VIDEO

Copyright 2009 RC Whalen

The photo below shows Charles Driza in a rare moment of rest during one of the lunches he organized for us each day.  Charles is a mechanical engineer by training and a registered Maine Guide.   Besides running Leen’s, Charles is particularly known for his excellent hunting trips, both in ME and in LA during the winter months.

Copyright 2009 RC Whalen

We had great weather this year and the cooperation of the Almighty in this regard also allowed me to capture some of my favorite economists and analysts for posterity.   First of course is our gracious host on TBP Barry Ritholtz, who is shown here in the dining room of the main lodge after a bit of surfing on his ever ready MAC notebook.  And yes, Leen’s has WiFi and the BB even works a little.  I left my BB in the cabin where it belongs.

Copyright 2009 RC Whalen

Barry looks like a very happy cat because we were all waiting for dinner, which at Leen’s is a feast.  I am amazed I was able to get back into my car after five days of eating great food and drinking the endless supply of wine provided by David Kotok, the genius behind this event.  As I said at dinner on day 2, David Kotok is not only a great manager of other people’s money and a great friend, but he is also a committed public citizen because he has taken as his mission in life to broaden dialog and understanding among financial professionals all over the world.    See David below holding forth on an island in the middle of the Big Lake during the lunches the the Maine Guides put on for us each day.

Copyright 2009 RC Whalen

We had almost 50 participants in this year’s fishing trip, including a number of new inductees.   We did not catch enough catfish to have the traditional investiture ceremony as last year, but we still had some fun with the newbies.  One of the names the readers of TBP will recognize is our friend Josh Rosner, who arrived at Leen’s sporting a very impressive rod and reel that it took us several days to learn how to operate.   Something about magnets and centrifugal force.  Finally, we read the instructions.  Duh!  The photo below shows Josh in the bow of a guide’s canoe.

Copyright 2009 RC Whalen

When we are out on the lake, we generally use these beautiful hand-build canoes with small outboard motors.  These craft have square sterns and are remarkably stable.  Our guide for the past several years has been Dale Tobey (djtobey[at]netzero.net), the past president of the Maine Guides Association and a real honest-to-God woodsman who builds his own canoes in the wintertime, raises hounds and hunts and traps in the woods of Maine.  In the photo below, you see Dale with Matt Greco of CNBC, who caught a good number of bass on the last day.

Copyright 2009 RC Whalen

Besides Charles Driza, the people who really make the trip work are the guides and the staff of Leen’s, who all live in the local community and work from dawn till late at night to make our experience a real treat.  The first photo below shows the Maine Guides after the lunch on Saturday.  The lady on the far right of the photo, Sue, baked us fresh pies and cobblers in a dutch oven over an open fire.  Randy Spencer of the Maine Guides is in the center front row.  Randy and CNBC’s Steve Liesman provided great musical entertainment in the evenings for the group.  Randy writes and performs songs, and has also written a history of the Maine Guides.

Copyright 2009 RC Whalen

Here are a copy of photos of Steve and the other campers during one of the lunches on an island in the middle of the Big Lake, including Bob Eisenbeis, Harvey Rosenblum and Jay Dwight.  There is also a shot of the canoes used by the group.

Copyright 2009 RC Whalen

Copyright 2009 RC Whalen

Copyright 2009 RC Whalen

Finally, we have to pay a special tribute to Laura King, our hostess at Leen’s Lodge. Laura is a Passamaquody Indian who lives in Princeton Maine. A life-long resident, Laura has many duties at the lodge, including cooking & telling the guests where the fish are! Laura is known for her helpful attitude and great desserts. Laura’s family members, including her husband Gary, and daughters Bea and Fay, are often helping her at the lodge as the work load increases in the summer season.   Leen’s Lodge is blessed to have Laura King and the other members of the Leen’s family to serve its guests.  And beware:  Laura is a great poker player.

Copyright 2009 RC Whalen

Tight lines,

Chris

Depending upon the news service one chooses to frequent, the swine flu is either dangerously spreading or is well on its way to being contained. Fearing the former, most foreign bourses were under decent pressure last night, but the stocks and bonds in the flu epicenter of Mexico were actually higher at one point today before finishing with modest losses. Perhaps the safest thing to say about this story is that it’s too early to really know whether this strain of swine flu can spread as rapidly around the globe as has the media hype surrounding it. In any case, U.S. stock index futures were down 2% or so as Tuesday dawned. That the Wall Street Journal ran a story about some major banks needing more capital probably also contributed to the early weakness (see excerpt below).

Yet, for the second day running, U.S. stocks suffered only half as much damage as the futures had been indicating. Some analysts take this action as a sign of latent buying power on dips in equities, but a better explanation (at least for today) lies in a piece of less negative than expected news on the housing front (see below). The S&P Case Shiller home price index, released 30 minutes prior to the commencement of trading, showed metropolitan home prices slipped 18% in February versus the negative 19% reading in January. Some tried to herald this better than expected data point as evidence that home prices are bottoming, but, as anyone with a “for sale” sign in their front yard can tell you, a slower rate of decline in price is cold comfort for those trying to sell a home.

After dropping approximately 1% just after the opening bell, equity prices were already on the comeback trail when the next economic news items hit the tape. Consumer confidence in April jumped to 39.2 from March’s 26.9 reading, the largest such rise in three years. Since most of the gains came from the “future expectations” aspect of the survey, economists were quick to hail the results as indicative of a pick up in consumer spending. I’d be happy if the vaunted U.S. consumer somehow found a way to climb up off the canvas, but taken in the context of the whole data series, a reading of 39.2 is not exactly bullish. Consumer confidence was in the 40s back during the dark days of last November, for example, and readings around 110 were not uncommon back in early 2007. Thus, while 39.2 may not be a great number, it was good enough to push stock prices into positive territory today. This happy economic backdrop was only reinforced when the Richmond Fed reported that manufacturing in its district declined at a pace that was gentler than had been forecast.

The major averages responded well enough to these data points to stay mostly above the unchanged mark. Helping to hold prices in check, however, was a follow up to the Journal’s story about the capital needs among the major banks. According to FBR, which administered its own, slightly more rigorous version of the government’s stress test on these institutions, said that Bank of America may need as much as $70 billion in fresh equity (see below). In a further blow to Ken Lewis and his directors, CalPERS announced it was voting against Lewis and his BOD slate at the upcoming annual meeting. BAC shares declined, as did those of Citigroup and other financial companies.

Despite these concerns, equities enjoyed an afternoon rally that saw the major averages logging gains of 1% or more. But this strength didn’t last and prices fell back at the closing bell. The final tally was mixed, with the Russell 2000 sporting a gain of 0.7%, the NASDAQ giving back 0.33%, and other averages finishing with fractional losses. Call today a draw. In contrast to the lack of volatility seen at the NYSE, the Treasury market saw plenty of it. Government bonds were down across the board, and yields rose between 5 and 14 basis points in a decidedly steeper curve environment. The dollar responded by dropping 0.7%, but, like equities, commodities were mixed. Other than a decent drop in metals both precious and base, most sectors comprising the CRB were trendless as the index itself dropped just less than 0.5%.

By almost any measure, fundamental or technical, the U.S. stock market looks to be a bit confused. Biding their time and waiting for more information, prices are thus moving sideways. The economic data has indeed seen some green shoots emerge, but it seems too early to tell whether these growings will become either flowers or weeds. The economic data and corporate earnings have been mixed, and about the best one can say about them is that the rate of decline is slowing. Given the Herculean efforts by the Fed, Treasury, and Congress, such an outcome, while not pre-ordained, is not surprising. The question before investors is whether this “less bad than expected” news flow is enough to signal the type of change President Obama promised when he was swept into office.

I’m no expert, but looking at the internal indicators of the market’s health, it’s just as hard to use technicals when trying to pinpoint an imminent trend in stock prices. The plunge into the early March lows and subsequent rebound into April has left the averages trading sideways at levels just below where they entered the year. Volume and volatility have both eased, and while the lows on the chart are rising, so too are the highs falling. One gets the sense that the indexes are coiling and ready to break out from their recent mid point at 850 or so in the S&P 500. Both the bulls who’ve declared a new bull market and the bears who are selling into what they perceive to be a bear market rally have both been disappointed of late.

Divining a directional change in market prices is tricky, even foolhardy, but perhaps the market leadership names will be instructive. Ever since the great bear market of 2007-2009 began, it has been led by the financial stocks. No matter which direction Mr. Market has chosen to wander, it has been the KBW bank index that has fallen hardest or soared the most. Falling more than 85% into March, the BKX rose just over 100% into mid April. But, while the other averages have been marking time, the BKX is now down 16% since its April 17 high. No matter what our government says about the true health of bank balance sheets, the real stress test for the U.S. stock market lies in what happens next to the BKX. I have a feeling the major averages will start following the banks should they continue moving lower, but who really knows? The safest prediction I can make is that the S&P 500 won’t be hanging around 850 much longer.

– Jack McHugh

U.S. Stocks Retreat, Led by Banks on Balance-Sheet Concern

U.S. Economy: Consumer Confidence Leaps, House-Price Drop Slows

Bank of America’s Lewis Loses Calpers Support, May Need Money

Fed Pushes Citi, BofA to Increase Capital
(subscription required for full article)

While I was away late last week, stocks tried to best the recent highs they had set in anticipation of Friday’s release of the “stress test” parameters. The less than stressful reality of these tests for large banks proved anticlimactic, and equities were unable to muster the energy to reach fresh, post-March 6 highs. As such, the averages may have been looking for an excuse to retreat when the news from Mexico made the rounds over the weekend. A strain of swine flu known as H1N1 was reported to be responsible for more than 100 deaths in Mexico. Though no deaths have been reported in other countries, tests have confirmed that this flu has spread to parts of the U.S. and as far away as New Zealand.

In reaction to these reports, the World Health Organization raised its alert level and investors accordingly raised their level of concern during today’s trading. Fears surfaced that global travel would be disrupted and that overly cautious trade sanctions (e.g. pork imports) would be put in place. The playbook from the 2003 SARS outbreak was dusted off and put to use, with hotels, airlines, cruise lines, and casinos among the day’s biggest losers. Since H1N1 appears to be treatable with Tamiflu and other anti-viral drugs, it came is no surprise that biotech and assorted health care names were among Monday’s winners. Eyebrows were raised, though, when GM managed to gain 20% in the wake of an equity-for-debt swap offer that will likely gain little traction (see below). Short-covering and capital structure arbitrage strategies aside, GM common and the company itself will need enormous measures of both luck and skill to survive in anything resembling current form.

Stock index futures were indicating losses of up to 2% prior to this morning’s open, but the actual damage was approximately half that amount when the opening bell rang in New York. Market participants were soon of a mind that the media was over-hyping the flu story, and they managed to push equities back above unchanged before lunchtime. The averages then resumed sinking during a relatively quiet afternoon before closing just above their worst levels of the day. Helped by GM, the Dow (–.65%) suffered least, while the Dow Transports (-4.7%) understandably brought up the rear. Just as they did during the SARS outbreak in 2003, Treasurys performed well. A large 2 year note auction was quite well received, and yields fell between 4 and 8 basis points. The dollar was somehow deemed a beneficiary of the swine flu, and it rose 1.4% today. Commodities were much less fortunate, as fears of protectionism hiding behind a fig leaf of health concerns hurt almost every major sector. The CRB index declined more than 2%.

While it’s still early by flu outbreak standards, most health experts seem to believe that the H1N1 strain of swine flu is unlikely to reach pandemic proportions. If so, and I’m particularly unqualified to doubt medical professionals, to what can we better attribute to today’s decline in the stock market? I have two candidates and the first is a piggish rise in bullishness among large institutional investors. The latest “Barron’s Big Money Poll” came out this weekend, and the results display anything but doubt for the future of either U.S. stocks or the U.S. economy. Fully 59% of portfolio managers in the survey counted themselves as bullish on equities, while only 13% said they were negative. Readings of 4-1 bulls over bears are usually reserved for the frothier portions of bull markets — or, perhaps, at the peak of a vigorous bear market rally. As BAC-MER economist, David Rosenberg, points out in his piece below, the figures are even more striking (in the opposite direction) for Treasurys. 84% are bearish on securities issued by our government while a mere 3% are constructive. I may not be bullish on U.S. debt, but maybe the overwhelmingly bearish sentiment means it’s a bit too early to short them.

