Is the Tide Turning?

By: Mark McMillan | Mon, Dec 8, 2008
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12/8/2008 9:44:41 AM


This week, we will cover our regular features of the Week in Review and our Market Outlook with a special subject dealing with the availability of credit.

The week in Review - Events & Fundamentals:

Monday, December 1st:
There were two economic reports of interest released:

Both reports came out a half hour after the open but gave investors little to cheer about. While weaker construction spending is a trend with the collapse of the housing market, the ISM index fell to its lowest level in many years.

The National Bureau of Economic Research (NBER) declared that the U.S. economy entered a recession as of December 2007. The NBER doesn't use the standard two quarters of economic contraction to define a recession. In July 2003, they declared the end of the recession that began in March 2001 as having ended in November 2001. So, that recession lasted 8 months but wasn't declared over for another 18 months. While this may be useful as an economic exercise, it isn't particularly useful to investors. It does, however, cast a pall over the markets.

The financial sector was hit the hardest recording a loss of 17.0%. Oppenheimer analyst Meredith Whitney said the U.S. credit card industry may cut credit lines by over $2T (yes that is trillion) or 45% over the next 18 months. She cited risk aversion, funding challenges, and regulatory and accounting changes. Whitney is widely followed as she correctly predicted the moves in financials over the course of the last year.

Citigroup made two deals which were news headlines on Monday. The first bit of news was along the lines of selling assets to raise cash. In this case, it will sell its Japanese Trust, NikkoCity Trust and Banking for an amount likely to exceed $400M. The second bit of news wasn't expected as Citigroup tendered an offer to buy a toll road operating unit in Spain from a Spanish company for a reported $3.6B in cash and debt. This is somewhat striking in that Citi was on the brink of failure before the U.S. government stepped in only a weekend ago to infuse $20B in capital and to guarantee $306B in Citi assets. How Citi can do such a deal after a Federal bailout is likely to result in a probe by the Federal government as instead of extending credit, they are shrinking their own capital base and issuing more debt.

Finally, Black Friday sales were better than expected, rising 2% to 7% above last year (depending on the source). The fear has shifted from Black Friday falling short to the rest of the holiday shopping season falling short of expectations and retailers fell 9.3%.

Tuesday, December 2nd:
There were no economic reports of interest released. Instead, the focus was on the automakers as they pleaded for a bailout. They also announced November U.S. sales results with GM sales falling 41%, Ford falling 31%, Chrysler toppling 47% and even Toyota falling 34%.

GM asked Congress for $12B and a credit line of $6B in case the slowdown is prolonged. GM expects to begin repaying the loan by 2011. Ford asked for $9B and expects to reach breakeven by 2011.

GE announced they expect Q4 to come in at the low-end of their guidance, which was better than analysts expected and investors rewarded GE as Tuesday's best performing stock in the DJIA. GE also stated it would maintain its dividend through 2009, which is at a healthy 8% of Monday's closing price.

The financial sector rebounded 7.9% on Tuesday following Monday's 17% sell-off. Goldman Sachs (GS) actually fell on the day ($65.10 -$0.66) as the Wall Street Journal predicted they would report a loss of $2B in the latest quarter which is five times the loss analysts are expecting.

Wednesday, December 3rd:
There were three economic reports of interest released:

The job losses were the largest in seven years. ISM Services are at the lowest level ever reported. Productivity was better than expected, which means that GDP won't fall as fast as job losses, but the effect of lower consumer sentiment and spending will still be felt throughout the economy.

The Fed released the Beige Book reflecting details of the last meeting of the Federal Open Market Committee (FOMC). Most of the details weren't a surprise given the negative reports that have been coming out regularly. There were two details that stood out, however. The Philadelphia Fed saw an increase in loan volumes in November. The Dallas Fed indicated that the capital investments made by the U.S. government have made larger financial institutions feel less constrained in their lending. This was a catalyst for the rally from 2:00pm which helped the financial sector outperform on a relative basis.

The major movers for the market outside of financials were retailers (+6.3%). A report on online retail sales saw online sales jump 15% on Cyber Monday, the second highest sales volume ever recorded. November sales are down 2% year-over-year but this is better than expected.

