Not Buying This Rally

The sharpest rally since 1933, which started March 10^th in U.S. equities, looks like it has finally come to an end. The leadership sectors of banking, insurance, REITS, retail and casinos have all started to roll over, and look like they are going lower.

There is a good reason for this. The outlook for these sectors is absolutely terrible. While TV pundits seem to see green shoots everywhere they look, we see more problems ahead for the U.S. and world economy. The government used every tool available to goose the market for the release of the stress tests, allowing America’s biggest banks to raise capital at much better rates than would have been possible a few months back. Those of you who expect a swift recovery, and buy this rally will soon be severely disappointed.

False Jobs

The jobs number that came out last Friday was heralded as the first sign the economy was getting better with only 539,000 jobs lost in April. Nothing could be further from the truth. The first 140,000 U.S. Census workers started in April according to Bloomberg, and the government added 72,000 workers to April’s unemployment report. The census workers will be hired for a few weeks to up to a few months depending on the position and paid anywhere from $10 to $25 an hour. The total budget for the project is 14 billion dollars. This means that the average census worker will earn less than $10,000 total in this new job if 100% of the budget is allocated to hiring as 1.4 million are scheduled to be hired over the next year. Removing the census workers would bring the job losses to 679,000 workers.

The infamous birth death adjustment added 226,000 jobs to the total as well. This adjustment is supposed to account for job growth by small businesses that are not counted in the main survey. Does anyone in their right mind honestly believe that small business added jobs last month? Taking out this ridiculous number brings job losses to 905,000 for the month. If you think jobs lost by small businesses totaled more than 95,000 the economy lost over 1,000,000 jobs in April. Individual federal income taxes collected in the first four months of 2009 are down 34.37% from a year ago. The consumer is dead, not just resting. No green shoots here, just tricks to make the numbers look better.

Insolvent Banks

The government stress test of America’s largest banks was a farce, and will have terrible results. We did an analysis of the 163 largest publicly traded U.S. banks that have more than 100 million in assets and at least 50,000 shares traded daily, and then removed bankrupt banks from the list, leaving 158 banks. These banks make up 93% of the bank loans in the U.S., and have a combined 10.273 trillion in assets. We added the common stockholder equity to the loan loss reserves and subtracted goodwill and intangibles then divided this total by nonperforming assets.

These are just the losses on regular loans not mark to market losses on structured financial products. This ratio shows ability of the banks to absorb future losses. We consider non-performing loans to be a good predictor of the banks' pending losses. I would consider a bank that has a ratio of three dollars of common equity and loan loss provisions to every dollar of non-performing assets to be adequately capitalized for the moment. Only 53 of the 168 had this 3 to 1 cushion of tangible equity and reserves against non-performing loans.

The 38 best capitalized banks totaled only 427 billion in assets. 57 of the banks had ratios of 1 or less, meaning tangible common equity and loss reserves are less than current nonperforming assets. These banks had 2.763 trillion in assets. Banks with less than a 2 to 1 ratio have assets of 5.927 trillion. 116 of the banks have loan loss reserves that are less than current nonperforming assets, even though we all know that losses are going much higher. Banks have not set aside enough reserves for these coming losses because many would fail to meet the FDIC’s capital adequacy measures if they set aside this money.

The data does not show a healthy banking system, but rather an insolvent one. As for the regulators' favorite metric, tangible common equity, Citibank (C), Bank of America (BAC) and Wells Fargo (WFC) all had a ratio of less than 4% before the latest round of capital raises. These banks as a group have 124 billion of tangible common equity and loan loss reserves after subtracting current loan losses, goodwill and intangibles. The capital raises from the stress tests this brings these banks up to 200 billion in tangible equity.

A 2% increase in losses will effectively wipe out all the tangible equity in the U.S. banking system. Unemployment, a leading indicator of loan losses, has gone up from 5% to 8.9% in the past year and is going higher. The banking sector as a whole is severely undercapitalized for the tsunami of losses that are coming. This does not include the mark to market games that the banks are playing with the so-called toxic assets. Citi has assets marked $70 billion above where they would sell in the open market today. Allowing banks to put false marks on their books in hope of price recovery does not make that price real. This is the equivalent of an individual buying a stock at $100 and saying he has no loss even though the stock is trading at a dollar because he hasn’t sold. Marking assets to market would wipe out the 200 billion as well. Amazingly Europe’s banks look worse.

