Leverage is Back in the Credit Markets

Last night I had dinner with a friend who works as a bank loan trader for a large and distinguished credit-focused hedge fund. We were chatting about the wild ride the credit market has taken over the last two years and commiserating how difficult it will be to make money in 2010 given how much spreads have narrowed since the depths of the market swoon last December.

In casually noting how difficult it is to get excited about bank debt trading at close to par (vs. 40-60% of par one year ago) with skimpy spreads and LIBOR close to zero, my friend told me his fund is now employing what is called a Total Return Swap (“TRS”) to juice their returns. Essentially, a TRS is a form of financing provided by an investment bank that allows an investor to lever their returns (i.e. if a security is trading at 80 cents on the dollar a hedge fund could finance some portion of this purchase to turn a low return investment into one with a mid to upper teen yield).

At the height of the credit bubble in 2007, levered purchases of bank debt were fairly common and contributed to the madness. However, this mountain of leverage came crashing down in 2008 when the trading levels of most securities fell below the face value of the debt issued to finance their purchase (akin to the price of a home falling substantially below the value of its mortgage).

As my very crude example below demonstrates, the use of a TRS can help juice a security with an otherwise paltry 5% current yield into a highly attractive 15% clipper (admittedly, the use of 80% leverage is probably high, but certainly existed at the height of the credit bubble). Since my firm never employs leverage in any of our purchases, much of the bank loan market has now been rendered off-limits to us.

Should liquidity in the credit markets remain robust and the economy continue to heal, many of these investments will pay off handsomely. However, it’s quite disconcerting to me that not only is leverage quickly coming back into the system, but that it is the leveraged buyer is who driving the sharp rebound in asset prices. Does the memory of investors extend beyond one year or is 2008 sufficiently in the past that we are ready to go back to our old ways?

Another somewhat related point – how perplexing is it that investment banks are willing to lend to hedge funds (who are using the cash to drive asset prices higher), but most Main Street businesses who operate in the real economy still can’t get a loan.

Investing Outlook and Strategy for 2010

Here is an article from the FT confirming that large hedge funds are betting on inflation. Obviously, there is nothing earth shattering in this article since Robertson has been touting his “steepner trade” since Jan 2008 and Paulson is the largest holder of the GLD (in addition to marketing a new gold focused fund), but thought it was interesting to point out how funds are positioning themselves to make money in 2010.

In reflecting on the market bottom that we hit in March 2009, if you had told me that the high yield index would be up 55% this year, leveraged bank loans up a similar amount, the Nasdaq up 40+%, the S&P up 60% from its March lows, gold at $1100 (having crossed $1200 along the way), I would have thought it nuts to see the 10-year at only 3.7% (and around 3% for much of this rally!). This goes to show you the incredible effectiveness of the monetary experiment initiated by the Fed. Essentially, quantitative easing (primarily through the Fed’s $300 billion treasury purchase program and $1.25bn agency-backed mortgage program), has kept the back end of the curve fairly low, even with a powerful rally in risky assets. One can chastise the Fed for its involvement in the financial system and dispute the long-term merits of such action, but in no way can one debate how successful it has been in the short-term. The ponzi-esque nature of the Fed’s actions are legendary (i.e. buying unwanted assets in the open market to keep their yields low and allow the treasury to fund our fiscal deficits at rock bottom rates), but even Madoff’s investors felt great in the beginning years. However, based on the recent rise in the long end of the curve it’s unclear that our creditors will remain as committed to us as Madoff’s unwitting investors were to him.

Rapped up in this “inflation” trade is actually a very bullish view on the economy. Assuming the Fed keeps rates negligible for some time, which is my own personal opinion (hardly differentiated, but certainly confirmed by Bernake’s extensive work on the failings of the Fed during the Great Depression), we could see a fairly powerful rally in the stock market for the early part of 2009. As forceful as the rebound has been off the March lows, the individual investor has remained almost entirely on the sidelines. This is confirmed by the persistent negative fund flows into equity mutual funds. March represented a capitalization of sorts on the downside; the pervasive skepticism that has greeted the current rally is hardly reflective of market tops.

I routinely like to call a bunch of friends in the industry to take a very informal poll of their mood and that of their firms. I like to say that everyone was a micro bottoms up investor in 2004-early 2007 and ignored (except John Paulson and a few other astute investors) the macro clouds hanging over the global economy in 2005/2006. Well in October 2008 to March 2009, everyone all of a sudden became a “macro investor.” Concerns over the systemic risk of the banking system, the Fed’s irresponsible involvement in the financial markets, and the death of capitalism dominated the conversation. Such “boring” things as single digit PE multiples off of cyclically depressed earnings and free cash margins in the double digits (for even unlevered companies) all of sudden became irrelevant in the context of the impending doom of the financial system.

As we emerged from the depths of the March lows, massive amounts of skepticism greeted the market rally. People conceded that asset prices were extremely cheap, regretted that they hadn’t bought more, but also doubted the sustainability of the rally. The “green shoots” sprouting in the economy (i.e. house price stabilizing in California, inventory liquidations abating at most large companies, credit worthy borrowers accessing cheap credit) were either ignored or outright dismissed by those seeking confirmation of their bearish bias.

As I stand here now in December 2009, I can sense a clear shift in the mood of my fellow investors. Skepticism is melting away as people are simply tired of being bearish. The macroeconomic concerns that dominated the conversation over the last twelve months are being replaced by “M&A is back”, “companies still look reasonably priced on historical metrics”, “which companies stand to benefit from China growing 10% next year.” In short, all the discussion topics that would have served investors well in March; ones that I found so hard to engage people in less than a year ago, are only now beginning to resurface.

While the individual investor still remains on the sidelines, the hedge fund community has clearly embraced this rally. Until the former joins the party, I think we could see a continued rally in the market, perhaps materially so. Improving economic data that will most surely surface in the early part of 2009 will only confirm this increasingly bullish disposition. However, as an unrepentant contrarian, I think investors should not so easily dismiss the “macroeconomic” views they so diligently added to their investing toolkit at the bottom of the market. An improving economy will have the perverse effect of encouraging the Fed to extricate itself from the economy. This is particularly the case as it relates to housing, which I have repeatedly pointed out since starting this blog, has been on an improving trend for much of 2009 (do in no small part to the strong hand of our government).

The Fed’s decision on whether or not to extend the $1.25 trillion mortgage-backed security market (set to expire at the end of Q1) will serve as the seminal data point on the sustainability of the market rally. Should they let this program expire, the impact on mortgage rates, housing, and the banking system will be immediate. The reverberations of this in the overall economy could take a few quarters, but under such a scenario I think 2010 could end up disappointing a lot of investors as we exit the year. On the flip side, should the Fed maintain its overall accommodative stance by keeping rates low and extending many of its liquidity programs, we could see a sustained rally for some time. At some point, the reckoning will have to come, but I doubt it will happen in 2010. If 2009 has taught me anything, it’s to never doubt the short-term impact of a massive Fed-induced monetary experiment.

Bernake and Co. unleashed every weapon in their arsenal to prevent another Great Depression. As long as they continue their fight, and Bernake’s academic background leaves little doubt that he remains committed for the long haul, it remains pointless to fight the Fed. The ramifications of sustained monetary stimulus will be inflation, which underpins the short treasuries/long gold thesis dominating the investing strategies of many hedge funds going into 2010. I remain in this camp, though I concede I derive little comfort from the growing consensus forming around this thesis. A sharp reversal in Fed policy will warrant a reassessment of this investing strategy, though I think investors will be well-served by maintaining a strong bias to equities and gold as we enter 2010.

Job Openings - Leading Indicator of Job Growth?

While the employment picture remains grim in the United States, the number of job openings has increased by over 4% since bottoming in July 2009. As a leading indicator, this provides a bullish data point for the employment situation as we close the books on 2009.

