Musing on the Markets : deleveraging

Beyond the Sound Bite: An Interview with David Rosenberg

Vinny Catalano, CFA — Wed, 07 Oct 2009 14:39:00 GMT

"Hope always seems to spring eternal in liquidity-driven financial markets. That is very much the case today in the aftermath of the biggest liquidity injection in modern history." So wrote Stephen Roach, Chairman, Morgan Stanley Asia in today's FT. And liquidity is where my interview with David Rosenberg, Chief Economist and Strategist with Gluskin Sheff & Associates (formerly chief north american economist with Merrill Lynch) begins. We go on to discuss the state of the global consumer and new frugality, the continuing process of deleveraging, the probabilities of top line growth, and asset valuations, among other timely topics.

The length of the interview is 14 minutes 55 seconds.

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Vinny Catalano, CFA, Global Investment Strategist with Blue Marble Research publishes the "Sectors and Styles Strategy Report" newsletter, which contains the market beating Model Growth Portfolio. To learn about subscribing as well as other benefits, click here.

Beyond the Sound Bite: An Interview with Michael Sheldon, CFA

Vinny Catalano, CFA — Sun, 16 Aug 2009 14:10:00 GMT

My interview with the Chief Market Strategist with the wealth management firm, RDM Financial Group, includes the prospects of a sub-par economic recovery due to rising US consumer savings, deleveraging, increased regulation, increased risk aversion, the structural advantages of emerging economies over developed economies, and the longer-term risk of deflation.

The length of the interview is 15 minutes 56 seconds.

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Beyond the Sound Bite: An Interview Dr. Neal Soss

Vinny Catalano, CFA — Thu, 02 Jul 2009 21:36:00 GMT

My interview with the Managing Director and Chief Economist with Credit Suisse (recorded Monday, June 29) includes the 2Q09 end to the US recession, expectations of a sub par recovery of 3 1/2%, a sustained level of relatively high unemployment, and a potential compositional shift in the US economy. The length of the interview is 16 minutes 58 seconds.

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Street Scan

Vinny Catalano, CFA — Tue, 10 Mar 2009 16:17:00 GMT

Billionaires are now Slumdog Millionaires because:

A. The credit markets remain frozen
B. The US economy is falling off the cliff
C. Corporate earnings are headed substantially lower (<$50 S&P 500 operating earnings)
D. The socialist programs of the Obama administration threaten capitalism as we know it
E. All of the above, and then some
***
from International Monetary Fund “Global Financial Stability Report (GFSR) Market Update”
January 28, 2009

“Until now banks have managed to obtain sufficient capital to offset existing writedowns, but that is mainly due to the massive public sector injections of capital in the fourth quarter. The worsening credit conditions affecting a broader range of markets have raised our estimate of the potential deterioration in U.S.-originated credit assets held by banks and others from $1.4 trillion in the October 2008 GFSR to $2.2 trillion. Much of this deterioration has occurred in the mark-to-market portion of our estimates (mostly securities)*, especially in corporate and commercial real estate securities, but degradation is also occurring in the loan books of banks, reflecting the weakening outlook for the economy.”
***
Aggregate assets in money market funds (institutional and retail): $4 trillion (approx.)
Total market capitalization of the S&P 500 as of March 9, 2009: $5.9 trillion
***
from Dave Rosenberg, North American Economist, Merrill Lynch
March 9, 2009

"Beige Book mentions nine positive areas
Even if we still do not see a bottom in sight just yet for the economy or the equity market, there are sectors that at least from a macro standpoint have a relatively firm underpinning even in the midst of this unbelievably severe recession and bear market phase. We have said it once and we will say it again, the Fed's Beige Book offers up the most timely and detailed information on sectors. The most recent report that was issued last week contained positive mentions on these nine areas of the economy:
􀂄 Food production
􀂄 Pharmaceuticals
􀂄 Apparel retailing
􀂄 IT services
􀂄 Biotech
􀂄 Aircraft manufacturing
􀂄 Fast food restaurants
􀂄 Discount stores
􀂄 Environmental services

Positives outperformed the market by 800 basis points
While these sectors, on average, were down 8% between the most recent Beige Book and the one that preceded it in early January, they collectively outperformed the market by 800 basis points.