Given today’s 5% drop in the KBW bank stock index, my other candidate for an old affliction that might be responsible for weighing down stock prices today is the epidemic of shoddy bank lending practices during the previous boom. Infecting far more than just subprime residential real estate, this contagion spread to commercial real estate, leveraged loans, junk bonds, CDS, and even plain old corporate bonds. This strain of poor lending was evident in the narrow spreads seen for all types of credit in the run up to mid 2007, and despite repeated assurances from so many government officials and bank CEOs to the contrary, this problem is still not contained. The contagious desire among banks to extend credit to so many parties with hardly more upside than the generation of upfront fees is the real swine flu of our generation. And, just like its pandemic namesake, this strain of sick lending can be found all over the world.

Let’s look at Wells Fargo, a bank that has been in the news quite a bit of late.. The Bank of Buffett, according to the Oracle himself, stayed mostly out of trouble during the last cycle by avoiding doing the “dumb things” that so many of its competitors felt an irresistible urge to do on the lending side. “But they’ve never felt compelled to do anything because other banks were doing it, and that’s how banks get in trouble, when they say, ‘Everybody else is doing it, why shouldn’t I?’” (source: Fortune article below). As a Wells Fargo mortgagee myself, I agree with Mr. Buffett that Wells maintained a unique sense of discipline during the last cycle. But now WFC is lugging around the old Wachovia, which was a poster child of “me too” credit practices prior to its merger with Wells. Strictly because it now owns Wachovia, I’m a lot less sanguine about the future of Wells Fargo, a sentiment apparently shared by Dick Bove (see below).

This Rochdale Securities analyst has been favorably disposed toward banks for quite some time (read: bullish at much higher prices than these institutions fetch today). For Mr. Bove to cut Wells Fargo from a buy to a hold and question WFC’s cash levels and ability to digest the Wachovia transaction may thus actually be news. Mr. Bove agrees with Mr. Buffett that Wells is very well run, but he also agrees with me that Wells will be hampered by Wachovia going forward. Trying to keep up with the Joneses in New York, the Charlotte-based bank caught the “everybody else is doing it” syndrome so abhorred by the management of Wells and its famous shareholder. Let me repeat: I’m not saying Mr. Buffett is wrong and I’m not advocating anyone be short of Wells Fargo. What I am saying is that bullish market sentiment is already running a fever just as a flu scare strikes a global economic sentiment that is already bedridden. H1N1 may or may not have much of an impact on the world, but the real swine flu is still wreaking havoc.

– Jack McHugh

U.S. Stocks Fall as Swine Flu Drags Down Travel, Hotel Shares

GM Bondholder Group Says Offer Isn’t ‘Reasonable’

Warren Buffett on Wells Fargo

Ahead of the Bell: Bove cuts Wells Fargo rating

Big Money Poll meets Bob Farre.pdf

I suggested that the big banks should not be allowed to repay TARP equity to long as the government is guaranteeing their debt. That is, if a bank wants to repay TARP capital, they must end the use of debt guarantees AND be able to refinance all guaranteed debt before the TARP capital is repaid.  Link below:

We will develop this further.  Look forward to your comments.

Best,

Christopher Whalen
Managing Director
Office: 914-827-9272
www.institutionalriskanalytics.com

The Mexican peso is having its biggest one day decline vs the US$ since Oct 22nd also in response as businesses where people congregate temporarily close. Most global bond markets are the sole beneficiary of the nervousness.

May German consumer confidence was a touch better than expected but the Euro is lower as two ECB members over the weekend said they will support another rate cut next week. The only question over the next few months is if they stop at 1% or not from 1.25% now. Earnings, auto restructurings, bank stress test capital raises and US Treasury supply will again be the focus this week.

>

Today – SPMs are down 14.60 in Sunday night trading because Obama’s chief economic adviser, Larry Summers, asserted while appearing on Fox News Sunday, that the economic freefall is over but, “I expect the economy will continue to decline… [with] sharp declines in employment for quite some time this year.” (Reuters)

• “The anticipation over the white paper appears to be much ado about nothing,” said Josh
Rosner…“The most significant numbers provided by the Fed in the paper appear to be the page
numbers.”…
• “A lot of triple talk,” said Jim Glickenhaus… “I think they’re going to say while things are bad, the end is not at hand. Maybe.”
• “The question I have, by using fourth-quarter numbers, is this skewed positively?” said Lawrence Kaplan, an attorney with Paul Hastings, who served as a senior attorney in the chief counsel’s office at the Office of Thrift Supervision. “Because January and February were pretty lousy, and as a result that’s when it hit the fan.” (Bloomberg)

As most people guessed, the ‘stress test’ is an innocuous exercise based on rosy economic projections. Besides, why is a ‘stress test’ needed when there are already three agencies (Fed, FDIC, OCC) that apply metrics to measure banks’ solvency and financial condition?

A major problem with the ‘stress test’ is it depends on modeling and it’s the precise practice responsible for much of this economic and financial mess. It’s extraordinary that so many people believe that the Fed and Treasury, after missing the financial disaster, housing debacle, recession and derivative implosion, can now extrapolate economic conditions and resultant financial affects from its models. How did all that rocket-science modeling for subprime defaults and securitization workout? Yet many people already forget or ignore this reality.

Here’s another reality that most investors are missing – banks must raise more capital. So who’s the patsy in recent days that has been driving financial stocks higher? The FT: Fed will seek bank capital increase. Some of the country’s biggest banks will be asked to raise more capital by US authorities following the completion of bank stress tests, senior Federal Reserve officials said on Friday. (Financial Times)
Banks May Need $1 Trillion After U.S. Tests, KBW Says (Bloomberg)

What few analysts realize is that economic ‘muddling’, the best case scenario for the next two years, gives no relief to an economy burdened with record debt. If you lose a high paying job and you are struggling to pay your debts, you will not suddenly be able to pay your debt with a job a Wal-Mart.

What analysts should do is quantify the US private and public sector debt load and then extrapolate the needed income and GDP to service the debt. And then they should calculate how much debt will implode with little or no income and GDP growth.

The ‘real budget deficit’, “Treasury Gross Public Debt”, is now $1.85 Trillion (Barron’s p. M70).

The most disturbing aspect of the current scheme to manipulate markets, economic data and industrial data into something benign enough to increase consumer confidence and reinflate assets is that it is the precise scheme that Easy Al and others perpetrated over many years. And it created the current mess.

Solons again are trying to inflate assets to a level that is a huge disconnect with economic reality in
the misguided belief that they can paper over structural US economic problems and fostering
‘confidence through asset bubbles’ that will translate into economic activity. We are back to square one in ‘the new economy’ gambit.

