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Third Quarter 2010 Outlook
“The Economy and Financial Markets Appear to be Suffering From Manic-Depression”
The good news is that July and August are historically favorable months for the stock market. This would be a refreshing change from the market’s second quarter when the major averages declined between 10% and 12%, bringing 2010’s first half decline into the 6% to 7 1/2% range.
On reflection, as we reach this year’s mid-point, we believe the market has displayed a case of manic-depression. After starting the year with a modest decline into February 5th, the market rallied 41 out of the next 54 trading days into April 26th. Since 1940 there is only one other time when the stock market exhibited this high of a percent of up days in a period of this length. That time was in the second half of 2007. Then the market was close to its top, and was followed by the devastating decline from the fourth quarter of 2007 until March of 2009. It now appears that we had a blow-off rally ending the year long recovery rally, just as in 2007 when we were ending the multi-year recovery from the market’s collapse after the bursting of tech bubble.
Since April 26th the market has suffered a meaningful and extremely volatile decline. The volatility is best depicted by the number of 90% up and down days. A 90% day is one where the volume and points gained or lost account for the 90% of that day’s action. A 90% up day is one where at least 90% of the volume is associated with issues trading higher on the day. Conversely, a 90% down day is one where at least 90% of the volume is associated with issues trading lower on the day. 90% days are relatively rare and represent days where investors are exhibiting what could be described as either manic or depressive behavior. What is particularly unusual about the decline since April 26th is that it has included ten 90% down days and six 90% up days. Historically, this erratic change in behavior in a two month time period is indicative of a change in the trend of the market.
As we expressed in previous quarterly reports, we expected economic strength early in the year as the government’s various stimulus programs were in progress and corporations needed to replenish inventories after dramatically cutting them over the prior twelve months. Also, tax refunds and employee bonuses tend to help the economy’s rate of growth in the early months of a year. However, we questioned the sustainability of that early strength as the debt financed government stimulus programs wound down.
Now it almost appears that the economy and financial markets hit a brick wall in April. Since April, economic reports depict a weakening economy as home sales, car sales, employment statistics, and consumer spending have either reversed their uptrends or shown significant slowing in their rate of growth. While government leaders and most economists and investment strategists worldwide proclaim we are on the right path for a sustained economy, Main Street and Wall Street are expressing extreme doubts. Investors sense that we are facing greater deficits (more indebtedness), a cutback in services and financial entitlements, as well as higher taxes. Furthermore, many municipalities, counties, and states are suffering from very weak finances, with estimated deficits well over one hundred billion dollars for the twelve months ahead, as well as severely underfunded pension plans. They are already obtaining government assistance to make unemployment payments, and more help is going to be required.
Numerous times in recently quarterly reports we have explained that market tops usually take the shape of an open umbrella. One-by-one prior leaders succumb to weakness until there is not enough leadership left to support the exhausting trend. In the current cycle the market began showing weakness over eleven months ago. It started with the early August top in the Chinese stock market, and was followed by the October high in Goldman Sachs, the top in Google on this year’s first trading day, and more recently the June high in the “do-no-wrong” Apple. Tops develop much like kicking the legs out from under a stool one-by-one. You can sense the weakening support but you never know when the stool will topple.
In summary, we continue to be trapped in the claws of excessive debt and the contractionary influence it entails. While the process of stopping excessive debt financing and then the paying down of our historic level of total debt will be long and drawn out, the financial markets will act as they always do. There will be periods where down trends get over done as investor sentiment becomes overly negative, and times where recovery rallies become excessive as will investor enthusiasm. We have been taking a neutral stance during the market’s current manic-depressive state. However, we are now seeing signs that the current downtrend is reaching maturity while investor sentiment is becoming close to excessively pessimistic. In addition, as we mentioned in our opening comments, the July/August time frame is historically favorable for common stock performance. Accordingly, we are looking for the period of panic that typically marks the end of a decline to move to the long side of the market. We expect that a rally could be sharp and measured in weeks not months. Late August through October tends to be a difficult time period for the financial markets, and if history is any guide we will likely be returning to a neutral then negative stance by that time. But, first things first.
Trinity Capital Management, LLC July 6, 2010
Second Quarter 2010 Outlook
“Headline News, The Whole Story, and Trends”
From an economic point of view, our First Quarter Outlook, “First, Some Good Economic News. Then What?” was pretty close to what transpired in the first quarter. As the quarter progressed, and this year’s record snowfall melted away, we began reading economic headlines reporting some modestly improved results. As one would expect in a midterm election year, each report was heralded as proof that a sustained recovery has begun.
Some examples of the improvement include: a “terrific” 0.3% gain in February’s retail sales, a 3.1 % gain in March’s Institute of Supply Management survey of eighteen manufacturing sectors from February’s reading, and last Friday the Bureau of Labor Statistics’ March report showing a gain of 162,000 new jobs. There should be several more favorable reports over the next week or so, especially as this month’s statistics are being compared to the panic conditions of March of 2009 when it seemed that business all but shut down. But we ask, now what?
