Friday, May 29, 2009

Mortgage Chaos

The government is buying Fannie Mae and Freddie Mac debt to force down yields and stabilize home prices. Could it reach still lower? 3.50%? Perhaps. But if it does it will likely be of extremely short duration as suddenly every mortgage in America will benefit from refinancing. If you haven't done your homework you will likely miss it. So do your homework, be prudent and conservative. If you plan in remaining in your home for more than a few years, this could be a windfall moment when you look back.

That was my view on April 10th and I am sticking with it. Particularly since it turned out to be right. Less than 1/10% from the bottom, I think we won't be seeing those rates again in our lifetimes. C'est la vie.

Unless the fed begins to increase purchase of mortgage backed securities massively that ship has sailed. Mortgage originators have frozen all new applications until they work through the backlog of committed but not closed loans on their books. Below is a letter being sent out by one mortgage originator.

John Barnyak

Mixed Messages

Today the Wall Street Journal reported the fed believes (how's that for second derivative thinking) that the rising interest rates are a function of improvement of the economy. I'm all for that if it's true.

However the falling dollar and rising gold prices indicate fewer "green shoots" and more a reluctance to own dollars, lend to the US at such low returns and a belief that inflation is lurking out there. The green shoot and wilting dollar aren't mutually exclusive, but prompt caution.

John Barnyak

Thursday, May 28, 2009

Gold in a Deflationary Environment

One of the more interesting developments on the web is Scribd. A means to publish online documents, even books. The paper below is one I've had in my files for years and dust off now for your perusal.

The Behaviour of Gold Under Deflation

John Barnyak

Gazing at Charts

Anyone involved in the investment industry knows that technical analysts are the pariahs of the business. My son who in ten days will take his first Chartered Financial Analyst exam already scoffs that technical analysis cannot predict the market future. Jeremy, well duh!

What charts do is describe, in a distilled fashion, the market response to all of the fundamental aspects of the economy. It does not predict, it shows. When in the midst of a maelstrom of information, opinion and pontification stepping back and looking at what a market is doing as it absorbs the information is invaluable.

We have had nearly three months of revisionist aftercasting as the pundits fall over themselves to celebrate "green shoots" and second derivative improvements. I am not privy to the machiavellian cabals of Wall Street and the White House. Interpreting the data which is at best statistically meaningless and at worst massaged ceaselessly for policy reasons is no better than a guess. (click on image to enlarge)

What I see in the S&P 500 market is a bear market doing a cowboy death kick. Not pretty, not quick but inevitable. It isn't unlike the high school horror film where the psychopathic killer is vanquished, everyone hugs and cries in relief, and then the camera pans to the spot where he died. The body is gone. He's still out there!

The recent bounce was powerful and feel good, but when we zoom out it is evident that all trends are not repaired. The market is above the 50 day moving average which was my initial buy indicator in early march, but like any wounded animal, this is when it when it is most dangerous. As this rebound has matured, the volume has dried up and it looks like late comers to the party.

The market short term cycle ebb and flow still shows lower highs and lower lows. Until I see a higher high and high low I will be cautious. In March the oversold chart combined with reasonable market valuations. In May we are now at an overbought condition and no longer attractive value. We went from an A/B market grade (oversold, reasonable value) to now a D/C market (overbought/neutral value). I do not expect to see significant valuation improvement but absent a market breakdown I will be taking a more positive equity position in portfolios on the next oversold condition.

I am hedging modestly to hold recent gains, and formulating the thematic guidelines of the next secular market forces. Following my daily thoughts will give a reader a good idea of those themes.

John Barnyak

Wednesday, May 27, 2009

Woodshed Time For Treasuries

Wow, in a benign world credit demand pushes interest rates up. This is not a benign world and it looks like lenders to the USA are voting with their feet.
The mortgage refinance market just had the knife put in. It's doubtful THAT will be driving the drivel of second quarter bank reports.

In the past we've seen both stocks and bonds in a bull market. I looks like that linkage may remain but in less favorable fashion. Investors will need to think more broadly to protect and grow capital.

The ten year treasury rate just hit 3.70%. Borrowers tied to variable rates could conceivably be seeing interest costs up nearly 70% since the first of the year. As commercial real estate loans begin to come due to roll over this can't be good. IF credit is available it is likely to be at onerous rates and inflict severe pain on all but the most credit worthy.

John Barnyak

Half Full, Half Empty or totally Full of it?

Yesterday CNBC shrieked all day "Markets Surging!" when the Dow rose 198 Points. Today the Dow retreated 173 points. Silence.

Bond Tsunami

Worms turn. They don't spin, but they do turn. Something seismic is happening in the bond market and while the world focuses on the equity rebound, bonds are collapsing. Having said that I have become very cautious short term on selling bonds in a hurry. But longer term, this goose is cooked.

The change in the 20+yr US Treasure ETF has had parabolic moves in the past nine months. With the time honored premise that trees don't grow to heaven have things gotten ahead of themselves? While I am a believer still that inflation is ahead of us in a few years the short bond trade is looking crowded.

When it hit the fan last November the Long Bond ETF (TLT) went from 93 to 123 in a month as the market went completely risk averse. Now, TLT is back to 93 as market participants have become less risk averse as well as concerned for the US debt policy.

The short Thirty Year ETF (TBT)is up over 5% in the past month and the Rydex inverse Long Government Bond Fund is up nearly 10%.

Whereas a month ago I was commenting on the Ten Year yield bumping up against 3.00% in my April 29th post, "Dog off the Leash" TNX broke through the yield is now decisively above 3.50%.

The spread between 2 year treasuries and 30 treasuries has never been greater. In normal times this would be a call to profit for the banks as they do what banks do, borrow short and lend long and make money on the difference. But this spread is telling us more.

