The Toughest Market ?: Bill Miller's Problems for the Rest of Us
It'll be interesting to see how the markets begin to process the economic data. Not so long ago a 1.9% bump in GDP growth and only -51K jobs lost instead of -72K would have seen the markets jump, especially when oil is "down" so far. Instead the S&P was essentially neutral for the week though the last two days saw significant drops, including in the Tech stocks. On the other hand the whispers were for 2.3% growth and the continued jump in the unemployment rate to 5.7% was a great surprise. But in a way that was the last of the big surprises for a while until the next round of big ticket economic news. Which might appear to leave everyone in limbo without clear directions. Hopefully our opinion is pretty clear at this point, since we put so much work into presenting the machinery, our reasons and conclusions. But just to summarize and set the table for this discussion: 1) the US economy looks to be crossing the tipping point from slowdown to something more serious, though it'll take a while to be visible, 2) the international economy is weakening rapidly both from "re-coupling" and the consequences of oil/food inflation plus mis-guided domestic policy problems and 3) none of this is yet properly priced into the markets. But we are beginning to see the mythology of a "V-shaped" recovery disappear though the implications of that have yet to be reflected in earnings estimates and valuations. Nor, based on past experience, would we guess that business executives have de-coded and integrated the notion of a slowing world economy and flattening dollar into the impacts on their revenues and bottomlines. After all they were largely sanguine as we began this journey into darkness, insofar as their public assessments were rearview mirror ones. After the break you'll find several interesting readings worth your time. One that's telling is the "time for a rally" meme flag that's being waved. The two very most interesting are a) the best compilation of the "week that was" by Prieur du Pleiss - comprehensive, thorough and educational. And the saddest as well as very most interesting was the reporting on Bill Miller's most recent annual investor's letter.
In case you don't recognize the name Miller had, until recently, an unbroken 17-year record of beating the market with a rigorous value-investing discipline. He's gotten creamed in the last year or so by value the standard wisdom of that discipline, particularly by investing in Financials (another area where we hope our opinion is crystal clear, having been hammered home enough we hope). Rather than schadenfreude our biggest response to the Mr. Miller's troubles are profound sadness and the conclusion that it stands as a critical lesson to us all. You see, and this is a point we return to often, the Financials got hammered because their business models are broken. They further got hammered, and will get more so, because we've a long way to go on the consequences of the credit crisis. Yet Miller got into severe trouble, we think, because he applied his old valuation approach and performance evaluation methods without thinking thru the consequences of these deep changes. Even sadder he apparantly had nothing much to say about how he was going to fix it. Before enlightenment chop wood, grow food, draw water. After enlightenment the same. But what do you do when your enlightenment fails you ? Well what we try to do around here...RETHINK THINGS.
We looked at the emerging markets when we looked at the International Economic situation so let's take a deeper dive on the US markets starting with the following composite chart which compares the SPX and NDX daily since Oct and weekly for three years.
The first chart shows Finance (XLF), Con. Discretionary (XLY), Con. Staples (XLP) and Healthcare (XLV). Staples are holding up pretty well, which looking back at the time trends of non-durable consumption is not surprising. XLF got really hammered of course but bounced. The great irony in all of this was the proximate cause for the rally's beginning was MER's earnings not being as bad as expected followed by a surprise, dare we say malfeasant, announcement of more writeoffs and capital raising a week later. Sure, they know what they're doing ? Yeah, right. And Healthcare is somewhat akin to Staples. 
The second composite charts looks at Utilities (XLU), Industrials (XLI), Materials (XLB), Energy (XLE), Technology (XLK) and Telecomm (IXP). All of which had been doing better thant the S&P though with distinct differences. Utilities of course are both defensive, more so than Staples, and a bit of an inflation-hedge. If anything holds up they'll probably be it. Industrials have sufferred slightly lately and as the world economy plays out the "foreign earnings will save us" theme will get stress tested. Materials and Energy have enjoyed significant strength due to worldwide demand for commodities and energy but have also sufferred recently. Looked at this way instead of via the NDX index Technology is fascinating - it's essentially back to where it was in early '07. What lies ahead we wonder ?
