August 31, 2008

Words from the (Investment) Wise for the Week That Was (August 25 - 31, 2008)
by Prieur du Plessis

The gyrations of financial markets ahead of the Labor Day weekend tested the patience of bulls and bears alike. As big swings took place in thinly-traded markets, I was reminded of Albert Schweitzer's words: "As we acquire more knowledge, things do not become more comprehensible but more mysterious."

None the wiser, I also did not succeed in capturing a leprechaun and finding the gold during my visit last week to the Emerald Isle. However, the beautiful Irish scenery, hospitality and "open for business" attitude resulted in a very successful trip and will keep me going back in search of the "buried treasure".

Nervousness about the financial system was still paramount as investors realized that none of the problems were likely to be fixed anytime soon. The upshot of the week's trading was a further weakening in credit markets, judging by the elevated credit spreads. Global stock and bond markets ended another volatile week on a mixed note, whereas crude prices gained surprisingly little on the impending arrival of Hurricane Gustav and a festering geopolitical situation with Russia.

Next, a tag cloud of the text of all the articles I have read during the past week. This is a way of visualizing word frequencies at a glance. As expected, words such as "banks", "prices", "credit" and "financial" featured prominently in my reading matter.

I do believe we are still in a primary bear market where stock markets are, at best, faced with a prolonged convalescence period characterized by sub-optimal returns. Whether significant further declines will take place from these levels and valuations overshoot to bargain levels is anybody's guess.

However, in the short term I give the nascent stock market rallies the benefit of the doubt provided the mid-July lows are sustained. For any rally to become more enduring will require further base building and an eventual shift in central bank policy to targeting GDP growth rather than inflation.

The rally's lack of breadth, however, is worrying, causing Richard Russell (Dow Theory Letters) to warn: "If July 15 was a true bottom, the market should be roaring up today, and that's not what's been happening. Caution is warranted!"

But we should also take note of the fact that 64% of stocks in the S&P 500 are currently trading above their 50-day moving averages, as pointed out by Bespoke. "As shown in the chart below, the reading has been creeping higher and higher since mid-July, and looks to be on its way to the 80% to 85% levels seen twice over the last year. Readings above 50% are signs of a healthy market, and it hasn't been above 50% for much of 2008."

Seasonality indicates that "September has firmly secured the rank as the worst month of the year" (Stock Trader's Almanac), but that a year-end rally typically starts in late September / early October.

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.

Economy
"Global business sentiment remains weak and fragile and consistent with recession in the US, Europe and Japan," according to the Survey of Business Confidence of the World conducted by Moody's Economy.com. The survey results suggest that the Asian economy (ex Japan) continues to post growth that is near its potential. "Across the globe, sentiment is consistent with an economy that is near recession. Pricing pressures remain very elevated, but fell notably last week."

The minutes from the FOMC meeting of August 5, released on Tuesday, indicate that committee members were concerned about the near-term risks to growth. Most participants expected inflation to fall, although they remained wary about upside risks to inflation. Given the problems in financial markets, members did not view current monetary policy as overly stimulative.

Other economic reports released in the US during the past week included the following:

• The GDP growth rate in the second quarter was revised upward to 3.3% from 1.9%, exceeding expectations. In the first quarter, real GDP increased by 0.9%. The better-than-expected outcome did not change most economists' view that the economy was weakening, with the beneficial effects of rebate checks and foreign demand fading fast. Corporate profits edged down for the fourth straight quarter, falling twice as fast as in the first three months of the year.

• New orders for durable goods rose by 1.3% in July, surpassing expectations for only a slight increase. Core capital goods orders also surprised on the upside, increasing by 2.6% over the month.

• Existing home sales increased by 3.1% over the month in July, according to the National Association of Realtors. This increase put the annualized pace of sales up to 5 million units. However, substantial slack persisted, with inventories hitting a record high of 11.2 months. Furthermore, the median price of an existing house declined by 7.1% in year-ago terms, slightly worse than in June.

• Personal income tumbled by 0.7% in July after rising by 0.1% in June. Excluding the tax rebate effect, disposable personal income rose by 0.5% in July, up from 0.3% in June. Spending growth slipped to 0.2% from 0.6% the previous month. Real spending fell by 0.4% as price growth remained high. The core PCE deflator rose by 0.3%, matching the fastest rate since September, while the top-line deflator rose by 0.6%. The saving rate fell back to 1.2% from 2.5% in June but remained inflated by rebates.

