Happy holidays, but be worried about global risks

The year end rally has been strong. It's not all surprising given the steady climb in auto and other retail sales. Consumers maybe back from more than two years of belt-tightening. That's a big deal.

Retail investors may be tip-toeing back to equity markets as well, moving away from bond funds as the long-term rates are rising.

Institutional investors may be pushing the winners all the way to the end of December. We don't know. But given the predominately bullish commentaries we read everywhere, there is a great likelihood the market is setting itself up for a big correction comes January.

Here is an interesting indicator of the extreme bullishness.

Banks and other financials may be in a good position to benefit from the firmer recovery undergirded by the Fed's QE2 and the Congress's tax deduction extension. We have benefited a great deal from our large positions in WFC, BAC, USB, and some home builders.

But, this is the time to be very cautious. Dark clouds are swirling, people just don't talk about them much. European debt crisis is very much alive and not going away anytime soon. US unemployment rate will be elevated for years to come. Deficit problem is not been tackled in any systematic way. China's inflation problem may require much more severe measures than expected. These are known problems. Granted, market's tolerance is higher when these problems are known. Still, it seems very likely that more surprises may be lurking around the corner.

Andy Xie, an independent economist, has this piece about US and China. His main point:

China may have won the last race. To win the next one, China must tackle its inflation problem, which is ultimately a political and structural issue, in 2011. If China does, the U.S. will again be the cause for the next global crisis. China will suffer from declining exports but benefit from lower oil prices.

On the other hand, if China has a hard landing, the U.S.’s trade deficit can drop dramatically, maybe by 50%, due to lower import prices. It would boost the dollar’s value and bring down the U.S.’s Treasury yield. The U.S. can have lower financing costs and lower expenditures. The combination allows the U.S. to enjoy a period of good growth.

One could describe the global economy as a race between the U.S. and China, to see who goes down first.

We're now 50% cash, increased our shorts. We'll be even more defensive if the market continues to rally next week.

State Budgets: Day of Reckoning

While the VIX has been trending down to below 16%, the lowest level since April of 2010, the Muni bond market may be telling us something quite different. The yield spread (against an index of the highest-rated muni bonds) on debt issued by the State of Illinois, for example, has been increasing rapidly from pre-crisis level of about 0.2% (2008) to about 2% in late 2010.

The video below from CBS 60 Minutes is a must see.


Will weak local governments create a similar systematic financial problem posed by the weak Euro members?

Rising mortgage rates goes with rising housing starts?

Housing starts have been in the dump for most of 2010, especially after the experiation of the tax credits. This morning's report shows some life in this important sector. Perhaps the sector is now ready to stand on its own feet.

Mortgage rates however have been rising rapidly since the Congress and the Administration started to work on extending the Bush-era tax cuts. Investors have been shunning Treasuries, in favor of cash, commodities, or equities. This is not necessarily a reflection of rising inflation expectations, although that could be part of the reason (judging from the implicit inflation rate priced into TIPs). On balance, investors are probably betting that the expansionary monetary policy as expressed in QE2 should work well in the thort term with the accommodative fiscal policy should it passes the House. Rising long-term T rates, which causes the T yield curve to steepen, is a sign that the economic recovery may quicken 2011-2012.

The Fed's goal was to stimulate the economy via asset inflation. It has so far succeeded in chasing investors away from the "safe haven" of the Treasuries, into more risky assets that are more tied to the US and global economies.

That's only the beginning. For this twin stimulus to work, the private sector needs to move up in a big way to employ more works. Millions more. More jobs would help housing starts. And more housing starts would jump start more construction jobs.

For people looking to buy a house, mortgage rates in 5-6% are still relatively low. The dominating variable is job security. Besides, when the rates rise to a certain level, bond funds and foreign government would purchase more long-term US government bonds to help hold down the rates.

In this mix, banks that have repaired their balance sheets and have successfully re-positioned themselves to take advantage of the steep yield curve and the economic recovery should be ready to print profits in the boat loads. One of the prime beneficiaries will be Wells Fargo, whose market cap has again overtaken that of JP Morgan today with its share rising over $30. A recent Barron's article has put WFC's shares at $35-40 range based on its normalized earnings power, which it should start to show itself in 2011 when Wachovia branches are all converted.

Investors should hold on to these bank shares, and some of the home builder shares for an interesting "rabbit ride" in 2011. 

Job news so bad that the market doesn't care

It was a lousy headline: the economy added only 39,000 jobs in November against the expectation of 150,000. Unemployement rate creeped up to 9.8% from 9.6%. You would think that the Dow should take a nose dive and gave up all gain from the two previous sessions. Instead all major indices held their grounds pretty well.

The BLS report stands in stark contrast to recent data from ADP (+93,000 jobs), and modest Challenger layoff announcements (+48,711).

The employment index from the ISM Non-manufacturing release today also showed a pick up in hiring.

So, perhaps the market is looking forward to upward revision in the BLS data.

Or, perhaps that the market takes the bad news as a piece of good news in the sense that the Fed now can use it to strengthen its bond-buying program announced in November. The next FOMC meeting is only 10 days away. The Fed's support was essential for the market's run from late August to early November.

If the headline had been a positive surprise, the market may actually get worried.

Gold runs up either way...

The European debt crisis ...

Greece. Bailed out.
Now Ireland.

But the sovereign debt crises, and Euro crisis, are merely delayed. See Krugman's article "Eating the Irish." See also some other discussions by economists.

It's striking to see how the bond market and the sovereign CDS market have behaved this year.

(Data source: Atlanta Fed)

The Greek bond spread continues its rise after the bailout. Ireland's looks to widen further, even after today's decrease. The fundamental economic problem has not been solved.

Next in line is Portugal, but the elephant in the room is Spain, because of its size and its huge unemployement rate of 20%.

How would all these affect the US? Here is an interesting analysis.

This is one of the big risks that can derail the global recovery, and the advance of the stock market.

Consumers back in the driver's seat

Car sales have been strong. So both Ford and GM are doing well. GM just had a big and successful IPO. What a change.

Holidays sales are going up strong for this season. Expect to see increased traffic in malls.

The big surprise today is the pending sales of existing homes. They rose a record 10% in October, aided by low mortgage rates and improving consumer confidence. That should help clear out more of the bloaded inventories. Home builder stocks are gaining grounds.

After two years of belt-tightening, are American consumers ready to take charge?

The graph below shows that the Personal Consumption Expenditures (PCE, the largest component of GDP) are on track to grow back to its trend line.

Much of this improved picture will continue to depend on job creations. Governments can help. Central banks can help. But it looks like the private sectors are slowly moving ahead to expand. 2011 will probably be slow going, interrupted by lingering credit flare ups (Euro zone especially). But if consumers start to take charge, we expect to see some acceleration of growth in the 2nd half of 2011.

It was a good day for the market today. Tomorrow's good news in employment number may have already been baked in. As Dow is closing in onto the height of the year, it would be wise to raise cash.

US Banks with funding cost advantage may be the place to be

Investors are focusing on Euro crisis. Quietly, US economy may be gathering steam, despite all sorts of political problems. Consumers are saving more, but they've not stopped spending. Manufacturing is still expanding.

Housing is soft, which is adding a big drag on the recovery.

Employment situation may be slowly improving. Economists are expecting 150,000 jobs being added in Nov. Most of them should be in the private sector, especially services. This Friday's report will be a key event.

The Fed will maintain low rates and east money stance, at least for the first half of 2011. Bonds are expensive. Stocks are relatively cheap.

US banks that are not exposed to the European problems may be a relatively safe place to park cash, to pick up some nice gains as we move into 2011.

Low funding cost will be a key advantage.

Credit default rate is coming down as consumers repair their balance sheets. Capital requirement is less of an issue now. The yield curve is fairly steep so the interest differential is healthy (10-year Treasury is yielding close 3% while the funding cost for banks could be zero.). The Fed will be slow to raise short term rates even when the economy starts to pick up.

Banks such as Wells Fargo that are focused on building the coast-to-coast distribution network and executing its time-tested business model are well-positioned for earnings growth.

Jeremy Grantham: QE may be blowing bubbles

Investors are pressed to choose between lousy returns and speculations. Well, there is a third choice: cash reserve.

How can QE2 help the economy?

