Monday, February 02, 2009

Fresh Money Thoughts

I've been away for two months, and in that time Obama has signed into law an $800b fiscal stimulus package, Ben has aggressively been pursuing QE, the BoE and ECB have both dropped rates, and no rally in the equity markets. I think it's safe to say the long hoped for bear market rally is well and truly not going to happen. We stay with our long term view that equity is overvalued, fundamentals will continue to worsen and we are buying high quality bonds through 2009.

As for trades, I'm stopped out on the SSO's and have sold all stocks except some MU and FXI. With the support at 7500 broken, I'll now be looking for shorts and lower equity lows. Insurance companies with their overstated balance sheets of BV investments come to mind. But mostly I'll short any bounces in the broader market. We must be more than 60-70% of the way to the bottom, so I won't try to get too excited about the short side now. I'm a bit late, plus after last week's damage, there's surely a rally coming this week. Gold is working nicely, if a little overbought, still there for the big move to new highs.

The TBT trade is crowded and over - I am betting that Ben will beat the traders and push the ten year back down to 2%. The r2 on the ten year and the thirty year mortgage is 0.96; they must go down to play a part in saving housing. Yes we have huge Treasury issuance's this year, and massive growth in fiscal debt, but the record sales last week went well, and, well, we're the best of the worst. Maybe worth going long a leveraged long bond ETF.

The Bear in Richard Russell

Based on the Dow Theory, the US equity markets have now established a double confirmation to the downside - that is both the Dow Transports and Industrials have broken to new lows and are on their way to test the '02 lows around 7200. For those that don't like the Dow as a market guiding index, the S&P 500 has also broken below its daily closing lows for this correction.

Through the past several months there has been a steady breakdown in confidence among institutional buyers. As the credit crisis moved from illiquidity for corporates and households to insolvency, it has become clear that earnings and dividends will continue to head lower while market valuations are still far from cheap. Richard Russell is in Kodiac mode, deep in the cave and sleeping.

The long established belief in the power of long term equity investing is officially in doubt, as US markets have moved sideways for the past ten years, while bonds have doubled. I have suggested in past notes that the institutional and boomer bias for investing will move to fixed income, and that this move will push equity valuations to their ultimate lows over the next 18 to 24 months.

Asset allocation changes are the final blow to lower equity valuations to a level that simple declines in earnings and multiples couldn't. Throw in public liquidation of stocks - out of near term fear and need to protect and maybe liquidate capital and longer term retirement needs - and you have a way to understand how the major indexes could move much, much lower.

This scenario suggests that investors focus on bonds and given their high yields and high position in the capital structure, they look compelling. We have yet to start the final march to peak corporate default rates. We should continue to see bond buying opportunities over the next nine months - first in high grade bonds and eventually in junk debt. More on bonds below.

Gold remains on the buy list, although as we approach the previous recent high ($1030?) we face the risk of resistance. The combination of growing sovereign default risks, frightening declines in Japanese and German GDP and industrial production numbers and a potential nationalization of US and UK banks has everyone searching for the high ground. This has had the unusual effect of driving both the $ and gold higher. I buy more on the breakout to new highs, but I am sitting tight on my position for now. Deflation is still the risk and greater price weakness should lead to a period of weakness for gold - maybe through the summer, waiting for the uncivil dissobediance crowd to flare up world wide.

Euro No-Go Zone

I made a comment in a past post about buying German bonds. I really don't know why I would say that. It was a pretty random comment. I also said that the Euro was a buy in the mid $1.20's. I'm not excited about anything Euro anymore, the currencies, the countries or the securities. The size of the deleveraging in the Eurozone is so big and disproportionte that it begs for a bit more review.

First, the banks in general have 50% more leverage than US banks. Second, they used this leverage to finance huge loans in Emerging Markets - $4t. The German banks are knee deep in this but they have such huge balance sheets that they are too big for the government to nationalize. DB has a report out saying the German economy may shrink by 9% in 2009.

Even worse, Austrian banks have loans out to E Europe equal to 70% of Austrian GDP. A 10% write off of these loans means bankruptcy for the Austrian banking system. Not only can Austria not nationalize the potential mess, but they will face receivership into the hands of Brussels Eurocrats.

W Europe might need more than $500b to recapitalize their financial system. this mess is maybe greater than the US mess in that it is cross border and much bigger as a percent of GDP. In either case the ECB is way behind the Fed in its response, as Germany drags its feet on rate cuts, fiscal stimulus and and small state bailouts.