A few points explain the spike in job openings. Firstly, the increase in listings reflects the normal frictions that occur in the labor market as companies prepare for an increase in employment. After all, you need to post a job offering before actually hiring someone. Secondly, with the pool of unemployed workers in excess of 15 million, companies are rightfully being very discriminating in who they seek to hire. Most executives remain suspicious of the apparent rebound in the economy and want to make especially sure they have a need for additional workers before adding to their payrolls.

However, I believe a third factor is having the greatest influence on job openings without a commensurate increase in employment. Simply put, the administration's repeated extension of unemployment insurance is making out of work Americans more selective in what jobs they are willing to settle for. As explained in this very enlightening NY Post article ("The Stimulus for Unemployment") if you subsidize something (i.e. unemployment) you get more of it. Extending unemployment benefits from 26 to 79 weeks has removed the ballast of necessity for many unemployed folks. Why settle for anything less than ideal when the unemployment check keeps rolling in?

With the benefit of hindsight, the administrations's worst case assumption of 9% peak unemployment used in the bank "stress tests" seems patently laughable. This has been the source of much ribbing by investors and economists alike. Ironically, it may be the administration's actions regarding unemployment insurance that resulted in such a sizable divergence from their original estimates. As suggested in the referenced NY Post, the government's forecast may not have been too far off if it left the labor market to its own devices.

China's Empty Cities

A good friend alerted me to the video below, which demonstrates the incredibly inefficient capital investment taking place in China as a result of its 4 trillion yuan stimulus program (~US$600bn). The video features the city of Ordos, intended to hold over 1 million people, but which remains virtually uninhabited.

The story of Ordos reminds me of the unoccupied homes on Dubai's palm-shaped islands. 60 Minutes did a great two-part segment on the country in August 2008. Here is a link to the video: A Visit To Dubai Inc.

While I remain convinced of China's long-term growth potential, there is little question that the government has fomented a massive investment bubble that will undoubtedly end very badly. While there are innumerable data points to support this view, a few stand out. Firstly, average Chinese home prices are nine times median household income, on par with the peak levels reached at the top of the US housing market in even the most speculative cities (more normalized levels should be ~2.5-3x income). Secondly, the volume of property sales has risen by 85% in 2009 and prices of new apartments in Shanghai have risen by nearly 30%.

While concerns over Dubai and Europe's "PIGS" dominate headlines, China scares me infinitely more. Dubai has public and private market debt of approximately $60-$80 billion depending on which source you believe (Dubai World, where much of the troubled debt resides, comprises just $25 billion of this total). On the other hand, Chinese banks unleashed over $1 trillion into their domestic economy in the first six months of 2009 alone! On an annualized basis this equals approximately 50% of GDP. After forcing them to aggressively lend earlier this year, the Chinese government is now encouraging banks to shore up their capital bases. Such a dramatic change in direction should not be dismissed lightly. (see: Chinese Banks Study Plans to Boost Capital).

Lending by government decree has undoubtedly contributed to the country's 8-9% GDP growth, but one has to question how efficiently such capital was invested. While there is little tangible data to support this assertion, most pundits speculate that a good chunk of this lending (perhaps a 1/3) was directed to real estate and stock market speculation. The video below provides some convincing anecdotal evidence to support this claim.

More Evidence of a Bottom in Housing

While housing activity will likely remain subdued over the next year as inventory in the existing home market gets whittled down, the data below provides convincing evidence that the new home market bottomed earlier this year. From the peak in September 2005, housing starts hit a trough in April 2009, some 79% below its peak levels. Subsequent to that time period, total starts have risen a healthy 19.8% and single family starts an even more robust 35.0%. While permits and housing starts have firmly rebounded, homes under construction continue to hit new lows in November 2009, suggesting the new home market could experience a rebound in pricing over the next year, particularly if mortgage rates remain at rock bottom levels.

Is Gold a Good Long-Term Investment?

Here is my response to a friend’s comment that “gold is a good long-term investment”.
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I am not sure I would ever hold a commodity “forever” and I disagree vehemently with your statement that gold is a good “long-term” investment. The nature of commodities is that high prices ultimately choke off demand and/or result in increased supply. Gold seems to be in the sweet spot of the cycle since annual supply continues to decline (despite the higher prices) and demand remains very strong among investors and central banks. However, nothing suggests that this dynamic will last indefinitely.

Remember gold was in a secular decline from 1980 to 1999 so while it has risen a lot since 1999, it will come back down hard at some point. It could take 5-10 years (frankly, I have no idea), but there is little doubt that it could come crashing down. The near consensus global view forming around gold's preeminence as a store of value should only serve to spark your interest in how best to short it. There is still much skepticism around its recent run; as such it could continue going higher (hopefully, materially so since I remain long through the GLD and options on the GLD). However, there will come a time where even the most ardent skeptics throw in the towel and the most strident bulls bask in their fleeting fame as TV personalities (many of which are already coming to the fore). At that point, I hope I am smart enough to spot the cracks in the bull case. Usually, it’s the most levered buyers who serve as the canary in the coal mine. To the best of my knowledge (albeit limited), I don’t think the current bull market in gold is being driven by the leveraged speculator and so the “foolishness” that characterizes most bubbles has yet to surface.

Every time a speculative bubble gets underway, I always try and call the top and every time I am always way too early. However, without fail no matter how high things go they always end up materially lower than ever I thought possible. So my point is that even if gold goes to $2,000, $5,000 or whatever, once investors’ faith is restored in paper currency, gold will decline precipitously. It is hard to imagine a world where paper currency reclaims its spot as a favored store of wealth; then again, it’s always difficult being a contrarian when others are getting rich riding a speculative wave. While the comment that investors will one day come to value paper currency again seems asinine given the ubiquitous money printing and fiscal deficits being run by nearly every developed economy; I can assure you that asserting in 1999 that gold would breach the $1,000 level seemed equally as preposterous.

The only thing I would blindly hold forever is the equity of an excellent company. Give me an early stage Coke, Disney or Microsoft and I will give you every ounce of gold residing in my portfolio (no matter what the concerns surrounding inflation are). There is absolutely no better way to generate long-term wealth than buying and holding the stock of great companies residing in countries undergoing secular growth. No matter how high gold goes, nothing will shake my conviction that equities remain a far superior long-term investment.

Bullard Comment on Fed's Asset Purchase Program

Amazing how the quote below, uttered by Federal Reserve Bank of St. Louis President James Bullard to reporters yesterday, is propelling the markets to a near 2% move today. Just goes to show that so much of this rally is being driven by the market’s perception that the Fed will retain its accommodative stance for far too long.

"I have advocated to keep the asset-purchase program open but at a very low level, and wait and see what happens, and as information comes in about the economy we can adjust that program while the federal-funds rate remains at zero," Mr. Bullard told Dow Jones Newswires in an interview Sunday. He said "no decision has been made" about the program's fate.

While bubbles appear to be forming in every asset class outside of the US dollar, the Fed has done nothing to temper these concerns (some would even contend that this is precisely the Fed’s goal!) While the contrarian in me believes that a sharp reversal is in the offering (I am actually considering buying long-term treasuries as a portfolio hedge), the massive rotation out of the dollar could be sustained for some time, particularly with Bernake & Co. at the helm. Interestingly, the collapse in near-term treasury yields has now made the US dollar a cheaper funding source than the Japanese yen. With the dollar replacing the yen as the primary vehicle for the carry trade, the momentum underpinning the declining dollar may only be beginning, particularly as these carry trades are typically executed using substantial leverage.

The short-term impact of a leveraged short against the dollar can be self-perpetuating and I believe we are currently in the midst of this phenomenon. Hedge funds and other leveraged investors are buying any number of assets – junk bonds, emerging market bonds/equities, oil, and gold & other base metal commodities, etc. The assets may be different, but the funding source is essentially the same (i.e. the US dollar). While everyone is currently consumed by their investing acumen, correlations between seemingly uncorrelated assets have never been higher (in many cases approaching one). The momentum in the markets is not dissimilar to what we saw in the summer of 2008 and we know how that ended.