Source: Slate

Summarizing the US economic situation, John Mauldin (Thoughts from the Frontline) said: "Even many mainstream economists are now suggesting we will be in a recession by the fourth quarter, if we are not in one now. The recovery, when it comes, will be tepid until credit spreads signal an end to the credit crisis. It is going to be Muddle Through for 2009. This is NOT going to be good for the stock market. When will it be safe to get back into the water? Pay attention to credit spreads."

Data releases from Europe and Japan underlined rapidly deteriorating economies flirting with recession. The Japanese government announced a $107 billion set of fiscal measures, including tax cuts and larger government-guaranteed loans, in response to the weakening economy.

Week's economic reports

In addition to the Fed releasing its beige book on September 3 and interest rate announcements by the Bank of England and the European Central Bank on September 4, next week's US economic highlights, courtesy of Northern Trust, include the following:

1. ISM Manufacturing Survey (September 1): The consensus for the manufacturing ISM composite index is 49.5 vs. 50.0 in July. If the consensus forecast is accurate, it would be consistent with weakness in other parts of the economy. Consensus: 49.5 versus 50.0 in July.

2. Employment Situation (September 5): Payroll employment in August is expected to have dropped by 85,000, taking the tally of consecutive monthly declines to eight. The jobless rate is predicted to have held steady at 5.7%. Consensus: Payrolls: -75,000 versus -51,000 in July, unemployment rate: 5.8% vs. 5.7% in July.

3. Other reports: Construction spending, auto sales (September 2), factory orders (September 3), ISM non-manufacturing (September 4).

Click here for a summary of Wachovia's weekly economic and financial commentary.

A summary of the release dates of economic reports in the UK, Eurozone, Japan and China is provided here. It is important to keep an eye on growth trends in these economies for clues on, among others, the trend of the US dollar.

Markets
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, August 31, 2008.

Equities
Global stock markets, in general, were mixed during the past week. The MSCI World Index rose by 0.6%, with the MSCI Emerging Markets Index closing unchanged.

Among mature markets, the US stock indices were mostly lower, but European stocks turned in good performances, for example Italian Comit 30 Index (+2.6%), French CAC 40 Index (+1.9%) and German XETRA Dax Index (+1.3%). Australia (+4.1%), Japan (+3.2%) and Canada (+2.4%) also shrugged off the gloomy economic outlook and moved higher.

The emerging markets category saw solid gains in Hong Kong (+4.3%) and Taiwan (+2.0%), whereas large declines were registered by Pakistan (-7.9%), Russia (-3.3%) and Turkey (-2.6%). The Russian Trading System Index ( 16.3%) and the Chinese Shanghai Composite Index (-13.6%) were the worst performers for the month of August.

With the exception of the Russell 2000 Index (+0.3%; YTD -3.5%), the US stock markets closed lower as shown by the major index movements: Dow Jones -0.7% (YTD -13.0%), S&P 500 Index +0.7% (YTD -12.6%) and Nasdaq Composite Index -2.0% (YTD 10.7%).

Particularly noteworthy, the MSCI World Index has outperformed the MSCI Emerging Markets Index over the past month (-1.6% vs -8.2%), past three months (-11.9% vs -21.0%), YTD (-15.4% vs -23.2%), and also since the stock market peaks of October 2007 (-20.7% versus -28.6%).

The Russell 2000 Index is trading above both its 50- and 200-day moving averages, whereas the Dow Jones Industrial Index, S&P 500 Index and Nasdaq Composite Index are above their 50-day averages but still below the important 200-day line - often used as an indicator of the primary trend.

Click here or on the thumbnail below for a market map, courtesy of Finviz.com, providing a quick overview of the performance of the various segments of the S&P 500 Index over the week.

The thrifts and mortgage finance group (+16%) was the best-performing group for the week, led by Freddie Mac (FRE) and Fannie Mae (FNM), up 61% and 37% respectively. This is a strong reversal from being the worst-performing group during the previous week with a decline of 23%. The stocks were driven down recently by speculation on whether a government bailout was imminent, a prospect that would probably wipe out the equity holders. Those concerns seemed to diminish last week after some analysts estimated that the firms had enough capital to last at least until next year.

