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Market Commentary - 3.30.2008

March 30, 2008

Are we there yet? That seems to be the theme over the last few weeks – since all of the major market indices made a short term bottom on March 10th (or the 17th on an intraday basis), all the talking heads are starting to believe that was indeed “the” bottom, and we can resume the 5 year bull market that stalled in October. The Fed/administration officials keep using the standard lines - the “fundamentals” of the economy are strong and the consumer is “resilient”. Like we always say, we are not bulls or bears, but opportunists. That being said, we do believe we are in a long-term bear market, and any rallies are just “bear market rallies” and should be treated as such. However, for now let’s play devil’s advocate and state a few arguments for the bull case:

  1. While we might have a recession (or may already be in one), it will be a short and shallow recession with earnings and GDP improving in the 2nd half of the year, and since the stock market is a leading indicator it will resume its uptrend several months before the economy starts to improve.
     
  2. The Fed has acted quickly and aggressively, using creative measures not utilized since the Great Depression, and between the rate cuts and lending facilities, the credit markets will see improved liquidity and the banks will begin lending again.
     
  3. The administration has acted as well, passing fiscal stimulus and mortgage relief packages which will aid the consumer/borrower and create a bottom in the housing market, enable people to keep their homes, and the consumer will quickly resume their spending habits.
     
  4. The recession/headline fear has already been priced into the market, the Sub Prime write downs are almost over, corporations are well capitalized with strong balance sheets, and the housing market is showing signs of a bottom.
     
  5. The major markets made a double bottom in March and valuation ratios are historically cheap, with many analysts stating this is the greatest buying opportunity in 20 years.

Okay, now that we got that out of the way, here is our view – we will not go point by point, but rather break up the argument into fundamentals and technicals/sentiment:

FUNDAMENTALS

Fed Actions – the Fed has now cut the target Fed Funds rate 300 basis points, from 5.25% to 2.25% since September 18th 2007, as well as lent hundreds of billions of dollars to banks/dealers through repo and direct lending facilities, while accepting even private mortgage collateral in exchange for treasuries. In addition they used $29 Billion of taxpayer money to orchestrate the bailout of Bear Stearns through JP Morgan Chase.

  • The credit markets are still in complete disarray, with most markets still essentially shut down and barely any trading going on – even products historically seen as safe, such as agency-backed mortgages, tax-free municipal bonds, and investment grade corporate bonds trading at or near historically wide spreads.
     
  • All of the banks and dealers the government is relying on to start lending again and passing on some of the rate cuts to businesses/consumers are still in the early stages of delevering. For all of those who say the Sub Prime write downs are almost over, they must realize that there are hundreds of billions worth of Alt-A, Option-ARM’s, credit card & auto loan receivables, leveraged LBO loans, etc. still on the books of these entities. It’s worth noting – Lehman Brothers alone still has over $80 Billion of Sub Prime and Alt-A paper on their balance sheet.
     
  • Even if we concede that the write downs are almost over, which of course has been stated ad nauseum for the last six months – these shops still have to offload all of this paper before they start lending again – the “new paradigm” financial system we are in doesn’t mean banks hold onto loans for 30 years, or even 10 years – they borrow cheap, originate loans, package them into a securitization and use the proceeds to start the process all over again. The argument goes – since the securitization markets are effectively shut down, if these products are held until maturity they will be “money good” and all the write downs will become write ups.
     
  • While it’s possible market pricing has overreacted and most of these loans/bonds will eventually be worth par, these are all long-dated products which were being short-term financed by leveraged banks/funds. Amortization is a slow process and it will take years for principal to be paid back – it’s nice that the Fed has been kind enough to finance a few hundred billion for the time being, unless they are willing to buy up trillions of dollars of hard to value paper (which of course isn’t out of the question), all of their actions are effectively a band-aid on a gaping wound.
     