In anticipation of the QE2, the stock market and the bond market have been rising since late August when the Fed chairman Ben Bernanke revealed his intention.

When the actual plan was announced on Nov.3, the market didn't move much either way. The amount of asset purchase ($600 billion in about 8 months) was in line with expectations. The trillions of paper wealth gained since August is now solidified. Could it translate into more spending power? If so then QE2 would be looking good.

There are other likely channels where QE can work. Bernanke published an op-ed piece on Washington Post today, which lays out clearly what he thinks how QE can help spur economic growth:

This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.

Housing market is in disarray. Home sales are at the rock bottom. Can lower rates help much? We'll have to see. One way to look for clue is again in the home building sector. Home builder stocks are moving up. So perhaps investors are buying into the QE2 story.

Lower corporate bond rates looks like are supporting new issuance. Bloomberg reports that

Corporate bond sales surged to $15.9 billion, the busiest day in almost two months, as the Federal Reserve’s move to stimulate the economy ignited a rush of issuers tapping credit markets at record-low interest rates.

Many big corporations are taking advantage of the lower rates. Will the cheap money then find its way into more hiring and more production? It's likely, but we'll have to see over the next few quarters.

It's quite interesting that he writes "And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending." Anyone with a 401k account would certainly understand the implications. One can argue about how likely the increased financial wealth can help consumer spending, given the skewed distribution of stock ownership, and the hard-to-establish relationship between financial wealth and consumption.

I think one likely group of consumers who will be able to borrow and spend more are the credit-worthy and asset-rich households. Their spending powers are likely to show up in luxuary good sales and other highend consumptions. We should be looking for evidence in those sales figures.

If the wealth effect kicks in, depneding on how strong it'll be, it can help increase GDP and income, thereby generate more hiring.

Contrary to all the Fed bashing out there, the rationale in Bernanke's QE move doesn't seem so hard to see. How effective it'll be is the real question. But given the observation that the fiscal side is at a deadend in terms of creating more supports to the economy, the Fed's latest effort is probably the only game in town.

What do you think?

Election day, so what?

Republicans may take over the House. Gridlock.

Government stimulus no more. The economy sinks some more. So says some of the economists on the left.

The heavy lifting would be on the Fed's shoulders. And tomorrow, the widely expected QE2 will be announced. Asset purchase should help, mostly via the wealth effect (lower risk premium, higher asset prices, HOPEFULLY more spending from those who have), and inflationary expections (higher inflation in the future makes businesses and consumers more likely to spend today).

Value investor Jeremy Grantham lists 18 points why QE2 is a bad idea. He is generally against the Fed's meddling.

On the right, economist/columnist Paul Krugman has been sure that only more spending will restore the American economy (see for example a good analysis). But I think he is too sure to be believable.

The American people are fed up. They're looking for solutions to improve lives. No one has a clue what the solution or solutions are. We're in a deep hole, and the hole is getting deeper. No clarity should be expected out of the mid-term election and the Fed action. Get used to the muddiness. But I like the view here.

China should return more wealth to its people

As G20 finance ministers gather in South Korea today, the central issue is around exchange policies and avoiding the outbreak of a global trade war.

China is under intense pressure from the U.S. and other emerging markets to revalue its currency, which is pegged to the US dollar and widely believed to be undervalued by 20-40%.

China has resisted such pressure by pointing out to potential disruption to its export-led economy and its recent efforts in stimulating domestic consumption. The central bank PBOC has recently raised benchmark interest rates by a quarter point, the first time since the onset of the 2008 financial crisis, despite signs of cooling economic growth. This may be the beginning of a series of interest rate hikes to rein in inflation.

Much of China's recent growth has been fueled by injecting loose credit into the banking system, which may have caused excessive domestic inflation, especially in the property sector.

These are happening in an environment that developed nations are trying to continue or enhance their loose monetary policies in a bid to spur growth, or at least to avoid Janpanese-style deflation.

Recent discussions (e.g. by Li, Dongrong) out of the PBOC make it very clear that Chinese officals are very aware of the international financial environment and the challenge facing China.

Leaving it at the status quo, China may face a greater risk of hot money chasing after higher returns. The flood of easy money, through various channels such as private equity, may contribute to rising asset inflation and consumption-good inflation.

Inflation, while necessary for growth if it's moderate, chips away citizens' purchasing power and helps to increase economic inequality and social unrests.

On the surface, China has become a rich country. Commentators often point to its ballooning exchange reserve (about $2.6 trillions). But much of this money cannot be used to help ordinary citizens; instead it's financing the U.S. government which in turn help to lower the already-low interest rates. In terms of GDP per capita, ordinary Chinese are still quite poor. China should return some of the wealth to its people, by appreciating its currency more and bringing down actual inflation and inflation expectations.

Raising intereat rate and the Yuan may actually go hand-in-hand in a gradual fashion, to power both domestic and international consumption. Higher interest rate puts more moeny in the hands of savers, and a more valuable currency obviously puts more purchasing power to any Yuan holder.

And, a lower inflation gives ordinary people a much needed break in the race to save enough for purchasing an apartment.

American kids are lazy and distracted?

There are real fears that America as a country has lost its touch, and the American as a people have become less competitive and too dependent on government largesee.

We don't really know if that's true. But there is that fear. In this new survey about American Dream, the middle class is in general still optimistic about the future and the access to opportunities. What's shocking to me though, is this:

Nearly half (49%) thought that countries like China and India are so far ahead of America that the United States won’t be able to catch up.

I think that's largely a reflection of economic growth rates. I doubt this impression is created by comparing per capita consumption or production.

What about the next generation and education?

Here it is very interesting to note a discussion by the CEO of the privately held SAS Institute:

His discussion about education in America was the most disconcerting. American students are not entering the fields of science, engineering, statistics, and math. These are the areas that would help America grow, invent and discover. He thinks American kids are too distracted by Twitter, Facebook, the Internet, Playstation, TV, iPhones, iPads and cell phones to do the hard work that is required in these fields. We have become a lazy distracted society. Our best colleges are educating foreign students who take that knowledge to their own countries.

There is a lot of truth in this observation. But this type of distraction has always been there, although the new technology has made it more pervaisive and compelling.

I remember growing up in China back in the late 70s and early 80s, the biggest distraction from school work was Kungfu novels and movies. Kids could spend all day reading and watching them for entertainment and excitment. The way to deal with the distraction is the same: keep a great distance and have great control over time. It's a struggle, as it has always been.

How do kids spend their time is an investment problem. Ideally we want them entertained, but we also want them to focus more on the production side rather than the consumption side.

When watching video games, for instance, I would like my kids to think about how to make these games instead of just playing them. I believe it makes a crucial difference.

High inflation, low inflation

China's central bank just announced a surprise increase of interest rates to help rein in the inflationary pressure.

It said it was raising benchmark rates by 25 basis points, taking one-year deposit rates to 2.5 percent and one-year lending rates to 5.56 percent.

Consumer-price inflation has already crossed above Beijing's 3% target for 2010. In August, the annualized rate was 3.5%.

Over here in the U.S., the opposite has been the case. The core consumer inflation rate is hovering around 1%, and maybe heading lower. In the face of slow growth, deleveraging, and high unemployment rate, this is alarming. Because the economy may be headed for deflation, when prices for goods and services are trending lower in general.

In other words, the economy is too "cold" in the U.S. and too "hot" in China. And higher interest rates in China may serve to attract even more hot money. On the other hand, the Fed's easy money policy would potentially add more liquidity to the world economy, much of which would find its way into China's asset markets, causing more inflationary pressure.

China has so far been quite successful in controlling credit expansion and contraction using adminstrative means, in order to maintain its currency peg to the US dollar. It's perhaps time to change that practice to help balance the world economy. A stronger yuan can help China take on more leadership role.

How can QE help the economy?

The Federal Reserve chairman Ben Benanke's latest speech has made it clear that both the current high unemployment rate around 10% and low inflation rate are inconsistent with the Fed's dual mandate. Therefore further action is appropriate.

Another round of "quantitative easing" (QE) is now widely expected by the market. How much and exactly in what form remain to be seen.

Has QE been successful? How does it help create jobs? Why do we need more large-scale asset purchase by the central bank? Should the Fed be even more aggressive?