The homebuilding group was the second-best performing group, gaining 9% on housing reports being interpreted as showing signs of a stabilizing market.

The trucking group (-7%) was the worst performer, led by its single member, Ryder System (R). A brokerage analyst downgraded the trucking sector, predicting that freight volumes in the peak shipping season through November might be weaker than expected because of the soft US economy.

The Internet retail group (-6%) was the second-worst performer, led by its largest member, Amazon (AMZN). A blog posting by a newspaper reporter raised the topic again of how well Amazon's Kindle electronic book reader was actually selling.

Fixed-interest instruments
Global government bond yields were mostly lower during the past week, as investors dismissed the threat of inflation and priced in concerns about a global recession.

The ten-year US Treasury Note declined by 4 basis points to 3.83%, the UK ten-year Gilt yield by 13 basis points to 4.48%, the German ten-year Bund yield by 5 basis points to 4.17% and the Japanese ten-year bond yield by 5 basis points to 1.42%.

Currencies
The US dollar maintained its recent rally as the currency benefited from the view that foreign central banks will be quicker to cut rates than the Fed will be to tighten rates.

The past week saw the greenback rising against the euro (+0.7% - a six-month high), the British pound (+1.6%), the Swiss franc (+0.2%), the Australian dollar (+1.2%) and the Canadian dollar (+1.6%).

Sterling has come under further selling pressure as pessimism about the UK economic outlook intensified, dropping to a 12-year low on a trade-weighted basis ahead of the Bank of England's interest rate announcement next week.

The Japanese yen was the only currency to gain against the US dollar during the past week, closing 1.1% higher on the back of better-than-expected economic data and the announcement of a $107 billion fiscal stimulus package.

Commodities
The dollar's strength and growing concerns of slowing demand knocked dollar-denominated commodity prices as seen in the Reuters/Jeffries CRB Index, which declined by 0.8%.

West Texas Intermediate crude traded between $115.0 and $118.76 a barrel last week before closing 0.8% up at $115.46 on Friday. The gain was relatively small given the impending arrival of Hurricane Gustav and concerns about the geopolitical situation with Russia, but word from the Department of Energy that it would release strategic oil stocks to combat any disruption kept oil prices in check. (The Gulf of Mexico is responsible for 25% of US crude oil production and 15% of US natural gas production.)

The chart below shows the past week's movements for the various commodities:

Now for a few news items and some words and charts from the investment wise that should be of help with keeping our investment portfolios on a winning path. As the Irish say: "Go n-eírí an bóthar leat. May the road rise with you." And also wishing you a fabulous Labor Day weekend.

Hat tip: Barry Ritholtz's Big Picture

YouTube: Take a load off Fannie
The story of Fannie Mae, as narrated by The Band.

Source: YouTube, August 24, 2008. (Hat tip: Barry Ritholtz's The Big Picture.)

Financial Times: Fannie and Freddie doubts grow
"Shares in Fannie Mae and Freddie Mac fell on Friday amid concerns foreign investors were reassessing their exposure to the troubled US mortgage financiers' bonds and guaranteed securities.

"Bank of China this week revealed it had cut its portfolio of securities issued or guaranteed by the two government-sponsored enterprises by a quarter, or $4.6 billion, since the end of June. The sale underscored signs of nervousness among foreign buyers of Fannie and Freddie's debt.

"Federal Reserve custody data on Thursday showed foreign official and private investors reduced their holdings of agency debt for the sixth consecutive week.

"Bill O'Donnell, analyst at UBS said: 'If this recent theme of cooling passions for GSE's debt becomes a longer-term trend, then it could be problematic for the GSEs given that the central banks have taken ... roughly 30% to 60% of new GSE issuance in recent months and years.'

"The US Treasury was granted powers last month to extend its credit lines to Fannie and Freddie and to invest in their debt and equity."

Source: Saskia Scholtes, Financial Times, August 29, 2008.

Times Online: Buffett predicts game over for Fannie and Freddie
"For Fannie May and Freddie Mac the game is over. The Sage of Omaha has spoken.

"Warren Buffett, the world's richest man, said it was no longer feasible for America's two biggest mortgage finance companies to exist independently. He went on to forecast that the US economy would remain in the doldrums for at least five months.