  • All of the “traditional” buyers of these long-dated products: hedge funds, pension funds, insurance companies, and vulture/distressed funds, have taken a beating trying to time the market since last summer, and along with the banks these entities are wary of taking any more risk until the fundamentals of the underlying collateral show signs of improvement.

Housing

While it’s nice to have “hope” that we will see some stabilization in the mortgage market, we’re just not there yet.

  • Based on both historical house price to rent ratios and what the house price futures markets are telling us, house prices will fall another 20%+ nationally from current levels, and keep in mind that in most bubbles prices overreact so that could be conservative.
     
  • You can’t start talking about a bottom in house prices until the inventory levels come off of their historical highs – with new/existing home sales the lowest they have been in decades, and foreclosures adding new supply at an ever-increasing rate, supply will continue to outstrip demand for at least the rest of this year.
     
  • Since the rate cuts began, 30 year fixed rate mortgages have only declined by about 35 basis points (6.10% to 5.75%) and 30 year jumbo rates are roughly the same as they were back in September at 7.12%.
30 year fixed rate mortgages
  • There are hundreds of billions in mortgage resets across all adjustable-rate mortgage product coming up over the next several years. As you can see below, Sub Prime is only the beginning. Although the rate cuts will mute the effect on the reset rates, millions of homeowners are having trouble paying the initial “teaser” rate and shouldn’t have been able to buy a home in the first place, so even with more rate cuts looming, the delinquencies and foreclosures show no sign of abating.

Monthly Morgage Rate Resets

 

  • All of the actions the administration has taken so far, similar to the fed actions, are only a band-aid – they are only willing to help borrowers who are current on their payments, with equity in their home, who can afford their current rate – this is a very small percentage of borrowers, and the process is extremely slow working on a case-by-case basis.

Consumer

Everyone has heard it by now – consumer spending makes up roughly 70% of US GDP, so the health of the consumer is essential to growth in the economy – the consumer is facing far greater headwinds than at any time since the 70’s.

  • The economic expansion from 2003-2007 was the first time since World War II that real income growth has been negative – in the current environment, especially factoring in the increases we have seen in energy/food inflation, this trend will continue into the foreseeable future.
     
  • So what accounted for this latest expansion if it wasn’t income growth? – debt, plain and simple – the consumer felt rich because they had access to easy credit no matter what their credit profile was. Their home became an ATM machine as house prices rose:
Home Mortgage Borrowing
Household Debt
  • Over the last 3 months, the unemployment rate has started to tick up and there have been 3 straight months of job losses. Many analysts have taken solace in the fact that unemployment hasn’t “fallen off a cliff”, and say because unemployment has held up well that helps support the view of only a “mild” recession at worst. However, if you take into account those who have given up on looking for work after unemployment insurance runs out, sole proprietors and contractors who don’t factor into the calculation, and the never-ending revisions downward of past data, the picture doesn’t look nearly as rosy.
     
  • Consumer sentiment readings have fallen to their lowest levels in over 25 years, and although month to month changes should be looked at with a skeptical eye, the trend is certainly in the wrong direction, and as long as the consumer is waist-deep in debt with higher unemployment and real-wage declines, consumer spending is going to continue to get weaker at least over the remainder of this year.
     
  • The administration/Fed like to think that the economic stimulus package, with its $600 per person, will somehow alleviate the situation, and another package is in the works as we speak. It’s impossible to predict how the consumer will use the rebate check, but it’s fair to say that if everyone spends it, this will only provide a one-time pop in consumer spending, while if they save it or pay down debt, it will barely make a dent.

Corporations

Almost every day we hear the corporate balance sheets are strong, and earnings will improve in the second half of the year. However, that argument seems to hinge on all of what was discussed above – that is that the housing market will stabilize, the Fed/administration actions will start to flow through the real economy, and the consumer will somehow find a way to either relieve themselves of their debt burden with the $600 check in the mail and housing relief bills, or find another means of continuing to finance their spending binge.

