Bad Times, Bad Companies, Bad Markets
Our normal chain of postings to present the week's news is Economy - Markets - Companies. We reversed that somewhat because of this last week+ bear rally largely driven by financials. Instead we started early with a review and re-discussion of what constitutes a good company and then dove into the financials (Bad Times, Bad Companies: More Finance Industry). Judging from the popularity of that post it was the right way to go about it. But we'd like to shift to looking at the consequences and implications - largely because the Financials were so hugely import. An argument that will be our primary focus here, along with some discussion of the hidden implications.
However, after the break, you'll find our usual collection of readings excerpts for your skimming pleasure. In four sections: Realities - largely a discussion of the earnings situation and outlook which we expect to continue to deteriorate. A view now more in line with the mainstream as more and more are conceding that a sharp V-shaped recovery is increasingly unlikely. Then more on Financials - particularly PIMCO's estimate that we're facing a total of $1T in losses !! And another huge shift in outlook is the rapidly growing recognition that the emerging/foreign markets are actually worse off than the US - as expected and predicted here since around Oct. Finally one of the better discussions of Bear Market Strategies we've found.So what about the Market(s) and Financials ? 
Market Sector Comparisons
The composite charts at right lay it out pretty well in our mind by showing the major S&P sectors (proxied by the sector ETFs) with Six months by day on the left and 10-day by hour on the right. Note - XLF is Finance,XLY Con. Discretionary, XLP Con. Staples, XLV Healthcare, XLI Industrials, XLK Technology, IXP Telecom, XLB Materials and XLE Energy. Over six months you can see what held up and what didn't with the SP500 and its' 50-day MA as the baseline. The top charts are those sectors which tended to be worse and the bottom better than the benchmark. Notice that over the last 10-days the running pattern almost completely reversed with Energy taking a dive and Discretionary and Financials bubbling up. The latter on fantasies we've just finished discussing. And almost all of which do NOT, IOHO, reflect the state of the economy our outlook (Readfest (Business): Back to the Future, Revisiting Old Themes).
Finance vs The Rest
You could look at those charts and pretty well buy-in to the argument we've been making about financial fantasies. But when we looked into a tad deeper there were several hidden implications. Triggered by one key quote we've kept hearing repeated many...many times. "If you take out the financials the rest of the market, and earnings, are doing well." That turns out to be true but the conclusions aren't what the Pollyannas - Goldie's sister who escaped a drug rehab program - might think. We took the monthly ETF data back to '98 and used the S&P market cap weightings to reconstruct a slightly different view of things. The top sub-chart shows a total market virtual ETF built from the weighted sum of them all (SPWta), the same synthetic without the Finance sector (SPWtxFa) and Finance alone, XLFa. You'll notice the two composites run along together until mid '07 and Finance runs with both until early '07. The lower sub-chart, built by taking the running % change since Dec98 in each, highlights these differences on the same scale and makes them very easy to see. The overall index has been slightly pulled down by Finance so that, when you extract it, the rest of the market is only slightly down. Financials meanwhile have taken it in the shorts - as the should given our analysis. So heres' the two things that aren't getting discussed, recognized or factored in.
Scary Implications
Since Oct07 the overall market is down only 16% by our metrics while the x-Finance market is down only 11% and Financials are down about 37% ! Here's the two thoughts we'd like to leave you with - and bearing in mind the other meme running around is that we've already "corrected" 20%. And either have no more to go...or worst case bears average -30% so not much more to go.
- If Financials are a) thru the crisis and into the crunch but b) won't bottom until Housing turns around circa 2010/11/12 and c) are facing other ripples from consumer and business loan losses how much further can they go ? Especially if/when the broken business model problem sinks in.
- If a) the rest of the market is really only down only 10% or so is that all there is ? Or b) will a continued slowing economy with an extended low growth rate further damage earnings and carry it further ? Or c) will employment damage consumer demand and a slowing int'l economy damage industrials, tech, et.al. and we'll see a real bear market - ala 20-30% in SWtxFa ?
Sleep well :) !
BtW - via a Ritholz interview on BNN, the Canadian Business News Network, we've taken to watching it over the last few days and discovered it's wonderful. Try this:
Friday : Market Call Part 1/3: Jaime Carrasco, investment advisor, Blackmont Capital.
