Quadrillion Dollar Problem

March 28, 2009

The S&P500 resumed its furious snap-back rally from 12 year lows reached only three weeks ago.  The hope rally, long overdue, has materialized, and is now in danger of pushing the markets into an overbought condition.

Amazingly, precious little has changed over these last three weeks, certainly not enough to explain, unambiguously, the violent swing up.  This week, the Treasury Department did flesh out its toxic asset removal scheme–to nobody’s great surprise, it centered around the taxpayer subsidizing private capital to bid higher than market prices for toxic assets held by mismanaged banks.

Both liberal and conservative critics have already pounced on the obvious flaw:  buyers, even with taxpayer incentives, will probably not bid enough to meet the banks’ asking prices.  This means that banks might not sell their toxic assets (because a sale below the asking price would force them to realize huge losses and further deplete capital, pushing many closer to official insolvency).  But the equity markets, unlike the credit markets, rallied anyway.

The economic data continued to point to an economy in deep recession:  prices for existing homes dropped 16% yoy; existing home inventories climbed to 3.8 million units; initial claims jumped up to 652,000 and continuous claims, at 5.56 million, hit another all-time record high.  Personal income fell 0.2% and the personal savings rate remained at an elevated 4.2%.

Technically, the S&P is still in an uptrend from a daily perspective.  But this rally is getting long in the tooth.  Many traders are preparing for a pullback that’s now becoming almost as overdue as a rally was three weeks ago.  On a monthly basis, the bear market is nowhere near violating the downtrend that was first established in December 2007.

Let’s not forget that we’re suffering from a recession that cannot be compared to most of the other recessions in the U.S. over the last 50 years.  The more recent recessions were of the inflation control type; this one is rooted in the bursting of an asset and credit bubble.  The best U.S. analogy is the Great Depression. 

And unfortunately, this time we’re suffering from several harmful forces that didn’t even come into play during the Great Depression.  One major force is the derivatives market.   Hernando de Soto in the WSJ reminded us that today’s global crisis is growing because the world has created an estimated one quadrillion (a thousand trillion) dollars worth of derivatives that are not regulated or properly recorded by our financial markets.  This massive overhang of MBS’s, CDO’s, and CDS’s is paralyzing the world’s credit markets, exaggerating the speed and magnitude of the deleveraging already taking place because of the above-normal ratios of debt to GDP worldwide.

Given that the U.S. GDP is about $15 trillion, is it any wonder that the global markets are worried about the risk from derivatives (described as financial weapons of mass destruction by Warren Buffett) where a mere 1.5% gross loss would equal the entire GDP of this country?

The Fed’s Gone All In

March 21, 2009

The equity market rebound continued this past week, but just barely.  Although the S&P500 finished up about 1.5%, it was fading badly as the week drew to a close.

Earlier in the week, the momentum from the prior week’s bounce continued to build.  Then the buying sputtered, and the selling returned on Thursday and Friday, mostly after the market reacted to the Fed’s latest FOMC decision.

Fundamentally, signs of hopeful economic data were generally missing.  The Empire manufacturing report and industrial capacity utilization results were the lowest on record.  Industrial production fell more than expected.  Initial claims remained in the mid-600,000 range, pushing the 4 week moving average up to the worst level since 1982.  The one supposedly bright spot–housing starts–wasn’t so bright after all because the spike was driven by a non-recurring jump in apartment construction, not single family homes.  Also, several corporations warned that their most recent outlooks are poor and still deteriorating; among these were FedEx, Nike and Adobe.

Technically, the two week rally is on the verge of breaking down.  Friday’s 2% drop in the S&P pushed most indicators to the limit:  if there’s any more selling early next week, the short-term rally could be over. 

So what did the Fed do, and what are the ramifications?  Simply put, the Fed decided it will print money, a lot more money–over $1 trillion’s worth.  With the fed funds rate at virtually zero and with economic demand still falling dramatically,  the Fed will buy Treasury and agency debt to shovel more dollars into the economy, hoping to drive down interest rates.  The bet is that consumers and corporations will find credit less expensive and more accessible so that they’ll be more likely to buy things, thereby pushing up demand to match supply and prevent deflation.

What’s the problem? 

First, our currency gets debased.  And sure enough, gold priced in dollars soared and the dollar fell in terms of other major currencies like the Yen and the Euro.  Second, and related to the first, is that the risk of inflation goes up.  If the Fed doesn’t mop up the extra dollars when (or if) demand picks up, then inflation may rise.  Inflation may also rise if the demand doesn’t pick up forcing the Fed to print even more dollars because the markets will expect and demand that the Fed do so.  Third, what’s the rest of the world going to think and do?  One risk is that other major economies begin a self defeating race to the bottom by doing the exact same thing;  in fact, the U.K. and even Switzerland have also started their own programs of quantitative easing.  Fourth, as Japan’s experience over the last 10 years has shown, quantitative easing is not likely to work.  It does not and cannot force people and businesses to spend.  Finally, what about the signal effect?  Are things so bad economically that the Fed is willing essentially to bet the house on a low probability move? 

From the looks of it, things are that bad.

End of the Bear Market? Fat Chance.

March 14, 2009

Finally, the S&P jumped almost 11% for the week to close at 757, still 52% off the peak in 2007. 

What sparked the bounce?  Something quite flimsy (which is typical of oversold rallies):  the CEO of Citigroup, which still exists only because of the good graces of the U.S. government, announced that, because they’re charging in interest more than they’re paying, they should be profitable in the first quarter of 2009–assuming no write-offs of bad assets.  Wishful thinking.