E Europe has $1.7t in borrowings, much of it in Swiss Francs (CHF). In Poland, for instance, 60% of mortgages are in CHF; as the Zloty drops the loan value grows and default risk balloons. The Ukraine has blown through its IMF loans and is looking for more. There is a slate of eurozone countries looking at rating downgrades and bond defaults. The Euro goes back to parity with the $, stay long the $.

Deleveraging Continues

As a reminder, the backdrop to all this is the ongoing deleveraging of bank, corporate and household balance sheets. The assets buying frenzy and general leveraging of assets relied on income streams insufficient to support the debt in matched maturities. As the false confidence grew, assets were then financed short term for an "asset-flipping" market. Bank balance sheets stretched as far as they could and stopped. The debt stopped flowing, asset prices began to fall and the full gap between current prices and fair value was revealed - huge. Commercial RE, credit card and corporate defaults still ahead. BAC is at 6% charge offs for 2008, on their way to 10%.

Balance sheets need to be refinanced to match maturities; those that can are, those that can't go bankrupt. This will take some time. Companies that relied on asset flipping - like GE's finance division - have no eps power and lots of writeoffs. Aggregate debt levels will be pared back and will not see the same relative levels again for a long time - as long as the institutional memory of this debacle lasts. There will assets for sale for years to clean up books. Babcock and Brown, the me-too infrastructure finance company in Australia, renegotiated a debt program with its bankers that gave the embattled group up to three years to sell assets.

As an aside, the biggest problem for the CEO's is the lack of humility and willingness to accept the change in the markets. The CEO for Babcock is still so clueless he made these stupid remarks: "Leverage was not the issue, it was the contraction of credit that became the issue," Mr Larkin said. "We were a highly leveraged model but it was not the leverage, it was the absence of credit. No one would have believed that in 2008 banks would not lend to each other." No, surely it wasn't your fault. It was the banks' fault. Douchebag.


One bank to buy them all, one bank to find them,
One bank to price them all, and in the darkness bind them.

The bad bank idea seems to have come and gone. looked like the US Treasury was going to try to use the same banking models that priced the securities so poorly in the first place to create new market prices for the Bad Bank. For the record, ten years of data on securities is not exactly statistically relevant - especially for securities that have a maturity well beyond ten years. A BA in statistics could have told them that.

From unknown sources: "The wild variations on the value of many bad bank assets can be seen by looking at one mortgage-backed bond recently analyzed by a division of Standard & Poor’s, the credit rating agency. The financial institution that owns the bond calculates the value at 97 cents on the dollar, or a mere 3 percent loss.

"But S.& P. estimates it is worth 87 cents, based on the current loan-default rate, and could be worth 53 cents under a bleaker situation that contemplates a doubling of defaults. But even that might be optimistic, because the bond traded recently for just 38 cents on the dollar, reflecting the even gloomier outlook of investors."

Banks carry loans on a BV basis, as opposed to debt securities that must be marked to market every quarter. If we start pricing those loans - for which no market exists and no mark to markets are required - then there is a whole nother asset group with write offs. As we price out assets in selling them to the bad bank, the banks will see their capital destroyed even more. So you end up with cleaned up assets on the left side of the balance sheet and no bank capital on the right. Again, more money from the govt. As I've argued before, just nationalize please (we're natioanlizing already but at a slow, expensive pace). The Lee Kwon Yew's and Sheiks of Ara-by will get over their losses.

Corporate Defaults

From FT Alphaville: "In August last year, Moody’s issued what was then considered a gloomy outlook for corporates in the US. The ratings agency said it expected the global default rate to reach to 6.3 per cent by the following August, and as high as 10 per cent by the end of 2009 “should the US sink into a protracted recession.”

"In December, following the collapse of Lehman, Moody’s revised its estimates for junk-rated companies slightly higher, to 10.4 per cent by November 2009 - compared with 3.1 per cent in the same period in 2008. These levels, if reached - and FT Alphaville thinks they will be attained and surpassed - were last seen in the aftermath of the 2001 dotcom crash.

"Consider the parlous state of (non-financial) corporates today, particularly in the US and the UK. The latter has already had a series of high-profile corporate failures, including (but certainly not limited to) XL Airways, Woolworths and Zavvi.

