Market retrospective - week of 24 April

Contents: Overview; Economic reports; The coming car wreck; Market stressors – the banks; Tea leaf readings; Conclusion

“Better than expected”

I’ve been advocating that this phrase should be the new mantra for the markets. 62% of the earnings reported this week were “better than expected.” Most of the economic results we’re seeing are “better than expected.” And still most of the media is trying to give the news a “yeah, but…” spin. It’s as if they’ve been pushing the end of times economic outlook for so long, they just can’t seem to let it go.

Have you noticed that the talking heads and their political brethren have moved away from using the word depression over the past few weeks??? If past is prelude, you can be sure that by the time the media says the recession is over and the economy is better, we’ll probably have seen a 50% upward move from the market lows…

In fairness, the market participants – I’m talking the pros here – are fairly evenly divided between we go higher from here or we go back to the abyss. It’s a monetary tug-of-war between those of us – yes, I’m one – who see positive stirrings and factual indications of upward movements and those naysayers who can’t seem to wait for the next bit of news they can attempt to spin negatively.

Look at these economic reports as proof that the trend is, in deed, becoming our friend.

Economic reports

Existing home sales ~ Existing home sales fell slightly in March, yet the number of existing homes sold in March remains 1.8% above the lows of January, showing that housing sales have probably bottomed. The Federal Housing Finance Agency reported that purchase prices for houses are up 1.7% in the past two months, the largest improvement since 2005.

Unemployment data ~ New unemployment claims increased by 27,000 a week ago to 640,000. Given that these are keeping pretty steady, it seems to indicate that the end of the recession is near. These numbers will be the last to turn positive of all the lagging indicators the government uses.

Durable goods orders ~ Overall orders for big ticket manufactured goods fell less in March than expected, but were revised down for February. Normally, business investment in equipment will lead an economic recovery. However, when a recession is due to a sudden and sharp decline in monetary velocity like we had in the fourth quarter last year, consumer spending should lead things out. Consumer spending was up in Q1 and, based on what I read, looks as if it will continue to rise.

New home sales ~ Sales were stronger than expected in March. Like existing home sales, it appears that sales hit bottom in the first quarter and are likely to rise over the next couple of years due to low interest rates and pent-up demand. The total inventory of unsold new homes fell in March, a process that will also continue. Most downward price pressure will be in, as the Wall Streeters like to refer to them, the four sand states of California, Florida, Arizona, Nevada, along with Michigan.

The car wreck

The White House announced that Chrysler would be getting $500 million through the end of this month to help its likely alliance with Fiat. It also said that up to another $5 billion would be going to the black hole of Detroit formerly known as GM to “help it restructure outside of bankruptcy.”

The WH also has floated the idea of exchanging $13 billion of GM debt for equity (stock) as a way to reduce the debt burden of the company. I don’t know about you but I don’t want to be a one quintillionth owner of a failing business.

Making these decisions, the White House just must not be on GMs memo list. I don’t know how, save for some bureaucratic magic wand waving, GM will be able to avoid reorganization. Here are a few reasons why I say that.

The company said it would be closing 9 plants for 3 to 11 weeks this summer, depending on the particular plant. The good news about that is they’re doing this to help reduce inventories. And the bad? The workers who are laid off will still get most of their pay. Their UAW contract requires that GM make up the difference between state unemployment benefits and their wages. Doesn’t look like a big money saver from here.

In 2006, the total compensation per hour – that’s wages, health care costs and retirement benefits – for the US car makers was $73.20. The total comp paid by paid by foreign car makers to their US employees is $48. Put another way, it’s 132% higher than that of the entire US manufacturing sector which averages $31.59. I wonder if that just might have something to do with the fact that US carmakers lose between $500 and $1500 on every vehicle they make…

The UAW has told members to “lobby the White House by phone and email to ensure that workers and retirees are treated fairly.” Fair according to whom was not disclosed.

GM’s chief financial officer has said that the company will not be able to pay a $1 billion debt that is coming due on 1 June – White House money or not. It owes bond holders $27 billion.

GM has announced that it will be dropping the Pontiac line, along with 37,000 hourly and 10,000 salaried jobs by year-end.

This is just me talking but unless GM actually does restructure through the bankruptcy courts, they aren’t going to be able to compete on any level. The central issue of the restructuring is the $20 billion dollar health care trust.

PS Interestingly, Ford – a company that has not asked for any handouts so far – has said this week that they plan to actually increase production of their vehicles by 25% in this quarter. Seems that not all Detroit car makers are really the same…

The market stressors – the banks

The markets have been following the bank stocks down and then up for the last 9 months. Now we hear about stress tests. What the heck are they? Here’s the short version.

There are 19 financial institutions in the US with at least $100 billion in assets. These are the ones that were “tested.” This was all brought about by the panic of last fall. The political reason for doing this is to demonstrate that the big banks are solid and the financial system in good shape. So, what’s involved in these tests?

The Federal Reserve did the tests. The idea was to find out how well each institution’s balance sheet would stand up to really bad economic conditions. They used two scenarios, a baseline and a “more adverse”.

