December 27, 2008

December 27, 2008

The S&P500 slipped almost 2%, on light volume, for the holiday week.  Volatility dropped again, but it didn’t help create the much hoped for Santa Claus rally.   And the flow of bad data continued.  Jobless claims spiked to 586,000, a multi-decade high.  Consumer spending dropped, and durable goods orders slipped.  Notably, new and existing home sales plunged and the median sales price of existing homes fell (year on year) by over13%–the largest decline since the Great Depression according to the National Association of Realtors.

Why is this notable?  Aside from the fact that the usually optimistically biased NAR has started to acknowledge the magnitude of the housing bubble debacle, the housing data is clearly pointing to more pain in the housing market.  Before this data was released, some bottom-callers had started to suggest that they could see the light at the end of the tunnel in housing.  After a peak to trough price drop of 20+%, they were desperately looking for signs that the rate of price declines was deccelerating.  This data proved them wrong.  Housing is still falling and arguably falling off a cliff.

Why does this matter?  One of the root causes of our global economic crisis was the bursting of the U.S. housing bubble, a bubble fueled (in part) by the Fed’s easy money policies after the dot-com bubble burst and by the accompanying spread of easy credit products and their securitization all over the world.  The S&P500 is down about 40% in 2008 as a direct result of the negative feedback loops created by this imploding housing market.

So, if the housing market is nowhere near finding a bottom, then it creates additional–and substantial–downward pressure on the U.S. (and global) equity markets.  Unless the Fed, or the Treasury, or Congress, or the tooth fairy, can come up with some miracle cure to stop the free fall in housing, then the odds of further drops in equity prices go up. 

And keep in mind that the U.S. housing market has approximately $20 trillion in total value–even after its drop from peak value in 2005-2006.  Using the Case-Shiller 100 year trend line as a rough estimate of fair value (long term price to income and price to rent ratios are equally suitable substitutes), then the U.S. housing market could easily fall another 20% just to revert back to this level (and this assumes that prices would not fall below long term fair value, as they typically do in major corrections).  This means that another $4 trillion in housing value could vanish.  If about 50% of house values are encumbered with mortages and related liens, that means that $2 trillion in credit values would need to be marked down, say by 50%. 

This may mean another $1 trillion in mortgage related losses have yet to be booked.  If all of the disastrous economic and financial events of 2008 resulted from $1 trillion in credit losses, then imagine what havoc a second trillion dollar loss would wreak. 

2009 promises to be challenging.  Buckle up.

December 20, 2008

December 21, 2008

Another relatively flat week:  the S&P up under 1% and the Dow down about half a percent.   The bad economic news kept on coming: industrial production slumped, building starts and permits plunged, CPI fell to historic lows, jobless claims stayed above 550,000 and leading indicators fell.  The biggest news was the Fed’s move towards quantitative easing, Japan style.  After dropping its target lending rate to near zero, the Fed essentially pronounced that it will increase the supply of credit as much as needed to stabilize prices and avoid deflation.  The equity markets initially cheered the news, but then  retreated to digest the gravity of the situation:  what happens if the Fed’s programs don’t work, as in Japan? 

U.S. banks are hoarding cash, depositing it right back with the Fed.  As they deleverage, the banks are not–by definition–lending as much as they did in the past.  And their customers–corporate and consumer–are not demanding as much credit as they did in the past.  Therein lies the problem.  Neither the Fed, nor the President, nor Barney Frank can force the reluctant lenders to lend to reluctant borrowers. 

But what if the Fed keeps printing more dollars?   The currency markets may have punished the dollar this week, but the treasury market soared–to historic highs–seemingly shrugging off the potential threat of inflation down the road.  Today, it seems, that investors around the world are worried more about deflation and are averse to assuming risk.  So they’re content to earn essentially no yield in 3 month T-Bills and only 2% in 2 year Treasuries.   This suggests that they expect further economic deterioration and prices to continue falling.  Obviously, this is not a good sign for equities.  It is probably a major reason why we have not seen a major and sustained rally beyond 900 and on to 1,000 in the S&P500.  We reached the 800’s in October, and we’re going to need to see signs of economic improvement to give buyers confidence to push the market up much higher.

On a positive note, the equity markets are not falling much.  Again this week, despite the steady stream of bad news, the market did not suffer from panic sell-offs, as it did in October and November.  This suggests that a bottom, at least in the short term, is being established.

Like thin ice, unfortunately, this bottom may prove to be fragile, with tragic consequences.  In just a few weeks, Q408 earnings will begin to stream in.   If they’re ugly enough, and if the outlooks are ugly enough, this might just crack the support levels built up around 850.  Throw in a few major nasty blow-ups (a big corporate or sovereign default, a significant bankruptcy, or even a revolution or war in a developing or emerging nation) and the panic sell-offs could easily return, pushing the S&P down into the 700’s and even the 600’s. 

In short, the upside is limited, but the downside could be painful.   It’s no wonder that so much capital is playing it safe.  At least over the next three months, it might pay to stay off the ice.

