The big economic statistic of the week was today’s unemployment rate for February. The expectation was for a poor jobs report and an unemployment rate to exceed 8%. What we got was exactly what was expected. The market breathed a sigh of relief in the morning but it’s Friday and the day is early. Expect unemployment to reach about 10% nationwide before it starts to improve. It will continue to rise even when we see evidence that the recession is waning. There is no evidence of that yet, but it will end despite what many think. The Depression word should not be part of the discussion. Could we go into a depression? Yes, but the probability is slim. 

There was a plethora of economic statistics released this week and I don’t want to go over all of it, but it is prudent and enlightening to touch on a few data points. First, the ISM (Institute of Supply Management) report for February rose to 35.8% from January’s reading of 34%, a very slight improvement which may or may not be statistically important but any reading higher month over month is good though any reading below 50% is a shrinking economy. Construction spending fell 3.3% when expectations were for a fall of 1.6%. This report was for January. January factory orders were down 1.9%, much better than the expectation of a fall of 3.5%. Finally, retail sales in February rose. All these are backward looking numbers but they certainly paint a picture of a falling economy with hints of stabilization. The recent bad news is a direct result of the liquidity crunch that froze all economic activity in October and November before it started to loosen. Liquidity is still tight. We are far from being out of the woods but we can see the end of the forest as we slog our way forward. 

If we look for any sign or spark of hope, it is in the news that seems to becoming less Draconian. Less bad news means we are still falling in economic activity, but the pace of the fall is slowing. A recent news article spoke to announcement of layoffs in February that appeared to be less in number than in January, but that was after a 14 year high in layoff announcements in the first month of the year. The consumer seems to be spending a bit more. Housing and refinancing is still very weak, but there are small signs of improvement in California where sales of existing homes was flat last month but rose the month before and inventory actually fell. However, new home construction is in the basement and digging a deeper hole. Foreclosures are increasing, but there is a plan released by the White House to help. It will take time to see any impact but frankly, foreclosures will continue to rise. In past loan work outs we have seen half of them return to the foreclosure process. I think much of this effort is wasted. Affordability is very good and interest rates low. Buyers are starting to come back but very slowly. 

The market has fallen 25% since the first of the year. That 25% can be directly contributed to the lack of clarity and focus of the stimulus package. Despite the President’s smooth speeches, the constant drum beat of the evils of our system and actual policies that have been announced and passed have been just as toxic to the stock market as toxic mortgages are to the banks. 

The hope the market had for the ’stimulus’ plan of $800 billion disappeared as the details showed it to be a multi year ’spending’ package packed with pork barrel spending. The public and the market see it for what it is not for what politicians try to spin it to be. 

For our clients we have turned very defensive with high cash levels, larger short positions and equities that are anti or out of the market. We have a few long positions in the stock accounts but only in those companies that have a clear growth of earnings path and at the same time are extremely underpriced when compared to price to book, price to earnings and price to sales. In the mutual fund program we have very high cash levels, two bond funds, a double short mutual fund and very few long funds. These efforts have enabled us to far outperform the market though we still have loss value this year. 

There will be a turn but we will wait for the bottom to show itself before moving into the market in any significant way.

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New home construction fell to a 50 year low as reported this morning. It could be worse than that as they only started counting 50 years ago. At the same time applications for mortgages last week spiked up by 40% or so over the week before, most of it for refinancing of course.

Today, Obama released his plan to save some people from foreclosure and the market didn’t really care much for it. So far the Obama Presidency has been a large disappointment from a stock market point of view. He does not really pay much attention to the industry, having repeatedly complained about the excesses of Wall Street. However, the stock market is a leading indicator of our economy. It is telling anyone who wants to listen that it does not see an economic turn around as yet.

It is time to be very cautious, holding significant amounts of cash on the sidelines with a few contra positions for protection. If you are going to own stocks, dividends are important as they will give you a cushion. Of course you need to be concerned that the companies you buy can maintain their dividend.

Most traders are waiting to see if the market will break the September lows. We are very close and it’s touch and go at this point.

Good Trading
Steve Peasley

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This has been a week of earnings reports and important economic statistics. We started the week with good news. MacDonald’s earnings were better than expected, but more importantly was the existing housing report which showed an increase in sales for December, not a reduction as expected and it showed a significant reduction in inventory from 11.2 to 9.3 months from the month before. Also, the leading economic indicators report, which gives us a gauge of future health for our economy, was up when the expectation was for it to be down. The beginning of the week gave us some hope.

That hope extended into mid week because of President Obama’s spending package and talk about setting up a good bank/bad bank to buy toxic loans and get them off the back of the banking industry. That hope faded on Thursday as we had a number of poor earnings reports, unemployment claims rising, durable goods sales falling and new home construction falling sharply with an accompanying spike in inventory of unsold homes.

