Housing Market Bottom?? Really??

(originally published on March 25, 2008)

Technorati Tags: existing homes sales,inventory,months of supply

 

We were informed this week that sales of existing homes in the US unexpectedly rose 2.9% in February to a seasonally adjusted annual rate of 5.03 million. This was the first increase in seven months. Understandably, it caused quite a flutter among economists, with some of them, perhaps prematurely, calling for a bottom to the unending housing spiral.

But as far as economic data go, one month do not maketh a trend. Also, there is a great deal more to this data than what the headlines would suggest. The median price of single-family homes dropped 8.7 percent from February 2007, the most in four decades of record keeping by the National Association of Realtors (NAR). Although sales increased 2.9% over January’s figure, they were down a phenomenal 23.8% from February 2007.

Existing Home Sales - Seasonally Adjusted Annual Rate

 

Further, as seen in the chart above, on a seasonally adjusted annual rate, February 2008 was the weakest February since 1998. That cannot be great news.

Existing Home Sales – Not Seasonally Adjusted

 

Excluding the seasonal adjustment – on a non-seasonally adjusted basis – sales have plunged in February 2008 as compared to the prior three years. Also, it can be seen that February is one of the less important months in the calendar as far as existing home sales go, with sales generally remaining muted, before the spring selling season that begins in March.

Existing Home Sales - MoM percentage change (2004-2008)

 

Also, over the past few years, February has always been better than January. The average increase from January to February over the past four years has been 7.2%. The 2.9% gain in February 2008 is less than half of what we have seen over the past few years. Part of the reason could be that February 2008 was a leap year. Small changes in ‘Not Seasonally Adjusted’ sales (due to leap year, weather or other factors) can have a significant impact on the headline ‘Seasonally Adjusted’ numbers.

But there were a few positive data points as well. Nationwide inventory of existing homes decreased 3% in February to 4.03 million homes available for sale, representing 9.6 months of supply at the current sales pace.

Existing Home Sales - Inventory

Existing Home Sales - Months Of Supply

 

Inventories have somewhat stabilized over the past few months in the wake of a nationwide plunge in home prices. But even as inventory levels have stabilized, months of supply have risen and have remained high, as sales have plunged (months of supply = inventory/home sales rate). Typically, inventories have tended to decline in December, slowly rebounding in January and February and rising more sharply starting March as the spring selling season starts. It is thus only natural to expect inventories to reach record levels again later this year.

Chart – Inventory : Normalized seasonal pattern

(data normalized to the ending level of the previous year = 100)

 

The data over the next few months will tell us if indeed inventories are stabilizing, or if the decline in February was just noise. Either way, any contention of a bottom to the housing market is preposterous.

P.S. : Charts courtesy of Calculated Risk

 

Update :

Housing Market Bottom?? Check out the plunge in home prices in January

A Bailout By Any Other Name...

(Originally published on March 24, 2008)

Technorati Tags: moral hazard,Federal Reserve,Bear Stearns,bailout

 

The Federal Reserve’s decision last week to put up $30 billion in the form of a loan to facilitate JP Morgan’s purchase of beleaguered investment bank Bear Stearns expectedly has come under a lot of criticism. Although the criticism was probably justified, it was argued by some that this was not really a bailout, because at $2 a share Bear was essentially worth nothing. Bear had lost over 90% of its value in just a week and was down almost 99% from its $170 high marked in early 2007. Bear’s shareholders were practically wiped out and the Fed was not doing anybody any favors. But the equation now changes a bit with JP Morgan quadrupling its bid for Bear Stearns to $10 a share.

Firstly, the argument that there was no bailout of Bear Stearns is incorrect, even if its share-holders were indeed practically wiped out. Insolvency necessitates 100% wiping out of a firm’s equity. A residual value of share-holder equity – even if only $200M – essentially implies that these share-holders still fully own the firm and that they stand to benefit from any possible increases in the market value of the firm due to the significant $30 billion liquidity support provided by the Fed.

Securities firms – except the very few that could be deemed to be systemically important – should succeed or fail of their own accord, without any guarantee – explicit or otherwise – that they would receive liquidity support in the event that they end up bungling up. As a thumb rule, non-bank financial institutions that are illiquid should be allowed to fail in case they mismanage their liquidity risk and are unable to find private sources of emergency liquidity. If they are insolvent, like Bear most certainly was, they should certainly be allowed to fail.

The Fed probably contended that Bear was ‘too big to fail’ – given its size and its interconnectedness with the system, Bear’s failing posed a major systemic threat to the financial system. But any such institution that is indeed systemically too important to be allowed to fail should be brought under the Fed’s ‘lender of last resort’ umbrella only if the said institution were regulated and supervised in the same manner as banks are. Currently, US securities firms are supervised by the SEC and have much lower capital standards than banks. Bear and others are only paying for their years of excess… reckless lending practices with practically non-existent risk management practices.

Prudence suggests that securities firms should properly manage their liquidity and credit risks, with the creditors to such firms providing additional market discipline by having their claims at risk if the firm becomes insolvent. A necessary corollary to such market discipline would imply that creditors to such firms should lend funds at rates that would fully incorporate all the relevant risks – credit, market, liquidity and others – that they face.

The appropriate resolution of the Bear Stearns insolvency – that would have minimized the moral hazard argument given the Fed’s liquidity support – would have been a complete wipe out of its share-holders, an en masse firing of its entire senior management (minus the golden parachute and rich severance packages) and an eventual nationalization of the firm. Public money was used to bail out the creditors of the firm in order to prevent a systemic collapse. Instead, it should have been used to ensure an orderly disposal of its assets or operations, including inflicting appropriate losses on its creditors. It is only appropriate that creditors of insolvent – as opposed to illiquid – securities firms not be bailed out when such firms get in trouble, even if they are dubbed systemically too important to fail.

Instead the manner in which the Bear collapse was handled, the Fed and the Treasury have only ended up creating the mother of all moral hazards. Bear share-holders are far from being wiped out, the senior management has stayed in place (and probably also played a role in the offer price being quadrupled) and the firm’s creditors, who lent without considering the significant risk they were undertaking, have not experienced the losses that they would have incurred had Bear been forced to close down.

This is a bailout irrespective of what the Fed or the Treasury prefer to call it. It may help to avert a systemic crisis in the short term. But it does nothing to provide a long term solution to what is being dubbed as the biggest financial crisis since the Great Depression.

That 70's Show!

Technorati Tags: That 70's Show,inside week,pole,pennant,Philly Fed manufacturing survey,Stagflation,Recession,Catch-22

We had earlier commented that last week's trading action was suggestive of an 'inside week' formation - a consolidation after recent steep losses. This week's action was similar, with the front-line indexes staying confined within last week's trading range, forming a 'double inside week'. Inside weeks are continuation patterns, with double inside weeks being even more so. Bears have certainly taken a breather after the sharp blood-letting in January. Despite the ups and downs during the week, bulls can probably claim a semblance of victory at the end, considering multiple negative news-flow (dismal Philly Fed data, sharp rise in inflation, crude rising to over $100 a barrel), finishing the week with less half a percentage gains. Other markets, however, did much better, with Bovespa closing the week with 7% gains.

