bizzXceleration: Performance, Value and Profit

Well here are the interesting stories on business for the week for industries and individual companies. Rather than summarize them, and there are worthwhile comments on the rising bankruptcy risks, the implosion risks as big banks and the finance industry being re-structuring (!), oil & energy, the wild world (literally) of the auto industry and more on tech, let's set the stage.

If it's not clear at this point we think the economy is slowing and seriously exposed to sudden & sharp disruptions as Housing and the Credit crisis worsen and it becomes more fragile. We also think that the Markets still haven't grasped this nor, definitely, is it reflected in pricing, earnings outlooks or valuations. Even on current course and speed with no major disruptions there's some serious re-thinking that needs to happen, at least IMHO. But if you start looking now and understand what's going on then there are going to be industries and enterprises that weather this storm, if not with style and grace. Finding them will be the trick and the trick to the trick starts with understanding the deeper structural fragilities that have been created by non-organic earnings and liquidity-driven buybacks. Well as is becoming a practice Paul Kasriel has already done the heavy lifting so we'll let his comments and charts speak for us. Here's the key point - on a macro level buybacks, real declines in profits and increased leverage indicate that business enterprises are very exposed to shocks if/when they come. In other words a hurricane will breach the dike and it'll take a well-founded company to manage the floods :). So pay careful attention to Paul's words and charts - think about 'em, 'cause they could be incredibly important.

Now it’s your turn, Corporate America. For starters, the growth in your “operating” profits has slowed to a crawl – just 1.9% year-over-year in the third quarter (Chart 13). Moreover, if it were not for your earnings from overseas operations, which are inflated when translated into depreciating greenbacks, your profits would be contracting (Chart 14.) As Merrill Lynch’s chief North American economist, David Rosenberg, has reminded us, corporate hiring of U.S. domestic residents and capital spending in the U.S. depend on corporate profits generated in the U.S., not corporate profits generated in Germany or China. And while we still are on the subject of domestically-generated profits, note that profits from the nonfinancial sector have contracted four quarters in a row and the growth of profits from the financial sector have slowed significantly (Chart 15). 

And the 2nd excerpt:

Despite this relatively poor corporate profit performance, the prices of corporate equities are up on the year. We wonder if it has something to do with the record amount of corporate equities that have been “retired” via share buyback programs and leveraged buyouts of late. Nonfinancial corporations have stepped up their credit market borrowing of late, both in absolute terms and relative to their cash flows from operations (Chart 17). Have nonfinancial corporations increased their borrowing to fund capital outlays? Apparently not, inasmuch as the ratio of their borrowing to their capital outlays is rising and now is just a shade below where it was in the first quarter of 1999 (Chart 18). So, as corporate profit growth is slowing, it appears that corporate treasurers are tapping the credit markets more to fund their share repurchases. With corporate borrowing costs rising absolutely and relative to the U.S. Treasury’s borrowing costs, how much longer will corporations be able to levitate the value of their shares via levering the corporation itself ?

Business

2008: Year of the bankruptcy Market analysts warn that more U.S. businesses are likely to hang "going bankrupt" signs on their doors next year as the twinned blows of slower economic growth and pricey commodities force the weakest companies to seek refuge from creditors. In a twist from this year's trends, the pain is likely to spread from mortgage lenders, homebuilders and consumer-oriented firms - all areas that contributed to a 40% jump in bankruptcy filings in 2007 and are expected to play a role in 2008's misery. Next year, industries at risk for the biggest increases in Chapter 11 filings include electronics makers, energy miners like coal companies and agriculture firms, according to Global Insight. Makers of durable goods like machinery are also more at risk and will likely contribute to a 13% rise in bankruptcies in 2008, says the private research firm, which bases its estimates on issuers' credit quality and operating conditions.

Outlook Darkens for Big Banks For major banks, the next few years will be a return to a simpler and possibly less-profitable time. The subprime crisis and ensuing credit crunch have thrown a wrench into the highly profitable bank business model: Make loans that are then sold off to investors while arranging corporate financing through off-balance-sheet vehicles that keep banks' capital costs down. Now, banks are holding on to more of the loans they make, as they did years ago. And the off-balance-sheet lending business is crippled. It isn't clear how long this will last, or how the banking model might evolve in response to the current market crisis. What is clear is that some of the banks' more profitable lines of business have been shut, either temporarily or permanently. The upshot: Bank investors expecting a big rebound in earnings growth after the debacle of 2007 will likely be disappointed.  Wachovia CEO ready for dour 2008, Citi, HSBC reportedly eye asset sales

• Happy New Year? Don't Bank On It  In the credit crisis, banks have been taking extraordinary steps to shore up their finances, selling stakes to foreign investors and snapping up loans from central banks. Now comes the yard sale. In a sign that they see tough times ahead, U.S. and European banks are considering sales of everything from branches to entire units. Buyers could be hard to find in an environment where many financial companies are in trouble. Still, say analysts, the motivation to sell is strong. For one, asset sales generate immediate cash at a time when banks are likely to face persistent difficulties borrowing money. Despite extraordinary efforts by central banks that appear to have fended off a year-end funding crunch, the interest rates at which banks lend to one another are still elevated amid worries about further losses on subprime mortgage investments.
  

Citigroup May Cut Dividend by 40% to Preserve Capital, Goldman Sachs Says Citigroup Inc., the biggest U.S. bank, may cut its dividend by 40 percent to preserve capital and write down more fixed-income securities than it has told investors to expect, according to Goldman Sachs Group Inc. The New York-based bank may write off $18.7 billion in collateralized debt obligations such as subprime mortgages, up from its Nov. 4 estimate of as much as $11 billion, Goldman's William F. Tanona wrote in a note dated Dec. 26. Citigroup, which paid out 54 cents each quarter this year, will have to raise $6.2 billion in extra capital to reach its target.

Oil gusher: Tough act to follow It's been a phenomenal time to invest in oil, but analysts say the huge gains of the last year are most likely a thing of the past. 2007 was truly a banner year for the industry. The big integrated oil companies - ones that produce and refine crude - saw stock gains in the 30 percent range. Oil company stocks tend to rise and fall with the price of crude, so any prediction on stock prices needs to start with a look at the underlying commodity. Although U.S. crude is trading near $100 a barrel, 2007 was a very volatile year. Prices began the year by dipping below $50 in January, spiking above $75 in July, then pulling back to the high $60s by the end of August before embarking on its recent record run. For the year, the average price for crude was around $72. Most analysts have bumped up their estimate for 2008to around $80 to $85. But others think the sector is played out. "Fundamentally, it's expensive," said Jack Ablin, chief investment officer at Harris Private Bank in Chicago. "A lot of investors are eager to get into energy, and it's pushed the values to unattractive levels." Ablin said stocks of energy companies are expensive by a number of metrics. Their price-to-book value - the value of all their outstanding stock compared to book value of their underlying assets - is about 5 percent higher than the S&P average. Normally, energy companies have a price-to-book value about 15 percent lower, said Ablin. He said he sees a similar pattern with other measures like price to cash flow and price to sales.

Autos' year of living dangerously If you followed the money in the auto industry in 2007 you got some clues about where the industry is headed. And the future doesn't look anything like the past. Start with Chrysler going private. The money guys at Cerberus Capital who now own Detroit's Number Three automaker are turning it upside down. They brought in industry outsider, Bob Nardelli, as CEO and Nardelli is taking a fresh look at everything. Going forward, Chrysler will be eliminating models and possibly some brands, closing dealers, and laying off workers. One area where Nardelli has been particularly aggressive is in pursuing foreign partnerships. But if Chrysler succeeds, it could create a new model of cross-national alliances. Meanwhile, speculation is building about Cerberus' exit strategy from Chrysler, as well as its timing. For another cataclysmic change, how about minnow Porsche moving ahead with its plan to swallow whale-like Volkswagen? Finally, there is the evolving adventure of India's Tata Motors pursuit of two iconic British brands, Jaguar and Land Rover. At $2 billion, the price could be a secondary concern. The larger question: is the manufacturer of a $2,500 car is capable of designing, building, and marketing luxury vehicles? If the Tata deal goes through, it turns the entire auto industry into a global bazaar. What's next -- a Chinese company buying Alfa-Romeo? With rivers of capital free-flowing across national boundaries, the possibilities are endless. The failed marriage of Daimler and Chrysler may have been only the beginning of a global shuffling of brands and owners. The other day, a GM executive was speculating that the auto industry was sorting itself into two categories: two super-companies, GM and Toyota, with annual production of nine million vehicles each, and all the rest.

Toyota Raises 2008 Sales Target to 9.85 Million Vehicles on Global Demand Toyota Motor Corp. raised its sales forecast for 2008 to 9.85 million vehicles, cementing the company's lead as the world's most profitable carmaker. Sales will rise 5 percent from an estimated 9.36 million this year, the Toyota City, Japan-based automaker said in a release today. Toyota plans to make 9.95 million vehicles, also a 5 percent increase. The company previously forecast sales of 9.8 million next year. Toyota, close to ending General Motors Corp.'s 76-year reign as the world's largest automaker by sales, needs to sell more vehicles in emerging markets to achieve its targets, as demand for automobiles is forecast to decline in the U.S. and Japan, the company's two biggest markets. Toyota opened a factory in St. Petersburg, Russia, last week and will add production in China next year. Automakers are boosting sales and production in emerging economies such as China, Russia, and India, where rising incomes are making automobiles affordable to more people. The growth is offsetting slumping sales in Japan and the U.S., the world's biggest auto market.

Faces of Enterprise: Ratan Tata The ‘one-lakh car’ continues the chairman’s transformation of the group to global conglomerate, challenging preconceptions. Mr Tata will be one of the most visible faces of the new India in 2008. He was on Friday waiting to hear whether Tata Motors, a truckmaker that has diversified into passenger cars, had been successful in its offer for Jaguar and Land Rover, luxury brands put up for sale by Ford. In the wake of this year’s audacious $13bn (€8.4bn, £6.5bn) purchase of Corus by Tata Steel, the Indian company’s bid for these two prestige marques has again highlighted the risk-taking verve of one of India’s most ambitious corporate empire builders. The news will come as Mr Tata prepares to unveil the most keenly awaited car ever to roll off an Indian assembly line. Tata’s small car, which the Cornell-trained architect helped design, is slated to appear at the Delhi Auto Show on January 10. It will sell for Rs100,000 ($2,550, €1,730, £1,275) – a rupee figure known in India as one lakh – and bring motoring to a mass market. With a new plant in West Bengal able to make 250,000 a year, the “one-lakh car” will more than double Tata’s car capacity. “Mr Tata encourages us to take big, calculated risks,” says Ravi Kant, Tata Motors’ managing director.

Tech can fly high and crash hard, too The real appeal of tech is the potential for hypergrowth by any company, at anytime. And it can happen with new companies and old ones. Any company in the sector can have a burst of phenomenal growth because there is a fashionable aspect to technology, whether at the base semiconductor level or the consumer-electronics level. Much of this has to do with infrastructure in which the better part of a tech company is virtualized through the use of chip foundries, outsourced manufacturing, contractors and other ancillary operations. This allows for quick growth . So investors are generally enamored with tech, and if you discuss the topic with many of them you discover that they are often so enamored that they can't imagine technology being subject to the whims of the business cycle. In fact, many will deny the business cycle exits.

New Dell PC Design Rivals the iMac Something interesting is going on at Dell. The Texas personal-computer behemoth, long associated with boxy, boring machines, has started emphasizing industrial design. And the company, which in recent years seemed to care only about corporate customers, techies and hard-core gamers, appears once again interested in average, mainstream consumers who value simplicity. The most tangible example of this new approach is Dell's XPS One desktop -- an elegant, handsome, cleverly designed one-piece computer. If it didn't have the Dell logo on it, the XPS One might be mistaken for a product of the PC industry's design leaders, Apple or Sony. Like Apple's iconic iMac, the XPS One looks like it's simply a sleek, flat-panel monitor. The guts of the computer have been stuffed into the back of the screen. But this new Dell is no mere iMac clone. It makes its own style statement, even though it shares the same 20-inch widescreen display and a similar Intel dual-core processor with the base-model iMac.

Motorola's pain is Samsung's gain An emphasis on the fast-growing global market for cell phones costing around $40 has catapulted the South Korean company into the No. 2 spot in handset sales. Samsung Electronics confronts bad news on many fronts. The South Korean company is facing probes into an alleged bribery scheme, and its money-spinning memory-chip business is in the worst slump in five years. That's why Samsung executives must be thrilled to have their mobile-phone business, where the future appears upbeat. The numbers tell the story. Samsung surpassed struggling Motorola in 2007 to become the world's second-biggest handset maker after Nokia . Samsung's global market share is up about 3 percentage points from last year, at 14.5% in the third quarter, compared with Motorola's 13.1%. Samsung has set sales records in every quarter this year, with the 115 million phones sold in the January-September period exceeding the 114 million sold during all of last year. And Samsung believes its record-breaking run is just beginning. The company expects to sell 160 million handsets this year, a 40% improvement from 2006. Executives expect sales of 200 million mobile phones next year and a growth pace that's about double that of the rest of the industry.

Bewkes May Dismantle Time Warner, End Its Reign as Largest Media Company Jeffrey Bewkes, who takes over as chief executive officer of Time Warner Inc. next week, may be measured by how quickly he can dismantle the world's largest media company. Bewkes may spin off the cable-television division and sell the AOL Web and Time Inc. magazine units, said Gamco Investors Inc. fund manager Chris Marangi and National City Bank analyst Daniel Poole. The remaining company, anchored by the film studio and cable-TV networks, would resemble Viacom Inc. -- and accordingly command higher multiples, Marangi said.

Posted by dblwyo at 06:58 AM | Permalink | Comments (0)

Well another interesting week in the markets, to say the least. Not quite the end of the year rally everyone was planning is it ? This living in interesting times bit is getting very old indeed but, if you've read any of our prior posts on the Economy, Business Cycle or Credit Crisis, we've got a long way to go. And the normal stable of prognosticators is just beginning to acknowledge all that, at least to some limited extent. In fact the "standard model" so far of an '08 outlook is for a not-so-good first half with a 50/50 shot at recession if something tips us over with a recovery in the second half of a sorts. In fact apparantly analysts consensus is for 15.7% earnings growth ! Now how one gets an economy growing at, at best 2%, and then gets 15% EPS growth is not only beyond us but beyond even the stretch of good YOY comparables :) ! Or should be.

What we've got and had for some time now is a sideways market, as benchmarked by the SP500, with some wild swings around the central trend. Which you can see in the above chart. Notice in the sub-chart btw that the Euro/Yen spread which has driven the market thru the carry trade mechanism is beginning to break down a bit. Also notice that, looking at the 90Da/200Da MA's that the market is consolidating but has huge swings around that center unlike earlier consolidation periods this year. What we think is going on is that reality is slowly seeping into market valuations but the uncertainty in sentiment and outlook is so high and the economic future so "unclear" that nobody can make up their minds to go or stay (thank you Jimmy Durante).

Meanwhile if you look at x-market comps (RUT, Nasdaq, Europe, EM, etc.) you can notice these general trends but with some of our earlier guestications being born out, e.g. the likely fading of the EM markets as the bubble begins to leak. This has shown up all of a sudden in the EM indicator (the ETF for Pacific ex-Japan, EPP). Similarly if you look across sectors (in the 2nd and 3rd sub-charts) what used to be a clear seperation between winners (better than SP vs worse than) is fading lightly as well. Only Energy is holding up, and while the outlook for oil prices is continued "strength" there's a good argument that that's already factored into valuation and prices.

BTW - a major point and the first time we've seen it in print. Floyd Norris reports on the widening of the credit crisis beyond mortgage related instruments. Hallaleuh ! An argument we've been making for quite some time (you may accuse us of shrillness hear and we'll bear that cross willingly if more folks will pay attention). Just for the record we refer you to Cracks in the Shell: Credit Crisis and Bubbles , which will also point to several other postings in the genre.

Markets & Investing

Credit Crisis? Just Wait for a Replay What if it’s not just subprime? As 2007 ends, it seems that the financial world shakes every time a company reveals some new exposure to the disastrous world of subprime mortgage lending. But just how different was subprime lending from other lending in the days of easy money that prevailed until this summer? The smug confidence that nothing could go wrong, and that credit quality did not matter, could be seen in the many other markets as well. That was particularly true in the corporate loan market. Loans were cheap, and anyone worried about losses could buy insurance for almost nothing. It was not an environment that encouraged careful lending. . Already, even without defaults, he says, about a tenth of high-yield bonds are trading at distress levels — levels that provide yields of at least 10 percentage points more than Treasuries. If a recession does occur, one can easily foresee a wave of defaults in junk bonds and their bank-loan cousins, leveraged loans. With highly leveraged structures supported by some of those loans, the surprises could be greater. It is sobering to realize that the issuing of leveraged loans set a record in 2007, even though the market contracted sharply late in the year. One of the more remarkable facts about the subprime crisis is that total losses to the financial system may be about equal to the amount of subprime loans that were issued. On the face of it, that appears absurd, since many such loans will be paid off, and those that default will not be total losses. But, Mr. Seides said in an interview, “the financial leverage placed on the underlying assets was so high” that the losses multiplied, as the profits did when times were good.

·         .Prior Posts Cracks in the Shell: Credit Crisis and Bubbles, Greasing the Skids or the Gears: Credit Repairs Working ?

·         ,LinkedIn Q: How widespread is the credit crisis, is it widely understood and what do you think the impacts will be ?,

Cracks Differ In Housing, Finance Shells It's now conventional wisdom that a housing bubble has burst. In fact, there were two bubbles, a housing bubble and a financing bubble. Each fueled the other, but they didn't follow the same course. Housing peaked in 2005. By early 2006 it was widely recognized the boom was likely over, and by mid-2006 it was beyond question. In June 2006, sales of existing single-family homes were 9% below their year-earlier level, sales of new homes were down 15% and framing lumber prices were down 19%. The Dow Jones Wilshire index of home-building shares had fallen 41% from its July 2005 peak. Yet throughout 2006, the folks who financed the housing bubble turned up the volume on their party. Issuance of collateralized debt obligations -- investments that held heaps of risky mortgage securities and other asset-backed securities -- hit $187 billion in 2006, according to Dealogic. That was up 72% from 2005. The biggest single month for such CDO issuance was March of this year, at $38 billion. By November, there was just one issue sold, valued at $23 million. Lenders wrote $600 billion in subprime mortgages last year, down a little from 2005's $625 billion, according to Inside Mortgage Finance. But they also wrote $400 billion "Alt-A" mortgages -- a category between prime and subprime loans -- up from $380 billion in 2005. The path of these two bubbles has a lot to do with the way mortgages are now made. In this boom, the financial institutions that wrote the mortgages didn't keep them. They sold them to firms that then repackaged and sold them to investors in the form of CDOs and other instruments. Lenders had less incentive to worry about the financial health of their customers. Why worry when you're just going to sell the loan to somebody else and make a big fee in the process? The same went for the Wall Street banks bundling the mortgages into securities.

J.P. Morgan Chase: Bar Is Rising for Rate Cuts In their weekly report on the global economy, J.P. Morgan Chase economists say the bar for Federal Reserve and European Central Bank easing is rising, even as the two central banks pump money into money markets to relieve unusual tensions. The ECB, they say, “is not persuaded that the disruptive repricing of credit risk will have significant negative growth consequences. And it remains concerned about the rise in inflation now under way.” As for the Fed, they conclude, “the path ahead is uncertain.” All is not well, though, in the J.P. Morgan Chase crystal ball: “Reduced stress in money markets will not deliver a cure for financial markets, which are absorbing the pain of substantial credit losses and a contraction in the use of structured products. Indeed, corporate credit spreads have drifted wider in recent weeks and US jumbo mortgage rates have moved higher.” J.P. Morgan Chase economists predicts a one-quarter point cut in the Fed’s key rate by March and then a one-half percentage point rate (ital) increase (end ital) by the end of 2008. It doesn’t anticipate any ECB rate moves in either direction.

Company Bond Sales Fall in Europe for the First Year Since 2002 on Rates Corporate bond sales fell in Europe for the first time since 2002 this year as companies abandoned borrowing because of soaring interest costs. Sales slumped to 285 billion euros ($417 billion) in the last six months from 616 billion euros in the first half, reducing the total for the year by 3 percent from 2006, according to data compiled by Bloomberg. Companies with ratings below investment grade haven't sold any bonds in euros or pounds since August, the longest shutdown in at least nine years. ``I've been in this business for 20 years and never seen anything as bad as this,'' said Eirik Winter, co-head of fixed income capital markets in London for Citigroup Inc., the third- biggest underwriter of corporate bonds sold in Europe. ``We're going to feel 2007 for a long time.'' ``Many corporates thought the subprime issue wasn't going to hit them because they're good companies with good ratings,'' Citigroup's Winter said. ``Now, most treasurers would admit that we have a completely different credit market out there.'' Citigroup, Goldman, JPMorgan Discount LBO Debt Up to 10% to Clear Backlog

Oops...Real Rally or Time to Rethink MSN Money Central is a pretty good finance and economics web site. In particular several of their regular columnists have proven out very well over the last several years (particularly Jubak and Markman). They also run a very interesting set of contests between investment pros. Two of whom had recent posts that are well worth thinking about. Paraphrasing them might go something like this, "hmm this really isn't working out well. What's going on here and how do I re-think my strategy, tools and techniques ?" Otherwise known as the Oops factors. Now one of the things I've noticed about the contest results is that their timing on market cycles has been extremely fortuitous indeed. No conspiracy just coincidence by and large. So contest results are skewed toward those folks who's style aligns with current conditions, the context.

Emerging Market No More? A combination of tighter credit conditions and rising inflation will make life tougher for many developing countries in 2008. South Korea may be the exception. Stock markets in emerging economies have had five very good years in a row. Don't bank on a sixth. A combination of tighter credit conditions and quickening inflation domestically will make life tougher for many developing countries in 2008. The two biggest emerging markets -- China and India -- have more downside potential than upside. One of the few bright spots in the year ahead is South Korea.In the past five years, high world liquidity -- caused by rapid U.S. money supply growth or a world "savings glut" -- produced rapid world-wide economic growth and a commodity-prices boom. These enabled indebted countries such as Brazil and Argentina to escape their trap and nourished a corresponding economic boom in China and India. This has become too good to last. The credit crunch, while it hasn't affected emerging-market credit directly, has forced many big international banks to reduce their off-balance-sheet assets and has lowered the appetite of both capital markets and banks to absorb the issuance of new debt. This will reduce the flow of funds to emerging markets, particularly those dependent on foreign debt such as Turkey, Brazil and Indonesia. The two largest emerging markets, China and India, have their own problems. China is determined to tighten monetary policy, which is already resulting in dwindling investor enthusiasm for thinly traded stocks. In India, the budget deficit is expanding, with spending up 28% in the first seven months of the current fiscal year. In both, the inflation rate is well above official targets. Thus both markets seem likely to be less robust in 2008.

Posted by dblwyo at 09:45 PM | Permalink | Comments (0)

After the continuation you'll find the "usual suspects" - our collection of the week's most interesting stories and data. Rather than summarizing them or point to key articles though we took advantage of the holidays (loosely speaking) to develop a bunch of deeper background postings on the nature and structure of the Business Cycle and high-frequency indicators so you can do your own regular spot checks. Or at least, at a minimum, have a better set of filters for collecting, collating and interpreting the flow of headlines and data. So we're going to point you to the four posts we made in the hopes that they'll be helpful and add to you toolkit.

To just dive into the high-frequency indicators and get a feel for just what the outlook is start with this one:WTWW Part 3: Jitterbugging - the High Frequency Indicators. And in particular we think Paul Kasriel captures the essence of things in this excerpt: 

Probing the Probabilities of a 2008 Recession What is the probability that the U.S. economy will fall into a recession in 2008? We would answer, 65.5%. We have been talking about the probability of a recession occurring without defining what a recession is. A popular misconception is that a recession occurs when real GDP contracts for two or more consecutive quarters. Although most, but not all, recessions do include two or more consecutive quarters of contracting real GDP, this is not the criterion for defining a recession used by the arbiters of such, the National Bureau of Economic Research (NBER). According to the NBER, a recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. It just so happens that these four variables are the same four variables in the Conference Board’s index of Coincident Economic Indicators. We are amused and you are confused by those talking heads on Bubblevision who claim that a recession is not imminent because payroll employment and/or personal income continue to increase. To repeat, these are coincident economic indicators and, thus, provide some information as to the current performance of the economy, not the future performance of it. I Have a Lot of Problems with You People!

Also for more background on our adaptation of his monetary base and spread indicators try this

Xmas Cheer ? - Disingenousness, Conundrums and Early Warnings.

 For a deeper background on the nature, structure and patterns of the business cycle along with some nifty pictures & graphics we point you to: Weigh the World Works: Understanding the Business Cycle.

 The first thing we'll start with is the linkages in the business cycle and what drives what - which ultimately tells you what data is important and what to look for. Digging in the patterns and structures will help out with getting the interpretations of headlines done a little better as well. We like to think of the business cycle as the "Great Circle (Economic) of Life" [Media file]. Also consider the metaphor which is really more like a model of how everything x-links, interacts and feedsback. Which takes us to the diagram. Oddly enough business cycles aren't as much talked about in your college econ classes though everybody recognizes them and applied economists deal with them all the time. Part of the problem is that modeling them turns out to be very difficult. So we end up with our best pass that's nonetheless consistent with both business and economic theory discussions (readings below).

And for a discussion of the actual time-series histories, patterns and interpretation, i.e. what data is interesting, why and it all relates to one another the follow-on is worth your time:WtW Part Deux: Patterns, Cycles & Indicators.

 We sincerely hope you'll find these writeups useful and helpful and plan on being able to use them as baselines to refer back. As for whether there're worthwhile or not we'll also point you to a post that excerpted some work based on these toolkits from this time last year which is also available online and, oddly enough, anticipated many of the years characteristics and consequences. It was, if anything, not pessimistic enough about the Housing and Credit Market problems. But the point remains - despite all the "woe is me" running around it is possible to frame the outlook: Looking Ahead:Seeing the Avalanche Before It Lands.

Economy

Don't count on a 'normal' recession Wall Street expects financial innovations and global growth to keep any US slowdown in 2008 short and shallow. But the stock market is likely to be seriously disappointed. The stock market doesn't much care whether a 2008 slowdown in the economy is an official recession or not. As far as Wall Street is concerned, there's just not much difference between economic growth falling to 1% or to minus-0.5%. As long as the slowdown, recession, whatever, is short. No more than two quarters. Over and done with by mid-2008. Then the economy and the stock market, Wall Street believes, can look forward to another long boom. But what if a 2008 slowdown or recession isn't normal? What if it drags on for 12 months and not just six or eight? Then the stock market has set itself up for serious disappointment, with multiple dips in the major averages as investors gradually realize that 2008's economic slowdown will be lengthier than expected. The odds of that kind of disappointment in 2008 are, unfortunately, high. This sure doesn't look like the "normal" recession. Because so many consumers got used to drawing against their rising home equities to fund their spending, the bursting of the housing bubble and the crisis in the subprime-mortgage market have resulted in far more damage than usual to consumer cash flows. The drop in consumer demand is well beyond what you'd expect in an economy that's still producing jobs at a decent rate.

·         Are you aware of and following the data on real retail sales and consumption ? Do you see it as impacting the '08 outlook ?

Plan ahead for a tough 2008 It's not difficult to get read on the economic year to come. Whether there's a recession or just a slowdown in our future, on one thing there is general agreement: 2008 figures to be a tough year for just about everyone -- employers, employees, homeowners and investors -- so plan accordingly. Don't wait for the National Bureau of Economic Research, the official arbiter of the business cycle, to make the call. I would remind readers that the initial look at the first quarter's GDP won't be available for another four months. If you haven't planned for tough times by then, you'll be way behind the curve. A look at the real world will give you better information sooner. Point in fact: Those who deny even a slowdown note that residential fixed investment accounts for less than 4% of real GDP, so housing alone is unlikely to exert much downward pull on economic growth. But this overlooks that home prices are falling, thus reducing both people's wealth as well as their ability to take out a home equity loan. Add to this the effect on households' budgets of rising food, energy and health-care prices, higher state and local taxes and transit fares, little or no savings, huge debts and stricter borrowing requirements and you have a consumer in distress. Even more important, the credit markets remain frozen. This means that, besides consumers, businesses and local governments -- even banks -- can't borrow needed funds. As you can imagine, money and credit grease the wheels of economic activity. Without them, business would inevitably grind to a halt. Central bankers are trying feverishly to inject liquidity into the system, but they won't be able to thaw out the frosty markets until lenders have confidence that borrowers can repay their loans. Too bad they did not think this way sooner. Tough Outlook for '08: Kellner on Avalanche Warnings, Rough Patch Ahead for US Economy (Mark Zandi of Economy.com video)

• Retail Sales in Europe Decline for Third Month as Inflation Curbs Spending
• Japan's Inflation Surges to Fastest Since 1998; Factory Production Slides

Food prices soar in America "That's the reason I cut down on milk consumption - so I can drive my car," said Norris. The Norrises aren't the only family getting pinched at the grocery store. Prices of food and non-alcoholic beverages rose 4.7 percent since the beginning of the year through November, outpacing the 4.3 percent increase in the overall cost-of-living, according to the federal government's Consumer Price Index. Everyday foods like fruits and vegetables, beef, poultry and cereals are on the rise. The price of milk is the biggest culprit, with a staggering increase of 23.2 percent through November. And with basic foods like dairy and wheat driving up the cost of other groceries, almost everyone is feeling the squeeze. Of the Brooklyn shoppers interviewed for this story, none of them said that they were eating less, but a couple of them said there will be fewer Christmas presents under the tree this year. Santa's tightening his belt, so the kids don't have to.

Oil-price prognosticators, bruised by volatility in the oil patch, have reached a rough consensus on next year: Oil will be even costlier, even if the economy cools. Prices are likely to be up at the pump, too. Consumers are likely to pay a lot more at the pump, too. The Energy Department predicts that far higher average oil prices will force gasoline prices to even out at $3.11 next year, up 10% from the average price of $2.81 this year. World crude prices have long tracked the thirst for oil in the U.S., which consumes about a quarter of the world's oil output. But recent months have shown how decoupled the oil market is becoming from the economic ups and downs of the world's largest energy consumer. Even amid fears that the U.S. could slip into recession next year, world-wide consumption is expected to strengthen, driven mostly by more demand from Asia as well as from Middle Eastern economies awash in oil revenue. That, of course, will further tighten global supplies.

Housing Futures: 11% Price Decline in 2008 for 25 Largest Cities Radar Logic provides a daily estimate of house prices for 25 MSAs in the United States. If you click on Historical Data, you can see price charts and data for each city. The Radar Logic data is similar to the Case-Shiller indices. I mention the Radar Logic data, because according to Goldman Sachs, the Radar Logic futures data is forecasting a price drop of 11% over the next year, and close to 25% over the next 3 years for the 25 largest MSAs. Home Prices in U.S. Fell 6.1% in October, More Than Estimated, Survey Says, Pace of Decline in Home Prices Sets a Record, More on New Home Sales

• How they got housing wrong Experts thought 2007 would bring a real estate recovery - not the worst collapse on record. What does that say about forecasts of a turnaround next year? Before you put much hope in forecasts for a 2008 rebound in the battered housing market, consider this: A year ago at this time many top economists were looking for that recovery to begin in 2007. Instead, the year saw historic declines in nearly every measure of housing strength and home building, and left a trail of predictions from some of the nation's top economists that look - at best - foolish.

Looking back at 2007 Housing Predictions  At the end of 2006, I offered some predictions for housing in 2007. Looking back it's hard to believe these predictions were out of the mainstream. My overall view for the 2007 housing market was "falling prices, falling sales, falling residential construction employment, falling starts, falling MEW, falling percentage of equity, and rising foreclosures". Tanta and I have been writing about subprime loans for as long as this blog has existed. And as far as a credit crunch, back in January I mentioned the possibility of "a credit crunch based on bad loans in the RE sector (and possibly in CRE and C&D too)". And many others were discussing these issues too. We all make errors in forecasting - no one has a crystal ball - but I'm endlessly amused by the 'no one could have known' excuse.