Outlook & Realities
Stocks: More Doldrums Ahead The first six months of 2008 ended with U.S. stock markets in the dumps. Now, with the major indexes in or near bear market territory after touching highs in October, hopes for a happier second half are fading fast. A toxic brew of sluggish economic growth, rising unemployment, and spiking inflation—otherwise known as stagflation—is prompting market watchers to backpedal furiously on earlier predictions of a rally later this year. Noticeably absent from the discussion are the traditional stock market drivers of strong earnings and interest-rate cuts, neither of which seem to be on the horizon. Economists, meanwhile, are beginning to tamp down expectations for global growth not only for the rest of this year but for 2009 as well—especially with oil surging to new heights. All of which is leaving traders tossing around adjectives like "tired," "nervous," and "depressed" to describe the mood heading into the slow July-August months.
- BNN Appearance: Shorts, Bounces & Banks It's not enough to play the market - it's how you play the market. Ritholtz Capital Partners chief investment officer Barry Ritholtz talks about the movers and tells BNN his strategy.
- (!!!) Market at bottom? Don't believe it The recent updraft is probably an illusion. There's no indication the bear market has ended and plenty of evidence it has a long way to fall yet.
S&P Earnings So Far Falling Short Of Q2 Projections Halfway through earnings season, banks are still a drag, tech firms are doing OK while the overall outlook remains cloudy. With 249 of the S&P 500 companies reporting results, second-quarter profits are on track to decline 17.9% vs. a year earlier, according to Thomson Reuters. "I'd rate (earnings so far) as pretty bad," said Sam Stovall, chief investment strategist at S&P Equity Research. S&P forecast a 10% drop at the start of the quarter but now sees about a 20% shortfall, he said. Financial firms' profits are forecast to dive 85%. The consumer discretionary sector, including automakers and home builders, also is a big loser. But excluding banks, S&P 500 earnings should rise a respectable 7.7%, Thomson Reuters said.
Earnings Are Heading into Even Rougher Seas It's earnings season and, as in the first quarter, downbeat results from financial companies for the second quarter are certain to dominate the news. Outside of finance, though, U.S. businesses have been coping surprisingly well, despite being caught between soaring materials costs and weak demand. Their strategy: cut labor costs, boost productivity, and lift prices where markets are still strong, especially overseas. Now comes the real challenge: The second half of 2008 is shaping up to be a lot less earnings-friendly for nonfinancial companies as well. Contrary to expectations heading into 2008, the economy may end up weaker in the second half than it was in the first. Until now profits have been squeezed, but they have not plunged as they do in a recession. First-quarter earnings of the companies in Standard & Poor's (MHP) 500-stock index, outside of finance, rose about 7%, and analysts expect a similar showing in the second quarter. In the first half, resilient economic growth, combined with cuts in payrolls and pay, boosted productivity and restrained labor costs. Even in a weak U.S. pricing climate, margins have held up. Plus, exporters have been able to flex some pricing muscle amid strong overseas demand. Making a buck in the second half will get a lot tougher. So far, the economy has been able to skirt an outright recession, with growth of 1% in the first quarter and expectations for 2% or better in the second quarter, but chances of a downturn appear to be on the rise again. A weaker economy would limit productivity gains, even as materials costs continue to rise. At the same time, the new round of financial market upheaval will mean tighter credit conditions, especially in the mortgage market.
Earnings Reflect Consumer Fears The deepening plight of the American consumer has started to take a big bite out of corporate earnings. A number of major U.S. companies who rely on consumer spending warned about their results on Monday evening, including credit card company American Express Co, Macintosh computer and iPod maker Apple Inc and cruise ship operator Royal Caribbean Cruises Ltd. The breadth of the warnings, which also came from makers of chips and carpets, may signal that the credit crisis is quickly moving beyond housing and banks and into mainstream Corporate America. The wrath of the credit crunch and housing collapse of the past year has largely been felt by middle- or lower-income people. But Monday's results reflected a broadening of fears. American Express executives said that even customers with solid credit scores were facing difficulties and even the very affluent have in some cases cut back discretionary spending. Monday's bad news came from a wide swath of sectors and raised concerns about how strong two of the major consumer events will be this year -- back-to-school season and year-end holiday spending.
