No Market Gain Without Economic Pain

Tuesday was a pretty light economic calendar so I refrained from posting anything. The only conclusion I can formulate from Tuesday’s economic data and related news events is that the recession continues to show signs of troughing, but the root cause of it, i.e. real estate, remains an unresolved issue.

Notes & Comments for June-09-2009

• Economic Data: For the month of April-2009, the Wholesale Inventories (representative of about 25% of the nations stockpiles) dropped -1.4% vs. last month’s -1.6% reading and missed the consensus estimate of -1.2%. Year-over-year, wholesale stocks dropped -6.2% as the overall inventory to sales ratio now stands at 1.31 months. Most of the contraction is attributed to the durable goods which showed a -2.2% drop vs. March’s -2.6%. Auto inventories declined -4.5% vs. previous month’s -2.02%. The auto industry will face further reductions since GM filed for bankruptcy. Computer equipment inventories hit their lowest level at -1.0% since November 2007. With sales declining faster than inventories, it is no surprise that businesses are reluctant to hold higher levels of stock. When speaking about the economy, it is polite to use both hands– the other hand is that eventually these stocks will need to be replenished to meet future demand. Related Securities: XLY; SHLD; HD: RTH; DELL; TXN; INTC;

• TARP Status: Some may try to put a positive spin on the repayment of $68bn in TARP (Troubled Asset Relief Program) funds by 10 of the nation’s banks, but it is actually a failure as the government’s original intentions for lending this money was to stimulate the economy by using key banks as a conduit for lending. Never underestimate the value of freedom. Some of these banks did everything short of breaking their piggy banks, e.g. equity offerings, asset sales, and issuance of debt, just to get out from under the yoke of the government. Some question if they will have adequate capital to deal with any future economic shocks. More notable is the list of banks who did not qualify for a get out of jail card, i.e. Bank of America (BAC), Wells, Fargo (WFC),Citigroup (C), and AIG . All four were either guilty and/or guilty by association due to risky acquisitions in the midst of the crisis. As a result, none is eligible for parole. Incidentally, Jim Cramer noted in one of his videos that B of A has about 25% exposure to the residential real estate market. I also reckon that Wells Fargo’s purchase of Wachovia entitled it to inherit its own fair share of additional exposure to bad real estate loans. Citigroup and AIG are a complete mess and remain on life support only for symbolic purposes as bastion remnants of American capitalism. My guess is that any institution deemed ineligible for repayment of TARP funds will not be able to move freely about financial society until this mess is over. Related Securities: XLF; RKH; KBW

• Real Estate: Speaking of any future economic shocks, $300bn of commercial loans either mature or require refinancing before the end of this year. If a report released by Real Estate Econometrics, a property research firm, holds water, then US commercial mortgage defaults could hit 4.1% by the end of 2Q-2009. At one point, the U.S. government considered a toxic asset clean-up plan to deal specifically with this issue, but may have decided to shelf it due to rising backlash against deficit centric stimulus programs. Besides that, the Obama administration needs to preserve some of its political currency for heath care reform, but that is another matter. Getting back to the matter, defenders of free markets just might have an opportunity to see true capitalism at work, especially if banks have no place to park these bad loans. However, judging from the way banks dealt with the onset of the credit crisis, they will probably sit on these loans and cause the commercial real estate finance market to freeze instead of realizing losses. Regional banks are the most vulnerable to commercial real estate defaults which the report estimates may not peak until the end of 2010 or early 2011 @ 5.2% - 5.3% range. Related Securities: XLF; RKH; KBW

• Bond Watch: What’s good for the gander is good for the goose… Not long ago, there was speculation that the U.S. Treasury just might see its goose cooked as investors weighed the possibility of a credit downgrade on our sovereign debt’s AAA status. Moody’s put these fears to rest Tuesday as it issued a broad sweeping comment that it does not foresee any wholesale sovereign downgrades due to large amounts of debt issued by governments' (substitute USA or Britain) attempting to stimulate their economies. It would only consider downgrades for countries whose economic models are "disproportionately affected" by "structural challenges". While Moody’s reputation and standards are no longer bonafide, one has to appreciate the creative ingenuity for dealing with this issue. As long as Moody’s refrains from downgrading other sovereign debt, the USA is safe. Hardly any country is issuing or borrowing debt like the USA. This is interesting because the definition of AAA has just succumbed to the new normal. On a more positive note, Tuesday’s $35bn auction of 3 year Treasury notes supported with healthy demand. I have my theories behind this too, but just do not have time to delve into them. Related Securities: TLT; UUP; GLD; DBA; DBC; USO; TIP; TBT

That’s all for Tuesday. I liken this economy to a sick patient with a desire to be healed but not the will to undergo the sometimes painful process of the healing itself. Collectively, the economy is all of us, i.e. businesses, consumers, government, republicans, democrats, etc. and we each have our preferred poisons and remedies. However, no amount of economic stimulants or bailout pain relievers used to temporarily mask the symptoms will do the job of time itself. In physical conditioning and training, I was taught to embrace pain and acknowledge it as weakness leaving the body. If America wishes to regain its economic prowess and strength, I think we are going to have to endure some pain and only then will the lingering weaknesses of this past secular economic bull market cycle leave the body of our nation. Unfortunately, in the digital age, no one has time for time anymore.

(These notes and comments are not intended to be a comprehensive analysis, but instead merely highlight current themes and events for the convenience of readers and encourage them to make and share their own conclusions.)

Disclosure: Hillbent.com, Inc. or its affiliates may own positions in the equities mentioned in our reports. We do not receive any compensation from any of the companies covered in our reports.

Comments

[John Lounsbury:]

JC - - -

Good discussion.

I would point out that, when you say "eventually these stocks will need to be replenished to meet future demand" you are not going on to say that this is at the center of current debate. The optimists would say your "eventually" is about six months and the pessimists would say it is of the order of six years.

I agree that we will necessarily endure some pain in order to get healthy again. We have some structural damage in the financial system which can not be papered over; it must be repaired or rebuilt. You mentioned embracing pain and acknowledge it as weakness leaving the body. There is an old adage: No pain, no gain. I think it applies currently.

Jun 10 10:38 AM

[ain't no fo...:]

Another great article with good insights J.C. I'm afraid, however, that I do not see a nation that deals with pain too well... we are still in denial and we are still doing everything possible that addicts in denial can do to avoid the pain of true recovery... we will call ourselves optimists, we will tell the world that we have reformed our ways, we will convince ourselves of everything that addicts convince themselves of in order to forestall their terrible day of reckoning, and so we will continue to move along pumping the green shoots and rationalizing/minimizing the negative data until something or someone finally takes control and makes our decision for us... and that may be a sad day of reckoning for the American people.

My name is America, and I'm an addict...

Jun 10 11:52 AM

[Alphameister:]

We are a nation devoted to instant gratification and pain avoidance, nowhere more evident than in the nation's capital. This nation's greatest generation emerged from the crucible of the Great Depression. I expect that considerable good will flow from today's somewhat lesser depression as well, though it is an environment frought with political risks.

Jun 10 01:25 PM