Bowling Ball Bounce for Markets

The last seven sessions have seen stocks surge from extremely oversold levels. The technical indicators pointed one and all to an impending rally. Even generally pessimistic analysts called for a bear market rally. It’s comforting to see Financial Stocks leading the charge. The I-Shares S&P Preferred Stock Index (PFF) comprised primarily of financial issues is up 62% from its low print of $14.10 on March 6th. The Financial Select Sectors Spider (XLF) has shot up 56% from its March 6th bottom of $5.88. It looks as though we have come far from the nationalization speak of just two weeks ago. I don’t know if it’s “real” or simply a bowling ball bounce. Frankly speaking I’m a bit tired of the financial news media selecting guests based on their ability to spew extreme and absolute clairvoyance about the direction of markets. Responsible money managers in my view have reasoned opinions and make tactical decisions on the margin to manifest those views in client portfolios.

Economic Data

In February economic data seemed universally bad and markets responded in kind. Just a few of the brutal disappointments:

Data Metric Consensus Actual Date Released

• January Dom. Vehicle Sales 7.7M 6.8M February 3
• January Nonfarm Payrolls -524k -598k February 6
• December Consumer Credit -3.5B -6.6B February 6
• February Consumer Sentiment 61.0 56.2 February 13
• February NY State Mfg -22.0 -34.7 February 17
• January Housing Starts 530k 466k February 18
• January Existing Home Sales 4.80 4.49M February 25
• Durable Good M/M Change -2.5% -5.2% February 26
• Q4 2008 GDP Annualized -5.4% -6.2% February 27

To be fair, several indicators offered positive surprises:

Data Metric Consensus Actual Date Released

• ISM Mfg Index 32.6 35.6 February 2
• December Pers. Income -.4% -.2% February 2
• ISM Services Index 39.0 42.9 February 4
• January Retail Sales -.8% 1.0% February 12

The four “positive” surprises in February were simply less negative. Both ISM numbers still show contraction as did personal income. Retail Sales were positive but indicate only a monthly change from an absolutely harsh fourth quarter. February also contained a big slug of poor S&P 500 Earnings (SPY) coupled with plenty of downward guidance.

So have things fared any better in March?

Data Metric Consensus Actual Date Released

• January Personal Income -.2% .4% March 2
• ISM Mfg Index 33.8 35.8 March 2
• February Motor Vehicles 6.2M 6.4M March 3
• January Pend Home Sales 85.1 80.4 March 3
• February Non Farm Payrolls -648k -651k March 6

The big equity rally began in the week after March 6th. A week which contained little in the way of economic data releases. We had seemingly choreographed statements by the nation’s private sector banking chiefs that January and February were good months. Also helping things along was FASB Chairman Bob Herz finally being forced to understand the urgency in providing new guidance on mark-to-market accounting. More importantly, providing said guidance before the end of this quarter.

This week’s economic data is still poor with one bright print in Housing Starts:

Data Metric Consensus Actual Date Released

• March NY State Mfg -32.0 -38.2 March 16
• Feb. Industrial Production -1.2% -1.4% March 16
• Feb. Housing Starts 450k 583k March 17

The Fed’s announcement Wednesday that it will substantially expand its balance sheet by buying longer dated Treasuries, expanding its agency debt acquisition and growing its purchase of mortgage backed securities is a sign of just how weak this economy is. The committee also unanimously agreed to keep the fed funds target at nil for an “extended period.”

The question for investors should not be whether or not the economic and earnings data is bad. It is awful. The question is whether or not one believes the massive and globally coordinated fiscal and monetary policy measures will return economic growth, and how quickly.

My view is the final results will be about 15% fiscal policy driven and 85% monetary policy. That’s pretty good news because I view about 80% of the Obama stimulus package as a thinly veiled attempt to expand the scope and reach of government. On the other hand the Fed is having success and seems to be implementing its strategy in a calm and measured fashion.

The Fed’s actions in expanding Discount and Primary Dealer lending have worked. The Asset Backed Commercial Paper lending program has worked and now has minimal credit outstanding. The Commercial Paper Funding facility has been a success. Guaranteeing loans related to Bear Stearns and AIG looks like a strong investment. TSLF and TAF also are moving smoothly. The MMIFF has been a perfect success. Now the Fed is getting really serious! PPIF which admittedly is still too vague is a $1 Trillion dollar program as is TALF which was kicked off yesterday with Citigroup’s (C) $3 billion debt sale. OK, here come the Jekyll Island conspiracy theorists! The bottom line is the Fed is not only making a profit on its programs (which is remanded to the US Treasury) but the Fed will in all likelihood interrupt the negative feedback loop associated with the credit crisis, thereby restoring economic growth.