"Fannie and Freddie, which underpin America's mortgage market by buying home loans and packaging them into bonds, did not have any net worth, Mr Buffett told CNBC. Both face losses of tens of billions of dollars on the bonds. Analysts said they look increasingly likely to need a cash injection from the Government and Mr Buffett said they were too big to fail, predicting: 'You will see some action fairly soon.'

"Mr Buffett was also downbeat about the housing market and, in turn, the broader economy. 'What we're seeing in business, in our retail business, or anything having to do with housing, is a further slowing down in June and July, both in terms of credit experience where people first got into trouble with house payments, and now credit card payments,' he said. 'In my judgment, it [the economy] won't be any better five months from now.'

"Mr Buffett, who runs the Berkshire Hathaway investment group from its headquarters in Omaha, Nebraska, added: 'You always find out who's been swimming naked when the tide goes out. We found out that Wall Street has been kind of a nudist beach.'

"Mr Buffett said he expected more banks to fail, especially in areas where there was a housing bubble. 'We will see failures where the bankers were dumb in what they did,' he said."

Source: Tom Bawden, Times Online, August 23, 2008.

John Authers (Financial Times): Credit crunch winners and losers
John Authers discusses how the big loser in the credit crunch has not been the United States but Europe due to the effects of a weaker dollar.

Click here for the full article.

Source: John Authers, Financial Times, August 29, 2008.

Financial Times: Bankers caught between hope and despair
"More than a year into the credit crisis, the world's top central bankers admit they are still in the dark as to what its ultimate impact on the global economy will be.

"By the same token they are unsure to what extent weakening growth will help to ease high inflation.

"'There is enormous uncertainty about where we stand at the moment,' Stanley Fischer, governor of the Bank of Israel, said at the close of the Federal Reserve's annual retreat in Jackson Hole, Wyoming.

"His comments came as US Treasury officials worked through the weekend on options for Fannie Mae and Freddie Mac, the troubled mortgage groups, amid expectations an announcement could come this week.

"Mr Fischer told central bankers from 43 nations 'we are in the midst of the worst financial crisis since World War II'. But it was still not clear how big an event it would turn out to be.

"So far, he said, 'in real economy terms we are not looking at anything exceptional'. But the crisis was entering a 'second round' in which economic and financial weakness could feed on each other.

"Other current and former central bankers shared this view. Alan Blinder, a former Fed vice-chairman, said: 'It is amazing a year later how much is still unresolved.'

"Monetary policymakers appear torn between hope that the global economy is turning out to be resilient - in part thanks to policy interventions - and fear that the worst could lie ahead.

"They think the economy will muddle through and recover next year. But they cannot rule out the possibility that the financial crisis - in conjunction with the oil shock - could deliver a bad economic outcome."

Source: Krishna Guha, Financial Times, August 24, 2008.

Barron's: Is the global liquidity tide turning?
"My invitation to hob-nob with the world's monetary muckety-mucks in Jackson Hole this weekend got lost in the mail, yet again. Amidst the Grand Tetons of Wyoming, the Federal Reserve hosts its end-of-summer junket for the movers and shakers and hangers-on to discuss the key monetary matters of the day.M

"Too bad they are little more than corks tossed on violent seas of global forces totally beyond their control.

"The inflationary tide in global liquidity could be turning ... The sharp break in gold suggests that could be happening, and that's being transmitted through the commodities markets. The dollar has stopped going down, and even has flattened out against the renminbi. The bear market in risk assets, such as stocks and particularly the Chinese market, also is symptomatic of a liquidity squeeze. As for the US housing market, it is at the nexus, resulting in wealth losses for borrowers and a reduction in lenders' ability and willingness to extend credit.

"That's something that the crowd in Jackson Hole can scarcely control. So they might as well enjoy themselves on their junket."

Source: Randall W. Forsyth, Barron's, August 21, 2008.

The Wall Street Journal: New credit hurdle looms for banks
"US and European banks, already burdened by losses and concerns about their financial health, face a new challenge: paying off hundreds of billions of dollars of debt coming due.

"At issue are so-called floating-rate notes - securities used heavily by banks in 2006 to borrow money. A big chunk of those notes, which typically mature in two years, will come due over the next year or so, at a time when banks are struggling to raise fresh funds. That's forcing banks to sell assets, compete heavily for deposits and issue expensive new debt.