Finally, homebuilders rose 11% as the government's $500B plan to support the mortgage market provided hope and a corresponding drop in the 30-year fixed rate to 5.65% and a rise in mortgage applications of 112%. Late in the session, the Wall Street Journal reported that the Treasury is working on a plan to reduce new mortgage rates down to 4.5% in order to stimulate the housing market.

Thursday, December 4th:
There were two economic reports of interest released:

The jobless claims four-week rolling average actually moved higher even with the weekly drop in claims. The jobless claims tend to be volatile so a four-week average is used to smooth the things. Factory orders falling less than expected was a bit of good news although they clearly show contraction in the economy.

The Bank of England (BoE) cut its target rate by 100 basis points to 2.00%. The European Central Bank (ECB) reduced its target rate by 75 basis points to 2.5%. The size of the cuts suggests that European central banks are behind the Fed in trying to stimulate economic growth.

Retailers were up on the session allowing consumer discretionary to be the only sector with a positive showing for the session. Even with difficult numbers being reported, value investors seem to be trying to time a bottom as they move into retail stocks. Wal-Mart (WMT) reported comparable store sales increased by 3% and is a standout among retailers.

General Motors (GM), Ford (F), and Chrysler continued their testimony in front of Congress as they plead their case for a bailout. Of course, the Big Three don't refer to the funds as a bailout but rather a bridge loan as they intend to pay the $38B back beginning in 2010/2011. They are sharing their plans and attempting to portray the ramifications of a collapse of the Big Three to the American economy. With the average salary of Big Three assembly workers about twice that of other workers building foreign cars in America, we are certain that union workers will have to accept significant wage cuts and the elimination of many positions if a bailout ensues.

Layoffs were announced by Dow Components DuPont (DD) and AT&T (T). Merck (MRK) maintained an in-line estimate for 2008 while taking down guidance for 2009. This is the norm for Dow components and many other companies.

According to Freddie Mac, the 30-year fixed-rate mortgage average fell to 5.53% with an average 0.7 point (up-front fee). Just last month, the average was 5.97%, and the year-ago average was 5.96%. The 30-year fixed-rate mortgage has not been this low since Jan. 24 when it was 5.48%. Conventional mortgage applications rose 150% last week. Refinances have led the rise with three out of four applications for refinance.

Friday, December 5th:
There were five economic reports of interest released:

The jobs numbers are in and they are a mixed bag with pay rates rising while hours are being reduced. The unemployment rate is now at the highest it has been in about the last fifteen years. While the official consensus estimate for the non-farm payrolls number was for a drop of 335K, the whisper number going around Wall Street was that it would exceed 500K so the 533K drop wasn't markedly different than what was already priced into the market

Financials led the rally through the day, dominated by bids for multiline insurers. Hartford Financial (HIG $14.59 +$7.38) more than doubled in price after it issued upside guidance for 2008. The stock price is still 85% off its 52-week high.

Finally, the drama of the Big Three Auto Maker CEOs asking Congress for money continues with Chrysler hiring legal firm Jones Day to recommend comprehensive options on bankruptcy.

TED Spread Unchanged

I have regularly covered the Interbank lending rate, in particular the spread between the three month London InterBank Offered Rate (LIBOR) and the 3-month Treasuries (known as T-Bills) rate. This difference between T-Bills (T) and EuroDollar (ED) denominated LIBOR is known as the TED Spread.

For the week, the TED Spread settled unchanged at 2.18. The T-Bills are yielding 0.01%. LIBOR is at 2.19%. Part of this is due to a flight to the safety of U.S. treasuries as they are in so much demand that the yield has been pushed down to nearly 0.0%. Given that the Fed's overnight lending rate is 1.0%, all excess funds held by banks should flow there.

LIBOR is a different story. Banks are still charging a premium to loan to each other due to perceived risk. With 23 bank closures year-to-date, bank failures have been a risk that other banks have to contend with. However, since the unprecedented action on the part of the Treasury and the Fed to flood the banking system with excess funds, this has curtailed failures and helped the TED Spread to fall from its high on October 10th of 4.64%.