Financials
Pimco: $1 Trillion Housing Losses Seen The best way to help the ailing housing market recover from the $1 trillion of losses it faces will be to cut the cost of mortgages via the housing bill and rescue package for mortgage finance giants, the manager of the world's biggest bond fund said on Thursday. "Lowering the cost of mortgage credit via the omnibus housing/GSE bill now placed before the Congress and the President is the best way to begin the long journey back to normalcy," wrote Bill Gross, chief investment officer of Pacific Investment Management Co (PIMCO) in his August Investment Outlook letter. The worst conditions in the housing market since the Great Depression have put many existing mortgages at risk. A total $5 trillion of mortgage loans are in risky asset categories, Gross wrote, adding that "nearly 1 trillion dollars of cumulative losses will finally mark the gravestone of this housing bubble." "The problem with writing off 1 trillion dollars from the finance industry's cumulative balance sheet is that if not matched by capital raising, it necessitates a sale of assets, a reduction in lending or both that in turn begins to affect economic growth, creating what Mohamed El-Erian fears as a 'negative feedback loop,"' Gross wrote. PIMCO's Gross: $5 Trillion Risky Mortgage Loans, Projects $1 Trillion in Mortgage Losses
The Short View: US financials "Shares in US financials have staged a big recovery because the earnings they have reported in the last week have been better than expected." This statement, or variations on it, has been well broadcast in recent days. While true at some levels, it is misleading. Judging by Tuesday's rally in US bank stocks, which gained 9 per cent in a matter of hours after a morning sell-off, some investors want to add another statement: "The worst is now over." That statement can probably be rejected outright. According to Bloomberg, the financial companies in the S&P 500 to have reported so far for the second quarter have suffered year-on-year declines of 95 per cent in their earnings. Plainly these results are terrible. On average, these were worse than expected, according to Bloomberg. So a fair statement would be: "US financials' earnings were terrible. But at least they showed that a crisis was not quite as imminent as many panicked investors had implicitly assumed."
International
US is Bright Spot in Global Gloom Fund managers across the world are dumping stocks and retreating to cash in a mood of extreme pessimism, fearing that the looming economic crunch is an even greater threat than inflation. The latest survey of investors by Merrill Lynch shows that an unprecedented 41pc now think that a world recession is either likely or very likely. The majority dismiss hopes of double-digit earnings growth next year as "fantasy". "People are a lot more scared about the macro-outlook. The survey has never seen anything like this before since it began a decade ago," said David Bowers, the organiser of the report. "Recession risk has taken over from inflation risk. Fund managers believe the global economy is deteriorating so fast that a wage-spiral is never going to happen, at least in developed markets," he said. The survey is based on 191 funds managing assets worth $610bn (£305bn). The US is emerging as the one bright spot in the global gloom, despite the credit mayhem. A net 7pc of investors are overweight in US equities, clearly betting that most of the bad news is already in Wall Street prices. The figure was negative in May. With the tailwind of 2pc interest rates and a cheap dollar, America stands to benefit from the "first-in, first-out" principle. Others have yet to take their full punishment from the cycle. "The US has now become the country of cheap manufacturing. You've got 20pc wage inflation in emerging markets so FDI (foreign direct investment) is flowing back there," said Karen Olney, Merrill's chief European equity strategist. The investor love affair with India, China, and Asian markets over the last nine months has turned sour.
Brazil Stocks Tumble Into Bear Market as Rates Rise, Mining Companies Fall Brazilian stocks plunged, pushing the Bovespa index down more than 20 percent from its May record, as higher interest rates and a decline in metal prices sent banks and mining companies lower. Gerdau SA and Usinas Siderurgicas de Minas Gerais SA led a drop in steelmakers on concern demand for metals is slowing as copper, nickel and aluminum futures retreated. Mining and chemical companies, which together with energy producers make up 57 percent of Brazil's market, slid 4.6 percent to a four-month low. Uniao de Bancos Brasileiros SA paced a decline in financial companies after the central bank raised its benchmark lending rate to 13 percent, higher than economists' forecast. The Bovespa, until June the best-performing index among the world's 20 biggest markets, retreated 1,986.49, or 3.3 percent, to 57,434.37, leaving it 22 percent below its May 20 peak. A 20 percent drop is the common definition of a bear market. ``The world economy may be entering a substantial slowdown and the market is trying to price that in,'' said Keith Wirtz, chief investment officer at Fifth Third Asset Management in Cincinnati, which oversees $23 billion including Brazilian equity. ``Brazil is following the U.S. and the other markets down. No one wants to take on risk right now.'' Gerdau dropped 6.1 percent to 30.85 reais. Copper fell to a six-week low in New York as a stronger dollar reduced demand from investors seeking a hedge against inflation. Nickel fell the most in two months in London.
