The Big Picture - Macro Perspective on the Capital Markets, Economy, Technology, and Digital Media

Good Evening: Departing from recent form, our capital markets spent a lot of time churning during the past two days. Trying to digest various bits of positive and negative news, investors received a touch of indigestion for their efforts. All things considered, however, it could have been worse as our markets continue what Jim Grant likes to call “the value restoration process”.

One of the most positive pieces of recent news affecting the markets came out Wednesday night in the form of a very strong earnings report from Apple. AAPL jumped 10% in after hours trading and lifted our stock index futures going into Thursday morning. The news flow turned decidedly more negative prior to yesterday’s open, however, when jobless claims spiked back toward 600,000 and housing starts fell to the lowest level on record (see Merrill’s take in “Dave’s Top 10″ below). Prices for new homes also fell, but while the housing data is definitely a short term negative for our economy, it should also be construed as a longer term positive. Now that starts are running below the rate of new home sales (for now), the important process of soaking up excess inventory can finally begin. And, since conventional mortgage rates are now below 5% (or even 4% — see below), housing can now start to bottom out as inventories get worked off. It will take time — months, not weeks — but cheaper prices and lower mortgage rates should eventually do the trick.

Yesterday also saw companies as varied as Microsoft, Fifth Third Bank, and Aflac all report earnings misses. There were other disappointments, too, as well as fresh worries about the U.K. and European banking systems, but the markets held in fairly well considering the preponderance of negative news. Friday had no economic releases to deal with, but Google reported a decent quarter last night and finished 6% higher today. On the other end of the earnings spectrum, GE reported a poor quarter even as it insisted it would try to hold on to both its AAA rating and its large dividend. I may not have attended a fancy business school, but one does not need an MBA to see that Jeff Immelt will have to part with one or the other (and perhaps both — see below). GE’s bonds already trade on a par with companies sporting ratings 5 or so notches lower, and the stock market is forecasting a dividend cut into the price of GE’s common equity. GE finished down 10.5% today, which leaves its stock within shouting distance of single digits.

During both Thursday’s and Friday’s trading sessions, the major averages opened with a swoon and spent the rest of the day trying to recover. Thursday’s efforts fell short, while stocks did manage to finish on the positive side of mixed today. The Dow transports (-2.2% today) still can’t get out of their own way, but Google did help lift the NASDAQ by 0.8%. The other averages finished somewhere in between and the indexes all fell for the third straight week. Stocks seem to be gearing up for another retest of the November lows, but the last hour rallies of late muddy up the picture as to timing. Treasurys represent another murky market, and bond prices continued to retreat both yesterday and today. Yields backed up between 8 and 16 bps as next week’s supply of bills and notes looms in the windshield. The dollar gave ground on Thursday before finishing flat today. Commodities rallied during this same period, and the CRB index gained 2.5% over the two sessions. I would like to note that precious metals and their associated equities shined brighter than almost any other market during this holiday-shortened week.

President Obama and his Treasury Secretary appointee, Tim Geithner, are none too pleased with Wall Street. The shenanigans foisted upon Bank of America by John Thain and others at Merrill Lynch prior to the closing of their recent merger has set tongues-a-wagging in Washington (see below). With the regulatory climate in D.C. turning chillier than a Chicago winter, I’m hoping someone in either the White House or Treasury Department will consider creative solutions in lieu of simply imposing a set of stifling regulations on Wall Street. My “matching gift” idea for the TARP is one such proposal, and I’ve seen some other good ideas bandied about in recent days. I’ve received a lot of positive feedback about my idea, as well as some pointed questions about how a matching program with the TARP would actually work. The following represent a set of sample transactions that I hope will provide readers with a little more clarity as to how my proposal works:

Let’s assume a $100 million bonus pool, and let’s use ABC bank as our candidate bank.
1. ABC has on its books a $200 million mortgage-backed bond (bond X) for which it paid a par amount of $200 million.
2. ABC has written down the value of this position twice and now marks it at a value of 120 million (i.e. a price of 60 on the bond)
3. The ABC bonus pool manager (with oversight by the independent directors on the ABC Board) decides to buy 50 million in face value of this bond for the same price (60) where it’s now marked, costing the pool $30 million (50mm face x .60 price). The bonus pool now receives the bonds and pays ABC bank $30 million in cash
4. The TARP, a separate fund owned and controlled by Treasury, now does the exact same trade with ABC bank. TARP pays $30 million in cash to MS, and receives $50 million in face value of bonds in return
5. The TARP would double these amounts if the matching was done on a 2-1 basis — paying $60 million for $100 million face amount of bonds