More Retail Sales Hype The most recent example of this are Holiday Retail Sales data. If you rely upon the Commerce department, then sales are going just swimmingly. However, looking at the actual Retailers sales data, you reach a very different conclusion.  Rather than take either the Commerce report or the sentiment surveys at face value, why not take a closer look at the various retail sales data we can find to prove -- or disprove -- about these conflicting reports. First, let's note that the Bureau of Economic Analysis Personal consumption expenditures (PCE) increased $110.6 billion, or 1.1% last month. To put that into context, this was ~triple the October gain, and was the highest sales gain in three and half years. Spending data shows:Personal Spending in ‘Chained Dollars’ (meaning, inflation adjusted dollars) was +0.6% in November.  Ex-food & energy it is 0.2%.  So to put all this econo-statistical gobbledy-gook into plain old English, food and energy price increases accounted for a full 67% of the November spending gains. (So much for ya merry retail Christmas). Weekend Surge May Not Rescue U.S. Retailers From Holiday Shopping Slump, Target Says December Sales May Fall, Missing Forecast

U.S. Durable Goods Orders Rise Less Than Forecast on Defense-Spending Drop Orders for U.S. durable goods rose less than forecast in November, restrained by a slump in defense procurement and declines in capital equipment. The 0.1 percent increase, the first gain in four months, followed a revised 0.4 percent drop in October that was larger than previously reported, the Commerce Department said today in Washington. Excluding transportation, demand fell 0.7 percent. Tougher lending standards, bloated inventories and slowing sales are causing some companies to limit spending on equipment such as communications gear and machinery. The report suggests the worsening housing recession may be spreading to other parts of the economy. Economists forecast durable goods orders would increase 2 percent in November, according to the median of 67 estimates in a Bloomberg News survey. Projections ranged from a drop of 0.2 percent to a gain of 5 percent. Excluding transportation equipment, orders were projected to rise 0.5 percent

Posted by dblwyo at 01:24 PM | Permalink | Comments (0)

In the two prior posts we worked thru the nature of the business cycle and our current situation and then looked at the recurrant cyclical patterns. The latter worked thru Consumption, GDP and Investment as well as linking in Employment. Previous posts were referenced in the business cycle post as well as some useful background readings. By this time if you've been playing along you've got a pretty good idea of how the thing works, why it's important and what data to watch and what it'll tell you. In other words how to turn a swarm of data and headlines into useful information. Now it's time for one more pass to look at more current, high-frequency data that will keep you more in the loop and might, potentially, allow you to have a feel for what could be coming. The table at right presents the last several months of key data elements we've found worth following and the associated charts are in the read-on section. But let's set the stage with a couple of interesting excerpts, one from Alan Sloan and the other from Paul Kasriel.

Sloan makes an interesting point that's worth paying close attention to when he says you should be looking forward:

Beware the dreaded R word Everyone and his brother seems to be talking about recession these days. It dominates every public investment discussion and is the topic 24/7 on cable TV. But let me tell you a little secret: When it comes to investing, the question of whether we're in a recession (or are heading for one) just doesn't matter. It's actually elementary. Investing successfully is about looking ahead, while determining whether we're in a recession involves looking behind. Way behind. We won't know that a recession has started until months after it's begun. And by that time, things in the economy may well be getting better rather than worse - which might make it a good time to invest. I have no idea if we're in a recession or heading for one. Nor do I know where the market is going over the next few months. If I did, would I tell you for $4.99 ($5.99 Canadian)? What I do know is that if you want to do well in the market, you've got to think ahead, not behind. The "R" word isn't helpful. What you need is the "F" word: foresight.

Unfortunately while interesting that didn't strike me as constructive though it does, hopefully, convince you to pay attention. Kariel is much more constructive:

Probing the Probabilities of a 2008 Recession What is the probability that the U.S. economy will fall into a recession in 2008? We would answer, 65.5%. We have been talking about the probability of a recession occurring without defining what a recession is. A popular misconception is that a recession occurs when real GDP contracts for two or more consecutive quarters. Although most, but not all, recessions do include two or more consecutive quarters of contracting real GDP, this is not the criterion for defining a recession used by the arbiters of such, the National Bureau of Economic Research (NBER). According to the NBER, a recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. It just so happens that these four variables are the same four variables in the Conference Board’s index of Coincident Economic Indicators. We are amused and you are confused by those talking heads on Bubblevision who claim that a recession is not imminent because payroll employment and/or personal income continue to increase. To repeat, these are coincident economic indicators and, thus, provide some information as to the current performance of the economy, not the future performance of it. I Have a Lot of Problems with You People!

Now that provides some useful definitions and explanations along with a pretty hard-nosed outlook based on very well grounded analysis. If you read nothing else read his Dec07 outlook as well as his Econtrarian piece adding on a diagnosis of all the problems that are likely to turn this into a real bear-wrestling match. 

The idea with the data tables is not to bore you too much but to let you look at it a bit and get some feel and also to see what drove the following charts and discussions. It takes a bit of work to collect but it's all readily available and freely downloadable, often from the STL Fed site FREDII. And it's worth just looking at the numbers (we won't put them up often) to get a feel. For example look at the accelerating decline in New Home Sales, continued negative capex spending (xAC), the decline in real wages and so forth. Generally, where appropriate, the data is YOY% terms, real as opposed to nominal and often moving averages, e.g. Auto Sales, Employment.

Basic Indicators

Let's start with what we know are the two primary drivers, Consumption and Investment, and look at the monthly series we feel are worthwhile to follow. The first chart shows data for both C & I. For consumption the indicators are real personal consumption (PCER), real retail sales (Sales) and autos, on the r.h.s. Autos continue to show negative growth - what does that say about Detroit's outlook, or Cerberus for that matter ? Both PCER and Sales have been downtrending though they've flattened off recently. Notice though the numbers bear NO resemblence to the headlines.

Investment is yet another story where we look at New Durable Goods orders, non-defense & excluding aircraft (xAC), which is about as pure a capex indicator as there is, Industrial Production which is a look at current economic activity and New Home Sales. The latter couldn't be any worse, to date. It's likely to keep falling off the cliff though. But notice that while IndProd's decline has leveled off, albeit at a low level, xAC is continuing to show negative YOY trends, although at a slower pace of decline. For anybody who thinks business spending's going to pick up the economy we give them these numbers. And for anyone sanguine about Technology we'd ask - hun ? Since when is Tech spending not capex ? This'll be interesting. Also bear in mind that capex is a lagging indicator and that New Homes are a leading indicator. 

Future Demand Indicators

In an earlier post we talked about how the outlook for consumer spending was largely driven by current and expected Jobs and Wages, along with financing (MEW). In the chart at left we start by showing the trends in Real Weekly Wages and in Employment. Job growth hasn't been robust and has never reached the level required for organic economic growth while Wages have been in a fairly  pronounced downturn. But the real interesting indicator is their combination, W+E. I don't know about you but the sudden sharp downturn there is a little scary. The indicator is also a pretty good diagnostic. Last year the anticipation was for a downturn/slowdown in the economy much worse than what we got but you can see the upward spike in real wages last Fall due to the major, suprise drop in Oil prices and drop in Inflation. Now that factor is running in reverse. 

Inflation, Rate and Credit Indicators

All of which naturally brings up the question of inflation, interest rates and the general credit situations which are charted at right. In the first sub-chart you can see that we were trundling along very nicely with CPI relatively flat while PPI was doing it's usual dance around it. Unfortunately about Aug. of this year PPI took off under Oil price increases and that inflation is being passed on this time. The Fed hopes that a slowing economy continued thru 2010 will bring it back under control and that the drop in 10Yr-Treasury rates (r.h.s) won't let the tiger out of the barn. Let's hope along with them but given the state of the economy, its' pronounced fragilities and all the major fault lines we've discussed along with Kariel's Econtrarian diagnosis I'm with them.

Meanwhile the second sub-chart has some very powerful, and in this case powerfully scary, rate and monetary indicators. It shows the spread between 10Yr's and Fed Funds, which is shrinking. An indicator of a downturn being anticipated. The spread between 3Mo Treasuries and Commercial Paper which has spiked severely as a result of the continuing seizures in the credit market, something which you can follow on a daily and weekly basis as well. And a very interesting indicator that Kariel pointed out to use - the inflation-adjusted Monetary Base on the r.h.s. This represents the real money base with which people buy things. And as a result of credit being destroyed faster than the Central Banks can inject it, it's not only declining, it has actually gone negative recently. That is really....really...really not good. 

Posted by dblwyo at 09:06 AM | Permalink | Comments (0)

The prior post laid out the "Weigh the World Works (WtW)"  by putting up a model of the business cycle, it's general time patterns and referenced some background readings along with some prior posts that illustrate the applications. We'd like to continue that line of investigation here by addressing the last of the four key questions. The first on Consumption and the second on Investment. As you probably know Consumption is approximately 70% of the US economy, though far lower a portion of other developed economies and far...far lower of the major developing economies. Investment, taken all together, has run about 14% of the US economy. The engine therefore that drives the economy is consumer spending while investment is the super-charger that acclerates it. That is if businesses anticipate a need for additional capacity thru capital spending and hiring. These in turn feedback on consumer spending by increasing Employment and Wages and so on. Of course that means that the feedback loop can run in reverse just as well. That's why everyone should be so concerned about how well Consumption, Investment, Employment and Real Wages hold up. It also explains why the ability of consumers to sustain their spending thru MEW resulted in a very abnormal spending pattern where Consumption has held up much better than post-WW2 experience would have suggested.

Macroeconomic Indicator Data 

Normal business cycles are consumer-driven, as we observed above and discussed in more detail in that prior post. The last boom/bust cycle was Investment-led because businesses were over-investing in technology. When a boom goes bust the "normal" result is a major economic downturn, with historical examples including 1928, 1912, the 1890s and so on. Since 1980 we've been experiencing what is called the Great Moderation where growth has been sustained, major downturns avoided and the duration of downturns has been minimal. Whether that will remain true or not this time is unknown but the odds against a benign downturn mount daily. Understanding how these business cycles work and the patterns thereof becomes critically important for investment, invidiual and business planning therefore. The accompanying table will give you a numerical feel for the size of the various key numbers and indicators that are worth following. It also includes YOY% changes, which we've previously gone into as great diagnostics.

Below we provide a couple of key longer-term business cycle charts that let you see the key relationships between Consumption, GDP and Investment. But before going there let's set the stage with the following excerpt:

Don't count on a 'normal' recession Wall Street expects financial innovations and global growth to keep any US slowdown in 2008 short and shallow. But the stock market is likely to be seriously disappointed. The stock market doesn't much care whether a 2008 slowdown in the economy is an official recession or not. As far as Wall Street is concerned, there's just not much difference between economic growth falling to 1% or to minus-0.5%. As long as the slowdown, recession, whatever, is short. No more than two quarters. Over and done with by mid-2008. Then the economy and the stock market, Wall Street believes, can look forward to another long boom. But what if a 2008 slowdown or recession isn't normal? What if it drags on for 12 months and not just six or eight? Then the stock market has set itself up for serious disappointment, with multiple dips in the major averages as investors gradually realize that 2008's economic slowdown will be lengthier than expected. The odds of that kind of disappointment in 2008 are, unfortunately, high. This sure doesn't look like the "normal" recession. Because so many consumers got used to drawing against their rising home equities to fund their spending, the bursting of the housing bubble and the crisis in the subprime-mortgage market have resulted in far more damage than usual to consumer cash flows. The drop in consumer demand is well beyond what you'd expect in an economy that's still producing jobs at a decent rate.

Take another minute or so and review the table to get a feel for the relative magnitude, the YOY changes, notice key things like the drop in Investment which is (to date) largely Housing related and other key variables like Employment, Wages, etc. Notice that these real numbers aren't as good as the headlines had it a while back nor as immediately dire as some of the bubblicious talking heads have it now. Nonetheless we've been in a very visible slowmotion slowdown for some time and the question is no longer is Goldilocks in the house ? It's what time is Cinderella's party and who's going to clean up the mess.

GDP, Consumption & Investment

The chart at the right shows YOY% changes in GDP and Consumption going back to 1960 using real (inflation-adjusted) GDP and Consumption data on a quarterly basis. Hopefully the first thing that leaps out at you is that there are indeed cycles. And despite various rhetorics from time-to-time the business cycle is alive and well. The next thing that should jump out is how closely correlated Consumption and GDP are, in general. In fact Consumption declines are leading indicators of overall economic health, though it's a little hard (click to enlarge) to see on this scale. As a result declines in consumer spending tend to foreshadow GDP declines by several quarters. Also notice, more specifically to our key points about differences this time around, how relatively well spending has held up despite an overall GDP drop. And also how both have shown that slowmotion decline. Also remember that there is no well of untapped spending to go back to this time because we've borrowed against it via the MEW ATM.

The next thing to look at is Investment and GDP. These days Investment is reported and available with some sub-detail by major category but not back to 1960 the accompanying chart has a shorter time-frame. Nonetheless it's very revealing as well. It shows both Resident and Capex investment on a YOY basis by quarter since '91. Notice that Capex is a lagging indicator while RE investment is a leading indicator. If you go back to the 1960s there has never been a recession no preceeded by a downturn in RE investment ! And this one looks pretty severe to me.

So there you have it - hopefully a good addition to your toolkit AND a set of data filters that will allow you to turn headlines and stories into meaningful information. (Looking Ahead: Seeing the Avalanche Before It Lands)

To summarize we're in a new kind of business cycle having gotten there thru unusual and sensible policies but are in uncharted territories. Because this slowmotion slowdown has been underway for some time now it is also unusual. Normally that would mean we could look forward to several quarters of sub-par growth (a growth recession). In fact the Fed's published outlook which we reviewed in an earlier post shows such sub-par growth thru 2010 ! The problems are a) that from the point of view of all of us the differences in hiring, outlooks, spending and investments is not much different. And b) such an economy is very fragile and "tender", i.e. sensitive to the boat being rocked. And with the Housing and Credit market situations we can guarantee more shocks are on the way. And that's before we talk about such things as geo-political suprises.

A final crucial point we've made before and the Jubak excerpt reinforces - the earnings outlook and general investment thinking is based on a 2nd half "recovery", such as it might be. Even for the core slowmotion slowdown that's unlikely. Factor in these other things and well...you decide. It's left as a question for the reader to think thru. Feel free to comment though :) ! 

And oh yeah, btw, the prior post has a listing of earlier discussions of applications and specific indicators like Retail Sales, Inflation, Employment & Wages, etc. If you want to follow up that'd be a good place to start. 

Posted by dblwyo at 02:54 PM | Permalink | Comments (0)

Well this morning's headlines on durables goods orders and new orders have, along with the geo-political news from Pakistan, sent the markets back down. It may not be entirely clear why this is important let alone how it should be interpreted and applied. Since it's coming onto the end of the year it struck me as a good time to review the nature and structure of the business cycle and what some answers might be to all those questions.

Specifically we'll look at four things:

1. The Nature of Business Cycles
2. The Time-structure and Phasing of the Cycle
3. GDP and Consumption
4. Investment and Acceleration

We also end up with a few recommended readings if you'd like to dig into things a little more on your own. If nothing else think of them as candidates for "putting-you-to-sleep" books :) ! The first thing we'll start with is the linkages in the business cycle and what drives what - which ultimately tells you what data is important and what to look for. Digging in the patterns and structures will help out with getting the interpretations of headlines done a little better as well. We like to think of the business cycle as the "Great Circle (Economic) of Life" [Media file]. Also consider the metaphor which is really more like a model of how everything x-links, interacts and feedsback. Which takes us to the diagram. Oddly enough business cycles aren't as much talked about in your college econ classes though everybody recognizes them and applied economists deal with them all the time. Part of the problem is that modeling them turns out to be very difficult. So we end up with our best pass that's nonetheless consistent with both business and economic theory discussions (readings below).

As you've heard endlessly by now Consumption is 70% of the US economy - which is a post-war high btw. But what it really means is that consumption is the primary driver. The thing to get our minds around is that economic logic is not simple A --> B linear it's more A->B->C->D->A non-linear feedback loops. The other thing to get wrapped around is that while specific prediction are nearly impossible the patterns are structured and repeat themselves and hence are open to informed analysis and interpretation. Another thing to bear in mind is that these patterns have a time-structure of leads and lags that's critically important.

Here we get around some of the "black box" nature of things by plugging in our own. Start with Consumption which is the engine. Then Business looks at and fulfills existing demand but also evaluates trends and events thereby setting Business Expectations for future demands. A major part of this is the availabilities of investment funds and the cost of those funds, i.e. the Credit Markets. The consequences of this evaluation result in spending to increase, maintain or decrease capacity by hiring, buying capital equipment or both. In other words Investment and Employment are derived decisions based on future expectations and lag both Consumption and Output (GDP).

So what drives Consumer decisions ? Well a similar evaluation process where expectations on future/continuing employment and wages are used to make consumption decisions. Hence good leading indicators of future consumption demand are changes in Employment and Real Wages. Consumers also evaluate their ability to borrow against future income and/or current/future assets. This is a Credit Market based analysis, however well done, as well and Mortgage Equity Withdrawls (MEW) have been the primary driver holding up consumer spending in this cycle.

Time Structure and Patterns

The next thing to look at is how the Business Cycle plays out over time which is illustrated, at least conceptually, in the diagram at left. There are two basic cycles - one that is Consumer-led, which is the one normal in the post-WW2 economy. Since it's almost the only one anybody's seen it's also (a really critical point) the one that forms most of the basis for judgments and the rules-of-thumb everybody uses in their investment decisions. However the Telecom boom resulted in the 2nd type of cycle, an Investment-led cycle where capital was invested in equipment in anticipation of major growth in demand ahead of its' existence. When a boom turns to bust the normal result is a major economic downturn and between 1870 and 1950 the US economy went thru several of these on a much more frequent basis. When business economists and others talk about the "Great Moderation" the avoidance of these wide and wild swings and their frequent occurances were what everybody had in mind.

Only this time thru emergency measures we invented a 3rd kind of cycle - call it the policy avoided or arrested cycle. In this case drastically lowered interest rates allowed housing prices to be bid up, equity was created and consumers were enable to borrow against the huge increase in equity to keep on spending. The bad news is that we now have to deal with a new set of linked bubbles in the Housing and Credit markets which may turn out to have major negative consequences.

The good news though is that we avoided a Depression. And in '00/'01 that was exactly what the Fed was and should have been worrying about. Go back and read their pronouncements. And then think about what happened in Japan which to this day has never yet recovered any serious economic growth. And in fact has seen serious social damage as a result and also seen their economy drop to the lowest proportion of the world economy in decades. All-in-all this seems like a brilliant policy to me.

The results of this effort though are that there's no "store" of pent-up consumer demand waiting to stimulate new growth. In fact while extremely low interest rates and the tax cuts were abe to maintain consumer demand it has never resulted in the development of a new and healthy cycle. A phenomenon sometimes referred to as alack of organic growth. Otherwise known as a failure to grow employment, stimulate consumption and have new investment & hiring accelerate the economy to longer-term, sustainable and organic growth. There are always tradeoffs. An earlier post on long-term employment delves into this (What Are They Smoking:Latest Payroll Data,More On Payroll Numbers). And the conceptual time patterns are illustrated in the 3rd curve where GDP growth is shown not dropping as far as it "should" have but not recovering either.

If you stop and think this thru it also resolves many of the dilemmas and conundrums that have bothered everyone. Why has employment growth been the lowest in any post-WW2 business cycle ? Why did long-term rates not rise ? Where have all the excess "savings" and liquidities come from that have helped create the credit bubbles we're now living with. 

Readings

1. Ahead of the Curve: A Commonsense Guide to Forecasting Business and Market Cycles by Joseph H. Ellis 
2. The Irwin Guide to Using the Wall Street Journal by Michael B. Lehmann
3. Macroeconomics by N. Gregory Mankiw 
   
4. Prior Posts on Macroeconomic Data
• Slowmotion Slowdown
• Slowmotion Slowdown in Review
• Pieces of Changes: GDP Components
  

Posted by dblwyo at 03:05 PM | Permalink | Comments (0)

Well it looks like the holiday spirit might fade rather rapidly. Barry Ritholz starts us off with a post on real retail sales over the holidays and makes a well-reasoned argument that sales growth was zero or less. These conclusions aren't a great suprise however if you've been following along with our looks at real sales and consumption (Reality Bites: Real Retail Sales).

Over the weekend we ran across an interesting WSJ editorial that argued that increased spreads between high (AAA) and low (Baa) quality corporates indicated an increased likihood of recession, or least a downturn. Unfortunately, that interesting indicator, when you dig into doesn't quite hold up with the arguement IMHO very well and the attack on Fed policy seems both gratuitous and ill-grounded. However that poking around did cause us to revisit the yield and other early warning (leading) indicator signs. In particular the work of Paul Kasriel at Northern Trust whose KWRI proprietary indicator indicates that recession might be approaching a 65% probability. Paul also looks at real money balances and the spread on the yield curve. We reproduce two of his key charts at right for your review and contemplation.

We found Kasriel's warning indicators so interesting that we did our own digging along with looking at the AAA/Baa spreads. Taken all together our digging around led to three arguments:

1.  Real money balances are declining sharply on a monthly basis and indicate both a reduction in the money supply AND turmoil in the credit markets despite the best efforts of the Fed.
2. The Fed Funds/10Yr yield curve spread is going negative further indicating a poor outlook since longer-term funds rates drop when economic growth is expected to be poor and the anticipated demand for funds drops.
3. The short-term spread between 3Mo Treasuries and 3Mo Corporates has spiked quickly, abruptly and sharply though. Which indicates that the problems are in the credit markets not in Fed (or central bank) policy on rates. A point we explored earlier as well (Let's Blame Uncle Alan)

Let's set the table with an excerpt from the WSJ editorial that triggerred our digging into all this.

The Fed's Predicament Day by day forecasters, already pessimistic, lose further confidence in the economy. I too must plead guilty to being drawn in, although I had argued for months that the economy would come through the subprime mess more or less unscathed. However, the indicator on which we at my firm rely most -- the tightness of spreads in the quality end of the corporate bond market -- has abruptly changed. As recently as a couple of weeks ago, these spreads were tighter than they had been all year. Now it seems that the corporate bond market has begun to corroborate the general panic. But just in the last couple of weeks, the Baa/Aaa spread has broken through 100 basis points for the first time in several years. Having traded in a range between 85 and 95 basis points all year, it had widened to nearly 120 basis points by mid-December, suggesting a hit to GDP and consumer spending by the first quarter of 2008.

 Actually when you look at the composite chart the AAA/Baa spreads have gone up slightly, as they should considering the gross mis-pricing of risk, but in our humble opinion they haven't moved out of the realms of historical norms at all. What does look more than a little scary is the 3Mo Treasury vs Corporate yields which were abnormally low for similar reasons. And have now spiked so sharply. As you can also see on the expaned sub-chart the 10Yr/FF spread (on the r.h.s. axis) has conversely narrowed a great deal. In fact it's been dropping since '04 and gone negative since later last year. This is the famous conundrum dilemma full-bore btw and now indicates at best a slowing economy.

In the second composite chart at left we mimic Kasriel's early warning indicators by looking at the inflation-adjusted  monetary base on a YOY% change basis and the 10YR/FF spread on the r.h.s. axis. As you can see from the longer-term sub-chart (top) they were both good indicators of the '01 recession (Kasriel's chart above takes the analysis back to the early 70s !). As you can see the YOY% growth of the monetary base has been at or below zero for some time - in other words the real spendable capacity in the economy is actually shrinking and has been declining for some time. Or put alternatively despite all the Central Bank efforts to unseize the credit markets in fact credit tightening is foreshadowing a downturn.

The shorter-term expansion of the chart shows that 68.5% of the variability in the base is captured and explained by a downtrend which is accelerating. All in all we think Kasriel's arguements prove out with the data and more while Ranson's about Fed policy mistakes do not. Aside from being back to the 3-corned dilemma of inflation vs recession vs credit collapse these early warning indicators endorse both the slowmotion slowdown AND rising risk factors.

Posted by dblwyo at 09:43 AM | Permalink | Comments (0)

May the best of the Spirit of Christmas find you and yours.

If you've read on perhaps you're wondering about the relevance to business. Well aside from business not being all there is of course but vitally important to my mind there are critical and wonderful messages and lessons in building a high-performance enterprise by instilling wisdom and compassion in the culture and HR practices. Perhaps, IMHO, best encapsulated by Bob Sutton in his "This I Believe" Rules:

Posted by dblwyo at 09:33 AM | Permalink | Comments (0)

Well this seems to be the day for key columnists to catch my eye with appropriate diagnosis and warnings. This morning Bill Kellner has chimed in with a very timely summary of the environmental context and economic outlook. We don't have a lot to add per se though we'll point you to some earlier postings that put some charts and tools behind his cautions.

So he....er's Bill: 

Plan ahead for a tough 2008 It's not difficult to get read on the economic year to come.Whether there's a recession or just a slowdown in our future, on one thing there is general agreement: 2008 figures to be a tough year for just about everyone -- employers, employees, homeowners and investors -- so plan accordingly. Don't wait for the National Bureau of Economic Research, the official arbiter of the business cycle, to make the call. I would remind readers that the initial look at the first quarter's GDP won't be available for another four months. If you haven't planned for tough times by then, you'll be way behind the curve. A look at the real world will give you better information sooner. Point in fact: Those who deny even a slowdown note that residential fixed investment accounts for less than 4% of real GDP, so housing alone is unlikely to exert much downward pull on economic growth. But this overlooks that home prices are falling, thus reducing both people's wealth as well as their ability to take out a home equity loan. Add to this the effect on households' budgets of rising food, energy and health-care prices, higher state and local taxes and transit fares, little or no savings, huge debts and stricter borrowing requirements and you have a consumer in distress. Even more important, the credit markets remain frozen. This means that, besides consumers, businesses and local governments -- even banks -- can't borrow needed funds. As you can imagine, money and credit grease the wheels of economic activity. Without them, business would inevitably grind to a halt. Central bankers are trying feverishly to inject liquidity into the system, but they won't be able to thaw out the frosty markets until lenders have confidence that borrowers can repay their loans. Too bad they did not think this way sooner.

Inflation Trends and Outlooks 

Real Retail Sales 

Payroll and Employment Realities 

Slowmotion Slowdown 

GDP Components and Spending Outlooks 

Posted by dblwyo at 12:19 PM | Permalink | Comments (0)

MSN Money Central is a pretty good finance and economics web site. In particular several of their regular columnists have proven out very well over the last several years (particularly Jubak and Markman). They also run a very interesting set of contests between investment pros. Two of whom had recent posts that are well worth thinking about.

Paraphrasing them might go something like this, "hmm this really isn't working out well. What's going on here and how do I re-think my strategy, tools and techniques ?" Otherwise known as the Oops factors. Now one of the things I've noticed about the contest results is that their timing on market cycles has been extremely fortuitous indeed. No conspiracy just coincidence by and large. So contest results are skewed toward those folks who's style aligns with current conditions, the context.

So, what's the context for investing right now ? 

Both of these "Oops" public confessions strike me, very strongly, as indicating that - as we've been saying - we're actually in a sideways market of increasing volatility of shorter periods. And part of th reason is the general lack of grasp of the on-coming avalanche. Remember that everybody was in denial about Housing until this Summer and there were widespread expectations that the Homebuilders were in recovery mode this time last year. Instead how many of them are teetering on the edges of the abyss right now ?

Well it might be worth thinking about, reading these columns and thinking thru your position, outlook and strategic adaptations. Mighten it ?

To help our with framing you thinking here are a couple of posts that ought to be worth your time:

• Looking Ahead: Seeing the Avalanche Before It Lands
• Bubble, Bubble, Toil & Trouble:Markets Review

 The column excerpts are below along with clickable URLs for the whole thing. Also to frame your thinking check out the homebuilder stock chart at right.

2 promising stocks and a course correction When you are losing money, do you stay the course or adjust your strategy? The decision to change your strategy is always a difficult one. It means selling stocks in industries you know well and investing in industries you do not have as much experience in. It also means the entire team you've selected and trained to assist you needs to be retrained to look for stocks that fit a different profile. Add to that the tax consequences of closing out a lot of positions, and it's easy to understand how a portfolio manager can decide to stay the course if there is even the slightest possibility that the reasons for the losses are short-lived. Deciding to stay the course is by far the easier choice. But when the reasons for the poor performance are not short-lived, it is the wrong choice -- whether for yourself or, in my case, for those who've invested in your fund.

Posted by dblwyo at 11:31 AM | Permalink | Comments (0)

Justin Lahart as an interesting column in today's Journal that nicely captures the situation in the cojoined housing and financing bubbles that's well worth your time to find and read. While he captures the unrealities of those immediate markets there are several things that deserve further investigation, reporting and thinking because we've got much farther to go than he reports with these problems. And as an interesting test of how far I posted a question on LinkedIn to which you're all invited. It asks "how widespread is awareness of the credit crisis and what do you think the consequences might be ?". The timing's likely bad right now but so far the responses aren't encouraging when judged by a large-scale grasp of the issues. Below we also point to some earlier posts expanding on these breakdowns.

So he.....er's Justin:

Cracks Differ In Housing, Finance Shells It's now conventional wisdom that a housing bubble has burst. In fact, there were two bubbles, a housing bubble and a financing bubble. Each fueled the other, but they didn't follow the same course. Housing peaked in 2005. By early 2006 it was widely recognized the boom was likely over, and by mid-2006 it was beyond question. In June 2006, sales of existing single-family homes were 9% below their year-earlier level, sales of new homes were down 15% and framing lumber prices were down 19%. The Dow Jones Wilshire index of home-building shares had fallen 41% from its July 2005 peak. Yet throughout 2006, the folks who financed the housing bubble turned up the volume on their party. Issuance of collateralized debt obligations -- investments that held heaps of risky mortgage securities and other asset-backed securities -- hit $187 billion in 2006, according to Dealogic. That was up 72% from 2005. The biggest single month for such CDO issuance was March of this year, at $38 billion. By November, there was just one issue sold, valued at $23 million. Lenders wrote $600 billion in subprime mortgages last year, down a little from 2005's $625 billion, according to Inside Mortgage Finance. But they also wrote $400 billion "Alt-A" mortgages -- a category between prime and subprime loans -- up from $380 billion in 2005. The path of these two bubbles has a lot to do with the way mortgages are now made. In this boom, the financial institutions that wrote the mortgages didn't keep them. They sold them to firms that then repackaged and sold them to investors in the form of CDOs and other instruments. Lenders had less incentive to worry about the financial health of their customers. Why worry when you're just going to sell the loan to somebody else and make a big fee in the process? The same went for the Wall Street banks bundling the mortgages into securities.

 And here's Dave on raising these other issues:

Posted by dblwyo at 10:51 AM | Permalink | Comments (0)

Well after yesterdy's Weekly ReadFest on the state of the economy and markets it's "almost" a shame to put up the business and company links that caught our eye this last week. Yet it's very much not and for several critical reasons. The central message of yesterday's stories, in our interpretation anyway, was that major storm flags were flying and the grasp on the depth of the risks and exposures is not good nor widespread. There are a bunch of things that can be and are being done. Nonetheless these are potentially very....very rough waters we're headed into. Aside from watching the weather and checking the charts to know where to sail THE question is, what ships to sail on ? With what crews and how handled ? In other words how do we find those companies that will do well in adverse circumstances ?

Let me move away from the metaphor a bit - the markets and the economic situation define the environment and ecology that we all have to live with, period, end of story. The question will be who're the most suited to prospering, surviving and taking advantage of the situation that's likely to be unfolding ? And who's going to take major damage and have trouble surviving ? Let's set the stage with the following excerpt:

Wall St. analysts still in fantasyland Despite years of reform, analysts are every bit as deluded and inaccurate as they ever were … Now, eight years after they were inflating the bubble, we again have to question whether analysts do retail investors any good. The latest evidence: Analysts have only just discovered that corporate profits in the fourth quarter aren't going to be nearly as strong as they had supposed a month or two ago. It has been obvious for many months that profit growth would have to slow way down simply because it couldn't continue at recent rates. To see the stubbornness of Wall Street's Pollyannas, look at new data from Merrill Lynch. The firm's chief North American economist, David Rosenberg, regularly and realistically forecasts S&P 500 profit growth. He cut his 2008 forecast sharply (to zero growth) in June, even before the credit crunch. He has since cut it twice more, and it's now -3 percent. But Merrill's analysts hold a far different view. Add up their 2008 profit growth forecasts for individual S&P companies, and you get 14 percent. In analyst-land, 2008 is going to be another knockout year, with profits yet again growing several times faster than the economy.

There are some good folks out there who understand their industries, how these environments are impacting them and know some good companies. You have to pick and choose. But by and large because analysts don't understand what makes a business really work you need to look to other information resources, including (& especially) at least some effort on your part. An excerpt we put up last week pointed out that recent headlines tell us where industries and companies are headed.

So as you skim over the links and excerpts below ask yourself - what does this tell me about the business conditions and surivival chances of the players ? 