And because we are back to square one in ‘the new economy’ of inflating assets to paper over problems, the markets are diving back into inflation mode. Commodities are soaring; bonds are struggling even with Fed support and the dollar is finally buckling.

~~~

Bill King is a Wall Street veteran with 35 years of institutional equity, proprietary and derivatives trading experience, giving him a unique perspective on current market conditions and forecast. As author of The King Report, Bill’s candid observations and forecast on the economic, financial, and political forces that are impacting the markets is read by major institutions and hedge funds. However, this report is not the usual garden variety tripe that is issued by the financial media and Wall Street. Bill, in plain language, refutes conventional rant about Wall Street activity and articulates the real factors and impetuses that drive market activity. The inside world of Wall Street is far different than what is disseminated to the masses. Wall Street insiders seldom adorn their own portfolios or trading accounts with ‘recommended list’ issues.

“Words from the Wise” this week comes to you in a shortened format as my traveling in the US precludes me from doing my customary commentary. However, a full dose of excerpts from interesting news items and quotes from market commentators is provided.

On Friday, Federal Reserve regulators have released a white paper outlining the criteria they used to assess the financial health of the nation’s 19 biggest banks. On the same day they also briefed the banks about how their companies had fared in the examination. The banks will have until Tuesday to dispute any of the results before they are made public on May 4.

According to the Financial Times, senior Fed officials said US authorities will ask some of the country’s biggest banks to raise more capital following the completion of bank stress tests. The officials also indicated that a second, larger, group of banks will be asked to improve the quality of their capital by increasing their amount of common equity.

Last week investors’ mood was also influenced by tentative signs of economic stabilization in a number of countries and a barrage of earnings report – generally better than feared. As the equity rally ground to a halt on some bourses, the US dollar and government bonds offered little safety appeal and edged weaker. Gold, on the other hand, advanced after China revealed it has almost doubled its gold reserves since 2003. Treasury Inflation Protected Securities (TIPS) also improved on the week.

The performance of the major asset classes is summarized by the chart below, courtesy of StockCharts.com.

After rising for six consecutive weeks, global stock markets experienced a volatile week, including the worst losses since early March on Monday. In the end, the MSCI World Index gained 0.1% (YTD -4.1%) on the week and the MSCI Emerging Markets Index 0.7% (YTD +14.2%), but the S&P 500 Index shaved off -0.4% (YTD -4.1).

Click on the table below for a larger image.

As far as the earnings season is concerned, Bespoke indicated that 156 S&P 500 companies had reported earnings by Thursday, beating estimates in 67% of the cases. Also, so far earnings are down 16.6% versus the first quarter of 2008. While down, this is much better than the -37.3% expected at the start of the earnings season. “The earnings season still has a long way to go, but the current trend has investors optimistic,” said Bespoke.

In an attempt to cast light on the debate of whether we are dealing with a bull market or a bear market rally, William Hester (Hussman Funds) highlighted the following: “Contracting volume is not enough evidence to qualify that this is a bear-market rally with certainty. There are other measures that are showing more strength – such as various indicators of market breadth. But new bull markets, whether at their inception or soon after, have a history of recruiting noticeable improvements in volume. So far this rally lacks that important quality. Over the next few weeks stock market volume will be a metric to watch closely.”

The stock market will show its hand in due course, but it is crucial that the lows of March 9 hold in order for base formation development to remain intact. Should these levels – 677 for the S&P 500 and 6,547 for the Dow Jones – be breached, further downside movements may be in store.

For more discussion on the direction of stock markets, see my recent posts “Video-o-rama: Economy – Recovery or relapse?” and “Has stock market rally run its course?” (And do make a point of listening to Donald Coxe’s webcast of April 24, which can be accessed from the sidebar of the Investment Postcards site.)

Next, a quick textual analysis of my week’s reading. No surprises here, with key words such as “banks”, “market”, “economy”, “economic”, “government” and “prices” featuring prominently.

Economy
“Global business sentiment remains very poor, but it has taken on a slightly better hue in recent weeks. Broad assessments of current and prospective conditions have also moved up measurably since the beginning of the year,” said the latest Survey of Business Confidence of the World conducted by Moody’s Economy.com. “It is premature to conclude that businesses are turning measurably more upbeat, but recent survey results are somewhat encouraging.”

For a further perspective on the outlook for the global economy, also read my posts “Economic rate of decline slowing down?“, “Goldman raises China’s growth forecasts” and “Chinese economy on the rebound“.

A snapshot of the week’s US economic data is provided below. (Click on the dates to see Northern Trust‘s assessment of the various data releases.)

April 24

• New Home Sales appear to be stabilizing
• Durable Goods Orders report – weak, but pace of decline is moderating

April 23
• Sales of Existing Homes appear to be stabilizing at a low level
• Initial Jobless Claims erase part of the improvement seen in recent weeks

April 22
• House Price Index points to moderation in pace of decline
April 20, 2009
• Leading Index – continues to send message of weak economic conditions
• Chicago Fed National Activity Index shows a small but noteworthy improvement
Week’s economic reports
Click here for the week’s economy in pictures, courtesy of Jake of EconomPic Data.

Source: Yahoo Finance, April 24, 2009.

In addition to interest rate announcements by the Federal Open Market Committee (FOMC) (Wednesday, April 29) and the Bank of Japan (Thursday, April 30), the US economic highlights for the week include the following:

Source: Northern Trust.

Click here for a summary of Wachovia’s weekly economic and financial commentary.

Markets
The performance chart obtained from the Wall Street Journal Online shows how different global markets performed during the past week.

Source: Wall Street Journal Online, April 24, 2009.

“To find yourself, think for yourself,” said Socrates (hat tip: Charles Kirk.) And we know the stock market is a dangerous place if you don’t think rationally and know your own investment personality. Hopefully the “Words from the Wise” reviews will assist Investment Postcards readers in crystalizing their thoughts to come up trumps with their investment decisions.

That’s the way it looks from Cape Town (or, more accurately, from beautiful Dana Point, California, for the next few days).

Source: Slate.com

Financial Times: IMF puts financial losses at $4,100 billion
“The deteriorating global economy means financial institutions now face total losses of $4,100 billion on loans and other assets, the International Monetary Fund said on Tuesday, urging governments to take ‘bolder steps’ to shore up institutions – including nationalising them where necessary.

“The IMF said in its Global Financial Stability Report that many loans sitting on institutions’ balance sheets were eroding in value, not just the toxic sub-prime securities which first triggered the crisis.

“The IMF estimated that total writedowns on US assets would reach $2,700 billion, up from the $2,100 billion estimate it made in January and almost double what it forecast in October last year. Including loans originated in Japan and Europe, the writedowns would hit $4,100 billion, it added.

“Banks would bear about two-thirds of the losses, it said, with insurance companies, pension funds, hedge funds and others taking the rest.

“Efforts to cleanse these bad assets from balance sheets and replenish viable institutions with capital had so far been ‘piecemeal and reactive’, the IMF said, calling for more decisive government action.

“‘The current inability to attract private money suggests the crisis has deepened to the point where governments need to take bolder steps and not shrink from capital injections in the form of common shares even if it means taking majority, or even complete, control of institutions,’ it said.”

Source: Sarah O’Connor, Financial Times, April 21, 2009.

The New York Times: Regulators disclose criteria for bank “stress tests”
“Federal regulators released the criteria they used to assess the financial health of the nation’s 19 biggest banks on Friday, but provided little new information for investors to distinguish the industry’s weak players from the strong.

“In a 21-page report, the Federal Reserve regulators broadly laid out the tools they used to project bank losses if the economy worsens, and officials established an unspecified baseline to measure how much additional capital the banks should add as a buffer against higher losses. But they provided no concrete metrics to assess the depths of the troubles facing the industry or specific banks.

“Still, the Federal Reserve report suggested that regulators are focusing on the amount of capital that they want banks to hold in common stock, which makes it easier for them to absorb future losses as the recession wears on. That could force at least a handful of the 19 banks to raise significant amounts of new capital and could lead to greater government ownership stakes in the banks.

“‘Losses associated with the deepening recession and financial market turmoil have substantially reduced the capital of some banks,’ the Federal Reserve report on the stress test said. ‘Lower overall levels of capital – especially common equity – along with the uncertain economic environment have eroded public confidence in the amount and quality of capital held by some firms, which is impairing the ability of the banking system to perform its critical role of credit intermediation.’

“The stress test criteria were released as federal regulators started briefing top executives from the 19 large banks about how their companies fared on the examination. In closed-door meetings at the regional Federal Reserve Bank offices, the regulators plan to review their preliminary findings and inform bankers if they need additional capital. The banks will have until Tuesday to dispute any of the results before they are made public on May 4.”

Source: Eric Dash, The New York Times, April 24, 2009.

The New York Times: US may convert banks’ bailouts to equity share
“President Obama’s top economic advisers have determined that they can shore up the nation’s banking system without having to ask Congress for more money any time soon, according to administration officials.

“In a significant shift, White House and Treasury Department officials now say they can stretch what is left of the $700 billion financial bailout fund further than they had expected a few months ago, simply by converting the government’s existing loans to the nation’s 19 biggest banks into common stock.

“Converting those loans to common shares would turn the federal aid into available capital for a bank – and give the government a large ownership stake in return.

“While the option appears to be a quick and easy way to avoid a confrontation with Congressional leaders wary of putting more money into the banks, some critics would consider it a back door to nationalization, since the government could become the largest shareholder in several banks.

“The Treasury has already negotiated this kind of conversion with Citigroup and has said it would consider doing the same with other banks, as needed. But now the administration seems convinced that this maneuver can be used to make up for any shortfall in capital that the big banks confront in the near term.

“Each conversion of this type would force the administration to decide how to handle its considerable voting rights on a bank’s board.

“Taxpayers would also be taking on more risk, because there is no way to know what the common shares might be worth when it comes time for the government to sell them.

“Treasury officials estimate that they will have about $135 billion left after they follow through on all the loans that have already been announced. But the nation’s banks are believed to need far more than that to maintain enough capital to absorb all their losses from soured mortgages and other loan defaults.”

Source: Edmund Andrews, The New York Times, April 19, 2009.

Financial Times: US to put conditions on Tarp repayment
“Strong banks will be allowed to repay bailout funds they received from the US government but only if such a move passes a test to determine whether it is in the national economic interest, a senior administration official has told the Financial Times.

“‘Our general objective is going to be what is good for the system,’ the senior official said. ‘We want the system to have enough capital.’

“His comments come as Goldman Sachs, JPMorgan Chase and other relatively strong banks are pressing to be allowed to repay their bailout funds. On Sunday, Lawrence Summers, President Barack Obama’s top economic adviser, told NBC’s Meet the Press that repayments could eventually help the government provide further resources to help the sector. Such a move could also allow healthier institutions to differentiate themselves from weaker banks and free them from constraints on executive pay, and other activities, that come with bailout money.

“‘Not surprisingly different banks are in different situations; they are going need different levels of assistance of taxpayers,’ Mr Obama told a press conference at a summit in Trinidad on Sunday, while promising: ‘I’m not going to simply put taxpayer money into a black hole.’

“The official, meanwhile, said banks that had plenty of capital and had demonstrated an ability to raise fresh capital from the market should in principle be able to repay government funds. But the judgment would be made in the context of the wider economic interest. He said the government had three basic tests. It needed first to ‘make sure the system is stable’. Second, to not create ‘incentives for more deleveraging which would deepen the recession’. Third, to make sure the system had enough capital to ‘provide credit to support the recovery’.”

Source: Krishna Guha and Daniel Dombey, Financial Times, April 19, 2009.

Fox Business: Will banks make the grade?
“Rochdale Securities analyst Dick Bove on the 19 banks receiving government ‘stress test’ results today [Friday]. Bove says the results could be dangerous to the overall economy and wonders if the banks that fail could raise capital either from the government or the marketplace.”

Source: Fox Business, April 24, 2009.

PBS: Bill Moyers talks to Simon Johnson and Michael Perino
“Bill Moyers talks about the economy and Wall Street’s future with Simon Johnson, former chief economist of the International Monetary Fund (IMF) and a professor at MIT Sloan School of Management, and Michael Perino, professor of law at St. John’s University and an advisor to the Securities and Exchange Commission.”

Source: Bill Moyers Journal, PBS, April 24, 2009.

Bill King (The King Report): Ken Lewis’s testimony
“NY AG Andrew Cuomo in a letter to Congressional Leaders about Ken Lewis’s shocking testimony:

‘Immediately after learning on December 14,2008 of what Lewis described as the “staggering amount of deterioration” at Merrill Lynch, Lewis conferred with counsel to determine if Bank of America had grounds to rescind the merger agreement by using a clause that allowed Bank of America to exit the deal if a material adverse event (“MAC”) occurred. After a series of internal consultations and consultations with counsel, on December 17,2008, Lewis informed then-Treasury Secretary Henry Paulson that Bank of America was seriously considering invoking the MAC clause. Paulson asked Lewis to come to Washington that evening to discuss the matter.

