Graphic Markets

The markets were downright giddy this morning following a better-than-expected GDP report. The markets nearly became euphoric when the summary tables revealed that it was consumer spending which was largely responsible for the rise in GDP. However as the day wore on, cracks were beginning to appear in the façade of the first read of third quarter GDP.

Economists and strategists fro around the street expressed doubts that consumers will be able to keep the economy chugging along. Zach Pandl of Nomura Securities told the Wall Street Journal: "We don't think the kind of pillars are there for a strong recovery." A report published by Citi Private Bank Global Fixed Income Strategy state: “The recovery in developed countries, however, is by no means robust, nor is it likely to resemble a “V”-shaped rebound that is typically associated with downturns of this magnitude.

Not all economists are counting on consumers to tow the economic line. Some experts believe that business inventory replenishment and business-to-business commerce will carry the economy to a sustained recovery. Others believe that a weak dollar, which lowers the cost of U.S.-made goods abroad, is the answer. However, a weak dollar causes problems domestically, such as higher food and energy prices. These headwinds can be disastrous for the economy. The truth is that U.S. economic growth hinge on the consumers’ ability to spend. With wage growth expected to be poor and credit availability to be based on prudent lending standards, the economy appears to be heading for peak growth in the 2.5% to 3.5% in the current economic cycle.

Attempts by the administration to reinflate the economy with credits, rebates and by forcing banks to ramp up consumer borrowing will cause serious problems down the road. The sooner the government admits that three percent growth is what is fundamentally sustainable and assets prices, including real estate, must be permitted to reset to reflect supply and demand the better off we will all be.

I have previously discussed how the equity market rally has been due in large part to the weaker dollar and the cheap short-term borrowing which is helping to cause the weaker dollar. The following is a chart which demonstrates the correlation between the weaker dollar (using the strength of the euro vs. the dollar as an example), crude oil and the Dow Jones Industrial Average:




Last year I argued that rising oil prices were not, as many commodities traders insisted, due to increased demand, but due to the weaker dollar. Oil was being used as a dollar hedge. When the financial crisis struck last September, the flight to safety had investors flocking to the dollar. Oil prices plummeted. This year, with the dollar weakening, oil prices are rising. Equity prices are also rising because of the weak dollar. As the dollar weakens it takes more of them to properly represent values of companies this causes equity prices to rise. The above chart bears this out. Therefore, if the Fed begins to tighten before the economy can fly in its own (sans stimulus), a significant correction could ensue. The problem is that the Fed will tighten by late 2010 and growth will be modest. It will be interesting to see if the market can maintain its strength in the face of tighter monetary policy.

True Colors Shining Through

The equity markets are getting a dose of reality as a series of economic reports and continued strong demand for U.S. treasuries weigh heavy on the minds of equity investors. A mediocre durable goods report combined with unexpectedly poor new home sales and consumer confidence data to push equity markets lower. Another strong treasury auction, this time the five-year note, demonstrated that not everyone is convinced the global economy is out of the woods.

In spite of the best efforts of market bulls and government officials, consumers and investors are wising up to the fact that much of the improvements observed in economic data has been due to inventory replenishment, after a long period of depletion, and government stimulus. Goldman Sachs cut its forecast for third quarter GDP to 2.7% from 3.0% due to the lackluster durable goods data. I believe Pimco’s Bill Gross had it right when today he said in an interview on CNBC: "The new normal recognizes the economy is deleveraging."

The problem is that the government is trying to leverage the economy back to health. Are government officials stupid? No, they are merely politicians. These hypocrites who criticized Wall Street for focusing on short-term profits over long-term results are guilty of the same offense. Rather than let the economy correct to fundamental growth rates and permit home prices to find levels at which those who can obtain credit (a shrinking group thanks to an over supply of homes and rising unemployment), the government is attempting to repeat past mistakes of too much leverage in an attempt to engineer another sharp, quick, but unsustainable recovery in order to keep the voters happy and themselves in office. They are sacrificing long-term prudence for the short-term goal of remaining in power.


This is what got us here! For nearly three decades, whenever the economy would falter, the Fed would bail out the economy by lowering rates. Wall Street helped by creating vehicles to package all kinds of sour loans into palatable investments. Politicians permitted (some encouraged) this to happen. All was good as long as the populace was happy and politicians remained in office.