In the business section, for example, you'll find articles on innovation (sadly neglected and under-executed but increasingly important), strategic employee development (ditto squared) and on major structural pressures in the finance, auto and telecomm industries. Each of which, and more, are reflected by linkable stories about specific companies, e.g. Goldman vs Morgan Stanley, JetBlue's major downturn, Chrysler's near bankruptcy, Circuit City's self-inflicted near death experiences and the same for AMD. More on the telecomm industry and key players and some key stories about big pharma players struggling to cope with the sudden emergence of the death of their business models. A disruption that was in fact long-predictable and predicted if you knew where to look.

Business

Innovation Predictions 2008 Building the next-generation enterprise—and maybe even the next-generation nation—will preoccupy most of us in 2008. The demand for innovation is soaring in the business community and is just beginning to gain traction in the political sphere. Most of the leading Presidential candidates have thoughtful positions on innovation (BusinessWeek.com, 11/15/07). And nearly all CEOs and top managers who have learned the language of innovation are now seeking the means to make it happen. It took the Quality Movement a generation to change business culture. The Innovation Movement is still in its infancy, but it's growing fast. You can see that in the vast changes taking place within the field. Companies are demanding new tools and methods to execute that change within their existing organizations, as well as for the kind of design thinking that transforms cultures.

Happiness Keeps Staff Checked In Housekeeper Anita Lum can tell a lot about the management of her hotel by the vacuum she uses. On average, hotels and restaurants will replace two-thirds of their workers this year, according to hotel survey firm Market Metrix. The company estimates that each departure costs a midrange hotel about $5,000 in lost productivity, and recruiting and training a replacement. Satisfied workers stay in their jobs longer, and they treat customers better, experts say. By contrast, unhappy workers tend to leave, particularly those in low-skill, low-wage jobs. At the Carlton, satisfaction ratings from employees and customers improved after Joie de Vivre took over, Chief Executive Chip Conley said. Though the basic principles sound simple, it is hard to craft workplace policies to retain low-wage hourly workers because they are very diverse… Still, it is possible to keep such workers engaged if they feel their jobs are valuable and fun, Mr. Conley said. Because of such efforts, Mr. Conley said, Joie de Vivre's turnover is 25% to 30% annually, about half of the industry average. At the Carlton, turnover is less than 10%, down from an estimated 50% annually from 2000 to 2002, before Joie took over. It is important to "focus on the impact they're making rather than just the task of cleaning the toilet," Mr. Conley said.

CEOs Should Stop Spinning, Start Thinking Forget the charisma and the polished speeches. Those may have been the qualities top executives were judged on this past year, when every other chief executive was publishing a book, appearing on prime-time television or socializing on Facebook.com. But today, with everyone predicting a more volatile year ahead, business executives are going to be graded more heavily on whether the decisions they make on everything from strategy to talent help their companies grow. They have to stop becoming experts on giving a positive spin to economic warnings and start analyzing the data at hand. This is particularly the case in banking and on Wall Street, as the subprime-mortgage troubles continue to unravel. It's also true in the media and entertainment industries, where the rapid growth of the Internet is upending traditional media; and in pharmaceuticals, where the expiration of patents threatens old giants. In a bumpy business landscape where there are so many demands on executives' time, leaders must determine what's critical to their companies so they can mobilize their people to take action. And they can't assume that just because a rival is succeeding with a certain strategy, they will, too. That's the mistake many finance executives made in recent months. Not everyone fell into this trap. Richard Kovacevich, chairman of Wells Fargo, and his lieutenants deliberately steered clear of the riskiest sorts of subprime mortgages -- "stated income" or "low documentation" loans to borrowers with sketchy credit. They stayed out even though it caused them to lose market share in the short term that would have generated big loan fees.

Wall Street Sees M&A Tumbling 20% as Suspect Credit Afflicts Shares, LBO Even Goldman Sachs Group Inc., the world's leading takeover adviser since 2001, is prepared for a decline in mergers and acquisitions income next year when a slowing economy reduces the market for leveraged buyouts. The value of transactions may fall 20 percent from a record $3.9 trillion this year, executives at JPMorgan Chase & Co., Lehman Brothers Holdings Inc. and Bank of America Corp. estimate. That may reduce fees on Wall Street and contribute to Goldman's first profit drop since 2002, the last year M&A decreased, according to analysts surveyed by Bloomberg. LBO firms, responsible for half of this year's 10 biggest purchases, now face financing costs that have more than doubled since June to the highest in four years. The pace of takeovers fell 33 percent since the end of the second quarter as chief executive officers at companies, including Virgin Media Inc. and Cadbury Schweppes Plc, delayed asset sales amid signs economic growth in countries ranging from the U.S. to Britain is ebbing.

What Lies Ahead for Car Makers? The question worrying everyone in the auto business right now is, Will demand for mass-market vehicles in the U.S. and European markets slump? (And if so, how badly?) More to the point, for consumers, is this question: How will the industry respond to something that looks and feels like a recession? Right now, it looks as if the big Detroit auto makers are trying to get ahead of the falling tide by cutting production, so they don't have to offer ridiculous discounts to clear unsold vehicles. That strategy, while sound from a business point of view, gets scary if the competition doesn't play the same game. Toyota and Honda executives still hope to increase sales in the U.S. next year. Partly, they expect their more fuel-efficient models will continue to sell well. But in the case of large crossovers, pickups and minivans -- where neither Honda nor Toyota's models have a big mileage advantage over the Detroit offerings -- the Japanese manufacturers could very well decide to dip into their superior profit margins to keep sales rolling and avoid laying off their so far non-union American and Canadian workers.

Toyota Tundra takes 'Truck of the Year' Motor Trend Magazine named the full-size Toyota Tundra its Truck of the Year for 2008 on Tuesday. Other competitors for the award were the Chevrolet Silverado HD, the GMC Sierra HD and the Ford F-250, -350 and -450 Super Duty trucks. Since the trucks have different capabilities, they were rated against a set of specific criteria rather than in a straight competition against one another, the magazine said. The trucks were scored for "superiority," a measure of general excellence in materials, engineering and workmanship, "value," a measure of what the truck offers compared to others available for the price, and "significance," a measure of how the vehicle changes the market in which it competes. The magazine tested two versions of each contender, each with different engine, transmission and suspension options. The General Motors and Ford trucks in the competition are all heavy-duty pickups designed to carry and tow large loads. The Toyota Tundra is a "half-ton" pickup of the type that is often used for personal transportation as well as for work.

Cell-phone spending surpasses land lines in US With Americans cutting the cord to their land lines, 2007 is likely to be the first calendar year in which U.S. households spend more on cell-phone services, industry and government officials say. To be sure, when corporate cell-phone use is counted, overall U.S. spending surpassed land line spending several years ago, analysts said. The most recent government data show households spent $524, on average, on cell-phone bills in 2006, compared with $542 for residential and pay-phone services. By now, though, consumers almost certainly spend more on their cell-phone bills, several telecom industry analysts and officials said. "What we're finding is there's a huge move of people giving up their land line service altogether and using cell phones exclusively," said Allyn Hall, consumer research director for market research firm In-Stat. As recently as 2001, U.S. households spent three times as much on residential phone services as they did on cell phones. But the expansion of wireless networks has made cell phones more convenient, and a wider menu of services, including text messaging, video and music, has made it easier for consumers to spend money via their cell phones.

As Cable TV Providers Lure Small-Business, AT&T, Verizon See Margins Erode AT&T Inc. and Verizon Communications Inc., the biggest U.S. telephone companies, lost millions of consumers to cable television providers. Small businesses, their most profitable accounts, may be next. Comcast Corp., the largest U.S. cable-television service, has snatched 3.8 million residential phone customers since 2004 and will spend $3 billion to sign up 20 percent of small companies in its territories by 2012. Time Warner Cable Inc. is also pursuing businesses with fewer than 1,000 employees. Phone companies dominate the $25 billion market and are offering discounts of up to 40 percent. The price reductions endanger the profit margins small businesses generate for San Antonio-based AT&T, which are about 10 points higher than for residential and corporate accounts. Cable's ``rapid push'' could derail a projected 17 percent trading gain for AT&T to $47 in the next year, while Verizon stalls around $44, said Sanford C. Bernstein analyst Craig Moffett in New York. The early stages of cable providers' entry into the small- business market won't provide much relief to their investors, Moffett said. The companies must spend to train customer-service staff and technicians before reaping the benefits, he said. Shares of Comcast and Time Warner Cable have tumbled more than 35 percent this year as a decline in new-home construction and rising foreclosures hurt their ability to attract new subscribers. AT&T and Verizon have begun selling TV service, taking some cable customers. Investors have snapped up AT&T and Verizon shares on the promise of growth in the wireless business and video service. Both companies forecast business sales, including revenue from big corporations, will expand by at least the rate of the U.S. economy.

Companies

Goldman scores but shows strains Goldman Sachs appeared to stay a step ahead of the credit crunch, as the Wall Street powerhouse reported better-than-expected quarterly results Tuesday. But slower growth in some of the bank's key divisions worried investors, sending its stock lower, as Goldman Sachs shares fell more than 3 percent in midday trade on the New York Stock Exchange. Adding to those fears were remarks by the company's Chief Financial Officer David Viniar, who said that he remained "cautious" about the company's near-term outlook given the current market conditions. But facing difficult market conditions during the month of November, the Wall Street firm saw a decline in revenue from the previous quarter in a number of key areas, including its fixed-income, debt underwriting and mergers and acquisitions businesses.

Mack's Costly Risk Strategy John Mack's project to make Morgan Stanley more like Goldman Sachs Group has come undone. His firm's $9.4 billion fourth-quarter write-down is a huge embarrassment. It overshadows good work elsewhere and raises questions about the firm's ability to deliver on its strategy. After Mr. Mack returned in a blaze of glory in 2005, he set about encouraging risk-taking. But the issue was always whether risk-taking would outrun risk control, the discipline so much in evidence at Goldman in recent months. That is what happened. A trading bet related to risky subprime mortgages racked up $7.8 billion of losses by the end of last month. As a result, Mr. Mack's tenure as chief executive has now destroyed several billion dollars in economic value, according to Sanford Bernstein.

JetBlue Nosedives Like People Express as Economy Sputters, Fuel Costs Rise JetBlue Airways Corp.'s $309.6 million infusion from Deutsche Lufthansa AG may not be enough to end a nosedive at the U.S. discount carrier, which has lost more than half its market value this year. Net debt at JetBlue surged fivefold since 2003 to pay for the fastest growth among major U.S. airlines. Now, with fuel costs rising, demand weakening and competition coming from Richard Branson-backed Virgin America Inc., the company's survival may be at stake. It must go beyond the balance-sheet boost delivered by Lufthansa on Dec. 13 to slash costs, cut unprofitable routes and slow its expansion. With its New York base and appetite for growth, JetBlue has spurred comparisons with People Express, a low-fare carrier that went on a six-year buying binge as it added new planes and acquired another airline before collapsing in 1986. For JetBlue, rising oil prices and economic weakness on top of its debt may become a ``death knell,'' Thompson said. ``While this $300 million liquidity injection buys JetBlue time to execute its turnaround, its long-term strategy remains in question,'' Frank Boroch, a New York-based Bear Stearns & Co. analyst, said in a Dec. 14 report.

Chrysler's Nardelli Crowns Cash `King' Before Sale ``It is debatable whether Cerberus will be able to fund Chrysler at the high levels of expense and investment required in this auto industry'' said Keith Crain, publisher of the Automotive News, speaking to the Economic Club of Detroit on Dec. 12. ``So Chrysler may have to make even more draconian cuts.''  As a chief financial officer at any automaker will testify, cash in hundred-million-dollar increments can and does get spent at an astonishing rate during slumps such as the one now gripping Detroit. Chrysler isn't disputing published estimates that its cash stands at about $10 billion -- hardly a lavish cushion by industry standards. General Motors Corp. has about $27 billion in cash and marketable securities; Ford Motor Co. has about $36 billion. First, though, Nardelli will make Chrysler as valuable as possible by cutting spending and selling unproductive assets. Next year promises to be a financial horror, with demand for new vehicles in the U.S. possibly at the lowest level in a decade. If Nardelli keeps his commitment to spend $3.7 billion on capital projects in 2008 and losses don't get worse, Chrysler's $10 billion of cash could drop to $5 billion a year from now. Nissan Motor Co. and Chrysler said last week that they are discussing joint development of some new models, which could reduce the amount Chrysler must invest. Chrysler CEO: We're 'operationally' bankrupt, Will Cerberus Pump More Money into Chrysler?

Circuit City Gets Crushed In the world of pricey consumer electronics, where customer service is arguably as important as quality products, Circuit City Stores (CC) is missing the mark and further eroding its profits. At the beginning of this year, the specialty retailer fired 3,400 of its highest paid, and presumably best qualified and performing, employees, as part of a broad cost-cutting program. That's led to substantial deterioration in customer service.. The company also said it now expects to report a modest loss from continuing operations in the fourth quarter, on an assumption that current sales and margin trends continue for the balance of the quarter. A fourth-quarter loss would be unprecedented for Circuit City… Schoonover said the company is still on track to slash expenses by $150 million this year and achieve $200 million in annual cost savings starting in fiscal 2009. Six of the 21 stores it opened during the third quarter were "The City" stores, its newest concept, which is intended to overhaul its store culture through smaller formats that make better use of selling space and improve customer service through new technologies…However, rejuvenation efforts such as The City have, in the past, proved to be temporary and not sustained, the note said. Replacing high-paid employees with lower-paid workers has clearly hurt Circuit City's attachment rates – its ability to get customers to accept extended warranties for products they buy, which raises gross margins -- and its ability to convert casual shoppers into returning customers... These execution issues are hurting the company during its most important season, when it should be benefiting from the fact that consumer electronics are at the top of many people's holiday wish lists. Struggling store looks to shining 'City', Circuit City Shares Plunge on Forecast for a Loss

AMD to 2007:Good riddance It has been one of the worst years for the Sunnyvale chip maker since its major turnaround that began at the start of this decade, during which it became a serious force for rival Intel Corp. to contend with. Always the perennial No. 2 in the personal computer space, AMD has been an investor favorite, the underdog that many in Silicon Valley have rooted for as it took a serious swipe at the Santa Clara chip behemoth. Its Opteron chip for servers and PCs put the scrappy company on the map with many big system makers, and it seemed to finally rise above its spotty reputation for manufacturing problems and inconsistencies of the 1990s. Until this year. AMD worked hard to establish itself with the major PC and server companies as a reliable maker of chips. As Kumar notes in a brief interview, computer makers "don't want to give Intel the license to print money," but they also don't want to take risks with unreliable suppliers. AMD earned the good will of the industry by developing great products and serving as a real competitive threat to Intel. The core architecture of the Opteron chip is considered superior by many computer geeks, gamers and general fans. This year though, the delays with Barcelona appear to be hurting. Kumar said its share of the server market dropped to about 13 percent in the most recent third quarter data, a big drop from 25 percent last year, as Intel rolls along with more new products.

New Sprint chief was Ma Bell's star Daniel R. Hesse spent much of his 30-year telecom career climbing the ladder at the old AT&T, culminating in a job running its huge wireless division in the late 1990s­, only to be passed over for the CEO post when AT&T announced plans to take the wireless company public. He was one of Ma Bell's bright stars, the executive equivalent of the gal who is always a bridesmaid, never a bride. Now, though, Hesse is moving center stage: This morning, Sprint Nextel said he would leave Embarq (itself a Sprint spinoff) to become CEO of Sprint, effective immediately. At Embarq, which had revenue last year of about $6.3 billion and a market capitalization of about $7 billion, Hesse was constantly experimenting with ways to integrate wireless and wireline services for customers, even though Embarq, a local phone carrier whose biggest markets are Las Vegas and Tampa, doesn't operate its own wireless service. Investors can expect to see Hesse try to push Sprint to come up with new plans and services that will help retain and attract customers. But don't expect him to reinvent the wheel. "It takes time to innovate," he added. "It takes a lot of the risk out of it to see what others have done."

Mobile Phone Spending in U.S. Rises to Record on New iPhone, BlackBerry Americans, previously hard-pressed to pay $50 for a phone, are now more like their European and Asian counterparts and paying $300 to $400 for the top devices. That will translate into higher sales for Apple and Research In Motion and may bolster rivals Nokia Oyj and Sony Ericsson Mobile Communications Ltd., which tried for years to promote camera and music phones to U.S. buyers. The trend will continue this holiday season, said analyst Ross Rubin at NPD Group, which collects retail data. Sales of pricier handsets such as the iPhone almost tripled last quarter and made up 11 percent of phones sold in the U.S., Port Washington, New York-based NPD said. Shoppers spent $3.2 billion on phones, or $83 each, up from $2.2 billion a year earlier and the most since NPD's records began in 2005.

A New Blueprint for Cisco Cordell Ratzlaff wants to expand the tech giant's reach by designing products customers can love. ….when Ratzlaff arrived at Cisco Systems (CSCO) a year ago, he found that instead of a design czar, the company had product-requirement specs. These dreary documents, crafted by engineers and marketers, tend to get crammed with countless features, with little attention paid to how the product will get used. Only at the last minute are industrial designers brought in to make an item user-friendly. Complains Ratzlaff: "It's a 200-page document that nobody reads, but everyone spends four months arguing about. It's like hiring the architect while the cement truck is idling outside." Now, Ratzlaff, 47, Cisco's director of user experience, hopes to borrow a page from his old employer. He and his dozen-or-so staffers have created a blueprint for how Cisco's products should work together for customers. With the support of CEO John Chambers and other top brass, they are trying to impose it on the San Jose company. Their degree of success will help determine whether Cisco can reach beyond the business of selling routers and other basic networking gear, an area it dominates, into faster-growing markets for products that make use of those networks.

New Lilly CEO a drug-biz rarity Eli Lilly's soon-to-be CEO John Lechleiter is an anomaly: few top executives have ever toiled in a research lab. Instead, the vast majority of chief executives in the drug business made their way to the top by way of the sales and marketing department. That lack of scientific sensibility, many believe, places most Big Pharma CEOs at a distinct disadvantage when making R&D decisions. In choosing Lechleiter, Eli Lilly  is bucking a trend and setting itself apart from industry peers. With a trained chemist at the helm, Lilly may have an ever-so-slight, but important edge over its industry peers. Lilly can't escape the realities of the business, of course. It faces slowing growth due to patent expirations and generic price competition - just like other drugmakers. Lilly's solutions, however, are often somewhat different. In the late '90s, for instance, when the company faced Prozac's 2001 patent expiry, the company might have been expected to cut back on research expenses. Instead, management increased R&D spending to an industry-leading 19% of revenues, at a time when the average drugmaker reinvested just under 15% of sales into its lab activities. If there's one caveat about Lilly's choice for a new CEO, it's that as a career-long Lilly employee, he may not be capable of making radical changes.

Pfizer Is Sued Over Marketing A former Pfizer Inc. official in a lawsuit accused the company of illegally boosting sales of its top-selling drug Lipitor through an elaborate campaign of misleading educational programs for doctors. Jesse Polansky, claims that the educational campaign was a key part of a marketing strategy that "led thousands of physicians to prescribe Lipitor for millions of patients who did not need medication" and could be harmed by overly aggressive treatment.

Posted by dblwyo at 08:21 AM | Permalink | Comments (1)

 Another interesting week, capped in the market by a nearly 4% surge in the NDX which drove a nearly 3% jump in the SP500, all driven by exceptionally strong earnings it would appear from ORCL and RIMM as well as news that the big banks failures to run their businessess are being offset by foreign capital.

Rather than provide more overview per se let me urge you to read the following pieces some from analysts and columnists who I greatly respect because they're thoughtful, analytical, clear and understandable and usually right. That last is pretty important as well. The rest are my own refreshed diagnosis of the credit problems and some backup readings. Taken together you get framework for understanding the state of the economy, the nature and structure of the credit crisis and the stratetgic outlook, which I find very credible, on the stock markets.

While you may not buy all of the arguments or even disagree with them completely they're all laid out so that you can see the tools and analysis and use them to reach your own judgements. Which we urge you to do in the strongest terms.

By way of setting the table let me also point you to an earlier post on whether or not it's possible to frame things so one can indeed see the future trends clearly. It reviews an economic/market assessment from about this time last winter and has turned out to be fairly accurate using simple tools: Looking Ahead: Seeing the Avalanche Before It Lands

General & Special

Probing the Probabilities of a 2008 Recession What is the probability that the U.S. economy will fall into a recession in 2008? We would answer, 65.5%. The bases for our answer are the Kasriel Recession Warning Indicator (the trademark-pending KRWI) and an econometric technique known as Probit modeling. Since the late 1960s, every recession (shaded areas in Chart 1) has been immediately preceded by or accompanied by both of the KRWI variables in negative territory. The KRWI has not given a false qualitative signal – i.e., it has not predicted a recession when one did not occur. In short, a recession commencing within the next four quarters is more likely than not based on the KRWI. Although we have yet to place a minus sign in front of any of our real GDP change forecasts, our estimated economic growth of 0.5% in the first quarter of 2008 is just a rounding error away from becoming a contraction.

Greasing the Skids or the Gears: Credit Repairs Working ? Despite this last week's Fed action to auction of open-market funds to raise liquidity and the massive,open-ended injections of the ECB (unlimited was the word used) which resulted in 1/2 $T in injections it's not entirely clear that's it working. Though the headlines as usual might suggest it's improving. However three recent very good analytical posts by some of my favorite bloggers are worth noting. Now our problem is that the credit markets are seizing up. In prior emergencies a major action with smaller-scale follow-ups were enough to turn the tides. That appeared to work in August but by late Oct and on into Nov. the credit markets were seizing up again. Which is what prompted the Fed, ECB, et.al. to act. If it works a couple of things will happen - more liquidity/money gets into the system to offset the destruction of capital balances by the banks losses. And the spreads between low risk and high risk debt instruments begins to narrow. Speaking of Avalanche Warnings: More Credit Crisis Readings

Stock market 'winter' is moving in Where in the world can you safely put your money? Not in equities, two top investors warn. They're not perpetual bears -- just investment analysts with enviable records. Growing numbers of market veterans in recent weeks have stuck out their necks and declared the 2002-07 bull market over, done and dead. At considerable risk to their reputations, considering the market is down a mere 8% from its high, they're asserting that a one-two-three punch of earnings recession, credit constriction and inflation have created bear-market conditions that could push the average stock down at least 20% over the next year. And the fourth phase, which is where we are headed now, is a time for protecting seeds to make sure you can replant the next spring. One thing he says he is certain of, however, is that although the market appears soft now, we ain't seen nothing yet. So far, he says, the market has drifted down primarily due to a lack of buying. It will really collapse later on, Desmond says, when investors lose hope and begin to engage in high-volume selling. Though many top economists still say the U.S. will avoid a recession, Rogers scoffs at that. He contends housing and auto manufacturing are in a depression, says financial companies are in a funk that's at least worse than a recession and notes that freight-car loadings are down. In summary, Rogers says: "We are in a bear market, and only a few big stocks that are holding up the big indexes make it look like we're not. Stocks are done, and many favorites will go down 80% after people figure out how long they've been reporting phony earnings."

Economy

Economists Bet Against Recession With the financial markets in turmoil and house prices sagging, there is a lot of talk that a recession is all but inevitable. Yet there's a case that the economy might avoid a painful downturn. In the latest WSJ.com survey of economists, forecasters on average put the chance of a recession -- often defined as two straight quarterly declines in gross domestic product -- at 38%. That's the highest in more than three years, but the forecasters' best bet right now is that the U.S. will skirt a recession. Predicting the economy's path is especially difficult at turning points, and the economy is sending mixed signals. But here are some reasons why the economy might avoid the ditch: Five Reasons Recession May Be Averted, Summers Interview Excerpts: ‘Perfect Storm’ for Consumers, Northern Trust Weekly Review (Excellent review, discussion and analytical charts; puts all the headlines in context. Well worth your time).

• $3 gas: America's braking point Gasoline demand has fallen for the first time in years as drivers appear to recoil from near-record prices, throwing doubt on America's seemingly insatiable thirst for fuel. Growth in gasoline demand has been slowing all year. In five of the last seven weeks, the amount of gas that Americans consume has actually fallen compared to the same time last year, according to retail sales data gathered by MasterCard SpendingPulse, a research report that tracks gasoline sales using MasterCard, other credit cards and cash purchases at approximately 140,000 service stations around the country. In some weeks demand has fallen by as much as 3 percent. Although the public has seen $3 gasoline before, 2007 has been different. Where previous price spikes were short-lived, this one seems to be here to stay. Another reason demand is falling could be due to a slowing economy, or even fears of a recession.

·         Housing outlook: Pain Street, USA The United States is deep in its worst housing slump since the Great Depression, and according to a new report, it's not going to get better any time soon. In a new survey, Moody's Economy.com says many metro areas will record losses of 20 percent or more during the downturn, with the national median price for single-family homes dropping 13 percent through early 2009. Factoring in discount offers from sellers, the actual price decline would be well over 15 percent. Eighty of the 381 metro areas covered by the report will record double-digit losses, according to the report. Most of the worst-hit markets are in once high-flying areas, such as California and Florida. The housing slump will have a substantial impact on the overall economy, according to Moody's, which says it will depress real gross domestic product by more than a percentage point this year and by 1.5 percentage points in 2008. Speculative investment in the mid-2000s helped fuel the current slump.

Stagflation May Return as Emerging-Market Demand Runs Into Credit Squeeze The world economy is facing the risk of both recession and faster inflation. Global growth this quarter and next may be the slowest in four years, while inflation might be the fastest in a decade, say economists at JPMorgan Chase & Co. The worst U.S. housing slump in 16 years, coupled with a tightening of credit by banks, has brought the world's largest economy ``close to stall speed,'' according to former Federal Reserve Chairman Alan Greenspan. At the same time, rapid growth in China and other emerging markets is driving energy and food prices higher worldwide. Still, it poses a dilemma for the Fed and other central banks as they struggle to decide which problem they should tackle first. How they respond will go a long way in determining which danger proves to be the biggest: a slumping global economy or rising prices worldwide.

• Fed’s Plosser: Inflation pressure “more broad based” Recent data suggest inflation is becoming more broad-based rather than isolated to energy, a sign of worrisome underlying price pressures, Federal Reserve Bank of Philadelphia president Charles Plosser said. In an interview with The Wall Street Journal Monday, Mr. Plosser said he doesn’t expect a recession, but even if one is due in the next few quarters, easing monetary policy aggressively now won’t do much to avert one. On the other hand, it could create a “terribly inflation-risky environment” if the economy is on the road to recovery later next year, as he expects.

`Tis Not the Jolly Season for Central Bankers: Policy makers in the industrialized world face the growing prospect of slower growth and higher inflation, at least higher reported inflation from the acceleration in energy and food prices. Inflation is a lagging indicator. Credit events are deflationary. The constriction of the credit channel will eventually lead to lower inflation. In the meantime, central banks can look forward to a holiday season of bad numbers and rising inflation expectations. The bad news is five-year inflation expectations five years from now crept higher last week following a coordinated effort to address banks' short-term funding needs and encourage them to make loans. The deterioration in financial market conditions and credit constraints threatening economic growth require the balm of lower interest rates. If central banks can pull it off without igniting inflation or another asset bubble it's sure to bring tidings of comfort and joy.

China's economic muscle 'shrinks'  China's economy, the world's second largest, is not as big as was thought, a report by the World Bank claims. According to the bank, previous calculations have overestimated the size of China's economy by about 40%. The revelation came after the bank updated the way it calculated the country's gross domestic product (GDP). The bank said the findings meant China would not become the world's biggest economy in 2012 as forecast. It also meant China was poorer than estimated. This in turn would influence future aid and investment plans, the World Bank said. China gains extra aid from international institutions and has asked for help in climate change talks because of its status as a developing country.  Based on the World Bank's new research, China's economy is now worth some $5.33 trillion (£2.64trillion). Despite the drop in size, the economy was still the world's second largest, the bank said. The US, at $12 trillion, is the world's largest economy. The method used for the calculations is called "purchasing power parity", and corrects for differences in prices, which are lower in China than in Western countries, for the same goods. However, the figures show that average incomes in China are still just 10% of those in the US. China averages $4,091 per person, while average income in the US is $41,000. Based on current exchange rates, China's economy is only half as big, at $2.24 trillion. In previous years, economists have tried to adjust their figures to take into account local prices in developing nations because they were often significantly lower than those in more industrialised countries. However, the bank said that many of the prices which were being used were out of date and gave distorted GDP figures. This time it has used updated prices to create more accurate figures. In its report, the World Bank found that five nations - the US, China, Japan, Germany and India - accounted for nearly half of the world's total GDP.

Markets & Investing

Stocks 2008: Fasten Your Seat Belts  Amid market volatility, S&P says expectations of weak economic and corporate earnings growth are already priced in to equities. Standard & Poor's Equity Research believes a sharp rise in U.S. equity volatility can be explained by growing fears that a looming recession will slow corporate earnings-per-share (EPS) growth in the months ahead. In addition to long-standing worries about U.S. housing weakness and high energy prices, recent unprecedented writedowns at leading financial institutions have investors concerned that tightening U.S. credit conditions will slow employment and wage growth, finally breaking the back of the U.S. consumer, say our analysis. Looking ahead, the question facing investors is whether recent weakness represents a healthy correction or the beginning of a new bear market. S&P Sector Countdown

·         Bet on dividend-paying stocks Climbing odds of a recession. Slowing earnings growth. Rising inflation. Rising interest rates. Falling dollars. And, yes, even falling interest rates. The list of things for investors to worry about is getting rather lengthy. And navigating a portfolio through a long list of worries is extremely tricky. What to do? What to do? Try my portfolio of Dividend Stocks for Income Investors. At times like this, dividends are king.

·         Why cash is golden right now Money market interest rates nearly match stocks' returns -- without the worry. And two foreign-currency ETFs deliver extra bang for investors seeking refuge from the falling buck.

Analysts Botch Profit Forecasts on Home Turf Wall Street analysts have been blindsided by the disappointing earnings season hitting banks and brokerage houses, having only this summer expected them to post increases.  In perhaps one of the biggest analyst lapses since Wall Street made darlings out of such 1990s Internet companies as Pets.com, most of the Street's researchers missed a chance to call the problems now taking place in their own backyard. In July, analysts surveyed by Thomson Financial expected banks and brokerage houses in the Standard & Poor's 500 stock index to post third-quarter earnings increases of 9% from a year earlier -- even as evidence mounted that the housing market and takeover boom were in jeopardy. The actual third-quarter result: Profits fell 27%. Analysts may have gotten the message. They expect fourth-quarter earnings to fall 45%. In July, they projected 10% increases.

·         Money managers remain optimistic about U.S. stocks, according to a new survey, despite the ongoing credit crunch and slowing economic growth. More than one-third of managers responding believe U.S. stocks are undervalued, up from 28% in the third quarter, according to the latest quarterly Investment Manager Outlook survey by Russell Investments. More than three-quarters expect the U.S. market to rise in 2008, and 30% think it will gain more than 10%. A year ago, 86% thought U.S. stocks would rise in the year ahead.

·         Wall St. analysts still in fantasyland Despite years of reform, analysts are every bit as deluded and inaccurate as they ever were … Now, eight years after they were inflating the bubble, we again have to question whether analysts do retail investors any good. The latest evidence: Analysts have only just discovered that corporate profits in the fourth quarter aren't going to be nearly as strong as they had supposed a month or two ago. It has been obvious for many months that profit growth would have to slow way down simply because it couldn't continue at recent rates. To see the stubbornness of Wall Street's Pollyannas, look at new data from Merrill Lynch. The firm's chief North American economist, David Rosenberg, regularly and realistically forecasts S&P 500 profit growth. He cut his 2008 forecast sharply (to zero growth) in June, even before the credit crunch. He has since cut it twice more, and it's now -3 percent. But Merrill's analysts hold a far different view. Add up their 2008 profit growth forecasts for individual S&P companies, and you get 14 percent. In analyst-land, 2008 is going to be another knockout year, with profits yet again growing several times faster than the economy.

The U.S. dollar has steadied as investors temper their economic pessimism, easing worries of a big exit by foreigners. The battered dollar is getting a reprieve as investors temper their pessimism about the state of the economy. While other markets continue to gyrate, the dollar has steadied since late last month and against many currencies has even strengthened somewhat. Friday, it made a significant move stronger versus such currencies as the euro and the British pound. For now, that is helping ease worries that the dollar's longer-term slide could prompt a massive exit from U.S. investments by foreigners. A combination of factors has helped to stabilize the dollar, though it remains quite weak. Some recent data have given comfort to those expecting the broader economy to escape the housing crisis with a slowdown in growth rather than an actual recession -- typically defined as two consecutive quarters of contraction. The Federal Reserve is taking new steps to tame the credit crisis. Countries in the Persian Gulf, which appeared on the brink of breaking their currency pegs to the U.S. dollar, have refrained from making any changes. What is more, inflation has perked up in the U.S., lowering the likelihood of steep interest-rate cuts by the Fed. The belief that the Fed would be forced to sharply reduce interest rates to stimulate economic growth has weighed heavily on the dollar. That is because lower interest rates reduce returns on fixed-income holdings in the currency, making the dollar less attractive to investors.Instead, investors are focusing on the possibility that further interest-rate cuts might not unfold as expected. Currency strategists say there is a strong belief the Fed will ultimately work to keep prices in line. One recent challenge to the gloomy view on the economy came Thursday, when data showed retail sales in November were more resilient than predicted.

