Words from the (Investment) Wise for the Week That Was (June 16 - 22, 2008)

By: Prieur du Plessis | Sun, Jun 22, 2008
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Sentiment deteriorated further during the past week as oil prices rebounded, more bad news in the financial sector surfaced, economic woes mounted and inflationary pressures intensified, compounding already-jittery investors' anxiety.

Status Quo's lyrics "Down down deeper and down" came to mind as global stock markets took a battering. The Dow Jones Industrial Index, for example, plunged by 3.8% over the week to below 12,000 - its lowest level since March. Commensurate with extreme bearishness, short interest on the New York Stock Exchange jumped to an all-time high during the week.

At the centre of investors' angst was the perception that the credit crisis has not yet played itself out. These fears were supported by Goldman Sachs analysts who said last week they did not expect the credit crisis to peak before 2009, and that US banks might need to raise $65 billion of additional capital (on top of $159 billion raised so far) to cope with additional losses from the sub-prime fallout.

On a related note, Moody's downgraded the credit ratings of Ambac Financial (ABK) and MBIA (MBI), citing their limited ability to raise new capital and write new business. Banks were also in focus as analysts cut their price targets for, among others, Goldman Sachs (GS), Citigroup (C) and Wachovia (WB).

In one of the most bearish reports for a while, The Royal Bank of Scotland advised clients to brace themselves for a full-fledged crash in global stock and credit markets over the next three months as inflation paralyses the major central banks. "A very nasty period is soon to be upon us - be prepared," said Bob Janjuah, the bank's credit strategist (who gained credibility after his warnings last year about an impending credit crisis).

Richard Russell, 83-year old author of the Dow Theory Letters, expressed concern about the stock market's negative breadth and said: "I did a double-take when I read Lowry's statistics ... Buying Power Index at a multi-year low and Selling Pressure Index at a multi-year high. And the two Indices at about their widest (most bearish) spread in history or since the 1930s. What the devil could this mean? My guess can be summed up in one word - trouble."

But there is hope still, according to David Fuller (Fullermoney) who pointed out that Investors Intelligence's sentiment index (bottom section of the chart on the left) was extremely bearish. "There has never been a reading at current or lower levels that was not soon followed by a sharp rebound, including during the last bear market. This indicates to me that we are within a week or two of a bear squeeze, providing at least a tradable rally ..."

Back to Richard Russell for the last word: "Lousy Fridays are often followed by rotten Mondays." To which I add: When in doubt (and there is a ton of doubt), better to err on the side of caution than to do something stupid.

I am flying to Slovenia and Switzerland, in my opinion the jewels of "old" and "new" Europe respectively, next weekend for a combination of work and leisure. Blog posts will unfortunately be rather slow during my 10-day absence, and specifically "Words from the Wise" will take a break next Sunday as I will be in midair when the review needs to be compiled.

Before highlighting some thought-provoking news items and quotes from market commentators, let's briefly review the financial markets' movements on the basis of economic statistics and a performance round-up.

"Global business sentiment appears to have turned a corner. It remains weak, but it has moved measurably higher since hitting bottom in late April," reported the Survey of Business Confidence of the World conducted by Moody's Economy.com. "Confidence remains weakest in the US where it suggests the economy is still contracting, and it is strongest in Asia where it is consistent with an economy growing near its potential."

Economic reports in the US were largely overlooked last week as market participants focused on corporate news, although there were several notable releases.

• The NAHB Housing Market Index fell by 1 point to 18, bringing it back to the record low reached in December and before that not seen since 1985.

• After plummeting since the beginning of this year, consumer confidence is showing tentative signs of stabilizing, according to the ABC News/Washington Post Consumer Comfort Index.

• Industrial Production fell by 0.2% in May, following an outsized 0.7% decline in April. Overall, the report is consistent with continued modest declines in manufacturing.

• The Producer Price Index for finished goods rose by a large 1.4% in June as expected, following a 0.2% increase in April. Inflation was once again led by large price increases of food and energy products.

Summarizing the US economic scenario, Paul Kasriel, chief economist of Northern Trust, said: "... despite the Fed's aggressive Federal funds rate reductions, money and credit growth have slowed significantly ... to absolutely low rates. The implication of this is that real economic activity is likely to be very sluggish until financial institutions rebuild their capital positions and that the inflationary flames are likely to subside as they are deprived of the 'oxygen' of credit growth."

The highlight of next week's economic news will be the FOMC policy announcement on Wednesday. Economists expect the Fed funds rate to remain unchanged at 2.0%, but uncertainty regarding the wording of the policy statement means it has market-moving potential.

"We fully expect that the FOMC will devote a relatively large amount of 'ink' to the inflationary threats in its no-change policy statement on June 25, but we also expect the FOMC to reiterate that the downside risks to economic growth still dominate its policy decisions in the near term," said Kasriel.

Elsewhere in the world, escalating inflation concerns are at the top of policymakers' agendas. In addition to rampant inflation in emerging markets, the Eurozone and UK are also shouldering strongly rising prices.

• Consumer price inflation in the Eurozone was up 3.7% in year-ago terms in May. The rate is far above the European Central Bank's 2% inflation target and, given the ECB's more hawkish tone lately, markets are increasingly expecting the bank to tighten.

• Consumer prices shot ahead in May in the UK, rising by 3.3% in year-ago terms. The deteriorating inflation outlook has reduced the likelihood of imminent monetary easing, while a recent statement by Bank of England Governor Mervyn King suggests that rate increases are also unlikely.