The recent treasury auctions show foreign central banks buying the two year note, but as one goes further out there is very little interest. The world is giving a mighty thumbs down to the US long term fiscal and monetary policy.

Pay attention, its getting way too interesting.

Next posting - Treasury Inflation Protected Securities

John Barnyak

Tuesday, May 26, 2009

We only owe to ourselves

The monetization of private debt by the Fed is reaching epic proportions. But as someone said to me recently, we only owe it to ourselves. Indeed. Last week one of the candidates for Japanese prime minister announced, if he is elected he will not buy anymore US$ denominated debt. The Chinese continue to calmly extricate themselves quietly from the US tar baby by buying hard assets and productive manufacturing capacity worldwide and by reaching swap arrangements with Asian trading partners to have debt denominated in remembi. Quite possibly we only owe to ourselves because we are the last suckers left.

Since we only owe it to ourselves, just exactly how do we pay it back? By raising taxes? By devaluing the debt via inflation? By simply canceling it? Ironically growing out of it, which seems to be the current whistling past the graveyard approach, will be much harder as more and more assets focus on debt service and not productive economic activity.

(click to enlarge)

John Barnyak

We're here because we're here

Back in the early 1980's one saturday morning in London I stood in the underground waiting for a train. Up drew a rather time worn carriage, when all others were newer and frankly looked safer. In any event, it stopped, I got on and quickly discovered why it was looking a little long in the tooth. This was one of the saturday football fan cars. The Transport Authority fully expected them to be beaten up, pissed in, graffitied and left for dead when the fans got to Wembley Stadium and I worried the same fate might be mine. Lovely bunch of fans they are. I was in it amidst the relentless singing of the Yobs (backward boys) "we're here because we're here because we're here" to the tune of Auld Lang Syne.

Blame it on whoever you wish, but the chart below seems to be singing the yobo song. We are here because we're here, and it shouldn't come as a great surprise. The whole country acted like a bunch of drunken louts, in suits and with credit.

I expect we may be riding the beat up cars for a while until we've paid for not only for some new ones, but for some beaten up junkers still unpaid.

John Barnyak

Case Shiller Quarterly88

The Case-Shiller house data were released to today. Not a lot of green shoots to be seen. As mentioned previously, investors (the entire country) really need to recalibrate their realities. It isn't easy when one's total experience does not prepare one for the current situation.

It is said to be bright is to learn from one's mistakes, to be genius is to learn from the mistakes of others. How many geniuses are among us since only history can teach us about this economic event. We haven't made these mistakes before.

In the first quarter, annual national housing prices fell 19.1%), quarterly (-7.5%) and monthly (-2.2%) data continue to show prices reverting back towards levels not seen for years.

One of the truths revealed in housing collapse is that a house is not an investment, it is a consumption expense. If one is fortunate enough to have no mortgage and not on the edge of downsizing, trading one abode for another is neither pain nor gain. However in a debt burdened nation of mortgages, the debt on a value of declining value is a huge problem.

It is not always easy to have perspective, particularly in housing. Housing is a cost/price that has generally only gone up in our life times. Unlike most people I have the benefit of living in a house that is more than two hundred years old. In researching the deed and changes in ownership over those years I have seen this very house decline dramatically in price twice in its history. Now perhaps a third time. It doesn't take a genius to see history repeats.

John Barnyak

Friday, May 22, 2009

Firmly Fixed on the Past

Investing is a pursuit fraught with emotion. Euphoria, despair, hope and fear all play a role and much of that is the result of not where we are, but where have been. Unfortunately that is largely irrelevant but the comfort of familiarity has a strong draw.

At my son's graduation last weekend I had a "discussion" of some investment precepts with an extended family member. (why do I let myself go that way!) This individual holds General Motors Bonds and was fixated on the fact that the bond has continued to pay its 6.75% coupon. The fact that the price has fallen from $100 to $5 seemed incidental. Thank god she didn't understand that the current yield is 121% or she'd have bought more. Her rational for buying and then holding the investment eludes me but the sun was shining and it was a beautiful day.

Likewise the investor who has the "$20" stock worth $5 now. "I don't want to sell it at a loss, but I'm out at $20 so I'll break even." WTF? Happily watching it lose 75% of its value, when (if pigs fly) the company finally turns itself around, the stars realign and business is growing THEN you sell it. That piece of paper that says "100 shares" on it has absolutely no memory of the day you bought it. Doesn't know, doesn't care. Get over it.

Lets look at some other stocks that seem to have gotten amnesia even if the holder is still dreaming of what was and must yet come again. (Click on the image to expand)




and the mother of all hope-springs-eternal investors.....JDS Uniphase

Investors holding on to financial and housing stocks should emotionally move on. You can't reblow a bubble and you miss the opportunities elsewhere trying.

John Barnyak

Thursday, May 21, 2009

Headline - (small print)

U.S. initial jobless claims fall in latest week

(continuing unemployment claims reach highest level since records have been kept.)

Widen Your Perspectives

As we flail around in the midst of the most troubled US economy in more than seventy years the focal point of most investors is the stock market. Fed by the likes of CNBC, and hourly updates on the Dow Industrial Average and our equity heavy brokerage statements the stock market is everything. If it goes up things are better. Right? Maybe not, as I watch the US debt burgeon to solve problems created by high risk in the financial backbone of the economy my mind wandered to the Weimar Republic.

In the face of global deflation pressure, the German republic created money at a pace never before seen. As in Weimar Germany, money creation in the U.S. is now being undertaken by a privately-owned central bank, the Federal Reserve; and it is largely being done to settle speculative bets on the books of private banks, without producing anything of value to the economy.

The $12.9 billion in bailout funds funneled through AIG to pay Goldman Sachs for its highly speculative credit default swaps is just one egregious example.To the extent that the money generated by “quantitative easing” is being sucked into the black hole of paying off these speculative derivative bets, we could indeed be on the Weimar road. We have been led to believe that we must prop up a zombie Wall Street banking behemoth because without it we would have no credit system.