Again, while I remain invested in gold and believe the Fed’s policy of zero interest rates provides investors a license to speculate in risky assets, I am becoming increasingly concerned by the uniformity underpinning this thesis, particularly as leveraged investors enter the fray. Selling my gold today would be a mandate on the world’s central banks ability to heal their economies without stoking inflation – at this juncture, I remain far from convinced that such an outcome will play out. However, to the extent that central banks begin to withdraw the artificial stimulus underpinning this asset bubble (or at least give us a credible timeline for doing so!), Lumpy Investor will not be shy about reevaluating his year long bullish view on gold. Until then – gold $2000!!

With the FHA Help, Easy Loans in Expensive Areas

The New York Times (“With the FHA Help, Easy Loans in Expensive Areas”) continued to hammer home the problems mounting at the FHA in today’s paper. Some of the most compelling quotes/data points include the following:
· On Thursday, the Mortgage Bankers Association said more than one in six F.H.A. borrowers was behind on payments [14.4% of loans are delinquent; 3.3% are already in foreclosure]
· In 2007, fewer than 4,400 F.H.A. loans were made in California. The Economic Stimulus Act of 2008 helped change that by temporarily doubling the maximum loan the F.H.A. insured, to $729,750. The F.H.A. has insured more than 107,000 loans so far this year in the state, according to DataQuick.
· “If one of these higher-limit loans fail, that’s equivalent to two or three cheaper loans,” Mr. Donohue said. “You have to ask yourself, was the F.H.A. ever intended to address these markets?”
· “It was kind of crazy we could get this big a loan,” said Mr. Rowland, 27. “If a government official came out here, I would slap him a high-five.” “We were resigned to waiting another year,” said a second partner, Michael Bedar, 31. “Then we read about the F.H.A. I had never heard of it before, and couldn’t quite believe it. But it was the answer to our problems.” They put down about $33,000, split among the three of them [the purchase price on the building was $963,000]. “Everyone should have the chance to do this,” Mr. Kurland said.
· Everyone may get a chance. Representative Barney Frank, the Massachusetts Democrat who is chairman of the House Financial Services Committee, said in an interview that he planned to introduce legislation next year raising the maximum F.H.A. loan by $100,000, to $839,750. His bill would make the new limits permanent.

Robert Toll Blasts the FHA

Below is a verbatim quote from Robert Toll, CEO one of the most respected public homebuilders in the country, on the government’s FHA program. Toll was addressing a large crowd of investors at a UBS building products conference when he was asked to comment on the FHA.

How disastrous must the FHA be, such that Toll felt it prudent to warn about a program that is directly supporting his industry? So far, few people, outside of concerned investors and knowledgeable folks in the housing industry, have lamented about the problems at the FHA. The fact that Toll is now speaking up against the agency should serve as a clear warning signal to those folks in government who think they are doing a service to the country by artificially propping up the housing market via this broken federal program.


A - Robert I. Toll, Chairman and Chief Executive Officer: We had all sorts of inspectors and qualifiers and administrators that made it a big pain in the butt [ph] so Fannie, Freddie was around with the same limits of much easier financing, so why would you go FHA. Well, the reason you go FHA, FHA is the new subprime. What the government is doing is beyond belief in that once upon a time until that had its glorious days like a year and half ago. FHA did very small percentage of the business in the country. I don't know what the actual percentage, I bet it was 2 or 3% and today FHA is doing 30% of the business. And the reason is yesterday's subprime is today's FHA and whereas on a Fannie, Freddie you are talking 20% down you can go and get the last 10% if you struggle hard from another guy and give a combo rate. But on FHA you're talking 3.5% down. And now if you're doing business at $120,000 and you're given an $8,000 credit, and you're only making the guy put down 3.5, not only does he get the house but he gets some cash to walk away from the settlement table with. So yesterday's subprime is today's FHA and I think it's not --

Q: So it's potentially a train wreck again?

A - Robert I. Toll, Chairman and Chief Executive Officer>: It's a definite train wreck and --

Q: Because a lot of the guys --

A - Robert I. Toll, Chairman and Chief Executive Officer: The flag will go up within the next couple of months. It already has preliminary going up, bail us out, give us some more money.

Q: Right. I mean not you guys but again a lot of the publics have 60, 70% of their volume now coming.

FHA's Net Capital Ratio Falls to .53%

Late last week the FHA released its long anticipated annual update report to Congress. As expected, the report highlighted the significant financial duress within the agency’s portfolio. Specifically, the FHA’s capital reserve ratio fell to .53% vs. a 2% mandated level and 2008’s cushion of 3.22%. While the agency’s leadership continues to believe it will not need a bailout, most close observers of the housing market (including myself) see little chance of that scenario playing out. Even within the guts of the FHA’s report, the agency does concede that under certain pricing scenarios the agency will eat through its entire capital buffer (though this will be temporary as a robust housing recovery will enhance the agency capital position beyond 2011).

While absorbing the FHA’s losses will be relatively small, particularly when compared to the hundreds of billions of dollars needed to prop us Fannie & Freddie, my concern is how distorting the FHA’s involvement has become. Private commercial lenders have been shut out of the market since most are unwilling to match the lax underwriting standards and high LTV ratios available through the FHA. Government involvement has enhanced affordability for marginal buyers, but derailed the inventory & pricing correction needed to bring the housing market to a healthy equilibrium. How sustainable is a market that requires a maximum 3.5% downpayment, $8,000 tax credit, and artificially low mortgage rates (less than 5% at current rates) to entice the incremental household to buy a home? Obviously, not very. The longer we put off the day of reckoning the more painful the correction will ultimately be.

At the end of 2008/beginning of 2009, I was very encouraged that housing was quickly finding a bottom. While pricing and new construction were breaching new lows each month, the inventory was starting to clear and real buyers (not 600 FICO subprime borrowers or speculators) were finding their way into the market. Pricing was falling to levels where the rent vs. buy equation was just too enticing for judicious savers that sidestepped the madness of 2004-2007 to pass up. However, with the strong hand of government manipulating the market, that price/inventory correction has reached a grinding halt.

It could take some time for the government to withdraw its stimulus from the housing market, particularly with the 2010 elections quickly approaching. Politicians hate to disrupt the apple cart lest it interfere with their #1 goal of getting reelected. However, until housing reaches a point where it can stand on its own, the apparent “recovery” evident in the incrementally positive data remains highly elusive in my opinion.

World Gold Holdings - As of September 2009

The World Gold Council recently updated the gold holdings for every major country, including the IMF. While little has changed since the Lumpy Investor last published the Council’s findings on May 21st (see post for comparison), it is important to emphasize how underinvested the US’s largest creditors remain in gold. Specifically, China and Japan, which collectively hold $1.5 trillion of US Treasuries, have only 1.9% and 2.3%, of their respective foreign reserves in gold. Conversely, the leading Western economies, including the US, Germany, Italy, and France have between 65-80% of their reserves in gold. Across the 107 countries surveyed by the World Council, the average country has approximately 10% of their reserves in gold.



China has publicly expressed its concern over the US dollar and demonstrated its unease by purchasing 400 metric tonnes of gold earlier this year. While unlikely in the near-term, I see no reason why China wouldn’t seek to bring its holdings in-line with the world average of 10%. Assuming such an outcome, China would have to increase its gold holdings by approximately 4500 metric tons. With mine production at approximately 2500 tons per year and declining (see chart below), this would represent 1.8 years of annual supply just to get China on par with the rest of the world. Applying similar logic to other reserve rich/gold poor countries, including Japan (2.3% of reserves in gold), India (~6% after its recent 200 metric ton gold purchase from the IMF), Singapore (2.2%), and Russia (4.3%) could have a massively distortive impact on the price of gold.