Here is an old paper by Joseph Gagnon at the Peterson Institute for International Economics that helps answer some of these timely questions.

QE and global liquidity probblem

The sluggish recovery in the U.S. economy is prompting the Fed to refocus on "quantitative easing" (i.e., buying more long-maturity securities to lower the borrowing costs). That may serve to flood the financial system with even more liquidity. Professor Joseph Stiglitz talks about the potential consequences:




The Fed’s move towards more quantitative easing, conveyed in its recent policy statement issued in September, follows Japanese intervention to weaken the yen and Swiss National Bank actions aimed at its currency.

Increasing exports by weakening the dollar is one channel by which the easing could boost the US economy. But it is impossible for every country to weaken its currency and export its way to higher growth at the same time. So we're looking at the competitive devaluation scenario of global currencies. This is one of the most strong supports for gold prices. More QE would mean even higher gold prices, unless we enter into another recession.

The Fed is facing another major conundrum, not unlike the one faced by Mr. Greenspan back in 2005. Back then, the global "savings glut" was seeking outlets in the U.S., pushing the yields ever lower for the long-term assets. The liquidity found its way to private equities and the real estate market, which led to the financial meltdown of 2007-2009.

The money supply has never gone away. And the Fed is adding to it.

More easing may do very little as the rates are already very low and there aren't many credit-worthy borrowers. On the other hand, there isn't any other option for the Fed to counter deflation risk in the face of high unemployment and consumer deleveraging.

The economy is sick, and drinking more liquid may not help.

It was over

So said the NBER today. The recession was over in June of 2009.

That was when my family was getting ready to move across the country, from the West Coast to the East. It didn't feel that way, although the market was on a rebound and GDP started to go positive.

For us, it took more than a year since then to finally have a sense that our lives are getting back on track, after we bought our house in August.

We've just moved in. Our new neighbors are getting to know us and vice versa. We're receiving welcoming notes and cookies. Our kids are already making friends with the kids in the neighborhood. There are doctors, engineers, businessmen, pilots, professors... mostly professionals. Interestingly, almost half of my neighbors are fairly new to the neighborhood. There have been a lot of turnovers. The new families will be fostering a sense of new community, I think.

But the lingering affects of the recession are visible. Home prices are still dropping... and just as we moved in to our new house, a house across the street was put on the market for sale. Its owner just had a surprise job change. Another home owner told me that he is closing down his business.

I'm still glad our moves are finally over.   

Education and Unemployment Rate

Laura Tyson, my former dean at Haas School of Business, wrote an op-ed piece on NYT in which she argues for a second stimulus spending. Her arguments are inline with some of the discussions I've read from Paul Krugman and Joseph Stiglitz. These practicing Keynesian economists are all for government intervention. So that's not surprising.

What's kind of surprising is she would say things like worrying about deficits and the size of the government is focusing on the wrong things. Wrong things? She probably meant wrong focus.

The statistics she cited about education and unemployment rate is very interesting:

Consider how the unemployment rate varies by education level: it’s more than 14 percent for those without a high school degree, under 10 percent for those with one, only about 5 percent for those with a college degree and even lower for those with advanced degrees.

Education in the U.S. does help cushion workers against the general and severe downturn. This is consistent with the outsourcing movements over the last decades: low-paying jobs that require little or no education moved mostly to countries like India and China. What U.S. should do is indeed to make college education more prevailent among its population of over 300 millions. But that cannot be accomplished in a few months or a few years.

In contrast, college degrees in China may not mean high level of employment. I have not seen any good statistic, but casual observation suggests that family background and connection play a much more important role in landing a stable job, preferrably in government or state-own companies,  in China.

Brain is still valued a lot more in the U.S.

   

Buying a house

We've been renting a house since we moved from SoCal to Penn last year. Renting was a good choice, as we needed to get to know the new area, and make sure the schools and neighborhood would work for us.

We rented our old house to a family moved down from NorCal to SoCal. They rented out their house too.

So for the first time in my life, I've become both a landlord and a tenant at the same time. It was quite an experience.

We tried to be open and communicative to our tenants, and stayed on top of all necessary repairs. I let them know all the things they should know to live in our house comfortably, especially anything that may become a safety issue. In turn, our tenants have done their best to take care of our property. We appreciate their paying on time and being proactive on any repair issue. In a difficult year, this relationship worked out quite well.

Our landlord, on the other hand, had been avoiding direct communication at the outset. If there is any repair issue, they would rather not be bothered... eventually, as one would expect, this kind of relationship ran into problems. We paid a generous above-market rent for them, in return we got almost no help from the owners who had lived here for a long time. Moreover, when it was time to renew the lease, they wanted to raise our rent, despite the softening market.

These problems pushed us towards buying. That aside, the economics appears to become more and more favorable for buying: home prices have been dropping steadily over the last year, mortgage rate has hit historical low and got lower. For a bigger house in the same neighborhood, our rent would more than cover the mortgage payment. With tax savings taken into account, we would be roughly ahead by the amount of principal payment we would pay against the house. That is, with a little bit of work as a homeowner, we would be building up equity every month. That equity would be totally gone to the landlord if we continue to rent.

In other words, if we buy the house we're renting now at market price, and rent it out as an investment property, we would be generating a small positive profit at year 1. Bear in mind this is one of the best neighborhoods in this area. Usually people tend to want to own, not rent. In such neighborhoods, it's usually hard to break even with rentals at the beginning. So this is a clear sign that it's about time to buy if one has a stable job. The housing may not have hit bottom yet, but it should be fairly close.

We found several houses we like. As we got into the market and started making offers, I quickly realized how thin the market was. You rarely see multiple offers. Very few buyers. At one point, our withdrawal on one house affected the pricing of some nearby properties immediately... Sellers have to price it right, or risk sitting on the market for months after months, and going through multiple reductions.

We didn't get the home purchase tax credit. Interstingly, the expiration of the tax credit have benefited us far more than $8000: The market had become markedly softer and the mortgage rate had gone down even more dramatically since June.

As I write this, we're getting ready to settle this week. After this local move, the turmoil of 2009 which had affected us in a big way will finally be behind us.      

Job creation as the leading indicator

Another Friday employment situation report, another disappointment.

Private-sector employers added just 71,000 jobs in July, according to a report released Friday by the Labor Department, fewer than the 100,000 plus jobs that economists were hoping for. Moreover, it also said private firms hired fewer workers in June than it had previously reported, as it revised that estimate down from 83,000 to 31,000 jobs.

The small increase in private-sector employment was more than offset by the loss of 143,000 temporary census jobs, and the nation's unemployment rate remained unchanged at 9.5 percent. Overall, the nation shed 131,00 jobs in July.

Remember when this measure, private job creation, fell off a cliff in May (reported early June) the stock market took a dive. Today's report also added pressure on the market which has been recovering quite well in July.

Recovery in housing market and consumer spending is now largely dependent on jobs. It's only logical that private job creation had become something of a leading indicator for the current economic recovery.

Corporate profit no longer seems to indicate job creation. And there aren't obvious leading sectors to point to that are creating many jobs.

Overall this year, private-sector payrolls have grown by 630,000 jobs, but about two-thirds of that increase occurred in March and April. After that, corporations have become more cautious in hiring.

Meanwhile, the strained state and local governments have shedded 48,000 jobs in July.

The sluggish job recovery is adding pressure to deflation.

Hedge Funds Not Knowing What to Do with Money?

May and June have been brutal for money managers. The volatility and conflicting economic signals made it very hard to stay the course or change the course. On hindsight, it would have been great to be 100% in cash since early May when S&P was at 1200. It's probably not a very good idea to raise cash after the 10% correction. But that appears to be what some of the big hedge funds have done, which has probably contributed to the market volatility and deepened the correction.

Barton Biggs, whose purchase of stocks in March 2009 gave Traxis Partners LLC a 38 percent gain last year (so?), said last week he sold about half his stock investments because of concern governments around the world are curtailing stimulus measures too soon.


“I’m not wildly bearish, but I don’t want to have a lot of risk at this point,” Biggs, who manages $1.4 billion, said in a telephone interview. “I’m not putting my money into anything. I’m raising cash.”