21 negative sectors mentioned
At the same time, there were 21 sectors that received negative mentions in last week's Beige Book. They are listed below:
􀂄 Travel/tourism
􀂄 Education services
􀂄 Luxury goods (jewelry)
􀂄 Agri-business
􀂄 Banks
􀂄 Homebuilding
􀂄 Electronic equipment
􀂄 Computers
􀂄 Motor vehicles
􀂄 Staffing services
􀂄 Commercial real estate
􀂄 Rails/Trucking
􀂄 Furniture/Appliances
􀂄 Health care services (elective)
􀂄 Oil drilling
􀂄 Metals and mining
􀂄 Wood products
􀂄 Media services
􀂄 Petrochemicals
􀂄 Construction equipment
􀂄 Semiconductors

So, for every positive mention, there were more than two negatives. The S&P 500 sector equivalents, on average, declined 26% between the last two Beige Books, and underperformed as a group by 1,000 basis points."
***
email sent last night to "Kudlow Report" producer Donna Vislocky in response to Larry’s plea for bullish commentators:

“On tonight's program, Larry said his producers were having a hard time booking those who were bullish. Well, here I am.

As someone who is now 100% invested, I am at the opposite end of when I last appeared on your program in early 2007 when I was highly cautious. Today, however, the picture is swung completely to the other side of the pendulum.

Here are a few bullish reasons that I am more than willing to debate a bear:

1 - Investor psychology is so thick you could cut it with a knife. Too bearish now, just like they were too bullish two years ago.
2 - A mountain of cash sits in money market funds - nearly $4 trillion. The stock market value for the S&P 500 stands today at $5.9 trillion.
3 - Valuation levels in many areas are very attractive and any upside earnings surprise would drive stocks higher.
4 - Technical analysis has recently begun to generate some positive divergences - downward momentum pressures have diminished, divergences (emerging markets, for example) have, uh, emerged.

Moreover, as someone who has criticized mark-to-market since March of last year, I am in complete alignment with one of tonight's guests, Steve Forbes.”

*emphasis added

Beyond the Sound Bite: An Interview with Joe Battipaglia

Vinny Catalano, CFA — Wed, 18 Feb 2009 06:59:00 GMT

In my second conversation with the Market Strategist/Private Client Group for Stifel Nicholas and Chief Investment Officer with Washington Crossing Advisors we discussed his deep and long recession call, the consequences to earnings, the inefficiencies of government spending, and the lack of a central theme to the Obama stimulus plan.

The length of the interview is 15 minutes 35 seconds.

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TARP Version 1 Revisited: Mark-to-Market Back in the Crosshairs

Vinny Catalano, CFA — Thu, 29 Jan 2009 00:38:00 GMT

“Senior Wall Street executives said yesterday that they had been sounded out on plans for an “aggregator bank” that would purchase toxic assets from banks. Under one of the plans discussed, toxic assets would be valued by an independent third party. Where assets are purchased at prices below their book values, the government might then inject common equity into the banks to make up for capital wiped out by the sales.”
Financial Times, January 28, 2009

On the surface, mixed signals are emanating out of the US Treasury department. Last week, Treasury Secretary Geithner stated that he was comfortable with mark-to-market accounting. Today, we learn of the above quoted plan, which is a direct assault on mark-to-market – the real villain in turning a recession into potentially a depression. What gives?