Insofar as the word Credit comes from the Latin word for trust, I would suggest that the bailout does the precise opposite of create trust. The lack of credit offered by the banking system seem to verify that we have created money, not credo.

During the money creation of the Weimar republic, the stock market soared. Hundreds and thousands of percent gains showed up in portfolios. But obviously inflation made the gains irrelevant and less.

I am not positing that the U.S. is about to enter into hyperinflation. It is a "Black Swan Event." That is, an unpredictable outcome unexpected by historical knowledge.

In January two Morgan Stanley economist first uttered the word in a report.Could it happen to Europe or the US? Morgan Stanley says possibly yes, under certain conditions.

Firstly, the rapid expansion of the monetary base by the Fed, ECB and BoE would have to continue and feed into a more rapid and sustained expansion of money in the hands of the general public. This we currently do not see

Secondly, Morgan Stanley says governments would have to face difficulties financing their bailout packages and funding their debt. Given the actions of treasury auctions which seem to find bids primarily from the Federal Reserve this would be a yes.

Lastly, public confidence in the government’s ability to service debt without resorting to the printing press would have to disappear, as well as the government’s actual ability to withstand the pressure to do so in the first place. This would seem to me to be the tipping point. If analysis inside the government were to come to the same conclusion, it would be no wonder the "green shoots of recovery" would be trumpeted from the ramparts. Two months ago I noted that the positive spin began as if someone had turned the feel good spigot on.

And while all of the above is an extreme scenario, the Morgan Stanley analysts say:

"…given the size of the current and prospective economic and financial problems, and given the size of the monetary and fiscal stimulus that central banks and governments are throwing at these problems, investors would be well advised not to ignore this tail risk, especially as markets are priced for the opposite outcome of lasting deflation in the next several years. Put differently, we believe that buying some insurance against the black swan event of high inflation or even hyperinflation makes sense and is relatively cheap "

Don't just watch the market, watch your wealth.

John Barnyak

Tea Leave Follow Up

Today we woke to a very interesting bit of news. Now it was the headline that initial jobless claims declined (yawn). It was that S&P was about to lower the rating on UK sovereign debt. Could the US be next? In keeping with this theme and my commentary yesterday the only green on my screen is, short dollar, gold, commodities and short treasury bonds. The macro environment is changing investors must as well.

With the UK Credit outlook lowered to negative from stable looking at the commensurate data for the U.S. is in order.

The premise for the change: debt/GDP will soon pass 100%. In that case the US should be afraid with some estimates for the comparable ratio in the United States at over 370%.

S&P's statment:

The negative outlook reflects Standard & Poor's view that, in light of the challenges to strengthen the tax base and contain public expenditures, the U.K. government debt burden could approach 100% of GDP by 2013 and remain near that level thereafter. The rating could be lowered if we conclude that, following the election, the next government's fiscal consolidation plans are unlikely to put the U.K. debt burden on a secure downward trajectory over the medium term. Conversely, the outlook could be revised back to stable if comprehensive measures are implemented to place the public finances on a sustainable footing, or if fiscal outturns are more benign than we currently anticipate.

First Japan, now the U.K., the pattern is pretty obvious.

John Barnyak

Wednesday, May 20, 2009

Housing Green Shoots, er, Shots?

Now that we're all sick to death of hearing about "green shoots" of economic recovery I think the truth is actually out. It was Green Shots! Not economic recovery, Lime Jello Shots. I have no other explanation for finding the excitement of recovery in this chart of US housing starts. Sucking down wiggly vodka can be the only reason to find glee here.

Don't worry, a month from now, you'll know you really didn't miss a thing

John Barnyak

Listen to the Market

Although the stock market has had an extraordinary rebound, what are the thematic tendencies we see. The last two months have been an exercise in return to risk and practically anything has been a profitable buy, but some areas are the tea leaves of the future.

We have seen the strongest move in our gold holdings. In the past twenty trading days, the S&P 500 index has risen approximately 4.5% while our gold investments have risen approximately 25%.

Our commodity stock fund and emerging market holding have advanced in the area of 15% over the same period. The other sector above 10% growth has been developed international markets.

At first blush one could reach the conclusion that money is flowing out of the US equity markets on a relative basis. The treasury bond market has sold off modestly in the past month and our negative US dollar investment has been moderately higher. Deeper analysis agrees with the first impression.

On balance I believe the guidance of the market leads one to be more wary of US Dollar denominated assets. The strength of the US dollar has been substantial over the past year but principally because of its position as the continuing global reserve currency and more importantly by the fact that as bad as the US economy has been, other economies, in Europe in particular have been worse.

As global recovery takes place over the next years, the green shoots of globalization will benefit other less debt burdened economies and the US dollar decline, higher interest rates and higher inflation are on the other side of the current deflationary environment.

John Barnyak

Now Back to Regularly Scheduled Programming

Just how high can a dead cat bounce? That is the question most investment managers are asking. The historical strong bounce since the March 6th market low has so many attributes that make caution the theme of the hour.

On a per-share basis, first-quarter earnings on the index came in a tad over $10. With forecasters looking for $40 or a bit higher for the full year, which means the S&P 500 is selling for over 20 times 2009 earnings. That is by no means a bargain or near historical market lows in recessions. The market which was at a reasonable value in early March is no longer so.

Despite the appearance of improving credit conditions, lending is still not flowing. Consumer credit is shrinking rapidly. Commercial Real Estate continues to collapse. Today Saks attempted to raise capital to pay down existing debt. Morgan Stanley floated a bond proposal of approximately $190 Million secured by owned real estate. The market's response was to require 15%. That is hardly a ringing endorsement for loosening credit.