While I doubt the conclusion of some analysts that such a scenario would drive gold in excess of $5,000, I see no reason why the yellow metal will not surpass its previous inflation-adjusted price of approximately $2,200/ounce hit in 1980. Given the unprecedented money printing and fiscal imprudence demonstrated by elected officials across the globe, such an outcome becomes more likely with each passing day.

The Lumpy Investor remains bullish on gold over the next several years, and while I am increasingly concerned by the growing consensus around that view (particularly with hedge funds and individual investors clamoring into the trade), the glaring underinvestment in gold by the world’s largest creditor nations, provides strong fundamental support for my thesis. Does that necessarily preclude us from seeing a short-term pullback in the price of gold? Most certainly not. There has been a massive shift out of the dollar and into risky assets, with gold an obvious beneficiary of this migration. Should the Fed begin to tighten, we will likely see a near-term snapback in the price of gold as the dollar-carry-trade gets unwound en masse. However, last week’s policy statement provides minimal evidence that the Fed views inflation as a risk, which would in turn lead to them raising short-term interest rates.

With the Fed's stamp of approval, investors have a license to speculate in risky assets, with gold being the most obvious currency. Until the Fed begins to show some backbone and/or foreign central banks reduce their negative rhetoric on the dollar, the Lumpy Investor will remain bullish on gold.

Pulte’s Reliance on the FHA

The quote below, taken from Pulte’s third quarter earnings call, demonstrates how critical the FHA has been to propping up the housing market. With its recent acquisition of Centex Homes, Pulte is the largest homebuilder in the US and an excellent proxy for the industry.

FHA loans were approximately 43% of loans funded from the financing line in the third quarter [Note: Pulte, like many public builders owns its own mortgage company] compared to approximately 34% in the second quarter of 2009. FHA loans in the quarter for Pulte, on a standalone basis represented 35%; in Centex it was 60%.

IMF Sells Gold to India, First Sale in Nine Years

The Reserve Bank of India became the latest central bank to stock up on its gold holdings, purchasing 200 metric tons directly from the IMF over the last few weeks. The transaction, equivalent to 8 percent of global annual mine production, accounts for almost half the 403.3 tons that the IMF in September agreed to sell as part of a plan to shore up its finances and lend at reduced rates to low-income countries.

Despite the sizable purchase, India’s gold holdings ($10.3bn) represent less than 4% of its total foreign exchange reserves ($285.5 billion) as of October 23, 2009. This is well below the 30-40% more reflective of developed country central banks.

While the pending IMF sale created a pull back in the price of gold in September, India’s sizable purchase suggests significant appetite on the part of foreign central banks eager to diversify their exposure to US dollars.

Even with China’s purchase of 400 metric tons earlier this year, bringing its reported gold holdings to 1,045 tons, the country remains way underinvested in the yellow metal, with gold representing less than 2% of its foreign exchange reserves. I wouldn’t be surprised if they take down the remaining 200+ tons the IMF intends to sell later this year.

Weekly Railroad Data - Still Negative

As suggested in the chart above, weekly railroad carloads (a favorite metric of Buffett to gauge the health of the economy) continue to experience mid-teens year-over-year declines despite a growing consensus that the economy is on the mend. While certain categories are showing hints of a bottom, including grains and chemicals, many continue to experience 30+% year-over-year declines (i.e. metallic ores, crushed stone, forest products, and lumber).

While some would argue that carloads provide less of a snapshot of the economy relative to years past (primarily because services & technology represent such a greater chunk of our output), a mid-teens decline exiting a recession would be unprecedented. As such, I remain skeptical that the massive rally we have seen in the equity and credit markets (particularly the latter) can be justified based on what is going on in the real economy.

Interestingly, high quality stocks such as Walmart, P&G, etc, which have done nothing since the March bottom in the equity markets, have performed relatively well over the last week. While only a few days old, I suspect we are finally seeing a reversion to large cap value names vs. the “dash to trash” that has occurred over the last few months.

Portfolios positioned defensively should hold up much better as we exit 2009.

America's Growing Short-Term Debt

This chart summarizes the precarious nature of the treasury’s funding situation. As suggested by the table below, the amount of US government debt maturing in less than a year has spiked to nearly 45% vs. approximately 30% over the prior 25 years. A shortening of the maturity schedule reflects the growing concern that foreign governments and institutions have over our ballooning debt. While the treasury continues to have minimal difficulty in raising money, just as with any distressed borrower, lenders are putting the US on an increasingly short leash.

While near-term risk to the dollar’s vaunted status as the world’s reserve currency remains minimal (if only because a credible alternative does not exist), central banks have collectively started to voice concerns over our fiscal predicament. Most intend to gradually reduce the dollar’s share of their foreign currency reserves. For the sake of the dollar, lets hope they don’t all head for the exits at the same time.

Lend America Faces Probe for Alleged Fraud on FHA Loans

The Wall Street Journal reported late last week that the government was investigating Lend America ("Lend America Faces Probe for Alleged Fraud"), a NY-based mortgage lender, for falsely certifying borrowers that received $14 million in FHA-backed loans.

Anyone in the New York area has probably seen their commercials, set in the style of a breaking news flash, encouraging borrowers to refinance into FHA-backed loans. According to the WSJ article, Lend America is the 22nd largest FHA lender by volume, having originated some 11,300 FHA mortgages over the last 2 years, with defaults on their mortgages running 2-3x the national average.

The investigation follows on the heels of HUD’s suspension of mortgage lender Taylor, Bean & Whitaker in August, which subsequently filed Chapter 11 only days later. Up until its filing, Taylor Bean was the third largest originator of FHA mortgages and the 12th largest mortgage lender in total.

While small in comparison to the total mortgage market, the recent problems at Lend America and Taylor Bean reflect the rampant fraud that has been occurring at the FHA (not dissimilar to what we saw unfold in subprime in early 2007). With the government-controlled entity insuring approximately 25% of new mortgages, investors should remain deeply skeptical as to the sustainability of the apparent bottom in housing.

A Top of the Market Quote From the Chairman of CIC

I recently came across the quote below from Lou Jiwei, Chairman of China Investment Corp, which pretty much sums up the investment philosophy of fund managers chasing this rally 60% off its lows.

“It will not be too bad this year. Both China and America are addressing bubbles by creating more bubbles and we’re just taking advantage of that. So we can’t lose.”

As long as the US and China continue to flood their economies with endless amounts of monetary and fiscal stimulus this mother of all bear market rallies could continue. However, with unemployment approaching double digits, credit in the real economy evaporating by the day (how many retailers have reintroduced lay-a-way programs??), and rising food and energy costs pinching the American consumer, this rally has far exceeded any justifiable levels based on the fundamentals.

Even more excessive has been the massive rebound in the high yield market. Whereas the average bond traded at 55 cents on the dollar at the depths of the market low in December 2008 (an absolutely once in a generation buying opportunity), the average high yield note now trades at a very rich 92 cents on the dollar. Nearly all CCC or lower rated bonds have rallied by over 100% off the lows, with many having high probabilities of receiving no recovery in a bankruptcy scenario.

While glimmers of an economic improvement have justified a rebound in credit, particularly given the depressed levels at the trough, fund flows are largely driving the compression in credit spreads. Flush with liquidity, bond managers are compelled to put money to work. Most professionals are shaking their heads, but as long as fund flows remain robust, they have to put this money to work no matter how overstretched the credit markets seem.

Bernake & Co. appears committed to maintaining a very accommodative stance. Backward looking measures of unemployment, inflation, and capacity utilization warrant their concern. However, just as steady interest rate increases in 2005/2006 eventually choked off the housing/LBO credit bubbles, the first hints of tightening by the Federal Reserve will undoubtedly cut short this resurgence in credit.

Liquidity is so elusive in the credit markets (particularly in high yield). Investors always think they can get out before the house caves in. Among the many lessons of 2008 is how quickly liquidity can dry up when everyone heads for the exits. Investors ought to heed this lesson as they ponder chasing this rally in credit higher.