December 13, 2008

December 14, 2008

The S&P500 lurched upward by 0.4% this week, not much of a December rally.  The Dow, by comparison, dropped a bit.  Several factors point to the possibility of more upside.  One major indicator was the ability of the equity market to disregard a torrent of bad news, including horrible jobless claims, deflationary PPI numbers, and weak retail sales.   The argument is that the market’s low prices have already discounted such bad news, so a short term bottom might have been established, providing bulls with confidence to push prices higher.

On a daily basis, an uptrend seems to have been established on November 24.   But this past week’s performance showed evidence of weakness, with the low of the week being made on Friday.  On a weekly basis, the market is still somewhat oversold, but much less so than it was on November 21.

Longer term, from a weekly and monthly perspective, the bear market and downward trend is still firmly intact. 

Fundamentally, the bad news continues to flow.  The Tribune and KB Toys filed for bankruptcy.  GM and Chrylser will live beyond 2008 only if the White House decrees that it will be so.  Other large firms are teetering:  Nortel, GMAC, XL Capital, General Growth Properties, most of the large newspaper publishers, and many others. 

Many firms need to roll over their debt in the upcoming quarters.  Unfortunately too many will need to pay an arm and a leg to get this financing; many others will not get it–at any price.  More defaults and bankruptcy filings are imminent. 

Earnings warnings are cropping up again:  FedEx alarmed the optimists (who were hoping for a boost from lower fuel prices) that decreasing shipments will mean much lower earnings in 2009.  And as a bellwether for the overall health of the economy, FedEx’s revelation is an ominous signal.  Although market analysts have slashed their estimates for Q4 and early 2009, they may more work to do revising estimates downward.

As corporations slash jobs and capital expenditures, as consumers slash spending (and borrowing), and as our trade deficit remains stubbornly high, the only entity available to take up the slack is the U.S. government, through fiscal and monetary stimulus.  And most economists agree that these efforts, at best, will only partially offset the massive reduction in the three other components of aggregate demand.  Total U.S. indebtedness of $55 trillion must come down by approximately $20 trillion to return to a more normal, long term relationship to GDP.  So even if our government throws $2 trillion (or even $3 trillion) at this problem, it still does not come close to replacing the potential reduction in spending that would result from the massive deleveraging already underway.

We have a long way to go in resolving our economic crisis.  Those who proclaim that the final bottom has been put in (in the U.S. equity markets) are being highly optimistic.  A miraculous V-shaped recovery to our recession would be nice, but a long and painful L-shaped outcome is more realistic.

December 6, 2008

December 7, 2008

The S&P500 ended the week down about 2%.  But the equity markets displayed massive intra-day volatility, often trading up and down 2+% in the same session.  The bear market continues, on a long-term basis.  However, the equity markets seem to want to climb in the short-term. 

Despite suffering through an onslaught of horrible economic data, the equity markets held up amazingly well.  They shrugged off plunging home sales, durable goods, personal spending, auto & retail sales, ISM services, consumer credit and payrolls data.  Especially after the payrolls data (loss of 533,000 jobs), it’s not an exaggeration to state that the U.S. economy is falling off a cliff.   Capital is fleeing to treasuries driving down yields to levels not seen in decades.  Corporate and municipal credit spreads remain high.  Corporate earnings guidance continues to sink.  And layoff announcements are soaring. 

But don’t tell that to the equity markets!  Our economic and credit disasters, according to equity investors, are already discounted in the current equity prices.  This is creating another massive divergence.  The fundamentals are falling apart, yet technically, the market seems to be forming a bottom–at least in the short-term.   Many are calling this the technical bounce from deeply oversold levels.  OK, but be careful!  On several occasions earlier in 2008, the equity markets day-dreamed their way up, temporarily, only to be rudely awakened by the grim reality of the economic and corporate data.  The problem this time:  never in 2008 have the economic data been more negative than during this past week.  It’s getting very ugly and very scary.

The fourth and final quarter of 2008 is almost over.  Look for many more earnings reductions in the form of guidance and actual misses from lowered guidance.  Look for more layoff announcements.  Look for credit defaults to rise–about a trillion dollars of U.S. corporate debt needs to be refinanced in 2009; more and more of it will not get rolled over.  If equity gets raised to replace it, stockholders will get crushed. 

The federal government is intervening on a massive scale to prop up the credit markets, and eventually–through fiscal stimulus–to prop up aggregate demand.  But the government will most likely not be able to replace, in it’s entirety, the implosion in the private sector.  It appears that aggegate demand is collapsing, resulting in a severe recession where deflation will become the enemy to fight.  But as in Japan in the 1980’s and the U.S. in the 1920’s, we will be fighting a massive deleveraging process (stemming from the bursting of the housing bubble) that can overwhelm the best efforts of the U.S. government.  No matter what the government does, it cannot force consumers or corporations to spend.  And it can’t fully replace that spending itself.   So the outcome, unfortunately is looking like it will resemble the deep and prolonged recessions of the U.S. in the 1930’s and Japan in the 1990’s. 

Perhaps the U.S. equity markets will agree, eventually.  Unless the bottom in the economic cycle is visible–even six to nine months from now–then the bottom in the equity markets has not been established.  The pain is not over, not by a long shot.