Bond Bears Capitulate as Treasury Notes Make Chumps Out of Chart Watchers The sudden rise in the cost of credit sparked by the subprime collapse forced technical analysts, who make market predictions based on historical price patterns, to change their expectations. The difference between the interest rate banks pay for three-month loans and government borrowing costs, called the TED spread, reached 2.21 percentage points on Dec. 11, the highest since Aug. 20. The last time the spread was this high this long was in the aftermath of the 1987 stock market crash. The subprime upheaval ``pushes out'' by ``years'' the time it will take for the 10-year note's yield to rise above 5.5 percent, said Louise Yamada, who runs Louise Yamada Technical Research Advisors LLC in New York. Yamada, the top-ranked technical analyst in Institutional Investor magazine's annual survey from 2001 through 2004, still says the U.S. bond market is in transition to a bear market. The bull market in U.S. government debt began after policy makers led by then-Fed Chairman Paul Volcker increased the target rate to a peak of 20 percent in March 1980, to stem inflation that reached as high as 14.8 percent. Bond yields rose in the bear market from 1946 to 1981. Historically, the shift between bull and bear markets hasn't been immediate, Yamada said. Her analysis of long-term cyclical trends stretches back to 1790, when Alexander Hamilton served as the first U.S. Treasury Secretary. The 8 percent return since mid-June is ``an extension of the trading range environment, which is characteristic of every reversal from falling rate cycles to rising rate cycles,'' she said. ``We're talking about a 26-year cycle that historically has taken two to 14 years to reverse.''

Posted by dblwyo at 09:13 AM | Permalink | Comments (0)

Well it seems to be a day for credit market news for some of us if you can step away from the euphoria in the markets - which we admit to being slightly puzzled at (though ORCL and RIMM earnings are cause for celebration there's lot's of bigger anit-celebration things going on). Despite this last week's Fed action to auction of open-market funds to raise liquidity and the massive,open-ended injections of the ECB (unlimited was the word used) which resulted in 1/2 $T in injections it's not entirely clear that's it working. Though the headlines as usual might suggest it's improving. However three recent very good analytical posts by some of my favorite bloggers are worth noting.

• UPDATE (12/21/07 2100): Run don't walk to read Jim Jubak's latest column which dovetails so nicely with the points made here and in much better writing as well: Wait out a weird stock market . And especially try out the accompany video.
  

Now our problem is that the credit markets are seizing up. In prior emergencies a major action with smaller-scale follow-ups were enough to turn the tides. That appeared to work in August but by late Oct and on into Nov. the credit markets were seizing up again. Which is what prompted the Fed, ECB, et.al. to act. If it works a couple of things will happen - more liquidity/money gets into the system to offset the destruction of capital balances by the banks losses. And the spreads between low risk and high risk debt instruments begins to narrow. Paul Kasriel at NT explains it very nicely in Gross vs Net Financial Investment btw. There are three other posts we think you should take a careful look at though. For the first two key charts are borrowed at the right and are worth taking a close look at.

1. From BigPicture: "As Bill King points out, this means that "Capital is now being destroyed faster than credit can grow." Net net, all these liquidity injections are merely moderating the collapsing credit facilities, and not actually injecting much in the way of credit into the economy.
   

2. From CalculatedRisk: According to the Fed, the discount rate spread is still increasing. This is the graph released this morning. Meanwhile, the Fed is still pouring liquidity into the market with another $20 billion TAF auction yesterday. The spread between the A2/P2 and AA paper shows the concern of default for the A2/P2 paper. Right now the spread is indicating that "fear" is very high.

  Now those posts speak directly to the issue of whether the interventions are working so far - though we should keep in mind it's early, this will need to be a sustained effort and this is a bigger and more intractable problem than anybody was prepared to deal with. However, some of the other ripples in these ponds may topple some ginormous boulders into the ponds indeed.

The metaphor/model here is the earlier "Rocks in a Pond" model we posted to try and conceptualize the structure of what's going on. Earlier this week we walked a friend thru it and found it took somewhat more words than anticipated. So below we take another pass at it. We keep finding, which is why we keep mentioning it, that more and more this is a pretty decent explanation for a lot that's swirling around us. Consider this post also from CR that walks thru a ginormous boulder about to generate some more ripples - possibly:

BofA: Attitudes Changing Towards Default  Within the next couple of years, probably somewhere between 10 million and 20 million U.S. homeowners will owe more on their homes, than their homes are worth. (See Homeowners With Negative Equity) One of the greatest fears for lenders (and investors in mortgage backed securities) is that it will become socially acceptable for upside down middle class Americans to walk away from their homes. If every upside down homeowner resorted to "jingle mail" (mailing the keys to the lender), the losses for the lenders could be staggering. Assuming a 15% total price decline, and a 50% average loss per mortgage, the losses for lenders and investors would be about $1 trillion. Assuming a 30% price decline, the losses would be over $2 trillion.

We've slightly modified the Rocks & Pond model to maybe make it a little clearer. Remember the problem here is that a whole set of perverse incentives were created by passing on "assets" thru links of a chain to be re-packaged into structured debt instruments. Instead of focusing on making money from returns on a sound investment the goal became to maximize the flow of instruments to collect both the service/orgination/banking fees and the supposedly safe interest payments, without regard to the soundness of the underlying asset that anchored each chain. And also remember that each link was built using a combination of assets from the prior stage and then melded with more borrowed money so that the synthetic asset was a minority of the final aggregate which was then re-sliced and sold in tranches. In the picture the links of the chain are the columns - as you proceed across the proportion of equity drop and leverage increases. When the original asset value drops the entire chain, which by it's end might be 30-70X the original equity, unravels in the opposite direction.

Now when sub-prime mortgages started heading south that chain was triggerred across the links. But also it spread ripples sideways so that, for example, Commercial Paper was impacted on a worldwide basis because banks had used them to construct SIVs. Over time that same ripple has spread to the rest of the housing market and caused Alt-A and now Prime to start going thru the same process. Meanwhile it turns out that x-ripples start occurring - the mortgage insurors are basically bankrupt having sold insurance on in MBIA's case on something like $30B of CDO2's.

Now consider the bigger rocks and boulders lined up at the side of the pool. According to CR all we've really seen is the front-end 1/4 or less of the sub-prime problem. As housing prices drop several hundred million shouldn't be homeowners will be facing arm resets with their values already underwater. So there's one darm big boulder about to roll into the pond.

BEAR IN MIND THAT ALL THE RIPPLES WE'VE SEEN SO FAR ARE FROM A  "SMALL PEBBLE".

Yet because it was borrowed and leveraged money turned into liquidity that underpinned buyouts, buybacks and stock purchases there are, have been and will be further major ripples into all these other assets classes and markets. Which we try and capture with the ripple wavefronts moving thru the pond. In other words stocks, bond and currancies are all experiencing severe risks from just the first set of small ripples. Not to mention the economy.

Given that many other markets created synthethic assets using the same dysfunctional methods, tools and incentives that went into mortgage securities what is the liklihood that the same impacts will occur. The prior post (Speaking of Avalanche Warnings: More Credit Crisis Readings) provided several more examples of other assets classes where pebbles, rocks and boulders are teetering. Put the question another way - if the same mechanism are in place what's to prevent these other boulders from toppling in ?

Not a lot that we can tell. 

Posted by dblwyo at 02:13 PM | Permalink | Comments (2)

Well we've been maundering on about the credit crisis, the mechanisms and Fed policy and strategy a few times in the last week. So, how're things going ? Judging from the markets and today's futures this is all coming under control again. Judging by the uptake on the ECB fundings and the Fed auctions there's a lot of folks out there looking for cash and liquidities. So is that good or bad - btw the ECB pumped $500B into the credit markets this week. Not the $50, 70 or 80 of prior efforts. Below you'll find some interesting readings worth your time to at least skim the excerpts of. Ones that you should look at include CalculatedRisk's comments about a $2T catastrophe in the housing market, Jesse Eisenger's story on the coming commercial real estate kabumpf (which CR has been forecasting down to the cyclic structure and timing for almost a year now - hint, hint,...) and Paul Krugman's essay on the risks of a Liquidity Trap. The one we'll particularly draw your attention to is Dennis Berman's on how the crisis could get worse. Partly because it tells us that at least the propagation of this Ebola credit virus is edging into awareness but mostly because, based on our little model, we don't think they've got the scope and scale of this thing at all grasped.

 How the Crunch Could Worsen Wall Street's latest parlor game is best played with a comforting cocktail in hand: trying to guess just how the ever-fragile banking crisis could tip into doomsday territory. The scenarios have the air of gritty science fiction -- a huge capital crunch triggered by bond-market selloff and a money-market bloodbath. The scenarios have, by all accounts, a slim chance of occurring. But they are a reminder of how much the rapidly changing financial system, for all its innovation, is still built on confidence. Here are two leading scenarios as described by Wall Street bankers, traders, and regulators. The bond-rating selloff: In the doomsday case, a bond-insurer downgrade or bankruptcy sets off this bond-market fire sale. The consequences of this could be unpredictable and severe. Breaking the Buck and Much More: Confidence is at the very heart of the money-market mutual fund, where the sanctity of the "buck" is one of the last American absolutes. "Breaking the buck" -- meaning to lose one's invested principal -- has proved so utterly verboten that it's only happened once. If the value of this SIV paper drops even further, it could touch off losses through the money fund. What would happen if a money manager had to make the choice between "breaking the buck" or paying for, say, a crippling $2 billion shortfall? For some on Wall Street, the threat is less about the capital shortfall and more about an ensuing crisis of confidence in money funds, leading to liquidations, which in turns creates forced sell-offs and still greater losses.

Not being able to leave well enough alone we also decided to write a little note to Dennis thanking him for his efforts but suggesting he explore the wider scope of the problem. Given the quotient of kooks he probably not a big suprise that there's been no response but as a public spirited kook let me put up the comment here in the hope that it'll draw some more small attention to the bigger problems.

"Dennis - nice survery and very glad, though scared to see it. Glad because it indicates that some on the Street and the financial press are beginning to wrestle with how widespread this problem is and how much further it could worsen. Scared - well that's obvious.Let me try and up the fear quotient a bit, or more. My feeling is that this problem would still be widely under-estimated and under-grasped even under the scenarios you describe. Basically the argument is that this problem is due to terrible perverse incentives where all the players built a chain of leveraged structured debt and got their, now clearly ill-grounded, returns more from the flow of business than from investment returns. And in the process ignored any sense of underlying asset quality. That's opposed to the "traditional" and assumed model of investing where one gets returns on the soundness of the asset and the resulting cash flows.These are structural deficiencies in the instruments and institutions and need to be addressed. While we may bandaid them teporarily until and unless we improve our understandings of the mechanisms and put in new regulatory and instituional regimes they will return to haunt us. Worse yet in the short-term these same mechanisms were applied to many other assets, e.g. buyout related debt. As a consequence the ripples from asset breakdown can and will spread to other asset classes, either directly when/if their own asset quality deteriorates under pressure or because of ripple effects. My phrase for this is "rocks in a pond".Consider, for example, that as housing prices - which are just beginning to reset and will keep heading down for many years - continue down, and as ARMS et.al. reset the tiny little rocks that got thrown into the mortgage asset pool will be followed by other boulders. Now apply that concept to these other instruments and voila' !"

General & Special

Krugman: No Liquidity Trap yet, but Risk Is Rising The fact the Federal Reserve has eased monetary policy but banks are reluctant to lend has aroused concern in some quarters that the U.S. might face a “liquidity trap.” A concept dating from the 1930s, a liquidity trap exists when the central bank expands the money supply by providing additional cash reserves to banks, but banks don’t lend the money out, either because they don’t want to, or because the public has no demand for credit. Mr. Krugman, now at Princeton University, said no, but the risk of one has increased. “In general, we wouldn’t say that there’s a liquidity trap unless you’re up against the zero bound,” that is, when the short-term interest rate falls to zero, and can’t fall any lower. “So we’re not in one by the normal definition, which is a situation in which people are indifferent between cash and bonds, so that open-market operations in which the central bank trades monetary base for bonds have no effect.”

Economy

ECB steps up liquidity fight Emergency help for financial markets entered new territory on Monday night as the European Central Bank announced it would on Tuesday offer unlimited funds at below market interest rates in a special operation to head off a year-end liquidity crisis. The surprise move, which follows last week's co-ordinated barrage of measures by the world's central banks to increase market liquidity, suggests the ECB is still frustrated at the failure to ease market tensions. The measure was reminiscent of the ECB's operation on August 9, at the start of the global credit squeeze. But that was for overnight loans while the new offer is for two weeks. Analysts warned that the measure…

·         Moody's Warnings on FGIC, MBIA Cast Doubt on $1.2 Trillion Debt Moody's Investors Service's warning that the top credit ratings of FGIC Corp. and three other bond insurers may be cut casts doubt on $1.2 trillion of municipal, corporate and asset-backed securities. Moody's late on Dec. 14 placed the top Aaa insurance ratings of Stamford, Connecticut-based FGIC and XL Capital Assurance Inc. in New York under review for possible downgrade. It affirmed the Aaa insurance ratings of Armonk, New York-based MBIA Inc. and CIFG Guaranty in Hamilton, Bermuda, though it said the outlooks were ``negative.''  The companies guarantee the timely payment on debt issued by local governments and by Wall Street firms that package existing bonds backed by items including payments on home equity lines of credit into new securities. If the insurers lose their Aaa ratings, so too may the securities they guarantee, forcing some holders to sell the bonds because of their investment guidelines. ``Everyone understands the systemic risk if even one of these companies is downgraded,'' said Peter Plaut, an analyst at hedge fund manager Sanno Point Capital Management in New York.

• $20bn from Fed to ease credit woe The Fed makes billions of dollars available to banks in an auction hoping to ease credit-crunch concerns. Money Market Rates Drop; ECB Injects Record $500 Billion to Ease Gridlock
• Fed's Auctioning Money Won't Fix Credit Problems:This is more of a credit and confidence problem than a liquidity one similar to that which followed the Sept. 11 attacks on the World Trade Center. The extensive damage in lower Manhattan disrupted financial-market communications so much that institutions had cash shortages, and the Fed pulled out all the stops to supply it. The issue now is the large losses -- both announced and unannounced -- that many financial institutions have experienced from securities backed by subprime mortgages, many of which have gone into default. It would be great if the auctions work and relieve pressure in the interbank market. If Libor is to be believed, that's not going to happen.
• MBIA Says it Has $30.6 Bln Exposure to CDOs MBIA Inc (NYSE:MBI - News), the world's largest bond insurer, said it has exposure to $30.6 billion in complex mortgage securities that it insures, an amount that eclipses its entire net worth. MBIA'S stock plunged by 27 percent on Thursday, bringing its total decline for the year to more than 70 percent.MBIA has exposure to $8.1 billion of collateralized debt obligations, or CDOs, including mostly risky debt known as CDO squared, or CDOs backed by other CDOs, it reported on its Web site late on Wednesday. The company's net worth as of September 30 was $6.5 billion. The announcement may imperil MBIA's $1 billion investment from buyout firm Warburg Pincus LLC (WP.UL), according to rating firm Egan-Jones Rating Co. MBIA Tanks on CDO Disclosure , Investing in MBIA at a Cost of $20 Million a Day
•  Investor to UBS: What’s With These Losses? , Joseph Lewis’ Cautionary Bear Stearns Tale, Lacker: Fed Auction’s Effect Unclear

Now, Even Borrowers With Good Credit Pose Risks Kenneth Lewis acted far ahead of the competition in 2001, when he got Bank of America out of the business of issuing subprime mortgages. While profit margins on these loans to risky borrowers seemed tempting, the bank's chief executive believed the default risks were too hefty to justify. It took a while for Mr. Lewis to be proved right, but BofA's payoff has been huge. So what is Mr. Lewis worrying about today? In an interview last week with Wall Street Journal editors, he expressed concern that even borrowers with strong credit scores might turn out to be default risks if housing prices keep tumbling. In other words, what is being portrayed as a credit-quality problem with the riskiest 20% of the mortgage market could spread to a much wider cross-section of home loans. Because of lax lending standards in the past few years, many homeowners never amassed much equity in their homes. Sizable down payments became a rarity, as many buyers borrowed close to 100% of the purchase price through a blend of first mortgages and home-equity lines of credit. Others kept refinancing their mortgages as property prices climbed, taking on bigger loans and draining the equity value of their homes. As a result, there is a new class of homeowners in name only. How did banks' lending standards get so far off course? Familiar answers include a race for market share, a herd mentality and the apparent profitability of risky lending in boom times. Lenders also may have grown too fond of credit-rating data that were cheap, meticulous and not well-suited to a fast-evolving market. If so, it's another reminder that when it comes to customer data, precision is nice, but relevance is better. What lenders really needed to know was something harder to pinpoint: the true depth of homeowners' commitment to their properties.

BofA: Attitudes Changing Towards Default  Within the next couple of years, probably somewhere between 10 million and 20 million U.S. homeowners will owe more on their homes, than their homes are worth. (See Homeowners With Negative Equity) One of the greatest fears for lenders (and investors in mortgage backed securities) is that it will become socially acceptable for upside down middle class Americans to walk away from their homes. If every upside down homeowner resorted to "jingle mail" (mailing the keys to the lender), the losses for the lenders could be staggering. Assuming a 15% total price decline, and a 50% average loss per mortgage, the losses for lenders and investors would be about $1 trillion. Assuming a 30% price decline, the losses would be over $2 trillion.

Wall Street's Next Crisis Now that the subprime shakeout is nearly over, another real estate mess looms, this time in commercial property. So far, the current credit crisis has zeroed in on mortgages for the less affluent. But easy credit was a sprawling millipede whose wobbly legs reached into the farthest corners of the financial markets. This is the year the other 999 shoes start to drop. Any loan to any borrower can begin to seem subprime if there's too little down and too much debt. And that, unfortunately, brings us to the commercial-real-estate market. For the past several years, the market for commercial property—offices, malls, apartment buildings, industrial plants, warehouses, and the like—has enjoyed the very best of times. Prices soared, and lenders lent readily. Owners had no problem meeting their payments. By early 2007, delinquencies had fallen to record lows. In their own way, however, commercial-real-estate loans were no less foolish than those made to home buyers with speckled credit. Amid the tall office spires of America's cities, big-money pros have simply been playing a game of greater fool, trying to bring in huge returns with borrowed money and sell out before the arrival of the crash they knew was coming. And in this case, the fools won't just be famous developers. Some of the same banks and Wall Street firms now entangled in the subprime residential crisis will also be caught in the mess. The commercial-real-estate meltdown will be a market failure, pure and simple. We will be able to look at the wreckage in the next several years with wonder and awe, untroubled this time by sympathy for those left holding the bag.

Posted by dblwyo at 08:56 AM | Permalink | Comments (0)

One of the things we'd really like to convince everybody of, and a major purpose of this blog, is that it is possible to understand the structure and trends of all the currents swirling around us. That is, to see and understand the patterns that are driving all the day-to-day noise that surrounds you. And better yet, with the right interpretative tools and filters, to translate that data into meaningful information and fit it into the overall patterns and understand what's going on.

Back in the day a friend persuaded us to take an avalanche control course since we did a little back country skiing and climbing. In that we learned what conditions tended to favor an avalanche, how to detect them, what preventative measures the Ski Patrol took to mitigate them including setting them off and how to deal with them when they arrived. One of the key tricks was not to walk in exposed areas when the conditions were ripe. Another one was when one was in the way to stay out of it's channels. Now some times it's pretty hard to see if one is underway if the weather is bad and the "data" is noisy but it sure helped to be alert.

Right now, as we approach the end of a very volatile year, everyone's telling us it's hard to look ahead. Well that may be true - it's certainly a near impossibility to forecast with precision. But we believe it is feasible to understand with accuracy what's going on around us and interpolate and extrapolate those environmental conditions into liklihoods and risk factors. Presumably everybody is asking what's going on with the economy, what are the conditions and where are things headed.

During that avalanche course a key lesson was if you found yourself in bad conditions you wanted to be aware of them. You wanted to avoide bad ground if and when you could. And, when you couldn't avoid the bad ground, you wanted to walk very carefully and softly.

Right now we're in a deteroriating general economic environment with housing a major cause of the weakness and likely to get much worse, followed by commercial real estate. Worse the credit markets are in terrible condition and they have under-pinned a financially driven market environment. So credit market weaknesses are likely to feedback and worsen the Housing markets and the general economy. Worse we also don't think the extent of the credit problems are grasped or factored in.

Yet each of these "conditions" has been foreseeable and foreseen since much earlier this year. Below you'll find a link to a newsletter we provide our network that takes a look at the economic situation and pretty well sets the expectations. That same newsletter talked about Housing and Credit market problems and the likely impacts on the economy. Not as presciently as we'd like to claim but usefully nonetheless.

We're on bad ground here and the tools we've put up on this blog, which are used in the newsletter, will help you diagnose the avalanche conditions. Or, as Sun Tzu, puts it:

Mountain forests, rugged steeps, marshes and fens--all country that is hard to traverse: this is difficult ground.In difficult ground, keep steadily on the march.

Here are the introduction and summary from the newsletter. It itself can be read in full in PDF format by clicking here. Hopefully this'll sever as an introduction and provide some evidence that the tools exist to filter all that noisy data and that you can, by using these tools, have a pretty good understanding of the sort of ground you're walking on ! And as a bit of lagniappe, a little something extra as my New Orleans friends say, there's also a brief introduction to evaluating enterprise performance.

Valuations, Values & Performance

 

The headlines have it that this is a “Goldilocks” economy which is admittedly slowing but which, at worst, will only slow slightly before picking back up. And in the meantime inflation is benign and there are no major risks to the outlook. There is a great deal of truth to that except for the question of how much is it slowing; and the related problem with increasing risks, especially from housing, leading to a much more rapid decline.

 

Meanwhile the markets did very well last year, especially in the last half and the private investment business did even better with a large and growing deal flow. Both reflect the growth in liquidities, the very generous financing terms that resulted and the growth in valuations in both private and public markets.

 

But it will pay us to take a deeper, more structured look at the economy and business cycle, at valuations and especially at earnings and business performance trends. We need to ask, on a deeper look are the structural currents supporting and aligned with the headlines or not ?

 

We’d like to argue that they are not, though it’s early days as yet, and operating companies, financial providers and service companies and, especially, investors and intermediaries need to give increased attention to the risks and triggering factors. In particularly an increasing level of concern with enterprise performance, earnings and operational performance is likely to be required. Or, in other words, is this Cinderella’s and not Goldilocks’ economy ?

 

Let’s consider that idea and the related one of whether it’s five minutes to midnight or the height of the ball. And do it by asking those deep value questions that we suggest should be applied to all the factors involved.

 

Summary

 

The economy is slowing and that will raise the premium for performance to ensure adequate investment returns. That slowing is at some risk, indeed serious risk, if deteriorating conditions lead to a more serious decline in housing that spreads to the rest of the economy. However, because of the unusual nature of this economy and business cycle – where slow growth has reduced hiring and business investment as well as the impact of the trade balance – liquidity has been and is likely to be plentiful throughout the rest of 2007. If something similar to the growing difficulties in sub-prime mortgage finance occurs in buyout financing that may change. That means that valuations and multiples are likely to remain high but increases the difficulties in generating returns for the future. More so if the economy turns down, as is quite possible, significantly. In both cases it is likely time to complement financial engineering with operational engineering to reduce the risks and, hopefully, increase the returns.

 

 

Posted by dblwyo at 03:44 PM | Permalink | Comments (0)

We've deferred posting last week's Business and Company stories of interest because off all the turmoil in the credit and other markets and the need to focus on better understanding that. HOWEVER, if there's any lesson we'd like to point to from prior posts and/or these readings, it's that at the end of the day competent business management is the essential requirement for sound investment and long-term economic performance. Conversely when that's lacking you get many, if not most of the problems, we're facing today. Just as a case in point today Goldman's stock dropped 5% on a luckwarm outlook for '08 - an outlook which is entirely consistent with many of the posts and readings here. Yet G-S started thinking thru a FORESEEABLE credit crisis at this time last year and convened a strategic task force to toughen up it's risk management and think thru it's credit positioning. Wilbur Ross had his funds and companies moving toward long-term finanancing early this year. It IS possible to look ahead and translate storm clouds into storms and start trimming up the sails, checking the charts and battening down the hatches.

To put a major point on it all of the postings here that provide economic, market, industry or firm outlooks plus all the readings provide some indicator of where you should be looking at for next year. We'll try to say some more about that whole thesis between now and the end of the year but the article excerpted below captures the basics in a nutshell. While it talks about job opportunities any reader of this blog should be thinking about business outlook and investment strategies as well. 

What '07 Headlines Say About '08 Job Market Today's top news stories could lead to tomorrow's jobs -- or tomorrow's layoffs. Here's a look at some of the biggest news stories of 2007 and their expected jobs-related impact in 2008. If you're wondering what jobs will be hot in 2008, take a second look at the past year's news. Major events and trends often set the stage for dramatic changes in recruiting, and this year is no exception. Headlines about soaring oil prices and the iPhone's introduction signal that more jobs will be created in such areas as alternative energy, online networking and mobile technology, say recruiters. Not surprisingly, though, some big stories are likely to be followed by substantial job cuts. Case in point: The lingering mortgage crisis has already resulted in mass layoffs for workers at many lending institutions, banks and real-estate companies. The jobs outlook for these concerns is expected to be even gloomier in 2008, say recruiters. Away from the headlines, recruiters say demand should continue strong in health care and retirement planning as the baby-boomer population continues to age. And the Sarbanes-Oxley Act of 2002 will continue to drive hiring at accounting firms.

 Please do both of us a favor and take the suggest model as that and apply it to at least the excerpts below and ask THE critical question - what does this mean for '08 and what can/should I do about it.

Business

The clues were in the (Nova)stars Now that we know what we should have been looking for, it is easy to spot signs that the mortgage morass was coming. Some warnings were more obvious than others, even if they went unheeded. Take, for example, the matter of insurance at NovaStar Financial Inc., once one of the leading independent subprime-mortgage lenders. In its heyday, as its stock was spiraling higher with a dividend yield exceeding 10%, insurance was a big part of the NovaStar story. It was so big that whenever I would raise red flags over its business, which I often did, investors would pepper me with emails that said the company couldn't lose because its loans were insured. But that assumed its loans were done properly. If they weren't, according to the fine print in NovaStar's regulatory filings, the insurers didn't have to pay on any claims. That was boilerplate, of course, but sometimes boilerplate is there for a reason. As it turns out, as far back as 2003, insurer PMI Group started refusing to pay on claims on NovaStar loans that had defaulted. That, in retrospect, was the first of three insurance-related matters that should have been a clue that the mortgage industry was starting to spin out of control. The second was that NovaStar started reducing the amount of insurance it bought, claiming that it decided to self-insure by taking more risk as prices of mortgage insurance started to rise. Rising prices, by themselves, should have been a sign of looming trouble. Insurers only raise prices as they perceive higher risk. Third, PMI started curtailing its subprime coverage. Among the reasons, it said, were that routine audits had resulted in a "meaningful" amount of claims on defaulted loans that were denied. NovaStar responded by suing PMI over the unpaid claims. This was the first time, the company said on an earnings call, that it had sued an insurer. But as the mortgage market heated up, and the appetite for pools of subprime loans seemed to become increasingly insatiable, concerns about insurance -- or a lack thereof -- were soon forgotten. Yet PMI didn't let the matter rest. In denying the claims, according to court records, it cited material errors and omissions in loan-origination documents. It went so far as to blame NovaStar's "own unclean hands." Furthermore, PMI said it had been under the impression that the subprime-mortgage lender "would use the income stated on a borrower's loan application to qualify the borrower for a stated income loan."

• Common sense might have helped Many of the old rules would have helped avert the current credit mess if anybody had bothered to remember them.

Citigroup Rescues SIVs, Takes on $58 Billion of Debt; Moody's Cuts Ratings Citigroup Inc. will take over seven troubled investment funds and assume $58 billion of debt to avoid forced asset sales that would further erode confidence in capital markets. Moody's Investors Service lowered the bank's credit ratings. The biggest U.S. bank by assets will rescue the so-called structured investment vehicles, or SIVs, taking responsibility for their $49 billion of assets, the New York-based company said in a statement late yesterday. Moody's lowered Citigroup's credit rating to Aa3, the fourth-highest level, from Aa2 late yesterday. The bank will probably ``take sizable writedowns'' for securities backed by home mortgages and collateralized debt obligations, Moody's Senior Vice President Sean Jones said in a statement.

LBOs Find New Source of Cash as Goldman, TCW Group Raise Mezzanine Funds Goldman Sachs Group Inc., TCW Group Inc. and New York Life Capital Partners are raising more than $30 billion to increase their investments in leveraged buyouts. At least 32 firms are starting mezzanine debt funds as investors shun bonds and loans used to finance LBOs out of concern that the collapse of prices for subprime-mortgage securities will spread. Mezzanine funds make loans to companies at higher rates than banks and buy their preferred stock. They earn returns from interest payments and the eventual sale of the equity interest. ``Today, virtually no one is willing to finance LBOs and it's created an opportunity for mezzanine providers,'' said John Morris, managing director at Boston-based HarbourVest Partners LLC, which oversees $24 billion of private-equity investments for institutions. Private-equity firms use funds raised from investors to finance as much as 30 percent of their acquisitions. They borrow the rest against the assets of the companies they buy, using the business's cash flow to pay down the debt. As much as 50 percent of the funding comes from senior debt, which banks package and sell to investors. The remainder is financed using high-yield loans and mezzanine debt, which is unsecured, high-yield borrowing that ranks last for repayment in the event of default. Mezzanine funds also acquire equity in some buyouts to generate higher returns for investors. They take the added risk to earn annual returns of as much as 20 percent before fees, said Patrick Campbell, a principal at New York-based Benedetto Gartland & Co., which raises money for mezzanine-fund managers. By contrast, junk bonds, often sold as part of LBOs, returned an average 6.97 percent from 1997 to 2006, according to indexes compiled by Merrill Lynch & Co.

·         Private equity: End of a gilded age

Kuwait to Pay Dow Chemical $9.5 Billion to Form Joint Venture in Plastics Dow Chemical Co., the largest U.S. chemical maker, said Kuwait's Petrochemical Industries Co. agreed to pay $9.5 billion to form a joint venture producing plastics and chemicals. The Kuwait-owned company will buy a 50 percent interest in assets that generated $11 billion in sales last year, Midland, Michigan-based Dow Chemical said today in a statement. The two companies will place the assets into a 50-50 venture that will employ 5,000 people. The venture includes all of Dow's plants that make polyethylene, polypropylene and polycarbonate plastics, as well as intermediate chemicals known as amimes, the company said.

The Most Expensive City to Leave: Cincinnati If you fly out of Pittsburgh, you pay 77% less on average for a domestic airline ticket for trips of the same distance than if you fly out of Cincinnati. Memphis is 38% more expensive than Nashville. And Newark, N.J., is 18% more expensive than New York's LaGuardia Airport. What's the reason for such wide disparities? It has little to do with airline costs and everything to do with competition. The presence of discount airlines makes all the difference. Efforts by airports and government officials to make room for discount airlines at congested airports like New York's LaGuardia and Chicago's O'Hare appear to have paid off. Of the 100 airports, LaGuardia ranks No. 54 in terms of the most expensive average fares, cheaper than Los Angeles, Seattle, Miami or Dallas-Fort Worth. Chicago O'Hare is even lower at No. 63. It can boast lower average fares than St. Louis, Philadelphia and Raleigh-Durham, N.C. What's more, many of the nation's big "fortress hubs" -- airports where one carrier dominates the competition and connects scads of passengers -- have gotten cheaper because of increased competition. Now that discount airlines have a larger presence in many hubs, prices have come down. Travelers from Denver, Philadelphia, St. Louis and Salt Lake City all paid less than 13 cents a mile for a 1,000-mile trip, on average. That's less than consumers in Hartford, Conn., Los Angeles, Portland, Ore., and many other cities.