It is obvious that foreclosures have pushed home prices to such a low point that sales that would normally go to new homes are going to used homes. This week’s numbers tell the story clearly. Builders are not going to recover in 2009 even though sales in housing might. The raw data for new homes was that 331,000 new homes were sold for December down from 399,000 in November. Inventory for new homes stands at 14.7 months up from 12 months. As this is the opposite of the existing housing numbers out earlier in the week the conclusion is clear.

Last Saturday at our conference in Berkeley we reviewed the reaction of the stock market in each recession going back to the Great Depression. The conclusion is that the stock market ‘will start’ to rally long before the economy recovers. The average lead time is 4 months with some stock market recoveries starting only a month or two before the economic recovery and some as long as 8 months. The average stock market rally for those few months is 23%. That does not include the continued rally after the economy continues to strengthen. The 23% is only from the start of the stock market recovery to the start of the economic recovery. That is a sharp move up that most people will miss. Also, we will not see the recovery in the economic numbers for at least 6 months past the start. These statistics mean you are not going to be able to look into that crystal ball and determine ‘when’ the stock market recovery will start. There will be bad news everywhere and the stock market will be ignoring it.

Finally, in last Saturday’s conference we looked for the economic recession that most closely matches the current one with a similar fall in stock prices. It appears the 1973-74 recession closely matches in many ways the problems we are having today. In that recession the stock market fell 45.1% from the start to the end of the recession, the stock market started to recover 2.8 months before the economy begin its recovery and the net change up in those 2.8 months was 33.0%.

The question is ‘when’ will this recession end? It is already one of the longest recessions on record if you count the start being that of when job losses began. It is very likely that we will have at least 4 quarters in a row of falling GDP and of course it could be longer since no one knows. Most count the start of a recession with two quarters of falling GDP in a row. Once that happens you are in a recession. So by any definition we are in a recession. This morning GDP numbers for the last quarter of 2008 were reported and it fell 3.8%. That was in sharp contrast to the expectation of at least 4.5% and some were expecting much higher. Most experts are saying that we will see two more quarters of shrinking GDP before the end. Of course most experts are wrong as well.

Since none of us know when the recovery will start you have to make a decision. That decision is all about ‘when’ not ‘if’. Once it starts it is going to be fast and very large if history is any guide. The pain will be in the waiting.

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This week was dominated by the new President taking the oath and grabbing the reins of power. The day of the inauguration the stock market had its worst day in history for that first day of a new administration. I don’t think that means much at this point but it is an interesting fact. More important is that the market tested support levels that day and the next day bounced up sharply from those lows. What will be important is the follow-through.

On the day the market fell it was because of bad news in the banking industry. That news was replaced with good strong earnings reports from IBM on Monday night and some very good news from different large banks that had earnings rather than losses. That was a surprise. After hours on Tuesday Apple reported numbers that were very good but before the opening on Thursday Microsoft reported poor earnings. That scared the market badly, so down it went to retest the lows it bounced off of the day before. The market is very nervous. It is looking for something from Obama. The banking sector is searching for something to help it. I think we need the same thing we needed in the dark days of the Savings and Loans bank crisis of 30 years ago and that is setting up a separate entity to take the troubled loans off the banks’ balance sheets. That is the solution. Also, that does not mean necessarily it will ultimately cost us much. Those assets have value if you wait long enough to realize a good price for them.

We are past the middle of earnings season with good and bad numbers being reported. On balance, at least so far, you have to be fairly pleased. I think there was wide expectation that earnings were going to be terrible. They were poor but overall they showed that there are companies growing their incomes even in the current poor economic conditions.

Now it’s up to confidence building by our new President and his team. Will the spending package be a net positive and when might that happen? What will they spend the second half of the TARP money on? Will any of this massive spending help? One thing is certain: there will be massive waste. Whenever the government spends money there is a lot of waste. Don’t buy in that there will be no pork spending. If there isn’t, as Obama promises despite his best intention, it will be the first time in history. Just like pet projects the Republicans spent on, the Democrats will do the same. Let’s just hope the net results will be good for our economy.

Frankly, I think our economy will recover on its own. We are in a normal deep recession. One in which we will see unemployment reach 8 to 10%, where the GDP will shrink for several quarters and where prices for all things go down. This will be a health restoring event- it’s just very painful to live through.

