Tuesday, July 21, 2009
[Following are excerpts from last week's commentary at Iacono Research discussing the raft of sales for model portfolio positions executed the week before.]
First and foremost, it's important to remember that it has been just one week - five trading days - since a good portion of the model portfolio was transformed from various investments in stocks and commodities into cash. In the broad scheme of things, that represents an almost insignificant amount of time and, though it may not feel that way right now, money.
The decision to make these sales had been contemplated for a few weeks after markets had made their highs in late-May and early-June after having moved up from the March lows. Talk of "green shoots" had investors of all stripes wanting to "get back in" so as to make up for some of the losses that were handed to them last year and prices had been bid much higher.
Meredith Whitney Leads the Reversal
What we've seen since spring has been a very strong "bear market rally" (clearly, we haven't been in a primary bull market for stocks since 2000) and after faltering during the month of June, many technical levels being threatened or exceeded in just the last week or two, some analysts (including myself) felt the odds did not favor broad continued exposure to stocks and commodities at this time and took action.
As it turned out, the gloomy mood in June and early-July all changed last Monday when bank analyst Meredith Whitney set the stage for a big reversal in equity markets by fawning over Goldman Sachs' second quarter earnings report that were no less than "blockbuster" when they were released on Tuesday. Her comments alone are believed to have pushed the Dow Jones Industrial Average up about four percent. Then, after markets closed on Tuesday, Intel raised their guidance for the third quarter and this was followed by a stellar earnings report from JP Morgan on Thursday. Citibank and Bank of America followed suit on Friday, all of this compelling investors to put aside whatever reservations they had over the prior month and start buying stocks again.
Equities, commodities, and nearly every other asset class rose while safe have bets such as Treasuries saw fewer buyers and, at least for the week, there was a sense that everything was back to normal - that stocks were not about to retest the March lows and that the "June swoon" was an aberration, one that was promptly corrected.
A handful of economic reports created some very positive sounding headlines, thus adding to the renewed optimism:
- retail sales rose (but the gain was due entirely to higher gas prices and auto sales)
- jobless claims fell (but odd seasonal adjustments belied the underlying trend)
- housing starts improved (but they are still far below the worst pre-2008 levels)
In each case, there was much more to the story than the headline, none of it positive.
This was exactly the combination of news and events that were needed in order for equity markets to pull up out of their recent funk and that's exactly what they did. If someone were to have written a script - a sequence of events to help the stock market avoid plunging through major technical support levels - they couldn't have done a better job than what was seen throughout the week last week.
To top it all off, Nouriel Roubini, one who has had a dim view of things for years (and has been far more accurate than most forecasters), was reported to have said that the recession would be over by the end of the year and this news was touted on CNBC for hours. Roubini loudly announced that he had been misquoted, but the impact had already been made - the bears had turned bullish and the skies had cleared.
But, have the skies really cleared?
A closer look at the bank earnings tells a story that most stock investors probably don't want to hear.
No Recovery for "Traditional" Banking
The combined $10+ billion in second quarter profits reported by industry titans Goldman Sachs, JP Morgan, Citigroup, and Bank of America did not arise from the traditional business of bank lending that might indicate Main Street is doing better, but, rather, from the business of Wall Street - trading operations, investment banking, and asset sales.
At Goldman Sachs, controversy continues to swirl about possible market manipulation due to a trading desk that accounts for an inordinate share of all transactions on the New York Stock Exchange, recent revelations of stolen software by a key trader shedding some much needed light on how the company dominates trading across many markets. They have recently been the subject of some scathing press and the outsized bonuses announced last week may yet have big repercussions as unemployment continues to rise and the outlook for Main Street and Wall Street diverge dramatically.
While JP Morgan collected record fees from trading and underwriting stocks and bonds (they are a primary dealer for U.S. Treasuries, a sector that saw brisk business over the last three months), revenue and profit in some of their key consumer and investment banking businesses were down from the first quarter and loan losses rose another $2 billion to $30 billion, a clear indication that consumer lending is getting worse and not better.
At Bank of America, the bottom line benefited from a wave of mortgage refinancings as interest rates dipped to historic lows, however, loan loss provisions increased by $13.4 billion and CEO Ken Lewis was less than giddy about the outlook for the second half of the year, noting, "Profitability in the second half of the year will be much tougher than the first half." A large portion of the profits at BofA during the second quarter came from trading at Merrill Lynch, acquired last year, and, at Citigroup, the bulk of their second quarter profits came from the sale of the Smith Barney brokerage.