‘At a meeting that evening Secretary Paulson, Federal Reserve Chairman Ben Bernanke, Lewis, Bank of America’s CFO, and other officials discussed the issues surrounding invocation of the MAC clause by Bank of America. The Federal officials asked Bank of America not to invoke the MAC until there was further consultation. There were follow-up calls with various Treasury and Federal Reserve officials, including with 2 Treasury Secretary Paulson and Chairman Bernanke. During those meetings, the federal government officials pressured Bank of America not to seek to rescind the merger agreement. We do not yet have a complete picture of the Federal Reserve’s role in these matters because the Federal Reserve has invoked the bank examination privilege…

‘On the issue of terminating management and the Board, Secretary Paulson indicated that he told Lewis that if Bank of America were to back out of the Merrill Lynch deal, the government either could or would remove the Board and management. Secretary Paulson told Lewis a series of concerns, including that Bank of America’s invocation of the MAC would create systemic risk and that Bank of America did not have a legal basis to invoke the MAC (though Secretary Paulson’s basis for the opinion was entirely based on what he was told by Federal Reserve officials).

‘Secretary Paulson’s threat swayed Lewis. According to Secretary Paulson, after he stated that the management and the Board could be removed, Lewis replied, “that makes it simple. Let’s deescalate.” Lewis admits that Secretary Paulson’s threat changed his mind about invoking that MAC clause and terminating the deal. Secretary Paulson has informed us that he made the threat at the request of Chairman Bernanke. After the threat, the conversation between Secretary Paulson and Lewis turned to receiving additional government assistance in light of the staggering Merrill Lynch losses.’”

Source: Cuomo’s letter, April 23, 2009 (hat tip: The King Report).

Calculated Risk: BofA CEO – “Credit is bad, going to get worse”
“BAC CEO Ken Lewis on the conference call:

“‘Let me make a couple comments about our given environment. Credit is bad and we believe credit is going to get worse before it will eventually stabilize and improve. Whether that turn is later this year or in the first half of 2010, I’m not going to hazard a guess … For the rest of the year we look for charge-offs to continue to trend upward …”

Source: Calculated Risk, April 20, 2009.

CEP News: IMF revises down global growth estimates

“The International Monetary Fund expects the global economy to contract 1.3% in 2009, a downward revision from the previous forecast calling for a contraction of between 0.5% and 1.0%, according to its semi-annual report released on Wednesday.

“The Fund also said that in 2010 the global economy should grow 1.9% versus a previous forecast for 3% growth.

“‘This is not the time for complacency, and the need for strong policies, both on the macro and especially on the financial fronts, is as acute as ever,’ said IMF chief economist Olivier Blanchard. ‘But, with such policies in place, there is light at the end of this long tunnel. World growth can turn positive by the end of this year, and unemployment can start decreasing by the end of next year.’

“All G7 nations are expected to contract in 2009 with the US economy shrinking 2.8% in 2009, with zero growth in 2010.

“The Japanese economy is expected to contract 6.2% in 2009 and grow 0.5% in 2010, the euro zone economy is forecast to shrink 4.2% in 2009 and 0.4% in 2010, the Canadian economy is seen falling 2.5% in 2009 and growing 1.2% the following year, and the UK economy is expected to decline 4.1% in 2009 and 0.4% in 2010.

“‘These projections are based on an assessment that financial market stabilization will take longer than previously envisaged, even with strong efforts by policy-makers,’ according to Blanchard and José Viñals, head of the IMF’s Monetary and Capital Markets Department, in a joint statement.”

Source: CEP News, April 22, 2009.

BCA Research: From economic free-fall to sliding
“The flow of economic and earnings data has continued to beat expectations in recent weeks, helping to gradually heal investor sentiment.

“Our global leading economic indicator and boom/bust index have both ticked higher, albeit from historically depressed readings. Similarly, purchasing managers’ surveys and business confidence measures appear to have bottomed across the developed world, after free-falling late last year. Even last week’s release of the Fed’s Beige Book highlighted that the level of economic activity remains extremely weak, although slightly less so than the previous report.

“Still, the economy has merely shifted from falling off a cliff to sliding down a slope. The latter is certainly less terrifying and justifies the unwinding of Armageddon trades but is hardly bullish. Risk assets may continue to move higher from oversold levels over the next few weeks but sustained upside will require evidence that the spate of positive second derivative of growth indicators will turn into a meaningful recovery.

“Aggressive fiscal stimulus in most countries, combined with the potential for a positive inventory adjustment, should stabilize GDP growth in Q3 and Q4. However, an ongoing improvement in growth conditions will be reliant on fixing the global banking system and credit channels, allowing liquidity to begin flowing to the real economy. While our financial sector stress index has eased modestly, it remains extremely elevated. Similarly, bank lending surveys have improved but standards are not yet easing.

“Bottom line: Policymakers will need to continue acting aggressively for the recovery in risk assets to persist. We are positioned modestly in favor of reflation but prefer taking bets in fixed income spread product rather than equities due to relative value and a better yield pickup in case a sustainable upleg takes time to develop.”

Source: BCA Research, April 24, 2009.

Nouriel Roubini (Rediff News): End of economic gloom?
“Mild signs that the rate of economic contraction is slowing in the United States, China and other parts of the world have led many economists to forecast that positive growth will return to the US in the second half of the year, and that a similar recovery will occur in other advanced economies.

“The emerging consensus among economists is that growth next year will be close to the trend rate of 2.5%.

“Investors are talking of ‘green shoots’ of recovery and of positive ‘second derivatives of economic activity’ (continuing economic contraction is the first, negative, derivative, but the slower rate suggests that the bottom is near).

“As a result, stock markets have started to rally in the US and around the world. Markets seem to believe that there is light at the end of the tunnel for the economy and for the battered profits of corporations and financial firms.

“This consensus optimism is, I believe, not supported by the facts. Indeed, I expect that while the rate of US contraction will slow from -6% in the last two quarters, US growth will still be negative (around -1.5 to -2%) in the second half of the year (compared to the bullish consensus of +2%).

“Moreover, growth next year will be so weak (0.5 to 1%, as opposed to the consensus of 2% or more) and unemployment so high (above 10%) that it will still feel like a recession.

“In the euro zone and Japan, the outlook for 2009 and 2010 is even worse, with growth close to zero even next year. China will have a more rapid recovery later this year, but growth will reach only 5% this year and 7% in 2010, well below the average of 10% over the last decade.

“Given this weak outlook for the major economies, losses by banks and other financial institutions will continue to grow. My latest estimates are $3.6 trillion in losses for loans and securities issued by US institutions, and $1 trillion for the rest of the world.”

Click here for the full article.

Source: Nouriel Roubini, Rediff News, April 15, 2009.

Alan Abelson (Barron’s): Don’t bank on it
“David Rosenberg of Bank of America/Merrill Lynch last week offered some worthwhile observations on the stock market and the economic landscape that just happen to buttress our own reservations.

“He points out that the two groups that paced the sharp upswing were financials and consumer cyclicals, in which there are, respectively, net short positions of 5 billion and 2.7 billion shares. Which strongly suggests that not an insignificant part of the rally has been provided by shorts running for cover.

“He also points out that the Russell 2000 small-cap index is up 36% since the March low, and has outperformed the S&P by some 980 basis points. As David says, ‘the last time it pulled such a massive rabbit out of the hat’ was in the stretch from late November to early January, and the major averages proceeded to make new lows two months later.

“Another amber light he spots is investor confidence. Over the past five weeks, he reports, Rasmussen, which takes a daily reading, has seen its investor-confidence index surge 32 points, an unprecedented climb in so short a span. This could be, he suspects, a ‘fly in the ointment for a sustained equity-market rally’.

“David has four markers that will signal to him that the economy is finally making the turn and starting an extended expansion. The first is home prices. The second is the personal-savings rate. Marker No. 3 is the debt-service ratio, and No. 4 is the ratio of the coincident-to-lagging indicators of the Conference Board.

“Aggregating those four markers, he calculates that we are roughly 44% of the way through the adjustment process. That is a tick up from where we were last month. However, the improvement, he laments, has been very modest and very slow.

“We should add that he also stresses that it’s critical for both the economy and the market that payrolls stop shrinking. All the talk about jobless claims “stabilizing” is so much poppycock, he snorts. That number of claims, he notes, is still consistent with monthly payroll losses of around 700,000. As with industrial production, which is also in a vicious slump, employment must stop falling before a recession typically ends.

“‘Call us when claims fall below 400,000,’ he says, which is his estimate of ‘the cut-off for payroll expansion/contraction’.

“Until then, he warns, ‘the recession will remain a reality. Rallies will be brief, no matter how violent, and green shoots are a forecast with a very wide error term attached to it.’”

Source: Alan Abelson, Barron’s, April 18, 2009.

Barry Ritholtz (The Big Picture): The (false) glimmer of hope
“Nice cover image from The Economist on the brown shoots.

“Excerpt: ‘But, welcome as it is, optimism contains two traps, one obvious, the other more subtle. The obvious trap is that confidence proves misplaced – that the glimmers of hope are misinterpreted as the beginnings of a strong recovery when all they really show is that the rate of decline is slowing. The subtler trap, particularly for politicians, is that confidence and better news create ruinous complacency. Optimism is one thing, but hubris that the world economy is returning to normal could hinder recovery and block policies to protect against a further plunge into the depths.’”

Source: Barry Ritholtz, The Big Picture, April 23, 2009.

Horowitz & Company: Recessions – past and present

Source: Horowitz & Company, April 2009.

Asha Bangalore (Northern Trust): Leading Index – continues to send message of weak economic conditions
“The Conference Board’s Index of Leading Indicators (LEI) dropped -0.3% in March 2009, after a revised 0.2% decline during February. The LEI posted the last increase in June 2008. On a year-to-year basis, the quarterly average of the LEI fell 3.8% after a 4.0% decline in the fourth quarter. The LEI appears to have established a bottom in the fourth quarter of 2008.

“The main message is that the LEI continue to point to weak economic conditions in the near term. More is required to declare that the economy is out of the woods.”

Source: Asha Bangalore, Northern Trust – Daily Global Commentary, April 20, 2009.

Asha Bangalore (Northern Trust): Chicago Fed National Activity Index shows a noteworthy improvement
“The Chicago Fed National Activity Index (CFNAI) was -2.96 in March versus -2.82 in February. The 3-month moving average of the index provides a more consistent picture of national activity. In March, the 3-month moving average increased to -3.27 from -3.57 in February. A bottom of the 3-month moving average of the CFNAI is associated with the likely end of a recession, most of the time. We will be tracking this information to get a heads up about the economy.”

Source: Asha Bangalore, Northern Trust – Daily Global Commentary, April 20, 2009.

Asha Bangalore (Northern Trust): House Price Index points to moderation in pace of decline
“The Federal Housing Finance Authority’s (previously OFHEO) House Price Index (HPI) for February moved up 0.7% in February after a 1.1% increase in January. From a year ago the HPI dropped 6.43% compared with a 6.88% decline in January. The sharpest decline was recorded in November 2008 (-9.06%). The Case-Shiller Home Price Index for February will be published on April 28. In January the Case-Shiller Home Price Index fell 19% from a year ago following an 18.6% drop in December.

“Two out of three house price indexes appear to have established a tentative bottom. The New York Times (For Housing Crisis, the End Probably Isn’t Near) story suggests that additional price declines, probably of a large magnitude, are likely in the near term. The elevated level of inventories of unsold homes and the weakness in employment conditions support the conclusion of the article. However, we should bear in mind that other sectors of the economy are showing preliminary signs of stabilization that could translate into a recovery given the historical size of the monetary and fiscal policy stimulus put in place.”

Source: Asha Bangalore, Northern Trust – Daily Global Commentary, April 22, 2009.

Asha Bangalore (Northern Trust): Sales of existing homes appear to be stabilizing at a low level
“Sales of all existing homes dropped 3.0% at an annual rate of 4.57 million units in March. Sales of existing single-family homes declined 2.8% to an annual rate of 4.10 million units in March. Sales of single-family existing homes have moved in a narrow range of 4.06 million – 4.25 million in last five months, suggesting that a bottom at a low level is being established. The Beige Book, prepared for the April 28-29 FOMC meeting, noted that there were ‘some signs that conditions may be stabilizing’.

“The seasonally adjusted inventory-sales ratio for existing single-family homes rose slightly to a 9.6-month supply mark in March from a 9.5-month supply in the earlier month. This ratio appears to have peaked in November 2008 (11.3 month supply) and has since moved in a narrow range between 9.96 months and 9.53 months.”

Source: Asha Bangalore, Northern Trust – Daily Global Commentary, April 23, 2009.

Asha Bangalore (Northern Trust): New home sales appear to be stabilizing
“Sales of new homes dropped 0.6% to an annual rate of 356,000 in March following an upwardly revised gain in sales during February (358,000 versus earlier estimate of 337) and January (331,000 versus earlier estimate of 322,000). The level of new home sales suggests that sales are stabilizing. … year-to-year decline in sales in new homes in March was smaller than in prior months.

Source: Asha Bangalore, Northern Trust – Daily Global Commentary, April 24, 2009.

Asha Bangalore (Northern Trust): Initial Jobless Claims erase part of the improvement seen in recent weeks
“Initial jobless claims moved up 27,000 to 640,000 in the week ended April 18 and erased a part of the decline seen in the prior two weeks.

“Continuing claims, which lag initial claims by one week, advanced 93,000 to 6.137 million, a new record. The insured unemployment rate rose to 4.6% from 4.5% in the previous week. The insured unemployment rate has risen one percentage point in a short span of 10 weeks which has occurred only on two other occasions. The jobless claims report presents a serious challenge to policymakers.”

Source: Asha Bangalore, Northern Trust – Daily Global Commentary, April 23, 2009.

Casey’s Charts: Pouring fuel on the fire
“In November, the Fed announced its intent to purchase agency mortgage-backed securities directly from the market ‘to reduce the cost and increase the availability of credit for the purchase of houses’.

“After pumping $350 billion worth of freshly printed dollars into the system, they’ve succeeded in forcing mortgage rates to near historic lows. Great news for homeowners able to refinance; yet new home sales remain stagnant.

“There’s no telling when the housing market will stabilize. But the Fed is certain to continue fueling the fire with cheap money until recovery signs appear.”

Source: Casey’s Charts, April 21, 2009.

Bloomberg: Zero percent on Treasury Bills as China, Fed converge
