Friday, December 19, 2008

A New Bubble

Our economy does not seem to be able to get out of the habit of lurching from one bubble to the next. This, "nothing succeeds like excess," approach makes life difficult in the transitions. We had Technology, Real Estate and now US Government bonds are entering bubblelonia. When a bond fund such as the iShares ETF which tracks the long term bond market moves upward 30% in five weeks, it gets my attention.

How long will investors or even sovereign nations be willing to accept 30 year yields of 2 1/2%? I suspect not very long. Putting money in a mattress is not a long term global strategy if one assumes commerce has a future.

The TIPS market (Treasury Inflation Protected Securities) is discounting five years of deflation. Tax-Free, pre-refunded municipal bonds backed by the US Government are paying returns higher than treasury bonds and without tax. The spread (interest rates over treasuries) on corporate bonds is 3.5 times the average of the past forty years and at the highest levels since the depression.

A little perspective is in order. During the Great Depression, when the United States gross domestic product fell 25%, the default rate on investment grade bonds was 4%. Currently the corporate bond market is discounting (allowing for) a 30% default rate.

The Fed's move to quantitative easing and purchase of debt across the quality spectrum eventually, I believe, will move into corporate debt to unclog the credit markets.

I do not presume to know when this bubble will burst. The government's need to raise $1.5 to $2 trillion in 2009 makes one expect that long dated treasury rates will continue to be under pressure....until they are not. The whisper numbers for fourth quarter GDP are around a negative 6%, so upward pressure on interest rates is not yet in sight.

It seems that fear of yet another shoe to drop is keeping flight to safety the watch word in both equity and fixed income markets. I would put myself in that camp as well. My concerns include disturbingly bad reports to come from financial companies as they incur more balance sheet impairment due to lower values on debt assets on the books. Later in the quarter I expect additional pressure on hedge funds as they open redemptions again and need to raise cash (ala Madoff) and find illiquid asset valuations, previously undisclosed, revealed in the cash raising exercise.

There is, I believe, value to be found in extremes in both bond and stock markets presently, but we should move very carefully since the tide is still going out, and we don't yet know who might still be standing naked, unrevealed, in the water.

John Barnyak

Slowly Slowly Catch a Monkey

I admit it, listening to the constant drone of certainty that THIS is the bottom from the media one is tempted to dream. There is an instinctual need to declare an all clear and move to more pleasant times. I THINK we MIGHT be near something approximating a buying opportunity but looking at the market action I just don't see it yet. It feels like short covering rallies followed by lack of buying interest.

The fundamental discomfort with the economy and the serious deflationary data prevents more than a tepid backdrop for buying into equities, or for that matter into automobiles, houses, plasma televisions or just about anything that requires credit or a job.

We've not seen a serious positive move over the 50 day moving average on the Dow since April Fool's Day and for all the drama of the past ninety days, the broad indices are where they were in early October. Irrationality and fear remains firmly in place and dictates caution but long term valuation provides some hopeful optimism.

The market is technically somewhat over bought and I would like to see another test of lows in an oversold condition to put a toe into the market or conversely a reasonable and understandable move above the 50 day moving average.

This weeks immediate positive reaction to the Fed move to our own zero interest rate policy (ZIRP) had me scratching my head. Since much of the demise of the markets has been led by the banks, I was puzzled how structuring interest rates in a way that is negative for banks (a flat yield curve) was cause for euphoria. Fed action created two signals for me. First the usual profitability of a, "borrow short, lend long" policy of banks has become highly compressed. Second, interest rates of essentially zero aren't a very ringing endorsement of the economy's strength.

We're looking across the valley to the next economic cycle, but the reasons to invest are all of the, "it can't get worse" variety. The clues will be in the bond market and will tell us when its safer to come out of the bunker.

John Barnyak

Tuesday, December 16, 2008

The Answer is the Problem

In discussions years ago when oil prices "seemed" high, I recall the first time I heard the statement that the "answer to high oil prices is high oil prices." This glib commodity traders' view of the world is the corollary of what we are now seeing, and I would say the answer to low prices will be low prices.

Eventually lower priced assets will attract new capital. The equity market is priced to provide better long term returns than we have seen in many years. Commodities are retracing to levels that have taken much of the speculative fervor out of the price. Distressed debt is priced at levels that predict armagedon in corporations. US Government debt is priced to provide zero profit in return for the security of principal. Tax Free Municipal bonds that are pre-refunded and backed by US government guarantee are yielding significantly more than taxable debt. Such inefficiencies borne of panic are the stuff that market bottoms are made of.