Date Time (ET) Statistic For Actual Briefing
Jun 16 8:30 AM NY Empire State Index Jun -8.7 0.0 -2.0 -3.2
Jun 16 9:00 AM Net Foreign Purchases Apr $115.1B NA $63.2B $79.6B
Jun 17 8:30 AM Building Permits May - 960K 950K 978K
Jun 17 8:30 AM Core PPI May - 0.2% 0.2% 0.4%
Jun 17 8:30 AM Housing Starts May - 1000K 980K 1032K
Jun 17 8:30 AM PPI May 1.4% 1.0% 1.0% 0.2%
Jun 17 8:30 AM Core PPI May 0.2% 0.2% 0.2% 0.4%
Jun 17 8:30 AM Housing Starts May 975K 1000K 980K 1008K
Jun 17 8:30 AM Building Permits May 969K 960K 960K 982K
Jun 17 9:15 AM Capacity Utilization May 79.4% 79.8% 79.7% 79.6%
Jun 17 9:15 AM Industrial Production May -0.2% 0.2% 0.1% -0.7%
Jun 18 10:30 AM Crude Inventories 06/14 -1242K NA NA -4560K
Jun 19 8:30 AM Initial Claims 06/14 381K 370K 375K 386K
Jun 19 10:00 AM Leading Indicators May 0.1% 0.0% 0.0% 0.1%
Jun 19 10:00 AM Philadelphia Fed Jun -17.1 -10.0 -10.0 -15.6
Source: Yahoo Finance, June 20, 2008.

In addition to the FOMC's interest rate decision on Wednesday, June 25, next week's economic highlights, courtesy of Northern Trust, include the following:

1. Conference Board's June Index of Consumer Confidence (June 24) - Consensus: 56.5, Previous: 57.2.

2. May Durable Goods Orders (June 25) - Consensus: 0.0%, Previous: -0.5%.

3. May New Home Sales (June 25) - Consensus: 515K, Previous: 526K.

4. FOMC decision (June 25) - Consensus: no change in Fed funds target.

5. Q1 Final GDP (June 26) - Consensus: 1.0%, Previous: 0.9%.

6. May Existing Home Sales (June 26) - Consensus: 5,000K, Previous: 4,890K.

7. May Personal Income (June 27) - Consensus: 0.4%, Previous: 0.2%.

8. May Personal Consumption Expenditures (PCE) (June 27) - Consensus: 0.7%, Previous: 0.2%.

9. May Core PCE Price Index (June 27) - Consensus: 0.2%, Previous: 0.1%.

10. June Final University of Michigan Consumer Attitudes Index (June 27) - Consensus: 56.9, Previous: 56.7.

The performance chart obtained from the Wall Street Journal Online shows how different global markets performed during the past week.

Source: Wall Street Journal Online, June 22, 2008.

The MSCI World Index dropped by 1.9% during the past week as concerns about surging inflation, further credit-related trouble and deteriorating corporate earnings spooked investors.

The Nikkei 225 Average (-0.2%) was the only developed market to survive the sell-off relatively unscathed. David Fuller (Fullermoney) regards Japan as "the best industrialized stock market for today's economic climate".

The performance of emerging markets (-0.9%) - the big casualties of the previous week with a steep decline of 5.3% - varied from the Hong Kong Hang Seng Index (+0.7%) and the Russian Trading System Index (+0.8%) that ended the week in the black, to the less fortunate markets such as the Brazilian Bovespa Index (-3.9%) and the Indian BSE 30 Sensex Index ( 4.1%). Year-to-date returns show the performance of emerging markets (+12.0%) still handsomely ahead of mature markets (-9.7%).

The US stock markets faced the brunt of heavy selling pressure and closed on a very weak note on Friday - option and futures expiration day. The index movements tell the story: Dow Jones Industrial Index -3.8% (YTD -10.7%), S&P 500 Index -3.1% (YTD -10.2%), Nasdaq Composite Index -2.0% (YTD 9.3%) and Russell 2000 Index -1.1% (YTD -5.3%).

At the centre of the sub-prime fallout, the Philadelphia Bank Index dropped to its lowest level in five years, closing down 5.9% on the back of further credit-related concerns and analysts downgrading their price targets for a number of companies.

Fedex (FDX), viewed as a bellwether for the broader economy, reported earnings that missed the consensus estimate and issued 2009 earnings guidance well below expectations, citing a weak US economy and record fuel prices.

Ford (F) and General Motors (GM) retreated by 8% and 16% respectively for the week after Ford said it would be difficult to "break even" in 2009, and Standard & Poor's put a negative credit rating watch on both companies. It makes one wonder about the old adage stating that "As GM goes, so goes the nation" ...

Gold stocks (+4.8%) and platinum stocks (+4.6%) were among the few to keep head above water during the sell-off.

The Dow Jones Industrial Index and the S&P 500 Index are solidly below both their 50- and 200-day moving averages, and are now challenging their March lows of 11,740 and 1,273 respectively. The Nasdaq Composite Index has also now succumbed to both moving averages, whereas the Russell 2000 Index is right at its 50-day moving average (and already below the key 200-day line).

I penned some (rather sobering) thoughts on the fundamental outlook for the US stock in a post a few days ago. Here is the link: US Stock Market: Muddling Through the Fundamentals.