Historically, new bull markets do not begin with the leadership of the sectors which led the bear market down. This rally has been largely the result of a bounce of the trash equity that collapsed, particularly banks and financial firms. It would be unusual that a new bull market would find leadership from the likes of Bank of America and Citigroup such as we have thus far seen.

The rebound of the market has had extraordinary and unusual aspects brought about by the enormous influx of government liquidity and curious market manipulation through futures markets. It has the look of a heavy thumb on the scale. While I expected liquidity would lead the market to regain its footing, I certainly underestimated its extent and effect.

As market bottoms go this one is still quite young, particularly considering the uniquely bad condition of the economy. The dotcom market collapse took more than one year to settle down. We appear to be in about the ninth month of a must more serious credit collapse. I think it reasonable to expect this will take at least as long to stabilize. The press and governmental positive spin has been remarkable and I doubt sustainable without pause.

John Barnyak

Passing the Torch

I spent the past few days blissfully seeing my elder son graduate from college. Walking through the town with him as he moved from person to person, hugging so many friends we'd never met, hearing adulation from teachers and staff I had to keep reminding myself that this WAS the same person who lay on the couch unmoving for days it seemed. The same young man who told me he had joined the army and was to report for basic training in three days after he kept it a secret for months from us. The same son who made it back from Iraq safe and sound. No, this is not the same son I moved into a freshman dormitory. This is a calmer, more mature, self reliant young man. I look forward to getting to know him.

The challenges ahead will be many and different, but he has already faced many and Sunday afternoon was the proof that he could handle them. To paraphrase Yogi Berra, he came to a fork in the road and he took it.

Congratulations son,


Thursday, May 14, 2009

Elizabeth Warren and TARP

Elizabeth Warren overseer of TARP plan interview on Charlie Rose.

Make an offer he can't refuse

"I'd hoped that we could come here and reason together. And as a reasonable man I'm willing to do whatever is necessary to find a peaceful solution to this problem." Vito Corleone

This from Bloomberg today:

"The big news from Goldman and Massachusetts Attorney General Martha Coakley this week was a $60 million settlement, under which the investment bank resolved her office’s investigation into its packaging of mortgage securities backed by subprime home loans. Per the usual custom in such accords, Goldman didn’t admit any wrongdoing.

The odd part is that Coakley’s office didn’t accuse Goldman of any wrongdoing, either. It filed no lawsuit. And it made no allegations that Goldman had violated any statutes or rules."

It seems to me there are two possibilities here. Either the state of Massachusetts is shaking down Goldman in a protection money racket. Or the state of Massachusetts is taking hush money. The third, Goldman Sachs is just charitable didn't pass the sniff test.

John Barnyak

More Moral Hazard

All of us have heard the tale of woe from borrowers who find themselves underwater on loans that they probably shouldn't have qualified for in the first place. The rallying cry of libertarians is that they shouldn't have taken on obligations they couldn't handle. While there is truth to that its not that clear cut. Who among us has not said at some point, "well lets give it a shot and see what happens"? Sure its kool-aid, but that's why they make it taste so good.

Today we see a rather extreme example of the misplaced incentive to throw money down a hole. The Yellowstone Club is/was a playground of the ultrawealthy which came unraveled in the financial meltdown and is now in bankruptcy. In a very unusual ruling by the judge a secured loan made by Credit Suisse has been downgraded to true junk. The $375 million first lien loan has been put behind ALL other creditors, included unsecured.

The judges rationale is the utter haphazard lending practice and disregard for risk assessment. CS asked for NO financials or verifications. The judges ruling:

"The only plausible explanation for Credit Suisse's actions is that it was simply driven by the fees it was extracting from the loans it was selling, and letting the chips fall where they may. The only equitable remedy to compensate for Credit Suisse's overreaching and predatory lending practices in this instance is to subordinate Credit Suisse's first lien position to that of CrossHarbor's super-priority debtor-in-possession financing and to subordinate such lien to that of the allowed claims of unsecured creditors."

As long as they could slice and dice and sell the loan through securitization and pocket a nice $7.5 million fee go for it! The judge's ruling speaks volumes of the decreasing tolerance for such behaviour regardless of the contractual aspects. Could common sense be about to devour legal precedent?

John Barnyak

Wednesday, May 13, 2009

Tales of the Unexpected

With apologies to Roahl Dahl and his collections of short stories titled Tales of the Unexpected, I doubt some of recent financial surprises would have risen to the level of "unexpected", although maybe spooky. Today Bloomberg reported consumers' retail spending unexpectedly dropped in April, "indicating that rising unemployment is prompting consumers to conserve cash."

Another half million people lose their jobs and then, bless their souls, they spend less money. I suspect some out of work real estate writers, (charming fixer upper; cozy eat in kitchen) have been picked up by the financial press. Who wants to buy a bank handyman special? Nothing a lick of paint and some air freshener can't make right.

John Barnyak

Don't Be a Yield Hog

One of the things many investors, particularly older, income oriented ones do is look first at the yield of investments. It is natural to see 8% as better than 4% and count those chickens long before hatching. The piece of the puzzle not on the page is risk. All those synthetic Merrill Lynch preferred shares looked pretty good once. Even the Lehman Brothers money market funds paid a little more than the average. Today we have an extreme example of why 8% is not 4% and why sometimes less is more.

General Motors. I have a friend who accumulated GM bonds for retirement and despite my groans and cautionary nudges held them. Today those 9.4% bonds due in 2021 are paying (excuse me, calculating) 196% yield to maturity. I could eat caviar everyday of retirement on that! I can only wince at her decision.

You have to buy a lot of bonds at 8 cents on the dollar to get much beluga. Of course that 196% is completely illusory and that 8 cents will shortly be 0 cents. The same thing happened in the latter part of last year (though not so dramatically) when a scan of stocks paying dividends over 5% produced a slew of well know companies. Alcoa, Citigroup, PNC, all have cut dividends to reflect cash constraints and market realities. A lot of chickens have crossed the road in the past months and more than a few didn't make it across.