Chemists Face Layoffs as Industry Struggles Chemical-based pharmaceutical research is being superseded by the newer field of biotechnology. The shift is exacting a toll, as companies like Pfizer lay off thousands of chemists, casting a pall over what was once a secure profession. Today, Lipitor is nearing the end of its patent life, and Pfizer hasn't been able to come up with enough promising new drugs to replace it. Following that initial breakthrough some 20 years ago, Dr. Sliskovic worked on several other research projects, but none panned out. His losing streak mirrors the industry's. A byproduct of the late-19th-century chemical business, pharmaceutical research thrived for more than a century by finding chemical combinations to treat diseases. But after contributing substantially both to human health and drug-industry profits, it has failed to produce significant innovations in recent years. High failure rates have long plagued chemistry-based drug research. Between 5,000 and 10,000 compounds are tested for every drug that makes it to market. In recent years, the problem seems to have gotten worse. Despite spending tens of billions of dollars more on research and development, pharmaceutical companies have fewer and fewer drugs to show for it. In 2006, the industry received Food and Drug Administration approval for just 18 new chemical-based drugs, down from 53 in 1996. Moreover, many of those drugs are variations of existing medicines. Differences between pharmaceutical, biologic drug making

Companies

General Electric Shares Show Immelt Forecasts `Not Flying' With Investors General Electric Co. Chief Executive Officer Jeffrey Immelt may tell investors today he'll deliver a fourth-straight year of profit growth exceeding 10 percent in 2008. It's how he gets there that may drive them nuts. Immelt needs to show that the world's third-biggest company by market value is as accurate with forecasts for individual businesses as it is with the bottom line, said Stephen Hoedt, an analyst with Cleveland-based National City Corp. GE posted earnings per share within 1 cent of the average analyst forecast in every quarter but one since the end of 2004, according to data compiled by Bloomberg. The stock dropped 10 percent in New York trading in the nine weeks since profit at its largest unit, GE Infrastructure, missed Immelt's third-quarter prediction. The Standard & Poor's 500 index fell 2.5 percent in that period. The shares rose 18 cents to $37.41 yesterday and are up 0.54 percent this year. GE gained 3 cents to trade at $37.44 as of 11:43 a.m. in Frankfurt trading. While GE's multiple divisions allow one unit to help make up for weaknesses in another, it can also result in earnings that meet targets for reasons other than originally forecast. The CEO has a goal of organic revenue growth, or sales from businesses GE has owned for more than one year, of two to three times annual global domestic product, or about 8 percent annually. Such growth has been at least 7.5 percent each quarter in the past two years, climbing to 10 percent in last year's third quarter and dipping to 7.5 percent in this year's first.

Is the Dreamliner 787 on track? While most analysts are expecting an upbeat assessment of plans to get the 787 airborne, several remain skeptical that the aircraft maker will be able to meet its goal of producing 109 planes by the end of 2009.  That target is just three fewer than the goal set before Boeing delayed the 787's first flight by more than three months and its first delivery by six months, largely due to parts shortages and kinks in its outsourced supply chain. In other words, Boeing expects it will take longer to get its first 787 into the air and to its launch customer. But once that hurdle is passed, production should go great guns. Wall Street, already disappointed once, is skeptical.

Dell chasing Hewlett-Packard into stores As its rival gains in PC market share, a hint of move into other retail deals.Traditionally, Dell has offered its PCs and servers for sale over the phone and the Internet. Its build-your-own model was popular for consumers and businesses who knew exactly what kind of computer they wanted. This was especially popular with corporate users who saw big savings from Dell's lean distribution system. But in recent years, the growth in notebook computers has outpaced desktops. Many consumers aren't comfortable buying a notebook over the Web and prefer to try them out in a store, gauging the comfort of the keyboard and seeing the size and resolution of the screen. Dell's chief rival, H-P, has capitalized on this trend with a broader retail presence, thanks in part to the legacy of Compaq's formidable retail presence. It also has gotten major buzz in the industry through a big ad campaign, and some analysts have compared H-P's new coolness factor with Apple's. Dell has opened up kiosks in malls and is now selling PCs and notebooks in places like Wal-Mart. In its conference call with analysts, Dell said it has broadly entered the retail channel where it will have a presence in nearly 10,000 stores by year-end. The company also expects to have one or two major partners in each of the top 20 countries globally over time.

Lament for CompUSA The shutting down of CompUSA is no big surprise to John Dvorak. There are lessons that Apple needs to learn from the debacle. As I have said in columns here and elsewhere, the idea of a computer megastore working is sketchy. Investors in Apple Inc. should pay attention. The problems are obvious to anyone who visits big computer stores. It begins with the fact that the sector is highly technical, and these vendors cannot afford to hire people who can sell intelligently. But it goes beyond that. Here's my list of issues:…. It's the last lament that has me concerned about Apple. The company is the first PC maker since Altair in the late 1970s to do the computer store correctly. This means opening a lot of small territorial sites, with a selection of everything within the product line. My concern is that the Apple stores are getting too big. People should note the RadioShack Corp. reference. These are examples of well-run stores, run by knowledgeable staff selling an incredibly broad line of products, within a very small footprint. While things are all working out for Apple during the iPod era, if there is any sort of slump the company will have to deal with what could be a herd of white elephants.  It's something investors need to monitor.

Murdoch's News Corp. May Take Three Years to Profit From Buying Dow Jones  Rupert Murdoch may take until the end of 2010 to show he was right to pay $5.2 billion for Dow Jones & Co. The takeover was completed today. By that time, Murdoch's News Corp. should be able to double Dow Jones's pretax cash flow to $600 million, giving it a 12 percent return on the purchase, said Larry Haverty, a fund manager at Rye, New York-based Gamco Investors Inc. Dow Jones may start adding to News Corp.'s profit in 2009 following investments next year, said Laura Martin, an analyst at Soleil Securities in San Marino, California. ``It's not a quick strategy,'' said Haverty, who helps manage Gamco's $30 billion in assets, including $308.1 million of News Corp. shares as of Sept. 30. ``Where he's going, we're very comfortable with it. It's just going to take three years.'' Murdoch said in November that one of his first steps will be to eliminate fees for the online Journal, at a cost of $50 million a year, to increase readership and advertising. He has said he plans to increase coverage of general news, politics and the arts in the U.S. print edition to take on the New York Times, and will upgrade international editions that he called ``a lot less than satisfactory.'' The Journal's Web site may get enough ad sales to make up for the loss of subscription fees once it gets 20 times more readers, Murdoch said today in an interview on Fox News. Luring the 20 million readers may take a year, he said. The biggest chances for growth will come from the Journal Web site and cable and satellite distribution of news outside the U.S., said UBS AG analyst Michael Morris, who recommends investors buy News Corp. shares and doesn't own them. News from the Journal, the second-biggest U.S. newspaper by circulation, may help News Corp.'s Fox Business Network challenge General Electric Co.'s CNBC and Bloomberg Television, owned by Bloomberg LP. It will take three to four years for the channel to secure distribution that News Corp. took seven years to get for Fox News.

Execs: Web Ad Spending Should Be Higher Online advertising jumped 25 percent this year, raking in a cool $20 billion, but Internet executives say that figure could have been even higher if advertisers had reliable and consistent ways to measure online audiences. Unlike traditional media, where each format has one main ratings provider -- The Nielsen Co. for television, Arbitron Inc. for radio and so on -- there are many sources of data on online audiences. And they frequently conflict. Disagreement also continues over which criteria best gauge users' potential interest in a product or service. And the resulting data aren't easily comparable to ratings in other media anyway. Web publishers are frustrated that the lack of cohesion is holding them back from capturing more of the $250-billion-a-year U.S. advertising pie, especially given the huge amount of time people spend online. As Internet executives hash over clickstreams, page views and user panels, 2008 is sure to see even more evolution of the way online audiences are measured. Other media -- including TV, radio and billboards -- also are revamping the way they calculate ratings in response to pressure from advertisers trying to measure how effective their ad dollars are. Online Ad Spend to Hit $42 Billion by 2011

Intel Scales Back Living-Room Branding Intel Corp. is scaling back an ambitious plan to build a brand in the living room. The effort, called Viiv, was announced with fanfare at the 2006 Consumer Electronics Show, along with partnerships with content and hardware companies. At a briefing in San Francisco to discuss plans for this year's show, Intel said it will drop the idea of promoting the Viiv brand on Internet video programming and living-room devices that connect to TV sets. Instead, Intel will use a modified version of the brand on entertainment-oriented personal computers that use its dual-processor chips. They will be labeled Intel Core 2 with Viiv technology, said Jeffrey McCrea, a vice president in Intel's digital-home group. As originally envisioned, the Viiv effort included Intel-developed media software and joint work with content companies to certify that movies, TV shows and other video fare delivered over the Internet worked well with a remote control and looked good on a TV screen. But the Viiv brand was mainly picked up by makers of consumer PCs. "It just never caught on," said Josh Bernoff, an analyst at Forrester Research, referring to the Viiv brand. "I don't think consumers understood it."

Posted by dblwyo at 05:29 PM | Permalink | Comments (0)

Well the search for the quasi-innocent to punish is underway (if you recall that old description of new project gone awry ?). While the Fed is not entirely blameless we seem to be heaping all the negatives on them and ignoring both the difficulties, the real situation and the malfeasances of many other players. The problem being that if we try and burn the witches to stop the plauge then the rats and fleas will still be with us; and we'll get another outbreak soon enough. There's a very good NYT story today which is well worth your time whose fundamental premise I disagree with. Which is not to say that there's not a lot that coulda/should been done and STILL will need doing. That's where we should be concentrating.

 UPDATE: CNBC has an interesting and useful discussion (not the typical debate) with Martin Meyer, Greg Ip, et.al. discussing what the Fed is trying to accomplish. Partly based on 'inside baseball' interviews with serious players. While you'll need to draw your own interpretations and conclusions this is one of the more realistics and balanced overviews I've seen. Particularly points to pay attention to are the discussion of outlooks, the credit mechanisms, etc. This is the first inkling that some folks are getting the idea of how badly broke the credit mechanisms are and what the constraints on Fed policy are.

Below the line you'll find an exerpt plus the URL's for my two favorite insightful bloggers on this topic. Here are my comments:

Sorry but this is an area where I need to caveat Barry's and the readers normal assessments a bit. Remember the conundrum ? Well with excess global liquidities the Fed and other central banks had limited abilities to raise long-term rates. Nobody's paying attention to that point but it is profound. Nor is anybody giving credence to another couple of critical points. The Fed would have had to start raising rates in '03 - think about what else was going on then and ask yourself if that was the time and place. Another point that Uncle Alan has made is that the Fed shouldn't be bursting bubbles as many have argued. Aside from whether they could or not the risk of inducing a major downturn to deflation, that's Depression, are too high.

The real problem here is that leveraged structured debt created perverse incentives to maximize the deal flow at the expense of rapidly declining asset quality. Instead of the supposed traditional model of making money by investing in sound assets. This was a regulatory problem and where the Fed did fail was in lacking the foresight and imagination to institute new regulatory regimes to a) prevent predatory lending and b)invent new mechanisms to reduce the proportion of bad assets that were re-leveraged. Any suggestions because it still remains to be done.

The final barrier was that these should have been put in in '04 when the possible impacts were first being discussed among central banks. Would there have been any support by anybody in that timeframe ?

Fed policy is actually pretty logical and reasonable within the limits of understanding and tools - not always right but a lot better than it has been among Central bankers. Try this on for size:

Credit Mess & the Fed: Credit Mess and the Fed: Understanding the Strategic Posture

Fed and Regulators Shrugged as Subprime Crisis Spread  Until the boom in subprime mortgages turned into a national nightmare this summer, the few people who tried to warn federal banking officials might as well have been talking to themselves.Edward M. Gramlich, a Federal Reserve governor who died in September, warned nearly seven years ago that a fast-growing new breed of lenders was luring many people into risky mortgages they could not afford. But when Mr. Gramlich privately urged Fed examiners to investigate mortgage lenders affiliated with national banks, he was rebuffed by Alan Greenspan, the Fed chairman.In 2001, a senior Treasury official, Sheila C. Bair, tried to persuade subprime lenders to adopt a code of “best practices” and to let outside monitors verify their compliance. None of the lenders would agree to the monitors, and many rejected the code itself. Even those who did adopt those practices, Ms. Bair recalled recently, soon let them slip.And leaders of a housing advocacy group in California, meeting with Mr. Greenspan in 2004, warned that deception was increasing and unscrupulous practices were spreading.

John C. Gamboa and Robert L. Gnaizda of the Greenlining Institute implored Mr. Greenspan to use his bully pulpit and press for a voluntary code of conduct.“He never gave us a good reason, but he didn’t want to do it,” Mr. Gnaizda said last week. “He just wasn’t interested.” Today, as the mortgage crisis of 2007 worsens and threatens to tip the economy into a recession, many are asking: where was Washington?An examination of regulatory decisions shows that the Federal Reserve and other agencies waited until it was too late before trying to tame the industry’s excesses. Both the Fed and the Bush administration placed a higher priority on promoting “financial innovation” and what President Bush has called the “ownership society.” On top of that, many Fed officials counted on the housing boom to prop up the economy after the stock market collapsed in 2000.Mr. Greenspan, in an interview, vigorously defended his actions, saying the Fed was poorly equipped to investigate deceptive lending and that it was not to blame for the housing bubble and bust.

• BigPicture: NYT: Blaming the Fed for the Sub-Prime Mortgage Crisis

• CalculatedRisk: Greenspan Shrugged

Posted by dblwyo at 08:29 AM | Permalink | Comments (0)

Well, that was an interesting week indeed. So much so that we put up several readings collections and analysis posts on the Fed, credit markets and the outlook. Rather than review the broad readings per se we'll just list them below the line and point you to the week's earlier postings for your review as well. One other quick word though - the first three links in the general section rather nicely sum up what we think is a balanced perspective on the end of the year and looking ahead to the next. Without further ado here are our posts which provide a combination of analysis, overview and readings that we think are worth looking at, at the end of the week :).

Markets

Bubble, Bubble, Toil & Trouble:Markets Review

Credit Crisis and the Fed 

More on the Credit Crisis: the Rocks in the Pond "Model", Rocks, Ponds, Perverse Incentives: More on Credit Contagion

• Understanding the Credit Crisis: More Readings & Resources,The Fed and the Credit Crisis: More Readings & Resources,The Fed & the Credit Mess: Readings II

Credit Mess and the Fed: Understanding the Strategic Posture

Economy

Reality Bites: Real Retail Sales and Consumption

More Reality Bites: Inflation Trends and Outlook

Some earlier posts on the economic overview:

• Slowmotion Slowdown in Review: Wessel Takes Notice
• Pieces of Change: GDP Components

General & Special

Why the Fed is running scared Fears of a recession are driving the central bank's decisions, but are those fears real? Check the numbers: The economy is slowing, not stalling. Personally, I'm worried about a slowdown in U.S. economic growth in 2008 to as low as 1.5%, but I think a full-blown recession, in which economic growth turns negative for two consecutive quarters, remains unlikely. As long as the job market holds up -- and it's holding up surprisingly well -- we'll skirt the edges of an official recession. First, the Fed fears that the debt markets will stop working because banks are so busy writing off billions and billions in bad mortgages and other loans that they'll stop lending. Lower interest rates are a Hail Mary pass flung at the markets in the hope that they will keep banks and investors in the game. Second, the Fed fears that the problems in the mortgage market, the housing industry and the financial sector, compounded by the effects of rising oil and food prices on consumer spending, will send the economy into a recession. Unless job growth stalls, however, I don't think we're headed for a recession. As of November, the economy was producing jobs at an average rate of 100,000 a month. Unemployment stood at just 4.7%. Those aren't the numbers you'd see in a recession. Count on the stock market, in general, to struggle. An economic slowdown is not fully priced into the market. Wall Street analysts are still calling for a 10% increase in reported earnings per share for the stocks in the Standard & Poor's 500 Index ($INX) for the first quarter of 2008, for example. As that forecast gets trimmed and investors react to those trims by deciding to pay less for shares, the market will probably trend lower. If the economic slump is as short-lived as economists now expect, the stock market would show a bottom sometime around mid-2008. But not every stock will struggle. Beyond your portfolio, the first six months of 2008 are shaping up as a good time to hold cash, as long as you've got it parked in something paying a decent yield and liquid enough so you can get at the dough in mid-2008. A slowing economy produces bargains in the financial markets, in real estate and in big-ticket items in general that you'd like to be in a position to jump at.

Profit Slump Fuels Recession Fears Corporate profits are being hit by both the slowing economy and credit-market turmoil, sharpening fear of a recession. U.S. corporate profits are being hammered by the slowing economy and credit-market turmoil, intensifying concerns that the nation may be headed for recession. Banks and other financial companies, which have taken huge write-downs on soured bets on subprime mortgages, have been among the most visible casualties. But businesses ranging from makers of artificial hips to surf-wear retailers to overnight-delivery services are also feeling the pinch. If profits fall far enough, it could discourage capital spending and make companies less willing to hire or retain workers. A hiring slowdown could magnify the downturn and hasten a recession. That's bad news for wage earners as well as those who own stocks.

Use ETFs to hedge your bets It's possible to buy exchange-traded funds for downside protection, cushioning the blow when your stocks drop. Here's how to build a hedge of your own. Next week the Federal Reserve will almost certainly cut interest rates for the third time in as many months. Last week stocks rallied strongly on that prospect. But what happened before last week -- a huge decline in equities that officially took the stock market into a correction, or a 10% retreat from its peak -- is likely to be repeated. "The economy is in the very late stage of the business cycle," says Alan Levenson, T. Rowe Price's chief economist. "We can debate whether we're on the fast track to recession, but now is more like 1999 than 1996."  The former year was much closer to the recession of 2001 than the latter. Levenson is forecasting that growth in corporate profits will shrivel to 0.6% next year from 3.3% this year and 13.2% in 2006. Unemployment will spurt to 5% from today's 4.7%, he predicts, as thousands more workers in industries related to housing are furloughed. This is a prescription for a serious stock correction and possibly a bear market. All of this speculation ranges between possible and probable, however; nothing is certain. Few investors dismantle their portfolios every time a setback looms. But it's increasingly easy for fund investors to do what institutional investors routinely do at times like this: Find some downside protection.

Economy

The Outlook: Tougher Times Ahead Standard & Poor’s Economics expects continued economic expansion in 2008, but at a slower pace, particularly in the first half of the year, as the contraction in the housing sector plays out and turbulence continues in the credit markets. The large inventory of unsold homes is likely to delay any recovery in building activity. We expect starts to hit bottom this year, and they should stay near that level throughout most of 2008. However, prices will continue to drop even after the recovery begins since there are so many homes on the market. We expect the economy to grow at an annual rate of 1.3% in the first half of 2008, down 1.5% from an expected 2.8% for the second half of 2007, before rebounding to a 2.5% rate through the second half of 2008. Some economists now believe a recession is likely next year. While we are less bearish, we still put the probability of a recession over the next 12 months at 40%. We think a recession would be more likely if there is a sharper-than-expected drop in the housing sector and an extended and more severe credit correction. U.S. dependence on foreign capital could cause a spike in bond yields, as foreign investors see the dollar sink and credit losses increase, thus complicating the housing contraction.

Economists Get Gloomier The risk of a recession is increasing, and the Federal Reserve should do something about it, according to the increasingly gloomy economists in the latest WSJ.com survey. Fifty of the 52 economists surveyed expect the central bank's Federal Open Market Committee to trim its target Tuesday for the federal-funds rate—the rate charged on overnight loans between banks. Only two see the Fed holding the rate steady at 4.5%, and none expects a rate increase. Some 61% say a quarter-percentage-point cut is the right move, while 27% say the Fed should cut rates by a half point. Only 12% said the Fed should stand pat. NT Week in Review (the best weekly summary and interpretative analysis out there. If you’ve just got time to skim one thing on the economy this is it).

·         U.S. Growth Will Slow to 1% This Quarter as Spending Falters, Survey Shows U.S. economic growth will slow to 1 percent in the fourth quarter as consumer spending cools and the housing slump enters its third year, a survey showed. Economists cut their estimates for the expansion this quarter from November's 1.5 percent forecast, according to the median of 63 estimates in a Bloomberg News survey taken Dec. 3 to Dec. 10. Gross domestic product in the first three months of next year will also be less than previously projected. Spending, which accounts for more than two-thirds of the economy, will grow in 2008 at the slowest pace in 17 years as higher fuel costs and falling home values limit consumers' buying power. The Federal Reserve will probably lower interest rates today and again early next year to fend off recession, the survey said.

·         Retail Sales Rise Twice as Fast as Forecast, Easing U.S. Recession Concern Retail sales in the U.S. increased twice as much as forecast in November, easing concern near- record fuel prices and falling home values would trip up consumers. The 1.2 percent increase, the biggest since May, followed a 0.2 percent gain the prior month, the Commerce Department said today in Washington. Purchases excluding automobiles jumped 1.8 percent, the most since January 2006. More jobs and higher incomes may cushion the damage from $3-a-gallon gasoline and declining home prices, preventing a collapse in demand, economists said. The increase bears out the Federal Reserve's decision this week to reduce the benchmark interest rate by just a quarter point. Policy makers took additional steps yesterday to spur bank lending.

·         Producer Prices Increase 3.2%, More Than Double Estimates, on Fuel Costs Prices paid to U.S. producers climbed at the fastest pace in 34 years in November, pushed up by surging costs for fuel. Excluding food and energy, prices rose the most since February. The 3.2 percent gain, twice as much as economists had forecast, follows a 0.1 percent increase in October, the Labor Department said today in Washington. Core prices, which exclude food and energy, jumped 0.4 percent after no change the prior month. The rising prices highlight the Federal Reserve's concern that energy and commodity costs may feed inflation at the consumer level. The Fed this week cut its benchmark rate for a third time in four months and said it would ``continue to monitor inflation developments.''  Economists had forecast a 1.5 percent increase in producer prices, according to the median of 77 estimates in a Bloomberg survey. Forecasts ranged from 0.3 percent to 2.5 percent. Excluding food and energy, the median forecast was for an increase of 0.2 percent following no change the prior month. Inflation in Europe Accelerates to Fastest Pace Since 2001 on Cost of Food

U.S. Housing Crash Deepens in 2008 After Record Drop For U.S. homeowners, builders, bankers and realtors, the crash of 2007 will only get worse in 2008. Everyone from mortgage-finance company Fannie Mae to Lehman Brothers Holdings Inc. expects declines next year. Existing home sales will drop 12 percent and existing home prices will fall 4.5 percent, Washington-based Fannie Mae says. Lehman analysts estimate almost 1 million mortgage loans will default in 2008, up from about 300,000 this year. ``We're only halfway through the housing shock,'' said Ethan Harris, chief U.S. economist at New York-based Lehman, the fourth- biggest U.S. securities firm by market value. ``It's just a matter of time before the weakness spreads to the rest of the economy.''  The housing market collapse has been anything but the ``soft landing'' that Federal Reserve Bank of San Francisco President Janet Yellen and David Lereah, former chief economist at the National Association of Realtors in Chicago, predicted for real estate at the start of 2007. Median home prices declined in the U.S. this year, the first annual drop since the Great Depression, according to forecasts from the National Association of Realtors. Krugman: After the Money's Gone

Paulson's Push for Stronger Yuan Weakened by China's Global Investing Boom As U.S. Treasury Secretary Henry Paulson visits China this week to push for faster appreciation of the yuan, the bigger issue may be what China is doing to strengthen the dollar. Paulson's fifth trip to the nation as Treasury Secretary has taken on added urgency as the U.S. grows more dependent on the dollar's decline to lift exports and keep the economy out of recession. While the pace of the yuan's gains tripled in the past 15 months, Chinese officials now plan to increase investments in America that may boost the U.S. currency instead.

·         Paulson Focuses on Product Safety in China After Being Stymied on Currency Treasury Secretary Henry Paulson elevated the safety of imported goods to the top of his agenda in Beijing as he tries to convince Americans of the benefits of trade with China. Paulson opened the third session of his twice-a-year Strategic Economic Dialogue today with Vice Premier Wu Yi. Ensuring China's product safety is the priority, a shift from the first two gatherings, when the pace of China's exchange-rate gains was the main focus. The Treasury chief is changing tack on concern that U.S. consumers' anger at Chinese exports of toxic pet food, contaminated vitamins and fatal baby cribs will stoke protectionism, endangering trade with the world's fastest- growing major economy. He may also find the issue easier to sell to China than pressure for a stronger yuan, increasing the chance of success at the talks, analysts said.

U.S. economic slide hurts Asia Asia's economic growth is likely to be constrained by an expected slowdown in the U.S. economy and potential spillover from the subprime mortgage crisis, two economic forecasts released Thursday said. Emerging East Asian economies, which includes China, will likely grow a collective 8 percent next year, down from the 8.5 percent rate forecast for this year, the Asian Development Bank said in a twice-yearly report. Even if the U.S. economy avoids a recession, the ADB predicted financial markets will remain volatile for some time. Other risks include further tightening of global credit, abrupt changes in exchange rates and a continued rise in oil and commodity prices, the Manila-based bank said. Similarly, the Pacific Economic Cooperation Council said in a separate report that because of possible fallout from the subprime crisis, the outlook for the broader Pacific Rim region is the most uncertain it has been since the 1997-98 Asian financial crisis.

Still, Singapore-based PECC predicted that the U.S. economy would not enter a recession and that the troubled American housing market will recover by the second-half of 2008.

·         China may be losing its edge, survey says China may be losing its competitive advantage, mainly because of rising costs, according to a survey of companies compiled by the American Chamber of Commerce in Shanghai. Rampant product piracy was another persistent problem highlighted in a report released Friday that was based on a survey of the group's 1,600 corporate members. Still, he noted that most companies with operations in China were still planning to expand capacity on the Chinese mainland, often while moving factories and offices inland to smaller cities where costs are lower. For many U.S. and other foreign companies, finding, paying for and retaining good employees remains the biggest challenge, the report said.

Our Misplaced Yuan Worries China's currency is not the cause of the trade imbalance. In 2007, China's current account surplus -- the sum of its trade surplus, and net receipts from foreign assets and foreign remittances -- will be nearly 10% of its GDP, or about $300 billion. Two-thirds of this represents a bilateral surplus with the U.S. The U.S. global current account deficit in 2007 will be about $800 billion, nearly 6% of the U.S. GDP. Thus, China's bilateral current account surplus with the U.S. is one-quarter of the global U.S. deficit. . If China fails to make this currency adjustment, the pending legislation in Congress would impose a tax on imports from China to offset the putative currency undervaluation. This reasoning, though plausible, is wrong. A country's global current account deficit depends on the excess of its gross domestic investment over gross domestic savings. Gross savings in the U.S. are about 10%-12% of GDP, largely consisting of corporate depreciation allowances and retained corporate earnings. On the other hand, gross domestic investment is 16%-17% of GDP. The difference between the two comprises the U.S. current account deficit.

China's current account surplus is the mirror image of the U.S. imbalance. Gross investment in China is above 30% of its GDP, but its savings are even higher, above 40%.

Markets & Investing

NT Week in Review At the same time, overall and core inflation present a problem, given November’s CPI report (see discussion below) and to the extent that inflation expectations (see Chart 2) have started creeping up. The Fed has these issues to weigh: (1) A credit crunch, (2) inflation, (3) weakening economic conditions marked with temporary bursts of strength such as nominal retail sales and factory production in November, (4) rising inflation expectations, and (5) a weak dollar. Policies suitable for some of these problems are damaging to others. Which is the appropriate course? For now, the credit crunch is at the top of the list and is likely to remain so until there is a significant improvement in money and credit market spreads because a failure to solve this will directly translate into a near shutdown of economic activity, in which case the problem of inflation will be irrelevant. Central bankers will have enough time and arsenal to address the inflation issue once the market crisis ends.

• After the Money's Gone On Wednesday, the Federal Reserve announced plans to lend $40 billion to banks. By my count, it’s the fourth high-profile attempt to rescue the financial system since things started falling apart about five months ago. Maybe this one will do the trick, but I wouldn’t count on it. In past financial crises — the stock market crash of 1987, the aftermath of Russia’s default in 1998 — the Fed has been able to wave its magic wand and make market turmoil disappear. But this time the magic isn’t working. Why not? Because the problem with the markets isn’t just a lack of liquidity — there’s also a fundamental problem of solvency.
• Money-Market Rates Fail to Respond to Central Bank Measures for Second Day Money markets failed to respond for a second day to the biggest effort by central banks to restore confidence in the world financial system. The euro interbank offered rate banks charge each other for three-month loans stayed near a seven-year high, falling 1 basis point to 4.94 percent, the European Banking Federation said today. That's 94 basis points more than the European Central Bank's benchmark interest rate. The two-week rate soared a record 80 basis points to 4.95 percent. Central banks in the U.S., U.K., Canada, Switzerland and the euro region agreed two days ago on a coordinated drive to promote lending into 2008, after financial institutions this year announced more than $66 billion of losses linked to subprime mortgages. Citigroup Inc., the biggest U.S. bank, said yesterday it will take over seven investment funds and assume $58 billion of debt to avoid forced asset sales.

What's keeping Wall Street afloat Despite the day-to-day turmoil, the stock market damage has been limited, with the Dow and S&P 500 not far from record highs. There's a credit market crisis so broad that the Federal Reserve has had to reach out to central banks across the pond. Yet the Dow Jones industrial average is within shouting distance of its all-time record. Bank of America and Wachovia both said Wednesday that they will record bigger multi-billion dollar writedowns in the fourth quarter than previously estimated, reminding Wall Street that the financial sector's exposure to subprime remains unclear. Yet, with all the bad news for banks, the group as a whole is up 9 percent off its 2007 lows, which hit in late November, as measured by the Amex Securities Broker/Dealer index. When the Federal Reserve "disappointed" stock investors by only cutting interest rates by a quarter-percentage point Tuesday, the Dow fell nearly 300 points. That's bad, but not that bad considering the level of day-to-day volatility seen in the second half of the year. That volatility was in full effect Wednesday, when stocks first rallied and then cooled off after the Fed said it was teaming up with other central banks to pour billions into banking systems around the world. Clearly stocks have been choppy of late - a fact of life that has been tough on investors. But a fair question to ask is: Why stocks aren't lower, considering all the negatives?

• Breakout? Top? Wait & See? We continue to discuss the technical aspects of the Dow action in the office. There is a divergence of informed opinions, ranging from "Breakout over 1500 SPX was bullish" to "Let's wait and see" to "a major top is forming."
•  Stock Market Rallies When Economy Slows to Less Than 1% Since Harry Truman Just because most economists on Wall Street predict the U.S. economy will slow next year, or sink into recession, doesn't mean their market strategist colleagues won't be right in their forecast of a record for the Standard & Poor's 500 Index. The benchmark for American equities climbed in eight of the 10 years the economy grew less than 1 percent since Harry Truman was in the White House 60 years ago, data compiled by Bloomberg show. Six of those increases coincided with periods when the Federal Reserve was cutting interest rates. ``A crisis leaves in its wake a wonderful rally cocktail of lower interest rates, lots of liquidity injections, cheaper stocks and a lot of pessimism,'' said James Paulsen, 49, who oversees about $200 billion as chief investment strategist at Wells Capital in Minneapolis. ``The period of greatest uncertainty or angst often begets the next ride.''
• Schultz sees an apocalypse now Shultz's latest letter, just in, is absolutely apocalyptical: "A financial tsunami is upon us," he says, caused by lax credit and complications introduced by Wall Street's derivatives craze. Among other interesting ideas raised by Schultz in his intense, somewhat terrifying introduction: recession, possibly depression; bank failures; exchange controls; housing prices down by 50%; credit card company failures; money market fund dangers; tripling of U.S. jobless numbers; federal bail-outs for Fannie Mae and Freddie Mac. His advice, translated out of his shorthand style: "If you have not already done so, take immediate measures to safeguard your assets against the global derivative crisis ... Most urgent is close out time deposits, buy non-U.S. government bonds." In other words, Schultz is saying the U.S. banking system is threatened.

Fed not only culprit in stocks' big drop  Investor sentiment also contributed to markets' decline. But I don't think the Fed deserves all the blame. Another cause of the stock market's drop, I suspect, was simply that it was due for a pullback. Advisers in recent days had been too quickly shifting back to the bullish camp. Consider the latest readings of the Hulbert Stock Newsletter Sentiment Index (HSNSI), which reflects the average recommended stock market exposure among a subset of short-term stock market timing newsletters tracked by the Hulbert Financial Digest. By Monday night, the day before the Fed's announcement, the HSNSI had risen to 47.7%. That represented a rapid shift to bullishness among the typical short-term market timing newsletter. Just ten trading sessions prior, for example, the HSNSI had stood at minus 13.2%. In other words, in just two weeks, the editor of the average market timing newsletter had increased his recommended stock market exposure by more than 60 percentage points.