Fixed-interest instrument

Federal Reserve and European Central Bank officials last week moderated market participants' expectations of interest rate increases, resulting in rates coming off the boil as seen in the US three-month Treasury Bill rate dropping by 16 basis points to 1.80%. Fed funds futures moved to price in only a 10% chance that the Fed will raise rates by 25 basis points at Wednesday's FOMC meeting, compared with 22% a week ago.

The front end of the Treasury yield curve, being most sensitive to Fed policy moves, gained, with the yield on the two-year Note dropping by 19 basis points during the week to close at 2.85%. The yield on the 10-year Note, which is more sensitive to inflation pressures, declined by 12 basis points to 4.14%.

As far as the rest of the world is concerned, short-dated bond yields were mostly lower. For example, the yield on the UK two-year Gilt declined by 16 basis points to 5.29%, whereas the German two-year Schatz yield dropped by 9 basis points to 4.60%.

Safe-have considerations played a role pushing up bond prices, but BCA Research warned that "... government bond markets will remain at risk until oil prices correct decisively or there is evidence that the disinflationary impact of the ongoing slowdown in the G7 economy is starting to unfold".

US mortgage rates were virtually unchanged, with the 15-year fixed rate declining by 1 basis point to 5.99% and the 5-year ARM 1 basis point higher at 5.88%.

Credit market stress increased as shown by the widening spreads in both the US and Europe. The CDX (North American, investment grade) Index rose by 11 basis points to 126, and the Markit iTraxx Europe Crossover Index by 14 basis points to 500.


A realization that the Fed might not hike interest rate as quickly as expected caused the US dollar to trade lower. The euro rose by 1.4% against the dollar in anticipation of the ECB carrying out its threat of increasing interest rates a notch next month. Other major currencies - the British pound (+1.4%) Swiss Franc (+1.0%) and Japanese yen (+0.9%) - also made headway against the greenback.


Commodity markets as a whole rose by 1.8% as a softer US dollar encouraged buying of precious and industrial metals.

However, movements in the crude oil price remained the focal point. West Texas Intermediate closed a volatile week nearly unchanged at $134.62 per barrel after trading as high as $139.89 (a new record) and as low as $131.19. Trading triggers included the US government's oil inventories report that showed a mixed picture of demand, an announcement that China was increasing its gasoline and diesel prices, and news that Israel performed a military exercise to simulate the bombing of nuclear facilities in Iran.

The chart below shows the past week's performance of various commodities.

Now for a few news items and some words and charts from the investment wise that will hopefully assist in navigating the stormy waters of financial markets. And remember, the emphasis at this point should be on the return of capital rather than the return on capital.

Hat tip: Phil's Stock World, June 17, 2008.

Giles Keating (Credit Suisse): World economy moves toward long-term balance
"Rising oil and food prices and inflation are making headlines worldwide. Giles Keating, head of the Credit Suisse Global Economics and Strategy Group, explains the economic impact of these issues."

Source: Credit Suisse, June 16, 2008.

Bloomberg: G8 says economy faces "headwinds", oil prices a threat
"Finance ministers from the Group of Eight nations said spiraling food and fuel prices are their chief concern in a statement following their meeting in Osaka, Japan, on June 14. Inflation is accelerating after the price of oil reached an unprecedented $139.12 a barrel last week and food costs from rice to soybeans set records this year. Central banks are already shifting towards tighter monetary policy even as expansion fades."

Source: Mike Fern, Bloomberg, June 16, 2008.

Bloomberg: Henry Paulson - "strong" dollar is in US's interest
"US Treasury Secretary Henry Paulson spoke at a news conference in Osaka, Japan, on June 14 following the meeting of finance ministers from the Group of Eight nations about the outlook for the US economy, dollar, the importance of supporting clean-energy projects, and the rise in oil prices."

Source: Bloomberg, June 14, 2008.

Ambrose Evans-Pritchard (Telegraph): RBS issues global stock and credit crash alert
"The Royal Bank of Scotland has advised clients to brace for a full-fledged crash in global stock and credit markets over the next three months as inflation paralyses the major central banks.

"'A very nasty period is soon to be upon us - be prepared,' said Bob Janjuah, the bank's credit strategist.

"A report by the bank's research team warns that the S&P 500 Index of Wall Street equities is likely to fall by more than 300 points to around 1050 by September as 'all the chickens come home to roost' from the excesses of the global boom, with contagion spreading across Europe and emerging markets.

"Such a slide on world bourses would amount to one of the worst bear markets over the last century.

"RBS said the iTraxx index of high-grade corporate bonds could soar to 130/150 while the 'Crossover' index of lower grade corporate bonds could reach 650/700 in a renewed bout of panic on the debt markets.

"'I do not think I can be much blunter. If you have to be in credit, focus on quality, short durations, non-cyclical defensive names. Cash is the key safe haven. This is about not losing your money, and not losing your job,' said Mr Janjuah, who became a City star after his grim warnings last year about the credit crisis proved all too accurate.

"RBS expects Wall Street to rally a little further into early July before short-lived momentum from America's fiscal boost begins to fizzle out, and the delayed effects of the oil spike inflict their damage."

Source: Ambrose Evans-Pritchard, Telegraph, June 19, 2008.

Telegraph: Morgan Stanley warns of "catastrophic event" as ECB fights Federal Reserve
"The clash between the European Central Bank and the US Federal Reserve over monetary strategy is causing serious strains in the global financial system and could lead to a replay of Europe's exchange rate crisis in the 1990s, a team of bankers has warned.

"'We see striking similarities between the transatlantic tensions that built up in the early 1990s and those that are accumulating again today. The outcome of the 1992 deadlock was a major currency crisis and a recession in Europe,' said a report by Morgan Stanley's European experts.