"The crunch will begin next month, when some $95 billion in floating-rate notes mature. JPMorgan analyst Alex Roever estimates that financial institutions will have to pay off at least $787 billion in floating-rate notes and other medium-term obligations before the end of 2009. That's about 43% more than they had to redeem in the previous 16 months.

"The problem highlights how the pain of the credit crunch, now entering its second year, won't end soon for banks or the broader economy. The Federal Deposit Insurance Corp. said on Tuesday that its list of 'problem' banks at risk of failure had grown to 117 at the end of June, up from 90 at the end of March. FDIC Chairman Sheila Bair said her agency might have to borrow money from the Treasury Department to see it through an expected wave of bank failures. She said the borrowing could be needed to handle short-term cash-flow pressure brought on by reimbursements to depositors after bank failures.

"As banks scramble to pay the floating-rate notes, they could see profit margins shrink as wary investors demand higher interest rates for new borrowings. They're also likely to become less willing to make new loans to consumers and companies, aggravating economic downturns in both the US and Europe."

Source: Carrick Mollenkamp, The Wall Street Journal, August 27, 2008.

Scott Bugie (Standard & Poor's): Second phase of credit crunch could be severe
"The credit crunch is entering a second, 'post-subprime' phase where banks' loan books deteriorate more rapidly and capital-raising efforts might become harder, says Scott Bugie, credit analyst at Standard & Poor's.

"'Loan book deterioration is starting to hit a wider array of financial institutions, as credit losses migrate from subprime into other sectors of household finance, such as credit cards, Alt-A and prime mortgages, and auto loans well into 2009,' he says.

"Mr Bugie believes losses on the loan books of US banks could reach $265 billion a year for the next two to three years. In Europe, he says, the focus of concern is shifting to commercial loans as European economies enter a downturn.

"While capital-raising has largely offset losses that financial institutions have incurred from writedowns, much of the capital raised has been in the form of hybrid securities with both debt and equity characteristics, he says.

"'Consequently, the quality of the banks' capital has eroded somewhat.'

"And he warns that in the US and Europe, a major concern is regional banks' ability to raise capital."

Source: Scott Bugie, Standard & Poor's (via Financial Times), August 26, 2008.M

GaveKal: The Libor spread points to financial stress

Source: GaveKal - Checking the Boxes, August 26, 2008.

Asha Bangalore (Northern Trust): Fed on hold, arguments in favor of supporting growth outweigh inflation concerns
"The main message from the minutes of the August 5 FOMC meeting is that the Fed is on hold for several meetings, barring unexpected developments. That said, the minutes lean toward favoring policy supportive of economic growth in the inflation-growth debate. Inflation did feature extensively, but growth and financial market stability are at the top of the list of concerns. The concern about inflation expectations appears overdone because, for now, the market is less concerned about inflation than a few weeks ago.

It is also interesting to note the following quote:

"'Most members did not see the current stance of policy as particularly accommodative, given that many households and businesses were facing elevated borrowing costs and reduced credit availability due to the effects of financial market strains as well as macroeconomic risks. Although members generally anticipated that the next policy move would likely be a tightening, the timing and extent of any change in policy stance would depend on evolving economic and financial developments and the implications for the outlook for economic growth and inflation.'"

Source: Asha Bangalore, Northern Trust - Daily Global Commentary, August 26, 2008.

Richard Russell (Dow Theory Letters): We're heading for de-leveraging and deflation
"Brilliant Bloomberg columnist Caroline Baum probably knows the bond market better than anyone else I know. Caroline starts her current column as follows. 'Inflation expectations are so weighted down that investors are buying 10-year Treasuries yielding 3.8% with inflation running at 5.6%. Federal Reserve policy makers couldn't ask for a stronger mooring in the face of disappointing inflation news. A pair of reports on consumer and producer prices for July showing year-over-year increases of 5.6% and 9.8%, respectively, the fastest pace in 17 and 27 years, failed to rattle the US Treasury market.'

"What's going on? 'One school holds that bonds are mispriced. Buyers are either complacent or smoking something stronger than tobacco. Even if they are in full command of their faculties, they are choosing liquidity over yield.'

"Russell Comment - Bond people tend to be very sophisticated. I think they are thinking in terms of the great international de-leveraging that may be coming up. Or why would the 10-year T-notes be selling at a lousy 3.8% yield which is actually below the rate of inflation? Obviously, the bond crowd sees deflation ahead. And nobody else does. Maybe the stock market is just getting wind of it now!

