Chris Lau - Seeking Alpha

Friday, July 24, 2009

A Backwards World

The sentiment in the market is reaching levels of optimism that needs to be viewed with risk adversity in mind. A general pros and con list would be a good way to determine, at a fundamental level, the reasons behind the market rise, and the risk factors that still exist to undermine it.

Pros for supporting the S&P 500 near 1,000:
  1. Companies beat profit expectations. Examples: Ford
  2. US Housing figures improved for 3 months in a row
  3. Some Banks are reporting strong earnings e.g. Goldman Sachs
  4. Demand improved e.g. Family Department Stores - FDO, automobile, housing
  5. Rising unemployment is not relevant because it is a "lagging" economic indicator (meaning it will keep rising even after the economy improves)
Cons (counter-arguments):
  1. Companies beating profit expectations did so by cutting costs. This "organic" growth is a temporary phenomenon and illustrates the overall economy is still contracting
  2. Improving housing figures driven by low mortgage rates. Are rates going to stay low? (Rising rates hurt market but would signal a recovery is underway)
  3. Some of GS profits are driven by profiting between the spread between government money and interest rates
  4. Demand driven by food stamps (FDO), tax credits (housing, auto)
  5. Rising unemployment is actually a coincident indicator because this recession is driven by problem of credit.
Moving on, I turn to John Mauldin's latest newsletter. In it, Mauldin is discusses his view on the government transparency in exposing its end game. In short, he references past materials illustrating reasons why this should not be done. Specifically, his view on increasing rates is described below:

The US Federal Reserve has moved faster but already seems to think the job is done. "Quantitative tightening" has begun. Its balance sheet has contracted by almost $200bn (£122bn) from the peak. The M2 money supply has stagnated since January. The Fed is talking of "exit strategies".

Is this a replay of mid-2008 when the Fed lost its nerve, bristling over criticism that it had cut rates too low (then 2pc)? Remember what happened. Fed hawks in Dallas, St Louis, and Atlanta talked of rate rises. That had consequences. Markets tightened in anticipation, and arguably triggered the collapse of Lehman Brothers, AIG, Fannie and Freddie that autumn.


General Comments: Is it too soon to talk about raising interest rates? I would think so. Mortgage rates would rise too soon, and the excess over-leveraged debt still in the market will cost more to finance.

In his July 17th newsletter, Mauldin comments about bank earnings and the associated write-offs:

Banks that are reporting so far this quarter seem to be saying that the write-offs will start to level off in about two quarters, although banking expert Chris Whalen says that the level may stay higher than we think for longer than we think. There are a lot of assets to write off, and they are just now getting to the commercial real estate problems. This is going to take time.
Disclosure: I have been expecting (and calling for) a correction in Commercial Real estate in the U.S. It hasn't happened yet. See SRS.

One more important point to summarize is global leverage ratios. Again, the key points are extracted. We need to get our heads around the importance of monitoring figures that matter, even though stock prices are nice to watch:
  • Tangible common equity is all the rage, and that is what the recent "stress tests" measured, as opposed to tier 1 capital, which includes preferred stock (which would basically be the blue portion.) TCE only includes common shares.
TCE for:
  • U.S. - mid-40s (leverage is 12:1)
  • U.K. - ~ 55 (leverage is 40:1)
  • Eurozone - ~55 (leverage is now 35:1)
Comment: It is for this reason that U.S. debt/treasury offers the best of the worst. See TLT.