"Just as then, Washington has slashed rates to bail out the banks and prevent an economic hard-landing, while Frankfurt has stuck to its hawkish line - ignoring angry protests from politicians and squeals of pain from Europe's export industry.

"Indeed, the ECB has let the de facto interest rate - Euribor - rise by over 100 basis points since the credit crisis began.

"Just as then, the dollar has plummeted far enough to cause worldwide alarm. It is potentially worse for Europe this time because the yen and yuan have also fallen to near record lows. So has sterling.

"Morgan Stanley doubts that Europe's monetary union will break up under pressure, but it warns that corked pressures will have to find release one way or another.

"This will most likely occur through property slumps and banking purges in the vulnerable countries of the Club Med region and the euro-satellite states of Eastern Europe."

Source: Ambrose Evans-Pritchard, Telegraph, June 17, 2008.

David Fuller (Fullermoney): Inflation threat more serious than banking crisis
"... obfuscation of financial data is creating many conflicting signals for investors. Also, the inflation problem is certainly a concern, although not a surprise to Fullermoney subscribers since the seeds for it, in terms of inflationary monetary policy, had been sown since 1997, as often mentioned.

"I agree that there are many economic difficulties which are not supportive of stock markets. I regard today's inflationary problems, which are global, as more serious than the banking crisis which is mainly confined to the west. There is a risk that central banks, having fanned the flames of inflation with excessive monetary growth relative to GDP, will now overreact in their efforts to douse this fire.

"I have often mentioned that most of the inflation was coming from resources prices and government services in many countries, not least the UK. Unfortunately but inevitably, soaring prices for food and energy are highly emotive. I maintain that the prices consumers pay for these staples will stay high, more often than not, despite sharp fluctuations in underlying commodity prices.

"However, given the annualised data, if commodity prices levelled out for a year, their contribution to inflation data would be zero. Thereafter if jawboning and the economic slowdown mostly contain wages, central banks will declare at least a partial victory against inflation, albeit at the less publicised price of a lower standard of living for many people. The claim of lower inflation would probably not hold up under close scrutiny but at least central banks would be able to switch their emphasis to stimulating economic growth for a while."

Source: David Fuller, Fullermoney, June 18, 2008.

CNBC: Goldman's Jan Hatzius on Fed rates, inflation and jawboning

Source: CNBC, June 16, 2008.

Bill King (The King Report): The recession in GDP is here
"Merrill's David Rosenberg: The recession in GDP is here - but it's in the monthly data, not the quarterly data. The MacroEconomic Advisers monthly database shows that real GDP dipped at a 0.5% annual rate in April and has contracted now in two of the past three months.

"Note that since January, the month we had been saying for some time that represented the peak of the business cycle, real GDP has declined at a 2.2% annual rate. So, do not be fooled by that 0.9% first quarter GDP print - it is masking erosion in activity beneath the veneer of quarterly averages."

Source: Bill King, The King Report, June 19, 2008.

Paul Kasriel (Northern Trust): Housing starts plumb new cyclical low
"After unexpectedly increasing in April, housing starts got back to the script, falling 3.2% in May to an annualized rate of 975 thousand units - a cycle low and the lowest annualized rate since March 1991. Housing starts have fallen 57% from their January 2006 peak."

Source : Paul Kasriel, Northern Trust - Week in Review, June 16 - 20, 2008.

Paul Kasriel (Northern Trust): Manufacturing output remains in the pits
"The Federal Reserve reported that total industrial production slumped another 0.2% in May after plunging 0.7% in April. On a year-over-year basis, the manufacturing index was down 0.4% in May, its first year-over-year decline since June 2003. We do not expect that manufacturing output will contract as much in this recession as it did in the 2001 recession because of support from exports."

Source : Paul Kasriel, Northern Trust - Week in Review, June 16 - 20, 2008.

Paul Kasriel (Northern Trust): Continuing unemployment claims continue to suggest recession
"Seasonally adjusting weekly economic data is an ambitious undertaking. With regard to the weekly unemployment claims data, I prefer to look at the behavior of the four-week moving average of the unadjusted data, taking the year-over-year percent change. In the four weeks ended June 6, the average of continuing unemployment claims is up a cycle-high 23.6% from a year ago. This percentage increase is a little low compared to the early months of the 2001 recession but a little higher than it was in the early months of the 1990-91 recession. Rest easy, continuing claims are going significantly higher before this recession is over."

Source: Paul Kasriel, Northern Trust - Daily Global Commentary, June 19, 2008.

Ed McKelvey (Goldman Sachs): Fed tightening would be inappropriate
"An interest rate rise by the Federal Reserve would be both inappropriate and unlikely any time soon, believes Ed McKelvey, senior economist at Goldman Sachs.

"He notes that interest rate futures are implying that at least one 25 basis point rise is virtually certain by the time of the Federal Open Market Committee's monetary policy meeting on September 16, with considerable probability of more increases to come.

"'We cannot rule out a rate hike given the warnings issued by Fed chairman [Ben] Bernanke and vice-chairman [Donald] Kohn about long-term inflation expectations,' Mr McKelvey says.

"'With retail sales also firming up, we can imagine a scenario in which Fed officials feel compelled to make good on these words.'

"However, Mr McKelvey lists three main reasons why a tightening would be inappropriate at this stage.

"First, the economy is fundamentally weak, with tax rebates driving the surge in retail sales. Second, financial markets remain fragile; and third, worries about inflation are overdone.