We will go back and examine the whole story accompanying the aforementioned headline items, but first we want to recall that last quarter we also sounded a cautionary note with Nobel Prize-winner Professor Paul Krugman’s comments. He said “it will be important to remember, first of all, that blips—occasional good numbers, signifying nothing—are common even when the economy is, in fact, mired in a prolonged slump. Such blips are often, in part, statistical illusions. But even more important, they’re usually caused by an ‘inventory bounce’. Unfortunately, growth caused by an inventory bounce is a one-shot affair unless underlying sources of demand, such as consumer spending and long term investment, pick up.” He then went on to state that it was his belief that “sustainable consumer demand, a lasting housing surge, nor a boom in business investment were on the horizon.”
Also some of the positive numbers should be taken with a grain of salt. Take for instance, the previously mentioned February retail sales which were a “terrific” 0.3% gain over January’s retail sales. Buried further down in the report was the notation that January’s originally reported number was revised lower accounting for the gain. Had January’s number been unrevised, February retail data would have been a drop of 0.1%. Not necessarily a “terrific” recovery in consumer spending.
Lackluster consumer spending becomes more understandable after the Bureau of Economic Analysis released its report showing that personal income dropped last year for the first time since 1969 when they began reporting the data. With that being the case, it became curious how consumers paid down over $90 billion in credit card debt last year. However, recently, the Federal Reserve reported that the bulk of the drop in credit card debt outstanding was not from consumers being more responsible by paying down their credit card balances, but was the result of banks being forced to write off loans that consumers failed to pay. In 2009 banks wrote off a record $83.27 billion of the $93.2 billion decline in credit card balances reported.
The March Institute of Supply Management survey is a strong report and demonstrated growth in the manufacturing sectors. However, the survey also reflects the complexity of analysis in these reports. The significant improvement in this report may be the “inventory bounce” that Professor Krugman discussed, but on a more optimistic note let us suppose it is more than that. Unfortunately, in addition to the growth the survey reflected, prices across the eighteen sectors rose 8% and nineteen of the twenty commodities followed had risen in price, increasing the cost of raw materials for the manufacturers. Accordingly, inflationary cost pressures were both steep and broad based. If this develops into a trend, it puts great pressure on the Federal Reserve to take restrictive steps when they have indicated they are not ready to. The bond market has taken note of these pressures as yields on ten year Treasuries have just climbed to 4%--a level not seen since last summer. So while the growth was good, the cost pressures and inflation implications were not.
Currently, the financial markets are responding positively to March’s employment report. The good news is that employment rose by 162,000, even though the unemployment rate held steady at 9.7%. Approximately 48,000 of those newly employed were census workers. History indicates that number should climb by several hundred thousand over the next two months, but the census workforce should disappear in the August/September time period as their work will have been completed. Also, the employment gain included 81,000 workers which is a guesstimate that gets plugged in based on the assumption that 81,000 new workers were hired by start up companies not yet in the Bureau of Labor Statistics’ database. This particular report included a weather adjustment adding 100,000 new workers. The addition is based on the BLS’s assumption that the severe weather prevented a significant number of workers getting to work, let alone hire new ones. Net of the part time nature of the census workers, the guesstimate, and the weather adjustment, the reported gain was actually a loss of 67,000 jobs.
The labor market is characterized not only by numbers of un- and underemployed workers but also by the benefits received by those who are unemployed. Probably the best measure of the strength and direction of the labor market is the unemployment calculation called U-6. It also includes the underemployed (part time workers who want to work full time), and it rose last month by 267,000 to a 16.7% unemployment rate. In total there are over eleven million, and growing, individuals receiving unemployment benefits. 4.66 million are receiving benefits under the regular state unemployment benefits programs. Often overlooked are the more than six million additional beneficiaries who receive their payments under the federal extended benefits program. This program was established to continue supporting those whose state benefits have run out. Not only are the cost of these programs rising rapidly, several states have exhausted their unemployment reserves and have begun borrowing from the federal government to meet current benefit payments. The federal government in turn has to issue even more debt to raise the funds. While we can only hope that the job market improves significantly, companies’ hiring plans--once their responsibilities under the new health care legislation are clarified--is a real wild card at this point in time.
In addition to the headlines previously discussed, there were numerous releases which indicate that economically we have at the very best just hit a period of stabilization, not the recovery spotted by our elected and appointed leaders. For example, crude oil has climbed into the mid to high $80s with gasoline nearing $3.00 per gallon. President Obama saying in a TV interview that the new health care policy was necessary because “this country was going to go broke” makes one hope the new program works as he suggests. The U.S. Government issued a net $332.8 billion in marketable debt in March, second only to the all time record issued at the height of the financial crisis in October of 2008. In late March Fannie Mae reported that its January delinquency rate for single family homes hit a new record of 5.54%, twice the level of a year ago. On April 5th, Reis, the commercial real estate survey firm said that occupancy of office buildings hit its worst level since 1994 at 17.2%. In addition, Elizabeth Warren, chairperson of the TARP Congressional Oversight Panel, said in an interview that about half of all commercial real estate mortgages will be underwater by the end of this year. She added that most of these mortgages were concentrated in mid-sized banks, and that we have 2,988 banks which have extreme concentrations in this type of loan. As a result, the economy will face another “very serious problem” that will have to be resolved. If California did not already have enough financial issues, a recent study indicates that their three largest state pension plans may be as much as one-half trillion dollars underfunded based on minimum funding standards. Los Angeles is discussing shutting down all non-essential agencies two days a week starting next week. Last, Social Security is not expected to take in as much as they pay out this year, a situation not expected for six more years.