 

S&P 500 - Weekly Chart

 

The trading action from the panic January lows can be likened to that of a bearish pennant. A bearish pennant occurs because prices seldom decline in a straight line for an extended period of time. Prices will typically take brief pauses, seemingly to 'catch their breadth', before resuming their trend. The lead-in phase (the pole of the bearish pole & pennant formation) occurs as the market adjusts to unfavorable events/news-flow pushing prices sharply lower, with nervous sellers and fresh short-sellers being quite willing to sell even at lower prices. As prices drop, early sellers who had sold short at higher levels look to cover their positions even as some others start bargain-hunting. The forces are now balanced between those who are willing to support the market in anticipation of a rebound and those who believe the negative economic/fundamental developments warrant lower prices going forward. The stock begins to consolidate in a narrowing range on decreasing volume, even as the bearish news-flow and negative market sentiment persists. Things finally come to a head, when a negative news trigger comes out that leads a secondary collapse in prices through the lower line of the pennant formation. This phase (lead-out phase) is marked by a noticeable increase in volume as sellers - new and old - outnumber the bargain-hunters and the profit-takers. Prices decline sharply in this period - usually as much as the height of the pole - albeit at a slightly more gradual pace.

 

Dow Jones Industrials - Daily Chart

 

While the action over the last few weeks fits this description rather nicely, it is important to remember that patterns that everybody looks at and recognizes tend to have a high failure rate. Everybody seems to have an opinion on what this consolidation means for the market. As with any chart pattern, the challenge is not how to trade the break, but what to do once the break occurs.

Interestingly, the indexes witnessed a phenomenal rebound (as much as 250 points on the Dow Jones Industrials) in the last half hour on Friday after CNBC reported that a bailout plan for troubled bond insurer Ambac Financial could be announced next week. As had occurred on Wednesday as well, investors at times set aside existing concerns and snap up stocks either to cover bets that stocks would fall or amid genuine, if tentative, optimism that policymakers could help right the economy. Wall Street's bursts of optimism haven't proved to be long-lasting though. A government-backed plan to aid bond insurers could nevertheless help boost confidence in the bond market, where a lack of confidence has choked the flow of money.

We dissect the Philly Fed manufacturing survey this week. Manufacturing has been reasonably resilient thus far; but as the survey reveals, chinks are developing on that front as well. We will keenly watch whether the ISM Manufacturing index, that measures manufacturing activity on a national scale, comes along similar lines (slated for release on March 3). We next review the looming prospect of stagflation that has been further emboldened by this week's CPI data. It is a catch-22 situation for a Fed that is caught between two evil damaging forces. This should make for an interesting read.

Economy Continues To Slide.

 

Technorati Tags: Philly Fed manufacturing survey,recession,ISM,Empire state index

The Philadelphia Federal Reserve's general business conditions index – a widely used gauge of the health of the region's manufacturing sector – plunged to a reading of minus 24 in February, from minus 20.9 in January. Negative readings indicate a contraction in activity, while positive readings denote expansion. This was the third straight negative reading for the index and its lowest level since February 2001. The sudden slide into negative territory is reminiscent of the plunge seen in the Dec 2000 – Mar 2001 period, just before the

2001 recession.

 

 

The Philly Fed index, whose history dates back to May 1968, has proved to be a fairly reliable gauge of business cycle turning points and often – but not always – a prelude to the ISM index, the most prominent of survey-based manufacturing indicators. The Philly Fed survey, however, differs from the ISM in that it is not a composite of separate metrics of activity; if an ISM-type of weighting of the Philly Fed sub-indexes were done, it would indicate a reading of 45.9 in February from 46.6 the prior month (source: Bear Stearns Research). This, coupled with the recent Empire State Survey raise the chances that the national ISM index, which has held fort thus far, will dip below 50 for the month of February (slated for release on March 3).

S For Stagflation

Technorati Tags: inflation,joker in the pack,core CPI,crude oil,stagflation,inflationary expectations

We have pondered earlier if inflation was indeed the joker in the pack that could potentially restrain the Fed's rate-cutting spree. Certainly inflation fears did not prevent the Fed from lowering the benchmark Fed funds rate by a whopping 225 bps in just six months. But this week's data will certainly force the Fed to rethink the magnitude and pace of subsequent rate cuts.

The Bureau of Labor Statistics reported this week that seasonally adjusted consumer price index jumped up 0.4% in January and is up 4.3% over the past 12 months, near a 16-year high. This is a sharp jump from the 2% reading in August, despite the economy slowing significantly in the fourth quarter. Even after stripping out surging food and energy costs - the Fed's preferred so-called 'core' inflation – prices rose 0.3% in January, up 2.5% from the prior year, a 10-month high. This was the biggest seasonally adjusted one-month jump in core CPI in 19 months.

 

 

This should not have come as a complete surprise at all. Crude oil crossed the much-watched $100 mark this week, much to the chagrin of pundits on Wall Street. Gains in prices of industrial materials and higher prices of grains, soybeans and other soft commodities pushed the CRB index to near record highs this week. Gold surged by another $40 this week to a phenomenal $948; not to be left behind, other precious metals have seen similar jumps over the past few weeks. Bond traders had certainly seen the future early, having pushed the yield at the long end of the curve almost 50 bps over the last few weeks.

A simultaneous rise in unemployment and inflation, coupled with dwindling growth  has the market wondering whether we are headed for 'stagflation' - a period of rising inflation despite slowing or stagnant growth. Stagflation, a term coined by British Parliamentarian Iain Macleod in 1965, came to define the US economy between 1970-1981. The economy suffered three recessions in that period, with inflation soaring to 15% and unemployment rising to 9%. It took a very severe hand from the toughest of central bankers, Paul Volcker, to finally conquer inflation by dramatically raising interest rates. The monetary tightening did have its repercussions, leading to a severe recession in 1981-82.

The seeds of the 1970s stagflationary phase were actually planted in the late 1960s, when President Johnson spurred growth by the frantic spending on the Vietnam war, helped by a complying Fed which failed to sufficiently rein in that growth. Things came to a head in the early 1970s when the Arab oil embargo dramatically drove up oil prices and overall inflation levels. President Nixon, in conjunction with the then Federal Reserve Chairman, Arthur Burns tried to rein in inflation by raising rates and imposing controls on wage and price increases. However, despite pushing the economy into a severe recession in 1974-75, inflation and unemployment failed to revert back to the levels of the previous decade. Political pressure finally led to the stepping down of Burns in 1978.

 

 

Stagflation is a scary word for most economists; it is almost the sum of all fears. Having said that, as with anything that scary, fears of stagflation have actually been more common than instances of actual stagflation. The beginnings of the past two recessions (1990-91 and 2001) have typically seen a brief rise in inflation, that subsequently trended down as unemployment kept rising. The current situation, although carrying a similar title, differs significantly in its contents. Sure, the current pace of inflation is a problem. In a speech in June 2006, Bernanke indicated that core inflation, then running at 3.2% over the prior three months and 2.8% over the prior six months, was at the upper end of his tolerance level. The 3-month and 6-month core CPI now works to 3.1% and 2.7% respectively, just shy of what Bernanke had deemed to be too high. Either we have reached the limit of what the (current) Fed has been willing to tolerate in recent years, or else they have moved the bar.

It is important to note that a persistent escalation of inflation would occur only if workers and the firms that employ them come to expect the elevated inflation to persist into the future and set their wages and prices accordingly. Expected inflation is an important determinant of future inflation. If the public expects higher inflation, workers demand higher wages, prompting employers to raise the price of their goods, which results in higher actual inflation.

Fixed-income securities markets usually provide timely information about inflation expectations. The expected inflation rate - implied by the gap between the yield on 10-year nominal Treasury bonds and that on bonds whose coupons and principal are indexed to rise with CPI (TIPS) – has remained largely unchanged over the last year. Further, the median consumer expectations of price change over the next 12 months, as indicated by the University of Michigan survey, has risen modestly over the past few months but remains well short of danger territory.