Posted by dblwyo at 06:26 AM | Permalink | Comments (0)

Our headline is adapted from the witches scene in Macbeth and seems to capture this week's volailities and suprises of which there were and are many. Not least the complete reversal of last week's runups in the markets based on renewed expectations of Fed magic as well as suprisingly high inflation numbers. Both of which we discussed extensively in seperate major postings. Before we review the markets and outlook though we'll refer you to this:Bob Dole of Blackrock says equities reasonably cheap: Bloomberg Video. The interesting thing is that the Bloomberg headline emphasized cheap valuations but when you listen carefully to what Mr. Dole really says he has a very hard-headed and balanced view of the economy, earnings, PE valuations and expectations. Not least of which is his statement about a small rally with the S&P likely to be in the 1450-1550 trading range for the next few months. 

Below you'll find our most recent summary table along with some appropriate charts. The chart above shows the SP500 enterring a trading range and the the 50/200-day MA converging into a consolidation. The 2nd sub-chart shows the Euro-Yen exchange rate vs the SP500 - notice that the EURJPY changes are driving this market. After watching the videos and thinking about our comments take another look at the chart.

Now as it happens that's pretty close to our view though we aren't as sanguine about some of the major structural and fundamental risk factors nonetheless his views are very much worth considering. If you find yourself disagreeing that process will clarify your thinking. In fact if you'll pop up the chart at the right you'll see that despite all our expectations thruout this year that the markets have a) been basically trading sideways again and b) volatility has been the constant. In fact one thing to note is that the period appears to be shortening while the swings may be widening. If this keeps up for the next several months while we work thru and settle on a common viewpoint on these various deep factors. then a sideways market might be what we see for the next several months. We particularly like Mr. Dole's final conclusion - invest in quality. If you're investing for a real investor's time horizon (5-10 years according to John Bogle) these are buying opportunities. If you're a trader then bumps on the bottom and against the top of the range define themselves. If however your horizon is 12-18 months this is a very difficult environment and it might be time to keep your powder in dry storage and what for more clarity.

Boy do I hate interesting times ! :). 

UPDATE: here's another interesting video which is worth your time from CNBC on Fri. talking about the market's having gone nowhere and no clear trend emerging. Worth a looksee IMHO.

We've approached thinking about these things by looking at four different timeframes and deep currents (Structural, Fundamental, Technical & Outlook) and then characerizing each by a situation description, a status evaluation on a letter grade and suprises to watch for. For some time now we've been grading the first two as C/C- but have changed that to C-, Technicals were recently re-graded to C- and Outlook as C- as well. Our feeling is that all the right things are being discussed, there's a bit too much alarmism on the economy though with a growth recession the fragility factor is escalating and growing awareness of the risks. In other words over the next several months we may see a fundamental shift in Outlook - ask yourself if all this doesn't recall the markets in '01 and early '02 while everybody was expecting a quick recovery but eventually gave it up. Followed by the establishment of a (basically) five-year uptrend that one could reliably invest in. Our feeling is that the economically grounded earnings are not being priced in nor are the other risks factors.

Market Evaluation Matrix

Stock Charts 

1. SP500 Trends - Short-term trading range

  The six-month chart shows some down-pressures building with a trading range building up in the 1410-1540 range while the YTD chart shows pretty similar tendencies with a slightly different range. Nonetheless they're pretty consistent overall, along with being in line with our overview assessments and Mr. Dole's opinions.

2. SP Long-term trend intact but vastly different YTD sector performances.

Valuations won't reflect the fundamental and structural differences we see until the long-term trends are broken. And the

3. International Markets and Exchange Rates

Emerging markets bubble premium beginng to weaken as expectations reset. Yen and Euro both appreciating against the dollar but recent large differentiation reflected in first chart above the line.Nonetheless EM will likely continue to be a worthwhile trading opportunity but not a long-term investment opportunity with growing downside risks.

4. Interest Rates and Gold

Treasuries have enjoyed a multiple month "flight to quality" which is evaporating a bit. However our long-term expectation is that the Fed will have to continue to lower rates. Paul McCulley has even mentioned the Fed having to go to a "2-handle" on the Fed rate to mitigate the economic risks. Certainly a 3% rate is not out of the question over the next year. Meanwhile fears of inflation as reflected in gold prices have appeared to subside recently. 

Posted by dblwyo at 04:04 PM | Permalink | Comments (0)

The other interesting economic data that came out was the current PPI and CPI readings where even core consumer prices showed significant upticks. The prior post on Retail Sales talked about the differences between real and nominal retail sales and established that real sales was nowhere, and we mean nowhere, as good in terms of either raw numbers or trends as the headlines would have had us believe. This is really important (puns unintended but appreciated) though sometimes it feels like shouting in the forest. Actually most times. On the other hand the YOY change analysis meme has spread faster as a graphical analysis tool than anything we've seen. And the last WSJ entries do a very nice job, with the exception of not depicting real retail sales, which is what you really needed to see.

Below we look first of all at inflation using the approach and updating some earlier charts that looked at the long-run trends in PPI, PPIx, CPI and CPIx. Especially the cumulative changes since Jan00. Along with that we also bundle in the associated look at the relationships between PPI and energy (Oil) prices. And pretty well confirm the prior analysis with the caveat that it appears to be acclerating.

The last set of charts borrows and compounds the retail and consumption charts so you have Inflation and Real Retail Sales are together for comparision. The bottomline is that PPI is up very sharply, it's due to a spike in energy prices AND (again the most important real reality) it's beginning to propagate into consumer prices. Last year at this time everybody expected consumer spending to slow but it didn't, much. What recent commentators are forgetting is that that was a Fall06 Xmas present from an abrupt downturn in energy prices, partly thru supply/demand balances and partly thru a reduction in speculation.

Well this time that driver has reversed direction, inflation is up and real consumer demand is not only slowing but is vulnerable. 

The chart at the right shows shows PPI compared to CPI changes. Notice the reversal earlier this year with the recent severe upspike. While CPI and PPI are on different scales their patterns are nearly identical. When you look at cumulative changes in CPI, CPIx and PPI since Jan00 you see some profound differences we discussed in a prior post. At the time we argued that the biggest danger was when/if producer inflation from increased supply costs spread into the consumer side of the economy. That appears to be happening and big time.

If you look at the previous discussion of the Fed's policy dilemmas you begin to understand how acute are the three-corned tradeoffs they're facing, how difficult they are and the downside risks.

And as promised here's the composite real sales and real consumption chart to put the inflation data in context with part of its' consequences. Sorry to say the phrase that comes to mind, as if the escalating credit crisis hadn't already done so, is "be scared, be very scared".

In some ways this is redudant with the prior post on retail sales but the purpose of that more detailed discussion was to establish a firm argument for why those indicators were important. And also how they have a long and sustained relationship. Now that that's established we look at this short-term chart and have some level of confidence that it does, in fact, represent structural characterisitcs of the economy that persist over time.

And which we therefore need to pay some sigificant attention to. Please, be my guest. 

Posted by dblwyo at 10:31 AM | Permalink | Comments (0)

In the midst of what can only be described as market chaos this last week the inflation and retail numbers didn't get the attention they deserve so we've refreshed our data and charts with a view toward looking into that.

As many people suspected while the headline Retail Sales number was up tremendously when adjusted for inflation it wasn't. Below you'll find a comarison of Retail vs Real Retail sales using YOY% changes on a monthly basis. You'll also find a comparsion on a quarterly basis of Real Consumption vs Real Sales.

While Consumption has held up, both on a monthly and quarterly basis it is slowing (discussed in the prior GDP assessments here and here). Those prior posts clarify how important Real Consumption is to the overall health of the economy, what the trends and drivers are (along with Investment) and why the retail sales and consumption data is so critical to understanding the outlook. If that's not real clear may we suggest a brief review of the argument ? :)

Anyway here's the retail charts as promised. Both sub-charts show Retail, Auto and Real Retail Sales on a YOY% change basis. The first sub-chart shows recent data while the second goes back to Jan93. Notice that the relationships for trends, cycle patterns and turning points seem to be consistent over time - which makes these powerful indicators. With that in mind take a very careful look at the most recent retail chart - the tail if you would. Retail sales shows the headline up-blip but real sales has a much slighter uptick after a steady decline from '05. The other thing folks forget is that last year at this time we were enjoying a sudden downturn in oil prices and therefore inflation which helped sustain consumer spending. That driver is no inverted !

And just to link things back together the next chart set shows real retail sales and real consumption on a quarterly YOY% change basis. The second sub-chart gives you a feel looking back to Q193 for how they related over the course of the cycle. The first sub-chart is recent data. In both notice how, by and large, they coincide. BUT also notice that retail sales seems to lead consumption. And both have been trending down recently with the slowmotion slowdown. If retail sales leads consumption and the latter leads GDP we're getting all the warning shots we need, methinks.

Posted by dblwyo at 10:08 AM | Permalink | Comments (0)

Well most of the folks in the Finance Industry must be feeling like they're living in "interesting times" (we'll spare you the old saw which my Chinese friends tell me is Thai in origin). If they don't now they will soon and likely all thru next year. In some ways there aren't many surprises here in either the short-term or the long-term. Lots of stories in the last year or so have had lots of executives and others admitting this was a "dance" built on thin, thin ice. Personally my preference would have been to stop dancing and either get off the water or find some way, better yet, to brace it up or stop melting it.

Well like the Chinese peasants of old who wanted nothing more than to run their farms, grow mulberry and make silk so as to build a prosperous life for themselves and their descendents the worker bees are about to reap the harvest sown by the Power and Thrones. Let's make up a new one - "when Princes dance in the Capital the pipers are paid by the peasants".

Time to pay the pipes and it looks to be expensives.

 Just to put it in a context we've discussed before the chart at the right traces at the share of GDP going to profits in financial, non-financial and rest-of-world industry groups. To repeat the prior question - is there anything that's gone on in the last 15+ years that would make one think that a shift into Finance as a primary driver was a total aggregate benefit to the overall health and well-being of the economy ? In other words did it help us run a more efficient and effective economy ? Well the honest answer has to be, at least in part. But only in part.

We hope to get to a strategic review of the industry as a whole but to lay the groundwork we've collected a bunch of relevant readings on the nature, structure and evolution of the Finance industry and the economic environment it lives in. Think of it as an introductory reading list on the "Ecology of the Finance Industry". And ask yourself whether Jared Diamond's last book "Collapse" shouldn't be on the reading list.

After the apparant triumph of financial rocket science, i.e. the conception, design, development and widespread adoption and adaption of structured derivatives without recourse to sound business practice (sound familiar - remember all the words wrapped around the Internet bubble ?) what's next ? We'd like to suggest that the industry is about to have go thru multiple shakeouts and workouts on the lines of the steel industry and for, oddly, similar reasons.

We could of course be entirely wrong about that hypothesis - consider it a strong opinion, weakly (sorta) held and politely presented. See what you think - the readings are a start.

General & Special

The Roots of the Mortgage_Crisis  On Aug. 9, 2007, and the days immediately following, financial markets in much of the world seized up. Virtually overnight the seemingly insatiable desire for financial risk came to an abrupt halt as the price of risk unexpectedly surged. Interest rates on a wide range of asset classes, especially interbank lending, asset-backed commercial paper and junk bonds, rose sharply relative to riskless U.S. Treasury securities. Over the past five years, risk had become increasingly underpriced as market euphoria, fostered by an unprecedented global growth rate, gained cumulative traction. The crisis was thus an accident waiting to happen. If it had not been triggered by the mispricing of securitized subprime mortgages, it would have been produced by eruptions in some other market. As I have noted elsewhere, history has not dealt kindly with protracted periods of low risk premiums. Although central banks appear to have lost control of longer term interest rates, they continue to be dominant in the markets for assets with shorter maturities, where money and near monies are created. Thus central banks retain their ability to contain pressures on the prices of goods and services, that is, on the conventional measures of inflation. The current credit crisis will come to an end when the overhang of inventories of newly built homes is largely liquidated, and home price deflation comes to an end. That will stabilize the now-uncertain value of the home equity that acts as a buffer for all home mortgages, but most importantly for those held as collateral for residential mortgage-backed securities. Very large losses will, no doubt, be taken as a consequence of the crisis. But after a period of protracted adjustment, the U.S. economy, and the world economy more generally, will be able to get back to business.

How to ride the boom-panic cycle Soon the financial markets will return to normal. That's the current prayer on Wall Street.But what if the August panic isn't abnormal? What if a panic that threatens to shut down buying and selling is instead a part of the normal pattern of the financial markets? The current panic is, by my count, the fourth of the past 10 years. On that evidence it's at least worth considering that "normal" now consists of a recurring pattern of market booms driven by excess global cash that leads to a global mispricing of risk and is punctuated at regular intervals by panics. If a pattern of boom, panic, boom, panic is indeed the new normal, it has profound implications for how we should invest. I'll try to spell out the case for the new normal in this column and how thinking about the market in this way suggests new strategies for your portfolio. But note the similarities below those surface differences:

• Each was rooted in a surplus of global cheap money.
• Each required a massive mispricing of risk.
• And each cycle led the world's central banks, often led by the U.S. Federal Reserve, to limit the fallout from the panic by flooding the market with cash, thus setting up conditions for the next turn in the cycle.

Growth -- real honest-to-goodness growth that comes from good management selling good products into a good market -- will still pay during this period. The ample supply of global capital is a big plus for companies that need to raise cash to grow or that are reinvesting in growth opportunities. And the search for extra return by investors means that companies that can actually deliver growth will be amply rewarded by rising stock prices. There's no reason to ignore growth companies in the developed economies, but the biggest opportunities -- and the hardest to research unfortunately -- will be in the developing world.

How foreigners are buying up our banks The fallout from Western bankers' reckless real-estate investments could usher in an era of 'reverse colonization,' a turning point in the world's financial history. A new wave of loan write-downs by major banks early this week was greeted by a big yawn in the stock market.  Even so, every new revelation from Washington Mutual (WM, news, msgs), UBS AG (UBS, news, msgs) and the gang makes it clearer that top U.S. and European bankers have acted much more like drunken sailors on shore leave than captains of industry over the past few years. It's not too harsh to conclude now, in fact, that bankers essentially threw away their families' life savings on reckless real-estate gambles and that with their shares down 50%-plus and their capital bases in tatters, they're now lying in the proverbial gutter begging for a hand from passers-by. Brother, can you spare a billion? With the Fed and the European Central Bank practicing tough love -- witness the Fed's paltry quarter-point rate cut Tuesday -- the banks are wide open to a blitzkrieg of life-changing investments and buyouts by the only parties in the world that seem to have the guts, foresight and cash to help: sovereign funds in Singapore, China and the emirates of the Persian Gulf. Make no mistake, this is a significant moment in world financial history. Seen from the vantage point of textbooks written 20 years from now, it's possible that we will view this as a time of "reverse colonization," an era in which nations that were once the poor, remote recipients of Western largesse have managed to turn the tables and dictate the terms of global finance.

What the big banks aren't telling you -- yet, Are we headed for an epic bear market?, Big banks about to lower the boom

As Profit Darkness Covers Wall Street, T. Rowe, Legg Mason, Barrow Say Buy Now that analysts on Wall Street are forecasting the worst to come for the securities industry, the biggest money managers are closing their eyes and buying. T. Rowe Price Group Inc. and Legg Mason Inc. spent about $1 billion combined since June to raise their stakes in Goldman Sachs Group Inc., Morgan Stanley, Lehman Brothers Holdings Inc. and Bear Stearns Cos. as earnings fell from the record first half of 2007. Billionaire investor Joseph Lewis paid more than $1 billion to buy Bear Stearns shares, while Dallas-based money manager James Barrow tripled his holding in the fifth-biggest U.S. securities firm. ``This is close enough to the bottom,'' said Barrow, who also owns Merrill, JPMorgan Chase & Co. and Citigroup Inc. ``You may suffer for a while if you buy now, but then within a year, these stocks will outperform the market.'' A recovery in 2008 will depend in part on how much the firms mark down the value of their mortgage-related holdings, Legg Mason's Miller said. By placing the lowest possible value on securities linked to home loans, investment banks will give themselves latitude to raise the values next year if markets improve -- or at least avoid further losses. ``There may be some real good upside but there's also potential for some more downside, so I'd be on the sidelines for a while more,'' said David Dreman, who oversees $20 billion as chairman of Jersey City, New Jersey-based Dreman Value Management LLC. ``We don't fully know the extent of the banks' subprime problems.''

Finance Industry

Credit Crunch Reshapes Banking Cash-rich investors in Asia and the Middle East are taking advantage of the global credit crunch to reshape the banking landscape. For cash-rich investors in Asia and the Middle East, the credit crunch is proving to be a defining moment. The broad pain caused by U.S. subprime mortgages -- as well as demand for capital for day-to-day operations and acquisitions -- is rapidly reshaping the global banking landscape, and these newfound investors are seizing the day. Western banks have taken in capital investments from these sources to the tune of $46 billion this year, with the potential for trillions of dollars more in coming years. Monday, Swiss bank UBS AG, reeling from increasing subprime losses it identified in the past week, said it would sell a 10.8% stake to an investment arm of the Singapore government as well as a Middle Eastern investor that UBS didn't name. The deal is the latest in a spate this year in which state funds or banks in Asia and the Middle East have taken stakes in Western financial firms hobbled by exposure to subprime securities as well as for strategic reasons. UBS joins a growing list of Western banks, including Citigroup Inc., Bear Stearns Cos., Barclays PLC, and HSBC Holdings PLC, that have received capital investments this year.

Beware of more 'hidden' subprime losses Commentary: Report says Washington Mutual, Countrywide most vulnerable.The reality of Generally Accepted Accounting Principles, or GAAP, is that they give companies just enough rope to hang themselves and their investors, if they so please. Much of GAAP is so subjective that you could drive side-by-side snow plows through the gray areas. That is something to keep in mind if, with the latest wave of write-offs, you believe it is time to start bargain hunting among the most beaten-down financial-services companies tied to the mortgage blowup. The time may very well be right, but a recent report by Gradient Analytics warns that financial-reporting practices of some of these companies yesterday and today could still come back to bite investors tomorrow.

Citigroup, Top Securities Firms Have Estimates Cut Citigroup Inc., the biggest U.S. bank, and Wall Street's four largest securities firms had their earnings estimates cut by analysts on concern additional writedowns for fixed-income assets and a slowdown in mergers and acquisitions will hurt profit. JPMorgan Chase & Co. analyst Kenneth Worthington said New York-based Goldman Sachs Group Inc., Morgan Stanley, Merrill Lynch & Co. and Lehman Brothers Holdings Inc. will probably face weak credit markets for the next two to three quarters. The companies fell in New York trading, with Goldman posting the biggest drop of 5.1 percent. Bove Says to `Sell' Lehman, Goldman, Bear Stearns: Video Dec. 7

·         UBS Writes Down $10 Billion, to Sell Stake to Singapore, Mideast Investors

·         More bad news from banks More troubling news erupted from the financial services sector Wednesday as some of the nation's largest banks warned of bigger-than-expected writedowns and admitted that this quarter's results would be disappointing. The news rattled an already jittery sector, which has been hit hard by the credit crisis and recent market turmoil.

Citigroup offloads assets from SIVs  Citigroup has slashed the size of its struggling off-balance-sheet investment funds by more than $15bn in two months through quiet side deals with some junior investors, according to people familiar with the business. The news that the troubled US bank has been finding ways to offload assets from its structured investment vehicles (SIVs) without resorting to fire sales comes as Société Générale on Monday became the latest bank to announce a bail-out for its own $4.3bn vehicle. SocGen’s decision follows similar moves by HSBC, Standard Chartered and Rabobank in the past fortnight. The moves appear likely to reduce the demand for the so-called “super-SIV”, conceived by Citigroup, Bank of America and JPMorgan with the backing of the US Treasury as a buyer of last resort for the industry that would prevent fire sales.

New real-estate funds are shameful The fund industry knew the housing market was a bubble, yet managers have started 37 of these trendy options since the end of 2006. What happened to serving the fund holder? Amid the fallout of the 2000-02 bear market, one of the fund industry's biggest embarrassments was a slew of Internet funds launched just before the bubble burst. Big companies such as Merrill Lynch (MER, news, msgs) and Strong Mutual Funds and small shops such as Amerindo, Turner and Westcott launched funds that soon lost a lot of shareholders' money. Nearly all of those mistakes have been swept under the rug -- that is, merged away or liquidated -- and many fund-company executives vowed never to repeat the debacle. They said they recognized that their greed for assets had blinded them to the need to do what's right for fund holders and that it's just plain wrong to launch a fund that you wouldn't touch. Yet here we are, eight years later, and the fund industry has launched a truckload of real-estate funds on unsuspecting and/or greedy investors. All told, 37 real-estate funds have been launched this year, including those launched on the last day of 2006. The timing of those launches is downright atrocious.

Wall Street doesn't want you After an era of innovation in financial services that benefited the middle class, The Street has abandoned individual investors in favor of big institutions and wealthy private traders. It's time for big changes. Wall Street doesn't care about the individual investor anymore. We're not profitable enough. Look at the billions the financial industry has made in recent years from trading, buying and packaging mortgages and credit cards, financing buyouts and selling ways to reduce risk. That kind of business drove operating income at Goldman Sachs) to $14.6 billion in 2006 from just $3.3 billion in 2002, a 340% increase, and at Merrill Lynch to $10.4 billion in 2006 from $2.3 billion in 2002, a 350% increase. Until they blew up, that is. It's not just that Wall Street's newest inventions -- collateralized debt obligations and asset-backed commercial paper and the like -- are irrelevant to the stuff we care about, like having enough for retirement. Wall Street's actions seem positively dangerous to our goals. It wasn't always this way. For 20 years, beginning in 1975, Wall Street produced a wave of innovation for middle-class investors that brought more and more people into the financial markets. The revolution began in 1975 with the invention of cash-management accounts at Merrill Lynch. From our position in time, it's hard to remember that there once was a day when all we had were savings and checking accounts, and that the two were so rigidly separated that you couldn't write a check from an account that paid interest

Financial Companies

UBS's Subprime Hit Deepens Credit Worries UBS AG became one of the biggest casualties of the U.S. subprime-mortgage meltdown yesterday, announcing that it would take a $10 billion write-down and sell a chunk of itself to the government investment arm of Singapore and an unnamed Middle Eastern investor. The disclosures stoked anxiety about potential losses lurking on the books of other banks. That UBS, long known as a conservative lender, could take such a financial hit suggests that the wave of industry write-downs, which so far total about $50 billion, may be far from over. In recent weeks, UBS began using a more conservative method for valuing complex debt securities tied to U.S. subprime mortgages. As a result, the bank said it might record a net loss for the year. The "ultimate value of our subprime holdings...remains unknowable," the bank said yesterday. Earlier this fall, as banks disclosed a first round of write-downs due to subprime problems, some investors expressed optimism that the worst was over -- that banks had used the third quarter as an opportunity to clean up their balance sheets. But the continuing erosion of the value of the mortgage securities now appears to be bringing another round of pain.

• Expect More Like UBS When UBS announced a $3.4 billion loss related to subprime mortgages in October, investors believed the Swiss bank had thrown in everything and the kitchen sink. It turned out to be only the first phase of the remodeling. Other banks almost certainly are going to be cooking up similarly bad news.

• Wachovia May Double to $1 Billion Quarterly Provision for Mortgage Losses

• Banks Sound Grim Notes Bank of America said it expects a fourth-quarter provision expense of $3.3 billion, forecast larger write-downs on CDOs and said its fourth quarter will be profitable but "disappointing." Wachovia also warned of more market-related losses. Bank of America to Write Down CDOs' Value by About $3 Billion

(WSJ) Citi Search Ends With Pandit, Bischoff  Pandit, Bischoff Enter Spotlight To Repair Citi In naming Mr. Pandit and Sir Win as chief executive officer and chairman, respectively, the bank's board yesterday tapped two insiders with relatively short Citigroup tenures who came aboard as the result of previous acquisitions. Mr. Pandit said he will immediately begin reviewing the bank's operations. "They are different businesses, and they need different strategies," he said in an interview. A former Morgan Stanley executive who ran its institutional-securities division, Mr. Pandit most recently has overseen Citigroup's investment-bank and alternative-investments operations. Indeed, investors have been clamoring for dramatic action, with many calling for a break-up of the company, whose stock has plunged about 40% this year. Citigroup was down 4.4% to $33.23 at 4 p.m. yesterday in New York Stock Exchange composite trading. A person familiar with the matter said that Messrs. Pandit, 50 years old, and Bischoff, 66, already are considering an overhaul that includes intensive cost cutting and job cuts. Other management shuffles may also be on the way. The bigger issue, however, is whether they believe the sprawling financial conglomerate should remain one company or -- as some investors and analysts believe -- be dismantled. Citigroup's Pandit Vows `Front-to-Back' Cost Overhaul , Pandit on Citi risk management (video), Levitt Says `Demoralized' Citigroup to Rally With Pandit:(Video)

• Weill Says Pandit May Have to Revise Citigroup's Strategy, Eliminate Jobs Sanford ``Sandy'' Weill, who spent 17 years merging banks, brokers and insurers to make Citigroup Inc. the largest U.S. financial company, said new chief executive officer Vikram Pandit may have to reverse that strategy. Weill, who retired as CEO in October 2003, said he consulted with Citigroup's board on Prince's replacement and thinks Pandit was a good selection to lead the company as it cuts jobs and decides whether businesses need to be sold or closed. The company will probably report its first quarterly loss in 16 years, after warning of as much as $11 billion of fourth-quarter writedowns on subprime mortgage investments. Weill didn't say whether he thinks a breakup would be good for shareholders, though he said Citigroup can't avoid cutting jobs to reclaim the ``efficiency'' it had when he was in charge. Citigroup's staff has grown ``dramatically'' and ``there's room'' to eliminate positions, Weill said. Citigroup had 327,000 employees worldwide at the end of last year, up from 253,000 in 2003, according to regulatory filings.

WaMu warns of loss, slashes jobs More fallout from the nation's housing crisis emerged late Monday as Washington Mutual said it would take a loss in the current quarter, slash its dividend and lay off more than 3,000 workers. Shares of the Seattle-based Washington Mutual (Charts, Fortune 500) tumbled more than 7 percent in after-hours trading. Making the announcement just after Monday's closing bell, the nation's largest thrift said its board of directors would cut its quarterly dividend, a move that have long been speculated by analysts, to 15 cents a shares from 56 cents a share. The company said the moves should provide the company with a combined $3.7 billion cash infusion. With the housing market showing little sign of improvement, the company also announced a number of changes in its mortgage business, including the elimination of 2,600 mortgage-related jobs and more than 500 corporate and support jobs. WaMu, which has been among the hardest hit by the housing meltdown, also said it would shutter more than half of its home loan centers and mortgage sales offices and that it was discontinue all subprime mortgage lending. Freddie Sees $5.5B-$7.5B More Losses

Posted by dblwyo at 09:43 AM | Permalink | Comments (0)

Part of today's posting plan was to put up an overview of our interpretation of the Fed's strategic outlook and discuss some of the problems they face - and us with them. The prior post was an updated addendum survey of recent policy actions and market assessments of same. While some few are balanced the emphasis is on few. A recent commenter had some nice things to say about our efforts and called our attention to Paul Volcker's historic efforts that broke the back of inflation. That created a benign regime for the last 25+ years but is no longer the world we face (cf. this earlier list of readings on the credit market particularly Uncle Alan's survery of the very long term structural changes - a must read to understand how the deep currents are flowing underneath your feet).

UPDATE: my favorite financial columnist Mr. JJ has some interesting things to say about LIBOR and freezing debt markets. If you'd like a little background more lightheartedly than myself start with that :) ! Seriously does put the core problem clearly and simply - it's inside baseball as he says.

To understand, as best we might, how those currents will flow and what the Fed is, IMHO, trying to do about it we need to understand a bit about how they see world and the problems they face. However, let me admit a major sense of amusement (a bit of black humor here) that everyone's been screaming at the Fed for months about "inflation ex-inflation" but now that the credit crisis is here big time that's back burnered in favor of screaming at them to cut rates, cut rates and cut rates. Amusing for beyond the obvious reasons too - the world is changing and the screamers haven't grasped that yet. Equally amusing was the screaming to raise rates more rapidly 2-3 years ago to prevent a bubble in housing assets & prices - which in the new world meant longer-term interest rates that were in fact held down by the new structural factor of a world awash in liquidity, credit & leverage; about which the Fed could do little. And ignores the fact that calls for rate increses in '03/'04 would have been in the midst of the start of the Iraq war ! Again the grasp on reality and deep structures is truly astounding here. We MUST understand these deeper structues and currents and how the Fed sees them (much better than the commentariat btw) to understand how the world is moving and how to navigate it. Which is our goal here.

Below the line we'll dive into this in some more detail with charts and pictures and everything and start with a quick summary of the points we'd like to make:

1. The traditional tradeoff for Central Bank/Fed policy is to weigh the evidence and find an appropriate balance between economic risks and inflation/currency risks. They've done a pretty good job but:

• the business cycle is the business cycle - they can't get too far above or below but simply try to manage as best they can around it. The economy is slowing on a worldwide basis (recent admission on many parts though visible to us domestically since early this year)
• inflation threatens to grow, get embedded and accelerate unless carefully managed because, for the first time post-WW2 we're facing a worldwide supply/demand imbalance in foundational goods due to the emergence and rapid growth of the BRICs. 

 2. The traditional tradeoff is NOT the major policy problem right now. The other major responsiblity of a Central Bank is to maintain orderly markets - or in peoplespeak to keep markets from screwing up and taking our livlihoods and lifes with them when they blow up. Right now THE major problem is the consequences of perverse incentives of structured debt finance and too much leverage which are periodically freezing the debt markets [again please see the earlier posts on the nature of the credit problems here and here].

• Traditional policy and tools aren't appropriate to address these problems. What's required is some technical mechanics to inject money into the banking system and free up the frozen gears of the credit markets. The last 24 hours have seen a wealth of announcements to do just that and it shor warn't on the spur of the moment nor war it without some real tool bldn, gosh darn it. In other words they've bloody well been thinking about this for some time and drawing on institutional memory and toolkits streching back decades.
• If you think you've got a better idea speak up because that whooshing sound you hear are the wings of the Angel of Death and all his minions (figuratively speaking of course).

3. While we've all been adgitating about this and that Dr. Ben and the crew have been wrestling with real problem in the real world with the available real data - which isn't so good. It's easier to be clever and profound ex-post than ex-ante and this is in "The Heat" as my milspec buds like to put it. These guys are playing Big Casino with enormous table stakes under near real-time pressures and dancing with about as much style and grace as anyone.

The last two times the US was edging into this sort of thing the years were 1907 and 1929 and it was "make-it-up-as-you-go" by amateurs following badly flawed mental models. In fact just as a historical sidebar you'll get a certain perspective reading Keynes' "Essays in Persuasion", one of which retales his very unsuccessful efforts to persuade Churchill (Chancelor of the Exchequer then) to NOT return to the gold standard just because common wisdome about sound money said to. The result was a depression for Great Britain prior the Great on. Be very thankful for what we've got, considering history, very thankful indeed.

• These guys either don't know what's going on or they've really got some big brass cojones. Let's all hope it's the latter 'cause this is going to go on a while and they seem to be in a minority who get it.
  

First to understand the strategic context that the Fed sees we need to understand how they view the outlook for growth, unemployment and inflation. Well, they've been increasingly transparent about all that but with the last meeting minutes containing their outlook thru 2010 transparent isn't the word. In fact their outlook is consistent with my own much short-term analysis and beyond my capabilities. Other issues aside we ought to be looking at this as one of, if not THE, best longer-term outlooks and using it to plan our assessments of growth, profits and earnings. Sigh...fat chance, right ? Anyway the Fed sees a relatively benign environment of slow growth (below potential), a pickup in inflation that's then dampened by that slow growth and slowly eases back to the target area. Along with an unemployment rate that worsens a bit but not severely. If the recession accelerates into existence because of a sudden slowing of consumer spending (a major risk and with a moderate/high outlook) or spillover from the credit crisis (an even more serious risk but with a low/moderate outlook if they can manage it) then all bets are off. Meanwhile THIS IS the picture of the world they're using and taking a fairly courageous stand to try and cut off inflation, protect against a downturn as best they can and still address credit problems. It's the picture you need to keep in mind - agree or not - when juding their actions.

Next are the credit problems, best captured in the spreads between risk-free short-term instruments and inter-bank lending rates. Now here's the thing that gripes me - for years and years all we had to do was pay attention to Tresuries, the yield curve and the spreads 'cause otherwise this was all divinely defined machinery that never changed. Well, nevermore quoth the Raven. All that machinery has gone bust big time. When I say the Fed's between a rock (growth) and a hard place (inflation) that's point one - and bear in mind the regime change that makes it more difficult than it's been in 25+ years. When I say there's a tsuanmi sweeping down the gulch we're trapped in this is the problem. So how do we keep our heads above water or do we bend over and making smaking noises under-water ? The chart at the left catches the spread problem (the earlier post More on the Credit Crisis: the Rocks in the Pond "Model" has an even better one that's worth reviewing because of the timeline).