  • Every month, analysts and economists lower their near-term expectations for GDP growth, corporate earnings, and business spending. However most of them have still kept their estimates in tact for the 2nd half of the year, still expecting corporate earnings growth in the double digits. If they have been wrong every quarter and every month, why should we believe them now – better put: what exactly is going to drive earnings growth later this year?
     
  • If banks are the key to financing corporate and consumer spending, and the executives of all these companies are not even willing to estimate what their earnings will be for the near quarter or when we will return to a “normal” earnings environment, and they are still saying things like “this is the most challenging environment we have ever faced”, why should we again believe that things will improve anytime soon?
  • Just as an example - listening to the latest congressional testimony, everyone said that Bear Stearns was well-capitalized and their meltdown was just a “liquidity” issue. If they were counting on financing from funds that pulled their money out of Bear for fear of bankruptcy, doesn’t that mean they were NOT well-capitalized – I mean, if every bank/dealer is that highly leveraged and counting on short-term financing to support their gargantuan balance sheets, are any of them really “well-capitalized”?
     
  • If all of these firms are so well-capitalized and the Fed actions will enable them to weather the storm, why is it every week we read about another firm having to either go to the capital markets to raise money or dilute their shareholders by selling stakes to Sovereign Wealth Funds? If Lehman was well-capitalized, why did they just need to raise $4 Billion?

Technicals/Sentiment

While it’s nice to think that we have evaded a bear market, and the 6 month downtrend in the major indices was just a blip on the radar on the way to making new highs, the facts at this point just don’t support the argument. We will use the S&P 500 as a broad proxy of the markets since it’s the most widely followed US market index.

  • If we look at a daily chart of the S&P 500 since the October 11th high, we can see that we are still in the process of making lower highs and lower lows, both on an intraday and closing basis. Although the index just broke its 50 day moving average, we’re still well below the 200 day moving average. We have now retraced almost exactly 38.2% of the decline from the October high to the March low. If this is indeed a bottom, we would first need to make a higher high, and that would mean closing above the 38.2% retracement line (1378.88), closing above the latest 2 intraday highs of 1388.34 and 1396.02.
Daily chart of the S&P 500 since the October 11th high
  • If and when we can clear those 3 hurdles, the next target would be the 50% retracement level at 1416.54. It’s interesting that volume has fallen off since the rally began, as we would normally look to a volume breakout to confirm a rally.
     
  • On a longer term basis, let’s take a look at a weekly chart going back 10 years, where we can get a picture of the last bull and bear market. Interestingly enough, we have been trading between 2 Fibonacci levels since the start of the year – we retraced almost exactly 38.2% of the bull market in February and March (1267.66) and are sitting right below the 76.4 level of 1385.54.
Weekly chart going back 10 years
  • Finally, if we look at an hourly chart going back to the December highs, we can see that the index is trading above its 50 and 200 period moving averages, and the MACD and RSI have both been in an uptrend since March 10th. The 50% retracement level from the December highs is 1390.03.
Hourly chart going back to the December highs
  • Basically, we have had a strong rally from early/mid March and most technical indicators have confirmed that trend. However, until we break the key levels of resistance in the 1379-1396 area, we are still viewing this as a rally in the context of an overall bear market. Most of the indices are near-term overbought, and if we break below the 1358 area we would expect to see the next leg down with a break below the March 17th intraday low of 1256.98.
     
  • Finally, we will take a look at 2 of the most popular sentiment indicators – the VIX, which is a volatility measure and probably the most popular “fear” indicator, and the % of stocks trading above their 50 day moving averages, which is popular market breadth measure:
    • If we take a look at a daily chart of the VIX vs. the S&P 500 since mid-June of last year, or around the time this “credit crises” began, we can see 2 things – a very clear trendline, and a very high correlation between market bottoms and VIX spikes.