"'As these points become apparent, we think Fed officials will see things our way,' Mr McKelvey says.

"'We continue to believe that most FOMC members want to see three things before tightening - labour market improvement, some clear signs of stability in the housing market, and much more progress towards normalcy in the financial markets.'"

Source: Ed McKelvey, Goldman Sachs (via Financial Times), June 16, 2008.

Bill King (The King Report): Bank credit continues to contract
"... bank credit continues to contract as banks dump assets and procure capital in order to de-lever. Ergo many companies must scramble for credit. And so far, the Fed is pumping furiously to keep the system from contracting sharply or worse."

US Commercial Bank Credit (seasonally adjusted)

Source: Bill King, The King Report, June 16, 2008.

Bill King (The King Report): Be careful about "bogus CPI"
"The deeply flawed and increasingly recognized as bogus CPI is up 4.2% y/y. Ergo real interest rates are sharply negative. This fosters inflation ... Seasonal adjusting for the spring has greatly understated energy inflation, which the BLS has noted will change with June CPI. We'll see.

"For May, the BLS has energy prices up 4.4% after showing no change in April and gasoline +5.7% m/m, with April -2.0%! In June, the BLS should rectify the under-reporting of energy inflation. Gasoline futures are up 33% since March. If the BLS actual allows the full fury of energy inflation from the spring to appear in June, the CPI will be horrendous unless the BLS finds other prices to seasonally adjust lower."

US Department of Energy (DOE) Retail Automotive Gasoline Total All Grades Average Price

Source: Bill King, The King Report, June 16, 2008.

Paul Kasriel (Northern Trust): PPI data point to profit margin squeeze
"The PPI for finished goods of all kinds was up 1.4% in May. Comparing the PPI for finished consumer goods with the CPI for consumer goods suggests that businesses are having a tough time passing-through to the consumer the higher prices they are paying for goods. ... that since the late 1990s, the ratio of the CPI for core goods has been falling relative to the PPI for consumer core goods. All of this suggests that profit margins are being squeezed. Narrower profits margins in conjunction with slower growth in physical volumes are a bad combination for business profit growth.

"Right now the Fed's bet and ours is that an environment in which aggregate economic demand is weak will be conducive to bringing down the overall inflation rate later this year after a month or two more of higher energy prices. Part of our bet on weak aggregate demand has to do with the ongoing credit crunch. Without rapidly growing credit, inflation has a difficult time sustaining itself. Bank credit and money supply growth have shown a sharp deceleration in recent weeks, which, if continued, will tend to damp aggregate demand and inflation going forward."

Source : Paul Kasriel, Northern Trust - Week in Review, June 16 - 20, 2008.

BCA Research: US inflation angst remains high, but core CPI should move lower
"US core consumer price inflation should continue to drift lower, dragged down by a weak domestic economy and the relentless slide in house prices.

"The Fed has sounded more hawkish of late, worried that longer-term inflation expectations will soon follow the rise in shorter-term expectations. The multi-year boom in pipeline price pressures and ever-sinking dollar have sparked heightened inflation fears, even in the face of a domestic recession and housing deflation. Importantly, pipeline pressures still hit a brick-wall when they reach retail outlets, and there is no likelihood of any leakage into wages given the uptrend in the unemployment rate.

"Bottom line: Core CPI should move lower over the balance of the year, but inflation angst may not ease until oil prices decisively correct."

Source: BCA Research, June 16, 2008.

Financial Times: Goldman close to $7 billion SIV bail-out
"Goldman Sachs is close to finalising a plan to restructure a $7 billion investment vehicle formerly run by London-based hedge fund Cheyne Capital, in a move that could potentially usher in a crucial new phase in the credit turmoil.

"The US bank's proposed reorganisation of the so-called structured investment vehicle is set to be just the first of a number of deals that could see about $18 billion worth of SIV assets restructured in the coming months.

"The deal, which could be signed as early as Tuesday, is likely to be closely watched by the financial industry, since Cheyne is one of the largest independent SIVs - and the deal marks the first time that any collapsed SIV has been restructured in this way. The SIV went into receivership last autumn when the value of its credit assets, such as mortgage-linked securities, plunged.

"The Cheyne restructuring, which has been brokered after nearly 10 months of negotiations, will require the receivers to organise an auction of the Cheyne assets in the coming weeks, to establish a transparent price for these instruments. This is important because in recent months it has often proved impossible to value these murky assets.

"Once this price is established, Goldman will then create a new off-balance sheet vehicle to buy the assets, with the transfer of assets being funded by the US bank for just one day before being sold on to the new vehicle. Under the plan senior creditors in the SIV will be given a range of options including reinvesting in this new vehicle.

"... the move will bolster hopes that banks are starting to create solutions to the long-running woes of SIVs, and the plethora of other, shadowy credit entities that have exploded in size this decade, in the so-called 'shadow banking world'."

Source: Anousha Sakoui, Financial Times, June 16, 2008.

Bloomberg: John Paulson says writedowns may reach $1.3 trillion
"John Paulson, founder of the hedge fund company Paulson & Co., said global writedowns and losses from the credit crisis may reach $1.3 trillion, exceeding the International Monetary Fund's $945 billion estimate. 'We're only about a third of the way through the writedowns,' Paulson told the GAIM International hedge fund conference in Monaco today. 'There are a lot of problems out there and it will continue to be felt through the year. We don't see any signs of stabilizing.'"