High yield is as much a yellow flag as a semi-annual check so choose carefully.

John Barnyak

Monday, May 11, 2009

Pundit Love

I admit, I've hated this historic rebound in the stock market. Historical events are never exactly predictable and they have a siren's call to join in at just about the wrong time. For better or worse Stonehouse portfolio discipline makes emotion driven action more difficult. A remarkable similarity is found in the in commentary in 2001 by that successful self promoter and motor mouth Jim Cramer and some of the statements of the past week.

A Bull Is Born

By James J. Cramer
Published Nov 19, 2001

Professionals hate this stock market. They think it's overvalued on earnings and going up solely because of the lack of other alternatives. They think it's a roller coaster poised atop a downhill drop, an accident waiting to happen. And they hate that there are no alternatives: Cash brings you next to no return and bonds seem downright dangerous given their skimpy return and monster run.

Individuals hate this stock market, too. They've had it with losses, they're fed up with bad advice from crummy mutual-fund managers, and they're tired of the blue-chip tech stocks they paid hundreds of dollars for that are now worth a fraction of that. Either they've sold everything and turned their back on the market or just decided it isn't worth throwing in good money after bad and started hoping to one day get back within a few dollars of where they got in.

Which is precisely why I think the market is poised to go higher -- perhaps dramatically so. Look how easily it's shrugging off bad news. Last week, after an American Airlines flight crashed in Queens, it barely blinked; traders paused to sell off the usual suspects -- travel and leisure -- and then kept buying. This market might well be a baby bull, conceived in the despair of September 11 and born on September 21, 2001, after the worst sell-off since the Great Depression.

The main reason is simple: Interest rates are lower than they've been in 40 years. And those lower interest rates that allow buyers to finance new cars for nothing,

But for the date, it would not be out of place in today's punditocracy.

May 11, 2009
Published in

Gray Emerson Cardiff of Sound Advice has been mulling a major market move for some time. He wrote in his most recent issue, published in April: "As noted in the March issue, we are approaching the cusp of a new SuperCycle,

So what happened to Mr. Cramer's bull? It flirted with the forty week moving average then expired, sending the S&P to a new low, 30% lower, a year later which eventually was tested and retested before proving to be the base from which a bull market could begin. (click on image to enlarge)

Plan your trade, and trade your plan.

John Barnyak

Green Shoots or Soylent Green

One of the all time film cult classics was the futuristic Soylent Green in which a world beset by overpopulation and food shortages depended on the government for nutritional supplement. Without giving away the ending, let is only be said that the government solved both issues in one policy. Who knows how many problems are being solved today with similar sweeping efficiency!

In early march there was a palpable acceleration of feel good data and market action. Two months later we've experienced the sharpest stock market rebound in history on the back of short covering of investments in the worst companies in the economy and Tim Geithner's loose change. The power of sentiment is great and it is important. But some perspective is helpful.

The point of the chart is to illustrate where we were and where we are. Bear market rallies are the most powerful rallies and like when we stop hitting our finger with a hammer, it feels so good.

The leading sector in the rally has been financials. That beleaguered collection of insolvent and powerful companies rode up higher on the fact that the hammering stopped. Given the trillions of loans, guarantees and bailout funds for short sellers it was a good bet the juice was no longer worth the squeeze. For example the short sale of Citigroup at 46 when it fell below its 200 day moving average looked pretty good at $1. The incremental added profit betting on the move to zero wouldn't add much to the game. At about $3/share, the technical analysis indicated a shift in risk to the upside.

What about the economic evidence to support an end to the recession. It remains in the realm of second derivatives. Less bad is the new good. The headline employment data looked good-ish. Here's the good news:

* 539,000 jobs were lost in total vs. 663,00 jobs last month.
* 110,00 construction jobs were lost vs. 126,000 last month.
* 149,000 manufacturing jobs were lost vs. 161,000 last month.
* 269,000 service providing jobs were lost vs. 358,000 last month.
* 47,000 retail trade jobs were lost vs. 48,000 last month.
* 122,000 professional and business services jobs were lost vs. 133,000 last month.
* 15,000 education and health services jobs were added vs. 8,000 added last month.
* 44,000 leisure and hospitality jobs were lost vs. 40,000 last month.
* 72,000 government jobs were added vs. 5,000 lost.

Don't misunderstand, things must get less bad before they are good, but several items give me pause.

The automotive plant closures haven't hit these data yet.

There are approximately 2 million college graduates about to hit the job market.

The Bureau of Labor Statistics has been particularly aggressive in downward revisions a month after initial release. Each month the revision has been greater job loss by between 30,000 and 100,000. So the green shoots are delicate indeed.

The statistical adjustments, which are statistically justifiable, still create obscurity. The Birth/Death adjustment calculates a projected gain or loss of jobs from failing businesses and new businesses. The BLS is assuming the net creation of 226,000 new jobs from new businesses in April.

The government creation of jobs was principally the hiring of census workers for the upcoming census, temporary workers.

I am keeping the vintage champagne corked and chilled still.

John Barnyak

Thursday, May 7, 2009

More Marcellus Analysis

For those following the local gas bonanza or bust, depending on your perspective below is an report from Toby Shute of Motley Fool put out this week.

By Toby Shute
updated 4:56 a.m. ET, Fri., May 1, 2009

Range Resources (NYSE: RRC) and Cabot Oil & Gas (NYSE: COG) may call Texas home, but don't let the zip codes fool you. These independent oil and gas shops have deep roots in Appalachia and are feeling right at home in the race to unlock the mighty Marcellus shale.