At the end of May, this same Big manager was voicing his opinion that the stock market was set to "pop" in days (yes, in no uncertain terms, "in a couple of days."). Apparently, he has been frustrated by June's continuing declines. But his earlier bullish call was a frustrating call at best. Did he actually know something or was he just wishing for something?

For more comments, see this Bloomberg article.

Nothing to Fear but Fear Itself?

There are a lot of talks about market psychology in recent days as the market went through a deep correction. For instance, the Wall Street Journal has a piece today that tries to argue that "[t]he biggest threat to recovery is the markets themselves." That is, the economic recovery would be back on track if the markets just believe it.

As if to confirm it, the market had a good rally today without any good news.

I do believe there is certain amount of truth in it, although I think there is far more than just investor psychology that's involved.

To a large degree, our modern economy is now very asset-based, in that consumers can spend based on the value of their assets such as homes and mutual funds. So if the markets for these assets are supported either by the Fed, or by optimistic views, we may see very positive effects on consumption and hence on recovery. That in turn may lead to higher asset values.

But that was how we got into the credit crisis, believing for example that home values would always go up. Consumers are now working hard to repair their balance sheets. In such an environment, we need actual income generation to support the economic recovery. That is, jobs.

This is probably why PIMCO's El-Erian thinks that unemployment has shifted from a lagging indicator to a leading one and is warning government policymakers to confront the structural problems in the economy. Eight millions of jobs have been lost since the beginning of the great recession. Despite historically low interest rate and trillions of dollars in stimulus spending, jobs are still scarce and are being added too slowly.

Investors have to ask, why these profitable corporations are not adding more jobs and who are going to lead job creation?

Rail and Retail

Rail traffic has been up over the past two months. Combined weekly traffic for new carloads and intermodal shipments is about 14% higher than a year ago, according to the Association for American Railroads.

U.S. retailers’ sales probably expanded at an average monthly rate of 4 percent in the first five months of the retail fiscal year that began Jan. 31, the biggest gain since 2006, the International Council of Shopping Centers trade group said in advance of its June report tomorrow. This maybe a sign that consumers are overcoming concern about unemployment and depressed home values. Just maybe.

Rail volumn and retail sales are not leading indicators. They're contemporaneous ones. While encouraging, they offer no assurance for the economic recovery.

2Q earnings season is underway. But even good earnings may not be enough to lift the depressed market sentiments. Stocks are cheap, if the outlook of good earnings continues to hold up and perhaps improve. The fear of a double-dip recession, however, has called that into question.

Additionally, the uncertainty around November's mid-term election and consequently the tax policy changes may not give market good enough reason to start its recovery from the recent lows.

Best Time to Buy a House?

John Paulson said he is optimistic on the American economy. "I think we're at the tail end of the credit crisis," he said "We're in the middle of a sustained recovery in the US. The risk of a double dip is less than 10 percent.” Europe, however, “is the one soft spot in the world," he told an audience at the London School of Economics on Wednesday.

"It's the best time to buy a house in America. California has been a leading indicator for the housing market, and it turned positive seven months ago. I think we're about to turn a corner."

The housing market is probably in its worse shape: Both new and existing home sales have plummeted in June to new lows after the expiration of the federal home buyer tax credit. Mortgage rate has been steadily going down, which is an indication that housing demand is weak and getting weaker. All these are tightly linked to the weak labor market: Private job creation is anemic, and unemployment rate is expetecd to stay elevated for years.

The economy is so dark that economist/columnist Paul Krugman has warned that we maybe entering the "Third Depression."

But if you're a contrarian and you believe in the basic soundness of American businesses, then this is probably one of the best times to take a bullish bet, on housing and on U.S. economy in general.

See this article for the contrasting views of the hedge fund manager Joh Paulson and the academic/journalist Paul Krugman.

I've been looking for a house to buy in recent months as our lease was expiring. There are many good reasons to buy. Prices have been dropping over the last two years, and continue to drop. It's definitely a buyer's market. Renting now costs more in terms of after-tax cash flow. It's a good time to take advantage of the historically low mortgage rates and to start building home equity again...

But, there is no hurry! Unemployment is going to be a long hard problem to solve. Without massive job creation, there is very little real pent-up demand for additonal housing.

But, for the same reason, if job creation is getting in gear and we start to see hundreds of thousands of private jobs being created, a housing boom would not be far behind.

Cash Better Than Gold!

Gold prices are retreating. Investors are raising cash, lots of them. We raised some back in May and June, but not nearly enough.

Long rate is heading down. This is in stark contrast to the market expectation at the beginning of the year.

There is one important thing that the markets across asset classes agree on: risky asset prices are heading lower. We're headed to a deflationary environment. And that has been baked into the market expectations, which may become self-fulfilling.

Cash not only will not lose value, it will buy more if you just wait.

Companies, big and small, are holding back. Because they can buy more later.

People who worry about losing jobs don't want to buy homes now. Mortgage rates can't help but to go down. People who have stable jobs are probably better off renting, because they can buy more home later.

Is there value in gold? Not in a deflationary environment and major governments are pursuing austerity.

There is only one entity that can turn this vicious cycle around: The Bernanke Fed.

Have Keynesians Lost the Battle?

We are now, I fear, in the early stages of a third depression. It will probably look more like the Long Depression than the much more severe Great Depression. But the cost — to the world economy and, above all, to the millions of lives blighted by the absence of jobs — will nonetheless be immense.

And this third depression will be primarily a failure of policy. Around the world — most recently at last weekend’s deeply discouraging G-20 meeting — governments are obsessing about inflation when the real threat is deflation, preaching the need for belt-tightening when the real problem is inadequate spending.

I'm afraid Paul Krugman maybe right this time. Much of the recovery we have had in 2009 and the first half of 2010 was dependent on government supports around the world. If the stimulus and easy money policy are withdrawn too early the economies may not be healthy enough to stand on their own. We're now facing a real risk of that.

In yesterday's NYT, a piece written by David Leonhardt has some good summary points on the current policy conundrum.

The world’s rich countries are now conducting a dangerous experiment. They are repeating an economic policy out of the 1930s — starting to cut spending and raise taxes before a recovery is assured — and hoping today’s situation is different enough to assure a different outcome. ...

The policy mistakes of the 1930s stemmed mostly from ignorance. John Maynard Keynes was still a practicing economist in those days, and his central insight about depressions — that governments need to spend when the private sector isn’t — was not widely understood. In the 1932 presidential campaign, Franklin D. Roosevelt vowed to outdo Herbert Hoover by balancing the budget. Much of Europe was also tightening at the time.

If anything, the initial stages of our own recent crisis were more severe than the Great Depression. Global trade, industrial production and stocks all dropped more in 2008-9 than in 1929-30, as a study by Barry Eichengreen and Kevin H. O’Rourke found.

In 2008, though, policy makers in most countries knew to act aggressively. The Federal Reserve and other central banks flooded the world with cheap money. The United States, China, Japan and, to a lesser extent, Europe, increased spending and cut taxes.

It worked. By early last year, within six months of the collapse of Lehman Brothers, economies were starting to recover.

The recovery has continued this year, and it has the potential to create a virtuous cycle. Higher profits and incomes can lead to more spending — and yet higher profits and incomes. Government stimulus, in that case, would no longer be necessary.

An internal memo from White House economists to other senior aides last week noted that policy makers “necessarily tend to focus on the impediments to recovery.” But, the memo argued, the economy’s strengths, like exports and manufacturing, “more than make up for continued areas of weakness, like housing and commercial real estate.”

Much of that optimism has faded in recent months. European sovereign debt crisis has proven more vicious than expected. Labor market has shown very little sign of improvement. Housing market may already be in its second dip. Consumers have turned more pessimistic.

And just as households and businesses are becoming skittish, governments are getting ready to let stimulus programs expire, the equivalent of cutting spending and raising taxes. The Senate has so far refused to pass a bill that would extend unemployment insurance or send aid to ailing state governments. Goldman Sachs economists this week described the Senate’s inaction as “an increasingly important risk to growth.”

The parallels to 1937 are not reassuring. From 1933 to 1937, the United States economy expanded more than 40 percent, even surpassing its 1929 high. But the recovery was still not durable enough to survive Roosevelt’s spending cuts and new Social Security tax. In 1938, the economy shrank 3.4 percent, and unemployment spiked.