So third is what straw to breath thru are we being offerred ? What the Fed's doing, to the best of my understanding is adapting some pre-existing tools in concert with the rest of the Central Banks, to inject funds and aim them directly the center of the fire. In other words instead of lowering the Fed or Fed funds rate it's created a much more selectively mechanisms that will put funds more closely on target instead of spraying the whole area. If you'd like a comparison it's the difference between WW2 carpet bombing and fire-storm setting and today's highly targeted smart bomb technology. The first may damage the enemy but the collateral damage is pretty extensive. The latter can get down to a 200' radius of destruction. Which is all to the good because, remember the tradeoff problem, the space between the rock and the hard place is darn narrow.

That, in a (my) nutshell is the three-corned policy dilemma and what the Fed is doing to resolve it. We don't know if it's going to work and it IS going to take a long while to work out. We're going to be sweating this for a long time. If you believe that and the prior analysis of the scope and magnitude of the credit problems a couple of final observations to think about:

1. You'd better hope they get it right.

2. Now doesn't strike me as time to be buying back into Financials. 

Posted by dblwyo at 02:32 PM | Permalink | Comments (2)

Well the flow of news in the last 24 hours is significant - one is tempted to say astounding. After a "disappointing" 1/4-pt cut in the Fed and Fed Funds rates the Fed yesterday announced a whole slew of policy initiatives designed to attack the freeze in the credit markets, especially the short-term and bank lending markets, directly.Make no mistake about it,

this is not only a serious problem in its' own right but thru freezing up the credit markets threatens to trigger a major economic downturn, potentially on a worldwide basis.

The Fed's announcement of upto $40B of short-term lending using these new, or newly applied, policy tools and the massive worldwide coordination efforts (not seen since the 911 crisis) are measures of how seriously they are taking this. Today's WSJ has a great summary article - if you've no subscription we've excerpted key portions below but get a copy however you can. And to add some spice to the sauce check out David Wessel's brief video commentary at right. In fact start there. Meanwhile the WSJ excerpts are below coupled with more readings below the line extending yesterday's post of readings and resources.

(WSJ) Fed Tries to Free Up Credit  The Fed said it will provide banks up to $40 billion in the next eight days as part of a coordinated effort with four other central banks aimed at reviving lending.

In the biggest coordinated show of international financial force since Sept. 11, 2001, the Federal Reserve yesterday joined four other central banks in a plan aimed at coaxing banks to lend more readily at a time when fear has seized up world credit markets. Just a day after it cut its key rate for the third time this year, the Fed introduced a new tactic, saying it will extend up to $40 billion in special loans in the next eight days to banks. To stoke banks' appetite to borrow and lend, the loans will carry less interest than Fed loans to banks usually do, and still can be backed by a wide range of collateral -- including the high-risk home mortgages at the heart of the current financial crisis. The action was the latest in a series of attempts by the Fed and other financial authorities to stem the credit crunch that has resulted from the U.S. housing meltdown. None of those have thawed out the credit markets yet, however, and it isn't clear whether the latest salvo will be any more effective. The European Central Bank and the British, Swiss and Canadian central banks simultaneously announced new or expanded operations to prime their nations' banks with additional cash. The Japanese and Swedes chimed in with rhetorical support. The Fed also agreed to provide U.S. dollars to the ECB and the Swiss central bank that can be supplied to their dollar-hungry lenders. The Fed last took such a step in the days after al Qaeda's 2001 terrorist strike on America.The Fed has faced two intertwined challenges since the financial crisis hit in August. One has been to cut rates enough to cushion the economy from a collapsing housing bubble, without igniting inflation. The other has been to overcome the credit crunch that stems from the housing woes -- and has muffled the impact of the rate cuts. So far, the medicine isn't working. The rates banks offer to consumers and each other have stayed stubbornly high. The Fed tried to encourage financial institutions to borrow from its "discount window" but there were few takers. Separately, the Bush administration has prodded big banks to create a new entity to buy some mortgage-linked securities that aren't selling, and has pressed for mortgage-servicers to freeze interest payments on perhaps hundreds of thousands of homeowners whose mortgage payments are set to rise.

Many analysts were more sanguine than the market about the Fed's latest move, but emphasized the increasingly big challenge the Fed still has in making market rates respond effectively to its moves. "The Fed is feeling its way in the dark here," said Ian Shepherdson, chief U.S. economist of High Frequency Economics, a Valhalla, N.Y.-based research firm. "Current conditions are unprecedented in modern times. We think these measures are a step in the right direction, but there is simply no way to know for sure how effective they will be." The markets' muted response reflects a painful reality: The steps the Fed has taken since August haven't made a substantial difference in restoring confidence. It is now clear that a lack of cheap funding is only one reason banks and investors are so reluctant to lend. Financial institutions remain suspicious of each other after multiple rounds of announcements of mortgage-linked losses, and are anticipating more. They also are eager to hold onto cash to shore up their troubled balance sheets.

Fed's Credit Plan Favors Calming Markets Over Spurring Economic Expansion The Federal Reserve's coordinated response to the global credit crisis is aimed more at easing strains in financial markets than at averting an economic slump. The Fed, along with central banks in Europe, pledged yesterday to offer as much as $64 billion to financial institutions. The joint action is designed to break a logjam in money markets that pushed up borrowing costs for lenders worldwide. Fed officials told reporters that they view yesterday's intervention as distinct from their interest-rate policy, which they anticipate will promote ``moderate'' growth next year. By attempting to keep the two tracks separate, economists said, policy makers are gambling that they will be able to avert a recession that would force them into deeper rate cuts than would otherwise be the case.

·         Fed Splits With Markets Over Recession Prospects, Seeing Continued Growth Federal Reserve officials still expect the economy to grow and are reluctant to deliver the deeper interest-rate reductions demanded by some economists and investors.

Fed, ECB, Central Banks Join to Add Cash, Ease `Elevated' Funding Pressure The Federal Reserve, European Central Bank and three other central banks moved in concert to alleviate a credit squeeze threatening global growth, in the biggest act of international economic cooperation since the Sept. 11 terrorist attacks. The Federal Reserve, European Central Bank and three other central banks moved in concert to alleviate a credit squeeze threatening global growth, in the biggest act of international economic cooperation since the Sept. 11 terrorist attacks. The Fed said in a statement it will make up to $24 billion available to the ECB and Swiss National Bank to increase the supply of dollars in Europe. The Fed also plans four auctions, including two this month that will add as much as $40 billion, to increase cash in the U.S. Central bankers took the action after interest-rate reductions in the U.S., U.K. and Canada failed to allay concerns that banks will reduce lending, which may send the U.S. into recession and hobble growth abroad. Borrowing costs have climbed as mounting losses on securities linked to subprime mortgages caused lenders to conserve cash. A Fed official told reporters that the U.S. central bank's efforts won't add net liquidity to the banking system. The plans are aimed at buttressing so-called term funding markets, such as for one-month loans, rather than overnight cash. The Fed will balance its various operations, including daily repurchases of Treasury notes and direct loans to banks.

• Fed, ECB, Central Banks Join to Add Cash, Ease `Elevated' Funding Pressure The Federal Reserve, European Central Bank and three other central banks moved in concert to alleviate a credit squeeze threatening global growth, in the biggest act of international economic cooperation since the Sept. 11 terrorist attacks.
• Everything You Want to Know About Today’s Fed Move But Didn’t Know Who to Ask

Why the Fed bailout might not work  The plan to make credit markets more liquid could end up having the opposite effect, Fortune's Peter Eavis reports. The Federal Reserve's latest move to make credit markets more liquid could deepen problems in the banking system and actually cause the markets to be even more illiquid. Wednesday, the Fed, along with other central banks, announced a plan that is designed to enable banks to borrow money directly from the Fed at below-market rates. This will allow a wider range of banks to access Fed credit, and simultaneously allow them to submit a broader range of collateral to the Fed when taking out those loans. Why do this now? The Fed explained in a release Wednesday: "This facility could help promote the efficient dissemination of liquidity when the unsecured interbank markets are under stress." In layman's terms this means that rates on loans between banks - measured by something called the London Interbank Offered Rate, or Libor - are too high for the Fed's tastes, so it is now prepared to itself lend to banks at much lower rates. What could go wrong with such an approach? Surely, it makes sense for banks to be lending to each other at lower rates, since that can spark more lending across the whole financial system. But Libor is a market rate, ultimately reflecting banks' views on each other's creditworthiness. Indeed, at 5.06% before news of the TAF was released by the Fed, Libor was considerably higher than the Fed funds rate, reflecting banks' caution about each other. But maybe the widened spread between Libor and the Fed funds rate is an inescapable product of the times. Given the credit problems U.S. banks are facing, they are naturally wary of each other. Maybe the Fed thinks banks are being overcautious, so the TAF is its way of bypassing what it sees as unwarranted skittishness. But it makes more sense to believe the banks' view of each other than the Fed's.

·         Euro Lending Rate Stays at Seven-Year High After Banks Try to End Gridlock Interest rates on loans in euros stayed at a seven-year high, a day after central banks in Europe and North America teamed up in an attempt to end gridlock in money markets. Three-month borrowing costs held at 4.95 percent, the British Bankers' Association said today. That's 95 basis points, or 0.95 percentage point, more than the European Central Bank's benchmark interest rate, compared with 57 basis points a month ago. It averaged 25 basis points in the first half of the year, before U.S. subprime-mortgage losses contaminated money markets. Rates at their highest since December 2000 suggest the first coordinated central bank action since the Sept. 11, 2001, terrorist attacks isn't enough to revive interbank lending. The cost of borrowing dollars fell 7 basis points to 4.99 percent today, still close to the highest compared with the Federal Reserve's target rate since 1999.

Posted by dblwyo at 11:20 AM | Permalink | Comments (2)

O.K. it's time to answer the question - while waxing eloquent about the credit crisis somebody asked the classic one - "what other asset classes ?". What I think they really meant was what in the bleep are you talking about. Well at the time a quick and dirty reply was ripped off that turned into a longish, well alright maybe more than that, comment on the credit crisis.

That comment though was based on a multiple set of accumulated readings plus a little "model" of how the credit crisis is operating that's built up in my head and the occasional chart (previously put up here a couple of months ago ?). So earlier today we reviewed the bidding - to wit some selected readings and resources on the history, structure and nature of the evovling credit problems (here) and a deeper dive on the "rocks in the pond" credit contagtion model (here) which are the background to the reply. 

SUMMARY 

Below the line you'll find our key arguments but let's just do a little summary so we can chat about the implications:

Posted by dblwyo at 07:15 PM | Permalink | Comments (2)

A while back we built a simple little picture of how the credit problems in sub-prime were rippling across the various links of leveraged/structured debt instruments. And how those ripples were spreading to linked cross-markets, e.g. commercial paper, and how other debt instruments were likely to be subject to the same risks of structural breakdowns. The chart at right (which we just re-linked the jpg too [Th:2100]) shows the small rock thrown in the sub-prime corner of the pool and - at least conceptually - the ripples away from. The notion being that as Housing values value and/or ARMs reset more rocks will topple and some pretty big boulders are lined up.

THE question is what's the line up of rocks and boulders in the other asset classes ? And will the ripples from mortgages spread and topple more of them ?

Some correspondents said "what other asset classes" but really meant what are you talking about ? For some reason that triggered off a long response compressing our best understanding into a longish note. But before we post that response it turns out to make sense to build up a slightly better picture of the rocks & pond(s) credit contagion model (somwhere in there is an acronym and I'll even bet that with a little cleverness we could get to PUKE or something else perjoratively appropriate - suggestions welcome). Meanwhile let us share some of the diagrams that "inspired" our own terrible and non-analytical chart work.

And oh, yeah and BTW - the two prior posts have a recent collection of readings on the Credit Crisis and the Fed's strategic outlook but are just the tip of the iceberg since we've been collecting this stuff for a couple of years now. If you think our apprehensions were building up exponentially to match the curve of articles you're right :) ! 

Below the line you'll find various chart collections that have led us down this thought process and are worth reviewing. Given the range of sample we don't point to the source in all cases but you'll find a bunch of them in the prior postings suggested readings. In any case the bottomlines here are that a) we didn't make this stuff up and b) a bunch of folks who're a lot smarter and more knowledgeable did. All we're trying to do is compress it into one central organizing framework to try and put a filter on all the chaotic data flowing over us (think of it like a whale's plankton screening filters :) ).

Let's start with the basic construction of a collateralized debt instrument, for which we've all likely seen a large number of pictures. We'd also like to note that, to the best of our understanding the basic construction processes, math models and statistical analysis are applied to other asset classes besides mortgages, e.g. buyout loans, etc. And broadly speaking the whole apparatus of speculative debt modeling that we got rudely introduced to during the Asian crisis of the late 90s applies here. So when we walk thru the CDO chart just substitue, say, a business and voila' there's another whole structured debt market.

Now the next little stream of thought that occurred to us once the "build a leveraged debt instrument" picture was a tad clearer was the one Bill Gross introduced us to in his essay "Ten Little Assets". As you can see from his picture his list of candidate assets that are going to go thru a de-leveraging workout is a tad different from the one we used to build our pond picture. We focused on ones that have experienced recent troubles and that are related so we could point to those readings. But here's an interesting thought - what if Gross is entirely correct and all these other classes will be subject to some similar pressures ? And if the only thing different will be some of the structural characterisitcs and timing ? In other words you could make our "pond" much....much bigger. Or build a bunch more ponds. Scary ain't it. Obviously for Bill's assessment it'd pay to read his column.

The next question is where do the ripples and waves come from - that is what rocks are being thrown in what ponds and how are the ripples spreading around. Well a great article by Greg Ip in the WSJ put up some wonderful charts we are pleased to reproduce here that pretty well walk you thru. What you see is the historical breakdown in housing investment spending relative to normal housing patterns as measured by the spread over many years between buying vs renting costs. If you think that chart looks a lot like the stock market bubble charts we'd sure tend to agree with you. As it's gotten increasingly difficult for folks to pay back the mortgages or maintain their payments what you've seen is an increasing spread between low-risk, high-quality debt instruments and riskier ones. When Uncle Alan and others talke about risk premia being arbitraged away there talking about this phenomenon - which is now in the process of reverseing. In particular if you look at the accelerating spread between various classes of commercial paper you get that ripple. And if you look at the terrible drop in the indices for credit instruments based on various tranches (splits) of mortgage-debt related instruments the Ebola-like character of the contagion is perhaps a little clearer.

The final spike in the coffin (and the reason that Jan Hartzius of Goldman-Saches has cogentely - and correctly IMHO - argued that a $150B+ credit problem results in a $1T or more of credit shortfall) is that these various debt instrument breakdowns were heavily built of borrowed money, that's Leverage my friends and there's gonna be trouble here in River City.

The bundling process is shown in the first sub-chart while the second shows the de-leveraging process. That is what happens when the value of the underlying asset, whether it's houses, mortgages, or CDO derivatives, is reduced/impaired and the instrument owner has to start selling off lower-rated chunks to pay off the higher-rated. This is the thing that scares the Bejesus out of the banks because the "margin" calls on their debt instruments/SIVs meant they'd have to be spending real money, of their own, and taking the writedowns back on their own balances sheets. Can you spell capital impairment ?

The final sub-chart shows how borrowed funds were used to build up the so-called assets of these instruments as they were crafted and how leverage was built up from, say, 3X to 30X. I've even heard some knowledgeable insiders mention 70X...whew. When that engine starts running in reverse the original real equity/asset gets written down to zero pretty rapidly.

By the way - one of the sadder things about this other than being a poster child for out-of-control greed and cleverness exceeding wisdome (as when doesn't it) is that these problems were first being seriously investigated, judging from my files, beginning in early '05. 

Posted by dblwyo at 01:57 PM | Permalink | Comments (0)

The other aspect of the credit crisis to understand is the Fed. While we don't pretend to speak for them, or even too them :), we do think that most of their actions are readily understood by a) understanding the deeper structure of the environment and trends and b) how they see the world. More on that later but we believe that they've become increasingly transparent and are being entirely rational and logical in their actions, within the limits of the available data, analysis and human insight of course.

The critical problem is not that the Fed is facing the classic tradeoff between inflation and a slowing economy. No - it's much....much worse. They're between the rock of inflation and dollar problems on the one hand the hard place of an increasingly fragile economy.

The real problem, though, is that there is a tsunami of credit market breakdowns due to structural problems in leveraged debt instruments mounting toward them.

And us. Anyway you'll find an appropriate collection of readings and resources below the line here... 

Federal Reserve

Fed's Favored Inflation Measure Says Rates Can't Decline as Traders Expect Any evidence that accelerating inflation is becoming entrenched may heighten the Fed's debate as policy makers consider cutting rates to keep the worst housing market in 16 years and mounting losses in securities related to subprime mortgages from tipping the economy into recession. The gauge used by Sack, dubbed the five-year five-year forward breakeven inflation rate, suggests bets on lower Fed funds rates may be too bold. The fact that the rate stayed steady for much of the past two months as pessimism about the economy grew bolsters that view, said Michael Pond, an interest- rate strategist in New York at Barclays Capital Inc., one of the 20 primary dealers of U.S. government securities that trade with the Fed. A cooling economy typically tempers inflation concerns. While Bernanke has cut interest rates by three-quarters of a percentage point since mid-September, his approach so far has been more calibrated than that of his predecessor, Alan Greenspan, in 2001. Greenspan, 81, cut rates by 1.5 percentage points in the first quarter of 2001 in an ultimately unsuccessful effort to head off a recession. Bernanke's more measured approach may, in part, be born of necessity. As Greenspan himself acknowledged in his book, ``The Age of Turbulence,'' he benefited as Fed chief from the disinflationary forces of globalization and faster productivity growth. Bernanke, who took over in February 2006, hasn't been so fortunate.

·         Bernanke May Have to Risk Becoming `Fool in the Shower' to Avert Recession Federal Reserve Chairman Ben S. Bernanke may have to risk becoming the proverbial ``fool in the shower'' to keep the U.S. economy out of recession. Renewed turbulence in financial markets puts Bernanke, 53, under pressure to open the monetary spigots wider to pump up the economy. Traders in federal funds futures are betting it's a certainty the Fed will cut its benchmark interest rate from 4.5 percent tomorrow, and they see a better-than-even chance the rate will be 3.75 percent or below by April.

·         Fed Splits With Markets Over Recession Prospects, Seeing Continued Growth Federal Reserve officials still expect the economy to grow and are reluctant to deliver the deeper interest-rate reductions demanded by some economists and investors. The Federal Open Market Committee lowered the benchmark rate by a quarter-point yesterday to 4.25 percent, and said cumulative cuts of 1 percentage point this year should promote ``moderate growth.'' Policy makers also dropped their assessment that growth and inflation risks were ``roughly'' equal and cited ``uncertainty'' about the outlook. The move put the central bank, which has struggled to contain the subprime credit collapse, further at odds with investors. The Dow Jones Industrial Average fell the most after a Fed decision since Ben S. Bernanke, 53, became chairman in February 2006 as traders speculated he will fail to avert a recession. Officials haven't ruled out further steps to ease the credit squeeze in financial markets before they meet Jan. 29-30. Officials are actively considering ways to stem a surge in borrowing costs among banks and increase liquidity in markets. Some economists were disappointed the Fed didn't announce a greater cut to the discount rate than the quarter-point that officials delivered yesterday.

(WSJ) Fed Sifts Options As Rate Cut Fails To Cheer Market With a deepening credit crunch threatening to drag the stalled U.S. economy into recession, the Federal Reserve cut interest rates for the third time since August, and left the door open to further cuts. The Fed lowered its target for the federal-funds rate, charged on overnight loans between banks, by a quarter percentage point to 4.25%. It also cut the discount rate, at which it lends directly to banks, by the same amount, to 4.75%. Fed officials, however, continue to consider ways of using various tools -- including the discount rate -- to combat banks' unwillingness to lend even to each other, which they view as a threat to economic growth. The central bank could take action within days. A variety of steps, widely discussed in the markets, are likely to be on the table, including another cut in the discount rate, longer-term loans to money-market dealers, easier collateral rules for loans from the Fed, and other steps last taken in 1999 to alleviate funding pressures ahead of the year 2000, when many feared a "Y2K" computer bug would disrupt markets and create economic havoc. The FOMC's 10 voting members approved the rate cut 9-1. Federal Reserve Bank of Boston President Eric Rosengren dissented in favor of a sharper, half-point cut. One FOMC member also dissented in October, but in favor of no rate cut. The shift in the dissents, from wanting less rate cutting to wanting more, shows the turn toward pessimism at the Fed. Unlike the previous two rate cuts, yesterday's wasn't portrayed as "insurance" against improbable but potentially damaging economic scenarios. That suggests Fed officials view the economy as weaker than they expected as recently as late October.

·         More Fed moves expected U.S. central bank is working on steps, which could come in days, to help banks lend more easily to each other, two papers report.

Posted by dblwyo at 01:16 PM | Permalink | Comments (0)

Whee, are we having fun yet ? How do we manage to have everybody and his brother talking about a 1/4 point rate cut and then have the markets drop almost 3% in a couple of hours ? So much for prescient markets doing look aheads. And then come back almost 1/2- way to the previous high ? And then loose 1/2 of that in the first half of today ? Clearly everygody and all their relatives, friends, and acquaintences was expecting 50 bps and a stronger statement.

Which really means that the markets don't have a clue, that the full extent of the credit crisis isn't well understood and we've got a long way to go and this may not only be the tip of the iceberg. It may be the first of a fleet of icebergs. It also means that Mr. Market and all his little minions really hasn't a clue as to what's going on.

Not sure I do either but, pardon the small taste of hubris, our feeling is a little schadenfreudish and also reflecting a small bit of our prescience in a couple of prior posts. The recent on that summarized the Economic and Market conditions and made the argument that we're enterring a new sentiment regime (for which the last couple of days seem to be ample proof): WRFest 9Dec07: the Dance Goes On, or the Emerging Cusppoint Shift. 

And a much earlier one on the "rocks in a pond" where this crisis isn't likely to be restricted to just mortgage related debt instruments. However there's so much going on that before diving into some specific thoughts & analysis we thought we'd try and provide a backlog of readings that those will be based on and which might be helpful to put into your library.

Those links and pointers are below the line but the one that provides an excellent historical summary of the long-term structural trends that underping the present crisis is Alan Greenspan's from the WSJ. BtW - it's so good that we've put the entire thing up as a PDF file for your enjoyment.

Credit Markets

The Roots of the Mortgage_Crisis  On Aug. 9, 2007, and the days immediately following, financial markets in much of the world seized up. Virtually overnight the seemingly insatiable desire for financial risk came to an abrupt halt as the price of risk unexpectedly surged. Interest rates on a wide range of asset classes, especially interbank lending, asset-backed commercial paper and junk bonds, rose sharply relative to riskless U.S. Treasury securities. Over the past five years, risk had become increasingly underpriced as market euphoria, fostered by an unprecedented global growth rate, gained cumulative traction. The crisis was thus an accident waiting to happen. If it had not been triggered by the mispricing of securitized subprime mortgages, it would have been produced by eruptions in some other market. As I have noted elsewhere, history has not dealt kindly with protracted periods of low risk premiums. Although central banks appear to have lost control of longer term interest rates, they continue to be dominant in the markets for assets with shorter maturities, where money and near monies are created. Thus central banks retain their ability to contain pressures on the prices of goods and services, that is, on the conventional measures of inflation. The current credit crisis will come to an end when the overhang of inventories of newly built homes is largely liquidated, and home price deflation comes to an end. That will stabilize the now-uncertain value of the home equity that acts as a buffer for all home mortgages, but most importantly for those held as collateral for residential mortgage-backed securities. Very large losses will, no doubt, be taken as a consequence of the crisis. But after a period of protracted adjustment, the U.S. economy, and the world economy more generally, will be able to get back to business.

Greenspan's entire editorial is HERE. It's very short, well-written, compresses a lot into little space and largely accurate IMHO. Close as a must read as anything there is right now. 

Money-Market Strain May Be Slow to Fade Strains in money markets may be slow to fade and some emerging-market assets may face stiffer headwinds, the Bank for International Settlements warned in its quarterly report. The report, released yesterday, said that money-market concerns "were particularly acute with respect to the expected liquidity situation around the turn of the year -- a period when liquidity demand normally tends to be heightened and markets particularly vulnerable to illiquidity." The Switzerland-based organization warned that spreads between key short-term interest rates are "consistent with investors anticipating tensions to remain high in money markets for an extended period of time." It also warned that while emerging-markets stocks have been robust over recent months that may not continue. Money markets were hit hard in August as the subprime-mortgage market fallout spilled over into a credit crunch that affected a broad swath of financial markets. Rising short-term borrowing rates and the evaporation of liquidity forced central banks to act to alleviate the strains.

Loan Mess Rivals S&L Meltdown The U.S. mortgage crisis looks manageable compared with the savings-and-loan crisis of the 1980s, but its economic toll could linger for years. The home has long been the bedrock asset of most American families. Now, its value has become the biggest question mark hanging over the global economy and financial system. Over the past decade, Wall Street built a market for more than $2 trillion in securities sold globally and backed by loans to U.S. homeowners on two long-accepted beliefs and one newer one. The prevailing logic: The value of the American home would never fall nationwide, and people would almost always make their mortgage payments. The more recent twist: Packaging mortgage loans and turning them into securities would make the global economy more resilient if anything went wrong. In a matter of months, though, much of the promise of the new financial architecture -- together with its underlying assumptions -- has proven to be a mirage. As house prices fall and homeowners default on mortgages at troubling rates, the pain has spread far and wide. An examination of the resulting crisis shows that it is comparable to some of the biggest financial disasters of the past half-century. So far, the potential losses look manageable compared with the savings-and-loan crisis of the 1980s and the tech-stock crash of 2000-02. But the housing debacle could yet take years to work out, thanks to the sheer complexity of it. Until the mess is cleaned up, investors will remain jittery and banks will likely hold back on all kinds of lending -- a credit crunch that is already damping global growth and could tip the U.S. economy into recession. The new financial system -- shifting risk from banks to securities markets -- has worked "pretty well" up until now, says former Federal Reserve Chairman Paul Volcker. "We're going to find out if it works well for a major-league crisis." Veteran financiers see in the current episode a pattern consistent with classic financial manias: Investors' enthusiasm for an asset -- in this case U.S. houses -- drove up prices, attracted more capital and lifted prices to levels that preordained a fall. Home prices rose sharply elsewhere, too, including in the United Kingdom, parts of continental Europe and Australia. "Old fogies like me expected the bust to come earlier than it did," says George Soros, the 77-year-old chairman of Soros Fund Management. "A lot of us got tired waiting for it."  Charts: Genesis of a Crisis

• Interview Excerpts: Volcker, Soros Weigh In

UBS's Subprime Hit Deepens Credit Worries UBS AG became one of the biggest casualties of the U.S. subprime-mortgage meltdown yesterday, announcing that it would take a $10 billion write-down and sell a chunk of itself to the government investment arm of Singapore and an unnamed Middle Eastern investor. The disclosures stoked anxiety about potential losses lurking on the books of other banks. That UBS, long known as a conservative lender, could take such a financial hit suggests that the wave of industry write-downs, which so far total about $50 billion, may be far from over. In recent weeks, UBS began using a more conservative method for valuing complex debt securities tied to U.S. subprime mortgages. As a result, the bank said it might record a net loss for the year. The "ultimate value of our subprime holdings...remains unknowable," the bank said yesterday. Earlier this fall, as banks disclosed a first round of write-downs due to subprime problems, some investors expressed optimism that the worst was over -- that banks had used the third quarter as an opportunity to clean up their balance sheets. But the continuing erosion of the value of the mortgage securities now appears to be bringing another round of pain.

·         Expect More Like UBS When UBS announced a $3.4 billion loss related to subprime mortgages in October, investors believed the Swiss bank had thrown in everything and the kitchen sink. It turned out to be only the first phase of the remodeling. Other banks almost certainly are going to be cooking up similarly bad news.

·         Wachovia May Double to $1 Billion Quarterly Provision for Mortgage Losses

• Banks Sound Grim Notes  Bank of America said it expects a fourth-quarter provision expense of $3.3 billion, forecast larger write-downs on CDOs and said its fourth quarter will be profitable but "disappointing." Wachovia also warned of more market-related losses. Bank of America to Write Down CDOs' Value by About $3 Billion

Readings & Resources

Bill Fleckstein and others (Nouriel Roubini) have been waving their  arms about the emerging credit crisis and the structural problems entailed for some time now, for nearly a year or more in fact. Meanwhile the smarter banks, et.al. started digging into the risk management problems at the end of last year, e.g. Goldman which convened a major risk assessment and strategic management evaluation at this time last year. Others, such as Wilbur Ross, were re-positioning themselves early as well. Meanwhile Merrill, Citigroup, et.al. were  BUYING into the bubble – after all you gotta keep dancing. Below are a few selected readings that have helped me build up my picture of what’s going on, from some of the folks who’s views I respect because they make sense and have proven right – time after time after time. It may be time to pay more attention to them ! J

Bill Gross of PIMCO has been sounding the appropriate alarms for some time:

• 02/07 Ten Little Assets, 06/07 Looking for Contagion in All the Wrong Places,10/07 Shadow Dancing, 12/07 The Shadow Knows

Similarly Jim Jubak has also been running a string of things to read to get some insights:

• Debt-market bomb could hurt us all  (2/23/07), Drowning in cheap money ( 3/6/2007), Why the debt bubble hasn't burst -- yet (3/23/2007 ), Deepening debt crisis hits close to home (6/29/2007), The threat to your money-market fund (9/14/2007), Fed, Wall Street are playing chicken (11/30/2007)

Another of my favorite columnists who’s also picked up the ball with several power posts that take you even deeper into the crisis is Jon Markman, a colleague of Jubak’s at MSN Money:

• Are we headed for an epic bear market? (9/20/2007), What the big banks aren't telling you -- yet (9/14/2007)
• Homeowner bailout is a lousy idea (12/6/2007),Big rally doesn't mean all is well (11/29/2007),Getting rich off the subprime mess (11/27/2007), For an elite few, credit pain means profit (11/15/2007)

Posted by dblwyo at 12:55 PM | Permalink | Comments (0)

Just to pick up with last week's interesting links on general business and specific companies let's re-grab theme #2 from this "symphony" that we appear to be developing:

 the pressures for crystalline focus on corporate performance will increase exponentially over the next several years; and put a premium on superb execution of good strategies and business models as well as good leadership.

The question then becomes who's doing well, who's not and what are the specific circumstances that will define their environment and their individual outlooks. Below you'll find collections of links to some answers for those questions for the Banking & Finance industries, Homebuilders, Retailers, Airlines, Pharma and Technology as well. We start off though with a look at how the continued problems with short-term interest rates are persisting and how & why it's damaging the outlook for the Finance and Banking industry. Which then raises acute questions of just what is a good Finance firm and how do you build one.

That ripples forward to looking at Homebuilders and in particular a wonderful long-term strategic assessment for their marketspace by our friend CalculatedRisk. His analysis from many priors shows that we have a much bigger bust as the Housing markets adjust back to "normalcy". This startling piece of work lays out the long-term definition of what normalcy might be. You won't like it but you should read it. It'll be good for you.

Another major ripple of credit market problems that hasn't been incorporated into everybody's thinking just yet is the pressure it will put on cash flow and corporate balance sheets. Which is beginning to creep up on various companies but is likely to worsen dramatically next year. Needless to say those companies who didn't re-leverage to do buybacks and maintained their credit capacities and ratings will have an enormous and appreciating competitive advantage. This last point is really important so let me reiterate it -

....those companies who have financial strength are going to be able to beat the crap out of the companies that don't over the next five years or more because of the emerging financial and economic climate. 

Meanwhile retailers are pulling back after decades of over-building, the airlines are reducing their routes and fleets again having failed to find a new and sustainable business model and the Pharmaceutical industry is facing its' biggest challenges since post-WW2 with the failures of it's historic development paradigm, a lack of new approaches and the resulting breakage in strategies, business models and performance. Not to be too harsh on them of course. And to continue another point we've made but is now widely reported on the outlook for Tech spending is slowing fairly rapidly in the US and decreasing worldwide. With all the same competitive pressures about to begin in that industry as well. Which is more problematical because they've really never regained their footing after the post-2000 bust.