Range Resources' first operations in the area date back to the 1970s, when predecessor Lomak Petroleum got its start. Cabot, as a spinoff of the eponymous chemical company, goes back over 100 years, to the days when the firm drilled gas wells in order to produce carbon black. Now, what's old is new again, with horizontal drilling and multi-stage fracturing technology breathing new life into the birthplace of the American oil and gas industry.

In case you're still wondering why you should care about the Marcellus, check out these rate of return estimates by Range:

Flat NYMEX Price (per Million BTU) Rate of Return

$7 75%

$6 60%

$5 46%

$4 34%

$3.25 20%

Figures from Range Resources' April 8, 2009 Hart Energy presentation and 2008 Annual Report. Assumed reserves of three to four billion cubic feet equivalent per well, and $3 to $4 million cost per well.

Those are simply killer economics, so long as you've got the right acreage. Considering their quality positions in the play, plus the solid hedges that both firms have in place, Range and Cabot are the envy of many a gas producer today.

Both firms just reported first-quarter earnings this week, so let's see what kind of headway these E&Ps are making, despite the headwinds of low commodity prices. So long as we're looking under the hood, let's also check out the firms' cost structures to make sure they're built for this environment.

Home on the Range
Range, a very technically savvy shop, got an early jump on the Marcellus play, drilling its first well into the formation in 2004. The management addition of Mark Whitley in 2006 really set Range's various horizontal drilling programs in motion. Whitley helped Mitchell Energy (acquired by Devon Energy (NYSE: DVN) earlier this decade) unlock the Godfather of Shale: the Fort Worth Barnett. Range just announced what it believes to be the highest 30-day initial production rate for any Barnett well. Considering that the competition there includes Chesapeake Energy (NYSE: CHK), XTO Energy (NYSE: XTO), and EOG Resources (NYSE: EOG), Whitley is clearly some kind of shale whisperer.

Range exited 2008 with 30 million cubic feet equivalent of daily gas production (Mmcfe/d) from the Marcellus and is looking to roughly triple that rate in 2009. The firm has been punching holes into the Marcellus at a pretty rapid pace -- so much so that the regional infrastructure buildout is hardly keeping pace. Fortunately, Range has found MarkWest Energy Partners (NYSE: MWE) to help it add gas processing and pipeline infrastructure to support this busy program. Cryogenic plants, for example, will help Range to extract more high-valued natural gas liquids from its hydrocarbon stream.

For the first quarter, Range cranked out 416 Mmcfe/d in total, with 82% of that production attributable to natural gas. Price realizations after hedges, which cover 83% of gas production for the balance of the year, came in at $6.62 per thousand cubic feet equivalent (mcfe).

As for cost structure, Range provided, in convenient form, all of the metrics that we need to calculate this. Note that some people prefer to exclude interest or corporate overhead (G&A), but let's be inclusive today. Combine the direct operating expense and production tax figures provided, and you've got $1.15/mcfe. Layer on G&A and interest, and you're looking at $2.36/mcfe. After depletion (DD&A) charges, Range's all-in costs roll in at $4.61, allowing it to net right around two bucks per mcfe of production, pre-tax. Not too shabby!

Cabot crackles
With a foothold in each of the two hottest resource plays in the country right now -- the other being the Haynesville -- Cabot's riding pretty high these days. Despite the hype potential, I do find this firm to be pretty conservatively run. The fact that last year's capital raise was the first since 2001 really grabbed my attention. Excessive equity raises have really turned me off of some of Cabot's competitors.

As far as Marcellus development goes, Cabot is at a slightly earlier stage than Range. The firm's got four horizontal completions under its belt now, with the most recent setting a new high. Having identified the Marcellus as its "most economic program," and with new rigs ordered for the region, Cabot is definitely committed to pushing this play forward.

In the first quarter, Cabot's high-priced hedges helped it achieve significantly higher price realizations than Range, at $7.51/mcf for gas production alone. Liquids appear to bump the overall take to $7.76/mcfe. This higher price allowed Cabot to realize a fatter pre-tax margin than Range, despite what I calculate to be a 10% higher cost structure for the quarter.

Of course, these figures bounce around from quarter to quarter, so keep monitoring these cost trends and hedge positions going forward. While I'm a bit more comfortable with Range as an operator, both of these shale players appear positioned to deliver strong economic returns in a lousy environment for natural gas.

John Barnyak

Dickensian World

"It was the best of times, it was the worst of times." Such timeless words can find fertile soil in the investment world of today. The system will endure. Like it or not, the changes will be incremental, protect the whales and occasionally toss a sprat into the pan. The SEC filing suit against the managers of the Reserve Fund for misleading investors is not a bad thing, if you like your sacrificial lambs small. Reserve was the money market fund that broke the buck and brought the short term commercial paper market to a stand still.

Actually it was Lehman that was the big fish behind that debacle, but tant pis as the french would say. That whale has left the building.

As an advisor of client portfolio's I have to say, this extraordinary run up has been very schizophrenic. My gloating at moving (or trying to move) clients to raise beta on portfolios has turned slightly bitter as my cautious entries were obviously far too modest. (Beta is the sensitivity to the market. An S&P index fund has a beta of one, more aggressive holding have higher betas as they move with greater force than the broad market. Long term positive? Increase beta. Have a negative outlook, decrease portfolio beta)

Investors would do well to memorize cliche's. They come in handy when you need a good dope slap.
1. Don't fight the Fed. When out to dinner with a guy with a trillion dollar line of credit, let him buy. Don't argue, just enjoy. If you think he's gauche and ordering the wrong things, swallow and smile.

2. The market can remain irrational longer than you can remain solvent. Lord Keynes comment still rings true. If your trillion dollar buddy is slipping 100's into g-strings, let him. Starting a fight will only get you bounced out of the club. Wait until he passes out and then drive him home. Until then you use $1's, and smile.

3. Don't fight the tape One thousand years ago King Canute sat upon the strand in England and ordered the sea to stop rising and the waves to still. He had no luck either. Go with the flow there may be more powerful forces at work than can be seen.

