Last Week in Review

Last week in every market segment was down including energy, materials and utilities. Overall, it was a tough week with the S&P500 down 3.1%, Nasdaq fell 2% and the Dow Jones Industrial declined 3.8%. Year-to-date the S&P500 is now down 9.3%. Small caps continue to outperform large (less negative) and growth is trouncing value investing. Market jitters continue and the bears are winning.
Oil troubles continue with prices rising to new highs. Increasing energy prices have stoked inflation fears. The numbers of speculators in the commodity markets is growing rapidly only adding to the feeding frenzy. In addition, escalating tensions between Israel and Iran is adding instability to an already rocky oil market. The scuttlebutt is that Israel will bomb Iran with assistance from the U.S. in the next six months. Oil prices will soar to over $200 a barrel if Iran is attacked. Baring an attack, the energy markets look very frothy and should retrench from these lofty levels.
Problems in the financial sector persist. Banks have only written off one-third of their bad investments and the housing market is rapidly disintegrating. These problems will not be fixed overnight. Until the housing market begins to recover the economy and markets will stay in turmoil.
Inflationary forces continue in the developed and developing world is reaching the choking point. Many economists feel inflation is not that bad because it has not spread to workers. Rising unemployment is keeping wages down. So in economist-speak inflation is not so bad.
In the real world the problem is that the collapsing housing market in conjunction with rising food, energy and healthcare costs have taken the consumer out of the market. I know I write this all the time but two thirds of our Gross Domestic Product (GDP) is generated by consumer spending. Consumers aren’t spending (look at the recent performance of retailers and automobile manufacturers). Consumer lead recessions (vs. business lead recessions) are always deeper and take longer to recover. It takes more time to build up consumer sentiment and get consumers spending again. This is not going to be an easy and quick V-shaped recovery. It will probably resemble a very wobbly wide W-shape.
The Fed is talking hard ball and many of its members want to raise the Fed Funds Rate when they meet. It will be difficult for them to raise rates any time soon because it would bring this fragile economy to a screeching halt. Instead, they will have to keep rates where they are and if things get worse they may have to lower rates again.
In the short run, the market will remain choppy with equities swinging significantly down on bad news and moderately up on good news.
I will be in Chicago this week at the Morningstar Conference. I hope to meet with numerous portfolio managers of mutual funds. I will be reporting back my findings and interviews.

Last Week in Review

Concerns over energy prices, weakening consumer confidence, a mixed inflation report and some increased activity in the merger-and-acquisition calendar caused U.S. stocks to experienced mixed performance for the week. The S&P500 Index was basically flat, falling one point to 1,360. After last week, the index was down just over 6.5% for the year. Large value stocks are the worst performing for the week and the year, down 7.8% year-to-date. Small and Mid Cap stocks are still out performing Large Caps.

Data last week pointed to continued weakness in consumer confidence, which acted as a drag on stock market performance. Historically, extremely low levels of consumer confidence have often presage market rallies. In fact, in the 12 months following the 10 lowest readings of consumer confidence over the last 30 years, stocks were up an average of 20%.

The big news last week was inflation. The CPI (Consumer Price Index) for May posted its largest monthly increase since last November, primarily due to energy prices. Core CPI inflation (which excludes energy and food prices) remained low. I do not believe that inflation is low even if you exclude food and energy. The government’s method of calculating inflation is flawed. It manipulates the calculation, substitute’s goods and then under estimates the price of improved goods. Inflation is a political hot potato and the incentive is to keep it low. The government has to increase social security benefits by the rte of inflation so low inflation equates to low benefit payout increases. Broad-based inflation in the U.S. is picking up and if our inflation is the same as most of the developed world then our inflation rate is around 7% which would mean we really are in a recession.