BUT...none of these indicators would seem to match up to our economic assessment so far. With that in mind AND the RETHINK THINGS THRU as well we highly recommend the following (via BigPicture):
Seven Forehead-Slapping Stock Blunders
Nassim Nicholas Taleb: the prophet of boom and doom
Market Readings
Words from the (investment) wise for the week that was (July 28 – August 3, 2008) As oil prices seesawed through the past week, fresh uncertainty about the outlook for the beleaguered financial sector triggered another wave of volatility in financial markets. With the exception of Friday, crude prices closed each day with a gain or loss of more than 1%, with US stocks doing likewise as sentiment waxed and waned on the back of a barrage of economic and corporate earnings reports. Economic data were mixed, whereas earnings were mostly better than feared. After all the action, the S&P 500 Index closed the week virtually unchanged, posting a small gain of 0.2%. David Fuller ([1] Fullermoney) re-emphasizes that the oil price is currently by far the most important factor in terms of global GDP growth. Consequently it is also a huge influence on the direction of various stock market indices, and big moves up or down have a psychological leash effect on currencies and other commodities.
Jobs report: Is the stage set for stocks to rally? As U.S. stocks enter the month of August, Friday's July jobs report may provide some needed upward momentum for this traditionally-slow period of the year. "Tomorrow's jobs report is going to be critical" for the market, said Paul Mendelsohn, chief investment strategist at Windham Financial Services. It's not that the market expects employment to have rebounded, pointing to an economic rebound. Instead, investors have been increasingly betting that enough bad news -- from ailing financial firms, to the slumping housing market, and surging oil prices -- might have been priced into stocks for now. "You can rally in here because we're extremely oversold," Mendelsohn said. "We're still in a bear market, there's no question about that, but technicals are pointing to a short-term bottom." A firmer dollar, meanwhile, can continue to put pressure on oil and other commodities, which have been sliding over the past several weeks after surging to stratospheric levels throughout the year. A stronger U.S. unit makes dollar-denominated commodities, such as crude oil and corn, more expensive for holders of other currencies. "The economy is setting up for a very moderate rebound," said David Kelly, chief market strategist at JPMorgan Funds. "If we get oil to come down, it would act as a tax cut to consumers."
Richard Russell now says stock market's long term trend now down Russell is the editor of Dow Theory Letters, a newsletter he has been writing continuously since 1958. I pay attention to what Russell is saying for the simple reason that his long-term record is quite good. Over the past 28 years, this portfolio is tied for first place on a risk-adjusted basis among the market-timing newsletters tracked by the Hulbert Financial Digest. Though I have been reading Russell's writings for more than 28 years, I must confess that I still have trouble integrating all of what Russell says into a coherent narrative. But, as best as I can interpret, Russell recently turned bearish on the stock market's long-term trend. I base my interpretation on an analysis Russell conducted a couple of days ago of a chart of the Dow Jones Industrial Average back to 1982, some 26 years ago. On that chart, he drew a trendline that connected the low of the stock market in August of that year to the low of the 2000-2002 bear market, which occurred in October 2002. What Russell found: "As you can see, the long-term trendline has been violated [by the stock market's recent action]. That means that the rate-of-growth in the Dow has been reversed. Until proven otherwise, the long-term trend of the Dow is now down." Russell goes on to address those who try to wriggle out from underneath the force of this bearish conclusion by dismissing the Dow as representing just 30 stocks. "Let's take the S&P Composite, which includes 500 large-cap stocks. Same thing here, the long rising trendline has been violated."