To refresh your memory, mark-to-market accounting is rooted in the failed ideology of the efficient market hypothesis, which (in its “strong” form) says that when it comes to determining the fair value of an asset the market knows best. This dogma is so entrenched in the thinking of mainstream economists and many naïve investors that even Nobel Laureates such as Paul Krugman ascribe to this fantasy of the “wisdom of the market” (see "More on the bad bank"). Moreover, there is little doubt on these pages that the primary reason why TARP Version 1 went from “price discovery” (code for attacking mark-to-market) to bank capital infusions was due to the intimidation of then Treasury Paulsen by mainstream, non behavioral finance economists.

Investment Strategy Implications

Conspiracy theorist alert: Clever guy this Mr. Geithner. Publicly advocate for free market principles (mark-to-market) while working behind the scenes to exploit it (through the aggregator bank and price discovery (courtesy the "independent third party")).

The significance of keeping mark-to-market intact is the extraordinarily positive impact it will have on bank earnings as assets held at 20 cents on the dollar are written up ("say what?" you say) thereby producing large earnings gains. Moreover, by stabilizing the valuations of “toxic assets”, write ups will thereby alleviate banks’ capital requirements, which is the primary reason why bankers are reluctant to lend. Under the bizarro logic of mark-to-market, they need the cash to remain solvent – hence no lending.

Once mark-to-market is replaced by something like mark-to-maturity (suggested by Bernanke during early days of TARP Version 1), then, miraculously, liquidity will begin to flow through the banking system to the real economy. Sounds too simple? Allow me to refresh your memory on another non real economy factor that wrecked a large amount of unnecessary havoc on the global economy – commodity speculation and the price of oil.

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Helicopter Hank

Vinny Catalano, CFA — Thu, 15 Jan 2009 00:30:00 GMT

“It is like if you are in an airplane and the oxygen mask comes down,” said Stefanie Kimball, (Independent Bank’s) chief lending officer. “First thing you do is put your own mask on, stabilize yourself.”

"In Michigan, Bank Lends Little of Its Bailout Funds"
NY Times, January 14, 2009

The above quote and article captures the essence of the TARP money dump by Helicopter Hank in 2008. This is, no doubt, a large part of the dynamic that has investors worried, but not in the way that may seem apparent.

Under Obama and the Democrats, TARP funds will be allocated in a striking different manner. And this fact justifiably has many investors concerned that a significant increase in bank failures will be a part of the economic landscape this year: something that the accompanying chart from the Economist strongly suggests. Moreover, with no political dynamic at work this year, it is hard envision any scenario in which the second wave of TARP money would find its way to undeserving banks and with such poor transparency and regard for the terms under which such money is made available. As a result, investors should expect that banks with shaky balance sheets are headed for the operational dustbin. And with them, the economic consequences of the deleveraging process will continue unabated.

Investment Strategy Implications

Were it not for the fact that the stock market is deeply oversold, this morning’s 10 to 1 down ratio (both the advance/decline and advance/decline volume) might lead some to conclude that a return to the really bad old days of last year (with 5% + down days, rising VIX levels, banking crisis du jour, and more pain to follow) is underway rather than a second selling climax based on fears well known, defined, and, yes, manageable.

On the assumption that the plethora of money already doled out and what’s in the monetary and fiscal pipeline (including the Fed’s acquisition of selected “toxic assets” and the prospects for bank “write ups”) will have the desired effect of injecting into the US economic body enough juice to trigger the badly needed multiplier effect on corporations and households beginning in the second half of the year, a cautiously optimistic view of equities does seem warranted - at least for the next several months.

Helicopter Hank did what he did and in a manner that only he fully appreciates*. In short order, his actions will be perceived as they should be – a prelude to the real work of restoring the US and global economy to a more balanced era of growth and stability.

*A more conspiratorial mind might suspect there was a political dimension to his largess as 2008 was a presidential and congressional year. Providing “walking around money” to banks who did not qualify under the agreement that healthy banks should receive TARP funds does make one wonder just what was Helicopter Hank thinking?

The Not-So-Smart Smart Money

Vinny Catalano, CFA — Wed, 26 Nov 2008 01:40:00 GMT

It should be fairly evident by now that heavy redemptions at hedge funds over the past two months contributed significantly to the recent pounding in the one area where markets are liquid – stocks. Moreover, the deleveraging process continues to impact many hedgies as available capital (for leveraged strategies) has dried up*.