 

Spread between yields on 10-year Treasuries & Treasury Inflation-Protected Securities (TIPS) of similar maturities.

 

University of Michigan consumer survey of inflationary expectations

The Fed's U-Turn

Technorati Tags: FOMC minutes,projections,Federal Reserve,recession,inflation,growth

In this context, it is also worthwhile to review the minutes of the January 30-31 meeting. We quote: “Most participants viewed the risks to their GDP projections as weighted to the downside and the associated risks to their projections of unemployment as tilted to the upside.... The possibility that house prices could decline more steeply than anticipated, further reducing households' wealth and access to credit, was perceived as a significant risk to the central outlook for economic growth and employment... The potential for adverse interactions, in which weaker economic activity could lead to a worsening of financial conditions and a reduced availability of credit, which in turn could further damp economic growth, was viewed as an especially worrisome possibility.”

The Fed also revealed details of its inflation outlook, stating that “several participants pointed to the possibility that real activity could rebound less vigorously than projected, leading to more downward pressure on costs and prices than anticipated. However, participants also saw a number of upside risks to inflation. In particular, the pass-through of recent increases in energy and commodity prices as well as of past dollar depreciation to consumer prices could be greater than expected. In addition, participants recognized a risk that inflation expectations could become  firmly anchored if the current elevated rates of inflation persisted for longer than anticipated or if the recent substantial easing in monetary policy was misinterpreted as reflecting less resolve among Committee members to maintain low and stable inflation.”

That said, the Fed's recently introduced three year projections for economic growth, unemployment and inflation are worth a mention. The average Fed member is now considerably more bearish as compared to October. The Fed forecast is for 1.3-2.0% growth in 2008 and 2.1-2.7% growth in 2009, a significant drop from October estimates that called for at least 0.5% faster growth. Also, interestingly, Fed members project inflation for the year to be between 2.1-2.4% with core inflation coming in at 2.0-2.2%. This is in stark contrast to what is currently being experienced. Clearly, for inflation to meet that projection, it will have to slow significantly in the latter part of the year.

This contention is not intellectually inconsistent; recessions are generally disinflationary. The Fed remains concerned about inflation as it should. But their forecasts reflect the logical effects of a slowing economy. The minutes reveal a projection, that is as subtly bearish as would be politically and socially acceptable. A forecast that anticipates an outright recession or a persistently high inflation or a 6% unemployment rate would cause panic on the Street and a loud call for the Fed chief's head. Having said that, missing a recession entirely would cause people to lose confidence in their projections entirely. It will be interesting to see how the forecasts change over time as the new data gets factored into the projections. We believe that the forecasts, at least the GDP projections, still remain fairly optimistic in light of recent data releases.

Catch-22 For The Fed

Technorati Tags: Catch-22,Federal Reserve,stagflation,interest rate cut

The latest frenzy over the multiple, repeated sightings of the dreaded stagflation enemy is perfect fodder for the media. Fear is the primary staple of financial journalism. Expect to see a lot more debate on stagflation in the coming days. Our take on this is fairly simple: the booming period of growth, in any meaningful sense of the term, is over. Whether we are technically in a recession or merely on the cusp of one is immaterial; there is growth only in isolated sectors and pockets of the economy. Further, there are compelling reasons to believe that a contraction this time around would be more severe and more protracted than the previous two recessions. The significant slump in demand should prove to be a sufficient douse to the inflationary fire. The peeling of the sub-prime onion has led to a collapse in residential real estate prices, on a scale not witnessed since the 1930s, a remarkable unraveling of the dangerously over-leveraged and reckless - yet all-important - banking system and a dramatic increase in household insolvency.  This has created an economic Lernaean hydra, not seen since the Great Depression.

Having said that, it is important to appreciate the risks as they are. A persistently weak dollar (the dollar has lost 37% of its value in the past five years) raises the price of all dollar-denominated commodities, such as oil and other raw materials, as well as imported goods. Even if consumption of products falls in the United States, resilient demand from emerging markets such as China and India could cause prices of many goods to remain persistently high. Counter-intuitively, the only malaise for a stagflationary scenario is a significant recession in the US that also takes down global growth with it.

The Fed is in a Catch-22 situation, caught between a possible stagflationary environment versus the serious risk of a general deflationary collapse and onset of a protracted, depression-like economy. The Fed now knows which is the greater of the two evils. A 125 bps rate cut in January signaled beyond doubt where the Fed's concerns lie. The sharp plunge in economic indicators over the last few weeks is consistent with an economy that is rapidly spiraling towards a recession. An expected slowdown which requires monetary easing of that magnitude will surely pull demand down with it.

We believe the Fed will cut rates at least another 25 bps at its March 18 meeting (and quite possibly 50 if we get another dreadful unemployment report) We would not be surprised to see the target Fed funds rate at 2% by the middle of the year. But, having said that, there will certainly be more reluctance to follow the easing path here on.

Bears Take A Breather

(originally published on February 16, 2008)

Technorati Tags: auction-rate securities,consumer sentiment,empire state index,mono-line,pushing on a string,recession,Warren Buffett

 

We had reaffirmed  last week that stocks were in a confirmed bear market. We also categorically stated that a pullback rally within the larger downtrend was overdue and should be used solely to lighten up on long-only exposures. Stocks played to script this week notching up modest gains despite heightened volatility that usually accompanies an options expiration week. Stocks gained sharply mid-week following Warren Buffett's bailout plan for the mono-lines and a narrower-than-expected trade deficit. But comments from Ben Bernanke and a remarkably weak consumer sentiment survey spoiled the party. The front-line indexes closed out the week with a respectable 0.5%-1.5% gain. Most indexes witnessed an 'inside week', that is in keeping with the idea of a consolidation after recent steep losses.

 

S&P 500 - Daily

 

Russell 2000 - Weekly

 

While our call for a rebound in global equities seems to be coming true (Asian equities managed their first weekly gain in 2008), the outlook remains largely unchanged. We view the current rebound as a mere pullback within a longer downtrend. A major sell signal on longer time frames (weekly, monthly and quarterly charts) spread across global indexes and across multiple sectors suggests tougher times ahead for equities. 1400 levels on the S&P 500 will continue to be a formidable resistance in this pullback.

We review the major economic headline this week - a drastic shift in consumer sentiment over the past few weeks that makes a recession now appear increasingly plausible. Although the Fed has dropped is benchmark Fed funds rate by 225 basis points in six months, it has had only limited success in bringing borrowing costs down for consumers and borrowers. Nevertheless, the market believes this failure is the very reason why the Fed will further reduce rates. This negative feedback loop has the Fed pushing on a string in vain. Further, the complete freeze in the relatively obscure auction-rate bond market is the latest shoe to drop in the sub-prime contagion that has now spread world-wide. We finally wrap up with Warren Buffett's keen sense of timing, that could potentially strike gold for Berkshire Hathaway amidst a pile of toxic waste.

Gloom Is Spreading

(originally published on February 16, 2008)

Technorati Tags: consumer sentiment,empire state index,recession,earnings

 

1. The University of Michigan’s consumer sentiment index tumbled to 69.6 in its preliminary February reading from 78.4 last month, marking its lowest point since February 1992 when the economy was emerging from a recession. The component of the index that gauges consumers’ expectations — a possible sign of their willingness to spend — dropped to to 59.4 from 68.1.