The money flow and source of trading indicates two things still. First, the weakest stocks and companies have done the best recently. This would suggest a strong short covering rally. Second, online trade activity has increased much more than institutional activity. This leads me to believe that this bottom still has some work to do, but the definite bias is to the long side.

John Barnyak

Wednesday, May 6, 2009

Light at the end of .....

Ok, I confess, I don't get it. The Treasury finally offers its assessment of the very weak stress test for BAC and the light shines brightly. The hard hitting stress test assumes a worse case of 8.5% unemployment when we are already at 8.6 among other soft pitches down the middle of the plate and then guess what? Bank of America is fundamentally insolvent to the tune of $34 Billion and the stock goes up like a rocket.

I once used to sell metals and alloys to a manufacturing company in Wisconsin and recall a conversation one day with the purchasing agent. This fellow dabbled in commodity trading for himself and was focused like a laser on the silver market. The day in question he said to me, "John, it makes no sense. The silver market makes no sense. Something is going on. It's being manipulated." I being the wise and youthful know it all smirked. Not long afterwards the Hunt brothers were arrested, silver plummeted from $40/oz to single digits.

This time its different. You don't have to look hard but what the outcome will be, I can only guess, change my mind and guess again.

Goldman Sachs is incredible. No, not incredible, god-like. In trading, being right slightly more often than wrong is the stuff of legends. A trader is going to be wrong, a lot. But the concept of cutting losses and letting profits run is what separates good from gone. That being said, GS was right in predicting the market 87.5% of the time in the first quarter! They generated over $100 million in trading profit 34 trading days, was profitable 56 days and lost money on 8 days. The days they lost over $100mm? Zero.

The NYSE's Supplemental Liquidity Program is designed to promote aggressive quoting activity and liquidity to the market. In return the NYSE will pay providers a 15 cent rebate per 100 shares traded. Additionally, it is designed to lead to tighter spreads between the bid and ask price. One of the reasons given for GS profits is very wide spreads in a program for which they seem to be the sole beneficiary. GS is currently the dominant trader on the NYSE, trading about 6x the trades as principalof the nearest competitor, Credit Suisse.

Look at the US Fed and Treasury activity, trillions of dollars in guarantees, purchases and loans. This administration clearly has a rocket in its pocket and Goldman is the fuse. But I can't help but hear in the back of my head the saying, "when the Fed taps on the brakes, somebody goes through the windshield."

Tread very very carefully people.

John Barnyak

Savings Bonds Stop Paying

'I Bond' Payments Get Wiped Out - When Inflation Goes Negative, Investors in These Savings Products Suffer

Wall Street Journal, May 2, 2009

Rates on government securities, certificates of deposit and savings accounts all have plummeted in recent months. Now, yields on another safe haven -- Series I Savings Bonds, or I bonds -- are dropping to nothing.

Friday, the Treasury Department said these inflation-linked bonds that are purchased between May and October will earn 0% for their first six months, the first time rates have hit 0% since the bonds were issued in 1998. The announcement also affects current I-bond owners, whose interest rate drops to 0% the next time their rates reset.

Blame the financial crisis. Normally, yields on inflation-linked investments gradually rise as prices rise. But amid the sharp drop in consumer-price inflation last fall, returns on many inflation-linked products were hammered.

Rates on I bonds, whose maturities are all 30 years, have two parts: a fixed rate, now set by the Treasury at 0.10% for new issues and which lasts for the bond's life, and the inflation adjustment, which reflects the change in the Consumer Price Index over a six-month period. Since that inflation adjustment worked out to a negative 5.56% annualized rate for the September-to-March period, the fixed-rate portion of every I bond will be wiped out during its next six-month rate period. The Treasury announces the rates each May 1 and Nov. 1.

The silver lining is that rates can't fall below 0%, so I-bond holders won't lose their principal. What's more, "prices tend to go up in the first half of the year, so because of that, we'd definitely expect there to be a positive inflation component" the next time the rate resets, said Tom Adams, editor of

Over the long term, inflation-linked investments are still a good bet, experts say. "In the short term, inflation will be hard to detect because of the weak economy and lack of pricing power," says Greg McBride, senior financial analyst at "But over the longer term, the substantial debt issuance by the government and large ongoing deficits bode for higher inflation than what we've experienced in recent years."

Until rates pick up, the best option might be to "suck it up" while the bonds pay 0%, Mr. Adams says. I bonds typically lag behind returns on other investments, so its investors are coming off returns of 4.92%, while stock-market indexes fell around 40%, he says. Returns on Treasury Inflation-Protected Securities, by contrast, fell last year, but have started to inch higher as signs of inflation emerged in recent months.

For those thinking about cashing in I bonds after the one-year minimum holding period, be sure to find out what your bonds are earning now and when their rates will reset, says Mr. Adams. The Treasury has an online calculator at

Wipe Out (or Hanging 60 Billion)

Well it finally happened GM stockholders had the fork stuck in and the juice ran clear. Turkeys do that. Last night it was announced that GM will do a 100 to 1 reverse split. Own 100 shares? Now you're going to own 1 share.

"If the restructuring as currently contemplated occurs, there will be very substantial dilution to existing holders of GM common stock." I love a good understatement as found in the SEC filing.
Existing shareholders will have 1% of the company. The other 60 Billion new shares will be issued to pay off the debt of the U.S. Government, Bond holders and the United Auto Workers Union.

Whether this approach will be allowed to broach the banking system which is effectively insolvent remains to my mind the largest question facing the economy. The insolvency and question of toxic asset pricing could largely be answered with the conversion of debt to equity in the banks.