Accordingly and in anticipation of continuing redemption demands (many of which remain unsatisfied due to gating), many hedge funds have sold more than has been requested thus far. Lastly, there is some talk that private equity commitments of institutional investors are also forcing redemptions in their hedge fund holdings.

Investment Strategy Implications

With the market cap of the S&P 500 sitting at $7.4 trillion and money funds (institutional and retail) amounting to more that $3.3 trillion, the momentum nature of hedge funds and their high cash positions would only need a less bad environment (see Barton Biggs’ comments in yesterday’s Financial Times) to trigger a stampede back into equities.

With valuation currently at deep recession (bordering on depression/deflation) levels, any earnings surprises into 2009 (as in something north of $70) would be the justification for buying what was just sold.

*One wonders what has transpired behind closed doors between financial institutions and government re lending to the masters of the universe.

Krugman and El-Erian in the Valley of FUD

Vinny Catalano, CFA — Wed, 19 Nov 2008 12:43:00 GMT

In his excellent book, “When Markets Collide”, PIMCO chief Mohammed El-Erian writes about the journey and the destination that the global economy and markets are undergoing and puts in context and helps clarifies much of the current economic and financial chaos. In it, Mr. El-Erian describes a world that will be but is clear to note that the process of getting there may be “bumpy”.

Nobel laureate Paul Krugman points to the same concept in his blog posting yesterday (“After the Stimulus”) in which he lists the components of the US economy for 2007 and their averages from 1979 to 2007. As the accompanying table from his blog shows, the economic mix of the US economy got to be quite imbalanced primarily due to credit inspired high consumption levels by the US consumer. In the process, net exports became the counterbalancing force*.

As El-Erian declares in his book, a transformational world (economic and financial) is inevitable and has been underway for some time (long before the current credit and now economic crisis). And Krugman states, “Consumption probably isn’t going back to a 2007 share of GDP — savings are back. So what will fill the gap, once the stimulus is gone? Housing? Not for a long time. Business investment? Hard to see why. The natural thing would be to trade lower consumption for a smaller trade deficit.”

It is logical to assume that the US economy will experience two mega trends in the coming years:

• US consumer spending will fall while US consumer savings rise (aided by the baby boomers’ need to provide for their retirement years now that the wealth effect has gone kaput) • Net exports will improve as global growth, particularly in emerging markets, continues to expand (certainly relative to developed economies)

It is also likely that non-residential investments (capex) will move closer to their average as corporations retool to meet the global export opportunities while government spending will increase as the US government seeks to stabilize the US economy (large fiscal deficits and other government programs like TARP).

Investment Strategy Implications

The bottom line for those investors willing to look beyond the valley of FUD (fear, uncertainty, and doubt) that we are currently wallowing in is to position their portfolios (what’s left of them) to exploit these mega trends. To follow this direction, however, requires context, perspective, and perseverance – something sorely lacking in a panic stricken financial climate. *table contents

C = Consumer N = Non residential investment (capex) R = Residential investment (housing) G = Government expenditures NX = Net exports (exports minus imports)

Just How Bad Are Corporate Profits?

Vinny Catalano, CFA — Tue, 18 Nov 2008 16:02:00 GMT

Today's earnings report from Hewlett-Packard raises the question posed in this blog postings' title. To help shed some light on the subject, consider the corporate results produced thus far re 3Q08.

Compiled each week from data published in the Wall Street Journal (and produced for subscribers in each weekly report along with more than a dozen other charts and tables), the accompanying table* shows that when you exclude Financials & Energy, the earnings results are less than great but nowhere near as dire as the headlines and sound bites would led investors to believe. Moreover, the quarter over quarter results ex Financials show a net gain.