"In North America, Circuit City’s descent into liquidation and the Chapter 11 filings of Nortel and LyondellBasell do not bode well for their industry peers.

"S&P expects the US corporate default rate to reach all-time high of 13.9 per cent this year, a significant revision of its previous projection a 7.6 per cent base-case and the consequence of “a substantial worsening of the economy and the financial environment”.

"The baseline projection of 13.9% would result in an unprecedented trough-to-peak increase of almost 13%, outstripping the rate of increase observed in any prior default-rate cycle since the start of our series in 1981.

"The continued high stress level in the financial system–which has wrought changes unprecedented since the Great Depression–is expected to ripple through more broadly, materially affecting the number of defaults.

"The ripple effect of corporate defaults, Chapter 11 filings and liquidations must not be underestimated.

"As Diane Vazza, S&P’s head of global fixed income research and the author of the S&P report referenced above explained in a radio interview:

[Defaults affect] the entire supply chain. And we saw that very clearly with the automotives. We saw that fan out to all the automotive suppliers. You know, it’s like an onion. And the layers of the onion are . . . you get larger and larger as it affects the entire supply chain.The Circuit City bankruptcy provides a compelling example of this, as the imminent closure of Circuit City’s 567 remaining retail outlets - on top of more than 150 that were shuttered in November - will have a pronounced effect on commercial real estate. Paul Kedrosky estimates these closures mean around 22m square feet of retail space is suddenly empty - in an already depressed retail environment. And, as Reuters rightly noted in a story this week, this will also put pressure on investors in CMBS and REITs:

The loss of the large tenant, whose stores typically run from 35,000 to 40,000 square feet, is likely to be felt by some publicly traded shopping center owners, such as Developers Diversified Realty Corp DDR.N, where Circuit City accounted for 1.7 percent of its annual base rent revenue, and Kimco Realty Corp KIM.N, where the chain accounted for 1.5 percent of its annual base revenue, according to Green Street Advisors analyst Nick Vetter.

"Other landlords include Inland Western Real Estate Retail Trust, Simon Property Group Inc SPG.N, Vornado Realty Trust VNO.N, Weingarten Realty Investors WRI.N, First Capital Realty Inc (FCR.TO), Kite Realty Group Trust KRG.N and Arcadia Resources Inc (KAD.A), according to financial data firm SNL Financial.

"About half the shopping centers where Circuit City is a major tenant have mortgages that have been pooled and manufactured into CMBS, with more than $4 billion left on the balance of the mortgages, according to Realpoint.

"The numbers don’t look good. Circuit City accounts for more than 20 percent of the revenue rent on 176 of the properties. Those properties contribute 38 percent of the total loan exposure. Without Circuit City, occupancy at 187 centers would fall to less than 80 percent, meaning it would hurt mortgage payments to bondholders, Realpoint said.

"Corporate defaults also put pressure on already strained banks and other financial companies that can scarcely afford to be stiffed by one significant debtor after another. And then, of course, there are the job losses, which compound the woes facing consumers.

"Nor is the developing world immune. Standard Chartered, for instance, believes “[c]orporate debt is going to be one of the biggest issues in emerging markets in the next two years,” according to this Bloomberg story.

"The story also cites data compiled by Commerzbank AG that show “businesses across emerging markets have more than $218 billion of bonds and syndicated loans coming due in 2009″:

"Russian companies need to repay $54 billion of debt, followed by Mexican issuers with $29 billion coming due and Brazilian firms with more than $24 billion. Currencies from all three nations have dropped more than 20 percent against the dollar in the past year, increasing the cost of servicing foreign-currency obligations.In Poland, for example, the defaults have already begun.

"As CreditSights analyst Chris Taggert put it,

The market is faced with the prospect of a default cycle tantamount to the worst historical periods outside of the Great Depression. Fundamentals hurt, weak balance sheets maim, but liquidity kills. All that, and it’s still only January. Tin hats, chin strap level five at least."

Roubini's Thoughts

"...the retail sales figures just published confirmed that a shopped-out, savings-less and debt-burdened U.S. consumer is now faltering as job losses, income losses, falls in home wealth, falls in equity wealth, high and rising debt and debt-servicing ratios and a severe credit crunch take a severe toll on the ability of consumers to spend. And reduction in spending and deleveraging of the U.S. consumer will take years to rebuild the savings rate of a household sector now hit by a severe shock to its net worth (as equity and home values fall while debts have been rising), and shocked in its inability to generate income as job losses mount and the unemployment rate surges.