Insolvent banks don’t lend. They sell profitable business units to raise capital. They sell stock every time the market rallies. They raise rates on credit cards; don’t forgive overdraft fees, and nickel and dime the poor. They reduce bank lines of credit and raise interest rates. The banks try to buy time, and earn their way out of the jam. The whole game is delay, delay, delay. We have an entire nation of zombie banks today ensuring that no recovery takes place as lending continues to tighten for the average American and small business owner. It is a recipe for disaster. And Europe is worse. I don’t want to own any company that uses a stock market rally as an opportunity to raise capital. No green shoots here either.

Trade and Transports

U.S. exports have now fallen 26.18% from their peak in July 2008. While Chinese exports dropped 22.6% in April from a year ago. Japan’s exports were down 45.5% year over year in March, the most recent data available. Germany was also down 15.8% year over year. India’s exports are down 33% year over year. U.S. Rail traffic is off 26% in the first week of May from a year ago. Industrial production had its biggest drop on a year over year basis since 1946. European retail sales just had the biggest monthly drop on record. U.S. retail sales declined 8.77% year over year in April. We don’t see green shoots in the economy, and we see the rally failing from this juncture. The Federal Reserve and Treasury seem to be blind to the problems that the country faces, and are continuing failed policies. Don’t buy the rally. Take your gains if you have them. This is going to have a painful ending.

Disclosure: No positions

Comments

[socrateazz:]

Wise in many ways. You have pointed out many of the problems the nation faces. There is a basic ignorance as to the real cause. Cycles are given as a cause often. I say the cycles are the symptoms caused by the results of the cause. Cycles take place because of actions taken many years previous. Reagan changed a cycle where demand for goods exceeded demand. The change would have best been made ten years earlier. But at the time there appeared to be no crisis involving inflation. Change comes when things go to extremes. The current crisis has two very real causes. The first is the continual negative ballance of trade. This will continue to take wealth from the nation and put it in OPH (other peoples hands). This should have been fixed ten years ago. But other nations were convinced the US dollar was where their wealth would be safest. Most market extremes are caused more by belief than reality. The ballance of trade will correct. It will be drastic though. The other reason seems like two reasons but I think they are so closely related they actually can be concidered one. Greed and power. Not where the average person thinks it is. The greed exists in front of everybody and yet is concidered fairness by many. Power is in the hands of those who use it. Those who use it often abuse it! Ballance has been the key to American government over the years. Today's government needs a major repair job. That does not mean it needs to get bigger. It means it should accomplish its job taking fewer resources. But what is happening is a failure to accomplish much using extreme amounts of wealth. Government does not need laws few understand. A tax system based on arbitrary control and spending for arbitrary reasons will cause extreme KAOS. Government needs to keep their taxes at levels where wealth can be created and partually retained in the private sector. Government spending has exceeded that level recently. A fix will not be effective over the long haul unless government allows businesses enough earning to increase or at least retention of wealth to effectively stay in business. My take: Actual total government needs to drop by 60% from current levels and remain at such a GDP relationship for the future. Goverment is a ravenous creature devouring all it can eat while telling its food (citizens) it is helping them. Government is acting like a rancher. Keep the cattle (people) in the fence. Utilize the meat (labor ) as you desire. Expect more production while taking more from the system. Any draught or exrtreme condition will cause a problem. Taking more while giving less does not help an already serious situation. The government has put a hurricane in the barnyard. What will we have after the storm passes?

May 21 07:08 AM

[John McLeod:]

I think it was for over a year I was posting sidebar links with "this isn't going to end well" comments to UK stories promoting getting onto the "property ladder" via speculation in Bulgarian condos. However, that carnage was trivial in comparison to what's going down when this historic C-leak rally turns.

Oh well, the tastiest coffee beans are harvested from the slopes of the volcano in the hours before it explodes. Party on, guys!

May 21 08:19 AM

[captainccs:]

The time buy this rally was March and April, not May. May and June are profit taking time. After that, we'll see what can be done.

I believe that focusing on the details of the banking circus is a waste of time. The Wall Street banks have the Fed, the Treasury and even President Obama firmly under control. Until the trust busters cut down the Wall Street banks to size, meaning making them small enough that they can safely be allowed to go bankrupt, without endangering the economy, the money changers will control our destiny.

Banks have to be small enough that we don't need the Fed as lender of last resort. For capitalism to work, failures have to be allowed to fail.

