Thursday, 22 November 2007

Tactical Nukes

The fundamental case for a bull market died a long time ago and has not terribly sound in a long, given the combination of high valuations, slowing growth and a significant portion of earnings that were an outright illusion. Strategically speaking, the last time the bull case made any sense was in early 2006. That has not prevented tactical factors from pushing an overvalued market still higher in the interim. The primary tactical focus has been "liquidity" which readers of this blog will recognize as simply a synonym for growing debt.

The UDB threw off a tremendous amount of this "liquidity" as debt expanded rapidly. The serial collapse of mortgage finance, CDOs, MBS, asset-backed CP and other debt markets has reversed the flow as outstanding debt/credit shrinks. But how is this affecting stocks, you might ask? Well, there is the obvious collapse of profits in the building and financial sector as well as similar impending action in the consumer sector. But these are indirect effects and failed to knock down the indexes for long until recently.

There is now a much more direct impact on supply and demand for stocks and the financial pressures are affecting both sides of the equation. On the supply side, many distressed financial firms will be forced to issue new equity to bolster their crumbling capital base. Two major sources of "greater fool" demand for stocks have essentially disappeared - leveraged buyouts and corporate buybacks financed with debt. Lenders are no longer willing to finance such foolishness now that it has been exposed as such. The WSJ has this to say:

Driven by billions of dollars in share buybacks, record-setting buyouts and a wave of mergers, the amount of stock in the market shrank by hundreds of billions of dollars in the past four years.

With the supply of stock down and demand strong, the market rallied. Now, as the economy slows and credit markets buckle, high-profile companies are cutting back on buybacks, and some wish they held on to the cash they gave back to shareholders.

The reversal of the trend exposes a flaw in the buyback strategy -- many companies bought high and are selling low.

Big Buybacks Begin to Haunt Firms

"Liquidity" has been removed. LBOs of any real size are dead. Instead of buying back shares to reduce the supply, corporations are starting to issue more stock and increase supply just as demand is falling. It looks to me as if the even the tactical bull case has been nuked at this point. The strategic case is long-dead. What is the reason to still own stocks today?

Saturday, 17 November 2007

Sea Change on the Street

Guys, there was a huge change of tone over the last two weeks and especially this week. The denial that has ruled Wall Street for so long is beginning to show major cracks. We're finally seeing grudging admissions that this is a much bigger problem than they were willing to admit. What used to be just a "subprime" crisis is now a "mortgage" crisis.

The terrible reports from major retailers like Pennys, Macys, Kohls and the spectrum of apparel shops along with restaurants like Starbucks, PF Chang, Chipotle, Brinker and Panera are causing the Street to question the "resilient consumer" thesis. They should since it is based on the ability of the consumer to dig themselves into an every deeper hole of debt. But McDonalds and Target did well and Walmart OK. What does it tell you when spending is switching from department stores to discounters and from premium or sit down restaurants to the golden arches?

We don't hear the word "contained" much anymore do we?

Smacking Fannie
Fannie Mae is messing with their accounting to hide rapidly rising losses. They snuck in the accounting change that cut reported losses by almost half. This sort of game has been very common at financial companies in the last few years. They usually get away with it but this time investors noticed and slammed the stock down 20% in just a few sessions. The executives at Fannie must feel like Mike Leach when one of his OLinemen gets called for holding. We're going to see a LOT more of this simply because there is so much out there to find.
More doubts about Fannie Mae's disclosures

Commercial Divers
Next, we get the first real world confirmation that commercial real estate pricing is now falling. Synthetic indexes like the CMBX and credit indicators have been indicating decline for many months. The MIT index covers CRE owned by large pension funds and showed a decline of 2.5% for Q3. That would imply that prices rolled over either during Q2 or early in Q3. Commercial joins residential and commercial construction spending should follow shortly.
MIT index shows first drop in commercial property value since '03

Just incidentally, the subtitle "Indicates housing woes, credit crunch 'may be spreading' " trips one of my pet peeves. There is not a housing crisis spreading to other sectors like a contagious disease. This is more like a genetic heart defect inherited by a group of brothers from the Credit family. One, let's call him "Bob Residential" has a near-fatal heart attack. Another, named "Joe Consumer" is in the hospital for major symptoms but nothing life-threatening yet. "Jim Commercial" and "John Corporate" are having chest pains. The media wants to blame Bob for everybody's problems but the reality is they were all flawed from birth (of the current crop of loans).

Goldman Shocker
Goldman Sachs, which had previously been very bullish, is now calling for $400 billion in direct losses from the crisis in mortgages, plus $2 trillion in withdrawn credit as bank reserves shrink. Well, at least they've got the right number of zeros now but they still fail to account for anything beyond residential real estate.
U.S. could face $2 trillion lending shock
"The macroeconomic consequences could be quite dramatic," Hatzius said in the note to clients. "If leveraged investors see $200 billion of the $400 billion aggregate credit loss, they might need to scale back their lending by $2 trillion."

Hatzius said such a shock could produce a "substantial recession" if it occurred over one year, or a long period of sluggish growth if it occurred over two-to-four years.

The related article in Forbes made me roll my eyes and mumble "nice job Goldman, what took you so long?" This was obvious to anyone who bothered to do elementary analysis even a year ago. It's also why the Ben Stein's of the world have always been full of it. His "analysis" failed to account for how much the losses would push down the price of everyone else's houses or how the damaged financial system would be forced to cut lending. Duh!
Cost Of The Crunch? $2 Trillion, Says Goldman
In July, for example, Fed Chairman Ben Bernanke put subprime-related losses at $50 billion to $100 billion. "Even at the time, these numbers seemed quite optimistic," wrote Goldman economist Jan Hatzius, in a note Friday. "Now it is clear to most observers that they are far too low."

So it looks as if the new bull case is huge losses and probable deep recession. Goldman has been a constant cheerleader since they have a lot to lose from this scenario. IMO, they have simply calculated that the loss of credibility from continuing to spew slanted nonsense now outweighs the loss of business if the economy and market fall a little sooner. Make no mistake, they would be extremely unlikely to make such a change unless they felt the events were already on the doorstep.

The Bleeding Edge
Of course, Hatzius at Goldman is just catching up to David Rosenberg at Merrill, who turned quite bearish 6 months. The guys who had this right from the beginning are Paul Kasriel at Northern Trust and a pair of academics - Nouriel Roubini at NYU and Robert Shiller at Yale. Notice that none of them work for investment or money center banks. Earlier, I linked the Bloomberg interview with Morgan Stanley's head of credit strategy, calling for a greater than 50% chance of the credit markets coming to a "grinding halt." The scary thing is that Roubini is now going further and saying the "risks of such a generalized systemic financial meltdown are now rising."
Nouriel Roubini's Global EconoMonitor

This is obviously not something I've foreseen. My expectation has been for severe and widespread losses, with a few major firms failing. Roubini has not yet published his full analysis but I pray that his conclusions are wrong though I will consider them with an open mind. Just as I've prayed that my own conclusions were wrong despite believing in them wholeheartedly. The problems seem inescapable. Hope for the best, prepare for the worst.