Before taking a look at the condition and our expectations for the financial markets, we wanted to share an article written by Douglas Holtz-Eaken former director of the Congressional Budget Office. On March 31st he wrote “The Congressional Budget Office released its assessment of the administration’s budget outlook. The numbers are shocking. Under the president’s policies the federal deficit will exceed $700 billion in every year over the next decade. The sea of red ink will more than double the national debt to $20 trillion. The upshot is that in 2020, the deficit is projected to be $1.2 trillion of which more than $900 billion will be borrowing to pay interest on the outstanding debt. In its assessment the CBO projects that, during the decade, the economy will fully recover.” Therefore, the CBO projection is not planned as a worse case estimate. The borrowings needed to fund these deficits along with the borrowings required by other companies and countries could put great stress on the bond market and interest rates. Based on these projections it is not at all hard to believe in President Obama’s promise for change. Unfortunately, not all of them may be welcomed.
As we have expressed in the past, absolutes are only known after the fact. Therefore, investing is the humbling exercise of recalibrating one’s investment strategy and specific investments with the probabilities associated with the levels and fluctuations in the market’s key underlying variables--valuation, investor sentiment, monetary conditions, and cycles. Recently John Hussman may have best assessed the stock market’s current condition as being “characterized by unfavorable valuations, overbought conditions, overbullish sentiment, and upward yield pressure from the bond market.” Our only deviation from that description is that we would change overbullish sentiment to one of near euphoria. Our reason for going one step further is based on the fact that in March investors purchased a record amount of newly issued junk bonds and in the sentiment surveys taken weekly, bears account for only 18.9% of all those polled. Obviously, the sustained recovery story has been thoroughly adopted and any adverse outcomes are being given a near zero weighting.
Mr. Hussman, went on to describe only three post-war market periods with similar data: August-September 1999, September-October 1987, and September-December 1955. The mildest reaction was an abrupt 10% decline in 1955. This was followed by 1999’s experience of another abrupt decline that was slightly greater than 10%, but became part of the top which constituted the end of the tech bubble. As you will recall that top ended a couple of months later and lead to a two and half year bear market and the beginning of the secular bear market we continue to experience. Of course the 1987 episode is now known as “the crash of ’87” where a two month decline exceeded 30%. Interestingly, we feel current conditions are reminiscent of 1987 right up to the heavy issuance and purchasing of junk bonds.
Based on the above, we have continued to exit our long positions and increase our short exposure, preparing for the decline we expect to begin at any time. From an historical cycle standpoint, the one year seasonal cycle, the four year presidential cycle, and the decennial cycle all are in synch at this time indicating at top of significance is due with the next low of importance being summer/early fall.
Even with our combined 128 years of investment experience at Trinity Capital Management, anxiety and frustration become the dominant emotions as we await a top to arrive. We have to remind ourselves that there is no room for emotions in the investment process. It does give us a sense of kinship to the fearless and exceptionally insightful Kansas City Fed President, Thomas Hoening. Because he understands the negative ramifications of keeping short term interest rates at an exceptionally low level for an extended period of time, he has been the only dissenting vote on the Fed’s Open Market Committee regarding maintaining their current interest rate policy. On being asked how he felt being the lone dissenter he offered the following response, “I may be alone, but that doesn’t mean I’m not right. It just means I’m alone.”
Trinity Capital Management, LLC April 7, 2010
First Quarter 2010 Outlook
“First, Some Good Economic News. Then What?”
This Friday’s employment report and the next report announcing 2009’s fourth quarter Gross Domestic Product should make for some encouraging reading. Throughout 2009 corporations fired workers and lowered inventories in an attempt to lower their operating costs. Reasonably good holiday sales further depleted inventories, and as a result, production and temporary hirings have begun to pick up in an effort to replenish inventories.
However, Nobel Prize-winner Professor Paul Krugman made this point in his recent New York Times editorial. He wrote, “it will be important to remember, first of all, that blips—occasional good numbers, signifying nothing—are common even when the economy is, in fact, mired in a prolonged slump…Such blips are often, in part, statistical illusions. But even more important, they’re usually caused by an “inventory bounce.” Unfortunately, growth caused by an inventory bounce is a one-shot affair unless underlying sources of demand, such as consumer spending and long term investment, pick up.” He goes on to state that it is his belief sustainable consumer demand, a lasting housing surge, nor a boom in business investment are on the horizon. Therefore, the necessary sustainable demand required for this blip to develop into a recovery is not present. His solution, as it almost always is, the government must continue, or even step up, its support programs or a dreaded second dip is coming. Therefore, we are damned if we don’t.