That said, several items warrant comment:

* Autos (Consumer Goods) had the largest swing from horrendous (-$42.6B) to just plain bad (-$2.5B)
* Broadcasting and Airlines hit the Consumer Services sector with negative swings of $17.5B and $3.5B, respectively
* Conventional Electricity (Utilities) were hit hard due to higher energy costs to the tune of $-5.3B

Going Forward

Needless to say, investing is a forward looking game. Guidance has ranged from cautious to the ever dangerous "challenging". Despite this fact, however, most bottom up analyst projections remain in what could only be classified as the enthusiastic category, as evidenced by 2009 S&P 500 operating earnings estimated in $90 range.

While obviously overly optimistic, the bottom up boys and girls' forecast may not be too terribly off the mark as lower energy costs and a more robust global growth scenario turn out to be two of the surprise events of the new year. Then there is the very serious prospect of write-ups in Financials as assets held get mark to market upward should any return to normalcy in debt and credit related assets pricing occur.

Investment Strategy Implications

Doomsday scenarios abound. The headlines are awful. And while the credit markets show some progress, the TED spread remains elevated as the improvement in LIBOR is offset by the deflation/depression fear driven levels in the 3 month US Treasury rate.

Thankfully, the equity markets are now past the November 15th notification date for hedge fund redemptions, which should alleviate some of the forced liquidations that have roiled stocks over the past six weeks. However, unmet hedge fund redemptions linger as something of an overhang remains (gradual liquidations replaced hurried forced liquidations) as does tax related selling by individual investors.

Lots of conflicting factors at play. Then again, what would you expect during the bottoming process of one of the worst financial and economic episodes in history?

Beyond the Sound Bite: An Interview with Liz Ann Sonders

Vinny Catalano, CFA — Wed, 22 Oct 2008 04:14:00 GMT

My conversation with Charles Schwab's Chief Investment Strategist includes a recession call, thoughts on the lasting consequences of the credit crisis (most notably deleveraging), and sector weightings.

The length of the interview is 12 minutes 45 seconds.

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Aftermath

Vinny Catalano, CFA — Tue, 21 Oct 2008 14:42:00 GMT

In his award-wining book, “When Markets Collide”, incoming PIMCO CEO, Mohammed El-Erian makes the following statement: “…in contrast to past episodes of US economic slowdowns, emerging economies have two distinct secular forces going for them; and these should prove sufficient to partially offset what is likely to be a relatively prolonged period of lower import demand on the part of the Untied States. First, the internal components of aggregate demand are coming online in a gradual and robust manner, thereby offsetting the prospect of reduced exports to the Unties States. Second, these economies – and in particular the commodity exporters – are looking to a period of relatively high export unit values.” Mr. El-Erian goes on to point out that “There is also a third factor that is more cyclical in nature. The robust nature of many of these countries’ balance sheets – historically unusual – gives them the ability to stimulate internal consumption and investment.”

Investment Strategy Implications In the aftermath of the credit crisis, three patterns re the equity markets and economy appear to be underway:

• Sector rotation (within a bottoming process, range-bound market) producing the likely winners and losers of the emerging economic environment • Secular trend of a slowing US (and other developed countries) growth • Secular trend of higher emerging economies growth rates (an evolutionary form of decoupling)

Should the second two patterns become a reality, the first will likely show some manifestation of them, although the full effect of an emerging markets global growth driver may take some time to register with investors. What appears to be very intriguing is the prospect that US domestic growth-oriented investors will find themselves disadvantaged (from an investment performance perspective) if the global macro secular trends Mr. El-Erian and others describe do in fact occur. The logical result will be an investment situation similar to the end of the dot-com bubble phase when many value investors were forced into owning growth issues just to maintain some semblance of relative performance.

Clearly, the longer-term investment winners in the above described scenarios will be those who recognize the secular trends and act on them sooner rather than later.