"Remember, years ago I said that the big problem coming up would be INCOME. Everybody's going to need income, and income will be hard to come by. I'm still of that same opinion. My dear subscribers - hunker down - there's a hard rain a'comin'. We're heading into de-leveraging and deflation, and nobody's positioned for it."

Source: Richard Russell, Dow Theory Letters, August 25, 2008.

Bloomberg: Feldstein says low Fed rates may not stimulate growth
"Harvard University economist Martin Feldstein, a member of the committee that charts American business cycles, said the Federal Reserve cannot count on low interest rates to buoy economic growth.

"'Lower interest rates are not going to get us anything more,' said Feldstein, who retired in June as president of the National Bureau of Economic Research. 'The economy has really shown one sign after another of weakening.'"

Source: Bloomberg, August 21, 2008.

Sheryl King (Merrill Lynch): Economic domino effect
"Did we really need a 0.7% MoM decline in the index of leading indicators for July to tell us that the US economy is in recession? The unemployment queue is now the longest since December 2001, according to the weekly claims data. Housing starts look to be closing in on 900,000 in the next couple of months, and even that is so far above demand that there is no dent in month's supply on the horizon. Any wonder that the 10-year note now has a firm grip on the 3-handle and the equity market has not boasted four straight up-days since last May?"

Click here for the full report.

Source: Sheryl King, Merrill Lynch, August 27, 2008.

Asha Bangalore (Northern Trust): Q2 GDP is history, focus should be on the future
"The US economy grew at an annual rate of 3.3% in the second quarter compared with the advance estimate of a 1.9% increase. This large discrepancy in the headline estimate came about due a significant upward revision of net exports and inventories. Net exports in the second quarter are now estimated as -$376.7 billion vs. -$395.2 billion in the advance estimate. In addition, firms decreased inventories by $49.4 billion compared with the earlier estimate of a $62.2 billion reduction.

"The upward revision of government expenditures (3.9% vs. 3.4%) was another category accounting for the upward revision of GDP growth in second quarter. Other minor upward revisions included a 1.7% gain in consumer spending vs. a 1.5% increase and a 3.2% drop in capital spending vs. a 3.4% drop in the advance estimate. Offsetting these upward revisions were downward revisions of expenditures on structures and residential investment expenditures."

Source: Asha Bangalore, Northern Trust - Daily Global Commentary, August 28, 2008.

BCA Research: US leading economic indicator - still no recovery in sight
"Massive policy easing and fiscal stimulus have not been sufficient to offset the drags from a housing bust and squeeze on consumption.

"The Conference Board's US leading economic indicator (LEI) fell again in July, providing a fresh reminder that the slowdown is far from over. A domestic recession is underway and policy efforts to stimulate growth have been short-circuited by a collapse of risk-taking in the financial markets.

"Mortgage rates rose as policy rates declined, underscoring that the housing slump will persist. Rumors that the Treasury Department may have to absorb the two large GSEs are proliferating, underscoring the seriousness of the banking and financial crisis (please see the next Insight).

"Bottom line: The economy will remain weak for the foreseeable future, implying persistently low Treasury yields and further struggles for the equity market."

Source: BCA Research, August 25, 2008.

Asha Bangalore (Northern Trust): Consumer spending - strong likelihood of decline in Q3
"Nominal consumer spending increased 0.2% in July, following a 0.6% gain in June. However, inflation adjusted consumer spending fell 0.4% in July after a 0.1% decline in June. Consumer spending will have to advance in leaps and bounds in August and September for a flat reading in the third quarter. In other words, a decline in third quarter consumer spending is nearly certain. Assuming our forecast is accurate, this would be the first quarterly decline in consumer spending since fourth quarter of 1991."

Source: Asha Bangalore, Northern Trust - Daily Global Commentary, August 29, 2008.

BCA Research: US durable goods orders - expanding, but ...
"US core durable goods orders rose further in July, underscoring that business investment has held up well in face of a domestic recession and tight credit conditions. However, risks remain to the downside.

"Investment spending has been a relative 'bright light' for the US economy, mainly because a weak dollar has allowed US companies to gain global market share, and overseas demand has been resilient. Indeed, core capital goods orders bottomed in 2007 and have been slowly trending higher, in contrast with domestic consumption, which peaked in 2004 and continues to decelerate.

