oil prices rise further – which discourages demand (as oil consumption does have some elasticity to price). Ironically, bold speculation (based on insufficient inventories) could further discourage oil demand at a very inopportune time …
“If the US falls into recession or simply slows down further this year, or if Europe enters a recession, or if Asia begins selling more of its production at home and shipping less across the Pacific, then demand for oil could drop dramatically. As we see it, these ‘ if’s’ are currently much more plausible than what oil is pricing in: a) a powerful surge in demand ahead, or b) a cataclysmic collapse in supply (while this risk is certainly still a concern, we note that production out of Iraq is now at a post-Saddam record high). All in all, we continue to believe that, for the oil price, the risks are far greater on the downside.”
Source: GaveKal – Checking the Boxes, January, 2008.
Michael Lewis (Deutsche Bank): Agricultural price rallies still in their infancy
“The current rally in many agricultural commodity prices is still only close to historical averages in both magnitude and duration, Mr Lewis adds.
“But he says inventories in a number of agricultural products have fallen to critically low levels at a time when global demand for food, cattle feed and biofuels is rapidly increasing. ‘We consequently believe the price rallies in corn, cotton, soyabeans and wheat are still in their infancy.’”
Source: Michael Lewis, Deutsche Bank (via Financial Times), January 15, 2008.
BCA Research: China – tentative signs of growth moderation
“Looking forward, we expect that the tightening campaign will continue. With the reserve requirement ratio for commercial banks already at a record high and proving ineffective in an economy that is increasingly privatized, the authorities are likely to use interest rate and exchange rate policies more actively than in the past.”
Source: BCA Research, January 15, 2008.
GaveKal: Be cautious of Chinese equities
Source: GaveKal – Checking the Boxes, January 15, 2008.
Times Online: UK government’s court order plan to keep creditors at bay
“The proposals would mark the biggest shake-up of personal insolvency legislation in years and come at a sensitive time for the financial services industry, which is bracing for an increase in consumer bad debts.
“The plans, which were outlined in a consultation paper yesterday by the Ministry of Justice, would allow consumers who fall into financial difficulties through a change of circumstance, such as losing their job or divorce, to stop making repayments on personal loans, credit cards and other debts for up to a year by applying for an ‘enforcement restriction order’.
“Bridget Prentice, the Civil Justice Minister, said: ‘We want to ensure that people who run up debts are given every opportunity to pay them off.’”
Source: Grainne Gilmore, Times Online, January 17, 2008.
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