 

 

Sharp plunge in consumer sentiment in last few months

 

As noted in the chart above, the dip in consumer sentiment is startling. Consumer confidence is now even below the lows seen in 2001-2002 recession and close to its worst levels since the early 1990s, when unemployment rate was up over 7%.

 

2. The New York Fed's 'Empire State' index, a widely tracked gauge of manufacturing growth fell for the fourth consecutive month in February to its weakest level since April 2003. The general business conditions index slipped alarmingly to minus 11.72 in February from plus 9.03 the previous month, the first negative reading in almost two years. Readings below zero signal contraction.

 

 

Empire State index: manufacturing takes a hit as well

 

These reports are not isolated. Best Buy, the largest U.S. consumer electronics chain, cut its full-year revenue and earnings forecast this week driven by what it termed 'soft domestic customer traffic in January... and weak near-term outlook'. The ABC News/Washington Post Consumer Comfort Index fell to its lowest reading since November 1993. Fewer than half of Americans surveyed rated their own finances positively, again a first since 1993. The Economic Cycle Research Institute (ECRI), a New-York based independent forecasting group, noted that its Weekly Leading Index skidded down to an annualized growth rate of minus 9.1 percent for the week ended February 8, its lowest reading since November 2001.

The evidence favoring a recession is now mounting. Economic growth screeched to a 0.6 percent stall in the fourth quarter. A quarterly survey issued by the Philadelphia Federal Reserve suggested a 47 percent probability of contraction in GDP this quarter and a 43 percent chance in the second quarter, levels not seen since the recession in 2001. Economists surveyed by Bloomberg and WSJ earlier this month forecast even odds of a recession. A contracting labor market (payrolls declined for the first time in four years in January) and sharp weakness across the services sector that accounts for 85-90% of the economy (ISM non-manufacturing index fell off a cliff to its lowest since 9/11 ) amplify the chances of the economy turning over into a recession this quarter. The housing slump has only accelerated further over the past few months. Builders broke ground at an annual rate of just over a million homes in December, the fewest since 1991. The National Association of Realtors estimates sales of existing homes fell more than forecast in December, while prices of single-family homes posted the biggest annual drop probably since the Great Depression.

Corporate earnings are also taking a hit. Bloomberg data suggest that the S&P 500 companies that have reported 4Q 2007 earnings thus far posted an average 15 percent decline in earnings. The outlook for the first two quarters of the year is not much better either, with analysts expecting a 1.4 percent and 0.7 percent decline in earnings. The only bastion of hope is the rise in exports, driven by sustained weakness in the dollar and more resilient economic growth abroad. US trade deficit shrunk 6.2 percent to $711.6 billion in 2007 from its record set in 2006, the largest annual percentage drop since 1991 and its first decline in six years. But as global growth falters, partly weighed down by the slowdown in the US, it remains to be seen if there would be enough takers for US exports going forward.

The gloom has spread steadily over the past few months, with the odds of a recession rising as economic data has turned nastier. Former Federal Reserve Chairman Alan Greenspan now believes that the economy is  "clearly on the edge", putting the odds of an economic contraction at  "50 percent or better", up from his guesstimate of a one-in-three chance just a few months ago. His successor, Ben Bernanke, asserted in a Congressional testimony that policy makers were prepared to lower rates further as the economy hurtles in its downward spiral, vowing to provide  “adequate insurance against downside risks”. He essentially said, as nearly as a Fed Chairman can, that we were indeed headed towards a recession. The telling statement:  “More-expensive and less-available credit seems likely to continue to be a source of restraint on economic growth”. This sense of caution, despite the "substantive additional action" of a 125 bps rate cutting blitzkrieg in January - the fastest pace of monetary policy easing in over two decades - will only serve to heighten anxiety in the minds of market participants.

History has taught us that economies do not normally slip gradually into recession; they plunge spectacularly as they turn over. This usually creates glaring discontinuities in the incoming economic data, of the sort clearly on display in the survey reports of the past few weeks. A degree of panic seems to have set in that could possibly tip the scales in a stalling economy, pushing it into a free fall.

Pushing On A String

(originally published on February 16, 2008)

Technorati Tags: crisis of confidence,pushing on a string,investment grade spreads

 

Lets recall that statement from Bernanke again...  “more-expensive or less-available credit seems likely to continue to be a source of restraint on economic growth”. We know where this is coming from, with the Fed having cut the Fed funds rate by 225 basis points in six months. But deteriorating credit conditions have undone pretty much most of what the Fed has done. The yield on Baa corporate bonds – a better measure of what drives actual business spending than the Fed funds target rate – has stayed largely constant, widening its spread over the Fed funds rate.

 

Spreads widening even for AAA rated corporate bonds as investors shun risk entirely

 

Merrill Lynch data indicating a sharp widening of spreads for investment grade issues

Data compiled by Merrill Lynch suggests that companies are paying more to borrow now than before the aggressive Fed rate cuts in January. Rates on so-called jumbo mortgages – mortgages with a value of over $417,000 and those not guaranteed by Fannie Mae and Freddie Mac – have increased in the past month, according to Bloomberg. Lenders and investors alike are demanding greater compensation for offering credit as losses continue to mount on sub-prime mortgage securities amid concerns of a cut in credit ratings of bond insurers. The increase in credit spreads has contrarily resulted in an effective tightening of financial conditions that the rate cuts were partly meant to address. It is as if the Fed were pushing on a string. The market perceives elevated borrowing costs will force the Fed to make further rate cuts, thereby reinforcing the 'negative feedback loop' that has been in vogue all through this crisis. Traders now place a 100% chance of at least a 50 bps rate cut on or before the FOMC meeting on March 18.

A crisis that began with loans made to a small group of home-buyers with shaky credit has disrupted pretty much the entire financial ecosphere. Indeed, small towns in far-flung Norway have lost money due to the sub-prime contagion in the US. It has proved to be much more than a credit crunch... it has become a crisis of confidence.

Buffett's Alchemy

(originally published on February 16, 2008)

Technorati Tags: mono-line,Warren Buffett,alchemist

 

This week, Warren Buffett offered to take over $800 billion worth of the tax-exempt insurance business guaranteed by the troubled big three mono-lines - MBIA, Ambac and FGIC. Buffett's Berkshire Hathaway Inc. would assume the risk of this debt in exchange for a hefty fee. The offer would exclude the bond insurers' sub-prime related obligations that caused over $5 billion in losses last quarter. According to JP Morgan estimates, a total of $2.4 trillion of debt is insured by the bond insurers, with potential losses ballooning up to $41 billion if the value of this debt continues to decline.

The offer seems like a non-starter at first glance. If the mono-lines were to actually agree to this deal, they would be ceding the book of business where there is value currently - the fattest, most profitable part of their business - giving up all the unearned premiums on the municipal bonds that they have insured. It would leave them with all the toxic waste from the various structured vehicles insured by them.

The looming prospect of major bond insurers losing their AAA credit rating has dominated the attention of the credit markets, as indeed the stock markets. Until this issue is resolved, states and municipalities will find it tougher and more expensive to borrow. In January, states and localities sold barely $20 billion in bonds, the lowest total for a month in two years, as issuers large and small postponed sales until there was more clarity on the insurers' health. Those municipalities that managed to sell debt are paying more to borrow. Since the middle of January, the yield on the Bond Buyer 20 General Obligation Bond Yield Index has climbed almost 20 basis points, from 4.15 percent to 4.33 percent.

