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!