The government is reaching way back in search of mistakes to make. The administration and its partners in Congress are pushing for wage and price controls and extension and expansion of stimulus plans such as the first time home buyer credit which may become available to existing homeowners looking to upgrade to a larger home. The government is also choosing favorites among corporations. If one lends to and for unionized businesses one can get government assistance. If one lends to small or medium-sized businesses, which are largely non-unionized, one is left to fend for oneself. Just compare GMAC to CIT.


The demand for treasuries is likely to remain strong as I (and most other fixed income experts) am expecting strong 10-year note and 30-year government bond auctions. If the Fed tightens, the lack of cheap leverage will take many equity buyers out of the market. The weaker dollar was also helping to buoy stock prices. As the dollar weakens more of them are required to represent the value of companies, hence share prices rise. Fundamentals will eventually rule, that is why we have corrections.
The true colors of the economy are about to come shining through

Making Sense

Rather than pick a topic and write extensively about it I am reverting my old form and will discuss a variety of current topics.

Let's begin with the economic recovery. An article in the Wall Street Journal ponders why investors remain jittery in spite of "clear signs" of economic recovery. The fact is that, other than equity bulls, problems remain within the economy. In actuality, much of the "recovery" has been due to cheap capital, inventory replacement and unsustainable incentives such as Cash for Clunkers and the home buyer tax incentive. Not every one sees the clear signs.


Also in the Wall Street Journal is an editorial by Christopher Wood points to the disturbing fact that the nascent recovery is heavily dependent on government stimulus. He points to the artificial demand for homes and cars bringing demand forward at best and enticing consumers to purchase for whom it is not in their best interest to do so.

This opinion was echoed by Bill Gross and Nouriel Roubini. Mr. Gross believes that growth will be below historical trends and Mr. Roubini believes that cheap leverage (for those who can get it) is creating more asset bubbles in equities and commodities. I believe that they are both correct. Consumers will not and cannot borrow as they had during most of the past 20 years. This will remove significant consumer demand from the economy. Since consumer spending is responsible for approximately 70% of U.S. economic activity, pent up demand may not be what the bulls expect.


On the auto front UAW workers at Ford continue to reject concessions to help make Ford competitive with GM and Chrysler which, after bankruptcy, have much lighter debt loads. What is going through the minds of auto workers. Apparently not much. Speaking of autos, FIAT announced that Dodge will specialize in "blue-collar muscle cars" and trucks. The more plebeian car line will consist of FIAT models, but that it will take several years to bring over the little FIATs as they do not currently meet U.S. safety and emission standards. The popular Dodge Caravan mini van will be axed. The smells a lot like AMC / Renault and we all know how well that turned out.

Morgan Stanley continues to hawk $1000-par fixed to floater LIBOR-based preferreds. The first MS argument was that when "rates" rise the value of these preferreds will rise. I have previously demonstrated that it is a flattening yield curve which results in higher prices. Contact me for mathematical and historical evidence.

Looking for another angle, MS is now marketing these preferreds by pointing to their attractive yields to call. Even though the calls are unlikely to occur for economic reasons, MS believes that they will be called as banks want to instill confidence by calling in Tier-1 securities. 1) Banks want more, not less Tier-1 capital. 2) If banks wanted to retire such securities they could buy them in the open market at discounts. There is no reason to call them at par. They are trading at discounts because the street does not believe a call to be likely. I have it from reliable sources that MS is loaded with these issues and is using retail accounts to move the inventory. Very few firms market $1000 preferreds to retail clients as they are institutional vehicles and illiquid in retail sizes. Trades of 1mm are the norm.

Never Assume

I had the pleasure to touch base with a financial adviser who was a reader of a former publication I published. We reminisced about days gone buy and he informed me that he respected my work in spite of my blowing the call with the GSE preferreds. I took a little exception to that.

It is true that I stated that I thought that a government seizure of the GSEs and a cessation of their preferred dividends was not the most likely scenario, I did warn that the government (for political reasons) could suspend GSE preferred dividends. It made no sense to do so from an economic standpoint as it only saves about $2 billion annually for each FRE and FNM. It also wiped out the non-cumulative preferred market which in turn helped to sow capitalization concerns among U.S. financial institutions. This helped to cause the runs which brought about the demise of Lehman Bros., forced Merrill Lynch into the arms of BAC and forced Goldman and Morgan Stanley to become bank holding companies (to be able to borrow from the Fed and acquire Tier-one capital via deposits). In fact, the government's plan to buy preferred stock interest in banks via TARP was the direct result of the banks in ability to issue Tier-one-qualifying preferred stock because of the treatment of the FRE and FNM preferreds. My opinion is based on logic. If asked, I will always tell what I believe makes sense, but will also warn that markets and government officials will often behave illogically.


