Breaking The Trend

For quite some time, the trading strategy du-jour has been to short financials and go long energy; however, at least temporarily this trade is dead. Let me take you on a journey that began in the fall of 2007. At this point in history it was common knowledge that the housing market was in the midst of a great decline, information about losses tied to structured financial instruments began to come to light and fears about the general strength of the U.S. economy started to creep into the public consciousness. At it’s September meeting, the Fed began down the road of monetary easing by slashing the Fed Funds Rate by 50 bps, taking us from 5.25% at that time to our current level of 2.0%. Additionally, the CPI was around 2.0% and NYMEX light sweet crude oil for the front month delivery was in the mid $70’s; most recently, CPI is at 5.0% and oil traded at the top end of the $140’s.The aforementioned information is fact, what I am about to portray is my opinion as to the series of events that lead us to our current market and economic position. In an attempt to add liquidity to a credit strapped market, the Fed lowered its key-lending rate; unfortunately, this action had the effect of further depreciating the value of the dollar, adding steam to a phenomenon that began in 2001. As time passes, the market begins to realize that loose monetary policy does not translate into easing credit conditions as banks begin to tighten their lending standards and mortgage rates perversely increase. Problems begin to accelerate as job growth turns negative and commodity pressures begin to have an effect on business activity and consumer confidence. Market confidence is shaken as one of the oldest investment-banking institutions, Bear Stearns, is ‘saved’ from bankruptcy by the Federal Reserve and JP MorganChase, prompting concerns about others in the industry. As the financial sector continued to weaken and the broader market went with it, large pools of funds began to search out a new temporary nesting ground. Energy and commodities began to rise in a parabolic fashion as the U.S. dollar weakened and these ‘real’ sectors were now seen to investors as a genuine asset class. As money chased after run away gains in the energy and commodities sectors, inflation concerns crept into main-street further exacerbating an already fragile situation. Now, take all this info and fast-forward to the present day…

Some indicators like existing home sales and the S&P/Case-Shiller Home Price Index seem to suggest that a bottoming process for the housing market may be underway, or at least we are starting to eat away at the glut of housing inventory currently outstanding. Although most data, as well as reasonable judgment, seem to point to a housing bottom somewhere in 2009; especially given the fact that today the average rate for a Jumbo loan is now around 8%! The banking sector has been riddled with asset impairment charges related to sub prime securities, and profits are being squeezed as many institutions are de-leveraging and limiting potential for future earnings growth. It was the strength of the housing and banking sectors that brought the US economy and stock market from its recessionary lows of 2001-2002; now these 2 sectors are the key to weakness (and recovery) in 2008. Over the past week and a half, both financial and housing related stocks have seen great gains. I believe this is due to a fundamental shift of funds out of energy and commodities and back into traditional investment vehicles; and since housing and financial companies have taken a dive into serious value territory, the market shifted to bring these 2 laggard sectors back to life. I would argue that this is a function of the combination of a pull back in oil prices and a strengthening (or at least bottoming) greenback. Unfortunately for the financials, worries remain as to how these institutions will generate profits without much of the structured finance boom coupled with a shrunken balance sheet. The one thing these companies do have on their side is that many are trading at fractions of book value, even after write downs have been taken into account. In fact, if the underlying assets stabilize, the value of these complex securities may not be as low as they are currently being priced at, creating the potential for a future upside asset write-up surprise.

If the Fed realizes that main-street credit conditions have essentially decoupled from the target Fed Funds Rate (take a look at treasury securities, the TIPS market and mortgage lending rates) they should turn their attention from attempting to prop up economic growth and focus on price stability. The Federal Reserve is already adding liquidity into the system by allowing non-bank financial institutions access to the discount window, now if they could come up with other creative ways to keep the market liquid and support new residential mortgage lending, prospects for the economy would improve dramatically. If a policy shift towards reducing inflationary expectations and managing price stability was undertaken, I believe continuing growth in the economy is a real possibility. Although dollar management is not a mandate of the Fed, a strong dollar is correlated to higher domestic interest rates and would help to ease commodity induced inflationary pressures. Thankfully, there appears to be no threat of wage-price inflation, and thus it is not unreasonable to assume that this type of policy would return CPI to the Fed’s comfort zone and create a supportive environment for economic prosperity.

The government should also do it’s part by lowering taxes and investing revenues in infrastructure programs instead of rebate checks that are the equivalent to giving a terminally ill patient a Tylenol and a pep speech. The American people need to stand up for the economy and say no to higher income taxes, corporate taxes and capital gains taxes, which is basically the economic platform of Barack Obama. The Congress needs to wake up and realize that although it would be stupendous if people drove around with windmill powered cars; in order to assert energy independence and curb the rising price of oil a drilling strategy to exploit reserves within American borders is absolutely essential. An ideal comprehensive plan would include investment incentives for renewable energy, increased reliance on nuclear power as well as exploration and extraction of energy sources like crude oil, natural gas and coal. I hope the public took note of the fact that the fall in oil, and rise in the stock market came when President Bush lifted the Federally imposed moratorium on offshore drilling, as this should indicate that this type of policy is very bullish for the stock market and the economy. The issues of taxation and spending policy as well as a comprehensive energy plan are crucial to the future outlook for growth in the US economy, and I hope that the upcoming election is centered on these important topics.

Maximum Pessimism?

