D Is For Deflation

Just a quick post to get people focusing on Fridays CPI number in the US. Whether we call it negative inflation or deflation (for the record I am clearly confused what the hell the difference is) we should see the first of many negative numbers. Remember the run crude went on in the first half of the year? The year over year changes will look staggering.

I am currently very long gold in this environment and am debating taking some off the table as historical gold does not perform well in deflationary environments. If it were only so simple. We were right in characterizing this move in gold to coordinate with USD strength. Since it appears every currency is in a race to devalue there currency (to increase competitiveness and boost exports) and to cut rates to zero (clearly there are more rate cuts in store of the UK, Euroland, Canada etc) I am less inclined to exit my trade. Since gold is essentially a zero interest rate investment what would I rather own? A currency about to be devauled or a "store of value". I'll keep you posted.....

Industrial Production As A Leading Indicator

January Industrial Production was aweful falling 1.8% month over month. Leading the charge was a 2.5% drop in manufacturing output. Since auto companies shuttered in production and cut capacity in the month I guess we should not be too surprised. In fact auto assembly units fell to 3.9 million units (this is an annualized figure). This in turn drove manufacturing capacity utilization to 68%. This an all time low for this 61 year old data series.

Unfortunately this isn't where the pain ends. We know that inventories are at decade highs. My guess is that sales will remain weak for a prolonged period of time due to consumer balance sheet repair and the fact that we pre-bought too many vehicles in the last few years of our debt-fuelled comsumption binge. The underlying trend of owning a vehicle for 10 years or more is going to come back in vogue.

In the mean time as auto production continues to be curtailed (until inventories can be worked through) all associated industries should suffer as well. These include plastics, textiles and everything else involved in the auto industry. These numbers have not come through in the industrial production as of yet. Industrial production as a leading indicator is not turning any time soon. This is true of every country globally.

The ISM (I prefer using NAPM but should use the current acronym) increase we saw last month looks to be a small positive blip in a very negative trend. Global industrial demand is in absolute freefall, the Empire State manufacturing survey and todays IP point to a sharp decline in ISM.

I would not like to be a long only fund manager at this point. There would few places to hide. I wonder how investors will feel when they see that there mutual fund beat the index by 30 basis points but was still down 30% this year. Its going to be messy. I would move into long / short fund (make sure there is no long bias please and little leverage) or opportunistic hedge funds that can capitalize without the market moving higher.

I Love Numbers BUT The Truth May Not Be In The Headline

Just spent the past hour getting caught up with all the economic data hitting the market over the past few hours. Attention is clearly on the Obama "save the homeowner" plan but I wanted to discuss the headline 46% surge in Mortgage Applications.

On the surface this is an impressive number. The "CNBC talking heads" get all fired up that is a sign that the economy is starting to bottom and that the supply of homes on the market is going to get sopped up, prices will stop declining and that banks will survive (assuming defaults stop). Okay so lets scratch the surface a little deeper.

First of all about 75% of the increase in Mortgage Applications was due to refinancing. This is solely a function of government purchases at the long end of the bond curve to bring yields down. This has worked as 30 year fixed rates dropped below 5% last week. When people are unsure about the future then tend to reduce risk. This is one way to do this. Fixing your payment for 30 years under 5% is compelling. To me this has nothing to do with reducing the supply of homes in the system (like the headline would like you to believe). On a side note in the past decade refinancing activity increasing has usually led to increased spending. I don't believe it will be the case this time. As personal net worth erodes (via house values and portfolios) consumers are forced to retrench. If we overlay this statement with low savings rates, high household debt burdens and rising unemployment it paints a very different picture. It is the reason why the saving due to lower gas prices over the past 8 months hasn't been spent and retail sales are dismal and getting worse.

The truth is in the trend. Actual purchase applications rose about 9% week over week but this follows steep declines the previous 2 weeks of 10% and 11% respectively. Lets do some quick simple math (my CFA designation allows me to do this). If we do a quick purchase application index it would look something close to this. If we start the index at 100 and reduce the 1st week by 10% it is at 90 now. Take another 11% off the index for week 2 now we are at 80.1. This doesn't look very healthy to me. Remember the headline about a 46% increase in Mortgage Apps. Well in reality is was only a 9% increase in purchase apps so this make the index now 87.3. Reality is that purchase appls are down 12.7% in just 3 weeks (100 - 87.3).