What illogical phenomena do I see?

1) Dow 10,000: There is no fundamental reason for the rapid and significant recovery of the equity markets. Unemployment will continue to rise and once inventory replacement subsided, economic data will moderate. Lending will not become as easy as it had been because too many investors have the consequences of lax lending standards fresh in their minds. To be fair, the deep decline of the stock market was equally unjustifiable. The equity markets are the least efficient at predicting or even reflecting economic conditions, followed closely by the high yield bond market, due to the amount of fear and greed prevalent in those markets.

2) The shunning of 10-year corporate bonds. Investors do not understand the difference between credit products and interest rate products. Corporate bonds ARE NOT interest rate products

3) The love affair investors have with floating rate bonds. Floaters are designed to NOT BENEFIT investors merely because rates rise. Most floaters have coupons which reset versus LIBOR, but trade off of long-term treasury benchmarks. This means that even if rates across the yield curve moved higher by 500 basis points in unison such bonds will trade at deep discounts because the coupon will be significantly lower than the trading benchmarks. A flat curve is needed for price appreciation. CPI floaters measure the change of the rate of inflation, not merely positive inflation. Hence the low or zero coupons we now see on such bonds.

4) The recovery has to be as robust as "always": What is always? The last two cycles is not "always", but that is what many investors and pundits use as their historical examples. With lending standards becoming more responsible, look for PIMCO's forecast of 3% - 4% peak growth to come to fruition.



I'll leave you with the reminder of the warning given back in 2004 that GM could file for bankruptcy and was not too important for the economy to not be permitted to file.

Dow 10,000 - So What

Media types are screaming from their electronic bully pulpits are telling us how Dow 10,000 is an indication that the economy is on its way back and the markets are back to normal. All Dow 10,000 means is that the DJIA has reached 10,000 for the third time (1999 and 2003 as well). The investing public has been guiled into believing that the markets are efficient. This is always true. The least efficient are the equity markets. Due to the diverse group of investors (coming in all stripes), the equity markets are more influenced by fear and greed than any other markets. This is why they exhibit the biggest booms and the biggest busts. They also attempt to be forward looking. When things look bleak, the equity markets try to get ahead of the curve and often slump severely. When conditions show even modest improvement, equity investors will pour money into equity markets. Today was a good example.

JPM reports better-than-expected earnings and the market loves it. Pay no attention to deteriorating asset quality and the probability of reduced trading revenue this quarter. Keep in mind that JPM is probably the best of the banks. What about economic data? Retail sales rose a modest 0.5%. However, because it beat the street consensus of 0.3%. Never mind that the prior report indicated a rise of 1.1%. How about import prices? The data wasn't so bad thanks to a year-over-year decline of oil prices, but oil is creeping higher and the weakening dollar can be inflationary among imported goods.

Forthcoming economic conditions may justify Dow 10,000. After all, it is not such a lofty number. The DJIA first reached that level 10 years ago! Still, no equity bull can answer my question: How will consumers spend without a job and without easy access to credit? They don't have an answer, at least one they want to give. Jobs improve AFTER consumers who can spend, do spend. The problem is that there are so many people out of work and running out of unemployment benefits and credit, they cannot spend enough to generate enough business to warrant rehiring of displaces workers. Also, the days of easy credit are over. Investors will no longer buy vehicles backed by liar or ninja loans (No Income, No Job or Assets), no matter what their credit ratings. The days of using one's home as a piggy bank which is refilled with equity every few years is over. The days of no money down unconventional loans are over. Thank goodness!

The truth is that the reduced borrowing and increased spending is good for the country in the long run. We have been on one big 25-year economic speed trip. Now we are going through withdrawal to come clean. It is painful, but necessary. If permitted to sober up, the U.S. economy will be more fundamentally sound in a few years, but the days of families earning $75,000 per year driving $50,000 vehicles and living in $500,000 homes are over.

Current conditions have fixed income investors reaching for yield. They see opportunities where none may exist. Beware high yield bonds. Yes, they have had quite a run, but now may be the time to sell before reality sets in rather than buy. I have also seen investors buy low-coupon preferreds at discounts thinking that they will reap a windfall WHEN they are called at $25. Here is a tip. An issuer needs to save between 75 and 100 basis points to make a par call economically feasible. This means that preferreds with coupons below 7.00% have a great chance of being traded by my grandchildren. Investors buying GSprB or ATT at yields dipping below 6.00% are borderline stupid.