It is important to realize that there are other larger issues at stake as well. If Buffett succeeds, investment banks who are counting on the cash flows from the mono-line municipal bond business to offset burgeoning toxic waste losses, would likely get nothing at all. They would thus surely look to step in and recapitalize the insurers, which although expensive, would be less than the losses they stand to incur if the mono-lines fail. UBS estimates that investment banks around the world could have to write off another $203 billion if the mono-lines go upside down, in addition to the $150 odd billions already lost.

There are other proposed alternatives. One idea is to break up the mono-lines into two parts – the good part that holds the tax-exempt insurance business cash cow, and the bad part that gets dumped with all the sub-prime and structured vehicle nonsense. FGIC apparently plans to do just that, having requested the New York state insurance regulators for a license to create a standalone municipal company. The other is for the insurers to raise some capital on their own, albeit a difficult task in partially frozen credit markets. Some even suggest that the government should get involved in order to prevent a major systemic crisis.

In this context, Buffett's proposal would be a win-win situation for Berkshire Hathaway as well as municipal bondholders... though certainly not for the bond insurers and possibly even the investment banks. Having said that, the regulators and the politicians would love to see this happen. Berkshire is one of the few companies with an impeccable AAA rating and it can easily take on the mantle of insuring the pile of debt, allowing issuers to lower their borrowing costs. At the very least, this move could potentially remove some of the systemic risk ('solve the crisis in one stroke of a pen' - Buffett). To us, it seems like a brilliant move in a developing end-game that could checkmate the mono-lines into giving up the attractive municipal insurance business ('high return, low risk' - Buffett) that Buffett covets so much. He would probably do a much better job of running it in any case. For Berkshire Hathaway and its share-holders, Buffett could just be the alchemist who managed to turn toxic waste laden garbage into gold!

Crisis Of Confidence

(originally published on February 16, 2008)

Technorati Tags: auction-rate securities,mono-line

 

Another shoe dropped this week in this saga with the state of Michigan suspending a major student-loan program led by the sudden collapse of the estimated $300 billion auction-rate securities market. Auction-rate securities are another one of those complicated securities that seemed to offer something in return for nothing. They are long-term securities that unusually behave like short-term bonds. The securities purportedly offered borrowers, typically tax-exempt local governmental or quasi-governmental authorities – a school district, hospital district or a municipality – a method to borrow long term without paying the relatively higher interest rates that investors usually demand to lend long term. This was achieved by the covenants of the bond that required securities to be auctioned every 7, 28 or 35 days. Investors (typically short term money market funds) did not mind this at all because they got an asset that seemed as good as cash – investors wanting to cash out their bonds could sell it back to the investment banks who subsequently sold it to newer investors – and yielded higher than bank deposits.

Because the borrowers bought insurance from mono-line insurance companies that then imparted an investment grade rating to the bonds, investors simply looked at the rating and made their decision. In theory, the market was always running the risk of auctions failing for lack of enough willing buyers... but that possibility seemed very remote. Issuers also ran the risk of invoking the covenant penalty clause that compensated the buyer for the lack of liquidity – if an auction failed, the interest rate that the borrower had to pay jumped up. But since the possibility of the market failing seemed so remote, borrowers continued to pile on the market.

Circa credit crunch 2007. What seemed remote is now reality. With the sub-prime genie out of the box, the creditworthiness of mono-lines is in serious doubt. Ambac, MBIA, FGIC and other mono-lines have been downgraded by rating agencies and face an imminent danger of having their ratings cut. A rating cut would be akin to a death knell for these mono-lines. Without their ratings, they would have nothing left to sell.

Also, it is a big big problem for those who bought into those ratings. With not enough buyers to take all the paper that was insured by these mono-liners, markets are failing. Investment banks are being forced to take that paper that they helped to sell. Investors' confidence in the financial order seems shaken. Investors no longer trust assurances given to them, having already witnessed what happened to those naïve enough to believe that their sub-prime filled toxic waste was safe. A loss of faith and confidence can quickly become a self-fulfilling prophecy. New investors will refrain from parking their money in these auction-rate securities knowing very well that they are not as good as cash, making these securities appear to be even worse investments.

In the last few weeks, a series of auctions have failed, leaving investors stuck with illiquid securities and borrowers facing hefty penalty rates. Fathom this. The Port Authority of New Jersey, which had a failed auction of $100 million last week, saw their interest rates leap from around 4% to 20%! Quick back of the envelope math... that's an extra $300,000 per week. The collapse of this market does not reflect any new problem with the borrowers; the Port Authority is as financial sound today as it was a fortnight ago. Instead this reflects the latest shoe to drop in the broader credit contagion. There are many other bonds from solid issuers that are quoting at over a 10-15% yield, up from 4-5% just a few days ago. Less than 1% of tax-exempt bonds actually default. Most of these are good-quality issuers (some even sovereign), yet the interest rates are higher than CCC junk bonds.

This has obviously put pressure on politicians to act. Eliot Spitzer, the Governor of New York, threatened mono-lines this week, giving them three to five days to find sufficient capital to resolve the crisis. Or else the state steps in and takes charge. It is in this context that Warren Buffett's offer to take over $800 billion worth of municipal bonds from the mono-lines seems like a masterstroke.

Road To Recession

(originally published on February 9, 2008)

Technorati Tags: ISM non-manufacturing,dollar,services,unemployment,recession,real GDP,ECB

 

The week ended February 2  saw the best performance on Wall Street in almost five years, with the broad S&P 500 posting solid gains of 4.87% driven by the largesse of the Fed rate cuts. But in a sign of the tumultuous times we are in, the front line indexes gave up most of those gains this week, posting average losses of over 4.5%. The losses were seen across the board, with only the defensive sectors such as medical labs, research, health care, drugs, medical equipment and supplies, health care information and beverages managing positive returns. 

The indexes struggled to build on to last week's gain on Monday, before finally capitulating on Tuesday following the release of pretty dire ISM non-manufacturing numbers (detailed below) and Richmond Fed President Jeffrey Lacker's comments of a possible mild recession. The Dow Jones Industrials declined a sharp 370 points on Tuesday, its largest decline in almost a year. Although bulls tried to regroup towards the end of the week, the battle had been won by bears emphatically.

 

Dow Jones Industrials - Daily

 

The S&P 500 is now down 9.5% YTD and a sharp 15.5% from its October highs. This is the fifth fastest 15% or more decline in the S&P 500. Following up on this week's losses, stocks look set to retest their recent lows in the coming days. However, we expect the trough marked last month to prove to be an area of support for the indexes and at least lead to a trading bottom.

 

S&P 500 - Daily

 

The mixed up-down action over the past two weeks is symptomatic of the troubles afflicting the stock markets. The tug of war between those lured back into the market by the relatively cheap valuations after January's sell-off (some calling it the best buying opportunity in stocks in twenty years) and those who remain wary of greater sub-prime and credit-crunch related trouble ahead is likely to continue in the foreseeable future and lead to considerable volatility. 

Having said that, it is important to keep the bigger picture in mind. There is a major disconnect between what seems to be happening in the economy and what the media sees as 'value'. We remain convinced that stocks are in a confirmed bear market and would remain so for most of this year at the very least. The market internals support that contention. The prevailing investor psychology also fits in with that of a typical bear market. Periodically, panic will set in and a trading bottom will be formed. Recall the January low when the DJIA was down over 500 points in pre-market trading before the Fed showered its largesse leading to a 1200+ point rally. While there are exceptions, these bear market rallies are to be used solely to lighten up on long-only exposures. There is a time to load up on longs... but the time is not there yet.