VIX Index - Where's the Fear?

The VIX (volatility index) has officially receded to pre-Lehman levels. The market has firmly transitioned from fear to greed.

F.H.A. Problems Raising Concern of Policy Makers

The New York Times ran an article today highlighting the mounting problems lurking in the FHA ("FHA Problems Raising Concern of Policy Makers"). The article also contained a skematic demonstrating how the most recent mortages are the most distressed. Specifically, more than 20% of all FHA mortgages underwritten in 2008 are in default (see below).



I have included below some key quotes/takeaways from the article. While I am convinced that the FHA will end up requiring a bailout from the federal government, it is striking to me how so many of our politicians are deluded into thinking this program is actually serving a valuable function.

• David H. Stevens [Head of the F.H.A]…acknowledged that some 20 percent of F.H.A. loans insured last year — and as many as 24 percent of those from 2007 — faced serious problems including foreclosure, offering a preview of a forthcoming audit of the agency’s finances.
• It appears destined for a taxpayer bailout in the next 24 to 36 months,” Edward Pinto, a former Fannie Mae executive, said in testimony prepared for the hearing. Mr. Pinto, who was the chief credit officer from 1987 to 1989 for Fannie Mae, went further than most housing analysts and predicted that F.H.A. losses would more than wipe out the agency’s $30 billion of cash reserves.
• The government is giving as many people as it possibly can the chance to buy a house or, if they are in financial difficulty, refinance it. The F.H.A. is insuring about 6,000 loans a day, four times the amount in 2006. Its portfolio is growing so fast that even F.H.A. backers express amazement.
• The number of F.H.A. mortgage holders in default is 410,916, up 76 percent from a year ago, when 232,864 were in default, according to agency data.
• 7.77 percent of the portfolio is in default, up from 5.6 percent a year ago.
• Got to love this asinine comment from Barney Frank: Barney Frank, the Massachusetts Democrat who is chairman of the House Financial Services Committee, said in an interview that the defaults were, in essence, worth it. “I don’t think it’s a bad thing that the bad loans occurred,” he said. “It was an effort to keep prices from falling too fast. That’s a policy.”
• Kenneth Donohue, the inspector general of the Housing and Urban Development Department, who is also F.H.A.’s watchdog said the drop in reserves was “a flashing red light” that the agency was not taking seriously enough…”He noted that if private lenders had raised their down payment requirements in the last two years, it raised the question, “what does the F.H.A. think it is doing by asking only 3.5 percent?”
• Chaz Fullenkamp, an automotive technician in Columbus, Ohio, got an F.H.A. loan even though he was living on the financial edge. “If I got unemployed, I’d be wiped out in a month or two,” he says. Thanks to the F.H.A., however, he is better off than he used to be. Mr. Fullenkamp used F.H.A. insurance to buy a house this spring for $179,000. The eager seller paid the closing costs and also gave Mr. Fullenkamp $2,500 in cash. He immediately applied for the $8,000 tax rebate. Even taking his down payment into account, he came out ahead. “I knew in my heart I could not really afford the house, but they gave it to me anyway,” said Mr. Fullenkamp, 22. “I thought, ‘Wow, I’m surprised I pulled that off.’ ”

Higher Downpayment for FHA Loans?

In a moment of apparent sanity by our elected officials, Congressman Scott Garrett (Rep-NJ) proposed a bill today that would raise the FHA’s minimum downpayment from 3.5% to a whopping 5%. The bill would also eliminate FHA financing of closing costs (apparently the legal and title fees are too much for many homebuyers to shoulder).

While hardly a meaningful deterrent from the speculative lending helping to inflate the housing market, the bill suggests to me that at least some legislators are waking up to the disaster that is the FHA. It will be interesting to see if the bill gets passed, though the pessimist in me says that the majority of folks in Congress will not want to do anything to disrupt the “nascent recovery” in housing.

The market has been due for a correction for a multitude of reasons, not least of which is a 60% run off the bottom. However, anything that results in a tightening of mortgage credit (i.e. higher downpayments for FHA loans, allowing the $8,000 new home buyer tax credit to elapse) or represents a lessoning of the government’s influence in the overall economy remains the most critical factors to monitor as investors gauge the sustainability of this liquidity driven rally.

For those who haven’t read it yet, I would definitely take a read of Fed Governor Kevin Warsh’s op-ed piece in last week’s Wall Street Journal (“The Fed’s Job Is Only Half Over”). While Warsh generally tows the party line that the economy remains very fragile and the Fed will likely need to maintain its accommodative stance for some time, he does suggest that the Fed should begin to plan its exit policy. While very subtle, it is the first time I have distinctly heard one of the Governors hint at a potential tightening by the Fed.

You be the judge based on these three paragraphs:

Today, even more than usual, we should maintain considerable humility about optimal policy. Financial market developments bear especially careful watching. They may impart more forward-looking signs of growth and inflation prospects than arithmetic readings of stimulus-induced gross domestic product or lagged composite readings of inflation. For example, the level of asset prices and associated risk premiums, and gauging their trend and durability, will demand careful assessment.

In this environment, market participants and policy makers alike should steer clear of ironclad policy prescriptions. Nonetheless, I would hazard the view that prudent risk management indicates that policy likely will need to begin normalization before it is obvious that it is necessary, possibly with greater force than is customary, and taking proper account of the policies being instituted by other authorities.

"Whatever it takes" is said by some to be the maxim that marked the battle of the last year. But, it cannot be an asymmetric mantra, trotted out only during times of deep economic and financial distress, and discarded when the cycle turns. If "whatever it takes" was appropriate to arrest the panic, the refrain might turn out to be equally necessary at a stage during the recovery to ensure the Federal Reserve's institutional credibility. The asymmetric application of policy ultimately could cause the innovative policy approaches introduced in the past couple of years to lose their standing as valuable additions in the arsenal of central bankers.

FHA - Leverage Ratio Exceeding Bear Stearns

As indicated in the chart above (courtesy of yesterday’s WSJ), the FHA’s leverage ratio has increased from a modest 14: 1 in 2003 to an expected 50:1 by the end of 2009. This far exceeds Bear Stearn’s 33:1 leverage at the time of its rock bottom sale to JP Morgan. While the FHA continues to insist that they won’t need a federal bailout, similar to the claims made by Fannie and Freddie prior to their government takeover, a mere 2% loss rate would wipeout the FHA’s capital position. Given that its loan delinquency rate (more than 30 days due) exceeds 14%, a national unemployment rate slowly creeping towards double digits, and the agency’s subprime like borrowers (who only have to come up with a mere 3.5% to qualify for a loan) I remain highly skeptical that the agency will avoid seeking some sort of federal assistance.

While yesterday’s Case Shiller index provided yet another positive data point for housing (only 2 of the 20 regions in the index posted sequential declines in housing), it is important to emphasis how dependent housing has become on the government. As I indicated in my prior post, the FHA’s market share has increased from a mere 2.7% in 2006 to approximately 25% today (and 40% in August alone!). The agency insures approximately $750 billion of mortgages today from $410 billion in 2006. Even more concerning is the projected growth in the agency’s portfolio, which is expected to exceed over $1 trillion by the end of next year. As a point of reference, Fannie and Freddie collectively insure approximately $5 trillion of mortgages or half all of all home mortgages.

Remember how fragile this housing recovery is the next time you see those shady infomercials encouraging you to refinance into an FHA loan. However, instead of some faceless pension fund in Japan taking a loss on its portfolio of securitized subprime Countrywide mortgages, US taxpayers will be left holding the bag from these busted FHA loans.