One can also make the case, that if the government follows Professor Krugman’s prescription, the resulting increased deficit and rising national debt will inevitably cause a rise in interest rates. The markets can only support so much borrowing by the U.S. Of course, taxes could be raised to pay for the debt service and eventual repayment of these new borrowings. In the past this has meant fewer dollars in the hands of the consumer and corporations, and therefore, lower spending by each. So, we are also damned if we do.
While neither approach seems especially desirable, we will just have to wait to see which course of action the White House and Congress pursue. In this regard the next three months will be key for three reasons. First, it appears that some form of healthcare legislation will be enacted. As always seems to be the case, the costs of financing new legislation are borne up front, with the financial benefits (savings) occurring in the out-years. History suggests the out-year savings fail to be realized.
Second, the most important legislation for the economy is a new jobs bill. So far, all Congress has done is to save and enrich failing financial institutions. Job creation has been given plenty of lip service but little money. Some form of a jobs bill will likely be passed as governments at all levels are cash strapped due to the large fall off in income tax receipts. As a result, there are not enough income tax receipts to pay for many of our safety nets. For instance, states are largely responsible for unemployment benefits. Over the last few months many of these funds have been exhausted, requiring states to borrow over $20 billion from the Federal government (who in turns borrows more money) to cover unemployment benefits. Many more borrowings will very likely be necessary. Bottom line, increased employment and the income tax revenues derived from the employed is really the only long term solution to the government’s money needs. We have already learned that borrowing and spending are not a long term solution.
Third, the real wild card could come from the yet to be enacted tax legislation. Due to the time spent on writing and quarrelling over the healthcare proposal, fifty tax breaks that have to be renewed annually were not renewed in 2009. This has happened before, and typically they are legislated back into law on a retroactive basis in the first few months of the following year. These breaks are not insignificant. Annual renewable tax breaks include items such as the deduction for state and local sales taxes, the $4,000 tax deduction for college tuition, the alternative minimum tax “patch” which keeps approximately twenty three million middle-income tax payers from paying AMT, business tax credits for research and development, and forty-six more. There is a chance, i.e. there have been rumblings, that Congress might also rescind the Bush tax breaks that are currently due to expire December 31, 2010. More important, they might make the revision retroactive to December 31, 2009. If this was to happen, individuals who were planning on selling appreciated assets this year to take advantage of the lower tax rate due to expire at yearend will be left out in the cold. The winner, of course, would be the government. At first blush this seems to be a highly improbable event. However, the government needs the money and there is a precedent for such action. In 1993, under the Clinton Administration, Congress enacted this exact legislation. Because the change was retroactive, and considered by many to be unfair, it was challenged but upheld in court.
It appears nothing can be taken for granted these days, as opaqueness and spins have taken over from the promise of transparency made by the Obama Administration in its early days. First, due to pressure from Congress, more lenient accounting rules favoring desperate financial institutions were adopted. These new rules allowed numerous high profile banks to report earnings when there were none. Second, in July, regarding the new issuance of government debt, our own Federal Reserve was moved to a category which included other foreign central banks. Therefore, when Treasury debt auction results are announced by buyer, one used to be able to assume the category labeled “indirect bidders” meant the quantity that foreign central banks had purchased. Now with our own central bank included in the category one can not decipher what real foreign demand is. One must consider that the answer must not be good. If not, why the change? Third, the latest questionable issue of handling a policy change was late on Christmas Eve when the Treasury announced that the heads of Fannie Mae and Freddie Mac would have salaries of six million dollars each. Not bad for CEOs of failing financial institutions. Also, slipped into the announcement was that the Treasury would supply “unlimited” funds over the next three years to keep those institutions going. What this really means is that the Federal Reserve wants to quit buying mortgages in an effort keep interest rates down with money that it creates electronically. Now, in the Fed’s place, Fannie and Freddie will pursue the same policy but with unlimited funds from the Treasury (i.e. our money). We find it highly suspicious that such an important announcement would be made on a day and at a time of day when there was a chance of it going unnoticed. The implementation of this new unlimited aid package for Freddie and Fannie must mean that more turmoil in the real estate industry can be expected. Of course, the attempted terrorist bombing on Christmas Day turned out to be the news of the weekend, sparing the Treasury from having to confront the financial press on this questionable new policy. Finally, possibly the biggest spin in recent months was the government’s initial “good news” statement that our anti-terrorist policy worked in stopping the Christmas Day bombing. A little over a week later existing policy is being thoroughly reviewed and likely revamped.
When analyzing the most probable course of the financial markets, one must remember that the markets are a leading indicator of the economy. Also, they are more of a frustrating process versus a single day event. Take the current Chinese stock market for instance. Almost daily the surging, unstoppable Chinese economy is heralded for its accomplishments. Nevertheless, most observers have failed to notice that the Chinese stock market is lower than it was over five months ago when it hit its peak on August 1, 2009. In a similar manner, it is quite likely that the current production blip associated with the inventory rebuilding is already discounted by the market. Even though it has yet to be discussed, the bitter temperatures and heavy snows we have been experiencing across the country may dampen current results which will prove to be a disappointment in the second quarter when first quarter results will be announced. The near constant servicing of our streets and highways will also likely prove havoc with already battered state and municipal budgets.