"Nevertheless, our investment spending model forecasts that capex growth will drop to zero by the end of the year. Sticky corporate bond yields, and a further slowing in final demand at home and abroad, will cause companies to defer expansion plans: expect more weakness ahead."

Source: BCA Research, August 28, 2008.

Bill King (The King Report): Goldman's Jan Hatzius - don't be fooled by durable goods numbers
"Durable goods orders beat expectations with a 1.3% month-on-month increase in July. But the apparent strength is due to higher prices, not stronger activity. In fact, deflating orders by the producer price index for durable manufactured goods shows a 9.4% year-on-year drop in real orders, the worst since early 2002. Even if we adjust for the unfavorable year-on-year comparisons that partly explain this plunge, the recent data look surprisingly similar to those seen in the run-up to the 2001 recession."

Source: Bill King, The King Report, August 28, 2008.

Asha Bangalore (Northern Trust): A perspective on home prices
"The price-to-rent ratio of homes ... is a useful measure to put home price trends in a big picture framework.

"The price-to-rent ratio (used here) is computed from the national Case-Shiller Home Price Index and Owners' Equivalent Rent of the Consumer Price Index. The Case-Shiller Price Index goes back to 1987:Q1. (For the convenience of reading a chart, I set the 1987:Q1 price-to-rent ratio = 100.) Excluding the go-go years when home prices climbed rapidly, the median price-to-rent ratio and mean price-to-rent ratio during 1987:Q1 - 2001:Q4 were 94.31 and 96.38, respectively.

"Compared with these numbers, the 125.4 price-to-rent ratio in the second quarter of 2008 is still at an elevated level. It appears that home prices have a long march ahead when compared with the mean (109.6) and median (102.5) price-to-rent ratio for the period 1987-2008:Q2 also.

"If history is any guide, the price-to-rent ratio suggest that the bottom of home prices is not here yet."

Source: Asha Bangalore, Northern Trust - Daily Global Commentary, August 27, 2008.

BCA Research: US house prices - no bottom in sight
"Both the National Association of Realtors and the Case Shiller Index confirm that US house prices continue to fall sharply.

"The outlook for US housing is still bleak. Mortgage rates remain elevated, inventories of existing homes are stuck at record highs and prices continue to fall. The only silver lining in this dark cloud is that a nationalization of the GSEs is becoming increasingly likely, which could provide much needed capital to finance housing transactions. However, even such an unprecedented step would not sound the 'all clear'.

"A domestic recession is underway and a rising unemployment rate means that the uptrend in foreclosure rates will spread beyond the sub-prime market.

"Bottom line: Even if the GSEs are nationalized, there will be no quick fix for the housing market, and it appears that the slump has at least another year to run."

Source: BCA Research, August 27, 2008.

Financial Times: Merrill losses wipe away long-term profits
"Merrill Lynch's losses in the past 18 months amount to about a quarter of the profits it has made in its 36 years as a listed company, according to Financial Times research that highlights the extent of the global banking crisis.

"Since the onset of the credit crunch last year, Merrill has suffered after-tax losses of more than $14 billion as its balance sheet has been savaged by almost $52 billion in writedowns and credit-related losses.

"Merrill's total inflation-adjusted profits between its 1971 listing and 2006 were about $56 billion, according to figures from Thomson Reuters Fundamentals and an FT analysis of reported earnings.

"The $14 billion in losses for 2007 and the first two quarters of 2008 equal half of Merrill's profits since the beginning of the decade.

"Merrill had the highest ratio of credit crunch losses to historical profits among 10 US and European financial groups analysed by the FT, which included Citigroup, JPMorgan Chase, Bank of America, Morgan Stanley, Goldman Sachs, Lehman Brothers, Bank of America, Credit Suisse and UBS.

"UBS, which has lost more than $15 billion during the crisis, had the second-highest ratio."

Source: Francesco Guerrera, Financial Times, August 28, 2008.

Financial Times: SEC plans for global accounting standards
"US companies are set to switch to international accounting rules in a move that will, for the first time, see all the world's most important listed groups reporting according to the same set of standards.

"The US Securities and Exchange Commission on Wednesday proposed a 'roadmap' to manage the migration of US companies from its rules to the international ones. The plans are open to comment for 60 days.