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A Thawny Issue

Vinny Catalano, CFA — Thu, 16 Oct 2008 23:09:00 GMT

As noted previously, stocks, having partially recovered from their deep oversold condition, are not the epicenter of the real economy impact of the credit crisis. The credit markets are. And in this regard, as lovely as the big oversold bounce in equities may have been and as astute as any investor might have been identifying the baby thrown out with the bathwater (oil services and global infrastructure, for example), investor focus needs remain firmly on the credit markets.

Over the past several days the TED spread* (LIBOR minus 3 month US Treasury rate) has narrowed some. LIBOR declined but so did the 3 month US Treasury rate. This is not what investors (and central banks) want to see – some improvement in inter-bank lending (lower LIBOR rate) offset by greater fear (lower 3 month US Treasury rate).

Investment Strategy Implications

Equities appear to be in that twilight world of leadership transition where the winners and losers of the next sustainable rally phase (and the inevitable bull market) will emerge. However, as confident as equity investors might and should be re the central banks and governments' actions, it does seem advisable to restrain any large amounts of enthusiasm until more visible signs that the freeze is thawing. In this regards, the credit crisis remains a thawny issue.

*To track the TED spread, click here.

*To learn about "Sectors and Styles Strategy Report" newsletter and other subscriber benefits, click here.

Lehman Credit Default Swaps Announcements Today

Vinny Catalano, CFA — Fri, 10 Oct 2008 08:35:00 GMT

If you are looking for a reason why stocks are plunging, here's one major reason.

Today, at 10:30 AM and then again at 2 PM (both eastern time) announcements re settlement of the massive Lehman Bros. credit default swaps will occur. According to one trading desk source of mine, the equity markets are far more concerned on this point than are the debt markets. Earlier this week, the settlement of Fannie and Freddie CDS' were announced.

While the settlement of the Fannie and Freddie loans was enormous, the CDS settlement prices were more than 90 cents on the dollar making the CDS losses far more manageable (less than 10 cents on the dollar). However, as the Financial Times noted last week, "In the Lehman case, numerous banks and investors have already made losses due to exposure to Lehman as a counterparty on numerous derivatives trades. The auctions next week are for credit derivatives which have Lehman as a reference entity. There are likely to be fewer contracts outstanding than for Fannie Mae and Freddie Mac because Lehman was not included in many of the benchmark credit derivatives. However, exposure remains unclear,..."

Expectations for Lehman CDS' settlements are in the 10 to 20 cents on the dollar range.

Investment Strategy Implications

The equity markets are pressured on multiple levels. One of them is the forced liquidations due to client redemptions, including mutual funds and hedge funds. In the case of hedge funds, it is unknowable at the moment but can be reasonably assumed that despite having an estimated 1/3 of their assets ($600B) in cash, many have exposure to credit default swaps and may incur huge losses as a result. Hence, forced equity liquidations.

By the end of day investors should have a far better idea just how extensive the counterparty damage is. Additionally, knowledge of the credit crisis process and the methods by which it will work its way toward resolution along with the interconnected dynamics of and impact to the real economy will advance. However, the psychological damage to confused equity investors may be far more long lasting.

Fear is feeding upon itself. And the greatest aspect of this fear is ignorance. Tragically, a leadership vacuum is evident with the failure to explain to the American public (and the world audience) what is happening and why. And in the process, panic in all its ugly forms is running rampant and time will show that many equity values being posted today do not reflect their true intrinsic value. In other words, we are clearly at the point where, just as with many credit instruments, mark-to-market in many equities do not reflect their fundamental realities.

To view the Lehman auction results, click here

To learn more about the credit default swaps settlement process, click here

Beyond the Sound Bite: My Interview on NPR

Vinny Catalano, CFA — Wed, 08 Oct 2008 10:27:00 GMT

The folks over at National Public Radio noticed my blog posting of yesterday re the credit markets, Treasury yields, LIBOR, and the TED spread and did an interview with me on the topic, which you can listen to by clicking on the following link.

To listen to the 20 minute interview, click here.

Note: To track the all-important TED spread, click here