Business

Making Sense of Puzzling Short-Rates Credit was supposed to flow easier in December. It hasn't happened yet. Morgan Stanley, Lehman Brothers Holdings, Bear Stearns and Goldman Sachs Group ended their fiscal years Friday. A worry had been hanging over the market recently that these four firms were hoarding cash to make their balance sheets look pristine as the year's end approached. The hoarding, some people surmised, was pushing up rates on the short-term loans banks charge one another. When Monday rolled around, the thinking went, the ice in the credit markets would break up and those lending rates would fall again. The opposite happened. Yesterday, the London interbank offered rate charged by banks on three-month loans to one another, at 5.15%, was above Friday's level and November's beginning level of 4.89%. It might have been wrong to think the Wall Street firms could have anything but an incidental effect on bank lending rates. That gives rise to the somewhat troubling realization that short-term rates are high because banks have broader and more pervasive worries that aren't going to go away overnight. This search for a turning point also suggests the market could be falling into a "things will get better after" mode, as in "things will get better after investment banks close their books" or "things will get better after the Fed meets next week." This sort of thinking could drive credit markets into a version of what economists call a paradox of thrift. It might make sense for an individual lender to wait until conditions get better, but if many lenders start thinking this way, the resulting absence of credit would only make things worse.

Good as Goldman? Financial institutions are notorious for responding to market shocks in a herd. They are driven to this behaviour by complex but flawed risk-management models that assume little interaction between the individual institution and other players in the market. Yet in spite of this impulse to conformity, the risk-management performance of banks in this credit market turmoil is anything but herd-like. What is striking is the sheer variability of outcomes. At one end of the spectrum Goldman Sachs sails sublimely on, churning out ever-improving earnings figures while offsetting losses on its exposure to the subprime market with vast profits on short positions in mortgages. At the other end, Merrill Lynch and Citigroup write off billions and shed their chief executive officers. How is this disparity to be explained? Much of it is down to culture. Until recently, Goldman was a partnership, which is one of the best risk-control mechanisms invented. The culture of partnership, which entails a high degree of mutual surveillance in the common interest, still survives in spite of Goldman’s status as a listed company.

Home Builders and Homeownership Rates

Builder dumps homes in Morgan Stanley deal In another sign of the collapse of the market for new homes, builder Lennar Corp. has dumped a portfolio of 11,000 properties for 40 percent of their previously-stated book value. Lennar (Charts, Fortune 500), the nation's largest builder in terms of revenue, is selling the properties to a joint venture it has established with the real estate arm of Wall Street bank Morgan Stanley (Charts, Fortune 500). Morgan Stanley will own 80 percent of the joint venture, while Lennar will own 20 percent. Lennar announced the deal late Friday as its fiscal fourth quarter came to a close. It is selling the properties for $525 million, even though it said their book value as of Sept. 30 stood at $1.3 billion. Lennar also will receive fees for continuing to manage the properties, which include mix of raw land as well as partially and fully developed homesites.

Investment-Grade Firms Find It Cheaper to Sell Debt Sometimes, skyrocketing risk premiums on corporate debt aren't so daunting. That's the case for highly rated companies, which -- unlike their counterparts with riskier credit profiles -- are finding it is now cheaper to sell new debt in the corporate bond market than before the summer credit crunch. This is occurring even as investment-grade companies have been hit by fears that the subprime mortgage problem will hurt their bottom lines, particularly financial firms that already have been forced to write down billions in mortgage-related exposure. To be sure, such companies have had to offer hefty risk premiums on their debt to entice investors, who are worried about subprime contagion impacting the financial resources of these borrowers. But the Federal Reserve's two rate cuts and accompanying sharp drop in yields on Treasurys have offset the increase in risk premiums.

Corporate Defaults to Quadruple on High-Yield Debt Next Year, Moody's Says Defaults by speculative-grade companies will quadruple next year as the era of ``easy credit'' comes to an end and economic growth slows, Moody's Investors Service said in a report. The global default rate will rise to 4.2 percent by November from 1 percent now, the lowest since 1981, Kenneth Emery, director of corporate default research at Moody's, wrote in the report e-mailed today. His forecast is based on an assumption the U.S. economy slows without falling into recession. In a recession, defaults may approach 10 percent, he said.

Retailers want to stop growing so fast pressed by a slowing economy, retailers are starting to scale back expansion plans, in an attempt to curtail expenses and boost profits at existing locations. Wal-Mart said earlier this year that it will slow square footage growth to 5 percent to 6 percent, down from a historical pace of 9 percent, a move that is expected to improve earnings by lowering projected costs. McDonald's, too, has drastically reduced store openings in recent years to better focus on improving operations at existing restaurants, a decision that has helped to fatten earnings and boost the company's share price. The result has been a glut of stores. Tim Finley, managing director with Alvarez & Marsal, a consulting firm that works with distressed retailers and apparel makers, estimates that the number of stores in this country outweighs the number of shoppers by a ratio of 4-to-1. One sign that retailers may look to slow expansion is a recent dive in returns on invested capital (ROIC), an important metric tracked by Wall Street. Richard Hastings of research firm Bernard Sands said ROIC dipped sharply for many retailers in the third quarter, as sales came in below plan. Target (Charts, Fortune 500) saw a 15 percent drop. At Kohl's (Charts, Fortune 500), ROIC plunged 30 percent in the period. Wal-Mart (Charts, Fortune 500) experienced a similar drop in ROIC for several quarters before it decided to slow expansion.

Airlines Trim Domestic Growth Concerned about high fuel costs and the impact of a slowing economy, several big U.S. airlines are putting the brakes on domestic growth for next year. The moves were disclosed as Delta Air Lines Inc. said it would report a fourth-quarter operating loss because of higher fuel costs, underscoring the threat pricier oil and weak economic growth pose to the industry's continuing recovery. Moves by Delta, Continental Airlines Inc., and Southwest Airlines Co. to pull back on capacity growth next year could help the industry avoid an oversupply of seats, which in turn could enable airlines to more readily raise fares and cope with any travel slowdowns. So far, airlines say U.S. economic worries haven't slowed business travel. Planes are flying fuller than ever. But airlines also have been curbing domestic growth in favor of more lucrative overseas expansion, where they face less competition and have more room to keep fares strong. If a downturn occurs, airlines will be better prepared than in the past, said Continental Airlines Chief Financial Officer Jeff Misner during a Calyon Securities investor conference in New York yesterday. Not only are airlines showing unusual constraint on capacity, but also they have cut costs substantially during the past few years, he said.

Tech spending: Get ready for slowdown Weakness in the U.S. economy figures to take a bite out of the technology industry's growth rate in 2008, when analysts expect tech spending to slow around the world. The picture is not exactly dire: A forecast released Thursday by analyst firm IDC calls for the worldwide information-technology market to grow 5.5 percent to 6 percent in 2008, the lower end of what has become a usual range. In the U.S., the market is expected to expand 3 percent to 4 percent. Those growth rates are softer than this year's 6.9 percent worldwide expansion and 6.6 percent growth in the U.S., according to IDC. Just a few months ago, IDC was expecting the U.S. tech market to grow 5.5 percent in 2008. The company pushed its estimate down to 3 percent to 4 percent as the mortgage crisis heightened and rising high oil prices enhanced the prospect of a recession next year.

Big Pharma Faces Grim Prognosis The pharmaceutical industry will hit a wall in the coming years as dozens of drugs lose patent protection by 2012. Generic competition is expected to wipe $67 billion from top companies' annual U.S. sales. At the same time, the industry's science engine has stalled. Over the next few years, the pharmaceutical business will hit a wall. Some of the top-selling drugs in industry history will become history as patent protections expire, allowing generics to rush in at much-lower prices. Generic competition is expected to wipe $67 billion from top companies' annual U.S. sales between 2007 and 2012 as more than three dozen drugs lose patent protection. That is roughly half of the companies' combined 2007 U.S. sales. At the same time, the industry's science engine has stalled. The century-old approach of finding chemicals to treat diseases is producing fewer and fewer drugs. Especially lacking are new blockbusters to replace old ones like Lipitor, Plavix and Zyprexa. The coming sales decline may signal the end of a once-revered way of doing business. "I think the industry is doomed if we don't change," says Sidney Taurel, chairman of Eli Lilly & Co. Just yesterday, Bristol-Myers Squibb Co. announced plans to cut 10% of its work force, or about 4,300 jobs, and close or sell about half of its 27 manufacturing plants by 2010.  Chart: Drugs Going Off Patent, Why 2008 May Be the Year of the Big Pharma Merger

Companies

Robert Rubin on the job he never wanted An extreme irony in all this is that it is Rubin who could right now use a Rubinesque defender. On Sunday, Nov. 4, the same day Rubin reluctantly moved from the job of chairman of the executive committee to chairman of the board, the company announced the startling news that it had $55 billion of collateralized debt obligations (CDOs) and other subprime-related securities on its balance sheet and that large write-offs of an estimated $8 billion to $11 billion were imminent. Within Citi, many employees - highly aware that Rubin was a risk wizard at both Goldman Sachs (Charts, Fortune 500) and the Treasury - are angry at what he didn't do to avoid both this disaster and earlier write-downs that Citi reported.

Fannie Mae could face $5B loss A look at the bonds it holds, and the extent to which Fannie has marked them down so far, indicates that it may see as much as $5 billion more in write downs. Could Fannie Mae be the next large financial company to announce billions of dollars of market losses on bonds backed by distressed mortgages? The vast majority of Fannie Mae's mortgages are loans to borrowers with good credit, but over the past five years the government sponsored enterprise became exposed to mortgages that were made to people with poor credit -- subprime mortgages -- and to mortgages that were made with incomplete documentation of borrowers' income, called Alt-A mortgages in industry parlance. One way that Fannie increased its exposure to subprime and Alt-A mortgages was to buy bonds backed with these types of loans. While these subprime and Alt-A mortgage-backed bonds are only a small proportion of Fannie's overall mortgage holdings, their combined value of $76 billion is almost double Fannie's $40 billion of capital, which is the net worth of a company and the last cushion against losses. Losses are climbing on these loans as borrowers default, which has caused the market value of bonds backed with such loans to fall sharply. Investors are bidding down the value of mortgage bonds in anticipation that defaults will prevent many of the bondholders from being paid back in full.

Goldman’s glory may prove short-lived Despite the air of infallibility that Goldman Sachs has at the moment, it has been bruised by past Wall Street crises. When a company is doing noticeably better than competitors in its industry there are three possible explanations: skill, luck or edge. Which of these factors explains the success of Goldman Sachs? There has to be a reason why it has carried on undisturbed while other banks have been plunged into problems from the housing slump and the credit squeeze. The answer is: all three.

Chery Drives Shift in China Barely a decade after it was founded, state-owned Chery has emerged as China's largest independent car company -- and one that is determined to compete against the world's auto giants. In this city on the Yangtze River, more than 25,000 blue-uniformed workers are busy churning out cars for Chery Automobile Co. As they motor through double shifts using the latest imported technology, they're also helping to change the dynamics of the global auto industry. Barely a decade after it was founded, state-owned Chery has emerged as China's largest independent vehicle maker -- and one that is determined to compete against the world's automobile giants. The tale of Chery's improbable rise is in large part the story of China's ballooning domestic car market, which has roughly doubled in size since 2004. Its products -- mostly inexpensive cars and SUVs -- are also gaining a following in developing countries hungry for low-cost vehicles. But rapid growth is already taking its toll, as executives strain to manage the company's expansion amid a shortage of experienced workers. In July, the company signed a landmark deal with Chrysler LLC to sell a series of small cars made by Chery under the American auto maker's Dodge brand. Chrysler has said it plans to start selling the cars in Latin America and other developing markets next year and aims to have them on the market in the U.S. and Western Europe by 2009. The pact marks the first time that one of Detroit's Big Three has outsourced the production of entire vehicles to a Chinese company. The deal also sends a warning to high-cost workers in the U.S. and Europe that even more of their jobs could be at risk.

Calpine Shareholders May Be Wiped Out by Creditors When Judge Sets Value A federal judge may award nothing to shareholders of Calpine Corp., including the California Public Employees' Retirement System, in their struggle with Hess Corp. and other creditors who are owed at least $20.7 billion. U.S. Bankruptcy Judge Burton Lifland in New York will decide on the winners when he determines the value of the reorganized company before it emerges from bankruptcy in January. Calpine will pay its debts with shares, based on the decision, ignoring whatever price the market puts on the equity later. If Lifland is wrong, there will be no way to take stock from one group and give it to the other. Lifland's decision after a trial this month will make the difference between equity holders' being wiped out or receiving as much as $11.46 apiece for their 482.2 million existing shares, a $5.3 billion difference. The shares haven't been higher than $10 since May 2002 and have not exceeded $4 since the bankruptcy two years ago.

Tesco upbeat on America British supermarket chain's U.K. sales hit top end of expectations, says foray into U.S. has been a success so far. 

All Eyes On Apple Yet this is also a dangerous moment for Apple. In a way the company has never seen, the barbarians are massing at the gates. From hardware to software to services, major competitors with serious R&D and marketing budgets are laying siege to the House of Jobs. As Apple moves into new markets, it has made powerful new enemies, some working in concert. Apple has been bid up in "paroxysms of excitement over the 'mobile Internet,'" Berman contends, and its shares have "benefited from a powerful hype cycle." The company's soaring valuation led the Jacob Internet Fund to chop its Apple position recently to 1% of assets under management from 2.5%. And Morgan Keegan analyst Tavis McCourt wonders about Apple's long-term prospects. While the company's pace of innovation has been "incredible," he says, its competitors are "also getting better." What's more, "the iPod business is maturing. Apple stores are packed, but they have been for two years now. This may be the last holiday season of substantial year-to-year growth for the iPod." IPhones Take Over the Internet

Nokia Raises Margin Forecast, Predicts Decline in Average Price of Phones Nokia Oyj, the world's biggest maker of mobile phones, raised its forecast for profit margins while predicting a further decline in selling prices next year. Nokia, up 78 percent this year before today, fell as much as 4.8 percent in Helsinki trading. Operating profit will be 16 percent to 17 percent of sales in one to two years, the Espoo, Finland-based company said in a statement, up from 15 percent predicted a year ago. Nokia also sees ``some decline'' in average industry prices. The Finnish company also forecast the industry will grow about 10 percent in 2008 from the 1.1 billion units shipped this year. Nokia said industry volume growth in 2008 will top 15 percent in the Asia-Pacific region, China, the Middle East and Africa, and will be less than 10 percent in North America, Europe and Latin America. Price isn’t right at Nokia

Motorola Investors Say New Chief Brown May Not Restore Lost Phone Cachet Greg Brown takes over the top spot at Motorola Inc. boasting 25 years in the technology industry and a resume stacked with operations expertise. That's precisely why some investors wanted someone else. The decision last week to replace Ed Zander with Brown, Motorola's current president, continues a tradition of leaders who know how to run the mobile-phone maker's manufacturing and distribution. Shareholders may have preferred a chief executive officer who can excite customers and employees with new products that juice up sales. Zander, a former engineer, couldn't do that and Brown, trained as an economist, may have the same problem, said Joan Lappin, a fund manager who had called for Zander's ouster.

Posted by dblwyo at 06:37 PM | Permalink | Comments (1)

Here's the weekly readfest of link postings for the General overview, Markets and the Economy all of which highlight several of the major themes and arguments we've been accumulating over the last several weeks and which are reflected in various posting series of our own, e.g. the "non-organic" nature of earnings, the slowmotion slowdown, the role of leverage & liqudity in market performance and so on. We'd like to suggest that those themes are NOT something we've crafted, though there's more than a bit of machinery and analysis that went into finding them, but rather they result from and emerge out of what's going on around is. In other words we think this is what's really going on, not something our own mistakes and biases have created. But, please, argue with us. In that process you'll reach your own conclusions, maybe even using some our tooks, ideas and arguments :) !

Several of our major posts since last Fri., if you didn't happen to catch them, are worth looking IOHO. Those postings are:

 Economic Outlook

• More on Payroll Numbers: Employment vs Employment
• Talking Heads: Mark Zandi on Payrolls, Economy & Recession
• Pieces of Change: GDP Components
• Slowmotion Slowdown in Review: Wessel Takes Notice

Market Outlook

• Market Assessment: Running of the Bulls or Cusp Points ?
  

Interestingly we've found a series of articles to point in the General section that taken as a whole, all together and in order pretty well encapsulate what we've argued (found ? :)  to be the trends and structures taking shape around us which will shape the outlook for '08.

If there's a central theme that ties this whole "symphony" together it's that we are on the verge of a major, albeit slow and hidden, cusp point shift to a new regime.

The General section starts with a financial column we intend as a strawman to shoot rather than posting it because we necessarily concur - but the arguements are cogent and grounded so it makes some sense to walk thru point by point and see whether you agree or not. Which in many ways the rests of the links do. David Wessel of the WSJ has a wonderful column we've excerpted on the deteroriating state of the economy and the role of leverage followed by an interesting article where the long....long path to credit recovery is beginning to make it into a broader awareness. The column from Bill Gross is especially worthy of your thoughtful attention.

That's followed by something we've been warning about for some time, both in the context of general economic analysis, earnings analysis and the buyback & liquidity series - to wit a "recession" is already here for Corporate Profits and it's likely to get worse before it gets better. Which is not something the Street analyst community is prepared to admit just yet btw. That's coupled with a perfect companion article on how buybacks will increasingly haunt corporations and make those decisions more painful. Which naturally leads to questions of how all this impacts valuations, deals and the Private Equity community - using the latter as proxy for all the other forces and actors that have been in this play.

The bottomline here is perhaps our second major theme with all this swirling around us (major theme 1)

the pressures for crystalline focus on corporate performance will increase exponentially over the next several years; and put a premium on superb execution of good strategies and business models as well as good leadership.

Those companies and industries who can perform are who you should be looking for because there's going to be more and more fecal matter hitting the rotary impeller device. 

General & Special

7 reasons to be bullish now Last week's rally was only the start of a move up. Here's how leading money managers suggest you can take advantage of the market's bounce back. Last week's impressive rebound in stocks was more than just a head fake. I see seven reasons why the reversal was the start of a bullish move in stocks. A safe way to play this turnaround is to get broad market exposure, using mutual funds and exchange-traded funds. For more oomph, build positions in companies that have the right characteristics for the slower economic growth ahead. To find those stocks, I picked the brains of several managers who have excellent records at diversified domestic-stock mutual funds. Before we go there, here's why I see better times ahead for stocks.

America's Grand Deleveraging The U.S. economy is succumbing to a number of pressures that are themselves being amplified by a dysfunctional market for credit. That one-two punch seems to be giving way to a "Grand Deleveraging." What's with all the gloom about the U.S. economy? The problem is that we have two problems. One is that the economy is slouching toward recession or, at best, slow growth. It's the consequence of falling house prices, higher energy prices, flagging consumers and shrinking profits. The other is that the market for credit, the lifeblood of a modern economy, isn't functioning well. That problem is amplifying the pain caused by the first. Just a few weeks ago, a lot of folks were arguing that the worst was behind us. Housing was still ailing. But after a big wallop, markets for credit seemed to be moving toward normalcy. The Federal Reserve ended its Oct. 31 meeting declaring that the "upside risks to inflation roughly balance the downside risks to growth." If Fed officials truly believed that then, they no longer do. They'll likely cut interest rates again on Tuesday. Only the most optimistic observers expect the U.S. economy to rebound quickly from its fourth-quarter slump. The argument now is between those forecasters who expect growth to be so slow in early 2008 that the unemployment rate climbs a little, and those who see a recession in which it climbs more. In ordinary times, this would be unpleasant, but not so frightening. The Fed knows how to treat this condition: cut interest rates. But these aren't ordinary times. For years, banks and investors lent freely. They took big risks for surprisingly little reward (known as "low risk premiums" in the patois of the trade). Now, they're shunning risk. Big banks are reluctant to lend even to each other for more than a few days, and are hoarding cash. In a symptom that the financial fever hasn't broken, interest rates for one- and three-month loans among banks are up sharply. At best, the economy has a hangover, and will feel better in a couple of months. But this may be more like a case of mono, an ailment in which the patient doesn't return to normal vigor for a lot longer.

Credit crisis: Long road to recovery A new year, a new start. For the credit markets, that's wishful thinking. Nearly six months since the credit crunch started, the situation is still grim - and there are few encouraging signs, which doesn't bode well for businesses and households next year. Toxic debt keeps cropping up on bank balance sheets. The housing slump still hasn't found a bottom, and investors remain skittish. Market watchers expect the credit environment to remain challenging into the better part of 2008. That will take a toll on corporate profits and squeeze American consumers, not to mention put a drag on economic growth. "We're pretty close to a point where the capital markets fail to function properly," said John Addeo, a high-yield fund manager at MFS Investments. "I believe the Fed has the ability and wherewithal to resolve that issue, but what we really need to see is a restoration of confidence in the financial system." When the mortgage mess triggered a wave of turmoil in the summer, investors had hoped problems would remain relatively contained. Instead, they've seeped into all pockets of the debt market. The culprit has been the loads of complex debt instruments tied to home loans given to borrowers with poor credit. From collateralized debt obligations (CDOs) to structured investment vehicles (SIVs), this alphabet soup of products has wreaked havoc on financial markets. Advice From Bill Gross

Recession Is Already Here for U.S. Corporate Profits; Economy May Be Next U.S. corporate profits are in a recession, and the entire economy may not be far behind. Slower sales and higher energy and labor costs are forcing companies from Bear Stearns Cos. to Pitney Bowes Inc. to reduce spending and hiring. Their efforts to keep earnings from eroding even further raise the risk that the economy, already weakened by the steepest housing slide since 1991, may shrink sometime next year. ``The earnings recession has already arrived,'' says David Rosenberg, North America economist for Merrill Lynch & Co. in New York. ``We are going to see an economic recession in '08.'' Corporate profits, as measured by the Commerce Department, fell at an annual rate of $19.3 billion in the third quarter from the second, as domestic earnings dropped by $41.2 billion. The drag from sagging U.S. sales and huge writedowns offset robust earnings abroad, fueled by the weak U.S dollar. The fourth quarter may be an even bigger bust.

• Big Buybacks Begin to Haunt Firms High-profile companies are cutting back on share buybacks amid pressure from a slowing economy and deteriorating balance sheets. 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.

The Game Private-equity funds will soon be making a very fundamental query: How much did private-equity firms -- aided by the Wall Street debt machine -- overpay for deals in 2006 and 2007? Wall Street has been roiled by the declining value of exotic securities that were tied to the housing boom. It might also want to explore the valuation of paper tied to another boom -- leveraged buyouts. Private-equity firms, the envy of securities firms a few months ago, have plowed billions of dollars investing in companies that they believed they could turn around and flip for a fat profit. Soon, investors in private-equity funds, and the employees who work in their portfolio companies, will be making some very fundamental queries. How much did private-equity firms, aided by the Wall Street debt machine, overpay for the deals done in 2006 and 2007? That matters immensely if a recession is around the corner, because companies may not be able to meet their basic financial requirements, such as servicing debt or funding new investment. And in deals that depend on rolling asset sales to reduce leverage -- such as Univision's struggling auction of its music group -- declining valuations make life all the more difficult. Of course, private-equity firms have the luxury of waiting out bad markets, and the terms of their debt packages were excessively forgiving. It's a long stretch to say that overpaying for a company leads to bankruptcy. But it can destroy the lifeblood of the private-equity industry: returns.

•  When Deal-Making Dries Up Video: Mid-Cap Deals Outlook for 2008 Chris Williams, co-founder of M&A firm Harris Williams & Co., is bullish on mid-market M&A. In an interview with WSJ Digital reporter Kelsey Hubbard, Williams says he expects mid-market M&A to remain strong in 2008, albeit at a slightly lower level than in 2007.

Economy

How to Avert Recession The American economy is now very weak and could get substantially weaker. Current economic conditions call for lowering interest rates and for enacting a tax cut now that is conditioned on economic developments in 2008. More generally, fiscal policy should be considered in the future whenever there is a risk that an excessively easy monetary policy could cause an asset-price bubble. After a surge of above-trend growth in the summer, there is likely to be virtually no rise in real GDP in the current quarter. Almost every economic indicator -- including credit conditions, housing and consumer sentiment -- has deteriorated significantly since the Federal Reserve's October meeting. In my judgment, the probability of a recession in 2008 has now reached 50%. If it occurs, it could be deeper and longer than the recessions of the recent past. Further interest-rate cuts can reduce the risk of recession and increase output and employment in 2008 and 2009. The current 4.5% fed-funds rate is essentially neutral -- not low enough to stimulate growth and not high enough to reduce inflation. Although there are risks that the rise in oil prices and the falling dollar will raise the inflation rate, the greater potential damage of an economic downturn calls for a more stimulative policy.

GDP Forecasts Continue to Move Lower , More Hints of Overstated Job Growth , CFOs See Glass Half-Empty , CBO Presents Grim Economic Outlook , Rapid Housing Turnaround Needed to Avert Recession, Study Says

Yellen cites risks  Developments suggest a bigger slowdown than the Fed official had previously expected. San Francisco Fed President Janet Yellen said Monday that developments since the last rate policy meeting in October suggest a bigger slowdown than she has expected. Yellen became the third top Fed official to suggest in the past week that further interest rate cuts might be advisable at the FOMC meeting on Dec. 11. It appears that any Fed officials arguing for holding policy steady are going to face tough sledding. In her remarks, Yellen raised a red flag about consumer spending, suggesting that the long-awaited never-arrived slowdown in shopping may have arrived. But it was the risks to the outlook that captured her attention. She reminded her audience that there is the possibility that "economic downturns can be difficult to reverse once they take hold." Yellen said it looks to her that the impact of the financial market turmoil that began in late July and August is beginning to slow the economy. If this supposition proves correct, "a more prolonged period of sluggishness in demand seems more likely," she said. Already, the fourth-quarter growth "is sizing up to show only very meager growth," Yellen said. Nervousness by some banks about their capital may restrict lending terms and availability of credit, Yellen said.

• U.S. Added 189,000 Jobs Last Month, Triple Economists' Estimates, ADP Says, Worker Productivity in U.S. Rises More Than Forecast; Labor Costs Decline

·         NFP: Birth/Death Adjustments To give you a better idea of how badly the B/D is currently skewing the data, consider these charts below (via Econbrowser). Looking at the changes of the past 3 years, its apparent that the B/D model went from being a modest portion of the CES data to being the increasingly dominant source of reported new jobs over the past 12 months. Indeed, the actual newly created jobs that are measured -- and remember, it is a supposed to be a survey measure of new jobs, not a hypothetical model --  has dropped radically. As the chart below shows, the measured portion of CES was near 70% in 2005-06. Now, it has become so increasingly dominated by the hypothesized B/D adjustment, that a mere 20% of the NFP data is truly a measure of the 400,000 participating firms.   

·         Jobs in U.S. Rise More Than Forecast, Reducing Bets on Larger Fed Rate Cut Employers in the U.S. hired more workers than forecast in November, and the unemployment rate was unchanged, suggesting the labor market may be strong enough to keep the economy from tipping into recession. Payrolls rose by 94,000 after a 170,000 increase in October, the Labor Department said today in Washington. The jobless rate remained at 4.7 percent for the third month in a row.

How low must housing prices go? Commentary: Figure at least another 20% before families can afford to buy. Housing will revive when prices come down to the point where demand rises enough to reduce the huge supply of unsold homes now overhanging the market. That said, this point is a long way off. Right now, there is at least a 10-month supply of unsold homes at current selling rates. This is twice the average for the nation as a whole. In some markets the supply is even larger. As a consequence, few new homes are being built. The seasonally adjusted annual rate of new housing starts in the past two months was 1.21 million - two-thirds of last year's average and the smallest for any two-month period in recent memory. Needless to say, this slowdown in new-home construction is taking its toll on builders, suppliers, labor and sellers of home furnishings, to name a few. And it's not too difficult to see the ripple effects on a wide variety of industries, from retailing to finance. To whittle this supply to more normal levels, demand has to rise. That will happen when prices fall, since right now, housing prices are much too high relative to family incomes. Today, median home prices are 3.5 times the size of median annual family incomes. This may be down from the recent peak of 4.2 times incomes reached last year, but it's way above the 2.8 times that home prices averaged during 1984-2000, when lots of homes were bought, sold and built. And if you think 2.8 is low, check out the early 1970s. That was when home prices were only 2.3 times median family incomes, and housing was selling like gangbusters. U.S. Mortgage Delinquencies Climb to 20-Year High, Foreclosures Increase, Auto-Loan Delinquencies Surge

·         Paulson's Subprime Mortgage Plan Surfaces Too Late to Stem Housing Slide U.S. Treasury Secretary Henry Paulson's plan to prevent as many as 1.2 million people from losing their homes by freezing interest rates on subprime adjustable-rate mortgages will bring no benefit to the depreciating housing market. Existing home prices may fall as much as 15 percent by 2009 from their peak last year, even if interest rates are frozen on one fifth of 2006 subprime loans resetting next year, said Mark Zandi, chief economist at Moody's Economy.com, a unit of New York-based Moody's Corp. About 2.8 million mortgage loan defaults will occur in 2008 and 2009, Zandi said in Dec. 5 testimony before the U.S. Senate Judiciary Committee. Subprime plan offers limited relief

Retail Fading Forget forecasting: You can't even begin to think about the Future if you don't understand the Present.Case in point: Holiday Retail sales. You may have overlooked the Black Friday weekend numbers, as the headline emphasis was on well, how strong they were relative to expectations. On that Friday, we saw an 8.5% gain thanks to huge discounting and door-buster giveaways. The thinking seemed to be "Sure, we lose money on each sale, but we make it up in volume!" Amazingly, the cheerleading in the space seems to be abating, as the MSM is now clued into the problem -- and reporting it freely. The remarkably sanguinity we have seen over the years is no more.

• It’s December, and America Is Not in a Buying Mood , Consumer Gloom Adds to Recession Risk , Holiday Sales Miss Forecasts With Discounts in Demand, The coming consumer crunch

•  U.S. Retailers May Struggle to Boost December Sales on Discount Prices U.S. retailers may struggle to boost sales this month as consumers grappling with lower home values and higher food and energy costs shun full-priced goods. Target Corp., the second-largest U.S. discount chain, said yesterday that it needs sales to ``meaningfully improve'' in December to achieve fourth-quarter profit growth. J.C. Penney Co., the third-biggest department-store chain, expects sales at stores open at least 12 months to fall for the five weeks through Jan. 5. Retailers may cut prices further during what the National Retail Federation in Washington forecasts will be the slowest holiday shopping season in five years. Consumers contending with defaults on mortgages and higher costs for milk and gasoline may wait until closer to Christmas to spend, hoping for discounts of 50 percent or more on sweaters and electronics. The NRF projects November and December sales will rise 4 percent, the smallest gain since 2002. That year sales added 1.3 percent.

European Economy Suffering From Subprime Fallout, EU Finance Officials Say Europe's economy may be more damaged than the European Union has forecast by fallout from the U.S. housing slump as banks curb lending and accelerating price gains prevent central bankers from cutting interest rates, EU finance officials said. Euro-area finance ministers endorsed an analysis by the International Monetary Fund suggesting that 2008 economic growth in the nations that use the euro will fall short of 2 percent for the first time in three years, Joaquin Almunia, EU Monetary Affairs Commissioner, said late yesterday in Brussels. The growth slowdown comes as inflation picks up, posing a quandary for the ECB, which has refrained from following the U.S. Federal Reserve in cutting interest rates. The central bank is concerned that price gains may trigger an inflation spiral by stoking wage demands. Euro-area consumer prices jumped 3 percent in November from the year-earlier period, the biggest increase in six years, driven by higher commodity costs. Factory-gate prices increased 3.3 percent in October from a year earlier, the most since December 2006, after rising 2.7 percent in September, the EU statistics office in Luxembourg said today. The rate exceeded the 3 percent median forecast in a survey of 29 economists by Bloomberg News.

`Decoupling' Debunked as Subprime Collapse in U.S. Infects Global Economy It turns out the U.S. economy matters after all. The credit collapse and dollar decline that followed a surge in U.S. home foreclosures jeopardize expansions in the U.K., Canada and Germany, economists said. They also debunk ``decoupling,'' an argument advanced by analysts at Goldman Sachs Group Inc. and Morgan Stanley that the world wouldn't suffer as it did during U.S. slowdowns in previous decades. Of the 38 countries they monitor, Goldman economists expect growth to slacken in 26 and strengthen in a dozen. That will cause global growth to slow to 4 percent next year from 4.7 percent this year, with Europe and Japan fading faster than the U.S., they say. Market lending rates have risen worldwide in the last three weeks as $70 billion of writedowns linked to defaults on U.S. subprime mortgages fanned international concern about the strength of financial institutions.

As Biggest Bull on India, Sanjiv Duggal Mulls Asking Investors to Cash Out India's biggest bull is on the verge of becoming its biggest bear. Sanjiv Duggal, who manages the world's largest h