"More than 100 countries use, or are adopting, International Financial Reporting Standards (IFRS), including all 27 European Union members as well as China, Japan, Canada and India. US GAAP, the accounting lingua franca until the sudden rise of IFRS, is the last significant standard to be switched.

"Under the SEC's plans, US groups are likely to adopt IFRS in 2014 providing certain conditions are met, a decision that will be taken in 2011. Some companies may be allowed to adopt IFRS sooner.

"Christopher Cox, SEC chairman, said more groups were reporting under IFRS than US GAAP and the number would rise as other large economies made the switch. He said US GAAP would be marginalised if the US did nothing, making it harder for international investors to consider US companies.

"A single set of globally understood accounting rules is expected to help cut companies' cost of capital and better enable cross-border investment. In countries without strong accounting traditions, the rules are expected to raise the quality of reporting, helping inward investment."

Source: Jennifer Hughes, Financial Times, August 27, 2008.

Bespoke: Credit spreads continue to get worse
"FDIC Chairman Sheila Bair commented in a press conference this afternoon that she expects the credit markets to continue to worsen, and judging by the recent action in credit spreads, the market seems to agree. According to Merrill Lynch data, interest rates on investment grade corporate bonds are currently not only at higher levels than they were at the Bear Stearns low, but they are also at their highest levels ever. As of yesterday's close, investment grade corporate bonds were yielding 312 basis points more than Treasuries, which is a 118% increase over year ago levels."

Source: Bespoke, August 26, 2008.

Financial Times: Government bonds reflect bad tidings
"When it comes to gauging how bad things may get for the global economy, central bankers say they are uncertain. A glance at government bond yields backs that nerve-wracking outlook.

"In the past month, US, German, UK and Japanese bond yields have been falling as investors have dismissed the threat of inflation and priced in a higher risk of global recession led by the big economies.

"The expectation of rate cuts in the UK and eurozone should be vindicated by weaker growth and lower inflation in the coming months. In the US, the sharp cuts earlier this year should suffice unless the economy hits a wall in 2009.

"At the centre of the big freeze, US policymakers still face challenges as home prices keep falling while inventories of unsold properties rise.

"With economic gloom deepening, falling US Treasury yields have been accompanied by rising yields for corporate and mortgage bonds. Until house prices stabilise, banking writedowns will sustain a bid for government debt at the relative expense of other riskier fixed-income securities.

"At some point, however, selling long-dated Treasuries and buying risky mortgage and corporate bonds will become the dominant trade for investors. One barometer to watch will be a sharply steeper yield curve, whereby long-term yields rise much more than those of the two-year note.

"Once banks have plugged all their balance sheet holes, a steeper Treasury curve will facilitate borrowing at low rates and the buying of longer-dated, higher-yielding mortgages and other debt. Call it a carry trade on steroids that slowly helps banks nurse their balance sheets back to health.

"Unfortunately for the Fed, the stars are not yet aligned for banks and investors to play the game of ultimate carry, which suggests that further selling of risky assets beckons."

Source: Michael Mackenzie, Financial Times, August 25, 2008.

Richard Russell (Dow Theory Letters): Lowry's Index shows worst lies ahead
"On August 26, Lowry's Selling Pressure Index reached its highest level ever - 756, while Lowry's Buying Power Index dropped to a multi-year low of 210. On that day, the spread between the two indices reached a record 546 points. And I wonder whether the August 26 negative spread (with Selling Pressure dominating) might be the ultimate extreme spread between the two indices. I was thinking that at some point the Selling Pressure Index was simply going to head down while at the same time the Buying Power Index was going to turn up. And someplace in the future, the two indices would re-cross as Buying Power finally assumed the dominant position (above Selling Pressure).

"I just talked to Paul Desmond, who runs Lowry's. I asked him why he was so sure that we were heading for 90% down-days. His answer was that this rally is so weak. Overall volume was only 3.7 billion today and today upside volume was only 62.8% of up + down volume. Furthermore, Paul noted that breadth is very weak - breadth should be exploding on the upside here, but that's not happening. In all, this is a weak rally, suggesting that worse action lies ahead!"

Source: Richard Russell, Dow Theory Letters, August 28, 2008.

Continue to Part II

Dr Prieur du Plessis
investmentpostcards.com

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.

Copyright © 2008-2009 Dr Prieur du Plessis

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