This leaves the Federal Reserve between a rock and a hard place. Deteriorating economic growth combined with the credit market issues has forced the Fed to keep dropping interest rates. On the other hand, the Fed is feeling pressure to increase rates due to rising inflation, the weak U.S. dollar and high oil prices. At this point, the Fed is talking tough (saying they plan to raise interest rates and that the dollar should strengthen) which is helping to bolster the equity markets. However, the Fed is unlikely to raise interest rates any time soon, given ongoing credit market problems. In fact it is entirely probable that the Fed may have to lower interest rates despite their hawkish rhetoric. The near term will continue to be bumpy in the equity and credit markets. The deteriorating economic climate here and abroad coupled with the worsening energy crisis will cause the markets to struggle for the next few months.

Commodities: Short Term Bubble

In January 2007 oil was $60 a barrel and this morning it is approximately $137 a barrel. It is a mind boggling rise in prices that has hurt consumers and attracted significant media attention.

Speculators are widely blamed for this rise. See the attached graph by JPMorgan which shows the marked increase in speculators participation. Speculators are partially to blame for this run up but there are sound fundamental reasons for this rise. There is more demand for oil (think emerging countries like China) and a tight supply. The third impetuous is rising political risks in the Middle East. It is very likely the U.S. and/or Israel will bomb Iran before Pres. Bush leaves office. This will destabilize the supply of oil causing the price to escalate further.

Goldman Sachs sees crude rising to $141 a barrel and possibly $200 a barrel in 2009. As with all bubbles it is hard to see where and when we will reach the top and how far and swiftly we will fall when it bursts. The bubble will burst as demand begins to wane (as growth in China continues to slow and demand in the developed country contineus to drop) and supplies stabilize. Speculators will leave the market like rats off a sinking ship. This might not happen for at least a year but it will happen. I do think long term that a 3% allocation to commodity futures is a good diversifying investment if you are using futures and the DJ AIG Commodity Index. The road will be pretty bumpy and beware of any erosion in the oil futures market.

Last Week in Review

The U.S. stock market fell sharply last week. The market consistently fell during the week with only positive trading day mid week. The bulk of the decline occurred on Friday due to new unemployment data for May and another dramatic rise in oil prices.
For the week the S&P 500 declined 2.8% and is down 6.5% year-to-date. Mid and Small Cap stocks held up better than the Large Caps last week and for the year. A trend not predicted by most market prognosticators, including myself.

Last Friday’s unemployment report showed greater weakness in the labor market than expected in May. The drop was significant, with payrolls declined by 49,000 and unemployment surged to 5.5%. Some economists postulate that this spike in unemployment may be a one-month aberration; however the labor market clearly has been weakening in 2008.

The negative side of the economic story is clear, with headlines focusing on housing and higher commodity prices. The primary main story rolling forward is going to be inflation, and its impact on consumers, interest rates and the markets. Inflation and tightening credit have restrained consumption in recent months and are likely to remain headwinds for some time to come.

Last Week in Review

Last week was brutal. The market traded down in front of the three day Memorial Day weekend. It is not unusual for the market to decline in front of a long holiday weekend. Many investment banks and market makers do not want to sit on a large inventory of stocks over a long weekend. What is unusual is the magnitude of that fall. The S&P 500 fell 3.5% over last week and has fallen 5.5% year-to-date. The pain was evenly spread between growth and value but Large Cap domestic stocks have fallen more than Small caps for the week and the year. No one is more surprised by these results then me. I truly thought that Small Caps would take it on the chin this year and Large Caps with their international exposure would outperform.

All major sectors of the market were negative last week and year-to-date only energy and materials sector are positive. It is not a surprise that financials are the hardest hit sector. The chart below is a pictorial summary of last weeks market action and was produced by JPMorgan.

Manage Your Credit Card Debt Away

Every once in a while you find a great website that is truly helpful and not gimmicky. I ran across one such website the other day. It was created by the cooperative efforts of Utah State University Extension and WebAIM.org. The website primarily helps consumers gain control of their consumer debt. It has a great calculator that lets you enter your specific debt information for each obligation. The site then calculates how long, at that rate, it will take you to pay it off and how much it will cost you in interest. You can also see the impact of making additional monthly payments to each credit card or loan.