For those excessively worried about inflation, I recommend Real Estate Investment Trusts via I-Shares Cohen & Steers Realty Majors (ICF) or direct ownership of Real Estate via the use of debt. Remember, inflation is a stealth tax that redistributes wealth from lenders to borrowers.

Since I don’t claim to know for certain which way the markets will move in the next days, weeks or months I likely won’t be invited on financial television this week. My best reasoned opinion is still that October 10 was the internal low which was retested on November 21 and again on March 6th. We will get into earnings season here in a few weeks and the numbers won’t be great, nor will the first quarter GDP print surprise to the upside. Despite that, I think equity prices are still recovering from fears of financial system insolvency and can drift higher on the reality of a very severe recession. Housing will soon show signs of stabilization, weekly jobless claims will begin to level off and even drift somewhat lower. Deal making and a return of the consumer will eventually ignite a sustained stock market rally.

Comments

[ArkansasAngie:]

And the stock market maybe where we see inflation first. If the dollar devaluates and the asset value remains the same then its (share) price in dollars must go up.

Mar 20 12:23 PM

[User 30417:]

Return of the consumer? I guess you're referring to the US consumer? Is this the same consumer who is currently tens of thousands of dollars in credit card debt and who is defaulting on home equity loans? Ah, yes, I forgot, you're counting on inflation to move wealth to the consumer by devaluing their current debt! So you're correct, how nice it will be to return to those '70's with double digit inflation. Wonder if the interest rate will remain near zero while the nation sells more bonds and counts on inflation to reduce it's debt burden? Not to worry, the treasury will issue the bonds and the FED will buy them. You're right, I guess our fantastic service economy and our consumer driven GDP will likely serve to sustain the country. What a dream, but please tell me, what happens when we wake-up?

Mar 20 12:47 PM

[THofler:]

Mr. Morgan,
Loved the article. But allowed me to be pedantic about one point.

Any good physical scientist will tell you that "negative feedback" leads to stability, whereas "positive feedback" causes instability and oscillations. The serious economists use the terms "procyclical" and "countercyclical." The dumb procyclical effects we have built into our financial system will generate both the booms and the busts.

The term you meant to use in the above piece is "procyclical feedback" or maybe "adverse feedback." Thanks again for providing some wheat to SA and not more chaff.

Mar 20 01:01 PM

[Carlos Lam:]

Well, Herb, I'm glad you show such confidence in Chmn. Bernanke, the same guy who claimed that subprime credit problems were contained. This is the same Chmn. Bernanke who on Oct. 7, 2008, told an NABE audience that the $700 billion TARP was "an authorization to purchase financial assets" even though the TARP was then used to re-capitalize banks. This is the same Chmn. Bernanke who eschews transparency by stonewalling Bloomberg's FOIA request. He is a man who claims to be a student of the Great Depression and Japan's Lost Decade yet is repeating the same mistakes made during those eras. Now, Chmn. Bernanke is about to monetize the debt. This Fed Chairman has been monumentally inept at every turn. His prior ineptitude should lead us to question his ability to make the correct decisions at this time.

Mar 20 01:19 PM

[Larrysyr:]

The market has priced in a lot of negatives. It would take some out-of-the-box blast to push the market down below the March 6 levels. The metrics presented are, indeed, awful, but they are hardly out-of-the-box at this point. Even the Fed's monetary announcement this week, while somewhat surprising, couldn't be considered really off the charts. "Quantitative Easing" they promised, and now they're delivering.

All of this will lead to a show of growth, some nasty inflation, a second dip in the recession to quell the infation, and then who knows?

What appears clearer at this point is that some industries will never be the same again. Print and broadcast media, auto manufacturing, and brick-and-mortar retail are all going to be severely down-sized, and probably reinvented in some unanticipated form. Housing, education, and medical care, just to name 3, will be very different on the other side. This will be the "destruction" side of creative destruction. I don't know what will be created, but I don't doubt it will be something.

The productive capacity of the U.S. remains huge, and hugely underutilized. Whoever finds new ways to harness it will prosper in future decades. Whoever thinks we'll return to business-as-usual 2007 style will fall by the wayside.

Mar 20 02:56 PM

[Mad Hedge F...:]

There have been 14 bear markets in the postwar period with an average 25% decline. This bear market is down 58%, and it still may have farther to go. No wonder everyone’s risk models are blowing up. This time it really is different. Over the last 100 years the average return on stocks has been 10% a year, with 40% of that coming from dividends. Today there are dozens of prime industrial companies offering dividends rates in the mid teens. Why investors are not loading the boat with General Electric (GE) stock yielding 12% at $9/share is beyond me. Take systemic risk out of the equation, and investors will leap at these.