“The last time US Treasury bill rates headed toward zero percent investors were panicking. Now it’s an indication Federal Reserve Chairman Ben Bernanke’s efforts to revive credit markets are starting to work.

“Rates on three-month bills turned negative in December for the first time since the government began selling them in 1929 as investors sacrificed returns to preserve principal. After increasing at the start of the year, rates have dropped 0.20 percentage point since the beginning of February to 0.13%.

“Demand for bills is rising again because investors including foreign central banks are snapping up the shortest-term US securities as the Federal Reserve buys Treasuries to drive down borrowing costs in a policy of so-called quantitative easing. China, the largest US creditor, with $744 billion of debt, has questioned the practice and shifted purchases to bills from longer-maturity securities.

“‘There’s a group of investors out there who are looking at what the Fed is doing and the policy action they’ve taken and the asset purchases, and saying ultimately this is inflationary,’ said Stuart Spodek, co-head of US bonds in New York at BlackRock. ‘You’re going to invest in very short-term bills because you absolutely need not just the quality but also the absolute liquidity.’

“China bought $5.6 billion in bills and sold $964 million in US notes and bonds in February, according to Treasury data released April 15. It was first time since November that China purchased more bills than longer-maturity debt.”

“While Treasury depends on China to fund the deficit, exports account for about 40% of gross domestic product for the world’s most populous nation. China’s exports to the US jumped 40% in March after slumping for five consecutive months.

“‘China and the US have a symbiotic relationship,’ said Win Thin, a senior currency strategist in New York at Brown Brothers Harriman & Co. ‘We need each other.’”

Source: Daniel Kruger, Bloomberg, April 20, 2009.

SmartMoney: Could municipal bonds really default?
“When Warren Buffett speaks, it’s usually worth paying attention. This time, the Oracle of Omaha is voicing concerns about the ability of some battered local and state governments to pay off their debts. The idea of cities and states facing insolvency is alarming for sure, and Buffett isn’t alone. Moody’s recently assigned a ‘negative outlook’ to the creditworthiness of all the nation’s local governments. The agency has rarely made such a sweeping generalization but said the magnitude of this recession warranted the move. The comments are the latest to have shaken the once-staid world of municipal bond investing.

“Traditionally, muni bonds offered lower yields – usually about 20% less – than Treasury bonds, since their income isn’t taxed. But the group was crushed last year, sending prices down and yields up. Now bargain hunters have started to emerge, attracted by yields that are as much as 70 basis points, or 0.7%, more than similar 10-year Treasurys, for example. As a result, the S&P Muni Index has climbed 7% this year, compared with the nearly 6% decline in the broader stock market.

“These low prices reflect investor concerns about possible downgrades, says Daniel Solender, director of municipal bond management at Lord Abbett. The Federal Reserve’s buying spree in other areas of the bond market is also depressing yields of Treasury bonds and making municipal bonds all that more attractive. And then there is the $100 billion fiscal stimulus headed toward the states that should help offset the shortfall in tax revenue, says TD Ameritrade Chief Investment Strategist Stephanie Giroux, who adds that historically there has only been a 1% default rate for muni bonds.”

Source: Reshma Kapadia, SmartMoney, April 23, 2009.

Bespoke: Muni Bond ETF makes a comeback
“Investing in municipal bonds is a paradox for investors right now. On one hand, they are attractive because of their tax-free status since taxes are expected to rise. On the other hand, with the economy as bad as it is, municipalities could come under duress and be at risk of default. Based on the performance of the National Muni Bond ETF (MUB) in recent months, it looks like investors are weighing the tax advantage more heavily against default risk. As shown below, MUB is up 14.4% from its lows last year, and it is trading near its all-time highs since the ETF was released in 2007.”

Source: Bespoke, April 24, 2009.

David Fuller (Fullermoney): Clues to stock market outlook
“Few of the Western stock market indices have rallied sufficiently to confirm that the bear market is over. Irrefutable confirmation, in our view, will not occur until share indices break above their 200-day moving averages, which then also turn upwards. Obviously markets will be well off their lows when this evidence of at least medium-term uptrends is apparent.

“However, there are many technical clues along the way. The first, specific to Western stock markets, is that tech-weighted indices such as Sweden’s OMX and the USA’s Nasdaq 100 did not break to new lows in February and March. Tech is often a lead indicator. The second clue is the number of downside failures which occurred with weaker indices. Third is the orderly and persistent six-week rally which tested the previous rally high in some although not all of these indices – Germany’s DAX, for instance and the S&P 500 got close to that 880 level which we have often mentioned in the past.

“There were enough downward dynamics yesterday [Monday] to suggest that reactions and consolidations were commencing in response to the short-term overbought conditions previously mentioned. If so, and if Western stock market indices hold at least half of their gains since the March lows during this pause, which could last for a number of weeks, and then move to new recovery highs, the bear market pattern of lower rally highs followed by new lows will have been broken. There is also a possibility that indices only hover near current levels for a short while before extending their rallies. If so, many would break their previous rally highs, providing a fourth clue by these indices that their bear market was over.

“I remain reasonably optimistic because we have already seen a bullish lead from many favoured Fullermoney themes, led by China and Brazil among the bigger capitalisation emerging markets, as mentioned so often in recent months.

“Meanwhile, all stock market indices show varying degrees of the ranging, base building reversion to the mean (the latter is represented by the 200-day MAs) which this service has been forecasting since the selling climax in late October and November. Consequently, downside risk, even for the weakest stock markets, currently looks to be no worse than base formation extension, consistent with the long convalescence also forecast.”

Source: David Fuller, Fullermoney, April 21, 2009.

Richard Russell (Dow Theory Letters): Are we in a bear market rally or a new bull market?
“(1) The market turned up in a V-shaped reversal off the March 9 low. However, almost all bull markets start with a period of accumulation. This entails a sideways move, sometimes taking weeks or even months. Or it may require a non-confirmation of the Averages as per December 1974. At the March low, we saw neither – no indication of accumulation. And that bothers me.

“(2) At the March lows, we did not see the ‘great values’ that usually accompany major bear market bottoms (i.e. P/E’s in the 5-8 area, average dividend yields of 5-6%).

“(3) The market was severely oversold at the March lows, a condition that often sets off a ‘relief’ (‘let off the pressure’) rally. The advance was probably triggered by the severely oversold condition of the market.

“(4) The one thing a money-manager cannot afford to do is be on the sidelines during ‘what could be’ a major rally. Once the market started up from the March 9 low, many money managers leaped in. The big short positions were immediately squeezed. The rise became a momentum advance. Retail buyers moved in, many trying to retrieve some of their brutal losses.

“(5) The rally moved up ‘too fast’ – action more typical of a bear market rally than the slow, plodding rise that is characteristic of the advance in a new bull market.

“(6) Two groups that led the rally were Financials and Consumer Cyclicals. Interestingly, these two groups contained respectively 5 billion and 2.7 billion shares sold short. This suggests strongly that a significant part of the rally was fired up by short-covering in these two groups (thanks Alan Abelson for this information).

“(7) Many investors and analysts turned optimistic after the market had rallied for only a few weeks. At true bear market bottoms, investors remain stubbornly sceptical or bearish for months after the bottom. Remembering 1974, people were actually angry when I turned bullish at the bottom. I was receiving hate letters and subscription cancellations.

“All of the above have kept me skeptical and cautious about this rally.”

Source: Richard Russell, The Dow Theory Letters, April 20, 2009.

Eoin Treacy (Fullermoney): Stock markets are vulnerable to a pullback
“In the short-term, all stock markets are vulnerable to a pullback for a number of reasons. The six week rally is beginning to look overextended. Some of the leading shares and commodities are beginning to lose their uptrend consistency. Taiwan’s key reversal on Friday is notable in this regard. Israel needs to rally from near current levels if it is to remain consistent. The same can be said for copper and platinum. However all of these markets have already posted impressive gains and have room to consolidate above their bases.

“Markets such as the Dow Jones Industrial or the FTSE 100 rallied well over the last six weeks but only managed to push partly back into their previous ranges. Taking the performance of leading global stock indices into account, we can probably deduce that they are in the bottoming process. However, the case that they have hit their absolute lows is much less clear than for the leading markets.

“‘Buy and hold’ is a suitable strategy for when relatively consistent uptrends have been established. These are not present in the lagging markets and it is too early to say with the leading markets. The conditions will be more suitable for such a strategy when the 200-day moving average has turned upwards and indices find support near it on downward reactions within their uptrends. However, let us not forget that the conditioning process of the bear market will influence or ability to stay with uptrends once they get going.

“… the Dow Jones World Stock Index has not reverted to its mean in the same way that some of the leading markets have. This supports the lengthy convalescence hypothesis for lagging markets. This index is capitalization weighted and heavily influenced by US shares, particularly in the oil and banking sectors. Neither of these is currently leading.

“As for the S&P 500, one could have argued that the rally from the November low was a failed break. However, the index was unable to sustain the initial rally and the progression of lower highs remained in place. It broke downwards again in February and made a new low. On this occasion, the rally has been larger and the Index is pressuring the progression of lower highs so an argument can again be made for a failed downside break. However, we have quoted 880 as an important level for the S&P for a number of months. It continues to need a sustained push above this level to reaffirm support from the lows.”

Source: Eoin Treacy, Fullermoney, April 20, 2009.

Bloomberg: S&P 500 will rise to 1,100 this year, Leuthold says
“Steve Leuthold, whose Grizzly Short Fund returned 74% last year betting against US stocks, said the Standard & Poor’s 500 Index will surge to 1,100 after valuations got to the cheapest levels of his career in March.

“Leuthold, 71, who helps manage $3.2 billion as founder of Minneapolis-based Leuthold Weeden Capital Management, said most investors should have 65% of their assets in stocks.

“‘This market was about as cheap as I’ve seen in my 45 years in this business,’ Leuthold said in a Bloomberg Television interview today. ‘We’re probably going to see the economy start turning upward, not now but toward the end of the year. The market is a lead economic indicator, so the time clock is about right for the market to turn up.’

“Leuthold also said that financial shares won’t be the stock market’s leaders. He favors technology and biotechnology companies and advised investors to avoid ‘defensive’ consumer shares and utilities.

“‘Investors should start buying gold over the next year or so because of the threat of inflation,’ Leuthold said. He started buying the precious metal three weeks ago.”

Source: Rita Nazareth and Erik Schatzker, Bloomberg, April 14, 2009.

Bespoke: Q1 earnings growth better than expected so far
“A fifth of the companies in the S&P 500 have reported earnings for the first quarter, and so far earnings are down 16.6% versus the first quarter of 2008. While down, this is much better than the -37.3% expected at the start of earnings season. When comparing actual earnings versus estimates, Consumer Discretionary, Financials, and Energy are leading the way. Consumer Discretionary was expected to see a year over year decline of 103.4% at the start of earnings season, but the companies that have reported in the sector have only seen earnings decline 22.2% so far. And Financials are actually showing earnings growth with 26.3% of the reports in.

“On the downside, the Industrial sector is the only one where actual earnings have come in weaker than expected. Earnings season still has a long way to go, but the fact that growth has come in better than expected thus far has been one factor driving the market higher.”

Source: Bespoke, April 22, 2009.

Bespoke: Earnings season beat and miss rates
“A total of 430 US companies and 156 S&P 500 names have reported their quarterly numbers since earnings season began with Alcoa’s report on April 7. We’re always monitoring how companies are reporting versus expectations, and below we highlight the percentage of companies beating and missing estimates as earnings season has progressed.

“At the start of earnings season, more companies were missing estimates than beating, however, this trend has changed significantly as the bulk of reports have come in this week. At the end of last week, 50% of US companies had beaten estimates, and this number has increased every day this week to its current level of 57%. Last quarter only 55% of companies beat estimates, so if we begin to see the ‘beat rate’ increase quarter over quarter instead of decrease, it will be a positive sign for the market.

“And stocks within the S&P 500 are reporting even better numbers. Again, after a slow start, the current ‘beat rate’ for the 156 S&P 500 companies stands at 67%. Earnings season still has a long way to go, but the current trend has investors optimistic.”

Source: Bespoke, April 23, 2009.

Bespoke: Retail stocks show relative strength
“At a time when the US consumer is supposed to be all but dead, retail stocks have been soaring. As shown below, the S&P 500 Retail group is up 51.29% since its low last November. Interestingly, when the overall market broke to new lows in early March, the Retail group failed to make a new low, which is indicative of its relative strength.

Source: Bespoke, April 21, 2009.

Casey’s Charts: SPDR Gold Shares growing rapidly
“SPDR Gold Shares (GLD), an exchange-traded fund, first hit the market in November 2004 with 260,000 ounces of gold. Today, GLD is the world’s 6th largest holder of physical gold with over 35 million troy ounces in the vault. In fact, since the general market meltdown last fall, the ETF has added over 16 million ounces and ended 2008 with a 5% gain – not many investments can make that claim.

Source: Casey’s Charts, April 23, 2009.

Vitaliy Katsenelson (Contrarian Edge): Who’s going to buy gold?
“After muting CNBC for years, I turned it on by accident yesterday and learned something very interesting. The gold ETF (GLD) is the sixth largest holder of gold in the world – the whole world, even ahead of China. When investors buy GLD they have to go out and buy gold driving up the prices. This raises a little question – who will be buying this gold from GLD when investors will decide to sell it?

“Gold is one of those weird assets where nobody knows what it is really worth. You cannot run discounted cash flow analysis to value it – it has no cash flows. It is an asset where perception and reality are deeply intertwined.

“Investors buying the gold ETF (GLD) are influencing the price of gold which is fair for the most part as otherwise they’d be buying the real thing. Though of course the ease of buying GLD creates a slightly higher artificial demand, but still it is fair game.