A leaked result of the bank stress test (which hasn't been particularly stressing) for Bank of America indicates a need for $34 billion in equity capital to be raised. I question whether the private sector will put up the $34 billion without restructuring and I am sure congress is not ready to foot the bill (dear God I hope not.) Expect some move toward ultimately diluting existing shareholder and removing debt similarly to GM. Otherwise the hole will devour the Fed and taxpayers with it.

John Barnyak

Tuesday, May 5, 2009

Public Pension Pinch

"The market has changed and has caught up with the rest of the world, but raising taxes is really the last thing we want to do," said Jon Rupert, business manger of the Highlands School District In Natrona Heights.

No Mr. Rupert, the tide went out as it does and you got caught naked. The Pennsylvania school districts, and therefore the taxpayers, are about to get their private parts burned. It is one thing to raise an eyebrow and tsk, tsk a private pension plan when the company clearly ran it into the ground, but a public pension plan has broader ramifications.

Ironically one of the worst things that could have happened to us was the unrelenting bullish attitude and market of the 1980's and 1990's. Mutual Fund Wholesalers and pushers drew lines that went up and to the right infinitely. Insurance salesmen made assumptive illustrations that used 12% and more as sales pitches. Brokers explained 10% average returns over the years and created financial plans that never faltered and left legacies for children and charities. And school districts failed to make pension contributions because the charts showed they were fully funded forever.

No one explained that those 10% average returns over many years included decades long periods of zero return.

Much like the corner we are painting ourselves into nationally, local taxing authorities have a problem that won't simply go away.

Pittsburgh Public Schools, the largest district in western pennsylvnia, has 2,700 teachers and full-time professionals. Chris Berdnik, chief financial officer and chief operations officer, estimates that contributions to the pension fund will rise from $10.08 million this year to $33.18 million in the 2012 school year. So sometime in the next three years between the city and state another $20 million a year needs to be found. Property tax relief? Right.

In 2002, after the state raised pension benefits for public school teachers by 25%, contributions from school districts in the state were $539,000, and the state contributed $662 million. Say what?! As school districts and board members jockeyed for no tax hike platforms, Rome smoldered. The high returns of pension plan assets allowed school districts to glibly take a pass on funding. We seem to be a country that does love to let infrastructure and deferred liabilities slide to the next administration or next generation.

Much like the stories one hears of elaborate ice fishing houses left too long on the lake, the school districts acted as if the 8 inches of financial ice beneath their feet would never melt. The districts and tax payers all over the states are about to find the water deep and cold. Expect active school district bond floats and taxes hikes to cover the debt service. Another reason to hope interest rates down, hoping public financing costs stay lower?

As the effects of poor planning slip into every corner, public and private, thinking as if it is business as usual will not cut it for investors. New challenges will provide new risks and opportunities.

John Barnyak

Tea Leaves and Crystal Balls

The market is in the midst of one of the more powerful up thrusts we've seen in many years. It should not be terribly surprising as we are in one of the worst collapses in even more years. What do we see inside the magic 8-ball?

1. Everyone in the investment world and economic world is delving deep into data and anecdotes for positive news. And with the idea that dropping a five pound sledge hammer on one's foot is so much better than an eight pound sledge, we agree. Feels great.

2. The stocks up the most are the stocks that were down the most. These were the most heavily shorted stocks in the world and the covering of short positions can make very powerful rebounds. If Citigroup was shorted near 45 when moving averages began to fall, buying to cover at 2 or 3 or even 4 is still a pretty good trade. With so much political uncertainly, take the money and run seems prudent.

3. Volume has been quite low. There is no indication that institutional money is doing more than edging in.

4. The internal technical issues are frankly strange. In a once in a lifetime decline that is hardly surprising but data going back seventy years is not so readily available as going back twenty. There is a lot of flying blind going on. The Supplementary Liquidity Providers (SLP) program of the New York Stock exchange has the appearance of making Goldman Sachs the spigot for the Fed. When it gets turned off and for how long is unknowable and makes this a follow the money market. The fundamental reasons for the market to rise or fall will be plugged in later.

5. The equity market is not the story here. Its the feel good part right now, but the real market is the credit markets. This is not Adam Smith's invisible hand. This is Timothy Geithner & Co's. dutch boy and the dike gambit. The question is how many fingers does the Fed have?

6. If you are looking back two years or ten you won't think straight. It is a new market. With perfect hindsight, what would you be doing in the 1930's?

As one can see from 1930 to 1940 the S&P Index began dramatically badly but created dramatic opportunity as well. The high of 1929 was not regained until 1946. To look backward and embrace the despair was very easy but not productive for anyone who had investment capital. There are similarities currently I believe.

Investors need to take a deep breath and look forward now. Take a breath, be patient, be prudent, be selective, be strategic, be positive.

As my sons begin their adult lives for the first time outside of the embrace of academia I hope they are not poisoned by the fear that is now so pervasive. They are looking forward and frankly don't care about 1990 or 2000 or 2007. That's ancient history now. The time for fear was two years ago. Now it is the time to make changes and move forward.

John Barnyak

First the Good News

Today a client brought us a bag of morel mushrooms. Now THAT is a client who knows how to negotiate fees. :)

John Barnyak

Monday, May 4, 2009

Comic Relief

Once again comedy provides the best synopsis of current conditions. The Onion has long had a tradition of cutting through the noise by bellowing it yet louder.

At the moment there seems to be almost total correlation amongst asset classes. In a "don't just sit there, buy something!" mood if you buy anything you buy everything. There seems to be no fundamental reason other than releveraging, and as I look at my screen I see bonds up, stocks up, gold up, real estate up, commodities up. It has the feel of a sugar high before a crash. I learned long ago, when it makes no sense, step back. The quantitative methodology of investments has come unglued. My only conclusion is that policy and a Black American Express card with Timothy Geithner's name on it trumps all else. As my wife used to say when the boys were particularly filthy and happy, "all fun ends in tears." I am getting a bad feeling about this market.

John Barnyak