When can we expect the banking crisis to end? That is what the stock market is trying to determine. Once they know, or at least when they think they know, stock prices will begin a long recovery. For the near term we are looking at very choppy waters. There will be rallies and retests of lows. Every stock market bottom acts this way. So far the lows made in October and November are holding. This is the real test. As long as they hold and the longer they hold the more positive the prospects. If the lows do not hold then we are in for a down stroke in equity prices. If we go lower we are looking at history making events. 2008 was the second worst year in history and you have to go back to the Great Depression to make comparisons. The 1973 to 1974 market is a close third, both for the market and the economy. In fact that market is a very good comparison with this market. What happened in 1975? The market rallied strongly.

If you own stocks hold them unless the stock market breaks the low. If that happens exit and wait for another bottom to be put in. If you have cash slowly invest it. The bottom is close if not already in. Also, keep your stops close. Let them take you out of the market if need be. Caution is the word that should describe your approach but long term this market is going to go higher; it’s the short term that is the worry.

One final word. The U.S. economy ‘will’ recover. It always has and always will.

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This week was the start of earnings season as Alcoa posted over a billion dollars in losses on Tuesday. On Monday, anticipating that the report might be worse, the market sold off. It came in at about what was expected, so on Tuesday the market tried to hold up. Selling pressure intensified on Wednesday with 90% of the volume for 90% of the stocks on the down side. That was a very strong sell off as the market appeared to want to retest the lows. A retest is normal though tough to handle if you are the one who is experiencing the fall in your asset value. Still, it is normal and a successful retest is very positive. On Thursday the low was not broken and the market turned around in mid day ending on the up side after an intraday slide of almost 300 points on the DOW, a positive sign that maybe we have seen the low in this mini cycle.

The market this week was dealing with some tough economic reports. Though most of the news was expected, the retail sales report for December showed a fall of 2.7% which was more than expected. However, I think it was the news about the banks this week that pushed the market down. Citigroup is selling assets to try and improve its balance sheet and Bank of America announced that they are in negotiations with the Fed for more money and then got it early this morning. This uncertainty is not what the stock market wants to hear.

Economic news not so well reported as the retail sales this week, was inflation which has fallen off a cliff. On the producer level for December it came in at a -1.9%. No one is talking about ‘deflation’ which is what we have at this time. The reason no one is talking about deflation is because almost every expert expects inflation to come back at some point. That will depend on the FED and when it starts to raise rates again. That is not going to happen for a long time.

Foreclosures are up strongly, especially in California. This recent spike is nothing more than a result of government interference. The government forced banks to postpone notices of foreclosures to try and work out loan defaults and all that did was push back the time line. The good news is not in the foreclosure rate. That is going to continue to be a problem long after the housing market settles down. Any good news will be in mortgage applications which were up last week another 25%. That was on top of the 25% increase the week before. Annually, applications are up 50%. Of course 85% of those applications were for refinancing, but with 30 year fixed rates falling to below 5% this bodes well for future sales of properties. As I have said before, look for a recovery to start in refinancing and sales of homes. Don’t expect prices to rise or foreclosures to fall for a while but sales are the important aspect at this time. Without an increase in sales a recovery is not going to happen.

Import prices fell in December by 4.2% and that is on top of a 7% drop in November. I wonder what this means when you consider the retail sales report? Net of auto and gas, retail sales fell 1.5% not 2.7%, but what have lower prices on everything done to the sales report? Maybe it is not as bad as we all think. Still it is not good.

It appears the market is marking time. It has established a range and is testing the low of that range. There is no great urgency to buy stocks at these very low levels as fear makes investors worry about going lower while at the same time everyone is waiting for the new president to take office and see what his stimulus package is going to look like. A huge amount of money is sitting on the sidelines paying zero to 1% interest rates. Traders are waiting for something. They just don’t know what that something is.

Maybe they are waiting for more clarity in the economy. We shall have to wait and see. Meanwhile, stock prices are at historic low prices. The market will rally but maybe it’s one to sell not buy as we struggle in this trading range.

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  The Fed announced a couple days ago that they have set a self imposed goal of buying $500 Billion of mortgage backed securities by mid 2009. I think the announcement was an effort to push mortgage rates down. The actual purchase will likely do the same thing. They are going to start buying these assets in January and $500 Billion seems very aggressive. 

Overall, I think this is a good thing. It will provide a couple benefits. One, it will give banks the ability to put cash back in their coffers which gives them incentive to make new loans. Banks can only make money by lending it.  Also, it gives them a market for these assets with transparency as to the value of these assets. Without a market there is no telling what these assets are worth and this unknown is a problem for the banks.  

The other benefit is for you and me. This effort has already driven mortgage rates down and with the Fed Funds rate (the rate at which banks can borrow money from the government) near zero, all the interest they charge us is profit. This means that with competition, and less fear in the banking industry, mortgage rates should continue to fall. They are very likely to go under 5% and could go to 4%. That will help the consumer put money in his pocket on a monthly basis. 

Good Trading
Steve Peasley 

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