The above math gives a very different outlook than the headline. In fact YoY activity is off 28%. Now ask yourself how is this taking supply away. Truth is it isn't. When we look at the "real trend" in conjunction with, unemployment (the US has lost about 2 million jobs in just 3 months), New Home Sales and Housing Start data it is even worse. This in no way should be viewed as a positive data point.

What should be talked about (and it is by a few such as Roubini, Rosenberg, Krugman, Case) is that bubbles create overcapacity. The US built roughly 2 million too many homes over the past 6 years. In order to work though this overcapacity prices will continue to fall. Truth is I have no idea how far ... no one does. All we do know is that overcapacity is deflationary and time is the only cure. Don't bet on the consumer (via the baby boomers) to come to the rescue this time! Rallies are still to be sold.

Swedish "Super" Models

Well the blog post won't be as exciting as the title. There will be no photos of Elin Nordegren (Mrs. Tiger Woods) or her twin sister here. We'll save that for another site.

I thought today may be a good day to publish and old internal piece I did briefly illustrating the "Swedish Model" for handling their housing crisis in the early 1990's. It was done in October of last year and illustrates some interesting points. Take a read. I have comments below....


ROAD MAP FOR THE GLOBAL STOCK MARKETS

Swedish Crisis of the Early 90’s Provides Guidance

Background

Probably the best model to look for parallels
Swedish government implemented a blanked guarantee for all bank liabilities (ex-equity) in 1992
Government injected government capital into most troubled banks (some still failed)
Loan losses were 12% of GDP (this compares to IMF estimates of US loan losses at 10% of GDP)

Swedish government intervened after GDP had been declining for 7 consecutive quarters YoY
US government / FED and central bank are taking a much more proactive approach (this is most likely due to the inter-connectedness of the global financial system)

Key Points

Recession lasted 3 years
Output declined sharply immediately after government intervention (we are seeing this right now)
The economy began to grow again 3 quarters after intervention
Credit growth to the private sector was negative for 2.5 years following intervention
Household savings rate rose dramatically (this is beginning as we speak)

Stock Market Implications

Stock market fell 45% from peak to trough (it took 27 months)
Global markets are all in this range
The bottom in Sweden was made approximately 1 month after government intervention
The following 12 months the market rallied 43% and was followed by another 20% the ensuing year and yet another 24% in year 3
Appears that government intervention provided the floor even though the economy weakened for some time

What can still be done …..?

Governments can guarantee inter-bank lending which will allow the global financial system to begin moving again (look for LIBOR to fall)
Purchase equity stakes directly in distressed financial institutions – so far equity holders have been left holding the bag allowing relentless selling and financial sector short selling (the ban was removed this week) – this would cease
Continued reducing interest rates where possible – a steep yield curve is necessary for the banks to be able to repair their own balance sheets – the ultimate goal would be to pass these reductions on to the end consumer (this has not happened yet)

What is needed ….?

Plain and simple and one word – TIME
Credit bubbles all have two things in common first is the excessive liquidity that gets us into this mess and the second is that TIME is ultimately needed to restore the financial system to equilibrium


Today is the day as the S&P looks to retest its low made in November 2008. Lots has happened in the past 3 months. It is clear that the leverage in the financial system was certainly more than anyone anticipated. For example leverage at Europe's largest financial institutions make Lehman look conservative - remember even though the for sale sign was out no one would buy them in September. This leads to the point that nationalisation in one form or another is inevitable. The sooner the Roubini coined term "zombie banks" are eliminated from the system the sooner the system can begin to get healthy. Don't mistake my words here. Eliminating the insolvent banks isn't the panacea to our problems but is a step in the right direction of a very long unwinding process.

Think of this example: lets say healthy bank A (this in itself seems like an oxymoron right now) has the ability to lend on its balance sheet through a combination of prudent lending and strong capital ratios but insolvent bank B keeps getting bailed out by the government with it unclear if there is more taxpayer money to come (lets refer to this as TARP1, TARP2, TARP3 etc.). Why would healthy bank A begin to lend? Bank A will continue to hoard money and clog up the system. We already know that unless mandated bank B will use the capital infusion to strengthen its balance sheet (they will also argue that they are too big to fail and should such receive more capital in the next TARP rounds). So nobody lends. This is part of our problem today.