Enjoy tomorrow's earnings releases. GS and C report.

It's Not That Bad - It;s Not That Good.

Don't read too much in to the poorer-than-expected 30-year auction today. Yesterday's 10-year note auction was a blow out. This week's auctions were re-openings of existing treasuries. Both trade at premiums (30-year over 107). This precludes some institutions from purchasing. Next month we have truly new treasuries. That will be a better gauge of interest. Even with the large premium investors bot $12 billion 30-years at 4.00% versus an expected 3.99%. 4.00% does not indicate a desertion of long-dated treasuries by any means.


Why am I not enamored with the recovery? It comes down to jobs, wages and spending. During the past 20 years, spending in the U.S. grew far more than did wages. This was due to easy access to ever cheaper leverage. Those days are gone. at least for now. They never should have arrived in the first place. Without consumer spending, job growth will be tepid. Without job growth, wage growth will be lackluster and spending will suffer. The U.S. economy has improved and will continue to do so, but going forward the economy will look more like the 1950s than the 1990s or 2000s.

In and Out and In and Out

I will be posting here sporadically during the next month. I have school work to which I must attend. I should be back in full force by mid November. In the mean time, pay close attention to the words of Stiglitz, Laffer and E-Erian

Stocks, Bonds and Automobiles.

This was a rough week for economic optimists and stock market cheerleaders. The stock market took its biggest beating in months. Long-dated treasuries reached their lowest yields in months. Auto sales dropped sharply in September without the benefit of "Cash for Clunkers." Let's discuss.

GM reported a sales decline of 45% and Chrysler a drop of 42%. The government and it's UAW supporters have their work cut out. Both companies are losing markets share and are directionless in terms of product. GM, Chrysler and Ford need annual U.S. market auto sales of approximately 15mm to 16mm. The current sales pace is just over 9mm. With traditional lending standards back in use (one actually has to prove their ability to make payments) it is unlikely that auto sales will reach necessary levels, even when the economy rebounds. How critical is it for the Detroit Three to sell to subprime borrowers? Prior to its bankruptcy filing, GM's management asked the government to assist GMAC in lending to subprime borrowers. GM and Chrysler are done in their current forms and as long as they have to depend on UAW labor.

Speaking of recovery, nearly every economic indicator is pointing to another moderation as inventory replacement peters out. Lenders report that foreclosures continue to be problematic and credit card defaults and delinquencies continue to rise. Asset-backed experts continue to warn of significant, permanent impairments to loans, especially those issued from 2005 onward.

The financial media continues to report that, in spite of encouraging economic signs, companies are reluctant to hire (actually, they continue to shed jobs). Either these journalists are trying to help jawbone the economy and especially) the markets higher or the are clueless as to how the economy works. It is the consumer which drives business, not the other way around.

The financial markets are telling a divergent story. The equity markets are (or were) indicating that the economy was poised to make a sharp, V-shaped recovery. The reason given is so lame. "It has to recover sharply because of the government stimulus" is not a valid argument when one considers why the economy fell into the deepest recession since the great depression. There is no leveraging our way out of this. The stock market is wrong. However, it was wrong when it sunk to its cyclical low in March.

The equity market may be considered the market of hope and fear, but one could argue that the bond market is the market of reality. This is not to say it has never been wrong in its ability to predict the economic future, but it is less influenced by wild springs generate by speculative greed and fear. The treasury market in particular is an institutional market with much foreign central bank involvement. Until the U.S. economy exhibits structural and not credit-driven or inventory replacement growth will foreign central banks reduce their purchases of U.S. treasuries.

The fear that foreign central banks will abandon the dollars are unfounded, at least for now. Remember, foreign exporters to the U.S. are paid in dollars and not their home currencies. They have a vested interest in keeping their exchanges rates versus the U.S. dollar favorable. One way to do that is to buy U.S. treasuries. This as the added benefit of helping to keep U.S. consumer interest rates low making it even more affordable for U.S. consumes to spend. This is not to say that long-term rates will never rise. It is not a far fetched scenario to see the 10-year treasury note approaching 4.50% or 5.00% in 2011, but that could be the cyclical high. I think we see the 10-year hit 2.75% before we see it hit 3.75%.

Investors and consumers had better change their outlook. We will be back to the days when buying a television required looking at the family budget and buying a new car was the talk of the neighborhood. In may opinion, this is not a bad thing, unless you work for the UAW and the Detroit Three.