The coming week is likely to be no less interesting than the week gone by. Besides the options expiry related volatility, January retail sales, industrial production, weekly jobless claims and Bernanke's testimony before the Senate Banking Committee on Thursday should keep market participants on their toes. Also, market participants would be wary of a Chinese-led Asian liquidation that could spread into Western markets. Remember that the Chinese stock market was closed for most of this week for the lunar new year holidays. Last year, the Chinese market triggered a global equity rout on just the second day after its new year break.

This week, we take a detailed look at the disastrous ISM non-manufacturing data that portends an imminent recession. We also comment on how the central bankers across the Atlantic have finally woken up to the possibility of a recession that will surely necessitate appropriate monetary policy action. This, counter-intuitively, augurs well for the dollar in the near term. We finally wrap up with anecdotal evidence of consensus opinion tilting towards a full-blown recession.

Services Take A Nose-Dive

(originally published on February 9, 2008)

Technorati Tags: ISM non-manufacturing,recession

 

The Institute of Supply Management's non-manufacturing index, released ahead of schedule this week amid concerns that the information had been leaked, reported that the US service sector contracted in January for the first time since March 2003. The index plummeted to 44.6 from 53.2 in December, its largest monthly decline on record and significantly below the median expectations of economists polled by Reuters of 53.0. This was the lowest reading since October 2001 in the aftermath of the Sept 11 terrorist attacks. A reading below 50 indicates contraction. The farther the reading is from the midpoint of 50, higher is the degree of expansion or contraction. As seen below, the chart of the ISM index looks like it has fallen off the edge of a cliff. 

 

ISM non-manufacturing index falling off the cliff

 

There have been only two occasions in the past ten years when the index has dipped into contractionary zone when the economy has not already been in a recession. That is not entirely surprising considering that this index reportedly captures roughly 80%-90% of the economy (Source: Bloomberg). A contraction of this magnitude suggests that business expectations are being drastically curtailed. Employment expectations are also sharply down from 51.8 to 43.9, corroborating last week's dire non-farm payrolls report that showed the first net monthly contraction in the labor market in more than four years. New orders declined sharply as did all the other forward looking indicators. 

 

ISM non-manufacturing data over the last few months

 

Skeptics will surely question the validity of the data set as it has a relatively short history (starting July 1997) and has not actually measured a deep recession. While the weakness could have been overstated, this is the most compelling evidence to date that economic growth has indeed slowed markedly from December. Although there is nothing to feel good about this data, the gloom that this report evoked (370 point sell-off on the Dow Jones Industrials), sort of justifies the Fed's aggressive 125 bps easing in less than ten days last month.

Time To Board The USS Dollar!

(originally published on February 9, 2008)

Technorati Tags: dollar,recession

 

The party is certainly over in the US. But the question that has lingered is whether the rest of the world would hang around for a few more drinks. This week gave us further confirmation to firmly rebutt the  'decoupling'  hypothesis. 

The Bank of England finally acceded to the markets' wishes, cutting its benchmark interest rates by 25 bps this week, following a similar cut in December in response to slowing consumer spending and the steepest decline in house prices in over a decade. BoE has been trying to balance the serious risks to economic growth against the threat that inflation may become entrenched above its 2% target. House prices slid for a third month in January, the longest stretch of declines since 2000. UK mortgage approvals fell in December to its lowest since at least 1999. Retail sales fell the most in 11 months, while manufacturing declined for a second month in December. To complicate matters, inflation is expected to reach its quickest pace in a decade this year driven by surging energy and food costs. The UK economy has expanded every quarter for the past 16 years. Billionaire investor George Soros, not exactly a friend of the BoE, commented last month that a recession in the US was  'almost inevitable'  and would be  'very difficult to avoid' in Britain. Consensus expectations are for a further 75 bps interest rate cuts by year-end.

On a similar note, the ECB President Jean-Claude Trichet reversed course and signaled his willingness to cut rates for the first time in five years as economic growth falters. Trichet had earlier threatened raising rates to quell inflation, hoping that growth in emerging markets such as China and India would cushion the effect of a US slowdown. Globally, private-sector business activity contracted sharply in January driven by the huge drop in US non-manufacturing activity as well as contraction in three of the Euro zone's four largest economies - Germany, Italy and Spain. JP Morgan's Global Total Output Index plunged to 47.7 in January, the lowest since the months after 9/11, down significantly from the 53.8 reading in December. Retail sales in the EU region are reported to have fallen the most since 1995.

The Fed has led the way in this crisis by metamorphosing from an inflation-fighter to an economic savior. The BoE followed suit and now the ECB has finally turned over (albeit later than one would have hoped). While the Fed has indicated its seriousness in getting ahead of the curve, the BoE and ECB have remained largely oblivious of the looming dark clouds thus far. The longer the ECB waits in cutting rates, the worse the possible outcome for the Euro zone. The stronger dollar, with the Fed finally looking serious of getting ahead of the curve, and the weaker Euro reflect just that. 

 

 

The Euro posted its biggest weekly decline against the dollar since June 2006 on speculation of interest rate cuts soon by the ECB. Since investors now know that the US is not the only ship taking on water - and since it is still the biggest and safest ship - it could well be time to climb aboard the dollar!

So, What Does A Recession Look Like?

(originally published on February 9, 2008)

Technorati Tags: real GDP,unemployment,recession

 

The Fed's aggressive rate cutting spree last month has raised more questions for investors than it has answered. It is now increasingly becoming clear that the US may have already entered a recession, possibly as early as December 2007. The data on December and January employment, retail sales, non-manufacturing ISM, housing and other macro variables pretty much confirm it. The anemic 0.6% GDP growth seen in 4Q further confirms a sharp slowdown and a possible tipping over into a recession. 

The average length of the post-war recessions has been around eleven months. It usually takes anywhere between six to eighteen months for the National Bureau of Economic Research's (NBER) Business Cycle Dating Committee to formally declare a recession. So by the time the NBER declares a recession, we might have already come out of it. 

A recession is defined by the NBER as a significant decline in economic activity spread across the economy, lasting more than a few months. In determining business-cycle turning points, the committee follows standard procedures to assure continuity in the chronology. Since a recession influences the whole economy and is not confined to one sector, the committee emphasizes economy-wide measures of economic activity. It considers real GDP to be the single-best measure of aggregate economic activity. However, since the Bureau of Labor Statistics reports real GDP estimates only quarterly, a variety of monthly indicators are used to determine months of peaks and troughs. Particular emphasis is placed on two monthly measures of economic activity : real personal income less transfer payments, and employment.

 

A comparison of real GDP and the unemployment rate. Note the spikes during recessions.

While both the real GDP and the unemployment rate have not entered recessionary territory yet, they are periliously close. It is interesting to note that debate has now quietly shifted from whether a recession is likely to how severe and prolonged the recession could be. According to a ABC News/Washington Post poll released this week, 59% of Americans think the economy is already in a recession. A Consumer Comfort Index from the same surveyors has dropped 13 points in the past month to its lowest in more than 14 years, just as it did in the four weeks prior to the 1990-1991 recession and near the 14-point drop preceding the 2001 recession. In a recent WSJ survey, Wall street economists put the chances of a recession at an even 50%. Ditto with a similar survey done by Bloomberg. Morever, if a recession does materialize, economists place a 39% odds of it being worse than the previous two  'mild' recessions.