+ Benefit to ABC bank: between $60 million and $90 million in fresh cash and most of these bad bonds on its books are now gone (either 1/2 or 3/4 of the total position — the rest stays on the books and remains marked at 60). ABC is now free to make new loans or investments
+ Benefit to ABC bank bonus pool: if the bond recovers in value, then employees actually make money in this pool that vests over time) If the bond loses money, then tough toenails for them
+ Benefit to the TARP (taxpayers): if bond recovers in value, then taxpayers make money. If bond loses money, then at least TARP (us) doesn’t lose as much as if they bought all the bonds on its own, since the employees had to eat some (1/3 or 1/2) of the same bad securities.
+ Benefit to the TARP (taxpayers): Requiring that the bonus pool chooses the price ensures that senior management and their bonus-eligible employees will have their interests aligned with those of taxpayers
+ Benefit to the financial system: With freed up capital, ABC bank (and, presumably, all participating banks) can now do other deals or lend to other clients, which will help get the financial system moving again.

Let me be clear: ALL banks taking TARP funds would be REQUIRED to join this plan, but all pools of money remain separate. ABC bank and the other banks will have their own balance sheets, the employee bonus pools will be held on a different balance sheet, and the TARP will stay in Washington. The only thing moving around will be the money and the bonds, but it will all be pretty easy to track.

One final point to make is that this requirement to have the employee bonus pool take a stake in their firm’s loans/investments could survive beyond the TARP. One of the biggest weaknesses of the securitization process is that the banks processing the loans or creating fancy structures is that they don’t have any stake in the outcome — they just take fees. By making them buy a piece of each deal they originate (or having the bonus pool do so), it would have the positive impact of making them do deals more carefully in the future.

– Jack McHugh

Most U.S. Stocks Gain as Stimulus Plan Offsets Earnings Concern

Obama Takes Aim at Wall Street Bonuses, Remodeling
Builder Offers 3.99% Rate on Mortgage

GE Sags as Investors Bet Dividend or Rating May Go

Dave s Top Ten.pdf

Adam Zyglis via The Buffalo News

an open letter to our new president.

a trailer for our upcoming documentary about the 2008 presidential election.
and my concession speech.

2009 Outlook—Markets Measure; They Don’t Forecast by David Kotok

December 27, 2009

David R. Kotok co-founded Cumberland Advisors in 1973 and has been its Chief Investment Officer since inception. He holds a B.S. in Economics from The Wharton School of the University of Pennsylvania, an M.S. in Organizational Dynamics from The School of Arts and Sciences at the University of Pennsylvania, and a Masters in Philosophy from the University of Pennsylvania. Mr. Kotok’s articles and financial market commentary have appeared in The New York Times, The Wall Street Journal, Barron’s, and other publications. He is a frequent contributor to CNBC programs. Mr. Kotok is also a member of the National Business Economics Issues Council (NBEIC), the National Association for Business Economics (NABE), the Philadelphia Council for Business Economics (PCBE), and the Philadelphia Financial Economists Group (PFEG).

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We are starting this commentary with two quotes that superbly summarize the state of the wealth effect, economy, and the outlook for applied stimulus. Cumberland’s strategy and rationale follow the quotes. We specifically acknowledge the effort of Howard Simons of Bianco Research for his repeated seminal work on how markets measure well and forecast much less well.

“The Federal Reserve Flow of Funds report showed a marked deterioration in the state of household balance sheets in Q3. Household net worth fell 4.7% q/q in Q3, translating to a $2.8 trillion loss in household wealth and marking the biggest y/y decline in the history of the series. Household real estate wealth fell 2.8%, reflecting the sharp decline in home prices… The decline in household wealth was accompanied by a decline in mortgage debt, which fell 0.5% q/q, the first decline since 1983. Homeowner equity fell to 44.7% of household real estate, marking a new record low. Household balance sheets also suffered from a 4.5% q/q decline in financial assets, driven by a sharp drop in the market value of corporate equities and mutual fund shares.”

– December 12, Julia Coronado and Michelle Meyer, Barclays Capital

Followed by this:

“The economy’s recovery depends critically on an energetic fiscal policy by the new Administration and Congress…President-elect Obama…will quickly enact significant stimulus for the economy. This is sure to include major new tax reductions…Also to be included is sizable additional spending on infrastructure, broadly defined to include support to state and local governments for a wide range of outlays.…On the monetary side, the Fed will soon be lowering its official rates close to the vanishing point…Yield penalties on investment-grade securities relative to Treasuries are likely to narrow once the extraordinary pressures created by year-end portfolio “window-dressing” pass, but if they do not, the Fed will broaden further the types of securities it buys…With such vigorous support, retail sales, housing starts, and business inventories may stop declining by mid-2009… even in such an environment of near-zero GDP growth, aggregate profits of non-financial firms (except those related to construction, autos, and, perhaps, oil), may actually hold steady or rise, cushioning the decline in capital spending. Net revenue will be well maintained as labor and import costs tend to decline…”