As we have discussed in prior reports, “history may not exactly repeat itself, but it often times rhymes with prior events”. In our current instance, the rally from last March’s low has been subpar compared to every other bull market over the past eighty years. Buying intensity has been lackluster and peaked in the May-June time period. Rallies have been more the result of a fall off in selling than strong sustained enthusiastic buying. Historically, this kind of activity has been the earmark of a rally in a bear market rather than the beginning of a bull market.
In our Fourth Quarter 2009 Outlook we delineated how our stock market of the last ten years has been almost identical to the one experienced in Japan from the end of 1989 through 2000--actually it is still going on. Like Japan in early 1990, we experienced a major bear market beginning in late 1999/early 2000. The NASDAQ for instance is still down over forty-five percent from that 2000 peak. That phase of the bear market was followed by over two devastating years, culminating with the bankruptcies of Enron, MCI, and Arthur Anderson. From there a several year recovery ensued, only to be followed from the 2007 peak to the near collapse into March of 2009. Since then we have experienced a powerful but internally subpar recovery. This rally is almost identical in time and price recovery to the one Japan underwent in 1999 to 2000. From there another bear leg began that took the Nikkei 225 Index from 20,833 to 7608 over the following two years. From its high on December 31, 1989 their market dropped from just shy of 40,000 to the 7608 previously mentioned. During this period they tried to pull out all the stops, implementing numerous stimulus programs and running up huge debts, identical to the path we have been following.
There are two statistical phenomena that are worth watching. Over the past one hundred years we have had a tendency to reach significant stock market highs in the latter part of years ending in nine through the first quarter of a new decade--i.e. years ending in 10. This peak has been followed by a bear market into the third year of a new decade, in this case 2012. Also, in nine of the past ten years declines have begun in the last few weeks of year or the first several weeks of the new year.
To summarize, stock market yields are now as unattractive as they were at the major highs experienced in 1972 and 1987. Then like now, in the weeks preceding the market downturns, stocks were overbought, bonds yields were creeping higher, and investment advisory bearishness had dropped to below nineteen percent (now 15.6%, one of the lowest levels ever). Admittedly, none of this means that the market has to turn down, however, the probabilities are very poor, as risks are high and the market’s internal strength is continuing to weaken. Until more weakness takes hold, we are maintaining a relatively small short position in the market indices, plus several long stock positions where we find the companies attractive and their stocks oversold.
Trinity Capital Management, LLC January 5, 2010
Fourth Quarter 2009 Outlook
“The Law of Diminishing Returns Meets the Law of Unintended Consequences”
In the 1950’s the addition of $1.36 of debt produced an additional $1.00 of Gross Domestic Product. This relationship has continued to weaken each decade since, and now it takes $6.02 of new debt to produce an additional $1.00 of growth in the U.S. This is a classic illustration of the Law of Diminishing Returns. While the consumer is retrenching, the government at all levels is following a path of borrow and spend. The tragedy of this approach is not only the level of debt exploding but the level of money it takes to service that debt in future years is also exploding. The Congressional Budget Office estimates that the interest payable on our federal debt for 2010-2014 will be $1.5 trillion—the fastest growing budget item. If interest rates go higher when the Federal Reserve adopts a more neutral policy, and/or the health care proposal or any new stimulus programs are adopted the problem will be exacerbated. Obviously, we are not on course to a permanent solution, but just taking an elixir with temporary benefits.
As happens to leaves at this time of year, the previously green shoots appear to be changing color as well. Economic reports over the past few weeks show an economy losing strength. Temporary programs like “Cash for Clunkers” and tax credits for first time home buyers just create a blip on the economic screen. According to the CEO of Fannie Mae, one in ten mortgage borrowers are behind on their loan payments and one in every twenty five homes is in foreclosure. Homeowners across the country have lost on average 40% of their home equity, making refinancing more difficult. The American Bankruptcy Institute reports that consumers filing personal bankruptcy rose 41% in September from a year ago, and have now reached over one million in first nine months of 2009. The American Banker’s Association released that delinquency rates are at record highs on home-equity loans, home-equity lines of credit, and bank cards. Sadly, the Food Research and Action Center declared that one in nine Americans (35,122,123 people) now receive food stamps.
The biggest bombshell had to be last Friday’s employment report declaring that nonfarm payrolls contracted by 263,000, approximately 50% worse that expected. Furthermore, The U.S. Bureau of Labor Statistics estimated that they have understated the number of job losses by 824,000, which they will have to reflect in their benchmark revision to be issued on February 5, 2010. This means that over the past twelve months, the labor force has actually declined for the first time in forty seven years. Furthermore, manufacturing aggregate hours worked fell to its lowest point since July 1940. It is no wonder that the consumer is retrenching even though we are being told to borrow and spend more to save our economy. Just in June of this year consumers cut back their credit by $21.6 billion, the most on record dating back to 1943. This retrenchment is being reflected in a very sharp slowdown in the growth of the money supply (historically a good forecaster of the stock market) as the M1 money supply has fallen from a year-over-year growth rate of over 50% in late 2008 to under 4% and the M2 money supply has gone from a little over 20% to minus 3.3%. Clearly, there can be no sustained recovery until debt levels are reduced and job losses or worry about job losses is cleared from the mind of the consumer.
