Market perceptions - week of May1, 2009

Contents: Overview; Tea leaf readings; economic reports; Car wrecks – part 2; Conclusion

Perceptions and reality

I believe that what people perceive/believe to be true oftentimes gets in the way of facts that are contrary to their beliefs. The basic reason is simple. Perceptions are emotionally based whereas facts are logic and emotions will always trump logic. I think we see this in response to the markets, the economy and, this week, the swine flu story.

Regarding the swine flu, a medical historian at the University of Toronto, Edward Shorter, has called the way the public has responded "mass psychosis." I’d say that’s pretty accurate. Here’s why.

Every year in this decade, 40,000 people have died in automobile accidents. Each year, about 4,000 people drown while swimming or boating and 60 people die from lightning strikes. However many cases of the flu there are in the US now, the reality is that, as a percentage of our population, it’s a very small number. But, it’s headline news.

"The public is driven by irrational fears. They didn't go to medical school," says Shorter. "They're responding to an abdication of leadership by political leaders." What he said.

So then, what about the markets?

How are perceptions and reality clashing now? Seems to me, this has a lot to do with how you’re interpreting the facts and data that have been coming out over this past week and before.

Later in this note, I will give you my perceptions of the current reality and you decide. The short version is we’re going up - broadly and strongly.

My disclaimer will always be that I am a card-carrying capitalist and advocate of the free-market system. The reason for that is simple. This combination has proven to be the most effective people have ever evolved for the creation of wealth and economic growth all around the world. No exceptions. If you have proof to the contrary, I would love to hear it.

First, here’s what some folks said last week about what’s been going on.

Tea leaf readings

I use this term to describe quotes from a number of opinion leaders about current market and economic events – what they see happening now and their expectations.
“This will be the worst financial crisis since the Great Depression and the worst global downturn in decades.” – Nouriel Roubini, aka, Dr. Doom

“You can’t sit on the sidelines. You’ve got to be involved in the markets. Financial markets are sending a very clear signal: ‘We’ve seen the worst, we’re starting a bull market and all the right sectors are performing well.’” – Hugh Johnson, Johnson Illington Advisors

“I would like to see oil at $70 a barrel before too long.” – Secretary General el Badri of OPEC (It’s currently at $51).

“We do think that the worst is past. Although the markets will still have some pullbacks, the pullbacks will not be as sharp or as extensive as before. The risk of remaining on the sideline is somewhat greater than putting money back into the market.” – Bruce McCain, chief investment strategist, Key Private Bank

(Referring to the first quarter GDP numbers released this week) “This is the combination you want for a turn in the economy – better sales and an inventory correction.” – John Silva, chief economist, Wachovia Corporation

“Are we really seeing a bottom in the market or a substantial bear market rally? This looks more and more like there are some real legs to this thing.” – David Twibell, president of wealth management, Colorado Capital Bank

“Recovery seems to be in the air and the market is now a forward-looking market. A feeling of being left behind seems to be pushing the market higher.” – Peter Cardillo, chief market economist, Avalon Partners, Inc.

“The S&P 500 Index may jump to 1050 (it’s 877 now) over the next six to twelve months as investors buy stocks trading at low valuations.” – Abby Joseph Cohen, senior investment strategist, Goldman Sachs

“The S&P 500 has rallied between May and October during, or shortly after, the 14 bear market bottoms since 1932.” – Sam Stovall, chief investment strategist, Standard & Poors

“The offer is unlikely to be accepted by bondholders who are, in effect, being asked to sacrifice most of their claims in order to help GM satisfy commitments to the UAW.” – Brian Johnson, Barclays Bank

“GM’s new proposal, clearly produced under government duress, is worse than virtually any of the alternatives. It would give GM to the UAW and the US government and make taxpayers pick up the bills. Of course, billions more from government would be drawn down right away. But the UAW could also depend on the Obama administration to keep up the subsidy for years and years to come. Government and union co-ownership: it would be as ineffective as it is un-American.” – Mitt Romney, former governor of Massachusetts

Economic reports from the past week

GDP (Gross Domestic Product; it measures total goods and services output within the US – a thermometer for how the economy is doing) was down 6.1% for the first quarter. It had been down 6.3% in the last quarter of 2008.

2.79 points of the drop were attributed to businesses reducing their inventories of unsold goods. This is seen as a positive thing as it suggests that this working down of inventories is about over and, therefore, the need to ramp up and start replacing them is close at hand.

Perhaps a more important part of the report said that US consumer spending – the driver for about 70% of our economy – was up 2.2%. When a recession has been caused by a huge drop in the velocity of money moving through the system as this one has, it’s spending – not increased employment – which you should track for signs of recovery. The employment numbers will be the last to recover.

The chief economist of JP Morgan, Bruce Kasman, upped his forecast for the second quarter GDP results from -2.0% to just about – 0.5% and said he expects the recession to end at mid-year.

The Commerce Department said that the “rescue package” (italics are mine) of spending and “tax cuts” had little impact on the data. This recovery is being driven by the monetary policy of the Federal Reserve and normal market rebounds – not artificial outside sources.

The Federal Reserve said they might increase the size of programs to buy mortgage-related and US Treasury securities, if needed, to keep borrowing costs down. They also voted unanimously to keep the rate at which banks lend to each other in the near-zero percent range.