– December 12, Dr. Albert Wojnilower, Craig Drill Capital

Cumberland Advisors’ portfolio management strategy starts with a few assumptions. In the United States both financial policy engines are at full throttle: they are the fiscal engine (deficit spending of $1.5 trillion or more) and the monetary engine (see: www.cumber.com for the weekly updated description of the Federal Reserve’s balance sheet and programs). As Dr. Wojnilower notes, and we agree, this “vigorous support” is expected to arrest the economy’s decline by the 2nd half of 2009. The Fed’s own forecasts are reasonably consistent with this conclusion; they argue that it is the target of Fed policy to bring this result to reality.

This massive stimulus is applied because there is (1) an extreme negative wealth effect (see the Barclays quote above) and (2) a decline in employment and (3) pressure on incomes. Note how this may not play out into a profits debacle (outside of the financial, housing, and consumer discretionary sectors).

Also note how the appearance of no positive outcome prevalent in many forecasts is dependent on the failure of the two-engine stimulus.

Read the rest of this entry »

Shorter Floyd Norris:

It is one thing when the best-paid people seem to be the smartest and the most accomplished. Those who make much less may not like it, but the differential seems understandable. It is another thing when those people are shown to have committed huge blunders that would have driven their companies out of business, and them into the unemployment line, but for government bailouts.

So it is now with Wall Street. In both Europe and the United States, antipathy toward the bailout is rising amid complaints that the money has not helped the economy by encouraging loans, but has kept the bankers in Champagne and caviar.

Are financial workers overpaid? And if so, will it continue? The answers, according to a new study by two economists, are yes, they are overpaid, and no, it will not last.

“Wages in finance were excessively high around 1930 and from the mid 1990s until 2006,” wrote Thomas Philippon of New York University and Ariell Reshef of the University of Virginia, in a National Bureau of Economic Research working paper released this week, “Wages and Human Capital in the U.S. Financial Industry, 1909-2006.”

Gee, I wonder why taxpayers are upset at the bailouts . . .

Source:
Wall Street Paychecks May Wither
FLOYD NORRIS
NYT, January 23, 2009

http://www.nytimes.com/2009/01/23/business/23norris.html

January 19, 2009

via WSJ

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Source:
Risky, Ill-Timed Land Deals Hit Calpers
MICHAEL CORKERY, CRAIG KARMIN, RHONDA L. RUNDLE and JOANN S. LUBLIN
WSJ, DECEMBER 17, 2008

http://online.wsj.com/article/SB122947172015212225.html

As previously noted, the dilly dallying around with these horrific banks and their grossly incompetant management must come to an end.

Sometimes the market gets it just right: The selloff in the financial sector might very well be the cumulative conclusion reached by a preponderance of traders that this sector cannot be rescued by mere recapitalization alone. The market, looking to open down 200 points, and cloosing in on those November lows, may also be sensing the inevitable nationalization.

The Brits, soon to nationalize Barclays, have the right idea: Go Swedish. Wipe out shareholders, bond holders, and all the bad debt and junk paper these firms hold. Zero it out, spin out the assets with clean balance sheets.

If the behavior of these corporate executives is nothing short than egregious: Their embarassing attitudes, foolish excesses, sense of entitled greed is annoying but tolerable when its on their ownshareholders dime; when the taxpayer is footing the bill, it is utterly unacceptable.

To paraphrase a Mellon, its time to liquidate the banks, liquidate capital, liquidate shareholders, liquidate bond holders . . .

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See Also:
Sweden’s Fix for Banks: Nationalize Them
CARTER DOUGHERTY
NYT, January 22, 2009

http://www.nytimes.com/2009/01/23/business/worldbusiness/23sweden.html

Since I am in Grand Cayman, a British Overseas Territory, I thought it only appropriate to note that its now official: the UK joins the US in the ranks of formally being in an announced — and pronounced — recession.

The British economy contracted 1.8% for the 2008 calendar year. For the first time since 1991, the country has felt 2 consecutive quarters of negative GDP: Q3 fell 0.3%, while the miserable 4th Q fell 1.5% — the worst quarter since 1980.

Both services and industrial production saw the largest declines since the 1970s.

I wonder if anyone in the UK wrote an editorial last month proclaiming how wonderful the British economy was . . . probably not. The Brits are known for having a stiff upper lip, and are neither delusional nor incompetent, with have always had a solid streak of realism.

A conversation with David F. Swensen