Given this history, why would policy makers want to put on another fiscal hair shirt today?



The reasons vary by country. Greece has no choice. It is out of money, and the markets will not lend to it at a reasonable rate. Several other countries are worried — not ludicrously — that financial markets may turn on them, too, if they delay deficit reduction. Spain falls into this category, and even Britain may.

Then there are the countries that still have the cash or borrowing ability to push for more growth, like the United States, Germany and China, which happen to be three of the world’s biggest economies. Yet they are also reluctant.

China, until recently at least, has been worried about its housing market overheating. Germany has long been afraid of stimulus, because of inflation’s role in the Nazis’ political rise. In responding to the recent financial crisis, Europe, led by Germany, was much more timid than the United States, which is one reason the European economy is in worse shape today.


The reasons for the new American austerity are subtler, but not shocking. Our economy remains in rough shape, by any measure. So it’s easy to confuse its condition (bad) with its direction (better) and to lose sight of how much worse it could be. The unyielding criticism from those who opposed stimulus from the get-go — laissez-faire economists, Congressional Republicans, German leaders — plays a role, too. They’re able to shout louder than the data.

Finally, the idea that the world’s rich countries need to cut spending and raise taxes has a lot of truth to it. The United States, Europe and Japan have all made promises they cannot afford. Eventually, something needs to change.

Double-dip?

Fear of a double-dip recession has returned to the U.S. market. Housing is weak, and looking weaker without more government support. European sovereign crisis has added to the global banking worry. China's tightening to release inflationary pressure has taken away another support for global recovery.

In other words, aggregate demand is weak. And governments are either not able or unwilling to create more aggregate demand.

All these are reflected in the U.S. bond yields. The interest rates for long bonds are heading to new lows, along with the mortgage rates.

We had expected that the private sector to start adding more jobs by now, but the reality seems to point to a discouraging picture of reluctance. Corporations are still waiting. Consumers are still reluctant. Banks claim they cannot find enough qualified borrowers. Every developed country is hoping that external demand will create enough pull for their export sectors. Aging population and pubic debt burden ... all seem awfully hard problems to solve.

It seems no news is good enough. Rallies are now short-lived.

The lack of confidence itself could aggravate the risk of the double-dip recession. The housing market appears already heading that way with the expiration of the home-buyer tax credit. Housing-related stocks have seen a steep selloff in recent months.

The risk of general deflation is much higher now than two months ago. This is the time for the Fed to renew its innovative push.  

At times like this, take it easy

May and June are looking pretty bad for equities. Europe's problems, signs of slowdown and deflation, persistent high unemployment,... not much to cheer for. This is what one expects when government supports are withdrawn gradually from the economies. At least U.S. and some emerging markets are not collapsing.

Gold is at new record. Some say it's a sign of inflation. Not really. It's just a flight to quality when major currencies are having major problems.

Home builders are taking a beating. The expiration of home buyer's tax credit is having a marked effect. But more important than that is the fact that the economy is not producing enough jobs. Momentum seems lost.

This is a good time for patient investors.

We're buying a house, finally.

Non-manufacturing ISM report shows job growth expanding

Service industries in the U.S. expanded for a fifth month and factory orders rose, pointing to a broadening economic recovery that’s generating more jobs. For the first time, the non-manufacturing ISM index's employment component shows expansion at 50.4 from last month's 49.5. Backlog of orders increased 6.5% from 49.5 to 56, also the first exapnsion since the recession started.

Of course, the manufacturing employment has been leading the job growth, expanding for a sixth month in May. But the service sector makes up almost 90% of the U.S. economy. There will be no real job growth if the service sector doesn't employ more people. It's a good sign that it is finally catching up.

Tomorrow's employment report should provide more color to the picture. Consensus is for 540,000 payroll jobs added in May, but this will include around 400,000 temporary Census jobs. More private jobs is key.

Pragmatic U.S. and China versus chaotic Europe

Two-hundred high-level U.S. officials are in Beijing, meeting with their counterparts to discuss a wide-ranging issues from currency to human rights. A sense of pragmatism seems to prevail over anger and finger-pointing.

Both countries have produced bold monetary and fiscal policy responses to comeback the global financial crisis that started in the U.S. As the result of their actions, the economies in the U.S. and China are recovering and providing the support for the global recovery.

More pragmatic, coordinated or joint actions will be needed, to deal with issues that arise from bilateral and multilateral trades. The economic interests of these two leading countries are too-intertwined and too influential to leave them under the emotional influence of sometimes over-blown protectionism.

In contrast, Europe seems to be in chaos. The ECB is consistently behind the curve in dealing with macro crises. This article from the Big Picture has a good summary of the main problems that need to be tackled by European leaders.

Greece's sovereign debt problem must be dealt with as what it is: The country is insolvent; both the Greek and the banks who have lended to them must live with the consequence. Debt restructuring should be done sooner rather than later.

Germany as a big exporter, is benefiting from the depreciation of Euro. As the leader of EU, it should act to provide stimulus to the regional economies.

The lessons from the U.S. and China is clearly that the central bank must act bolding to promote market confidence in the financial system. The fate of the Euro and the ECB are tied up with its member countries. Independence does not mean inaction.

We hope that pragmatism will also prevail in Europe.

When the market is so fearful, get greedy

It is Warren Buffett who stated that “Be fearful when others are greedy and greedy when others are fearful”.

Market has turned very fearful, with the VIX shot up into the 40s over the last weeks. It's all coming from the fear that the Greece crisis may turn into a global credit crisis, Lehman Style. Hedge funds are unwinding the pro-growth trade, a bet on growth oriented countries and companies, with the belief that the concerted efforts of central banks and governements are sufficient to turn things around.

The European sovereign crisis calls the thesis into question. Many have concluded that the economic growth is not going to be very robust. The New Normal thesis is back.

Flight to quality has driven up US long bonds, making it one of the best performing asset classes year-to-date.

The pullback this time is over 10%, more severe than the early February pullback. Yet, other than the European problem, the U.S. recovery is now on a firmer footing.

Perhaps it's time to get greedy.

Wells Fargo has become the largest U.S. bank

Less than four months after my earlier post about Wells Fargo becoming the largest capitalized U.S. bank, it has now overtaken JP Morgan and Bank of America in market cap. At $33.5/share, Wells is valued at about $175B, while BofA is at $172B, and JP Morgan which used to be the largest is now at about $164B.

This change of positions are largely due to the potential impacts from the pending financial regulations which aim squarely at Wall Street and trading operations. Among the large banks, Wells Fargo has the least exposure.

In addition, the recent European sovereign turmoil, and the worry about writedowns that many of these European banks and international banks may suffer from, have added to the change. Wells Fargo is more of a pure U.S. commercial banking play, whereas B of A and JP Morgan, Citigroup all have sizeable international franchises.

It is also interesting to observe that HSBC which has more concentration in Europe and Asia, has seen its market cap drop to about $172B, behind Wells as well.

It pays to be more focused on earnings quality and being truely conservative.

The widening criminal investigation on Wall Street firms from Morgan Stanley, to Citigroup, to JP Morgan in particular may do a lot of damage to trading firm's reputation. Interestingly, Goldman Sachs, being the first to be investigated now may start to gain back its composure because everyone on Wall Street is in the same boat. When Goldman's clients look at this picture, what are they going to conclude? You still go with the "best."

Jobs jobs jobs

Non-farm payrolls increased by 290,000 in April, much more than the 180,000 expected by economists. March figure was revised from 162,000 to 230,000. Even after subtracting the temporary census jobs added in April, the economy has started to add substantial amount of jobs (about 224,000), mostly from the private sector. This is not surprising anymore given the robust earnings reports from retailers to hotels to car makers.

The recovery is no longer jobless. NBER should be comfortable to declare that the Great Recession was over.

Unemployment rate will remain high near 9-10% for some time as more workers now become active in searching for jobs.

We expect the jobs numbers to accelerate in the coming months. We need 300,000 or more per month for the rest of the year.

The news did little to help the market which appears to continue to be absorbed by the fear of Greek contagion. It's a real opportunity.

How panicky it was today!

As all major indices dropping straight down today, I felt like the episode of August 2007 had returned. That was when the two Bear Stearns mortgage funds were shuttng down, and most quant equity strategies were losing money big time. It was the harbinger of what was to come in 2008.