As a result of the job losses and business slowdown Government tax receipts are falling at an 18% rate, the largest drop since 1932. Furthermore, an unintended consequence of the poor job market is that applications for Social Security benefits rose almost 50% more than expected this year according to the federal retirement program. It is seeing a significant increase in both retirement and disability applications as it is easier to get the benefits than it is to get a job. This creates an even bigger federal budget deficit since the government borrows any excess of contributions to benefits paid to use in that year’s budget. The Federal Deposit Insurance Corporation has run out of funds, and the Federal Housing Authority is on the verge of falling below its required reserve of 2% of loans. To our amazement, the administration has just allocated $10.5 billion (was $3 billion two years ago) to the USDA’s home guarantee loan program. This program allows the home buyer to put nothing down—just like the programs that created many of our current problems.
Corporate insiders who are often early but usually correct in forecasting the future share price of their own corporations have voted a resounding “no confidence” over the last few months. Despite encouraging words regarding the economy from our government, corporate insiders’ trading trends have been extraordinarily lopsided to the sell side, running over six sellers for each buyer. Furthermore, corporations selling new stock through secondary offerings have sharply expanded to take advantage of what they must believe are high stock valuations. CEO’s who are members of the Business Roundtable offered a dire forecast in their recent survey. Forty-nine percent expect their company’s sales to be flat or down in the coming six months, 79% expect capital spending to be flat or down, and 87% expect to do no hiring in the 6 months ahead.
In March of this year the Federal Reserve began a policy of not only lowering short term interest rates to 0% - 0.25%, but it also began “Quantitative Easing”, a government term for buying debt issues for their own account in an effort to keep intermediate and long term interest rates down, mainly to stimulate housing. Basically, the Fed is temporarily attempting to override market forces in an effort to produce an interest rate stimulus. In order to do so it was recently reported (and totally ignored by the mainstream media) that in this year’s second quarter the Fed accounted for almost half of all Treasury purchases ($164 billion out of $339 billion). In fact the Fed bought more Treasuries than the next three largest purchasers. It is well know that over the past decade we have been highly dependent upon foreign central banks to purchase our debt to fill the gap between our revenues and spending. Their unwillingness to continue would likely create a huge problem, and likely shock the financial markets. Therefore, it was distressing to see that this summer the Treasury changed the way it categorizes buyers of its debt. Now purchases by the Fed are included in the category which measures the purchases of foreign central banks. With this change it appears that foreign interest in our Treasury issues is still strong, however, it has actually been falling with our own Fed taking up the slack. That slack is now a large portion of the buying, and we have trillions of dollars of new Treasury debt coming to market in the future. Therefore, the Fed must keep monetizing the Treasury’s debt by creating money with the push of a keystroke, or interest rates must rise to the level that foreign central banks find the interest rate attractive, considering that holding dollar denominated securities has cost them dearly as the dollar has continued its eight year slide. If the Fed keeps monetizing our debt the dollar situation is unlikely to improve over the long term.
This condition has created an investment situation much like the one which Japan faced following the collapse of its banking system in the early 1990’s. Back then the Bank of Japan lowered very short term interest rates to 0% in an effort to stimulate a banking rescue. At the same time the yen was in a long term decline. The unintended consequence associated with this policy was that institutional investors and hedge funds borrowed money in Japan at almost no cost and then moved the funds to other countries where returns were better. Due to the yen’s weakness, when they paid back their yen denominated debt they actually made money on the currency portion of the transaction as well. The catch was that it became so popular that the investors started using a tremendous amount of leverage to further benefit from their “sure thing”. As happens when investors are all of like mind, something undermines the up-to-then unthinkable. When the Japanese would have one of its many temporary recoveries, interest rates would rise, and the yen would strengthen. With investors heavily betting on the opposite condition, they would have to rapidly shrink their positions causing very disruptive market reactions around the world.
Currently, this same unintended consequence is developing in the world’s financial markets. Institutional investors and hedge funds have borrowed heavily in the U.S. and then converted the dollar borrowings to what they believe are more profitable opportunities around the globe. With interest rates near 0%, and the dollar declining (surveys show that 97% of investors believe the dollar will continue its decline) it appears to be a “sure thing”. Is it? Several circumstances can radically and rapidly change what appears to be an ideal opportunity. First, with 97% of investors in agreement that the dollar can do nothing but fall in value, it reminds us of the old Wall Street saying, “When everyone is thinking alike, nobody is really thinking at all”. Second, our stimulus programs will show temporary results from time to time. The yet to be announced third quarter results should be one of those instances as “Cash for Clunkers” and first time home buyers getting tax rebates temporarily spurred economic growth. As a result, interest rates could pop higher, the dollar strengthens, and once again a “sure thing” backfires. Third, little attention is being paid to the fact that at the current rate of China’s growing imports versus falling exports, its huge trade surplus could reverse by early 2010. If these trends continue and the surplus turns to deficit, they will not have the funds to increase holdings of foreign securities, i.e. U.S. Treasuries. Finally, as other countries currencies have appreciated (dollar depreciated) their exports have become more expensive for foreigners to buy. Even though global cooperation is much discussed, eventually governments must respond to their electorates. Over the past week, it appears that the Swiss central bank undertook a massive foreign currency intervention to lower the value of their currency versus the dollar in an effort to stimulate business for their domestic corporations. This was followed the next day by separate announcements from Honda and Toyota that their businesses were suffering from the weak dollar (strong yen). While countries usually try to avoid currency intervention, the pressure to do so is building. If it occurs it could set off a scramble to shrink holdings of risk assets and repay dollar based loans.
