Did the Green Shoot Get Weed Whacked?

The market has experienced a smart rally off the March lows. We’ve most recently set into a digestive phase. Interpreted to mean, the market is taken a breather of sorts to consider the how and why we’ve rallied to the current levels, and equally important, are these levels deserved based upon where we are in the recovery. As we’ve witnessed over the last few weeks, the market has what appears to be a nasty case of indigestion. When the bears resurfaced and began imposing their will on the general markets, they point to the mounting staggering job losses and ballooning budget deficits. Add in the continuing deterioration in housing prices and it leaves investors with one real option, bid up TUMS futures.

Then a funny thing happened on the way to the retracement, earnings season got in the way. Nervous longs and traders have been taking profits and hedging positions leading up to the real kickoff of earnings season with Goldman Sachs (GS) this week. The bar has been set sufficiently low in my opinion to allow for significant outperformance to the upside, primarily by the financials. Consider in the financial arena, three major competitors no longer exist or are a lot less formidable, Bear Stearns, Lehman Brothers and Merrill Lynch. Also, while M&A(Mergers and Acquisitions) and Investment Banking (IB) business is off dramatically, the need to raise capital by Publicly traded companies along with the astronomical borrowing needs from the Treasury should have the financials coffers overflowing. In the not too distant future, look for M&A to experience a spike in activity. Corporate America has been hoarding cash. Companies are on the prowl. Dell with in excess of $6 billion is an acquirer. Microsoft is still a passive pursuer of Yahoo. EMC outbid NetApp (NTAP) in a bidding war for Data Domain. So, does the prowler NTAP now become the prey? NRG refuses to blink in a standoff with Exelon’s attempted buyout. There are many deals being looked at currently. However, much like in real estate negotiations, buyers look at current conditions and put out a wish bid. While sellers stubbornly remember the high water mark when times were better. How do we close these gaps in proposed valuations? It comes down to a restoration in confidence and fortitude. Confidence in the economic recovery and the fortitude to execute ones strategy. The companies willing and able to correctly look out six, twelve, eighteen months, know their markets, identify opportunities and then have the backbone to commit the necessary resources to execute their plans will ultimately be the survivors and winners. Think about Berkshire’s Buffet, back in September, when fears of financial Armageddon were at their heights, made an opportunistic investment into Goldman Sachs. The investment called for receiving 10% interest rate, with the option of buying Goldman stock at $115.00. Shortly thereafter the stock plunged to $47.00. Many claimed the old man had lost his touch. Today those shares change hands at $149.00. He also made an investment into GE. The jury is still out on that investment. But, while he waits for that to play out, Berkshire will also be receiving 10% interest. The current environment continues to be extremely favorable for the financials. The yield curve remains steep. Meaning, short term rates remain quite low, .25%-.375 vs. 30year treasuries at 4.3%. So, banks can pay virtually nothing on savings accounts, checking accounts, CD’s etc., and lend, when they actually approve a loan at 5-6%. Netting out 4 ¾% - 5 ½%. Multiply that by a few $billion and you can see the cash flows being generated. They’ll need them to offset the mark downs still coming.

Where are we?

There is plenty of reassuring news. The fears of financially important companies failing creating systemic risk, has been effectively neutralized. Another positive notes, The Conference Board’s Leading Economic Index (LEI) came in at +1.2% for the month of May, following April’s +1.1% increase. As the name clearly implies, this is a leading indicator of future economic activity, contraction or expansion, in this case expanding. Focusing further on the domestic economy, we look to the Manufacturers Purchasing Managers Index (PMI), which registered 44.8 for June. Yet another Month over Month improvement over May’s 42.8 reading. This still represents a contracting domestic economy, but with continued improvement. The ISM’s Non-Manufacturing report on Business came in at 47% up 3% from May. Importantly, new orders came in at 48.6%. Nestled in the data was further good news, 7 of the 18 reporting groups reported a resumption to growth in June. Participants also noted bloated inventory overhangs was seen significantly reduced. With the real orders emerging, they believe real domestic demand is reappearing and not merely a restocking of depleted inventories. I’ll continue to monitor this closely. Inflation? In the current environment the Federal Reserve is more concerned with breaking the deflationary spiral we were caught in. I believe they are having success, but work remains. That being said, with the massive treasury borrowing coupled with all the creative programs the Federal Reserve has implemented, inflation will come into focus, Also, an exit strategy for all that liquidity sloshing around must be formulated and articulated to investors. But, we’ve kicked that can down the road.