Could today's event be something similar? Or the market just got short-circuited due to the fear of European contagion?

The selling was across the board. Everything, including stocks that are unrelated to international trade or finance, went down rapidly, before recovering some.

Dow at one point was down nearly 1000 point. Some of the stocks I was watching were down more than 20%. Truely amazing.

I have been reading up on European Union and Euro. I'm inclined to think that the sovereign debt problem is nowhere near the mortgage debt problem we've had. Greece will be dealt with or will linger on and shrink. Portugal and Spain will be dealt with or will linger on and shrink. Euro may continue to drop or even collapse. It will be a source of great volatility. But then so what? It was just a monetary experiment, an idea or a strategy to counter the dominance of the U.S. and the rise of Asia. ECB is not an effective central bank. If the problems it now face will bring it down, so be it. The nations in EU would then have the freedom to choose their own destinies.

The real economies will continue. Businesses that can take advantage of the weak Euro are going to thrive.

So why the panic given the small size of all PIIGS economies? They're neither a critical source of energy or raw material nor a major consumer market. They're not going to derail  the global economic recovery led by US and China.

I actually bought some shares during the few minutes of big drop.

Gold price, reflecting the great uncertainty over Euro, has gone over $1200/oz. This is precisely the reason to hold gold. Yet, some of the precious metal funds have been disappointing. For example, Vanguard's VGPMX has not only under-performed some of its peer funds, but have under-performed both GLD and GDX. Now we know for the hedge using gold to play well, we should get the real gold, or gold futures.

We've been right about raising cash, limiting exposure to banks and increasing short. But, rotating more into industrial, material and energy now appears a bit pre-mature.

Subprime Crisis Act II: The Greek Tragedy

Goldman's testimony was just a distraction. The real act was the country that gives us those letters to describe derivatives and volatilities.

Following last Thursday's report that Europe’s statistical office (Eurostat) had revised up the Greek 2009 budget deficit and Moody’s subsequent downgrade of Greece’s credit rating by one notch, another major rating agency S&P lowered Greece’s credit rating to BB+ from BBB+ and warned that bondholders could recover as little as 30 percent of their initial investment if the country restructures its debt.

That means Greece's credit standing is now "junk," or the sovereign equivalent of a subprime borrower.

The downgrad marked the first time a euro member has lost investment grade rating since the currency’s 1999 debut. S&P also reduced Portugal by two notches to A- from A+.

According to Bloomberg news, Greek 2-year note yields soared 505 basis points to almost 19% and Portugal’s jumped to 5.7% as credit-default swaps on Europe debt surged to a record. The yield on Greek 10-year bond climbed 45 basis points to 10%. That makes the Greek bond yield curve even more inverted, signalling a short-term tragedy and a long-term pain.

The fear in the market is that the sovereign credit crisis may spread to other euro members, notably the other PIIGS countries.

What's the way out?

According to Stratfor,

An EU-IMF bailout of Greece would ultimately give Athens the choice of becoming either an Argentina or a Latvia. A financial assistance program that does not involve substantial structural reform on Greece’s part would lead to a default a la Argentina. A bailout that forces Greece to get serious about reforms would mean Greece becomes an IMF-ward like Latvia, with default still a serious possibility down the line. In either case, Greece will essentially lose control over its destiny.

Yet another way out perhaps is to let Greece out of the euro pact quickly, so that it can persue its own independent monetary policy (i.e. print money).

Whatever it is, the European banks or other investors holding these sovereign debts are facing the pressure of a massive writedown, thereby weakening the already weakened European banking sector. This threatens the nascent global recovery currently underway, but shouldn't derail it.

See a more detailed analysis on why PIIGS crisis matters.

Is Goldman a buy?

Goldman Sachs is facing a political firestorm. Some heads may have to go, but it has a deep bench.

The forward P/E and the trailing P/E all look attractive at 6-7 range, now that the price is at $152/shr.

Is it a buy? Popular bank analysis Dick Bove thinks so.

We note in the Abacus deal, John Paulson came out ahead with $1B, and the losers were a German bank, IKB, which lost $150M, and Royal Bank of Scotland (RBS), which lost $840M.

The congressional hearing on Tuesday may yet create more discount on the shares.

What drive the V-recovery?

More and more investors and business leaders now believe we are onto a normal V-shape recovery. The supporting evidence from GDP growth and leading economic indicators to corporate and consumer spending are just too strong to ignore. Yet this vision of a normal recovery clashes with other pieces of hard evidence of sluggish job creation, persistent high unemployment, sluggish construction spending and slow lending to consumers and small businesses.

So where does the apparent V-recovery come from? Is it for real and sustainable?

Many economists and analysts have tried to gain insights for these question by examining aggregate reports and statistics such as GDP, Employment Situation, Housing Starts, Existing and New Home Sales etc. While these analyses are useful, many important forces can get lost in the statistics and aggregation. Skeptics and conspiracy theorists will continue to find holes in any of these numbers and trends. Discussions can easily become sports fans' wars of taking sides, or economists' religious fights, both are largely a matter of which college they've gone to.

I'd like to do this differently. Much like what Warren Buffett has been doing by looking into Berkshire Hathaway's component businesses that are vital to the economy: Railroad, Banks, Home Construction and Mortgage, etc.

Today, let us examine one of Mr. Buffett's long-time holdings, American Express, in hope to gain more insights into the question imposed above. American Express (AXP) is nearly perfect for this purpose, as it is a global business focusing on credit-based transactions and credit lending. We all know that the great recession we are now recovering from was in large part caused by a credit crisis. Whether or not we're indeed experiencing a V-recovery must be reflected in its various business segments.

Last Thursday, AmEx reported first quarter net income of $885M, double the $437M it earned a year ago during the depth of the recession. Consolidated revenue increased 11% from $5.9B to $6.6B. Both exceeded analysts' expectations. Provisions for losses totaled $943M, down nearly 50% compared to $1.8 billion in the year-ago period. The decline reflected continued improvement in credit quality on the overall portfolio.

It is a very strong rebound. Almost V-shaped, as we will see below in more details.

AmEx has two broad segments: payment business (called "Billed Business" by the company) and lending business ("Cardmember Loans"). So it is very transaction- or spending-based, with about a quarter of sales coming from its leading business. Both businesses are international. They are very sensitive to the speed of economic activities and credit quality.

Chart 1 below from AmEx shows customer spending in dollar amount and in year-over-year (YoY) growth rates in both "as reported" and "FX adjusted" bases, month by month. Click to enlarge.

 
For the first quarter of 2010, customers increased spending by 16% from a year earlier. And the YoY growth rate has reached 20% for March. During the first quarter of 2009, the business had a most steep deline YoY in February when the growth rate was negative 20%. The recovery in growth rate is remarkably V-shaped.

In fact, according to the CFO, March 2010 has been the highest March ever for the billed business. During the conference call, when asked how can that be when more people are unemployed and companies seem to be spending less, the CFO said (my amphasis):

I think what we see here is when things improve that discretionary spending is coming back. I think it is really the impact of a more affluent customer base. I think that is one part of it. The next part has to do with corporate card. Corporate card generally is more of a V. It goes down sharper than the rest of spending and it comes back a lot steeper and I think we are seeing that make a strong contribution here. We have a very strong position in corporate card.

Thirdly we have a strong G&S ["Global Network Services"] business. As you can see from the charts spending on cards issued by our partners that run on our network is performing very well. ..

Right there are three important insights for the V-recovery. First, more affluent consumers have generally recovered, perhaps due to both of their more stable income and wealth recovery. We see more and more retailers catering to affluent customers reporting knock-out earnings and revenue growth. And, they are big spenders.

Second, corporations have come out of the recession in a much more healthy shape than consumers. It is really interesting to see the V-shape remark on corporate spending. Executives need to travel more as soon as business starts to pick up and corporate accounts are not as pinched as consumer accounts.

Third, both export and import have been surging. Trade with emerging markets has been a growth contributor, which has bounced back a lot faster than consumer-focused businesses.

We should also note that the current recovery has also been led by manufacturing and technology, most of the activities going there are tied to business-to-business and trade.