May 21 08:36 AM

[raytayzmd:]

...one can only hope that your current assessment will be every bit as accurate as the advice you offered in March:

seekingalpha.com/artic...

...of course, the S&P 500 rallied from 683 that day to over 900 a few months later...but, heck, who cares?...it's just money -- right?

May 21 09:48 AM

[VictorHAustin:]

The analogy between government and ranching is spot on! The federal government has become its own end. It attracts all the codependent control freaks that are the most common neurotics produced by our culture. It's not about left or right, parties, or issues. It's about people being "in control" -- solely for it's own sake and because it is unthinkable to fearful and less competent people to let any natural system take its course. Nazism and Communism have shown us that populations will not throw off that control until things get extremely bad. I am personally hunkering down for a declining and besieged existence for the remainder of my life. I think there are a lot like me, and the next "recovery" is going to be missing a whole lot of the most capable and productive former participants. I hope the gen-somethings can produce something. All I've heard so far is "hope" for more consumption.

May 21 10:00 AM

[Lsente:]

Great article, thank you.

May 21 10:03 AM

[Bill40:]

raytayzmd, Thomas makes perfect sense yet was hugely wrong in March. I feel your pain. (As I'm guessing does Thomas.)

Thomas, thank you for the info. Those uncooked job loss #s are staggering and the objective info on the banks is appreciated.

My contributing thought: The govt. kick started a rally by making the US$ somewhat a joke. Short sellers covering I'm sure contributed to the run-up, as well as the vast momentum of the investment industry who have trained Americans that stocks are it, no matter the reality.

Last thought, wouldn't it be great if we had a government that was responsible and respected dollars so that you could hold comfortably hold cash? Shouldn't a beneficial govt. try to preserve dollars and not push people into investments in garbage companies? But our govt. is incompetent and the political-financial complex says people must suffer.

May 21 10:47 AM

[ArtfulDodger:]

Mr. Ryan:

Part of your article, as most do, assumes that the economy and the stock market run in tandem, which is not always the case.

You do, however, present some excellent points for investors to concern themselves with.

I have but a couple of investments in America, GD, CISCO, & FWLT, and I'm keeping them for now, because I believe they can withstand another economic Katrina.

However, I have recently taken profits in a feww of my foreign investments: CEO, PKX, POT, PTR, & AGU.

But I'm holding the rest for now: STO, KHD, NTES, PWRD, HNG, FTE, NOK, SBS, STD, YZC, VALE, & VISN.

Thank you for the serious warning, and the best to your investing.

May 21 11:23 AM

[Henrique Si...:]

Not only not buying but selling short agressively.

May 21 11:31 AM

[Henrique Si...:]

I am short both the S&P and Oil Futures.

As I been posting in my blog, patience pays.

May 21 11:33 AM

[Spartacuss:]

Investors in very dangerous waters, however, the non-investment waters are very unattractive as an alternative...CD's anyone?

Then with the FED buying treasuries we know where treasuries are headed.

Of course there is always gold which, it may turn out, may be the safest bet. Energy plays look good right now, but then if all the dire stuff talked about is real, the mattress might just be the thing.

I am out and sitting. Did not make a dime on the run up...too bad, but then when the sudden drop occurs, if it does all those gains will be gone and then some.

May 21 01:44 PM

[Alex Trias:]

It's normal for bear market rallies to race up to their 200 day moving averages, which is about what we're seeing in various US, international and global stock indexes. This area often acts as resistance, and when it does, markets tend to fall. To where, who can guess? By the same token, we've seem some equities markets strike out high above their 200 day moving averages, in some cases, taking their short term buying momentum way above the long term selling momentum. This is true in many emerging markets and most notably in China. Whether broader markets will follow is anybody's guess, but at the moment, they have not and, in fact, are facing some stiff resistance indeed.

It is too soon to conclude whether equities are entering into a new bull market or simply bouncing up in the context of a very long term bear market. Why take a position one way or the other? Seems like a fine place to sell, if you asked me, but I wouldn't short anything either.