“The violent sell off in GLD will drive the prices of gold down dramatically unless a real buyer steps in (like another government sick of owning the US debt for instance) and the gold price could get cut in half overnight. Suddenly perception of not being a store of value will create a reality of gold not being a store of value. The gold game will be over.”

Source: Vitaliy Katsenelson, Contrarian Edge, April 18, 2009.

Guardian: Zimbabwe’s central bank raided private accounts to prop up ministries
“Zimbabwe’s central bank governor admitted today that he took hard currency from the bank accounts of private businesses and foreign aid groups without permission, saying he was trying to keep his country’s cash-strapped ministries running.

“In a statement that would be unthinkable coming from most central banks, the governor of the Reserve Bank, Gideon Gono, appeared to be issuing a plea to keep his job in the face of growing criticism.

“Gono said it was time ‘to let bygones be bygones’ now that Zimbabwe has a new coalition government dedicated to reversing its economic decline.

“The central banker said he gave the money he took from the hard currency accounts as loans to various ministries, and the private accounts would be reimbursed when the ministries repaid the loans. He said the bank’s efforts ‘sustained the country’ in its hour of need.

“Gono’s statement showed the practice was widespread. It was first hinted at last year, when the international aid agency Global Fund threatened to cut off funds to Zimbabwe for fighting Aids, tuberculosis and malaria unless money taken from its account was returned. The central bank returned $7.3 million to Global Fund.

“The raiding of foreign currency accounts is just one of the highly questionable actions for which Gono has been sharply criticised.

“In the last two years, Gono has slashed 25 zeros from the local currency, printed more local money without backup reserves or assets and distributed agricultural equipment to many in President Robert Mugabe’s party who were given farms seized from white people.”

Source: Guardian, April 20, 2009.

Barron’s: Jim Rogers isn’t buying a US stock recovery
“Legendary investor Jim Rogers is skeptical of the latest rally in equities – as well the health of the global economy. As such, he is scorning stocks and bonds while embracing commodities as his investment vehicle of choice. Barron’s John Kimelman got the chance to interview the CEO of Rogers Holdings, with the following excerpts appearing on the website yesterday:

Q: When you last did a lengthy interview with Barron’s magazine a year ago you were lightening up on emerging markets investments. Well, you called that one right. But now that many of those markets have fallen from their highs of recent years, are you more optimistic?

A: No. I’ve sold all emerging markets stock except the ones in China. I bought more Chinese shares in October and November during the panic, but I have not bought China or any other stock markets including the US since then. I’m not buying anything in China right now because the Chinese market ran up maybe 50% since last November. It’s been the strongest market in the world in the past six months and I don’t like jumping into something that has been that run up. Still, I’m not thinking of selling these stocks either. I think if it goes down I’ll buy more. I think you will find that it’s the single strongest market in the world since last fall.

Q: That being said, you currently think Chinese stocks are bid-up now, so you’re not buying at these levels. So what have you been buying lately?

A: I have been buying commodities through the Rogers commodity indexes I developed because my lawyer won’t let me buy individual commodities. I recently bought all four Rogers indexes – the Elements Rogers International Commodities Index (ticker:RJI) as well as the three specialty indexes, the International Metals (RJZ), the International Energy (RJN), and the International Agriculture (RJA.) That’s how I invest in commodities and that’s what I bought last week. I have been buying these shares since last fall and up to last week.

Q: Now despite the recent stock-market rally that started in March, many US stocks are trading well off their 2007 highs. How come you see no value to this market?

A: I am not buying US companies mainly because I think we may have seen a bottom but I don’t think we have seen the bottom. I am skeptical about the rally, the world economy for the next year or two or three. But if stocks go down, I can make money with commodities. In the 1970s, commodities went through the roof even though stocks were a disaster. In the 1930s, commodities rallied first and went up the most long before stocks pulled it together.

Q: Can you summarize the reasons for your bullishness about commodities?

A: It depends on the supply and demand. And we have had a dearth of supply. Nobody has invested in productive capacity for 25 or 30 years now. The inventories of food are the lowest they have been in 50 years and you have a shortage of farmers even right now because most farmers are old men because it has been such a horrible business for 30 years. And as for metals, nobody can get a loan to open a mine as you know. Who is going to give you money to open a zinc mine? It takes at least 10 years to open a mine so it’s going to be 15 or 20 years before we see new mines come on. Nobody has been opening mines for 30 years and they are not going to. And in the meantime reserves are declining. As for oil, the International Energy Agency came out recently with a study showing that oil reserves worldwide were declining at the rate of 6% or 7% a year.

That does not mean that if suddenly the US goes bankrupt that everything won’t collapse in price. But I would rather be in commodities because it’s the only thing I know where the fundamentals are improving. They are not improving for Citibank or General Motors but the supply situation in commodities is such that when demand comes back, then commodities are going to be the best place to be in my view.”

Click here for the full article.

Source: Barron’s, April 20, 2009.

Bespoke: Baltic Dry Index on 9-day winning streak
“The Baltic Dry Index is used to track the globalization trade, as it measures the supply and demand for the shipment of goods around the world based on transport costs. The Baltic Dry Index has had some big ups and downs this year, going on multiple winning and losing streaks. This year alone, the index has had a 17-day winning streak, a 21-day losing streak, and it’s currently on another 9-day winning streak. The trend in 2009 has been upward, however, as the index is up 145%. And it’s still important to remember that we’re working off a very low base after the globalization bubble burst last year. The index is still off 84% from its highs in May of 2008.”

Source: Bespoke, April 24, 2009.

Bespoke: Bespoke’s commodity snapshot
“Below are our trading range charts for some commodities. The green shading represents 2 standard deviations above and below the commodity’s 50-day moving average. When the price moves above or below this green shading, the commodity is in extreme overbought or oversold territory.

“As shown, after reaching overbought territory a few weeks ago, oil has pulled back to just above the middle of its trading range. After trending higher since last October, gold and silver have recently moved to the bottom of their trading ranges, but they bounced nicely off of oversold territory a couple days ago. Platinum has held up better than gold and silver and is closer to the top of its trading range than the bottom.

“Not shown, copper continues to trend higher, along with orange juice, while corn, wheat, and coffee are in a sideways trading pattern.”

Source: Bespoke, April 23, 2009.

Financial Times: China reveals big rise in gold reserves
“China has quietly almost doubled its gold reserves to become the world’s fifth-biggest holder of the precious metal, it emerged on Friday, in a move that signals the revival of bullion after years of fading importance.

“Gold rose to a three-week high of more than $910 an ounce after Hu Xiaolian, head of the secretive State Administration of Foreign Exchange, which manages the country’s $1,954 billion in foreign exchange reserves, revealed China had 1,054 tonnes of gold, up from 600 tonnes in 2003.

“The news could spark interest in gold among other central banks. ‘When the largest holder of foreign exchange reserves discloses an increase in gold holdings, other countries may decide to think more carefully about underweight gold positions,’ said John Reade, a precious metals strategist at UBS.

“The increase in China’s gold reserves has come primarily from domestic production and refining. However, the news raises questions about the future of Beijing’s foreign reserves policy.

“Ahead of the G20 summit in London this month, China suggested global reliance on the US dollar as a reserve currency should be reduced.

“China has been diversifying away from the dollar since 2005, when it broke the renminbi’s peg to the US currency and officially marked it to a basket of currencies, but it still holds more than two-thirds in US dollar-denominated assets by most estimates.

“As its trade surplus and forex reserves ballooned in recent years, Beijing continued to buy huge amounts of US Treasury bonds while raising the proportion of purchases it allotted to other currencies and to gold.

“‘China’s announcement signals a broader shift in central banks’ attitude towards gold,’ said Philip Klapwijk, chairman of GFMS, the precious metal consultancy.”

Source: Jamil Anderlini and Javier Blas, Financial Times, April 24, 2009.

Eugen Weinberg (Commerzbank): Copper rallies too soon
“The rally in the copper market, where prices have risen by about 50% in the past eight weeks, looks to be premature, says Eugen Weinberg, commodities analyst at Commerzbank.

“He notes three main points put forward by market bulls.

“First, signs of a stabilising economic environment justify a cyclical recovery in base metal prices; second, purchases by China’s State Reserve Bureau will prevent a strong decline in demand; third, London Metal Exchange copper inventories have declined sharply, and falling inventory levels normally point to a market tightening.

“But Mr Weinberg believes an improvement in the economic situation is still uncertain. ‘And even if sentiment indicators have sustainably turned round, previous economic cycles have not seen a recovery in base metal prices right after sentiment has bottomed.’

“He also believes that the purchases by the SRB in China can only support prices in the short term. ‘Given that its strategic stockpiling effort is at an advanced stage, the SRB will gradually withdraw from the market during the coming weeks. The shrinking LME inventories, especially in warehouses in Asia, reflect the strong Chinese import-driven pull.

“‘We therefore expect a significant correction in the copper price during coming weeks – although this might be delayed by rising interest from financial investors.’”

Source: Eugen Weinberg, Commerzbank (via Financial Times), April 23, 2009.

Reuters: Boone Pickens sees oil at $75/bbl at end-year
“Texas oil billionaire T. Boone Pickens on Monday reiterated his prediction that crude oil prices would hit $75 a barrel this year as producers scale back production.

“Pickens said about OPEC producers: ‘They told you they want $75 by the end of the year, I would count on that, I believe them.’

“OPEC has scaled back output to help support crude prices, which have dropped from record highs over $147 a barrel in July to around $47 a barrel on Monday.

“‘I think you are going to clean up the stocks because the people who have the oil are cutting supply,’ Pickens said at an alternative fuels and vehicles conference, referring to the nearly 19-year high on US inventories of crude oil reported last week by the federal government.

“The United States would likely burn through its supply overhang in three months, he told reporters.”

Source: Reuters, April 20, 2009.

CEP News: Euro zone PMIs hit six-month highs, suggesting economic stabilization may be in sight
“Euro zone output improved by a record margin in April, suggesting that the economy could begin to stabilize by the end of the year, Markit Economics reported on Thursday.

“According to advance estimates, the euro zone manufacturing purchasing managers index hit a six-month high of 36.7 in April, beating expectations of a 34.7 print.

“The services PMI also reached its highest level in six months, rising to 43.1 in April, up 1.7 points from the forecasted figure and up 2.2 points from March’s level.

“Taking both the manufacturing and services PMIs together, Markit noted that the composite PMI jumped by a record 2.2 points to a six-month high of 40.5 in April, up from both the 38.9 print expected and the previous month’s 38.3 reading.

“The improvements were widespread in the month, Markit said, noting that declines in new business and backlogs of work had eased sharply. Furthermore, the ratio of new orders to stocks rose to its highest level since August, hinting at good news to come regarding future output, Markit said.

“However, employment levels continued to contract, falling at record speeds as companies adjusted to weakening demand, the report said.

“Despite the strong gain in the PMI figures, Markit senior economist Chris Williamson warned against being overly optimistic.

“‘The ongoing severity of the situation should not be underestimated,’ he said ‘The latest numbers are still consistent with a double-digit annual rate of decline of manufacturing output and a quarterly rate of contraction of GDP of at least 0.5%.’”

Source: CEP News, April 23, 2009.

CEP News: ZEW headline figure rises to 2-year high on strong German investor optimism
“Stronger-than-expected German investor optimism for the six-month outlook pushed the Centre for European Economic Research’s economic sentiment indicator above zero for the first time since July 2007 and to its highest level since June of the same year.

“According to the ZEW, the German economic sentiment indicator rose to +13.0, overshadowing both the +2.0 reading expected and March’s -3.5 level. However, the research firm was quick to add that the headline figure still remains significantly below its long-term average of 26.1 points.

“In a report issued on Tuesday, the ZEW noted that sentiment likely benefited from recent government stimulus packages, as well as easing inflationary pressures and the improving economic outlook in both the US and China

“‘Along with other indicators, the ZEW sentiment indicator reveals that there are well-founded expectations that the downward dynamics of the business cycle are bottoming out,’ ZEW President Dr. Wolfgang Franz said. ‘It is even becoming more likely that the economy will slowly recover in the second half of this year.’”

Source: CEP News, April 21, 2009.

Ifo: Rise in the Ifo Business Climate Index
“The Ifo Business Climate for industry and trade in Germany has improved somewhat in April. The firms are no longer quite so dissatisfied with their current business situation than in the previous month. With regard to the business outlook for the coming half year, the sceptical assessments have again been reduced somewhat. It is thus likely that the decline in economic output will slow clearly.”

Click here for the full report.

Source: Ifo, April 24, 2009.

Financial Times: Darling “flying on a wing and a prayer”
“Martin Wolf, FT chief economics commentator, analyses the UK Budget 2009. He says nothing in today’s Budget will ensure chancellor Alistair Darling’s optimistic growth forecasts will be achieved and that he is at the mercy of a global recession. He says the government appears to want to spend as if nothing has happened at least until next year and the election.”

Source: Financial Times, April 23, 2009.

CEP News: UK plans to borrow £703 billion over five years to fight recession
“The UK government plans to borrow a record £703 billion over the next five years – £269 billion more than in the previous budget – to continue supporting a suffering economy and counteract large job losses.

“Presenting the fiscal 2009 budget on Wednesday, UK Chancellor of the Exchequer Alistair Darling said the UK economy is expected to contract 3.5% in 2009 and grow 1.25% in 2010.

“To counteract large declines in employment, the UK is proposing to spend an additional £1.7 billion to create jobs and provide guarantees for the unemployed over a period of 12 months. The initiative applies to persons under the age of 25 and is expected to support 250,000 jobs.