23rd Bank Failure of 2008

The last bank failure was announced Friday as another Atlanta area bank went under. In this case, it was First Georgia Community Bank. The four branches of First Georgia Bank re-opened their doors on Saturday as branches of United Bank, which paid a 0.811 premium for the $60.6M in deposits while the FDIC paid out some $72.2M for the privilege. On November 7th, First Georgia's assets were at $237.5M with deposits of $197.4M. Clearly, there was a run on this bank.

Cutting off the flow of credit starts with Home Equity Loans

Banks have been steadily cutting off the flow of credit. Home equity lines have been sharply curtailed due to the loss of home values. This primarily affects individual homeowners and reduces cash available for other uses, and in particular, purchases of consumer goods.

I have heard specifics from home owners who had used their lines of credit to finance their lifestyles. With the fall in home values, many of these homeowners received a letter from the bank that indicated their line of credit was being reduced. In general, this is a one-way process where the bank sent them a letter indicating the bank had conducted a review and the bank was immediately reducing their line of credit. In some cases, the homeowners were asked to provide the funds back to the bank to bring their balance in line. Also, in some cases this reduction was to eliminate the line of credit entirely due to the fall in the value of the home.

Credit Card credit limits are the next shoe to drop

Credit cards are next in-line with banks slashing credit limits. The nearly $5T (trillion) tied up in credit card balances has allowed U.S. consumers to live beyond their means and continue to make purchases.

On Monday, December 1st, Oppenheimer analyst Meredith Whitney said the U.S. credit card industry may cut credit lines by over $2T (yes that is trillion) or 45% over the next 18 months. She cited risk aversion, funding challenges, and regulatory and accounting changes. Whitney is widely followed as she correctly predicted the moves in financials over the course of the last year.

What is the Fed up to?

This doesn't even take into account commercial lines of credit, which have been reduced, and the lower number of commercial loans being written.

The Fed on November 25th introduced two new programs. The first program will purchase GSE direct obligations in the amount of $100B. That program will also buy up to $500B of Mortgage Backed Securities (MBS) expected to start before the end of this year. It appears that the MBS buy-up will be conducted by asset managers chosen by the Fed, but not the Fed itself so the details are a bit murky.

A second program was announced a Term Asset-Backed Securities Loan Facility (TALF) to purchase Asset-Backed Securities (ASB). The Treasury will kick in an initial $20B as guarantees against losses. The facility will fund loans to the private sector to purchase up to $200B in ABS that are based on consumer loans, including collateralized auto loans, student loans, credit card loans, and loans guaranteed by the Small Business Administration (SBA). The loans will be made for up to one year.

TALF will require that new loans be granted by participants in the program, since they will not purchase old loans. The Federal Reserve Bank of New York (FRBNY) will put up the $200B to loan against new and recently originated AAA-rated consumer and small business loans. Note this should work to soften the 18-month 45% contraction in consumer credit predicted by Meredith Whitney.

On December 5th, the Justice department ruled that the Treasury is legally bound to inject capital into Government Sponsored Enterprises (GSEs). The Federal Reserve has reportedly bought $5B in debt from Fannie Mae (FNM) and Freddie Mac (FRE) and FHBL.

September saw the bottom fall out on the issuance of new ABS with a halt of new ABS in October. The interest rate spreads on AAA-rated tranches have soared as the risk premiums have sky-rocketed. If consumers and small businesses can't get access to credit, this will further weaken economic activity.

This brings up an interesting dilemma. How will the Fed balance the huge outflow of funds with a balance sheet of $2.2T but only $500B worth of Treasuries? This is why there is speculation the Fed will purchase long term treasuries and the prices of these treasuries have been rising with private sector investors betting that the Fed will pay top dollar for these instruments.

It appears the Fed has already begun implementing quantitative easing, meaning the money supply is being expanded as a tool to create liquidity without actually changing interest rates.

Market Outlook

Let's take a look at liquidity. Recall the TED Spread is the difference between the 3-month LIBOR rate and the 3-month T-Bill rate. The recent high was on Oct 10th at 4.64%.