Mar 20 03:46 PM

[Darrenfox123:]

Kraft (with a Mkt Cap: $32.56B) should buy General Mills ( with a Mkt Cap: $15.56B). This is going to be huge as it would create a company with market valuation of +$48B. Putting Kraft’s brands alongside General Mills' brands the world's largest branded food and beverage company with revenues of over $55.85B annually. The synergies alone would be worth $2B annually.
Kraft has at least eight or nine brands with annual revenue of at least about $1 billion each. These include Kraft cheeses, dinners and dressings; Oscar Mayer
meats; Philadelphia cream cheese; Maxwell House coffee; Nabisco cookies and crackers and its
Oreo brand; Jacobs coffees; Milka chocolates; and LU biscuits. The combined companies could be reorganized into the following business segments: Beverages, Cheese, Convenient Meals , Grocery, Snacks & Cereals. Each business would focus on finding synergies for Existing and Developing Markets. With operations in 70 countries and the selling of products in 150
countries, there are a lot opportunities for synergies from a backroom perspective
A merger between the two companies would like to earnings improvement in 2nd, 3rd, and 4th quartiles.
A merger with Kraft would allow for expansion of GIS joint ventures which is a real hidden gem. GIS joint ventures include a 50% equity interest in Cereal PartnersWorldwide (CPW), a joint venture with Nestle S.A. that manufactures and markets cereal products outside the U.S. and Canada; and 50% equity interests in some Asian-related joint ventures for the manufacture, distribution and marketing of Haagen- Dazs frozen ice cream products and novelties.
Unconsolidated joint ventures, which are reflected in GIS's financial
statements on an equity accounting basis, contributed an aggregate of after-tax income of $111 million in FY 08, up from $73 million in after-tax income in FY 07. This includes a net benefit of $8.2 million from restructuring, impairment and other exit related items in FY 08, versus a negative impact of $8.2 million in FY 07. In July 2006, the company's CPW joint venture acquired the Uncle Tobys cereal business in Australia for about $385 million. GIS funded 50% of the purchase price.
GIS has longer-term growth opportunities, including new products and international expansion. Investors can expect efforts will be made to expand gross margins in the U.S. retail business, including opportunities for increasing the mix of higher-margin products; trade spending efficiency; discontinuing less attractive products; investment in technology; and global sourcing. In the international business, we expect GIS to seek profit improvement in emerging markets and a leveraging of its infrastructure.
In the second quarter of FY 09, GIS sold its Pop Secret microwave popcorn business to Diamond Foods, Inc. (DMND: $23) for $192.5 million. GIS received pretax cash proceeds of $158.9 million, net of transaction-related costs, and had a pretax gain of $128.8 million (after-tax, $0.22 a share). A merger between Kraft and General Mills would generate significant spin-off opportunities and help finance the merger.

GIS posted $1.09 vs. $1.14 Q2 EPS on 8.3% sales rise. Note Q2 FY 09
incl. $0.49 net reduction related to mark-to-market valuation, $0.22 gain from the
sale of Pop Secret. Reaffirmed '09 input cost inflation estimate of 9%, says forex
translation now expected to reduce FY 09 reported sales, EPS for the year. Despite
this, raises $3.81-$3.85 FY 09 EPS guidance to $3.83-$3.87 before any impact
from mark-to-market valuation and excluding the Pop Secret gain.

General Mills has a relatively stable market, strong cash flows, and an S&P Quality Ranking of A- that reflects GIS's historical earnings and dividend performance.
The company formed by a Kraft and General Mills merger would benefit by leveraging the demand of both companies are facing competitive conditions, and other factors such as commodity costs.

Mar 20 04:27 PM

[dcb:]

There was a great deal of bias in your article. I see what the fed has done as much more destructive to the free market than Obama's policies. In contrast the the fed liquidity programs his has amounted to almost nothing. To me this is the huge over reach. But it's only over reach when it doesn't benefit your ideals. I believe the solution is helping out the consumer to lower debt levels (which doesn't benefit wall street) instead of attempting to re expand the credit bubble. I think the European Central Bank has the right focus not the Fed. Of course the two approaches lead to money in different pockets and that's why we have folks like christopher dodd rigging the game.