Even with freakishly low short-term interest rates, JP Morgan, Bank of America, and Citigroup all lost money on the traditional banking business of lending money and will likely continue to do so until there are improvements in the labor market, the housing market, and the commercial real estate market. While a bottom in investment banking may now be behind us, the worst is yet to come for credit card delinquencies, mortgage defaults, and small to mid-size banks where exposure to commercial real estate remains quite high.
At a Senate Banking Committee hearing on Thursday, Senator Jim Bunning (R-Kentucky) related a comment by FDIC Chairman Sheila Bair that another 500 banks could fail.
In my view, the bigger picture is unchanged - the spring stock market rally, reinvigorated as it was by bank earnings, is on borrowed time and, sometime this year there is likely to be another leg down for equities, testing the March lows and maybe worse.
That was the primary reason for taking dramatic action a week ago and, after looking inside both the recent bank earnings and economic reports, that assessment has not changed.
In the fullness of time, we will see how this all works out - one week does not make a financial market recovery or an economic recovery.
A Look Back at the Last Eighteen Months
But, for those of you who made sales similar to those executed for the model portfolio last week, how do you deal with this? After all, markets are very much based on momentum and there has clearly been a big shift in momentum over the last week, the losses in broad equity markets incurred over the prior four weeks being wiped out by just five days of gains. The recent move up was a powerful one to be sure and it's quite possible that the stage has been set for another leg up, not down, in the near-term during what are usually lightly-traded summer months.
Well, the first and most obvious thing to look at is the history of the last eighteen months because there is a compelling comparison that is quite easy to make, one that is very telling. As indicated by the red arrow in the graphic below, though the partial sales of model portfolio positions made early last year looked ill-advised for months, in the end they were quite prudent and prevented even worse losses for 2008.
While I'm not expecting another late-2008 stock market melt-down this year (although anything is possible), we are about to enter what has been, historically, the worst time of the year for equity markets and neither the economy or company earnings are anywhere near as good as most investors would like to think that they are. Moreover, there are a host of negative factors that, at some point, will impact investors' attitudes.
The success story of 2009 so far - China - has a stock market that is increasingly viewed as a bubble about to burst as more than $100 billion in bank lending so far this year is said to have gone to purchase shares. Despite calls by the government to restrain lending, banks doubled the amount of loans made from May to June and government officials are now planning to restrict credit growth in order to "prevent China's economic recovery from being hijacked by unchecked speculations on assets", according to one central bank official. Last week, economic growth during the second quarter was reported to be 7.9 percent and, with massive infrastructure projects now underway, their economy may continue to expand, but that doesn't necessarily mean that share prices will continue to rise.
The top lender to small and medium sized businesses in the U.S. with some $75 billion in assets - CIT Group - may file for bankruptcy and this will have an unpredictable impact on financial markets. The U.S. government has spurned their requests for a bailout and this is being offered up as a test of how much the financial system has recovered in recent months - whether it can stand the shock this is likely to produce.
The labor market woes continued last week as state unemployment rose across the country, the jobless rate in Michigan now at 15.2 percent, the first time in 25 years that a state has recorded an unemployment rate in excess of 15 percent. The conventional thinking that the labor market is a lagging indicator will soon to be put to the test as the employment situation shows no signs of improving, though it continues to worsen at a slower pace.
On Friday, I caught Larry Kudlow on CNBC for just a few minutes and he was heralding the steep drop in weekly jobless claims as being proof that the recovery was now underway. Naturally, he failed to mention the impact of seasonal adjustments and went on to say something about "don't look a gift horse in the mouth" when referring to the recent stock market rally.
It's important to understand that most people desperately want conditions to improve - we are optimistic by nature and media outlets such as CNBC and a good portion of the financial press are only too willing to spin the news in that direction.
It is quite possible (if not likely) that, after the events of the last week, equity markets will continue to go higher for some period of time. While that will make last week's sales look and feel increasingly worse, I remain comfortable with the decision that was made as it relates to both the model portfolio and my personal accounts.
An ideal decision? No. A prudent decision? Yes.
Over the past eighteen months, we have clearly entered a new era for investing, but, it seems that most people are still expecting a speedy return to the ways of old. Just last month, Money Magazine ran a story about how to "make back" the losses suffered over the last year citing a study that provided three scenarios for future returns - slow, fast, and faster.
The rates of return for slow, fast, and faster were 5.5 percent, 9.6 percent, and 12.8 percent!
While there may be even more angst in the period ahead over last week's sales, the fact that a respectable gain for 2009 is now virtually assured makes me feel a little bit better about things. The downside has been limited and there remains a huge potential upside for the remaining positions.
[Note: Subscriber RN sent a link to this story with recent comments by Dr. Marc Faber advising "investor vacations" over the summer. It seems I was in good company.]