Bill Miller: Toughest market I've seen Shareholders of the battered Legg Mason Value Trust mutual fund won't find many answers in manager Bill Miller's second quarter letter, which went out July 30. In his note Miller, who famously beat the S&P 500 for 15 consecutive years until stumbling in 2006, deplores market conditions that continue to punish value investors, but doesn't discuss his strategy. His $9.7 billion LMVTX (LMVTX) fund has dropped 34% since last July, while the S&P 500 fell 12%, and suffered outsized losses as financial stocks plummeted. But aside from reminding shareholders that the best time to buy the fund is during its grimmest stretch, Miller offers no specific plan for fighting his way back. Unlike his missive after the first quarter, in which he suggested the worst was over after the collapse of Bear Stearns, he also offers no timelines. Instead he writes that the crisis around Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500), which have dropped over 65% this year, has convinced him that this market is the most difficult he's faced. Still, he seems to dismiss critics who suggest that his bad bets on housing and banking stocks were foreseeable, or that he should have anticipated the commodities boom driven by growth in China and India. He also asks, but doesn't answer, whether buying fallen financials or correcting energy stocks are "obvious" moves today.
Brazilian, Mexican stocks may wait on recovery Latin America's largest stock markets, already reeling from two straight months of losses, could stay in a funk until fall. Brazilian and Mexican equities finished July with a second consecutive month of losses, and Latin America's largest markets may not begin to see a rebound before September, say some market observers. July was rough for investors in the face of higher inflation that led to interest-rate hikes and currency gains, as well as a sharp pullback in commodity prices, which aided in the brief decline of Brazil's resource-heavy stock index into a bear market. August, with its reputation for being a notoriously poor month for equities, may deliver another period of declines. But analysts said that from the short-term pain has come some relief for companies whose financial positions improve with lower oil prices, and a refocus on investment opportunities that have been overshadowed by the overall commodity boom. Brazil's benchmark stock index, the Bovespa, fell 8.5% in July, extending a loss of 10.4% in June. Brazil's last run of consecutive monthly losses was in 2005, when equities fell in March and in April. In Mexico, the benchmark IPC index fell 6.4% in July, on the heels of June's decline of 8.1%. Mexico's most recent string of monthly losses was in November 2007 through January of this year. As corporate results for the second quarter have rolled out in Latin America and on Wall Street, crude-oil prices remained a dominant influence over the stock markets. Crude-oil futures recorded record intraday highs above $147 a barrel on the New York Mercantile Exchange earlier in the month before tumbling back by $15.62 by July's end, the biggest decline for oil ever in dollar terms. See full story Rio de Janeiro-based Freitas said "exaggerated" movement downward in commodity stocks in Brazil in the past few weeks helped pull the Bovespa more than 20% below its all-time high largely on fears that crude's spiral upward had no end in sight and that its advance would hit global economic growth.
Real estate sector fears huge increase in CMBS defaults Defaults on commercial mortgage-backed securities issued at the height of the credit bubble will more than quadruple from their current levels under conditions in the US economy expected by the commercial real estate industry, according to a report from Fitch Ratings. Borrowers would default on an average of 17.2 per cent of securitised commercial mortgages over 10 years if the US economy dips into a recession with 0.2 per cent contraction in growth, compared with current very low default rates of 4 per cent, a rise of 330 per cent. Such a scenario corresponds "to the negative predictions currently offered by commercial real estate experts", analysts at Fitch wrote. This would happen if the economy suffered a similar downturn to 1991, and assumes that the value of properties covered by the deals falls by 25 per cent, and cash flow from rents by 15 per cent. The higher defaults under such a slowdown compares with a historical default rate of 7.9 per cent, and with the milder scenario that Fitch thinks is more possible of 0.8 per cent economic growth and a 13.7 per cent rate of default. It would cause non-investment grade bonds - B and BB rated CMBS - to suffer loss rates of 100 per cent and 95.9 per cent, respectively. Meanwhile, 30.6 per cent of the lowest-rated investment grade bonds - BBB rated - would experience losses, while loss severities would rise to 37.9 per cent from an historical average of 33.5 per cent. The data suggest that recently issued CMBS may fall victim to inflated property values and weaker underwriting standards experienced at the height of the US property boom in 2006 and 2007, as well as the weaker economy. Those bonds make up about 49 per cent of the outstanding CMBS market of more than $800bn. The survey covers all Fitch-rated bonds issued during those two years, making up 74 deals worth $217.3bn. That was about 60 per cent of all CMBS issued during the period.