When we review the current economic/investment environment versus a year ago it appears that conditions have worsened. A year ago the U.S. had too much debt and a concentration of toxic assets on the balance sheets of our largest financial institutions. Now we have significantly more debt and still have a concentration of bad assets being carried on the balance sheets of our major institutions. Actually, the issue of concentration may be worse since a number of the too-big–to-fail banks and brokerages have had to merge making them really-too-big-to-fail. Due to this lack of improvement we continue to believe that we are in a long term bear market interrupted with an intermediate term bull swing.
Shorter term, “while history never exactly repeats itself it oftentimes rhymes”, our recent stock market’s cycles are almost identical to those of Japan’s from 1982 through 1999. In our instance the pattern begins in 1992 up to now. In each instance the market mounted a seven plus year major Bull Run. Ours ran from late 1992 to late 1999/early 2000 when the tech bubble burst. In each instance a severe 50% plus bear market followed. Then a four plus year recover was followed by an even more severe downturn (for the U.S. that was the latter half of 2007 until March of 2009). Then Japan experienced a sharp multi-month uptrend almost identical to the one we have been experiencing. In Japan this recovery was followed by a bear market lasting over two years which took the Nikkei 225 Index from 20,833 to 7,608. We will be closely watching to see if the tracking remains intact. Interestingly, our ten year Treasury note is performing almost identical to the performance of the Japanese Government bonds in the comparable time frame.
History supports that our market may well continue the prior experience of the Japanese market. Over the last 100 years, our market has usually experienced a major high in the ninth year of a decade followed by the next significant low in the second year of the next decade. Furthermore, the four year Presidential cycle, as well as, the cycle following a Democrat administration taking over from an incumbent Republican administration is in agreement with the ten year cycle.
Realizing that the future does not have to mirror the past, we measure what we believe are the key indicators of the stock market’s strength or weakness on a daily basis. In doing so we find it uncomfortable that the rally has occurred on low and continually contracting volume, an indication that currently there is a lot more talk than buying conviction. Last quarter we mentioned one of our most reliable indicators of the stock market’s health and likely future direction is to measure the intensity of buying and selling on a trend basis. We went on to say that the rally from the March lows to when we wrote our letter on July 1st, was particularly inferior in its underpinnings. As indicated by the lack of decline in our selling index, the desire to sell never really receded. In addition, the buying index never showed the surge that has always been present during the early stage of a lasting bull market. Both of those conditions still exist. Our buying index has not been able to surpass its high of early May, and the selling index is still at the level where it was in January of this year. Overall, it appears that on an intermediate term basis the market’s internals hit their high point in June of this year and the recovery highs in the stock market indices since then have been three short term spikes that are totally unsupported by underlying market dynamics. In prior periods where the market’s internals have started to decay on an intermediate term basis, but the market goes on to register higher highs, it is particularly vulnerable to a sharp reversal.
While flexibility will remain to be the key in these volatile times, we currently are prepared to take advantage of a market correction, and to a small extent an improving dollar.
Trinity Capital Management, LLC October 5, 2009
Interim Update
Long Term: Secular Bear Market
Intermediate Term: Rally Topping
Short Term: Rally Topping
Secular bear markets (years) are historically interrupted with powerful intermediate term rallies (months) which in turn are comprised of numerous short term rallies (weeks). These up trends serve the purpose of drawing investors back into the market before another major bear phase begins. The last few months have served that purpose, and as historically happens, economists see green shoots and market strategists declare the worst has been seen.
All clear? Hardly. Of course, there are temporary improvements, but not sustainable ones. Case in point, car sales are improving. Why? The government is borrowing money to share with a few car buyers, who in turn borrow more money to buy a new car. If this was the road to lasting riches, then Argentina would be an economic powerhouse. Furthermore, it appears that our citizens now recognize that the administration’s health care program is at the policy forefront (right or wrong), because its passage will offer the government an excuse to hike taxes. Again, hardly the cure for what ails the U.S. economy.
Most important is the stock market itself. In recent weeks the market has become very selective with sharp, short term zigs and zags. These abrupt gyrations typically indicate a change of direction. As investors have gained confidence, corporate insiders are dumping their shares at a rapid clip. In addition, late summer/fall is a treacherous time frame for the equity markets. We are entering this seasonally weak time period in an almost euphoric mood, but with an extremely overbought stock market -- not the recipe for further substantial gains.
As a word of caution, market peaks tend to take on an umbrella-like look. At first, the weakness is barely perceptible but it continues until a sharp decline, recognizable by all, takes place. Our work indicates we are in the early, almost unrecognizable stage, and have prepared our portfolios for the decline we expect will follow. While we must remain cognizant of the fact that the deteriorating market conditions can substantially improve, it currently appears that the markets underpinnings are weakening to the degree that lower prices can be expected over the next several months.