Inventories of homes available for sale fell, indicating stabilization in that sector. Most of the nation’s real estate troubles are in five states – CA, NV, FL, AZ and MI. The data from them skew the averages quite a lot, though it appears that CA and FL may have seen their lows. Real estate is a highly localized market. For example, in my market, foreclosures are at less than 1% - and that’s the way it’s been throughout this period.

With 30 year fixed mortgage rates having matched historic (back to 1991) lows this past week of 4.78%, it would seem likely that home sales should be trending higher fairly soon.

The Reuters/University of Michigan Surveys of Consumers said its final index of consumer confidence in April climbed to the highest level since September, 2008. It was the first yearly increase since July, 2007.

Unemployment – According to Business Week, there are nearly 3 million jobs that employers are actively recruiting for but unable to fill. A lack of flexibility and training are contributing to the problem. Many unemployed workers come from industries where their skills don’t fit those companies need, such as those in education, health care and accounting.

The car wrecks – part 2

Less than 30 years ago, the - now – Tiny 3 accounted for just about all the cars sold in the US. Today, only about half of the cars that are US made will be “Detroit iron.” In 2010, according to CSM Worldwide, a forecasting firm, foreign-owned automakers will be making more cars in the US than Ford, Chrysler and GM together.

Since Chrysler is now in bankruptcy court and may ally with Fiat, I just want to focus on the GM deal.

According to the latest boondoggle plan that GM has put forth to keep it from bankruptcy – see previous comments in the Tea leaf section – the federal government gets 50% of the company, 40% to the unions, 10% for the bondholders and 1% to shareholders.

Here’s one problem with the, since the Feds own 50%, Obama Motor Company math. GM bondholders - individuals, along with mutual funds, pension funds and hedge funds, all owned by individuals – own about $27 billion of unsecured bonds. For this, they would get 10% of the stock or about 5 cents on the dollar. I see. Yet the UAW, which owns $10 billion of those same type bonds, gets 40% - plus another $10 billion in cash over time? That works out to about 76 cents on the buck, according to some estimates. And the Feds have determined that the $16.2 billion in unsecured loans it made to GM entitles them to 50% of the stock and an additional $8.1 billion in debt? Just like Vegas, the house wins. Their part is worth 87 cents to the dollar. This is truly the new math.

I guess that’s what the UAW gets in return for the $25.4 million it has donated to federal candidates over the last 20 years – 99% of whom just happen to be members of the current majority party. Sure, their members lose some pay and benefits. However, in comparison to the airline and steel workers who were impacted when their companies went bankrupt, they are nowhere near as deep.

In a real Chapter 11 bankruptcy proceeding, these three groups would be treated similarly since they all are unsecured creditors. Yet, in this deal, those with the largest dollar investment – the individual bondholders - would get the shortest end of the stick – by a huge margin. To me and many others, it looks as if this has been engineered solely to create a nationalized car company run for political ends. At the next labor contract bargaining session – if this deal stands – the union would sit on both sides of the table. And, of course, the unions would be motivated to try to run the company for profit. Oh, sure they would.

With the Obama Car Company and Chrysler Italia being run for the benefit of the UAW, thanks to their political ties, don’t be surprised if you hear about proposed tax incentives to coerce you to buy these things. Shoot. People weren’t buying them before – why should they now?
One can only hope the bond holders can hang together and force this to a real – and fair - bankruptcy so a privately-run, for real profit company will come forward to the benefit of everyone – not just DC and Detroit politicians and union members.

Conclusion

Here’s my perception of the current reality.

There are still a number of people who aren’t buying this rally. Too bad. Many trading desks report that, in spite of the moves up, a large number of market bears have been betting that stocks would sell off because they were convinced that first quarter corporate earnings would be bad. With 64% of the S&P 500 companies reporting so far doing so in a positive manner – they now have had to cover their positions, unintentionally helping to drive prices higher by their purchases.

Here are facts to drive my perceptions.

Capital goods orders are now up – that’s the big ticket stuff. Bank earnings are continuing to improve as the spread between what banks are paying for money and what they are lending it at is very positive – and highly profitable. As I noted earlier, both consumer confidence and home prices are improving – it’s all about attitude.

Importantly – speaking of attitude – the markets have held up very well in spite of stress tests, swine flu, the car trouble and whatever. There is what’s termed a positive feedback loop emerging from all this. Better economic news, a better market and the confidence rising all tend to feed on itself.

Since hitting the 12 year lows in March, the NASDAQ has gained 32%. The S&P has gained 27% and the Dow 23%. A 20% gain is considered a bull market – at some point, even the media will understand that.

Speaking of the media…

How much real coverage has been given over the past 8 weeks about the turn in the markets? We hear all about the car company challenges, finger waving at hedge funds, the seemingly everlasting story of the stress tests – and now delays and, oh, yes, some health story.

In the popular (oxymoron?) media, you haven’t heard about the economy getting better, improved consumer spending, commodity prices leveling and turning up as demand improves.
All you hear are fear and gloom. Good news hardly ever gets the front page. Fear does. As the old journalism adage says, "if it bleeds, it leads." Meaning, if it's bad news, it's the top story. Ever hear about the fully loaded 747 landing without incident???

The economic and market news is getting better. Look around. It’s not perception – it’s reality.

Be sure to make it part of your reality and don’t succumb to the sirens of doom. They’re old news – and they know it.

All my best,

Mike