Source: Tom Cahill and Poppy Trowbridge, Bloomberg, June 18, 2008.

BCA Research: Commodity pits driving monetary policy and government bonds
"The run-up in commodity prices is dominating media headlines and is spooking investors. However, the annual rate of change in food and energy prices is now at an extreme, which is unsustainable. Crude oil prices have risen 100% from year-ago levels and would need to surge close to $200/bbl by the end of 2008 just to maintain the current pace of inflation.

"Moreover, the macro backdrop in the developed world is not conducive to sustained underlying price pressures. The US and Japan are close to or in recession, the UK economy is heading there rapidly, and the euro area is on target for a period of below-trend growth.

"So far, there is no evidence of second round effects in any of these economies or risk of a wage inflation spiral. In fact, monetary restraint in response to commodity induced price pressures over the next few months would likely amplify the downturn in global growth. Still, government bond markets will remain at risk until oil prices correct decisively or there is evidence that the disinflationary impact of the ongoing slowdown in the G7 economy is starting to unfold. For now, we recommend standing aside and maintaining a benchmark duration allocation. Stay tuned."

Source: BCA Research, June 19, 2008.

Bloomberg: China "not smart" to invest in US bonds
"China's government, which invests up to a third of its $1.68 trillion in currency reserves in Treasuries, is 'not smart' to invest in US debt and should seek higher returns, a former legislator said.

"'I don't think it's a smart move to invest in US bonds,' said Cheng Siwei, former vice chairman of the National People's Congress, China's legislature, at a Beijing conference. 'We need smart capitalists to invest ourselves,' instead of lending money to American investors and earning interest, he said.

"Cheng's remarks on November 7 that China should improve the structure of its foreign reserves by favoring stronger currencies helped pushed the dollar to record lows against the euro. He said today his comments represented his 'personal opinion, not the government's policy.'

"Countries in Asia have amassed a record $4.2 trillion in foreign exchange reserves since the 1997-98 financial crisis, seeking to protect their economies from a similar regional currency slump."

Source: Belinda Cao, Bloomberg, June 13, 2008.

David Fuller (Fullermoney): "It is different this time" is seldom a good bet
"It may seem counterintuitive but if we have learned two important things over our investment years, they are:

1. Cease buying and commence selling when the crowd is euphoric.

2. Buy or at least hold onto your long positions when the news is all gloom and doom.

"But, David, what if it really is different this time?

"It might be, but that is seldom a good bet. Meanwhile, stock markets appear at least temporarily oversold and crude oil has not extended its uptrend. Today's pessimism is not a dramatic, climactic signal such as we last saw in January and March, but it is an indication that people are becoming too pessimistic once again."

Source: David Fuller, Fullermoney, June 19 2008.

David Fuller (Fullermoney): Bearish sentiment indicates stock market rebound
"... this graph speaks for itself. There has never been a reading at current or lower levels that was not soon followed by a sharp rebound, including during the last bear market. This indicates to me that we are within a week or two of a bear squeeze, providing at least a tradable rally in which I aim to participate."

Source : Investors Intelligence (via Fullermoney), June 18, 2008.

Richard Russell (Dow Theory Letters): Lowry's statistics spell trouble
"I did a double-take when I read Lowry's statistics after the close of yesterday's market. Buying Power Index at a multi-year low and Selling Pressure Index at a multi-year high. And the two Indices at about their widest (most bearish) spread in history or since the 1930s. What the devil could this mean? My guess can be summed up in one word - trouble."

Source: Richard Russell, Dow Theory Letters, June 19, 2008.

Financial Times: US corporate earnings expected to fall
"US corporate earnings are expected to decline for the fourth straight quarter when the reporting season kicks off next month as companies battle a sharp rise in production costs.

"Second-quarter earnings for S&P 500 companies are forecast by analysts to fall 9%, according to Thomson Reuters.

"The bulk of the latest quarterly decline in profits is led by financials, seen falling 53%, and consumer discretionary groups, forecast to slide 14%.

"In contrast, energy companies are expected to boost earnings growth by 22% during the quarter as oil remains near a record $140 a barrel.

"However, the surge in energy and food prices in recent months is feeding into much higher production costs at a time when the economy remains sluggish. Given the weak economic backdrop, economists doubt that companies can fully pass along their higher production and service costs to consumers.

"In spite of recent stimulus cheques being sent to many consumers, corporate profit margins look vulnerable.

"Analysts expect third-quarter earnings growth to rebound with a gain of 13.9% over the same period last year when the first impact of the credit crisis was felt."

Source: Michael Mackenzie, Financial Times, June 18, 2008.

Reuters: Goldman reduces price targets for US banks
"US banks may need to raise $65 billion of additional capital to cope with mounting losses from a global credit crisis that will not peak until 2009, Goldman Sachs & Co analysts said on Tuesday.

"The new capital would be on top of $120 billion already raised by the industry, analysts led by Richard Ramsden said.

"'Banks will not turn until a peak in credit costs is in sight,' the analysts wrote. 'Moreover, weaker banks are unlikely to benefit from consolidation as bank deals always slow when credit is deteriorating and larger banks are hamstrung by their own problem assets as well as accounting requirements.'

"Goldman said it lowered its price targets for 14 banking companies and cut its 2008 earnings-per-share forecasts for 11.

"Among the banks for which Goldman cut both are BB&T, PNC Financial Services, SunTrust Banks, US Bancorp and Wells Fargo.

"Goldman also lowered its price targets for Wachovia and Washington Mutual, and its earnings outlook for Bank of America."