May 21 02:11 PM

[Mookie J:]

While I share some of your concerns regarding the economy, your data on the banking sector is misguided. First, NPAs are not leading indicators of future losses. In fact, since the advent of FAS 114, they are more of a coincident (or perhaps even lagging) than leading indicator. The reason is that under FAS 114, many banks typically charge down loans to net realizable value that have entered the NPA bucket. However, when this occurs, banks do not get the benefit of the loan immediately going back to performing loans. A quick example: A bank has a $10M commercial real estate loan on its books that it no longer feels it will collect the full amount on. Under FAS 114, it charges the loan down to $8M (its estimate of net realizable value). The remaining $8M loan shows up in NPAs and remains there for a year (i.e. or a period long enough to show the borrower will remain current on the loan). The net result is that NPAs are not a leading indicator of future losses. Second, your analysis does not give any credit for pretax, pre-provision earnings that banks will generate in the coming years. The spreads that banks are putting loans on their books right now are the highest in many years, which should cause net interest margins at most banks to trend upward over the next few years. To declare most banks insolvent and not give any credit for banks' future earning power is ludicrous.

May 21 05:35 PM

[Missing_Link:]

I don't think any part of the article assumes that. The underlying assumption is that the market eventually corrects to match the underlying economy, not that they "run in tandem."

The recent rally was a pullback that turned into a speculative rally. It was based on the notion that we'd hit the bottom and the recession would be over soon.

I agree with the author that this turned out to be an overly-optimistic assumption, and the market must now match those lowered expectations. And like Henrique Simoes, I've now sold all my long positions and am shorting aggressively.

On May 21 11:23 AM ArtfulDodger wrote:

> Mr. Ryan:
>
> Part of your article, as most do, assumes that the economy and the
> stock market run in tandem, which is not always the case.

May 21 11:52 PM

[Jayshree:]

Nice article.
Incidentally there is an interesting website that is specifically dedicated to recession victims.It offers help and discusses all issues related to recession- www.angstcorner.com. It’s worth a visit!

May 22 06:40 AM

[Mark Anthony:]

All the facts the author listed are true but he conveniently left out one of the most important facts in the whole picture: The US dollar. The FED is massively printing more dollars in order to buy our own debts, as foreigners are growingly reluctant to buy US treasury bonds. So the author drawed the completely wrong conclusion.

Don't buy this rally? Then what do you buy? Where do you put your money?

Leave your money in US dollar cash? Stuck it under your pillow? Watch them become worthless paper as hyper inflation kicks in?

Or buy more US T bonds? Or buy a house? Or loan your money to a bank before the bank is shut down by FDIC? Or maybe loan your money to GM? Where do you put your money?

To me the conclusion is clear: Put your money in commodities, in companies that produce commodities. And put your money in shipping companies as you need ships to transport commodities.

You need to buy this rally! Don't be a bag holder holding useless cash or debt notes. My favorites: Shipping stocks, and precious metal palladium plays SWC and PAL. Best shipping stocks are EXM, EGLE, TBSI, DRYS, GNK....

seekingalpha.com/autho...

May 22 10:09 AM

[DonFurio:]

Look I don't think anyone would deny that the economy is strained, however stocks were priced as if they were on their way to a depression back in March, and people have realized that a long recession is more likely the outcome. You fail to note the demand for loans is down, so the fact the banks are offering higher rates on money they loan out, is not necessarily a horrible thing bc many of the banks competition that were driving spreads down are no longer around. Even if you don't like the banks, I find it hard to believe that you do not find any stocks attractive, especially considering how low the yields are for short-term money.

May 22 10:12 AM

[DonFurio:]

A bunch of idiots got busted this year too believing that the Dow was going to 5,000.


On May 22 09:16 AM dividendmachine wrote:

> enjoyed the article
>
> However like others have mentioned you seem to believe that the stock
> market and economy move in tandem
>
> Nothing is further than the truth
>
> In 1997 you would have thought the market was due for a correction
> after the past 2 years of37.6 and 23 % returns and that many stocks
> sold at 20-30 times earnings
>
> Instead the market went up 33.4 28.6 22.1 respectively
>
> Many short sellers went broke shorting stocks at 150 times earnings
>
>
> remember the markets can stay irrational longer than most people
> can stay solvent

May 22 10:14 AM

[Kinabalu:]

"The leadership sectors of banking, insurance, REITS, retail and casinos have all started to roll over, and look like they are going lower."

This is a pretty broad statement. GSE mortgage REITs have, for the last six months been blessed with a license to print money. Current financing spreads, which are not likely to change soon, are an ideal environment for these companies.

May 22 11:17 AM

[E Nuff Sed:]

On the contrary normalcy is returning to the market as risk appetite returns.

Jun 08 10:45 PM