Russian Stock Markets Plunge Investors piled out of Russian stocks Friday after the abrupt departure from the country of a foreign oil boss and the prime minister's unexpected severe criticism of a large steel firm. MICEX, the exchange where the bulk of trading in Russian stocks takes place, plunged 5.5 percent by the close of markets, while the RTS Index lost 5.6 percent to sink to its lowest point since March. After Prime Minister Vladimir Putin's scathing attack on Mechel late Thursday, heavy trading in New York sent the steel and coal maker's stock down nearly 40 percent, wiping more than $5 billion off its value, although the stock recovered about 15 percent in New York Friday. The losses were mirrored Friday in Russian trading. Putin criticized the company, which is the largest supplier of coal for steelmakers in Russia, for charging much higher prices for raw materials domestically than it does for its exports. He called for an antitrust investigation into Mechel's activities. Earlier Thursday Robert Dudley, CEO of the embattled Anglo-Russian oil producer TNK-BP, left the country three days before his visa was due to expire. Russia has not renewed the visa on the grounds that he allegedly does not have a valid work contract. Dudley, who said in a statement his departure follows a sustained assault on the company in the past several months, vowed to run the company from abroad. The developments rattled investors, leading to a heavy sell-off in Russian equity, which is dominated by oil stocks.
Mexico's peso falls after halt in dollar auctions - Mexico's peso weakened sharply on Friday after the central bank said it would suspend its daily dollar auctions, and stocks rose after unexpectedly strong U.S. consumer confidence and housing data. The peso MXN MEX01 weakened 0.98 percent at the central bank's final 1:30 p.m. (1830 GMT) reference to 10.11 per dollar. The benchmark IPC stock index .MXX closed 0.77 percent higher at 27,084.77 points after stocks fell to a six-month low on Thursday amid fears about the U.S. housing market. Mexico's central bank said on Friday it would suspend on Aug. 1, until further notice, a daily sale of $32 million from its foreign reserves after the government bought $8 billion from the bank to cover foreign exchange requirements for the coming months. Many traders had expected the peso to break past the psychological level of 10 pesos per dollar in coming days on bets the central bank will boost interest rates again in the next months after already hiking rates twice since June in its fight against inflation. "The market overreacted a bit. ... There has been a lot of nervousness surrounding whether the peso could move below 10 per dollar," said Daniela Blancas, an analyst at Scotia Capital in Mexico City. "In reality, the daily impact of this (dollar auction) won't be much since the auction amount is really low compared to the amounts in the market in general," she said. The Mexican currency has been trading around five-year highs recently as foreign investors snapped up pesos and Mexican bonds to take advantage of the relatively wide spread between U.S. and Mexican benchmark interest rates. In debt trading, the government's benchmark 10-year peso bond <MX10YT=RR> rose 0.122 of a point in price to bid 92.771, pushing its yield down 2 basis points to 8.89 percent.
Strategies
5 top funds for this bear market As the market slides deeper, these defensive holdings offer a measure of safety without losing their appeal over the long haul. The S&P 500 Index ($INX) officially entered bear market territory last week, and those of you who own bear market mutual funds and exchange-traded funds have been preparing for this moment. Most of us, though, don't venture into that arena, because those funds are not good long-term holdings. But current events remind us how difficult it can be to reconcile our long-term plans with the punishment a bear market can inflict. Are there funds defensive enough to stand up to today's market yet with qualities that will endure for tomorrow?
- Gambling on a Guru Everyday we're bombarded with investment advice from so-called stock gurus, but does anyone really have the winning ticket?