Japan's Demographic Time Bomb

This weekend’s Barrons featured a very grim article on Japan’s demographic time bomb (Is the Sun Setting on Japan?). Although I have always appreciated the structural debt & population challenges facing the country, I never really understood how grave they were. Some scary data points from the article include:
- Japan's gross national debt now equals 217% of its gross domestic product, compared with 81.2% for the often-maligned U.S. and an average of 72.5% for the G-20 nations (the 19 largest economies, plus the European Union), according to the International Monetary Fund.
- The latest United Nations median forecast estimates Japan's population will fall from a current 127 million to just 101.6 million by 2050 (a decline of 20%), while the U.S. count will rise from 317 million to 404 million.
- The number of Japanese of prime working age (15 to 64), which totaled 83 million in 2007, is likely to tumble to 49 million in 2050, while the over-65 cohort jumps from 27.5 million to nearly 38 million. This implies more than 77 elderly dependents for every 100 workers by 2050, compared with just 33 per 100 now.
- Japan's household savings rate—more than 20% in the early 1970s—has dipped to about 3%. That's less than U.S. households' 4.2% as of July.
- Japanese businesses are highly inefficient and shielded from domestic and foreign competition by complex regulations. Output per man-hour in Japan trails that of the U.S. by approximately 30%.


While many pundits are encouraged by the strong victory of the Democratic Party of Japan (DPJ) in last month's national elections (which has promised to implement badly needed structural reforms to the country’s ailing economy) it will be extremely difficult to overcome the demographic tsunami facing the country. If you are not a Barron’s subscriber and would like to read the article please send me an email and I will be more than happy to forward along.

Government Involvement in Housing Market

As noted repeatedly over the last few months, several recent data points suggest the housing market has begun to improve off the unprecedented lows reached in April. Seasonally adjusted housing starts are up 25%, standing inventory of existing homes has been whittled down to 9.4 months (vs. over 11x months at the peak, though well above the 4-6 months indicative of a healthy housing market), and pricing has begun to firm, with the Case Shiller Index posting its first sequential monthly increase since July 2006. Although some regions of the country continue to experience declines (Vegas and Phoenix being amongst the most troubled), the recovery has generally been broad based, with some of the hardest hit markets (southern California, western Florida) demonstrating the strongest hints of recovery.

While a stabilization in the housing market is encouraging, investors must realize how critical the government’s role has been in driving this improvement. Firstly, the $8,000 tax credit for new homebuyers has significantly brought forward demand. This is particularly the case in California where residents also benefited from a $10,000 state-specific tax credit (though the program’s funding was exhausted in July). Further, mortgage rates have been artificially suppressed thanks to the Federal Reserve’s program to buy $1.25 trillion of mortgage-backed securities and up to $200 billion of Fannie & Freddie debt securities by year-end. With a combined $810 billion expended to date on these two programs (see below), the Fed has kept conforming interest rates below 5.5%. Low mortgage rates and 30% peak to trough declines in home prices have resulted in off the charts affordability. However, once these spending programs are exhausted, we are very likely to see mortgage rates creep up. Even a 50-100 bps widening could have a meaningful impact on the housing market, particularly as unemployment moves towards double digits.
Despite the one-time tax credits and government orchestrated effort to suppress mortgage rates, no federal program has been more distortive than the Federal Housing Administration (FHA). Created during the Depression to help minority and poor households realize the promise of homeownership, the FHA has become the government’s vehicle to prop up the housing market. With required downpayments of only 3.5%(much of which will be recouped through the $8,000 tax credit), the FHA has essentially taken the place of subprime in providing financing to at-risk borrowers. In 2006, the FHA insured 2.7% of all loans in the United States. Year-to-date, the agency has provided a government guarantee for 23% of all new mortgages and nearly 40% in August. Many of the public builders suggested in their most recent earnings calls that between 40% and 75% of all their buyers received FHA-insured mortgages last quarter. In fact, when combined with Fannie and Freddie, the government is now insuring close to 90% of all home mortgages and probably close to 100% for all new home buyers (see chart below)!
Several recent articles have highlighted the problems festering in the FHA. In fact, this morning the Washington Post ran an article suggesting that the FHA could breech its minimum capital ratio of 2%. Further, some 7.8% of FHA loans at the end of the second quarter were 90 days late or more, up from 5.4% a year ago. Even more perplexing is that the agency has never operated with a chief risk officer and has only recently sought to fill the position (even AIG Financial Products, Countrywide, and Lehman had chief risk offers!).

While the government will likely continue to support the housing market through the FHA, particularly with the 2010 election around the corner, I would be extremely wary of the headlines suggesting that the housing market is on stable footing. Just as Fannie, Freddie, and later subprime massively distorted the housing market over the last decade, so too has the FHA.
I will continue to report on this organization and Ginnie Mae (the government agency whose primary function is to guarantee mortgage backed securities comprised of FHA-insured mortgages) over the coming weeks and months. While I will also continue to highlight the improving trends in housing, it is always with an eye towards the government’s overarching influence that my enthusiasm will be vastly tempered.

Rapid Growth in e-book Sales

Great chart above showing the steep rise in e-book sales since the end of 2008. E-book sales were $37.6 million in Q2 2009, rising 45.7% from Q1 2009. In June alone, e-book sales were $14mm or 1.5% of the month’s overall book sales of $942.6 million. While still a tiny sliver of the overall book publishing market, sales are set to rapidly rise over the coming year with several new products in the pipeline including a new wireless reader by Sony (launched on August 25th), Apple’s highly anticipated tablet (hopefully released by Q4 2009, but more likely in early 2010), and Plastic Logic’s 8.5 x 11 inch touchscreen device (sometime in 2010). Further many of the new product launches, including Sony’s new Reader Daily Edition, are using a more open approach, allowing for easier use of content across multiple platforms. The leading open format appears to be EPub, created by the International Digital Publishing Forum, and utilized by Sony’s new device.

China's Underconsumption

Great chart from the Economist showing how little Chinese consumption comprises of the nation's GDP -approximately 35% vs. nearly 70% in the US. In fact, despite signficant growth in the nation's economy over the last decade, consumption as a percent of GDP is actually down from 49% in 1990. With over 1.3 billion people, a robust and growing economy, maturation of the country’s financial system, and the government’s increasing focus on expanding its social safety net for its aging populace (which discourages saving and permits a higher level of consumption during one’s most productive years), the Chinese consumer remains the most compelling investment story of our generation.

NY Law Firm Sees Big Reduction in Rent

The following WSJ article provides a pretty scary datapoint about the state of NYC commercial real estate market. According to the piece, the law firm Orrick, Herrington, & Sutcliffe, recently signed a lease in the CBS Headquarters building located at 51 W. 52nd Street in the low-mid 70s per square foot vs. $120-$140 per square feet for equally comparable real estate at the top of the market in 2007. Further, the landlord agreed to contribute $150 per square foot of improvements, allowing Orrick to move into the location with essentially no out of pocket expenses.

The article also quotes a Reis study that suggests that the vacancy rate in Midtown Manhattan has spiked to 10.6% vs. only 5.9% pre-Lehman (enough to fill 6 1/2 Empire State Buildings) and rents have fallen by 7.2% over a similar time period.

While evidence continues to mount that the worst of the recession is behind us, particularly in the lower end of the residential real estate market, Orrick's experience suggests that the commercial real estate downturn has only just begun.

http://online.wsj.com/article/SB124882179252188243.html

Leveraged Loan Index Getting Frothy

Here is an interesting chart showing how much leveraged loans have bounced back from their December lows. Two points are worth noting:
1. Bank loans have nearly bounced back to their pre-Lehman levels and now trade close to 90 cents of par. While fund flows could continue to tighten spreads (and certainly have over the last few weeks), much of the easy money, and the absolute/generational no brainer money of Nov/Dec 2008, has been sucked dry.
2. Loans bottomed well before stocks made their March 9th low. In fact, despite the modest bounce in Jan/Feb, as credit-related hedge funds prepared for March 31 redemptions, the leveraged loan market has been on a steady trajectory upward.