Trinity Capital Management, LLC August 10, 2009
Third Quarter 2009 Outlook
“Less than Meets the Eye”
After a devastating first quarter, the stock market reversed smartly in 2009’s second quarter. This brought most stock market indices close to where they began the year. Tempered bullishness has returned as investors (or at least TV pundits) are beginning to project an extension of the second quarter stock market recovery. However, the question remains, “Are we experiencing nothing more than a sharp recovery in a bear market?” Bear market rallies are notoriously impressive in their quick and sharp ascents that serve the role of returning investors to a point of complacency or all-out bullishness. That has definitely been achieved with the recent recovery as the rally cry is now “the worst is behind us”. Is it?
We believe the financial markets are a much better predictor of the economy’s future than are economists, and, therefore, rely heavily on their “message”. Nevertheless, we want to provide a thumbnail sketch of what has transpired to produce the green shoots spotted by government officials and market pundits, but are yet to be observed by businessmen, employees, and consumers.
For years the U.S. government and its citizens have spent beyond their means (current revenues/current wages), using an ever increasing debt load to bridge the gap. Now it appears this is no longer the path over-burdened consumers want to follow. However, the government instead of allowing the economy to return to a natural level of growth sustained by wages, has instead stepped into the debt gap with massive borrowings, more than offsetting its citizens’ desire to go slow and repay debt. In essence, while the economy will eventually return to a normal growth pattern, the government feels it is too painful of a process, and is instead promoting rampant borrowing in hope of maintaining spending at an unnatural and unsustainable level.
So, where do we stand? Wages and salaries are down 1.1% from a year ago. Interest income is 5.2% lower. Dividend income has fallen 12.4%. Business income is down 4 %. In addition, home mortgage debt has fallen 1% while real estate values are down 10%. Home equity as a percent of household real estate is at a record low of 41.4%. The private sector experienced modest deleveraging in the last quarter, however debt/equity ratios climbed across the board, hitting new postwar records in the private sector, the household sector, the business sector, and the nonfarm, noncorporate business sector. Employment continues to fall as do wages, making it difficult to cover existing debt payments. The only bright light (actually a dark cloud) is that government transfers (food stamps, welfare, unemployment insurance) are experiencing booming growth at over 12% year over year. As a result government debt is 100% of GDP, the highest in history. It almost goes without saying that in addition to the above, the Social Security, Medicare, and Medicaid situation is by no means improving.
Accounting rules have been modified to produce profits where there are none, banks have done nothing to rid themselves of the toxic assets, and the governments’ (federal, state, and local) policy of borrowing, spending, and transferring money among classes is not a course of action that can produce a healthy economy with a strong financial underpinning.
What is the stock market’s verdict? As we mentioned previously, the second quarter snapback brought most stock indices back to where they started the year. However, on close inspection the rally has some major flaws. First, the rally has been lead by the stocks of the weakest companies with overly-leveraged balance sheets. They were previously the weakest performers with many having fallen 80% or more from their highs of the past two years. Therefore, it looks like a bounce back rally versus an initial bullish thrust. It appears investors believe that the government will save everyone. If so, why not make the riskiest bets? This is similar to the “Greenspan Put” which eventually failed to keep the market on an ever-rising trend.
One of our most reliable indicators of the stock market’s health and likely intermediate term direction is to measure the intensity of buying and selling on a trend basis. Based on data going back to the early 1930’s, we find the quality of the rally from the March low was particularly inferior. First, the desire to sell never receded, as reflected in the almost side-ways pattern of the selling index from early March to early June. Second, although buying did improve from the March low to early May, the gains were far less dynamic than typically found in new bull markets. Currently, the buying index has given back almost all of its gains from the March low. If the index had retraced only about one-third to one-half of its earlier gains during the recent market weakness, the probabilities would suggest that a brief correction was likely, to be followed by at least a test of the rally highs. Since the index has lost almost all of its March to May gains, the probabilities suggest that the major price indexes could lose a significant amount of their gains from the March low. Even lower prices could quickly occur if selling intensifies during any further weakness. Third, total volume, as reflected in a 30 day moving average of up to down volume, began to contract in early April, showing that investors were not willing to expose increasing amounts of capital to risk as the rally continued. Fourth, instead of broadening, the rally narrowed, as fewer and fewer stocks participated during May and June. All of these factors are contrary to conditions found during the early months of every bull market during the past 76 years. If the March low did not mark the start of a new bull market, then it would follow that the March-June upswing was a rally within a continuing bear market.
To summarize, neither economic nor market conditions appear to favor a long lasting bull market. Instead, they indicate, and we expect, the market will continue to experience sharp declines and advances into the foreseeable future. Accordingly, we will continue to follow our strategy of using inverse exchange traded funds during downtrends in an attempt to protect and enhance capital while using long exchange traded funds to exploit the quick, sharp rallies that occur during this period of a flat to declining secular trend.
Trinity Capital Management, LLC July 1, 2009
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