Let’s expand our view a bit and look overseas. First, let’s look to the leader, that turns out to be India. That’s right, India leads the global recovery as measured by the Purchasing Managers Index (PMI), which registered 55.3. Included in that reading was the new orders index which came in at a very strong 58.1. Next up is China, whose PMI registered 53.2. That is four months in a row for these emerging Tigers. While the Euro-zone, Japan and Russia remain in contraction the trend is clearly one of healing. All have made continued significant improvement in stabilizing their respective financials and economies.

Now, the balance, the not so good. Only 3 economies are expanding. Granted 2 are large globally significant, the remaining economies, including the US, are simply contracting at a less rapid rate. We can’t ignore the 800 pound gorilla in the room. Real Estate. Prices continued to decline. Albeit, at a less rapid pace. What I’m finding worrisome is the Pay-Option-Arms have overtaken Subprime mortgages in terms of default and delinquencies. These products were primarily designed for Real Estate “speculators”. A moment please, I need some mouthwash to get out that bad taste in my mouth from that one. These “investors” are worse than Subprime borrowers in my opinion. Subprime borrowers were in many cases less sophisticated and or educated. These “speculators/investors” gambled on Real Estate, and made few if any payments, simply opting not to pay. As they began to realize their “investment” wasn’t working out, since they had no skin in the game, simply are waking away. Reworking these loans will not work. When a borrower decides not to make a full payment, the payment not made is added onto the principle amount of the loan. It is only when these loans get to 125% LTV are the borrowers forced to begin making full payments. Then the delinquencies kick in. So, the loan is now 125% of the original inflated property value. Attempting to refinance when the value of the underlying property has fallen 25-40% makes it undoable. These “investors” in essence rolled the dice, it came up craps, then they took their chips off the craps table. I wonder what would happen if they attempted that at one of the Riverboat Casino’s?

The employment prospects don look promising yet. The US economy has significant spare capacity as reflected in the Capacity Utilization numbers which at 68.3%. Think GM. You’ve got 100 workers and 31 of them are sitting in the job bank, parked on Facebook all day. Didn’t work out to well for them. This is the reason you may hear the unemployment figures being referred to as a lagging indicator. Before companies will add new hires, they need to fully utilize existing assets/workers. Things must clearly be on a path of sustainable recovery and spare capacity sopped up, before companies will take on the time and expense of new hires.

Lending. The free flow of credit has not been restored to pre-crisis levels. For a number of reasons. Banks are still hoarding cash. The securitization markets are thawing but the pipes are still clogged. Prudent financial institutions have strengthened underwriting guidelines. The result, rates for small and mid sized business loans remain stubbornly elevated, if they can access them at all. While noting progress has been made, the Treasury and Federal Reserve recognize the need to address the velocity with which capital is flowing. What needs to be addressed also is that banks are appropriately pricing risk premium reflected in these elevated rates. How and why will this risk premium compress? Just see above. When banks have confidence in Asset prices, Housing Prices, Business climate and that borrowers will continue to be employed, spreads will compress and rates will come down.

Regulatory Risk.
Wall Street dislikes uncertainty. Implementing business plans when the playing field is virtually moving beneath your feet leads to a lot of trips and falls. The SEC is about to announce new rules and regulations surrounding the Uptick Rule and Naked Short Sales among other things. The CFTC is looking into position limits on a basket of commodities. Why is this important? Two timely examples. Oil nearly doubled in 6months time, boosted by hot money. Now, the CFTC steps in to investigate any manipulation,(although there was none when oil hit $147 in 2008). Long positions have been liquidated aggressively pushing down prices over 20% in 2 weeks. Just look at the drama playing out with CIT. The FDIC and Treasury have the ability to further assist CIT (already a recipient of $2.3 billion in TARP and the number one lender for small businesses) with their short term liquidity. However, as of this moment they have not. Why? No one is really sure. Do they wish to test there new plans and capabilities for an orderly dissolution of a non-systemically important financial? We don’t know. With all this uncertainty, institutional investors are using patience and restraint in not chasing this market too far. Which caps potential rallies, but puts a soft floor under the market as market participants are willing buyers on weakness.

What to do?
As the market rebounded smartly, investors as a group, whether Hedge Funds, Mutual Funds, Traders or Retail Investors, wished they had bought in March and April. A retest of those lows is highly unlikely as the catalyst for those lows was the potential failure of systemically critical companies, now has been removed. Now that we are experiencing a digestion phase, and the market, chart wise, completes a back and fill, we may get an opportunity to buy some companies on sale. Earnings season will be vitally important in dictating the depth of this correction and dictating direction. We’ll just need to have a keen eye in recognizing the need to use our trimming shears on the rose bush or spot the dandelions and break out the weed whacker.