Most fundamentally important is not that production is altered but that behaviour is adapted. Life is a dynamic, not static endeavor whether in governance or economics. In my corporate experience, every meeting to discuss future strategy contained countless graphs and charts and they generally showed continutity, embracing the idea that the same conditions that got us to the moment were the new paradigm. Always a wrong conclusion.

As we watch dramatic policy adaptations unfurl and the markets' pricing process, the volatile but boring market of the past two months gives hope that the worst of this bear market is behind.

John Barnyak

Friday, December 12, 2008

Veal Market Ahead

I wouldn't go so far as to call this a bull market except by a purists' definition, but I am hopeful we are within reach of reasonable opportunity for long term gains.

As I have written before, aggregate corporate earnings cannot grow at a rate above that of GDP ad infinitum. There are tangential arguments with this view concerning private companies and their growth, but in a macro view, trees simply do not grow to heaven.

I have been working to test the waters with some reason and looked back to a prior moment to establish a benchmark for growth. I have used the post 1987 meltdown as that base. Taking a economic growth rate about 6% over the 125 years the market is now about fairly valued on a normalized growth rate. If Goldman Sachs new S&P earnings estimate for 2009 of $53 is right there is still the possibility of downdrafts, but investors can begin legging into positions now.

The market response to the automotive bailout refusal by the senate indicates a degree of selling exhaustion and discounting of negative news.

It's not a bull market, but could be a baby bovine.

John Barnyak

Slowly Turning the Ship of State (of mind)

This morning we awoke to the news that the U.S. Senate had rejected the automotive industry's pleas for a rescue package. It is difficult to imagine a more definitive and negative headline that is yet to come than "General Motors Files for Bankruptcy." Afterall, what is good for General Bullmoose is good for the USA. I think such a headline must come and should come.

Clearly the failure of the TARP package to banks has colored the attitude of enough senators that carte blanche is not in the cards this time. Who can blame them? The money provided to financial institutions as a quick fix has certainly shored up their balance sheets but as of yet done nothing to goose economic activity. Banks are not lending. Per Federal Reserve data on September 10th, banks held $2 Billion in reserves excess to requirements, essentially nothing. Two months later, November 19th data shows they have $600 Billion in excess reserves. In other words not much is moving. At least one of the two basic conditions of lending is missing apparently.

Banks must feel strong enough to lend, and they must feel their customers are strong enough to pay back the loan. Earlier this week fully one half of the issued debt of U.S. corporations is rated lower than investment grade, junk. It would seem that confidence to let much of that $600 Billion stroll out the door assured that it, plus interest, will come back is lacking still.

I have until this year been in the camp of those who felt money supply was the font of all inflation. Clearly that is only half of the picture and is the combination of money supply AND credit. Currently as money supply soars courtesy of the Fed, destruction of credit is happening even faster. Until credit flows once again we are in a net deflationary environment. The question is for investors, for how long and what do we do in the meantime.

The nation has little option now but to provide, in the public sector, fiscal stimulus. But in a note of optimism, not my generally view, if we as a nation can embrace the idea that it is not a government imposed action, but a public, national call to action we will prevail. The United States has had a history of rising to its greatest challenges. This will be one of them.

A few months ago my son said to me, "its not often I can say I've seen you be too optimistic about the market. This time you weren't pessimistic enough." Ouch! But like the ship of state, I think it is time to begin slowly turning the state of mind.
It won't be easy and the strategies slightly different but we should be looking at beginning to buy into moments of fear.

John Barnyak

Wednesday, December 10, 2008

It's No Wonder We Feel Sick

It's not the size of the wave, its the motion of the ocean? In this market we have both.

From 1945 through 2007 there were 49 days when the S&P 500 moved 4% or more, less than once a year on average.

Thus far in 2008, a year not yet finished, we have seen 28 days of more than 4% moves either up or down!

Is it any wonder investors have gone fetal?

John Barnyak

Why I Used Charts

Years ago, I was more of a technical trader. "Don't tell me what you think, tell me what you see!" The following make me wonder why I ever started to listen....