The TED Spread finished Fridayat 2.18 which is the same as it ended the previous week at. In fact, the TED Spread hardly varied through the week. We are still looking for the TED Spread to drop below 180 basis points at a minimum. Without that, it shows that credit remains tight.

The week saw continued signs of a flight to safety as U.S. Treasuries saw the yield close as low as 2.57% on Thursday before rebounding nine basis points to close at 2.66%. That low had not been seen in decades and indicates the extreme level of fear in the market place. We believe that traders are front-running the Fed before the Fed begins to buy treasuries en masse, which will put pressure on price and drive yields down. Traders expect to unload their positions to the Fed and this could take quite a while for these positions to be unwound.

Last week, the near term futures contract for a barrel of oil fell twenty-five percent to close at $40.81. That is a four year low and more than 72% off the summer high.

We will take a look at all the daily charts and offer comments on them as a group. First, let's take a look at the QQQQs (NASDAQ:QQQQ), as they are the ETF that mimics the NASDAQ-100.

The QQQQs didn't move all the way down to close the gap from Monday a week earlier so this is a bit of unfinished business. They did, instead, break upward and through resistance. The QQQQs appear to be moving to a leadership position, which is quite bullish for equities overall.

We continue to believe the market will remain range bound and will reverse on a rally up to the upper Bollinger Band. It is bullish that the QQQQs were able to break above the 20-day moving average and sets up a challenge to reach and move above the 50-day moving average which is likely to come into play for the QQQQs and the other major index ETFs as well.

Next, let's take a look at the DIAmonds (Amex:DIA), as they are the ETF that mimics the Dow Jones Industrial Average.

The Dow may be losing its leadership position to the NASDAQ, which would be bullish for equities in general. The DIAmonds are now struggling to move much higher but have broken above resistance and should mimic the other major indexes in a quest to reach the 50-day moving average or the upper Bollinger Band.

Let's take a look at the chart of SPYders (Amex:SPY) since they mimic the S&P-500.

The SPYders are now enjoying the heavy weighting of financials as sector rotations is occurring into financials. The SPYders could move to outperform in the short term, even as the NASDAQ appears to be positioning for overall leadership.

We are concerned about an eventual retest of the November low, but a trade up to the upper Bollinger Band seems like a high probability winner at this time. Until a retest of the lows occurs, we recommend caution on long entries. A cash position is best, with a trading opportunity to short on a reversal at the prescribed levels. Shorting bonds at these lofty levels would be a prudent trade, and one that we will look to be positioned in over the long term.

A rally to the 50-day moving average or upper Bollinger Band would be a great place to take profits on remaining index call options you may be holding. There will be a trading opportunity to take a short position for a test lower before another rally attempt to try to establish an up trending market.

We will look to take a short position at these levels for a trading position only.

We believe that, at some point, the November low will still be challenged. The question remains how long this will take. With side-lined cash being put to work, we may be seeing the early signs of accumulation. Money managers can't afford to be caught out and there is a seasonal effect known as the Santa Clause Rally that occurs from around early/mid-December into the New Year. Recent strength may be a move by traders to front-run this effect.


Equities have moved above resistance on an increase in volumes so the tide may be shifting as side-lined cash is being put to work. We still expect an eventual retest of the November low, but the bulls have regained control for now.

We have been using Bank of America (BAC) as a bellwether for financial stocks. BofA fell back $1.01 for the week to $15.24 but Friday's move was impressive as Financials led the rebound. If financials are actually rotating back into favor after having been out of favor for a year, this could provide new leadership for the markets to begin moving higher.

With oil moving down 25%, this provides the Fed plenty of room to stimulate growth by lowering rates without becoming to worried over inflation. In addition, with global economies struggling, commodities demand and prices have been steadily dropping, which provides even lower inflation concerns. In point of fact, many central banks are more concerned with avoiding deflation, which is why they have been acting so aggressively.

You should have exited partial positions with index call options at the resistance areas we outlined last week and should be looking to exit the remainder of those positions this week at/near the 50-day moving average or the upper Bollinger Band.

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Mark McMillan

Author: Mark McMillan

Mark McMillan
The McMillan Portfolio

Mark McMillan

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