The cover on Newsweek magazine a fortnight back was titled 'The Road to Recession'. The fact that this cover story title was written without even a question mark is a signal of how far the consensus has moved towards the recognition of an unavoidable recession that may have actually already started. Businessweek carried two back-to-back gloomy editions titled 'Meltdown' and 'Credit On The Edge'. While the efficacy of the magazine cover indicator as a contrarian signal is debatable, if things do indeed become as bad as what the media seems to be predicting, it will be the most widely predicted crash in history!

What Will The Fed Do?

(published a day before the FOMC meeting on January 30, 2008)

Technorati Tags: Federal Reserve,FOMC Update,Term Auction Facility

 

This emergency update on the FOMC meeting contains data that was not available at the time of release of last week's Weekend Market Review. We now strongly believe the Fed will most certainly cut the benchmark Fed funds rate again tomorrow by another 50 bps. This is in addition to the massive emergency 75bps cut announced last week.

We have a sound basis for such a bold argument. Not least because the market itself is betting on that.

 

 

There are other subtle hints as well that can be picked up by a more discerning eye. The biggest of them all is the January 25 announcement for the fourth and the last planned Term Auction Facility on January 28. The Fed started accepting bids yesterday on $30 billion of 28-day credit at a minimum bid set at 3.10%. Remember the current Fed funds rate is at 3.50% and the current rate at the discount window is 50 bps higher at 4.00%. This implies that the Fed is willing to loan reserves to member banks at the specified rate of 3.1%.

If we call our previous discussion on this topic , TAF is the discount window in a new avatar. Most of the collateral rules are the same for the TAF as for the discount window and both are processed through the twelve regional reserve banks. The only significant difference is how the rate is set. TAF involves a bidding process and is for a fixed term, while discount window is at a fixed rate. Having said that, TAF involves none of the stigma attached to the discount window ('you only borrow from the Fed when nobody is ready to lend to you').

We had hoped, rather surmised, that the TAF would succeed in bringing credit spreads back to earth. Indeed, as we have seen, credit spreads have indeed normalized since the TAF was introduced. So the exercise seems to have worked alright.

 

 

So what makes us think 50 basis points? If we look at the three auctions conducted thus far, the Fed has positioned the TAF minimum bid between its expectations of Fed funds rate and its expectation for the discount window rate. The rationale behind this is intuitive. It is implied that there should be some sort of a penalty for using a direct access to raw cash reserves directly from the central bank. But nonetheless, the penalty has to be lesser than that at the abandoned discount window.

So if the Fed keeps the Fed funds rate unchanged (3.5%) or cuts it only by 25 bps to 3.25% tomorrow, it would have effectively provided the TAF funds to member banks at a subsidy, rather than at a penalty. Remember that the Fed is a lender-of-last-resort and the TAF is pretty much its last-resort facility, with the discount window apparently not serving the purpose.

To be consistent with modern central banking practices, the Fed must cut the Fed funds rate by at least 50 basis points tomorrow. Failure to do so would be tantamount to rewriting time-tested rules of monetary policy. An event of this magnitude would further discredit this Bernanke Fed after all the criticism heaped on it over the past week. Also, excessive market volatility would be a obvious effect if the Fed stays put as investors would realize that the Fed's policy-making apparatus has become inconsistent and unpredictable... hardly what the Fed wants to do in the midst of an unrelenting credit crunch.

Further, it must set the discount rate such that it is higher than the minimum bid rate. If it does otherwise, a situation would be created where the TAF borrower would have paid a penalty above the discount rate by using the TAF instead of availing the discount window.

Lastly, the Fed would be eager to dispel the widely held belief that the emergency inter-meeting rate cut last week was prompted by the possibility of a major sell-off in the equity markets. Another 50 basis points cut would assuage fears of the Fed backstopping equity market punters as well as signal its seriousness in tackling the unraveling economy. If the Fed needed one shot at getting ahead of the curve, tomorrow is it.

Fooled By The Markets?

(Originally published on January 26, 2008)

Technorati Tags: emergency rate cut,rogue trader,Federal Reserve,SocGen,fooled by the markets,fiscal stimulus

We had signed off last week suggesting that a near term recovery may be on the cards, but just stopped short of making a decisive call. That indecision was vindicated by this week's volatile trading action. Although there was a sharp rebound in the front-line indexes from their intra-week lows, stocks had a wild ride. On the back of sharp losses in equity markets world-wide on Monday and Tuesday, front-line indexes were slated for a disastrous opening (Dow futures down 550 two hours before the opening bell). Then news trickled in of the emergency 75 bps rate cut by the Fed and futures rebounded sharply, before reflexively giving up most of their gains as traders wondered what had suddenly gotten into the Fed. After opening 350 down on the Dow, stocks gradually rallied towards the close but still ended up negative for the day. Whatever 'shock and awe' the rate cut elicited quickly disappeared. Stocks opened on a negative note again on Wednesday in line with weak cues from global markets. After trading weak for first half of the day, front-line indexes staged a dramatic rebound towards the latter half. From being down 300 at one point, Dow Jones Industrials eventually closed up 300. This was the second largest intra-day reversal ever in absolute terms, although a far 30th in terms of percentages. Stocks added onto their gains on Thursday on the back of a global equity rally and the announcement of the Bush stimulus package. Stocks opened in the green again on Friday before losing ground in the latter half of the day.

 

S&P 500 - Daily 

 

The emergency 75bps rate cut this week came with just eight days left for next week's scheduled FOMC meeting. It was the single largest reduction in lending rate since the Fed began using it as its main policy target in 1988 in the wake of the Oct 1987 stock market crash. To be exact, it was the largest single-day rate reduction since 1982 and the first inter-meeting rate cut since the central bank acted in the aftermath of the 9/11 terrorist attacks.

 

Cycles In Federal Funds Rate

A couple of weeks back, we had anticipated that an inter-meeting rate cut was certainly a possibility. We had also highlighted how the market consensus was gradually shifting towards the more aggressive 50 and 75 bps rate cuts as evidence mounted of a significant slowdown in economic activity in December. In this context, we are reminded of Bernard Baruch's words, successful speculation is about anticipating the anticipators. Although our timing was a bit skewed, the script seems to have played out just fine.

 

Dow Jones Industrials - Weekly 

 

This week's action does suggest that a possible trading bottom may have been established. Although the rate cut elicited only a delayed response in the stock markets, the medicine seems to have worked. We got to a point this week where markets became completely oversold with sentiment hitting an extreme negative. The bottoming process actually started last week, affording enough clues for us to believe that a trading bounce was overdue. The front-line indexes now look set to enter a counter-trend rally - a 5-15% rally in 2 weeks-2 months. This rally could see the S&P 500 test 1380-1410-1440 levels. Having said that, it is worthwhile to bear in mind that this will only be a trading bounce, and not a change in trend. A reasonably deep recession is possibly on the cards; recessions are usually accompanied by earnings compression and lower - often, considerably lower - stock prices. Globally, several international benchmarks have entered a technical bear market, having declined over 20% from their recent highs. Most of them, though, look set for a trading bounce.

This week, we take a preview of the proposed Bush stimulus package and whether it will actually do the economy any good. We also seek to answer whether a rogue trading scandal at one of France's largest banks could have possibly fooled the Fed into taking a hasty decision.

 

 

What Stimulus?