The returns in Sweden post government intervention were tremendous. After falling 45% (peak to trough) they rallied 43%, 20% and 24% in the 3 years following intervention. I think we will differ from Sweden on one key point. That being the relative strength of the consumer. Clearly in the years 17 years after the Swedish crisis saving rates in the Western world collapsed (remember when they went negative for a quarter in 2006) while debt expanded. This is what sets this apart. My view is that consensus earnings targets for the S&P are too high (really pick any western world stock market it will be the same if I am correct) and the multiples applied to the earnings are also too high. Markets must go lower to find equilibrium. This is not going to be fun.

U.S. Fiscal Stimulus - Devil in the Details

Looks as if the House and Senate have finally agreed on the stimulus package and it should be signed into law tomorrow. However, it appears the headline numbers (and the ones being reported by all the talking heads) is much more impressive than should be reported. I continue to hear how the $787 billion is equivalent to 5.5% of 2009 GDP. One is left to believe that all the stimulus is actually going to be spent in 2009. It leads to hope (on a side note I have to put that hope is not an investment style) which both the sell side and the long only buy side are banking on. Reality is that only $184 billion will be spend in this fiscal year (ending September 2009). Now it is only 2% of GDP. Lets put that against Q4 GDP of -3.8%. First of all the revision will most likely take this to -5%. Q1 doesn't look any better. How will earnings meet current expectations? They won't! Not as massive an injection as one might believe.

Here is what should be being reported:
1) the $787 billion is the estimated cost over 11 (yes eleven) years
2) $184 billion will be spend in fiscal 2009 - maybe adding 1% to 2009 GDP
3) the spending is NOT cohesive and is a complete free for all of projects
4) spending will be dispersed as follows: $115 billion on tax cuts (my guess is that these will be added to savings), $54 billion on education, $46 billion on transportation infrastructure (wasn't this suppose to be the rebuilding of America - not for $46 billion) etc...

The reality is that this is only the initial spend and is no where near what is needed to add or save the jobs that Mr. Obama targets. What you have not heard yet is that there is an Omnibus bill planned for this summer. Look for this to be Fiscal Stimulus 2. My guess is that when the economy continues to perform poorly through Q2 and the Omnibus bill comes to the forefront the USD will begin to fall. In the mean time look for the USD to hold in as both the EURO and POUND look much weaker in the near term. My guess is that markets will rally off the news that this stimulus plan has actually been passed (looking passed the reality of the spending) and that Mr. Geithner will actually have some concrete solutions with TARP 2. I continue to believe in selling this rally and protecting yourself for the back half of the year - earnings are not coming back anytime soon.

Japan's GDP Shrinks At Annual Pace Of 12.7% in Q4 2008

Well the headline pretty much sums it up. What is becoming more frightening to me is that I have yet to see how Q1 2009 will be any better. The global economy is in free fall. I know I will hear arguments about the Baltic Freight Index, copper prices and any oil other than WTI as proof we have seen bottom and fiscal stimulus is working. My point is that the Western World consumer has shut down. Without the consumer consuming unemployment will continue to rise. I know the consensus is for around 9% unemployment by the end of 2009. This is understated in the current environment. This is where we differ. Not in direction but in magnitude.

If we dig into the GDP data from 2002 - 2006 we see that the majority of consumer spending was aided by withdrawing equity from the home. Hey I'm not here to criticize this as my family has done this as well. But reality is that when we purchase with debt we are saying I will consume now and pay later. The pay later portion takes future cash flow and applies it to paying down debt - not consuming. In other words the consumer portion of GDP is going to collapse. Again nothing new. My argument is that the magnitude will shock everyone.

I'm sure you all caught the headline on Thursday that consumer spending increased 1% in January. Both the buy and sell side "believers" continue to tought how the worst is behind us and that the back half of the year will be rosy. Don't be fooled. They all fail to mention some key facts: first is one month does not change a trend. If you look at YoY changes consumer spending is off 10.6% from January 2008. This changes ones perspective just a little. How about the 3-month change (November - January) of -9.5% (+-.5%) from the same period a year ago. Now the 1% increase doesn't look so good. But the kicker is that the rate of change appears to be accelerating. January sales are 2% below Q4 2008. This doesn't seem positive to me.

FSP - the new TRAP or TARP

Well here we go again. Looks as if the Obama team is off to a great start. I quote from Mr. Geithner "We are not going to put out details until we get it right". To me this is code for we really have no idea how this is going to work and are really hoping we get it right. I'm not the only one to think this the S&P was down 5% and the KBW Regional Bank Index down 9%. This is quite ugly. I'll have more comments on the FSP later. For now I think it prudent for investors to watch the VIX index (it moved up to 46.67) and gold (up $22). Neither moves are a good sign for equities in here.