I find it pretty amazing how in the absence of any real fundamental improvement in the economy investor psychology has swung so dramatically in the last 3 months. We’ll see over the coming months/quarters whether such enthusiasm actually makes its way into the real economy.

Home Prices Continuing Their Ascent in California

Southern California home prices continued their steady ascent in June, rising by 6.4% over the prior month. Home prices rose in each of the six regions reported by DQ News, with Los Angeles and San Diego showing the most pronounced sequential increases. While some industry analysts have rightly pointed out that mix may be driving the sequential increases as higher end homes enter the foreclosure process (particularly many financed with Alt-A loans and pay-option ARMs), I think this argument ultimately misses the point. Whether April 2009 represented the bottom or we have another 5-10% to go (certainly quite possible, particularly as unemployment picks up), the data clearly shows that the home price contraction in Southern California is nearing an end. New supply has come to a screeching halt, affordability is off the charts, and the rent vs. buy equation is clearly in favor of the latter for most parts of California. Further, the $8,000 federal stimulus and the $10,000 state-specific tax credit are making homeownership an incredibly attractive option for first time buyers in what was once considered the most troubled housing market in the country.

Another Bubble Forming in China

China’s massive 4 trillion yuan stimulus package appears to be successfully fomenting another credit and stock market bubble in the country. Chinese banks are estimated to have lent 7.3 trillion renminbi (~$1 trillion) in the first half of 2009 alone, compared to Rmb4.9 trillion in all of 2008, Rmb3.6 trillion in 2007, and Rmb 3.2 trillion in 2006. At the end of June, loans outstanding were 34.4% higher than a year ago and M2 grew by 28.5% year-to-date; two clear signs of an overheated market.

Providing further evidence of a forming bubble, the Shanghai A-share market has jumped by ~70% year-to-date. Further, individual investors have seemingly forgotten the stock market meltdown last year, opening more than 1.6 million stock trading accounts in June – 68% more than the year before (and certainly a good sign of the speculative juices forming in the country). While the headline GDP growth number of 7.9% confirms a clear rebound in the economy, investors ought to be concerned with the massive growth in bank lending – much of it directed by government officials. Further, the uses of this newfound liquidity should raise a significant red flag to discerning investors - some economists suggest that as much as 15% or $145 billion has been diverted into speculation and real estate.

Unfortunately, it is exceedingly difficult to call the top of a speculative bubble and I suspect that we are only seeing the beginning of what is to come in China. With over $2.13 trillion of government reserves and banks acting as agents for the state, the Chinese stock market could continue to be buoyed by an easy lending environment. Chinese officials have yet to raise interest rates or increase reserve requirements; actions which popped the previous bubble. In the absence of these actions, which presumably would curtail bank lending, I would refrain from shorting the Chinese market. Like investors who thought the Nasdaq was “irrationally exuberant” in 1996, only when lending begins to decline and liquidity is drained from the system, is it safe to short an overheated market. Just as an inability of CLECs to refinance their bloated capital structures served as the peak in the tech/telecom bubble, so will bankruptcies in China’s most speculative companies provide the all clear sign to short the market. Though until that point, which could remain years away, I would patiently observe from the sidelines.

Over the coming months/quarters (and potentially years!), I’ll be on the lookout for the proverbial canaries in the coal mine.

Initial Jobless Claims - Leading Indicator for Recovery in Q3?

As suggested in the chart above, initial jobless claims have fallen by over 150,000 since peaking at 674,000 for the week ending March 27, 2009. While new jobless claims of over 500,000 hardly reflects a robust economy, a peaking of jobless claims has generally preceded the official end of a recession by 2-6 months (see data on the last seven recessions under the chart).

The steep drop in this figure over just the last three weeks (105,000 reduction in claims) provides compelling evidence that the worst of the recession may be behind us. While Q3 may very well show GDP growth, particularly with a narrowing of the trade gap, the economy still remains highly fragile and dependent on unprecedented government involvement. Though I have no particular insights into what 2010 brings (much less tomorrow!), i would posit that we could see a double dip recession by the first half of next year as the Fed’s liquidity programs roll off and the nation’s banks are compelled to stand on their own.

Manufacturing Capacity Utilization Breaches New Lows

Manufacturing capacity utilization breached a new post-WWII low, declining to 64.6% in June. As indicated in the chart above, the June results are off the charts when benchmarked against prior recessions in the US (note the prior low was in the severe recession of the early 80s when capacity utilization troughed at 68.6%). While unprecedented money printing by the Fed supports the long-term inflationist view, the massive slack that exists in the economy, suggests that deflation remains the most pressing issue over the near-term. Talk to any homebuilder, retailer, or mall owner for confirmation of the lack of pricing power that exists for a broad swath of US companies.

An interesting takeaway from the chart, which lends some credence to the argument put forth by the inflation bulls, is how sharply capacity utilization ramps up exiting each of the post-WWII recessions. While avoiding a Japanese-style debt deflation is critically important, the Fed must be very careful to ease up the breaks once the economy begins to heal. Should the economy follow the trajectory of prior recessions, a combination of the supply destruction going on in most industries coupled with the massive monetary stimulus provided in the Fed, could stoke an inflationary spiral that puts the 1970s commodity bubble to shame.

Natural Gas Rig Count

The natural gas rig count continues to crater, falling by another 16 units to 672 total rigs. Since peaking in September 2008 at over 1600, the number of natural gas rigs in operation has fallen by nearly 60%. While prices remain under severe pressure due to excess supply and lackluster demand, the rapid falloff in rig count suggests a major bull market is in the works. Further, current spot prices ($3.50 BTU) remain well below the marginal cost of production for most fields (generally around $6-$7), almost guaranteeing that prices will have to rise to coax new supply onto the market. Finally, current spot prices incorporate almost no risk premium for seasonal hurricanes and/or legislation that will likely favor natural gas in Obama’s impending energy bill.

The cure for low prices is lows prices and nowhere is that more evident than in the natural gas market.

Personal Savings Rate - May 2009

Americans continued their uncanny ability to save last month, with May's personal savings rate increasing to 6.9%. While lower consumption will undoubtedly have a negative affect on GDP, the restoration of consumer balance sheets serves as a necessary prerequisite for a fundamentally healthy domestic economy upon which sustainable growth can be achieved.

CA Home Sales – May 2009

The greatest story never told continues to be the remarkable stability in Southern California’s home prices (ground zero for the housing bubble). Home prices rose a modest 0.8% last month and have essentially been flat since the beginning of 2009 (though over 50% off its peak levels). While California remains way over-inventoried, with a high level of foreclosures still in the pipeline, year-over-year transactions remain brisk (up 23% last month) suggesting that the inventory is finally starting to clear. This stable pricing, despite foreclosures sales representing over 50% of transactions (which undoubtedly weigh on home pricing), suggests the market is firmly in the healing stage.

Commentary on New & Existing Homes Sales

Existing and new home sales and inventories were released by the National Association of Realtors and Census Bureau, respectively. As suggested in the first chart below, new home inventories continue their steady assent downward. At 292,000 units available for sale, inventories have retrenched to levels reflected in prior housing downturns. Though seasonally adjusted months of supply remains elevated at 10.2, the metric is somewhat skewed by extremely low levels of new home sales (which are off 75% from the peak hit in July 2005). Most economists believe 4-6 months of supply generally reflects a more normalized housing market, though I posit that by the time we see these levels, housing will firmly be in the correction phase.

While several data points in the new home market are encouraging, the existing home market still faces several challenges (and note that existing sales generally comprise more than 80% of total home sales). Positively, homes for sale have declined by 13.9% and now stand at 3.8mm. Negatively, this is well above the 2-2.5mm homes reflected in a healthy market. Further, months of supply still stands at 9.6, though down from the peak of 11.2 months recorded in November 2008.