It will also help you establish an Emergency Fund plan so you are prepared if you lose your job or the unexpected happens. It also has a calculator that helps you determine how much debt you must pay off to qualify for a mortgage.

There is also a section that helps individuals develop a spending plan. It helps you allocate your take home pay and makes suggestions for different expense categories (i.e. food usually comprises 18% to 25% of your income).

The Educational Center has dozens of helpful how to articles on topics as diverse as selecting a credit card to how to protect your self from insurance fraud. These are pithy articles just chocked full of good tips.

You will need to setup a profile with username and password to start exploring this site but it is totally worth it.

Please pass this site on to anyone who has is having trouble managing their debts. It is also a great site for educating teenagers or kids about money. I always wonder how many kids would run up credit card debt if they knew how much it costs. There is a great article offering helpful suggestions for parents on managing allowances.

Powerpay

The Fed at Work: A Play-by-Play Commentary

Relying on both conventional and unconventional means, the Federal Reserve (Fed) has been attempting to break the credit crisis’ stranglehold on the economy. It has been extraordinary to watch the Fed take actions that have not been used since the Great Depression, and a few actions that have never been used.
The Fed needs to be aggressive because the current liquidity crunch in the credit and mortgage markets is creating a negative feedback loop between the financial markets and the U.S. economy. The strain in the credit markets is putting pressure on the broader economy, leading to further weakness in the housing market, which then creates further dislocations in the credit markets, etc., etc., etc. Additional aggressive policy action by the Fed will be essential to break this self actuating spiral.
Since September the Fed has slashed its overnight lending target to 2.25% from 5.25%. It has also injected $200 billion into the credit markets by opening the Fed’s borrowing window to non-banks (such as investment banks), and has loosened collateral standards for these short term loans and now accepts lower rated asset-backed securities. In other words, an institution can pledge riskier bonds as collateral and receive Treasuries from the Fed. The Treasuries can easily be sold to generate the cash needed by the firm to meet its obligations. These loans are short term and will have to be paid back but in the mean time liquidity has been improved which will prop the credit markets up and keep the asset-backed bonds and lower credit quality bonds from falling further.
The Federal Reserve has now committed approximately half of the Fed’s portfolio to the fight and has pledged to commit more if necessary. Essentially, the Fed is using its own balance sheet as a tool to inject funds into the market right where it needs it the most. It is this type of creative aggressive action that is requisite if the Fed hopes to break the negative spiral between the economy and the credit markets.
The Fed also stepped in to ensure that Bear Stearns did not go under. Bear Stearns found itself in trouble because Wall Street began to question whether the investment bank had the necessary capital to back all its trades and bets. The firm was the highest levered investment bank (least assets to greatest debt) on the Street by a significant amount. Bear Stearns was not a very popular investment bank with its compatriots due to its aggressive brass-knuckle tactics. The combination of its bad rap and the high leverage ultimately set the stage for its demise. The firm began to go under as investors pulled their money on rumors of illiquidity and lenders called their loans and refused to extend additional credit. It was a classic run on a bank, the kind we saw Jimmy Stewart stave off in “It’s a Wonderful Life.” It was the old one-two punch. I feel no sympathy for the executives at Bear Stearns. If you swim with sharks, you do business with sharks, you act like a shark, then you are a shark and may be attacked, killed and eaten by other sharks.
The Fed stepped in and helped negotiate the purchase of Bear Stearn’s by JPMorgan for $1.2 billion in stock. In addition, JPMorgan will also absorb any losses on the first billion dollars of $30 billion of Bear’s riskiest assets. Those assets will be managed independently by BlackRock. The Federal Reserve Bank of New York is guaranteeing the remaining $29 billion, and in return, will reap any gains from that portfolio.