“On housing, the UK plans to guarantee asset-backed securities and extend mortgage support to people who lost their jobs, and extend the stamp tax duty holiday on homes worth up to £175,000 until the end of the year. The budget also allots £500 million in aid to homebuilders.

“Also included is an automobile scrapping agreement that will offer a £2,000 discount to those trading in used cars for new ones. The initiative will be in place until March 2010.

“The budget also allots £750 million to set up a strategic investment fund.

“The UK’s Debt Management Office will issue £220 billion in gilts over the 2009-2010 fiscal year to finance £175 billion in public borrowing. Total borrowing is projected to decline to £97 billion by 2013-2014.

“Public borrowing will total 11.9% of GDP in 2010, said Darling, who wants to cut the current budget deficit in half over the next four years.”

Source: Erik Kevin Franco, CEP News, April 22, 2009.

CEP News: UK house prices post three-month winning streak
“UK house prices continued moving higher in April, marking three-months of gains, according to a report from Rightmove.

“House prices climbed 1.8% in April to an average price of £222,077. A month earlier, house prices had increased 0.9% to an average price of £218,081.

“On an annual basis, house prices are down 7.3% in April, better than March’s 9.0% decline.

“Although the news bodes well for the Island Nation who’s housing sector was hard-hit by the financial crisis, house prices in London plunged 3.2% month-over-month in April, reversing a 3.1% gain the month prior. This resulted in an annual decline of 4.1% versus the 1.8% contraction seen in March.”

Source: CEP News, April 19, 2009.

Financial Times: Japan to issue $110 billion bonds for stimulus
“Japan is to issue an extra Y10,800 billion ($110 billion) of government bonds this fiscal year to help it tackle its worst recession since the second world war.

“The bonds will fund the bulk of the government’s $154 billion stimulus plan and will bring its expected total new issuance for the fiscal year starting this month to a record Y44,100 billion, a 33% rise on last year.

“This comes as governments around the globe are taking on record debt levels to bail out loss-making banks and bolster economies as they attempt to spend their way out of the downturn.

“The US is expected to issue about $2,000 billion in the fiscal year starting last October, more than double last year. The eurozone governments are set to raise €800 billion ($1,050 billion) this calendar year, 23% up on 2008.

“The UK government in Wednesday’s annual Budget statement is expected to announce plans to issue £180 billion ($270 billion) in the 2009/10 financial year, a 25% rise on last year’s record levels.

Source: Lindsay Whipp, David Oakley and Michael Mackenzie, Financial Times, April 21, 2009.

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]]> http://www.ritholtz.com/blog/2009/04/words-from-the-investment-wise-42609/feed/ 2 http://www.ritholtz.com/blog/2009/04/back-to-the-future-recession/ http://www.ritholtz.com/blog/2009/04/back-to-the-future-recession/#comments Sat, 25 Apr 2009 11:37:20 +0000 John Mauldin http://www.ritholtz.com/blog/?p=24473 Back to the Future Recession

April 24, 2009
By John Mauldin

Financial Innovation: The Round Trip

Back to the Future Recession

The Fed at the Crossroads

How Did We Get It So Wrong?

The Trend Is Not Your Friend When It Ends

Orlando, Naples, Cleveland, and Grandkids

This week we look at the second half of my speech from a few weeks ago at my annual Strategic Investment Conference in La Jolla. If you have not read the first part, you can review it here.

The first few paragraphs are a repeat from last week, to give us some context. Please note that this is somewhat edited from the original, and I have added a few ideas. You can also go there to sign up to get this letter sent to you free each week.

MV=PQ

Okay, when you become a central banker, you are taken into a back room and they do a DNA change on you. You are henceforth and forever genetically incapable of allowing deflation on your watch. It becomes the first and foremost thought on your mind: deflation, we can’t have it.

MV=PQ. This is an important equation, right up there with E=MC2. M (money or the supply of money)
times V (velocity — which is how fast the money goes through the system — if you have seven kids it goes faster than if you have one) is equal to P (the price of money in terms of inflation or deflation) times Q (roughly standing for the Quantity of production, or GDP)

So what happens is, if we increase the supply of money and velocity stays the same, and if GDP does not grow, that means we’ll have inflation, because this equation always balances. But if you reduce velocity (which is happening today) and if you don’t increase the supply of money, you are going to see deflation. We are watching, for reasons we’ll get into in a minute, the velocity of money slow. People are getting nervous, they are not borrowing as much, either because they can’t or the animal spirits that Keynes talked about are not quite there.

To fight this deflation (which we saw in this week’s Producer and Consumer Price Indexes) the Fed is going to print money. A few thoughts on that. The Fed has announced they intend to print $300 billion (quantitative easing, they call it). That is different than buying mortgages and securitized credit card debt — that money (credit) already exists.

When they just print the money and buy Treasuries, as with the $300 billion announced, they can sop that up pretty easily if they find themselves facing inflation down the road. But that problem is a long way off.

Sports fans, $300 billion is just a down payment on the “quantitative easing” they will eventually need to do. They can’t announce what they are really going to do or the market would throw up. But we are going to get quarterly or semi-annual announcements, saying, we are going to do another $300 billion here, another $500 billion there. Pretty soon it will be a really large total number.

When we first started out with TALF and everything, it was a couple hundred billion, and now we just throw the word trillions around and it just drips off of our tongues and we don’t even think about it. A trillion is a lot. It’s a big number. And the total guarantees and backups and all this stuff we are into — I saw an estimate of $10-12 trillion. That’s a lot of money.

Understand, the Fed is going to keep pumping money until we get inflation. You can count on it. I don’t know what that number is; I’m guessing maybe as much as $2 trillion. I’ve seen various studies. Ray Dalio of Bridgewater thinks it’s about $1.5 trillion. It’s some very big number way beyond $300 billion, and they are going to keep at it until we get inflation.

Side point: what happens if the $300 billion they put in the system comes back to the Fed’s books because banks don’t put it into the Libor market because they are worried about credit risks? It does absolutely nothing for the money supply. Okay? It’s like, goes here, goes back there — it doesn’t help us. The Fed has somehow got to get it into the financial system. They’ve got to figure out how to create some movement.

Will it create an asset bubble in stocks again? I don’t know, it could. Dennis [Gartman] talked about being nervous yesterday. I would be nervous about stock markets both on the long side, as I think we are in a bear market rally, but also there is real risk in being short. Bill Fleckenstein will be here tonight. He is a very famous short trader. He closed a short fund a couple of months ago. He says he doesn’t have as many good opportunities, and basically he’s scared of being short with so much stimulus coming in. So it’s going to work, at least in terms of reflation, but the question is, when? A year? Two years?

Financial Innovation: The Round Trip

Financial innovation is one of the drivers of the velocity of money. We started in approximately 1991 creating the first securitizations and CDOs. It was done at Merrill Lynch, if I remember right. But they started getting copied, and then we went into warp speed, creating all kinds of new CDOs and SIVs that invested in loans, securitized mortgage debt — most of which was rated AAA — banks loans, credit card debt, etc. Without thinking about it, we created a shadow banking system that funded a huge chunk of our total credit markets. It was outside the bailiwick of the normal regulatory authorities.

Then in 2007 we began to destroy the shadow banking system. If it was working so well, why did we do that? Because they mismatched their liabilities and assets. They were borrowing short-term and lending long-term, and doing it highly leveraged. They were buying up long-term assets at 4-5-6%, some (or most) of them rated AAA. Then they were selling commercial paper at 1% or 2% — so you get a 2-3% profit spread.

A 2-3% spread doesn’t really make you anything, you’re not really excited about that; so since we’re dealing with AAA investments that everyone believes to be absolutely safe, let’s leverage it up 6-7-8 times. Now you’re talking a 20% return. Now you’re talking about making money, real money. And I should note that we were also talking real commissions and monster bonuses.

I think one other side note needs to be made here. In hindsight, we can now look back and wonder what the investment banks were thinking. They “must” have known they were pushing bad paper into the system.

But their behavior tells us they didn’t know. If they really believed they were, there would not have been so much of the toxic debt left on their books. Bear Stearns launched very large funds to buy this debt at obscene leverages and sold it to their best customers. At least some people in management thought there was real value in these securities, which just goes to show how lax or ignored the risk managers were in all parts of the financial industry.

Then it all began to implode, because people started paying attention to some of the assets on the balance sheets of the various SIVs and CDOs and suspected they might not be worth what they had originally thought. You have subprime mortgages in your Special Investment Vehicle? Hey, I’m not going to buy your commercial paper. Suddenly, the commercial paper market simply imploded. This was the start of the banking crisis.

So we started taking the innovation of securitizations off the table. The innovation that had driven the velocity to new highs was now slowly being pulled off. So, velocity slows down, and it’s continuing to slow down with each passing month.

Let’s survey the economic landscape. We have an unstable economy. Housing doesn’t bottom until 2011 or 2012, unless, as I wrote the other day, we give immigrants a green card to come here. We need the immigrants anyway. We need smart immigrants. By the way, I’ve never had as much response to my letter, both positive and negative. It ran about 60/40 for. Many of the “against” were people outside of the US, saying why are you trying to take our best, we need them. I suppose there is a certain logic to that, but if we could pull a million homes off the market, it would solve a big part of the US credit crisis right now, not to mention, we would have people putting money into our system and it wouldn’t cost taxpayers
anything.

But back to the current scene. Consumer spending is slowing, and it’s going to slow for years as savings increase. At one time we were savings 7-8-10% of our incomes, back in the early ’80s. We grew from 63% of the economy being consumer spending, to 71% in 2006. We are going back to the mid –to low 60s in terms of the percentage of consumer spending in GDP. We are not doing it all at once, it’s going to take years; but, gentle reader, it’s the blue screen of death! We are hitting the reset button.

Economists have a term for this process. It’s called rationalization. We have too many stores to sell “stuff,” all sorts of stuff. Too many malls. We have too many factories to build too many cars, too many plants to build too many widgets for an economy where 65% of GDP is consumer spending. When we built all that capacity it was for an economy in which consumer spending was 71%; and because we were enthusiastic and believed we would grow at 3% forever, we probably built it for 73% or 74%.

We are watching capacity utilization fall off the table. It is down to 67%, fully 15% below normal. What
happens when you see that? You start closing factories. It’s just what you have to do. We are going to have fewer restaurants, fewer clothing stores. The survivors will get bigger market shares; that’s just what happens. Schumpeter called it creative destruction.

And this being a different type of recession — because we are hitting the full credit-cycle reset, it’s going to take longer. I think the recession — the actual, honest, mark-to-market numbers –will be negative through 2009. Then we’ll start to improve. This current first quarter is going to be ugly again, then it will be a little better in the third quarter. The second quarter — I don’t know how bad it’s going to be, but it’s not looking good.

But in 2010 we could start seeing slow growth again, maybe Muddle Through. There might be a sluggish recovery in 2010, but we have to put an asterisk on that possibility because the Democrats are going to push through the largest tax increase in history.

First of all, the tax increase is the Republicans’ fault. They didn’t make the tax cuts permanent when they had the chance, so consequently they go away in 2010. US taxes are going to go way up, whether there is no compromise, so that we go back to the pre-Bush years, or there is some compromise because the Obama Administration realizes that putting in that type of a tax increase will throw us back into recession.
Remember Roosevelt? What did he try to do? He raised taxes in the middle of a recession (1937), when unemployment was 14%, driving it back up to 20%. Unemployment will be 10% or 11% by this time next year, and maybe by the fourth quarter.

If you count those who are working part-time but want full-time employment, the unemployment number is closer to 15%. Yesterday, my taxi driver was a mechanical engineer who lost his job, but had kids and had to do whatever he could to put food on the table. He said there are a lot of people like him here in California.

The deficit is going to explode way past $2 trillion unless somebody can show some sense. Let’s look at the carbon credit problem. Obama wants to impose this new carbon credits program, which sounds benign. We call it a credit and not a tax. Here’s the issue. It gives us two bad possibilities, one of which is going to happen. Number one, he is assuming there is something like $800 billion coming in over the next decade from these carbon credits, and he’s put that as income in his proposed budget, like it’s going to get passed into the system. He is assuming that revenue. If he doesn’t get it, deficits are much higher in the near term.

But if he gets it, it’s even worse, as US industry becomes uncompetitive with Third World industries that don’t have the same carbon credits and energy costs. Do you think China or India will pass the same legislation? They are building more coal-fired plants every month than we build in a year.

We are going to be seeing factory after factory shut down and moved off-shore, because they simply won’t be able to compete. Either way, we go back to that economics technical term I used earlier: we’re screwed. The carbon credits program is just a massively bad idea. There are things that we should do to cut down energy usage, but this is not the way to go about it. We can talk about other ways to do it if you want to.

2010-11: Back to the Future Recession

I think the country could re-enter a recession in 2010 and 2011; we would go right back into it when those tax hikes start to hit. What do tax increases do? They take money out of consumers’ pockets — and the consumers that actually spend. Plus, 75% of those who will see their taxes rise are small businesses that employ people, so we deflate ourselves.

Liberal economists are going to argue, “Wait a minute, John. We are taking it from these [rich] guys, but we are giving it to lower-income families, so it will get spent.” But it’s going through the government — we don’t get the same bang for our buck. We don’t get new employment. We’re simply transferring and creating a new welfare state; plus, we have a number of recent studies which show that the propensity now
is not to spend the new money but to use it to pay down debt. This is not a pro-growth policy, and growth is what we need. Not wealth transfers and a new welfare state.