As demonstrated in the chart below, we probably need to work through another 1.5-2mm of excess homes before pricing will comfortably find a bottom. With that said, prices are artificially being suppressed due to the overwhelming presence of distressed sales, which comprised about 1/3 of home sales last month and up to 70% in the most troubled markets. However, I view the high proportion of distressed sales as a positive since it demonstrates that the market is clearing. Unfortunately, it could take some time for this overhang to abate as several states recently extended foreclosure moratoriums that were previously implemented at the end of last year (CA being the most prominent).
In summary, I continue to believe that the housing market is in the midst of a prolonged bottoming process that will reward investors with a long-term time horizon. At approximately 500K, housing starts remain 1/3 of “natural demand” and approximately 35% below trough levels hit in the 1987-1991 housing recession. While the bubble exceeded any of the post-WWII housing upturns, the correction has been equally as severe. Further, low prices and record affordability (off the charts frankly) have skewed the rent vs. buy equation squarely in favor of homebuyers. Finally, the $8,000 federal tax credit and a friendly lending environment (thanks to the FHA) have made homeownership a viable option for a whole new crop of homeowners who prudently avoided buying during the bubble.

Weekly Railroad Data - Still Negative

There is still little evidence of a rebound in the US economy based on the weekly carload data reported by the Association of American Railroads. While year-over-year declines have moderated to 19-20% in June vs. 25-26% in May, this is hardly a cause for celebration. Perhaps one positive takeaway gleaned from the data is that “Farm Products, Excluding Grain” experienced 4.8% year over year growth, though the other 18 categories were decidedly negative. Since transports generally serve as a leading indicator for a recovery, its hard to get on board with the “economy is healing” train in the face of such negative data (though I'm trying!).

S&P Earnings - 1st Favorable Revision for 2009

Below is an interesting chart I put together tracking consensus earnings forecasts for the S&P 500 over the prior year (when S&P actually starting tracking 2009 estimates). As evident in the chart, the sell-side completely overestimated the earnings power of the S&P last year when a bottoms-up forecast of the individual components resulted in a $110 per share estimate. Each subsequent week resulted in a downward revision to the forecast, which appears to have bottomed on May 19th, when S&P reported a mean estimate of $54.20/share.

Perhaps the most bullish takeaway, and one to keep track of over the coming weeks, is that consensus estimates have started to increase. As of June 16th, the mean forecast was $55.80/share, valuing the S&P at a reasonably comfortable 16x earnings. While certainly not cheap, an important milestone may have been reached with the street’s bearishness being fully reflected in the earnings power of the S&P. Historically, favorable earnings revisions have been a harbinger of future stock market gains so I will continue to follow closely.

As someone who is trying to identify fundamental data points to support the rally over the prior 3 months, this chart provides reasonable confirmation that the bulls may be justified in their early enthusiasm. With that said, 2010 consensus earnings growth of 33.1% ($74.32/share) bake in a sizable rebound in the economy. In my opinion, little evidence has emerged to support this bullish scenario, though I would love to be disproved and admittedly the industries I cover (housing and media) have fundamental secular challenges that may unfairly taint my view of the overall economy. As companies begin to report 2Q earnings, investors will be able to judge whether the supposed "green shoots" are actually finding their way from politicians' lips to corporate earnings.

Household Net Worth - as of Q1 2009

Household net worth declined by an additional $1.3 trillion in Q1 2009 and now stands at $50.4 trillion. From its peak in Q3 2007 (when household net worth touched $64.3 trillion), American households have lost an astounding $13.9 trillion or 21.6% of their total net worth. Declines have been most severe in corporate securities (down $4.6 trillion or 47.2%), mutual fund shares (down $1.7 trillion or 33.8%), pension fund reserves (down $3.5 trillion or 26.2%), and real estate (down $3.8 trillion or 16.3%). While $1.3 trillion of net worth destruction is significant, the decline was well below Q4 2008 and Q3 2008’s decline of $4.9 trillion and $2.7 trillion, respectively.

P&G Media Spending in Q1 2009

Despite cutting its total measured media spending by 18% in Q1, P&G more than doubled its spend on internet display ads, which now comprise 4% of P&G's total spend (up from 2.2% of total US measured media in 2007). Even more startling is the substantial cuts P&G made in certain traditional forms of media, including network & spot tv (down nearly 50%) and magazines (down 30-35%). As the US's largest advertiser (and more generally CPG's high reliance on TV), the reallocation of P&G's marketing spend will continue to have dramatic impacts on the major broadcast networks.

E-books Penetration Taking Off

The chart above puts to rest any doubt over the rapid growth of e-books, which accounted for 2.6% of book sales in March 2009 from only 1.1% in Jan. With the introduction of Amazon's Kindle in June and other competitive products in the offering (with Plastic Logic's creating the must buzz) we are sure to see continued increases in this metric. While I have little conviction on who will be the biggest beneficiary from the adoption of e-book, I think it is safe to say that the business model of traditional book retailers will come under considerably pressure over the coming years (Barnes & Noble and Borders being the most obvious). Just as there are no pure play big box music retailers still in existence, I am hard pressed to imagine a world necessating 25K-40K square foot book retailers.

Reflections on the Recent Market Rally

After living through the fierce market rebound since March 9th, I thought it prudent to distill some key takeaways from Q4 of last year to now:
1. The market is very smart – when the rebound started occurring in early March it was important to question one’s bearish orientation and continuously strive for positive data points in a sea of negative news – both of which I think I did sufficiently well)
2. Government stimulus works – whether you are politically or morally opposed to it is irrelevant when considering its short-term implications on the market and psychology. On a longer-term basis, perhaps we will be debating the merits of TARP, TALF, PPIP, and other government programs (frankly, I am still unsure what to think). However, stimulus generally works and in this instance I think the government played its exceptionally difficult hand right (at least in terms of infusing capital in the banks)
3. The market and economy are all about confidence – the world was ending in Q4 and early March only because the media would have you believe that was the case. Now that the media has moved on to the next story, the American public can go about the business of living (admittedly, a bit more frugally)
4. It is always darkest before the dawn. I remember listening to a few earnings calls with CEOs commenting that orders were down 40-50% in their businesses and the outlook appearing just as grim. I don’t care how bad things are – the world was not decelerating at such a pace. After two quarters of 5-6% GDP declines, it should be apparent to everyone that we would need to rebuild inventories.
5. Investing is all about valuation (and this is where I fault myself for not truly appreciating the potential magnitude of this rally). I’ve said it many times, but it bears repeating. When industry leading businesses with solid franchises begin trading at single digit PEs off of trough earnings, you have to buy. You just never know when the bottom will hit and people will always miss the “easy” move off the lows if they obsess about trying to catch this elusive trough. One has to buy prudently, but once the market recedes into “the world is ending territory” the name of the game is to consistently average down (and try and contain your glee as great businesses get handed to you at generational lows!).
6. I think in many instances I saw a lot of the credit excesses coming. However, in 2005 & 2006, I certainly didn’t appreciate the magnitude of the housing decline (almost to the point of being clueless). I remember reading how subprime accounted for more than 20% of mortgage originations in 2006, but somehow never put the pieces together that it would cause 35% peak to trough declines in housing (and still counting). I was extremely skeptical of the private equity bubble (even mystified), but never considered how that should be wrapped up in a truly macro bearish scenario. In short, I would grade myself a C over the last 4 years as an investor (and believe me I take no pride in that self-evaluation). However, I would argue that a lot of other supposedly smart investors didn’t see the tsunami as well. In fact, many that didn’t see the storm in 2005/2006 have convinced themselves in 2008/2009 that the world was ending. Why the media hangs onto these bearish views at market bottoms from people who failed to forecast the current situation is beyond me. However, the media loves a good scare story and there were plenty of investors willing to provide the fodder. Our economy has tremendous self-correcting mechanisms built into it and the world was no sooner going to end in Q4 2008 as it was going to continuously operate at the peak levels of 2006.

As always, I could very well be wrong and perhaps the worst is yet to come (certainly if history is any guide, the former will prove correct).