Mar 20 06:15 PM

[Between The...:]

I greatly appreciate the tone of this article, that of a humble commentator trying to present facts, regardless of the actual content. I'm not so keen myself on the Fed's actions - they are literally the most powerful organization in the world now, completely on tilt, trying to make drastic interventionism the solution to all problems, and growing their balance sheet to the size of France's GDP ($2.5T) in 6 weeks...but I digress. I can respect his points, and like the way they are presented (maybe some tables instead of data points in a list).

I really liked the statement "...getting tired of the financial news media selecting guests based on their ability to spew extreme and absolute clairvoyance about the direction of markets." That shrill screaming does nothing but prevent the measured discussion that is necessary given the current circumstances. I would even end my months long MSNBC boycott to watch a show if they would bring Mr. Morgan on.

Mar 20 06:17 PM

[hmorgan:]

Thanks, I don't know what happened to the format but the article was submitted with tables. I'll check with SA editorial to see if there is a better way to keep the formatting next time.

Herb


On Mar 20 06:17 PM betweenthenumbers wrote:

> I greatly appreciate the tone of this article, that of a humble commentator
> trying to present facts, regardless of the actual content. I'm not
> so keen myself on the Fed's actions - they are literally the most
> powerful organization in the world now, completely on tilt, trying
> to make drastic interventionism the solution to all problems, and
> growing their balance sheet to the size of France's GDP ($2.5T) in
> 6 weeks...but I digress. I can respect his points, and like the way
> they are presented (maybe some tables instead of data points in a
> list).
>
> I really liked the statement "...getting tired of the financial news
> media selecting guests based on their ability to spew extreme and
> absolute clairvoyance about the direction of markets." That shrill
> screaming does nothing but prevent the measured discussion that is
> necessary given the current circumstances. I would even end my months
> long MSNBC boycott to watch a show if they would bring Mr. Morgan
> on.

Mar 20 06:32 PM

[econjunkie:]

Among the risks is that associated with a lack of current market knowledge. You would have seen that GE cut it's dividend not long ago to about a 5% yield (at the time) in their press releases. A lot of financial sites use trailing dividend data to calculate yields as I'm sure you know. Many of those yield statistics can therefore no longer be trusted as divs have changed for a large number of firms this year.


On Mar 20 03:46 PM The Mad Hedge Fund Trader wrote:

> There have been 14 bear markets in the postwar period with an average
> 25% decline. This bear market is down 58%, and it still may have
> farther to go. No wonder everyone’s risk models are blowing up. This
> time it really is different. Over the last 100 years the average
> return on stocks has been 10% a year, with 40% of that coming from
> dividends. Today there are dozens of prime industrial companies offering
> dividends rates in the mid teens. Why investors are not loading the
> boat with General Electric (seekingalpha.com/symbo...) stock
> yielding 12% at $9/share is beyond me. Take systemic risk out of
> the equation, and investors will leap at these.
>

Mar 20 06:34 PM

[hmorgan:]

Never too pedantic, thanks for the fine tuning!

Herb


On Mar 20 01:01 PM THofler wrote:

> Mr. Morgan,
> Loved the article. But allowed me to be pedantic about one point.
>
>
> Any good physical scientist will tell you that "negative feedback"
> leads to stability, whereas "positive feedback" causes instability
> and oscillations. The serious economists use the terms "procyclical"
> and "countercyclical." The dumb procyclical effects we have built
> into our financial system will generate both the booms and the busts.
>
>
> The term you meant to use in the above piece is "procyclical feedback"
> or maybe "adverse feedback." Thanks again for providing some wheat
> to SA and not more chaff.

Mar 20 06:34 PM

[Moon Kil Woong:]

Thofler, very good comment. Looking at most actions by the government places them in the court of adding to the cyclical nature of things which will put the montary expansion into overdrive when the market turns causing inflation.

Unlike the author, I am not too positive that government/Fed (Fed isn't the government) action will do that much on the downside aside from protect financial institutions and slow the fall. And I tend to side with the belief a long slow slide is much worse than a fast one but I thank him fore his argument to the contrary.

This forum is a place for discussion based on balanced and thought out reasoning.

Mar 21 01:18 AM

[BlueOkie:]

The mood of the nation needs to change before the markets will rebound. How many TV stations gave coverage to the recent launch of the shuttle?

Mar 21 08:22 AM

[prudentinve...:]

I agree that things may start to look better soon, but believe this is already priced into the stock market. If market participants were expecting a depression, the S&P500 would have been at 400-450 or even lower.

If depression expectations pick up, which I hope they don't but cannot rule out, I expect another plunge. If weak recovery becomes the consensus expectation, I see little upside as current stock valuations are close to their historic long-term trendline, valuation metrics look reasonable, but stocks are by no means cheap except relative to the recent bubbles.

Mar 21 08:30 AM