Hoping to give a quick adrenaline shot to the ailing economy, President Bush and House leaders struck a deal this week for a $150 billion fiscal stimulus package, including rebates for most tax filers of up to $600 for individuals, $1,200 for couples and, for families, an additional $300 a child. The deal capped a series of fast-paced and intense negotiations, in which the Bush administration and lawmakers in both parties agreed to numerous compromises after more than a year of acid relations. While efforts to provide a stimulus to the economy are laudable, any such legislation will only further add to our soaring fiscal deficit. So it is of utmost importance that we get as much 'bang for the buck' as possible.

Although the package includes a reasonably designed tax rebate, the two most targeted and economically effective measures under consideration - a temporary extension of unemployment benefits and a temporary boost in food stamp benefits - were zeroed out, apparently at the insistence of House Republican leaders. Moody's Economy.com estimates that for each dollar spent on extended UI benefits, $1.64 in increased economic activity would be generated. Increased food stamp benefits would generate new economic activity worth $1.73 per dollar spent. No other options rated as high. Further, every dollar in 'accelerated depreciation' - the principal tax cut in the package - would result in only 27 cents of increased economic activity. A 2006 joint study by the Congressional Budget Office and the Federal Reserve indicated that business tax cuts adopted in the last recession, that closely resemble those in the current package, had only modest stimulative effects. The business tax cuts also would cause states to lose at least $4 billion in state revenue, due to linkages between Federal and state tax codes. The proposal does not include any relief measures for the states. Consequently, many states could enact deeper and more painful budget cuts, acting as a drag on the economy.

On the positive side, the reasonably designed tax rebates are vastly superior to the earlier proposals mooted by the administration, under which more than 25 million low and moderate income working families would have been shut out. Most of those families would get a substantial rebate under the new package. Nevertheless, the rebates for working-poor families (who will spend, rather than save, the largest share of their rebate dollars) will apparently be smaller than those for middle and upper middle-income families.

Standard economic theory propounded by Milton Friedman suggests that for stimulus funds to be spent, they should go to people in temporary economic difficulty who are likely to be liquidity-constrained. But most of the measures that would have done just that appear to have been bargained away. Even the tax credits are apparently not fully refundable, so those who need it the most, and are most likely to spend it, will probably not get the full amount. But any stimulus plan, even if poorly designed, is probably better than no stimulus at all. Not enacting a stimulus package would leave the entire recession-fighting to the Fed and as we have pointed out below, the Fed may be running out of ammunition. As shown in the table below, lawmakers have a penchant for enacting stimulative legislations at the fag end of recession and the early stages of a recovery, thereby completely missing the point. With the added election incentives this year, we hope Congress can put together a package as speedily as it can.

 

 

 

Another Rogue Trader

The rogue trader's elite community had a new entrant this week : 31-year-old Jerome Kerviel. In one of the most unsettling disclosures in the banking industry in recent memory, Société Générale, France's second largest bank, announced that the rogue trader had made unauthorized bets on stock index futures, costing the bank I €4.9 billion ($7.2 billion), the largest trading loss in banking history. To put the figure in perspective : this loss exceeds the $6.6 billion Amaranth Advisors LLC lost in 2006 and is more than four times the $1.4 billion of losses piled up by Nick Leeson that brought down Barings Plc in 1995. SocGen now plans to raise €5.5 billion from its shareholders after the loss and large sub-prime related write-downs significantly depleted capital. The Bank of France, the country's banking regulator, is investigating the alleged fraud.

A letter by the Chairman posted on the company website indicates that the transactions were simple but were hidden through extremely sophisticated techniques. Kerviel used his intimate knowledge of the bank's risk control systems ('breached five levels of controls' - Christian Noyer, Governor, Bank of France) to build a massive long position on European stock index futures, amounting to some $73 billion. The trades were massively in the money by end-2007, but had started bleeding losses when the equity markets dived starting this month.

Société Générale has a reputation for its expertise in equity derivatives which has become a big money spinner for it. Risk Magazine has ranked it first or second during the past five years in client surveys of equity derivative firms. It earned the ‘Equity Derivatives House Of The Year’ tag from both RISK magazine and Banker, a London-based monthly magazine.

The accident highlights how vulnerable bank's security controls still are and how an insider with sufficient knowledge of the systems can still create havoc. Kerviel is no trading legend who let a transaction get out of hand. He was a low-level trader in the bank's ‘Delta One’ desk in western Paris, earning about €100,000 ($145,000) a year. Clearly, banks are yet to learn their lessons from 13 years ago, when a single trader by the name of Nick Leeson brought down a 233-year old British bank.

 

 

Fooled By The Markets?

Details of this incident sparked speculation that the selling by SocGen, estimated to be 10% of market trades, caused the massive downside volatility earlier in the week. It is now apparent that the European Central Bank knew early on about the problems at SocGen, but the Fed apparently was caught napping. 

Some serious questions are now being asked. Was the Fed duped into a clumsy and panicked move by a cleanup operation at a French bank? Why did their French and ECB counterparts not tell the Fed about the happenings at SocGen? What was the motivation for an aggressive rate cut just seven days before a scheduled FOMC meeting?

We are on record in suggesting that the Fed has been largely behind the curve for much of last year. We have also suggested that the increasing gloom about the economy warrants an aggressive easing in monetary policy. But the timing here is baffling. Slashing rates with such aggression a little over a week before a scheduled meeting, smacks of panic. 'Downside risks to growth' surely exist; but the economy had not grown any weaker over a long weekend. Considering the inherent delay before changes in monetary policy affect spending, the sudden urgency seems odd. 

It is hard not to conclude from this sudden change of tack that the Fed acted mainly to shore up markets, which had alarmingly switched to panic mode in just a week. Indeed, the Fed noted that 'financial market conditions have continued to deteriorate'. Were the equity markets not functioning properly? Globally, equity markets are in a process of re-pricing risk and lofty valuations after a long bull market amidst an increasingly likely possibility of a concurrent US, European and Asian economic slowdown. Why should the Fed try to disrupt a market-based process of wringing out some excesses out of the system through a healthy capitulation? With Fed funds already at 4.25% before the cut, it would be fair to say that the Fed decided to use its limited ammunition to intervene, nay guarantee, equity prices. The Fed is charged with keeping employment high and inflation low, not back-stopping equity market punters. 

To be fair, the Fed may just be using equity prices, as many economic analysts do, as a useful aggregator of private and public information about near term prospects for economic growth. With all recent indicators suggest a significant deterioration in real economic activity over the past two months, a recession may be already upon us. Just as the 50 bps cut in April 2001 failed to prevent a recession, this one may fail as well. Bernanke probably simply intends to do what he can to mitigate the damage. But the action is so disproportionate (the sudden change in tack) and ill-timed that it will only further unsettle markets. With people pondering 'What does the Fed know?', we believe this action has only strengthened wide-spread belief that a recession has already begun.

The reactions in the past week have polarized the financial world. While the emergency rate cut was cheered on by some sections, others rightly have jeered. Bill Gross, manager of the world's largest bond fund, quipped that it is a sad state of affairs when the Fed has to cut interest rates just eight days ahead of a meeting to salvage equity markets. Barry Ritholtz, widely read blogger, columnist and a respected voice in financial media, remarked that the panicked rate cut would prove to be an historical embarrassment and that the Fed allowed itself to be bossed around by futures traders. 

The markets initially failed to view looser monetary policy and cheaper money as a nice surprise. Dow futures traded down over 550 points on Tuesday morning before the markets opened; after a gradual recovery through the day, the indexes finally closed down 'only' 128 points. Although the indexes rebounded strongly thereafter, we have a lingering suspicion that all the Fed may have achieved this week is merely delay the inevitable.