Chart 2 takes a further look at the growth rate of the billed business by its following segments: U.S. Card Services (USCS), International Card Services (ICS), Global Commercial Services (GCS) and Global Network Services (GNS). The first quarter revenue of these segments are, respectively, $3.5B, $1.1B, $1.0B and $997M. Click to enlarge.

The most V-shaped recovery is the GCS segment, "reflecting increased spending by corporate cardmembers and higher travel commissions and fees."

The GNS segment has been the most remarkable. It never stopped growing, although its growth rate was tempered by the great recession. The first quarter result reflects "higher merchant-related revenues from the rise in global card billed business, as well as an increase in revenues from Global Network Services’ bank partners."

Of course, not all of AmEx's business receovery is V-shaped. Its card member loan business has continued to decline. Chart 3 shows the growth rate comparison between this business and the billed business discussed above. Click to enlarge.

During the height of the housing boom, AmEx made a strategic mistake to expand its lending portfolio, thereby increasing its credit exposure to consumers who were already very stretched.

The credit crisis has put a huge dent in AmEx's financial performance. But over the course of 2009, the company has sought to shrink the credit exposure by lending less and by controlling credit risk. Recovery for loan growth, however, is nowhere in sight. This also reflects consumers' de-leveraging behavior coming out of the crisis. The declining loan growth is consistent with the "soft demand" claimed to experienced by U.S. commercial banks.

We are witnessing bifurcated recoveries: There is a strong V-recovery, at the same time there is also a very sluggish L-recovery, with the former more tied to corporate spending and international trade and finance, and the latter more tied to domestic and less-affluent consumers. Depending on where you look, you see a totally different recovery.

For the economy as whole, it will take the shape of where the leading/expanding sectors are point to: a "normal" V-recovery.

Watch Out for Standard Pacific’s Massive Dilution

This week’s releases on existing home sales and new home sales have ignited a sharp rally for home builders. The momentum seems un-stoppable, as more and more investors looking to participate in the government-assisted housing recovery.

According to Google Finance, year-to-date, the shares of Hovnanian (HOV) has gone up more than 80%, while Standard Pacific (SPF) has gone up more than 70%, and Lennar (LEN) more than 60%. The sharpest rally has been in the month of April, especially this week.

I have turned bearish on Hovnanian based on valuation concern. For Standard Pacific, I like its business model and its dominating exposure in California and in the South. But at $6-7/share, there is a massive potential share dilution hanging over its head.

When Standard was teetering on the edge of bankruptcy two years ago, a private equity firm MatlinPatterson from New York came in with a several hundred million dollars infusion. It saved the company. Moreover, the turn-around management team it installed has been successful in restructuring the company’s debt structure. At the same time, the team led by Ken Campbell was focused on controlling costs, selling off non-performing assets and other areas that are crucial for profitability. The company has also been early in acquiring lands in promising locations and communities. Impairment has stopped, and the company is now well-positioned.

All these did not come cheap. As of December 31, 2009, MatlinPatterson owns 450,829 shares of Series B Preferred Stock which are convertible into 147.8 million shares of common stock (as a point of reference, the current shares outstanding is 106 million). The conversion price is $3.05. As the stock heading higher, it’s only a matter of time before MatlinPatterson converts this massive amount of holding in preferred.

On top of that, the private equity firm also holds a warrant to purchase 272,670 shares of Senior Preferred Stock at a common stock equivalent exercise price of $4.1 per share, which is exercisable for Series B Preferred. And the shares of Series B Preferred will initially be convertible into 89.4 million shares of the common. The warrant may not be exercised in full before the stock reaches $10.5. But at this point, it is already quite far in the money.

A comparison in dollar value will help us understand just how much dilution the share holders will be subject to. For this purpose, let us fix the common stock price at $6.5/share. The current market cap is $689M.

If the preferred is converted into common right now, its value is $147.8*(6.5-3.05)M = $510M.


If the warrant is assumed to be fully exercisable and converted into common, its value is about $89.4*(6.5-4.1)M = $215M.

Add these all up, the if-converted total market cap would be $1.414B. Given the book equity of $435M, we’re looking at a potential market-to-book ratio of 3.25. That’s usually associated with high-growth stocks (Google’s is about 4.5, Cisco’s is about 3.8).

Just two months ago, when SPF was trading in $3-4 range, this was not a big concern yet. But now in the $6-7/share range, MatlinPatterson’s massive holding is becoming much more valuable than the current market cap. It’s only a matter of time before they flood the market to exit their astute investment.

For investors at large, it’s not a great idea to bid up the shares too much ahead of earnings. At this point, the company only has the potential to deliver, but has not consistently delivered the earnings that would justify the high multiple.

Other home builder stocks, especially the still-highly-levered Hovnanian (run by the same management that drove it to the ground), also appears to be running too much ahead of their earnings.


(I want to thank Seeking Alpha member Searsdog for bringing up this important issue. I’ve earlier put out a warning on my blog after Standard Pacific’s Q1 earnings release.)

Perma Bull?

Jim Paulsen's view on Normal recovery.
See my summary of his view earlier.

Wells Fargo, positioning well

WFC missed on revenue, but beat profit estimate. Unlike other large banks, Wells Fargo does not have an big investment banking or trading operation. So it didn't benefit from security underwriting or trading. The flip side of this is that its business would be the least affected among big banks if Washington pushes through its regulation to separate deposit-based banking from investment banking and trading.

It has two main sources of revenue: interest income and non-interest income. They are about equal in size, each brought in $11B last quarter. Mortgage income about flat, which means the company saw a soft loan demand. Deposit had continued to grow. Net interest margin came down a few basis points at 4.27%, largely due to this good problem: lots of deposit that earns no interest, but Wells could not find meaningful ways to park them. So they are keeping their gun powder dry. Wait for the loan demand to grow with the economy.

The biggest positioing story is of course the Wachovia integration, which appears to be on track. Company expects to achieve $5b in merger savings. The value in this merger is to convert Wachovia into an extension of Wells Fargo, using the same focused business model to realize higher efficiency and revenue generation by cross-selling more products to the same customer base. The end result will be a stronger coast-to-coast national franchise.

For a good summary, other than my take on its positioning, see this. Wells is getting everything ready to thrive in a growing economy when unemployment rate starts to decline materially.

Standard Pacific: Don't sweat the small stuff

Earnings was released early in the morning. Missed revenue projection by a mile. Surprisingly, the stock held up OK.

Despite the miss, there are things to like about the company's position: both  net new orders and backlog are up substantially year-over-year and Q-to-Q. Land acquisition is up significantly, and according the CEO, approved land deals in April was above $100M, which is about the amount approved in all of Q1 (itself a significant increase). These will translate into substantial land holding this year.

The company focuses on higher price points than entry level homes, so it's not competing directly with foreclosures. That is, it is focusing on move-up home buyers.

It is still focusing on controlling the cost structure and profitability, not so much on increasing sales and revenue. Company not looking to increase sales a whole lot year-over-year, due to high unemployment rate. Higher sale should arrive when the employment picture improves. That's when things get interesting.

During the call, CEO estimated that the company can comfortably do $2B in revenue when the housing market recovers. It did $1.1B in 09. With a disciplined margin control, if and when that happens we can expect annual net income to hit $100M. Roughly, the market cap can reach $1B. So from here to there, we're looking at a double.

CEO also mentioned that there are prospective buyers who do have jobs and qualified, but still need to feel more confident about keeping their jobs before making new home purchases. They need to see that the economy is adding jobs consistently to jump off the fence. That's my view as well.

This is the kind of micro-cap I like to play: it has a clear plan and is focused on a long term vision that it knows it'll come out ahead. At this point, Standard's stroy is all about positioning. When buyers return, which they will, the company will do very well.

Caution for investors: Watch out for the massive dilution that will for sure arrive when the private equity firm MatlinPatterson converts their Series B Preferred shares and their warrants. Until then, enjoy the bumpy ride.

Focusing on earnings

The first week of the earnings season turned to be rather eventful.

Intel and JP Morgan reported fantastic results that pushed the market higher. Google's somewhat disappointed.

March housing starts was a positive surprise, even though it's still way below average.