In the baseline, the GP loses 2.0% this year, adjusted for inflation, and grows 2.1% in 2010. (That would be quite a flip, to be sure.) Unemployment nationally averages 8.9% this year and 8.8% next. Housing prices drop 14% from the December, 2008, levels and another 4% in 2010 from where they wind up in December, 2009.

For the more adverse section, the GDP would fluctuate between a drop of 3.3% this year to an increase of 0.5% in 2010. (I don’t know how they come up with these.) Unemployment would be 8.9% this year and 10.3% next. Housing prices drop 22% this year from the December, 2008, levels and another 7% from the December, 2009, level.

The Fed asked the banks to provide projections of their “resources available to absorb losses under the two scenarios” over a two year period and to maintain what’s called a tangible common equity (TCE) of 3%. TCE is the book value of each bank’s common stock, minus intangible items like goodwill and deferred taxes.

Likely outcome?

The White House and Treasury are now talking about turning TARP loans for the 19 biggest banks into common stock by converting the preferred they received from the banks. That idea cratered the market on Monday to the tune of a 4% loss. The reason is that the markets see that move as a backdoor path to nationalization.

I believe that those which are proven to be “unhealthy” should get the same treatment the S&Ls did in the 90s. They were taken over by the FDIC, the good parts sold right away and the other assets held until they were worth something. That worked out quite well.

It doesn’t appear that, based on these stress test criteria, any bank is really struggling. That’s one reason the market went up Friday. Moreover, the banks want to pay back any TARP funds they received. They certainly don’t want any congressional person or the Feds telling them how to run their businesses.

Monetary policy – not bureaucratic/political “solutions” – has been all the fix the banks needed. The reason their earnings are doing so well is the combination of the low cost of money from the Federal Reserve, together with a rapidly growing demand for new mortgages.

As some traders have stated it – and I agree – no bank will “fail” but some will be forced to raise more capital and/or to make management changes.

Tea leaf readings – comments from various opinion leaders during the week

“Wall Street and Main Street banking are very different. Of the over 8,000 banks in this country, very few ever made a single subprime loan and they did not engage in the highly leveraged activities that brought down Wall Street firms." - Edward Yingling, president and CEO of the American Bankers Association

"We own stock in four banks: US Bank, Wells, M&T and SunTrust. SunTrust I don't know about because South Florida is going to be the last to come back and they've got a concentration down there. The other three, they're going to have a lousy year, but they'll come out of it with far more earnings power. The deposits are flowing in. The spreads are wide. It's a helluva good business." - Warren Buffett, investor of note

"We're starting to see a little light at the end of the tunnel. The challenge is I don't know how long the tunnel is." - Frank Ingarra, co-portfolio manager at Hennessy Funds, referring to some of the recent earnings data

“We’re turning the tide.” – Alan Mullaly, CEO, Ford

“The vast majority of banks have enough capital to keep lending.” – Tim Geithner, Treasury

"It's probably the first time in several quarters that we've seen some stabilization with
earnings." - Ashwani Kaul, director of research at Thomson Reuters, referring to this quarter’s numbers

“Citigroup will pay back every penny of TARP money it’s received.” – Vikram Pandit, Citigroup CEO

“For people who say there are green shoots, I see only yellow weeds. Frankly…it’s just a bear market rally.” – Nouriel Roubini, NYU, aka, Dr. Doom

“There’s so much cash on the sidelines, it needs to find an entry point. Any time we have a dip, buyers are coming in.” – Robert Doll, Vice Chairman, BlackRock

“’Pretty soon, even here in Washington, it adds up to real money,’ says the president. Except, you know, really it doesn’t. Let’s say the administration finds this $100 million in efficiencies every working day for the rest of the Obama administration’s first term. That’s still around $80 billion, or around 2% of one year’s federal spending. Given the president's proposed $3.6 trillion budget for the coming fiscal year, $100 million dollars is the amount of money the federal government will spend in just 15 minutes. 15 minutes is probably how much time the average American spent eating breakfast this morning.” – Paul Krugman, economist, writing in the NY Times

“The cuts ‘are intended to signal the president's determination to cut spending and reform government.’" – an unnamed administration official quoted in the Washington Post

Conclusion

This week, we get a preview of the first quarter GDP numbers. Probably won’t be great but the worst is behind us, to be sure. Another 146 companies in the S&P 500 will be reporting their earnings numbers. We’ll learn how car sales went last month and, of course, more conjecture about the banks ahead of the 4 May release of the stress test results.

As noted, many people are looking for the market to pull back from here. We’ve had a tremendous run up – more in just seven weeks than is made in a series of years. Profit-taking is not a bad thing and is an indivisible part of the ebb and flow of the markets. We’re bound to get some of that. You can bet that the sky is falling crowd will come out in droves saying how this is the start of the slide back.

I truly don’t get it but, if I see something that changes my fundamental view, I’ll be sure to tell you.

Economically, in my career, I’ve experienced interest and inflation rates above 20%, a top income tax rate of 70% and more than one telling of the “this time, it’s different” fairy tale.

Logically, we’ve taken pretty much every adverse thing the economy and markets can throw at us. We’ve suffered through political ineptitude before, from artificial price controls to profligate spending. For sure, don’t get down on the markets now.

We’re just getting started.

As always, all my best –

Mike
509.747.3323