Source: Reuters, June 17, 2008.

GaveKal: Lower oil prices should boost Chinese equities

Source: GaveKal - Checking the Boxes, June 20, 2008.

Telegraph: China and India lose their appeal for investors on inflation fears
"The world's fund managers are pulling their money out of China and India at a record pace on mounting fears of inflation and are now more pessimistic about global equities than at any time in the past decade.

"The latest survey of investors by Merrill Lynch shows that Europe has become the most unpopular region, while Britain is still trapped in the doldrums.

"But the big surprise is the sudden change in view on the emerging powers of Asia, as overheating and spiralling oil costs spoil the boom.

"'World growth is slowing and yet central banks might still have to tighten monetary policy, that is what is scaring people,' said David Bowers, the organiser of the survey. The vast majority of fund managers think earnings forecasts have lost touch with reality.

"The exodus from China reached fever pitch this month as investors slashed their net 'weighting' position to -58, down from -14 in May. The Shanghai bourse had already fallen by almost half since October.

"India fell to -63 as investors took fright at the country's budget and trade deficits. There is concern over a relapse towards Nehru-era policies after Delhi halted trading in a range of commodity futures and restricted rice exports.

"The survey of 204 fund managers worldwide suggests that the love affair with emerging markets is going cold.

"Fund managers are still super-bullish on Russia, betting that the energy boom has life yet. A net 62% are overweight oil and gas shares. The most hated trio are travel and leisure (-66), banks (-62) and property (-60).

"A record number (net 29%) are now underweight on European equities; many have switched into cash as they wait for the European Central Bank to inflict punishment - ever more likely after eurozone inflation reached an all-time high of 3.7% in May.

"As the new story unfolds, America is coming back into favour, emerging as a sort of safe haven in a fast-changing world where trusted institutions command a premium. Investors are quietly rotating back into Wall Street - despite a chorus of pessimists. A net 23% are overweight US equities, the highest since August 2001.

"The long awaited 'decoupling' has begun. The United States looks like the winner after all."

Source: Telegraph, June 19, 2008.

David Fuller (Fullermoney): Japan - the best industrialized stock market for today's economic climate?
"Is this the best industrialised stock market for today's economic climate? Oh no, I can sense some of you thinking - he is going to mention Japan. Yes, and you may recall the adage: The best investment opportunities occur when those who know it best, love it least, because they have been disappointed most.

"Sure, one could easily argue that Japan is a politically ossified old people's home, destined to disappoint investors in perpetuity. This claim is not short of circumstantial evidence.

"If the bears are right, Japan's stock market will soon break downwards once again. After all, on weekly charts the Nikkei and Topix bounced in March from where one might expect, looking at the earlier data, but have now rallied back to their overhanging top formations and the declining 200-day MAs.

"Interestingly, however, Japan is the only developed country stock market that I am aware of where the reaction lows for major indices since March are still rising, albeit only just. Consequently the Nikkei and Topix have shown relative strength since mid-May, as we can see from the daily charts.

"I have said before that Japan cannot hold out on its own, but if Wall Street and other markets are now steadying in response to an oversold condition then Japan is a likely upside leader. Obviously the higher reaction lows need to hold, otherwise Japan falls back into its trading range of the previous three months, as have many other indices.

"Why might it maintain this relative performance? I can think of two good reasons: 1. Japan, I believe, is the most efficient user of oil, although Germany is probably a close second. 2. Japan certainly has the lowest inflation rate of any country, but it is likely to rise.

"These two factors could be significant at a time when everyone is understandably concerned about high oil prices and global inflationary problems. However Japan has the world's highest savings rates, partly due to the long deflation, but the prospect of higher inflation should encourage consumer demand. Also, we often hear about Japan's demographic problems but at least that means fewer poor to feed. Japan also has the lowest interest rates and a soft currency."

Source: David Fuller, Fullermoney, June 16, 2008.

GaveKal: Is this the beginning of the commodities correction?

Source: GaveKal - Checking the Boxes, June 20, 2008.

News Daily: T Boone Pickens - oil production has topped out
"World crude oil production has topped out at 85 million barrels per day even as demand keeps climbing, helping to drive a stunning surge in prices, billionaire oil investor T. Boone Pickens said on Tuesday.

"'I do believe you have peaked out at 85 million barrels a day globally,' Pickens, who heads BP Capital hedge fund with more than $4 billion under management, said during testimony to the Senate Energy and Natural Resources Committee.

"The United States alone has been using '21 million barrels of the 85 million and producing about 7 of the 21, so if I could take just a minute on this point, the demand is about 86.4 million barrels a day, and when the demand is greater than the supply, the price has to go up until it kills demand,' Pickens told lawmakers."

Source: News Daily, June 17, 2008.

Bloomberg: Emergency oil summit preview

Source: Bloomberg, June 19, 2008.

Financial Times: Saudi plans to raise oil output
"The price of crude hit a new all-time high of $139.89 on Monday as a weakening US dollar and fresh disruption in North Sea oil production overshadowed Saudi Arabia's plant to boost its oil production to its highest level in more than 25 years, Carola Hoyos, FT's chief energy correspondent, analyses the 'high-risk' Saudi move."

Source: Richard Edgar, Financial Times, June 16, 2008.