"Our research at RGE Monitor suggests that the U.S. and global recession will continue at least until Q4 2009 (a nasty, 24-month, U-shaped recession) and that the recovery in 2010-'11 will be very weak, with growth around 1%--well below a potential of 2.75%. And we cannot rule out that a more severe L-shaped stag-deflation (as in Japan in the 1990s) will take hold. Indeed, as I have argued, while the odds of a systemic financial meltdown have been reduced by the actions of the Group of Seven and other economies, severe vulnerabilities remain.

"The credit crunch will persist and spread beyond mortgages. Deleveraging will continue, as thousands of hedge funds--many of which will go bust--and other leveraged players are forced to sell assets into illiquid and distressed markets, causing price declines and driving more insolvent financial institutions out of business. Credit losses will mount as the recession deepens, and a few emerging-market economies will certainly experience full-blown financial crisis.

"So 2009 will be a painful year of global recession and further financial stresses, losses and bankruptcies. Currently, the probability of an L-shaped, stag-deflation is now rising to one-third, while the probability of a severe U-shaped recession is two-thirds. Only aggressive, coordinated and effective policy action by both advanced and emerging-market countries can ensure the global economy starts to recover, however slowly, in 2010, rather than entering a more protracted period of economic stagnation.

"So while our benchmark scenarios see a severe U-shaped global recession with very weak growth recovery in 2010, we cannot exclude the possibility of a worse outcome--i.e. an L-shaped recession that, in our view, has at least a one-third probability. So the worst is ahead of us rather than behind us, both for the real economy and for financial markets.

"With my forecast of 2009 earnings per share for S&P 500 firms being in the $50 to $60 range, and with price-earnings ratios likely to be in the 10 to 12 range, given a severe global recession, the S&P 500 could bottom at some point in 2009, at best at a level of 720 and, in a worse scenario, as low as 500 or 600."

From Greed and Fear

...deflationary forces will reassert themselves in market psychology in coming months as US data remains awful, leading to ever greater monetary activism. This process will climax ultimately, as previously mentioned, in the dollar debasement trade. In GREED & fear’s view this process plays out over the next 12 to 24 months. It does not happen right now.

Still at this juncture it is also worth reminding investors that at the bottom of a deflationary
spiral gold becomes part of the policy solution for increasingly desperate central bankers and
politicians, and is no longer considered part of the problem. This is why FDR revalued gold in
1934 in the midst of the Great Depression. But this time around gold is, for now at least, freely
traded which means it could soar in price amidst a perceived policy vacuum in terms of what
will replace a by then discredited US dollar paper standard. This is why GREED & fear’s price
target for gold is maintained at US$3,360 per oz by the end of 2010.

If the dollar starts strengthening again on renewed deflationary concerns triggered by collapsing inflationary pressures in the American economy, it is likely that gold corrects again. In this sense the current dollar correction is the same counter trend move as the current rally in equities. The tricky part is exactly when it ends. For those who do not want to get involved in tactical trades, the fundamental point is clear. Deflationary pressures are still accelerating.

Dubai Notes...

Looks like the venerable Sheik Mo is has lost his seat at the top of the Middle East bubble. While the UAE Central Bank has amde some emergency loans to Dubai, the word in the mosque is in return for Abu Dabhi refinancing Dubai's massive debts, Mo will turn over the best properties and resign as the top dog of Dubai. This is a seminal moment in the rise of the gulf states, and signals the credit crunch's arrival in official force in the Middle East. Not to mention lower oil.

Summer of Pain

"What people really are worried about is that the consumer-spending recession only started four or five months ago," Mr. Trennert says. "Unfortunately, I think we are in the relatively early innings of that recession."

As we exit the winter months, unemployment benefits wear off and more jobs are cut, savings accounts depleated, more home defaults and foreclosures, more homeless and angry people - a potent brew for civil disobedience. It will not take much to get the masses excited and destructive, and remind the comfortable on the hill in Specific Whites that they too are part of the broader San Francisco community. A brick through each of your windows...

With equity markets hitting new lows and so much more balance sheet destruction coming, it seems as though capitulation may be headed our way this summer. Soon comes the time of Benjamin Graham and the balance sheet investor - liquidity, solvency and replacement value of assets over earnings growth. Start with bonds and work your way down the capital structure.


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