Political “Experts”

“The Federal government will not bail out lenders — because that would only make a recurrence of the problem more likely. And it is not the government’s job to bail out speculators, or those who made the decision to buy a home they knew they could never afford.” (George W. Bush, Sept 2007)

“These institutions [Fannie and Freddie] are fundamentally sound and strong. There is no reason for the kind of [stock market] reaction we’re getting.” (Christopher Dodd, Chair, Senate Banking Committee, Financial Post, July 12, 2008)

“Misery sells newspapers. Thank God the economy is not as bad as you read in the newspaper every day.” (Phil Gramm 7/10/08)

“I do think I do not want the same kind of focus on safety and soundness that we have in OCC [Office of the Comptroller of the Currency] and OTS [Office of Thrift Supervision]. I want to roll the dice a little bit more in this situation towards subsidized housing.” (Barney Frank regarding Fannie & Freddie, 2005)

“I believe there has been more alarm raised about potential unsafety and unsoundness than, in fact, exists.” (Barney Frank regarding Fannie & Freddie, 2007)

Financial “Experts”

“Improvements in lending practices driven by information technology have enabled lenders to reach out to households with previously unrecognized borrowing capacities.” (Alan Greenspan, October 2004)

“There is a chance that housing prices could fall, but its effect on the economy will be limited.” (Alan Greenspan, 2005)

“The use of a growing array of derivatives and the related application of more-sophisticated approaches to measuring and managing risk are key factors underpinning the greater resilience of our largest financial institutions …. Derivatives have permitted the unbundling of financial risks.” (Alan Greenspan, May 2005)

“I suspect that we are coming to the end of the housing downturn, as applications for new mortgages, the most important series, have flattened out…I think that the worst of this may well be over.” (Alan Greenspan, October 1, 2006)

“The market impact of the U.S. subprime mortgage fallout is largely contained and that the global economy is as strong as it has been in decades.” (Henry Paulson, January 2007)

“All the signs I look at show the housing market is at or near the bottom. The U.S. economy is very healthy and robust.” (Henry Paulson, 4/20/07)

“I’m not interested in bailing out investors, lenders and speculators.” (Henry Paulson, 3/2/08)

“At this juncture, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained.” (Ben Bernanke during Congressional Testimony 3/2007)

“We will follow developments in the subprime market closely. However, fundamental factors—including solid growth in incomes and relatively low mortgage rates—should ultimately support the demand for housing, and at this point, the troubles in the subprime sector seem unlikely to seriously spill over to the broader economy or the financial system.” (Ben Bernanke, 6/5/07)

“It is not the responsibility of the Federal Reserve—nor would it be appropriate—to protect lenders and investors from the consequences of their financial decisions.” (Ben Bernanke, 10/15/07)

“Changes in financial markets, including those that are the subject of your conference, have improved the efficiency of financial intermediation and improved our confidence in the ability of markets to absorb stress. In financial systems around the world, the capital positions of banks have improved and capital markets are becoming deeper and playing a larger role in financial intermediation. Financial innovation has improved the capacity to measure and manage risk. Risk is spread more broadly across countries and institutions.” (Timothy Geithner, May 15, 2007)

Investment “Experts”

“The worst is over.” (Warren Buffett, on Bloomberg TV, May 3, 2008)

“Sometimes, we drink the kool-aid.”(Moody’s internal email)

“It could be structured by cows and we would rate it.” (S&P internal email)

“Let’s hope we are all wealthy and retired by the time this house of cards falters.” (S&P internal memo)

“Chairman Bernanke has succeeded; the economy has been positioned on a sustainable track for manageable expansion: A Goldilocks scenario that is neither too hot nor too cold.”(MikeThomson, Financial Post, April 25, 2007)

“And I believe there will be NO FALLOUT whatsoever beyond the funds, despite the innate desire by so many people to rumor and panic the marketplace.” (Jim Cramer regarding Bear Stearns, 6/22/07)

“I am indeed sticking my neck out right here, right now… declaring emphatically that I believe the market will not revisit the panicked lows it hit on July 15, and I think anyone out there who’s waiting for that low to be breached is in for a big disappointment and [they’re] missing a great deal of upside. My bottom call isn’t gutsy. I think it’s just a smart call that all the evidence points toward. Bye, bye bear market. Say hello to the bull and don’t let the door hit you on the way out.” (Jim Cramer, August 4, 2008 – market is down 28% since then)

“The stock market is cheap on a price-earnings basis, profits are fabulous, both here and abroad, stocks are a lovely place to be. I have no idea what the S&P will be ten days from now, but I am confident it will be a lot higher ten years from now, and for most Americans, that’s what we need to think about. The subprime and private equity and hedge fund dogs may bark, but the stock market caravan moves on.” (Ben Stein, August 13, 2007 – market down 40% since then)

“The losses in the stock market since the highs of October 2007 are about 14 percent. This predicts — very roughly — a fall in corporate profits of roughly 14 percent. Yet there has never been a decline of quite that size for even one year in the postwar United States, and never more than two years of declining profits before they regained their previous peak.” (Ben Stein, January 27, 2008)

Corporate “Experts”

“We finished the year positioned better than ever to capitalize on the array of opportunities still emerging around the world as a result of what we believe are fundamental and long-term changes in how the global economy and capital markets are developing.” (Stanley O’Neal, former CEO of Merrill Lynch, January 2007)