Why bail out Bear Stearns? After years of never allowing any of our financial institutions to fail, these banks have become so interwoven and enormous that nobody can be allowed to sink beneath the waves. Otherwise, a tsunami would swamp the hedge funds, banks and other brokerage firms that remain afloat. If Bear Stearns failed, for example, it would result in a wholesale dumping of mortgage securities and other assets onto a market that is frozen and where buyers are in hiding. This fire sale would force surviving institutions carrying the same types of securities on their books to mark down their positions, generating more margin calls and creating more failures, further hurting the economy and the housing market (the spiral). This bailout is less about saving Bear Stearns and more about shoring up the financial markets, housing markets and the economy.
On the flip side, this deal does not pass the sniff test. Why hasn’t there been another bidder? I find it difficult to believe that no one else was interested. It couldn’t have been that unstable because if the situation were so precarious, why wouldn’t shareholder ownership position be completely wiped out. Instead, a week later the bid is raised from $2 to $10 a share (a $1 billion increase in value). Is JPMorgan manipulating the situation to protect its $91.7 trillion dollar derivative exposure (per Office of Comptroller of the Currency September 2007 reported data) which is backed by only $123 billion of equity? How much of this counter party exposure did JPMorgan have with Bear Stearns? I can only surmise that JPMorgan made a sweet heart deal with the Fed and other governmental agencies. The deal would require JPMorgan to commit whatever resources would be necessary to prop up and acquire Bear Stearns. In return the Fed would not allow other suitors to bid up the price and they would not disclose JPMorgan’s full exposure to Bear Stearns. In essence, the Fed propped up both JPMorgan and Bear Stearns. One bank ate another and won. The game goes on.
The government has also reduced capital holding requirements for Fannie Mae and Freddie Mac from 30% to 20%. This frees up more money that Freddie Mae and Freddie Mac can use to purchase mortgages, thereby shoring up the mortgage-backed securities market. This increase in funds will help add liquidity and hopefully begin to break the gridlock that is crippling the credit markets. The regulatory body that oversees Fannie Mae and Freddie Mac has said they would lower the capital requirement even more if needed.
Congress has begun to do its part to break the spiral. As part of an economic stimulus package enacted last month, the cap on standard mortgages was temporarily increased from $417,000 to $729,750 in high-cost markets through the end of the year. Standard mortgages usually have lower interest rates than jumbos because they can be purchased or guaranteed by Fannie Mae or Freddie Mac. This is a great idea and could have made lower cost mortgages available in some of the most hard-pressed expensive housing markets. Unfortunately, this has just created an intermediate tier to the mortgage market. These tweener-loans are less expensive then the jumbo mortgages but the interest rates are not as low as a standard mortgage under $417,000. The loan originators are pricing the loans to reflect the additional risk they are taking with these tweener-loans because Freddie Man and Fannie Mae could decide to not purchase or guarantee them. So this part of the stimulus plan has been a bust.
Despite the efforts of the Fed, credit markets are not functioning properly. Sizable losses on subprime loans have lowered the capital base of many financial institutions. The situation is exacerbated by a financial system that has, over a period of years, become intertwined in a spaghetti-like fashion through the spread of complex financial products (CDOs, CLOs, CDSs, and the like). This complexity makes it difficult to clearly understand what assets may be at risk, how big those risks may be, and also who is at risk. This uncertainty has led financial institutions to retrench, which in turn makes credit (loans) more expensive and less available—even while the Fed tries to make credit less expensive and more available. If there are any more major disruptions in the credit, the Fed will have a very difficult time restoring equilibrium. According to Bill Gross at Pimco, what Washington really needs to do is get off its “high moral-hazard horse and move(s) to support housing prices… Authorities must act quickly, with a shot of adrenalin straight to the heart of the problem: housing prices…The decline needs to be stopped quickly in order to avert additional crises.”