Daily chart of the VIX vs. the S&P 500 since mid-June

  •  
    • Right now we are sitting right on this long term trendline, and this means the market has become complacent – the talking heads say the market has “priced in” all of the bad news. It may be the case that the market expects write downs from banks, and weak first-half earnings. But what happens if the recession is worse than they fear, or corporate earnings disappoint, or all of the measures taken so far don’t fix the problems in the credit markets. We see this complacency as a great time to look for short opportunities – if the resistance holds and we can get up to 1400, we expect another large spike in a VIX corresponding to a large move down on the index.
       
    • For all the talk of how much the market has declined, and how many stocks are down 50% or 60% off their highs, it’s pretty impressive to see how many stocks are still trading above their 50 day moving averages.

 

50 day moving averages

  •  
    • Considering the index itself is down over 13% from its highs, it’s surprising to see roughly 2/3rds of the stocks comprising the index to be trading above their 50 DMA. Considering that we are nearing the level we saw at the market high in October, that tells us that a relatively small number of poorly performing stocks have been weighing down the overall index (banks, homebuilders, etc.), while the majority of stocks have held up relatively well. Using a contrarian point of view, we would look at this as another sign that it’s almost time to short again, and it also says that there are probably a lot of stocks that have yet to start feeling the pain.

That is our overview of the current market fundamentals, technicals, and sentiment. In the long-term picture, we foresee a bear market lasting at least until the end of this year, with the ultimate bottom being the 68.2% retracement of the last bull market, or roughly 1077 on the S&P. Past experience has certainly taught us that it will be slow and painful getting there, with quick and sharp selloffs interwoven with quick and sharp rallies. With each of these moves, we expect to be able to find opportunities both trading the indexes sectors, as well as finding strong/weak stocks to trade options on. Always remember never to be bullish or bearish, but rather an opportunist willing to look past all the talking heads and experts who try to predict the future. With every trade, you should have an entry point and an exit point, and whenever we are in tight trading ranges always use tight protective stops. Although we are uncertain about the near-term direction of the overall market, there are several items on our radar that we are looking to take advantage of this week - check out the watch list to see our best ideas right now.

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Market Commentary - 3.23.2008

March 23, 2008

This past week reminded us a lot of the emergency rate cut the Fed announced at the end of January – again, the hope that the actions by the Fed will outweigh the continual stream of negative headlines and poor economic data. If you just look at the data, it doesn’t look very promising –

  1. Lehman Brothers, Morgan Stanley, and Goldman Sachs all reported a 50%+ drop in earnings from last year along with multi-billion dollar write downs, and admitted that things don’t seem to be improving in the credit markets.
  2. Employment numbers, leading indicators, and manufacturing data all continue to deteriorate, further pointing to a recession.
  3. CIT Group, the largest independent commercial finance company in the US, had to draw on a $7+ billion emergency credit line as their normal funding channels all but disappeared.

The market chose to look past the bad, and hope that the rate cuts along with creative new lending facilities will help ease the strain in the credit markets. Even while the Fed disappointed the market with only a 75 bps rate cut, the holiday-shortened week ended on a very strong note as the S&P was up over 3% for the week. Commodities from oil to gold to soybeans plunged the most in decades, the dollar rallied, and short term treasury yields hit 50 year lows. However, it was options expiration and volume wasn’t very strong, so we will be looking for some follow through on Monday to see if the rally has legs.

Earnings

Monday, we’re watching Walgreens, the nation’s largest drugstore chain, and Tiffany, which will provide an indication of how the high-end consumer is fairing. Deutsche Bank reports on Wednesday – looking to see how the European banks are fairing compared to their US counterparts. Also several of the homebuilders are reporting – Lennar and KBH – everyone expects the earnings to be bad, but will be more interested in what the CEO’s have to say about the outlook for the rest of the year.

Economic Data

A lot to watch for on the data front – Housing: existing home sales on Monday, new home sales and Case-Shiller home price data on Tuesday; Consumer: consumer confidence on Tuesday and consumer sentiment on Friday, personal spending and income data on Friday. We also have crude inventories, weekly jobless claims, and final Q4 GDP revisions.