Ahhhhh, the exciting, action packed, topsy-turvy, ridiculous week that was: Fannie and Freddie seemingly on the brink of failure; rumours swirling about PIMCO pulling business and money out of Lehman and refusing to engage in counterparty transactions with the Investment Bank; a new all time high for oil reached on intraday trading above $147 a barrel; and reports of military activity from both Israel and Iran, as that potential conflict becomes more possible each day. When taking all of these negative factors into consideration, you would probably guess that this past week would have been a bloody one on Wall Street; but you would have been wrong! The S&P 500 was down a measly 1.85% for the week, and the Dow Jones Industrial Average was off even less. Has the market priced in all the possible negative scenarios and is finally coming to a point where a temporary bottom may be formed? That is of course the million-dollar question. I am, by no means, proposing that a floor is now on the market and we can assume that prices can only go up from here; what I am suggesting is that I think we may have reached a point where a piece of bad news would have less of a detrimental effect in relation to the positive gains associated to a piece of good news, of comparable size and meaning. In this type of environment, I expect to see volatility decrease as the market moves sideways before deciding which path it will commit to for it’s next run.

I would like to take a moment to discuss the situation surrounding Fannie Mae and Freddie Mac. Although I am not an expert on these companies, I feel the need to express my views on the broader economic consequences of having a pseudo governmental agency holding over half of the mortgage debt in the United States. When such an entity attempts to operate in both the public and private spheres, conflicts that reach down to the very fabric of socioeconomic goals come to light. Public and private enterprises have starkly contrasting mandates, while commonalities in their function are few. The concepts of equality and fairness, freedom and property can spawn a heated debate among political economists. At the centre of that debate would be the distinction of public and private boundaries surrounding socially sensitive sectors of society. To create a GSE that has an obligation to produce profit for shareholders, when at the same time is forced to take on a portfolio of shady loans due to a government decree is counterintuitive and thus is less efficient in its current form than it would otherwise be if it were either completely public or private. The private sector has shown time and again that it has the ability to satisfy a popular need, and can do so without added bureaucracy and cost inherent in public ventures. It would be a very difficult undertaking to rearrange these GSEs, especially at such an inopportune time; however, action needs to be taken to ensure that these companies have the ability to stand on their own without having the government telling it how to do business.

As I said in last weeks post, inflation remains the primary concern for this economy, although it was on the proverbial backburner this past week. Import price inflation data, which was released on Friday, showed that even prices excluding petroleum have jumped markedly higher (you don’t want to know what they are when petroleum is included! J). This could pose a concern if these higher prices are passed on to the consumer, further solidifying and amplifying inflationary expectations. To take a cue from my personal role model, Larry Kudlow, inflation remains the single most significant tax on economic growth. In order to ensure a good long-term standard of living and stable economic progress and prosperity the Fed needs to take control of the inflation situation… like, yesterday!

Stagflation Stinks...

Although I have been predicting an impending period of stagflation since September 2007, I was secretly hoping my thesis would not materialize. Unfortunately, data continues to pour in from different sectors of the economy that point towards an inflationary induced profit squeeze and the dreaded no-growth high-inflation combo (the ‘un-happy meal’). The newly released data from the Institute for Supply Management (ISM) showed a developing trend towards a contraction in the non-manufacturing sector brought about by higher input prices. In fact, respondents of the ISM survey in the Transportation and Warehousing sector say that “Oil prices are affecting most every supplier we have” http://www.ism.ws/ISMReport/NonMfgROB.cfm. As input prices of production rise and businesses are unable to pass on those costs to the consumer, profits across the economy will be squeezed. It is my view that corporate profit expectations for the 3rd and 4th quarters are too high, and although those companies with an international presence could continue to benefit from a weak US dollar, growth across the broader economy will remain sluggish. A systematic lowering of profit expectations across the economy will be a negative for the stock market as traders discount prices for stagnant growth and a fragile profit environment.

Expectations are what drive markets, and the key to a successful turnaround in this economy will therefore come from a fundamental shift in this crucial area. It is inflationary expectations that are causing a decrease in production and a cut in jobs. Profit expectations are tied to input costs and capacity utilization, which is closely linked to inflation. Investment spending in the US is linked to the expectation of currency appreciation and tax policies; both of which look grim under the current easy money Fed and the strong possibility of the country having a Democratic President and Congress. All of the aforementioned expectations can be successfully controlled by a coordinated policy effort aimed at a strong dollar and low corporate tax rates to induce a sustained level of investment spending. I don’t think the fed has to worry too much about the classical negative effect that slightly tighter monetary policy has on growth as the linkages in private sector borrowing have already deteriorated from the fed funds rate. Also, if the Fed continues to hold open access for nonbank institutions to the discount window, sufficient liquidity will remain in the system to prevent the possibility of a crisis of confidence in the financial sector. Inflation will likely be the buzz word for the remainder of 2008 as the Fed tries to walk the tightrope of pursuing economic growth and price stability. I say let the government handle growth through a liberal tax policy and the Fed can unleash the inflation hawk that will soar in to contain the detrimental effects of protracted inflationary expectations.

The best type of strategy for investing in this uncertain environment is coincidently the model that I believe works best under any scenario: follow the trends that are paying off now while keeping an eye on contrarian opportunities. Many hard commodities are off their highs and provide a good entry point for an investor looking for a good hedge to inflation as well as to take advantage of continuing infrastructure growth in emerging markets.