Other fundamental data continued to disappoint:  Initial claims were sky-high at 654,000 and continuing claims rose to 5.3 million–the most on record (since 1967).  The trade balance shrank, but for bad reasons: trade is collapsing (as opposed to the good reason:  the U.S. exported more goods).  Michigan sentiment remained near record lows.  Although retail sales were better than expected, many analysts warned that massive retail discounts sparked more purchases–this is both unsustainable and harmful to retailer margins. 

Technically, the equity market is showing a classic turn from an oversold level–especially from a daily time horizon.  In fact, even after this week’s snap back rally, there’s plenty of room and momentum to see more upside movement next week or the week after.   But from a weekly and monthly perspective, the market trend is still pointing down.

So is the bear market showing signs of abating?

Amazingly, with the market hitting another bear market low (667) on Monday of last week, there was no shortage of “experts” popping up in the media to spew some version of the same message:  the market, forward looking as it is, is starting to show signs of a turnaround.  More alarmingly, these experts resumed peddling the age old myth of buying and holding, claiming that now is a good time to buy–as if the worst were over.

Is it over?  Considering that jobs are still being lost at record-setting rates, that the housing bust is not slowing at all, that stock market wealth is at 12 year lows, that corporate earnings have imploded and show no signs of bouncing back soon, that consumer and business spending is literally depressed, that state and local governments are slashing spending to avoid defaulting on their bond obligations, that global trade is collapsing at rates that rival those from the 1930’s, and that total U.S. indebtedness, public and private, is still near record highs, the answer is most likely:  fat chance.

Investing vs. Trading vs. The Bottom

March 8, 2009

This is getting serious.  Another week, another massacre on Wall Street.  The S&P closed at 683, down 7% for the week.  The S&P is now down 56% from peak, reached in October 2007.  And it has fallen for 8 out of the first 9 weeks of the year–down over 24% this year alone.  If the 2008 meltdown had never occurred, this year’s sell-off would amount to a severe bear market in its own right. 

The fundamental data this week were, unsurprisingly, weak.  Pending home sales, auto sales, and construction spending came in below expectations.  Initial claims remained at the mid-600,000 level first breached several weeks ago.  But the big story of the week was jobs.  Non-farm payrolls declined by 651,000 and the unemployment rate hit 8.1%, the highest level since 1983.   What’s scary is that the momentum of these losses suggests that the worst is yet to come–there is nothing on the horizon that points to a decline in the rate of such job losses.

The technicals seemed to have worked well.  When the 750 support level broke down, the path of least resistance was down, and the market behaved as expected.  In fact, the techicals have been pointing downward for quite some time now, and simply being short the broad market would have paid off handsomely. 

So the inevitable question of “where’s the bottom?” seems to be on everyone’s mind again.  For almost half a year, too many market analysts, money managers, and writers have been calling bottoms, only to be burned–over and over again–as the market continued sliding downhill. 

The problem is that nobody can nail the absolute bottom.  Unless we get lucky, the only way we’ll know we’ve hit bottom is by missing it.   That means the bottom will be called, with the benefit of hindsight, while most prudent investors miss the initial movement up in prices.

Traders who, unlike investors, seek to realize gains over short time horizons (days or weeks) are due for a technical bounce.  The markets, by most technical indicators, have become very oversold.  Traders can jump in, grab 5% to 15% gains, and jump out at the first sign of trouble.

But investors, who seek long term capital appreciation over months and years, must stay out.  Prices have not bottomed, because they are still falling.  We are in a bear market, and buying and holding–today–is likely to disappoint.

The Good News about Depression

March 1, 2009

Here we go again.  February ended in disaster.   The S&P lost 4.5% for the fourth and final week of the month.  For the month, the S&P lost 11%, its worst February since the 1930’s.  It’s declined for 7 out of the first 8 weeks of the year. 

The fundamentals were bad, as usual.  The economy is showing signs of slipping deeper and faster into a downward spiral.  The Case-Shiller index revealed another month of record-setting price declines.  New and existing home sales volumes continue to erode.  This is especially worrisome given that prices are plunging; the implication is that prices must fall some more (much more) to clear the market of unsold new and existing homes.  Durable goods orders dropped and consumer confidence fell off a cliff, signalling even more trouble ahead for consumer demand.  Weekly claims spiked to 667,000–the worst since 1982.  And the revised Q408 GDP report came in at a staggering 6.2%, also the worst since 1982.

Corporate earnings continued to disappoint.  Target, Home Depot, Safeway, Dell and many others reported results that were below expectations.  To add insult to injury, dozens of major firms began to cut dividend payouts; Ameren, GE, Gannett, and Textron announced reductions that were not well received by shareholders. 

Technically, the S&P breached an key support level:  it took out its November 2008 low.  This means that a lot of traders will now be even quicker to sell because the 742 low from 2008 was widely viewed as a critical line in the sand; now that it’s been crossed, the perception is that there is no nearby level of support.  To technicians, it’s look out below!

From a historical perspective, the current drop is astounding.  At 735, the S&P is down 53% from its peak in October 2007.  Officially, this bear market is now the second worst ever, trailing only the bear market of the Great Depression when it fell 89% (using the Dow, because the S&P500 was not yet in existence). 

But here’s some good news:  the peak-to-trough drop from September 1929 to July 1932 consumed 2 years and 10 months.  Today, with February concluded, we are 1 year and 4 months into our bear market.  So if we assume that our current bear market will be no worse than the 1929-1932 bear market , then we could reasonably argue that today we’re in the fifth inning of our bear market.

So regardless of the severity of the drop to date, and regardless of the currently depressing economic news, we could see the end of this bear market sometime later this year, and possibly early next year.

Now that’s something to look forward to!