Strategy

The upcoming week will say a lot about where we are headed in the short term. If the S&P 500 can close above 1344, we are looking at a short term rally to the February highs of around 1396. If this rally doesn’t have legs, we would look to buy index puts with the expectation of a retest of the January lows of 1270. Also watch very closely at commodities and the dollar – was this just a minor pullback or a major correction that has just begun? If gold, crude, and natural gas can find support, we will look for attractive entry points to the long side. However we believe this correction will continue with prices coming back down to earth from their meteoric rise.

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Market Commentary - 3.16.2008

March 16, 2008

Wow, what a week! Just when you think it can’t get any worse, there goes Bear Stearns. In a week in which Crude Oil touched a record $111/barrel and Gold topped $1,000/oz, the dollar hit multi-year if not record lows against just about every major currency, the Fed pumped an additional $200 billion into the banking system,…there was the CFO of Bear Stearns on Thursday to reassure the market that they had a strong liquidity position. And then on Friday, that liquidity had somehow deteriorated so quickly they had to be bailed out by the Fed and JP Morgan. Well, folks it just hit the wires – JPM is buying the once mighty Bear, who’ve been around for 85 years, for $2/share – no, that’s not a misprint. It’s also worth noting the Fed is taking on $30 billion of Bear’s really crappy assets.

So, what can we expect in the upcoming week?

Earnings

Several of the major investment banks are reporting this week, including Lehman Brothers, Goldman Sachs, and Wachovia on Tuesday, Morgan Stanley on Wednesday, and well Bear was supposed to report on Monday, but I guess that’s not necessary. The credit markets, as well as put option activity last week would indicate Lehman might be the next to need some help from their friends.

Fed Action

Tonight the fed announced it has reduced the discount rate 25 bps to 3.25%, as well as created another new lending facility to increase liquidity in the credit markets. When the Fed meets on Tuesday they are expected to cut the Fed Funds rate by somewhere between 50-100 basis points, with the consensus being about 75 right now. It seems each time the Fed acts, the lift it provides the market is smaller and lasts for a shorter period of time than the previous.

Economic Data

We’re focusing on PPI (Producer Price Index) data on Tuesday – after Friday’s somewhat “tame” CPI numbers, the market will be looking to see if the PPI follows suit. Also on Tuesday are Housing Starts and Building Permits, but honestly who bothers to even look at this any more – forget about the housing market getting better, when is it going to stop getting worse? – don’t worry, it won’t be this year but we’ll let you know. Also, weekly Jobless Claims and Leading Indicators on Friday.

Strategy

Since we recommended closing all the open positions back on March 7th, we have been in a wait and see mode as far as the near term for the broader markets – it will be interesting to see how the market reacts to the Bear Stearns bailout, additional Fed actions and the perception they will save any institution deemed “too big to fail”, and whatever interest rate action they decide to take on Tuesday. Of course we will all be hanging on their every word in the release to see just how far we can expect them to cut (1% anyone?). That’s not to say we are not in a bear market, or looking to get short for the next leg down – we just wouldn’t be surprised to see a rally into the middle of the week.

What’s not in question is that none of this is good for the dollar, but it certainly is great for commodities. How many times have you heard the “experts” say the dollar is going to bottom soon? Or that oil has to come down because there is no “fundamental” reason for it to be over $100/barrel. Investors are searching for hard assets to protect them from inflation, commodities from precious metals to fuels to corn to wheat to coffee are all the rage.

With a looming rate cut, more possible bank blowups, banks’ earnings, quadruple witching Thursday, and a holiday-shortened week, we would suggest sitting out the next couple of days for the most part – sometimes the best trade is no trade at all. We will provide updated picks next weekend in the March newsletter. Below are a couple of setups we are watching closely. It’s really hard to find attractive long trades in this market – commodities should be the easy play but they’ve run up so fast in the last couple of months there has to be some sort of pullback - but we’re hoping this week will present some opportunities.

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