Friday was a bomb. SEC's charge against Goldman, combined with weak reading on consumer sentiment sent the market sharply down, erasing the gain for the week. Goldman story will linger on for months, as it's a poster child for Wall Street's greed and power. Everybody will be jumping up and down on this unfolding saga, and people are expecting more and more followup scandals and discoveries... the political risk of owning bank shares is getting even higher.

For bank stocks, two things to focus on. (1) We can avoid these Wall Street concepts. I've sold off JPM and BAC for that reason. I've stayed with my long-term holding WFC, for it has a very small I-banking business inherited from Wachovia Securities, and the rest is doing very well. I still think it could become the largest bank stock in market cap. (2) Pick up some of the bank stocks such as GS if they are excessively over-sold, so that the political risk is well-compensated. One of the Barron's articles argues that GS already looks under-valued after Friday's selloff. I agree somewhat, but the article may have underestimated the political fervor. Similarly, JP Morgan also looks expensive. Jaime Dimon's approach to dealing with Washington may not help. These Wall Street firms don't seem to get it: Washington will not leave them alone to do business as usual, doesn't matter what they say or do.

Last week, Sandra Ward had an article on Barron's about how retail investors are finally following the lead of institutional investors in getting into equity funds. It's well worth a read. I think there is more to come, which can turn out to be a powerful factor for the stock market.

James Paulsen's thesis on the recovery appears to be intact. This week, he re-confirmed the view by observing that "Despite persistent, widespread economic anxiety, the contemporary recovery appears remarkably normal."  That is, there is no "new normal."

According to Tax-Refund Monitor,

... taxes withheld in March  showed a very large increase over February. There were no changes in law or withholding schedules ... it often indicateds activity has accelerated, but is not yet being captured in the labor-market data. ...

Last Friday's WSJ, however, did have an article on "Tech Leads Jobs Recovery" that shows that Silicon Valley is ramping up hiring on tech talents.

Investors with a long term view informed by economic data will be in an advantageous position to play this market. Stay in the market, raise some cash when your winners become too large, and pick up good stocks when they're wacked by short-term forces. This is a sound strategy that I've played with with good results.

On Monday my favorite builder SPF will report Q1 earnings at market open. I'm somewhat optimistic. Citigroup, Goldman Sachs and Wells Fargo will report too. During the week there will be existing home sales and new home sales reports. It'll be very interesting.

Consumers to solidify the recovery

Consumers are out shopping in March, despite lower income and still grim job prospect. Confidence is getting back up.

Sales surged 1.6 percent, the Commerce Department said, up from February's revised 0.5 percent gain. Economists surveyed by Thomson Reuters had expected a gain of 1.2 percent.

The increases were across the board. Car dealers, home furnishing stores, building suppliers, sporting goods stores, clothing retailers and general merchandise stores all reported gains. Auto sales surged 6.7 percent, the department said, the most since last October.

I was wrong, the retail strength now looks quite solid.

JP Morgan reported great earnings today. Its nonperforming loans, those that are in default or close to being in default, totaled $2.7 billion, up $946 million from a year earlier but a $763 million improvement from the final three months of 2009.

"We continued to see delinquencies stabilize, and in some cases improve, in our credit portfolios," Dimon said. "Ultimately, the health of these portfolios will track the health of the economy."

The strong result is also telling me that I may have been too cautious about big banks.

Bernanke, testifying before Congress, said that consumers are spending again after having cut back sharply during the recession. Going forward, consumer spending should be helped by a gradual pick up in jobs, a slow recovery in household wealth from recent lows and some improvement in the ability to get loans.

High unemployment rate and low inflation, however will keep the Fed from raising the rate anytime soon.

Will Standard Pacific Pacify?

Investors have bid up Standard Pacific Homes (SPF) ahead of its Q1 earnings release next Monday (4/19). Since the company has a very large exposure in California, this is likely due to the March sales data just reported by MDA DataQuick. SoCal's sales volume has gone up 5% over the same period last year, and the median price has been up by 14%.

According to the same source, similar trend but smaller magnitude has been observed for January and February Southland home sales.

For Q1, analysts are expecting a $0.06/share loss, which is about -$6 M in net income, on revenue of $184 M.

The revenue estimate is very likely an underestimate.

In the March quarter of 2009, Standard recorded $209 M in revenue. Given the increases in both sales and prices year-over-year in one of the major markets where Standard operates, and the fact that the company has been ramping up in California, we think it's likely that the revenue will increase, rather than decrease substantially.

Newer communities, which may account for more than 10% of the company's total sales, should contribute higher margins. Compensation cost is expected to come down a bit. It is likely that the company will report a small profit excluding tax benefit this quarter.

While increased sales is certainly a big welcome, investors should look for increases in community counts and backlogs as the company heads for the Spring selling season. We will also be looking at the company's use of capital in new land acquisition, and the geographic distribution of its communities. How it positions itself to benefit from a rocky recovery is at least as important as how the last quarter turns out.

This is a very volatile stock. The share price can go up or down 20% easily around earnings release. Should the stock price continue to rise in the next few days, the stage may be set for a big selloff after earnings. If that doesn't happen, we may see a more pacific trading next week.
    

Is the U.S. Treasury Yield Curve Getting Even Steeper?

(This article has appeared on Seeking Alpha and has a lot of followup comments: http://seekingalpha.com/article/198205-why-the-u-s-treasury-yield-curve-should-get-even-steeper )

The yield spread between 10-year and 2-year Treasury notes has widened to record levels. In other words, the yield curve has never been so steep for a long long time. When it is steep, it is predicting future economic growth, usually. Could this time be different? Will it get even steeper?

There are many implications from the steep yield curve. Banks are obviously benefiting from it. Are are hedge funds who have access to low interest funding sources. Savers and retirees who depend on fixed income, however, are out of luck.

To fund deficit spending, the government may need to offer higher yields to investors. On the other hand, some investors seem to find it already attractive to own long bonds, helping the Treasury to raise billions of dollars.

The Fed 's easy money policy and massive federal spending however argues for the possibility of an even steeper yield curve.

The Fed is determined to keep the interest rate at the short end near zero for an extended peiod. Inflation is not yet a concern because capacity utilization is still very low and unemployment rate is still very high. In fact, it is conceivable that the Fed is determined to wait until it succeeds at creating inflation. Inflation will get the economy going, and it will help get the U.S. out from under its debt burden. Moreover, a weak dollar policy also helps to ease the trade deficit.

So for at least 2010, the short end will continue to be ancored down at zero. The long end will depend on two things: (a) investors' expectation of economic growth and (b) inflation.

People talk about these two factors as if they're independent. We think they're intertwined. Higher growth brings about higher level of economic activities, which means higher velocity of money. That's inflationary. On the other hand, higher prices will help jump start business activities by increasing investment and employment. That will help generate growth.

Now throw in the desire of major external Treasury investors to diversify away from their massive holdings, the odds are we'll see an even steeper yield curve.

Weekend reading: Cautiously optimistic for Q1

What might be in store for the first quarter corporate earnings? For sure, many (perhaps more than 50%) will beat. More important, revenue picture should continue to improve, along with profitability. But most important of all is the outlook. Do companies feel more optimistic about the business, and they will thus invest more and create more jobs?

We'll be reading and watching these outlooks.

Perusing through this weekend's Barron's. Surprised to find something missing: Where is the deeply sarcastic perma-bear Alan Adelson? Has the market advance towards 11000 finally convinced him? Or is he taking a nap? Anyway, it's hard to continue to press for a pessimistic view in front of all the improving economic data and more importantly the markets.

The cautiously optimistic Michael Santoli is alive and well with his continuing caution for a potential correction. This time, we obviously agree. We think Q1 could have some surprises. The generally optimistic mood could have set it up for "buy on rumor, sell on news" kind of trade. But if the fundamental pictures are sound, we should see opportunities in post-earning blues. This is our thinking for raising cash last week.

Santoli mentions China being a factor. We do see RMB rising within a bigger band. The move won't be large. China needs to release some inflationary pressure that has been building up. And to transform itself into more consumption oriented, China should empower the consumers a bit. On this front, the Obama administration seems to be handling it well by pursuing an engagement policy, despite all the protectionistic noise.

If RMB rises substantially over the course of 2010, say another 5-10%, the increased raw material purchasing power should help crude, copper, steel, and other raw material producers. We want to be overweight in these areas.

See Big Picture for an interesting discussion on market sentiment.