At some point inflation starts to show up again, because when you start running two-trillion-dollar deficits and you start trying to borrow it, at the same time the Fed is printing money, at some point in this process the bond markets (and the currency markets) are going to rebel. An unsustainable trend will keep going until it stops. I don’t know when that day is, but the current policies mandate that we will hit the proverbial wall. One day it will be just like August 2007. Someone is going to ring a bell and the Treasury bond market is going to look the deficits and wonder how they will fund them, and they are going to let out a huge gasp and then throw up. Because you can’t run two- to three-trillion-dollar deficits as far as the eye can see.

As Woody Brock so capably points out, the key to watch is the debt-to-GDP ratio. You can grow debt fast; but at some point you start to have to grow the economy faster than you are growing debt, or you become an economic basket case, where the dollar is devalued and interest rates go up fast. At that point, the Fed will have lost control. The key item to watch now is the budget debates. Are we going to build in $2
trillion deficits, or we will show some fiscal restraint?

The Fed at the Crossroads

And, are we going to try and do this when unemployment is at 10% or more? The Fed at some point is going to come to a crossroads. They can allow inflation, like the ’70s. (And some of us are old enough to have lived through the ’70s, though I really didn’t notice much — I actually made money on inflation during the ’70s. I was in the printing business before I went into the investment publishing business. I would buy traincar loads of paper on credit and put it on warehouse floors; and because I was the only guy who could get paper and I had it at a good price, I got a lot of business. So I made money off of that inflation cycle.

We figure out how to Muddle Through, even during periods like the ’70s. So the Fed can bring that back — which they all swear they won’t do — or they can withdraw liquidity. What happens if they withdraw liquidity? It slows the economy down, because we are pulling money out of the system. Just as higher interest rates begin to take a toll on the economy, they will have to start pulling money out of the system to avoid higher inflation. By the way, if rates are rising that means the interest payments on the federal debt are rising, because we have a lot of short-term federal debt. Frankly, as a government, we should be buying all the 30-year bonds we can possibly buy. But we are not, because that would increase the pressure on the current debt. We have the long-term forecasting ability of a mongoose.

We are in the middle of a Great Experiment, the one truly great experiment of this time; so the economists are fascinated. We have Keynes versus von Mises versus Irving Fisher versus Friedman, and they all have theories about what you should do after depressions and what works. Someone commenting on Keynes said, “In a world organized in accordance with Keynesian specifications there would be a constant race between the printing press and the business agents of the trade unions. With the problem of unemployment largely solved, the printing press could maintain a constant lead.”

Printing money. That’s what the current Fed is doing. Just as aside, here is a great quote I came across. It really doesn’t have anything to do with anything, but it’s fun. John Ehrlichman told us about a conversation between Richard Nixon and Arthur Burns, who was Nixon’s nomination to be Chairman. Nixon said, “I know there is the myth of the autonomous Fed [short laugh]. When you go up for confirmation some Senator may ask you about your friendship with the President. Appearances are going to be important, so you can call Ehrlichman to get messages to me, and he’ll call you.” I’m sure that’s not done today.

Seriously, the independence of the Fed is critical, Nixon notwithstanding. Given the recent revelations about Bernanke and Paulson supposedly telling Ken Lewis at Bank of America not to tell the public about how bad the Merrill situation was — do you think there might possibly be some pressure on Bernanke? His term is up early next year. It is quite possible we get a Fed chairman who would be more accommodative of a left-wing agenda than Bernanke, who I believe really will pull back from allowing inflation to get too high.

This would force budgetary discipline on Congress, which the left will not like. I can see some real issues in the upcoming nominating process if Bernanke is not left at the helm. Do we really want Larry Summers?

Let’s get back to our discussion of the Great Experiment. Von Mises said there is nothing you can do about a deleveraging cycle, you basically just let it all go to hell and then pick up the pieces. The hair-shirt economists, I call the Austrians: just let it drop, take your medicine, take your 15-20% unemployment, and just deal with it, because you’ll be able to come back faster from the lower base. By the way, to von Mises, the velocity of money was a meaningless concept. Gold was where you should have had your money to begin with.

Then there is Friedman, who produced his great work that says inflation is always and everywhere a monetary phenomenon. He had his studies to prove it. But when he did his studies, in the 30 years that he analyzed, the velocity of money was remarkably stable. So of course, inflation had a 1-to-1 correlation with money supply.

Fisher says, “The velocity of money is important.” For Fisher, debt deflation controlled all other economic variables. It was the driving economic force. You’re going to have to rationalize all your debts. There’s nothing you can do about it; but what you do is, do as much as you can to provide a soft landing for the people who lose their jobs. Do whatever you can to get them along and to keep the system
working, but you are still going to have to go through a credit reorganization. We are going to find out in 5-6 years who was right. That is the experiment we are living through. My bet’s on Fisher, just for the record.

How Did We Get It So Wrong?

So how did we get it so wrong? How did we get here? Let’s go back to first principles: Ideas have consequences. And bad ideas tend to have bad consequences. We’ve taught two generations of financial managers theories that were patently absurd. Rob Arnott is going to be here later with us for the panel discussion. Rob recalls standing in front of 200 academics, professors in schools that teach economics. He asked them, “How many of you believe in the efficient market hypothesis?” Something like two or three raised their hands. “How many of you teach it?” All of them raised their hands.

We have been teaching generations of MBA students economic garbage. Gaussian curves and things you could model. The classic line is from Ibbitson, is a brilliant professor and a brilliant mind, who said economics is a science. No it’s not. It’s barely an art form. It’s voodoo. That’s what we practice. We look at the entrails of the Wall Street Journal and try to predict the future. Sometimes it’s
about as bloody as sheep entrails. CAPM… poor Harry Markowitz’s Modern Portfolio Theory got so twisted beyond recognition. I remember being with Harry Markowitz. I gave a speech at a big hedge fund conference about five years ago, talking about why Modern Portfolio Theory was not going to work. The next year it was the 50th anniversary of Modern Portfolio Theory, and they brought Harry out to speak. He of course talked about why it was. I remember meeting him in the hall of this big hotel. And I asked him a couple of questions; I forget what they were because he so staggered me with, “Oh, you missed the
whole concept of correlation and assets. Correlations change.”

And he started drawing quadratic equations in the air. But because I was standing in front of him, he was
drawing them backwards so I could see them. I mean, this guy is absolutely brilliant. But he’s right, you should have a diversified portfolio of noncorrelated assets; but as John was showing yesterday, correlations in a crisis all go to one.

What money managers did was to create models that said, “If you do this, diversify your portfolio like this, and here are all your noncorrelated asset classes — see what happens? You get long-term positive results.”

And they would project that into the future. But they didn’t project crises, when correlations go to one. Modern financial theory only works in models if you assume a few things that are patently not true in the real world. So we trained a generation of managers and investors that they should buy 60% stocks and 40% bonds. Yet for the last 40 years, bonds have outperformed stocks. Where was that in the model?

Well, we can go back to the 19th century and see it. But we created a trend from 1944 to 2000 that said we were going up, and we trained a generation to believe they could model, and they did it. They modeled garbage, and now we’ve wiped out a generation of retirement income. I could go on and on, but it’s nonsense.

We let the rating agencies become way too important. They were supposed to be the adults supervising the sandbox, and they weren’t. They started out perfectly acceptably, but then they decided they wanted to rate multiple-obligor securities like real estate mortgage bonds using the same ratings they used for corporate bonds. They sold their business souls and didn’t even realize it.

Remember, we trained a generation of people to think they could model this stuff. So they modeled what potential defaults would be, based on past performance, and not even past performance that looked like the assets in the investments they were rating. But it was scientific and looked like the models they learned in school.

Every time you get a letter from me, there is a page and a half down there at the bottom, full of disclosures. At least twice in those disclosures I say past performance is not indicative of future results. It’s like, “coffee is too hot, don’t spill it.” We don’t pay attention to it, but it’s the most important thing, because past performance has nothing to do with future history.

The future is going to look different, yet we think we can model it. The models are bullshit. (That’s a technical economics term that requires advanced degrees to use.) They just are. Now you can take some comfort from them, and you have to try and figure stuff out, and you look for correlations. That’s what I do, and we all do that. I confess I use models every day.

But you have to recognize that the model has a huge asterisk beside it. You just can’t bet the farm on it. And God, have I learned that the hard way. I’ve got bruises on my back from making assumptions. That’s why I don’t go around half-naked, because it would just look ugly.

We let the rating agencies use a corporate bond-rating system — AAA, AAB — for multi-obligor bonds
that had nothing to do with reality, and they rated them up on the way up and now they are rating them down on the way down, and they are screwing us both ways. Because if you lose 1% on a triple-A bond, it immediately goes to junk. That means the banks have to write it off their capital and sell it for 50
cents on the dollar.

When did this problem start? July of 2007, when we introduced mark-to-market accounting. When did AIG have a problem? When they had to start writing their AAA’s down. Now we should never have let it get to that place to begin with, but now we have to deal with reality. You can’t just sit there and say, “Tsk, tsk, we need to let these guys go bankrupt.”

No, you can’t, not unless you want 25% unemployment again. We have “X” amount of pain to go through to get back to whatever the “new normal” will be. Think of this as a big tube of pain, OK? We can do it in one year or in seven or eight years. I vote for seven or eight. I don’t want 20-25% unemployment. I would rather have 10% unemployment for seven years. Now, that’s just me, because I know when my neighbor is unemployed, when my kid is unemployed, that it hurts.

The Trend Is Not Your Friend When It Ends

So, the establishment is now saying, “Let’s keep the system going.” Now, are we going to have problems when the Fed starts trying to pull the extra cash they are printing out of the economy? Yes. Is that going to create a different form of future history than we have experienced in the past? Yes. Therefore, trying to model the future based upon that past, will not work.

We believed the trend. The trend is not your friend when it ends. OK? It just isn’t. Now, I’m the guiltiest person in the world. I live on what one of my friends calls “psychic income.” That is the income you get when you take a current business model, the current business you are in, and you say, if I could grow these assets to “Y” I would make “Z”. That “Z” charges me up. I haven’t earned it yet and the train probably won’t go there, but it gets me up in the morning. That’s my psychic income. We all do
that. But we rarely realize that it’s just psychic income; it’s not real income until the cash is there.

Given all that I have said, I still contend I am not a pessimist, at least not in the long term. Stocks go from high valuations to low valuations to high valuations. They’ve done it in US markets and world markets, and we are halfway through the trip in a secular bear market. We haven’t gotten to low valuations yet, I don’t care what they say. The P to E at the end of July was something like 289 on the S&P. You can go to the S&P website and you can see that. Now you smooth it with five-year
curves and performance, and it goes to 20. 20 is not cheap. But it’s going to get cheap — at least that’s what history tells us.

Now maybe history is wrong, because past performance is not indicative of future results; and I could be wrong, but sometimes you just have to set an anchor and say this is what I’m believing. I think we are going to lower valuations, and when that happens we will have compressed price to earnings ratios just like we did in 1982. The world will be coming to an end and we’ll be moaning and groaning. We haven’t gotten as bad as we were in ’82 — whoever pointed that out is correct.

But what will happen? The stock market will be a coiled spring and we’ll have a bull market and we’ll get to have fun in the stock market again. Until then, be careful.

Orlando, Naples, Cleveland, and Grandkids

I am writing today’s letter at the St. Regis Hotel in Laguna Beach, California. I am going to hit the send button a little early so I can get out and walk around, as it looks to be too beautiful a place to be in my room writing. This weekend I join Rob Arnott and his friends (Mohammed El-Erian, Harry Markowitz, Jack Treynor, and Peter Bernstein, among others) at his annual conference. It is one of the few conferences I attend where I just go just to absorb as much as I can, and don’t speak. This one looks to be special.

On Monday I fly out to Orlando to speak at the Chartered Financial Analyst’s national conference on the “state of the union” of the alternative investment industry. I think my talk will garner mixed reviews, and is certain to be controversial in a few circles. I hope I get invited back some time.

Then
I am back home for most of the next two months. I will make a quick trip to Naples to be with my friends at Jyske Global Asset Management for their conference the 29-31 of May (www.jgam.com). And I am going to schedule a quick trip to Cleveland to get a full physical at the Cleveland Clinic with my good friend and best-selling author Dr. Mike Roizen. I have put it off too long. I will tell you more about the really interesting program they have, where you can get a three-day, thorough physical in one long day. I think it is a real value.

And then there was a call from Tiffani last Saturday. She was in Kentucky visiting friends. One of my standing rules is that when I get back from Europe I am not to be disturbed before 10 at the earliest the next morning. But I got a call from her, and I groggily took it, worried that something was wrong.

“Dad, I’m pregnant. It’s going to be a Christmas baby. What do you think?” Didn’t she just tell me January 23 or so that they were going to try? That didn’t take long. Not long at all.

Henry and Angel are due in June. Chad and his SO Dominique are due in October. I will go from no grandkids to three in the space of a few months. And Amanda is getting married in August. Lots of things happening in the Mauldin clan. And it’s all good.

I need to wrap it up. Tiffani will be here in a few hours, and then the meetings start. Have yourself a great week; and if you are at the CFA conference, be sure and look me up.

Your almost ready to be a grandfather analyst,
John Mauldin

John@frontlinethoughts.com

Copyright 2009 John Mauldin. All Rights Reserved
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