“We deliberately raised more capital than we lost last year … we believe that will allow us to not have to go back to the equity market in the foreseeable future.” (John Thain, another former CEO of Merrill Lynch, April 8, 2008)

“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” (Charles Prince, former CEO of Citigroup, July 2007)

But as I do reflect on it, and I do a lot, that nobody saw this coming. S&P and Moody’s didn’t see it coming, but they simply just downgrade bonds, they don’t take hits. Bear Stearns certainly didn’t see it coming. Merrill Lynch didn’t see it coming. Nobody saw this coming. (Angelo Mozilo, former CEO of Countrywide Financial, July 2007 after he sold $138 million of stock)

I’m confident our company is in the right businesses for the long term and that our strategy of being in high growth businesses and markets, our laser focus on customer service, our expense discipline, and our commitment to strong credit risk management, will create value for our shareholders in the future. (KenThompson, former CEO of Wachovia, October 2007

John Barnyak
Stonehouse Asset Management

The Big Blunder

One of the smartest guys in the room is David Swensen who runs the Yale endowment and wrote a brilliant book on portfolio management some time ago. The greatest mistake I've made in this past year has been to not heed one of his dictums, or worse half of one of them.

"Bonds exhibit the most extreme misalignment of interests, as most debt issuers benefit by reducing the value of debt obligations, resulting in direct conflict between the goals of borrowers and lenders....

...Investors frequently own more fixed income than necessary to protect against hostile financial environments, leading to behaviour that undermines the fundamental purpose of holding bonds. Confronted with a larger than ideal allocation to fixed income, investment managers often seek to enhance returns by accepting credit, option, and currency risk. Although under normal circumstances, risky bonds might generate superior returns, investors face likely disappointment in times of financial stress."

Mr. Swenson pretty well nailed it in his book published in 2000. I knew that reaching for yield could end in tears and I chose to put clients into a bond fund that has long been among the best multi sector bond investors. I trusted the value of the management of the fixed income portion of porfolios at a time when market stress erupted. The credit debacle decimated the value of the Loomis Bond Fund as every variety of bond other then US Treasury issues plummeted.

The value of struggling to gain the incremental gains in yield in fixed income has been a lesson to many. There are no free lunches.

John Barnyak
Stonehouse Asset Management

Better in the Mattress!

Yesterday the world gave a collective vote to its view of the economy. Blah! The United States Treasury had its regular auction to borrow money. We've got lots to pay for and feed the recent largesse so borrow we must. Could it have gone better?!!? We should all be so lucky.

The Three Month T-Bill went to a negative yield. "Investors" actually paid the U.S. Government to take their money. That -0.005% yield is the the lowest since the auctions began in 1929. They actually paid more than they will get back!

It doesn't get more cautious than handing over money JUST to get it back.

If you believe that the massive global fiscal stimulus and monetary easing will fail and deflation will prevail, such such caution is warranted. It won't and irrationality is the place where long term thinking is best used.

Think ahead.

John Barnyak

Don't Blink

As of yesterday, we are in a bull market! Before you start throwing shoes, plates anything not nailed down, consider the definition of a bull market. A twenty percent rise, preceded by a twenty percent decline is by definition a bull market. All hail the bull. Over the past 408 trading days, this is the first moment when equity markets have risen twenty percent or more. From 10/9/2007 until 11/20/2008 we have been in a bear market. Yes it IS all a bit of bull but an instructive one nonetheless.

Consider what the market is telling us. Some of the relentless downward pressure seems to have abated. Either long term buyers are beginning to emerge or short traders are beginning to cover their positions and beginning to go to neutral if not bullish postures. Do not be certain that we have passed the bottom of this market though.

During the popping of the dot com bubble, there was a thirty percent rally ending a six month bear market on 9/21/2001. Over the next year, that thirty percent rally was followed by another thirty percent loss to a lower low; which was followed by another twenty percent gain, followed by another twenty percent retracement…..followed by yet another twenty-six percent upswing……and another eighteen percent drop. All of this was within the period from 3/3/2002 to 3/9/2003, twelve months of gut wrenching volatility. Each move would have been a full year’s result in a trending market.

But the process of bottoming is not a trending market. Market bottoms do not occur with an all-clear siren wailing. Rather they emerge, after months or even years of testing and retesting. Unfortunately such volatile swings are the domain of nimble traders, not investors. But the time to panic is past and the time to strategize is now. Investors should be returning to long term strategic allocations. Add to equities slowly aware that the end of this terrible market will be a process, not an event.

John Barnyak