GaveKal: Can oil roll over?
"Today, the main question for investors everywhere is still oil. If crude stays at US$135/bbl, then this spells lower growth and lower margins for business. In Asia the implications would be growing budget deficits and more rapid money creation, which would add to inflationary pressures. Inflation, in turn, implies lower price-to-earnings multiples. This is obviously not a very attractive scenario for anyone. So the key question is: can oil roll over and, if so, how?

• Option # 1: New supply comes on stream. This takes time. Even if OPEC opens the spigot (and Saudis looked poised to do just that), increased production will not come on line overnight.

• Option # 2: Demand backs off. We are already seeing this. Not just with America's gas guzzlers cutting back, but in Asia where slowing growth in industrial production/fixed asset investment will get an extra downward shove as many governments reduce fuel subsidies.

• Option # 3: Sledgehammer monetary policies. Central banks could kill off liquidity to cool inflation (the Volcker method), but they would kill their economies in the process, and put companies into bankruptcy.

• Option # 4: A 'Plan B' on energy: Governments could take coordinated action to reduce the speculative component of the oil bubble by: cutting back subsidies, announcing rational energy programs, tightening regulations on the trading of energy futures, etc.

"In light of the unattractiveness of the other three options, it is reasonable to think that a global coordinated effort - a 'Plan B' - would come to fruition. After all, the current generation of policymakers will not want to be remembered for having fiddled while Rome burned. However, after nothing happened at last weekend's G8, hope is waning. At this point, it looks like 'Option #2' is the more likely outcome - fuel demand will back off. But in the process, someone out there, a marginal or less stable member of the world economic community, will go bust. That's the reality we are living in today, and that is why we are seeing things like China's domestic stock market declining ten days in a row, India intervening to support its currency, Vietnam swooning under 25% inflation, etc.

"What's an investor to do in this environment? As we see it, it makes sense to stick with countries where inflation/monetary aggregates are within reason: i.e., the US, Japan, Taiwan and Switzerland. Coincidentally, these are also the nations that have been outperforming over the past couple of weeks."

Source: GaveKal - Checking the Boxes, June 18, 2008.

The New York Times: Americans finally driving less
"As the price of gasoline quadrupled over the last decade, American drivers seemed to defy the laws of economics by pumping more into their vehicles year after year.

"But this is the year American drivers appear to be finally succumbing to price shock at the pump, according to a new report by Cambridge Energy Research Associates ... It says the slowdown in the economy and soaring gasoline prices have finally persuaded Americans to drive fewer miles in fewer gas-guzzling vehicles.

"'US gasoline demand will likely decline in 2008 for the first time in more than 17 years,' says the report ... 'For the first time since the 1970s and early 1980s the number of miles driven by Americans has clearly begun trending downward.'

"The Transportation Department reported on Wednesday that Americans drove 1.8% fewer miles on public roads in April 2008 compared with the same month last year, the sixth consecutive month of driving mileage declines.

"Sales of pickup trucks, minivans and sport utility vehicles have fallen below 50% of new passenger vehicle sales this year for the first time since 2001, the report says, as consumers turned to smaller vehicles in favor of fuel economy. 'It's kind of stunning,' said Aaron F. Brady, a co-author of the report. 'It was over 50% as late as February and by May it fell under 44%. It's like falling off a cliff.'

"Drivers, meanwhile, are becoming more prudent in their driving habits, either by using public transportation, carpooling or just cutting down on unnecessary trips, the two authors said in an interview. 'Public transit ridership is surging all over the country,' said Samantha Gross, the other author."

Source: Clifford Krauss, The New York Times, June 19, 2008.


Continue to Part II



Prieur du Plessis

Author: Prieur du Plessis

Dr Prieur du Plessis

Dr Prieur du Plessis

With 25 years' experience in investment research and portfolio management, Dr Prieur du Plessis is one of the most experienced and well-known investment professionals in South Africa. More than 1 000 of his articles on investment-related topics have been published in various regular newspaper, journal and Internet columns. He also published a book, Financial Basics: Investment, in 2002.

He holds the following degrees: BSc (Quantity Surveying) (Cape Town), HonsB (B & A) (cum laude) (Stellenbosch), MBA (cum laude) (Stellenbosch); and DBA (Doctor of Financial Management) (Stellenbosch).

Prieur is chairman of the Plexus group of companies, which he founded in 1995. Previously he was general manager: portfolio management at Sanlam, responsible for the management of investment portfolios with total assets in excess of $5 billion.

Plexus is a pioneer in the mutual fund industry and has achieved a number of firsts under Prieur's leadership. These include the authoritative Plexus Survey, a quarterly analysis of the consistency of the performance of unit trust management companies, the Plexus Offshore Survey, the Plexus Unit Trust Indices, and the PlexCrown Fund Ratings.

Plexus is the South African partner of John Mauldin, American author of the most widely distributed investment newsletter in the world, and also has an exclusive licensing agreement with California-based Research Affiliates for managing and distributing its enhanced Fundamental Index™ methodology in the Pan-African area.

In 2001 Prieur received the Santam/AHI Business Leader of the Year award for corporate leadership, business acumen and entrepreneurial flair. He was also profiled in the book South Africa's Leading Managers (2006). Plexus received the AHI/Old Mutual Enterprise of the Year award in 1997 and was also included in the book South Africa's Most Promising Companies (2005).

Prieur is 52 years old and lives with his wife, TV producer and presenter Isabel Verwey, and two children in Welgemoed, Cape Town. His recreational activities include long-distance running, motor cycling and reading. He belongs to the Cape Town Club, Johannesburg Country Club, Gordon's Bay Yacht Club and Swiss Social & Sports Club.

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