Which Way Wednesday, Fed (Up) Edition

by: Philip Davis

I don’t know what Fed minutes the market read yesterday, but the ones I read scared me!

As usual, I went through the minutes in Member Chat (and there’s a highlighted version in Seeking Alpha minus my color-coding) and the red (negative) statements are far outnumbering the green (shoots) in the minutes including little blow-offs like "the Federal Reserve’s total assets had risen to about $2.3 trillion" and "the Desk had been reinvesting all maturing Treasury securities by exchanging those holdings for newly issued Treasury securities" which, if you put them together in non-BS language, pretty much says: "Of the $1.3Tn in Treasuries sold in 2009, it’s hard to see how the Fed bought less than half of them, maybe closer to all of them since we rolled our short-term paper over each time, therefore buying much more than it seems."

Once again, the finger is pointed sqarely at Commercial Real Estate as, according to the minutes: "Conditions in the nonresidential construction sector generally remained poor. Real outlays on structures outside of the drilling and mining sector fell again in the fourth quarter, and nominal expenditures dropped further in January. The weakness was widespread across categories and likely reflected rising vacancy rates, falling property prices, and difficult financing conditions for new projects." In a real economy, that statement alone would send investors running for the exits, but we also got these three - all in a row:

The dollar value of commercial real estate sales remained very low in February, and the share of properties sold at a nominal loss inched higher. The delinquency rate on commercial mortgages in securitized pools increased in January, and the delinquency rate on commercial mortgages at commercial banks rose in the fourth quarter. The percentage of delinquent construction loans at banks also ticked higher in the fourth quarter.

Delinquency rates on credit card loans in securitized pools and on auto loans at captive finance companies remained elevated in January but were down a bit from their recent peaks.

Total bank credit contracted substantially in January and February. Banks’ securities holdings declined at a modest pace after several months of steady growth, and total loans on banks’ books continued to drop.

The Fed blows off this bad news by noting that CDS rates were ignoring the weakness in CRE (so we should too?), and even worse is the way the Fed keeps pretending inflation is something that only happens in science fiction stories by saying: "Although increased oil prices had boosted overall inflation over recent months, the staff anticipated that consumer prices for energy would increase more slowly going forward, consistent with quotes on oil futures contracts. Consequently, total PCE price inflation was projected to run a little above core inflation." My note to members on this was:

This is important, they were TOTALLY wrong about energy prices so the summary of the whole thing so far is: The Fed has been pursuing a disastrous free money policy and ignoring the plight of the consumer based on completely misguided expectations that energy prices would not derail the economy. As energy prices are already up 10% since this meeting and up almost 25% since early February, when these idiots were gathering data - we can pretty safely assume that the policy they came up with was totally wrong!

I had much, much more on the subject but, suffice to say, we went short on the rally, grabbing very aggressive DIA Apr $111 puts for $1.62 and TZA Apr $6 calls for .50, neither one of which made big moves by the end of day so we’ll see if reality hits us this morning or if we have to scramble back to cash - where we feel warm and safe as this insanity storms around us.

Are we missing out on something? Perhaps, but so far, we’re only just testing the top of the range we discussed on March 12th, where we were looking for moves to the 61.8% Fibonacci levels from our indexes at Dow 11,138, S&P 1,226, Nasdaq 2,206 (well above that one), NYSE 7,972 and Russell 677. As it was a month ago, the S&P remains our lagging index at 1,189 and we are not waiting for the Fib levels to put our cash to work on the bull side, we have our own set of crosses that we’re still patiently (hah!) waiting to confirm.

So if you were BUYBUYBUYing yesterday, it was us who were selling to you because, according to the MSM, the Member population of PSW must be pretty much all the people on this planet who are bearish on the market; the rest of the planet has their rally caps on with the average IBank analyst targeting 1,350 on the S&P at the year’s end. We’re not even that bearish - we’re in cash but we are made to feel like bears for not participating in the rally and for having the nerve to take a few short plays. This is so much like 1999 I don’t think I can explain it to you if you didn’t live through it. We have participated in most of the major rallies off the bottom - right now we’re just catching our breath and taking a little time to count our money - which is the kind of strategy that ultimately kept people from being wiped out on the other side of January 2000.

Yesterday, for example, we made bearish plays with EDZ, GLL, FXP, Oil, DIA and TZA and a few of bull plays on Massey Energy (NYSE:MEE), Gilead Sciences (NASDAQ:GILD) and Research in Motion (RIMM), so it’s a little mixed and, as I said, we stop out our bear plays and get back to cash at 11,000, which is where we were doing our shorting. As you can see from the Weekend Wrap-Up, last week we also had a fair mix in our 28 plays, with just 6 that didn’t work out and 8 long-term bullish plays, so it’s not like we’re sitting the rally out in protest - it’s just that we have no faith in it whatsoever - something we like to call healthy skepticism…

Housingwire has a great article by Paul Jackson that explains the total disconnect between our defective economy and the rise in consumer spending. Jackson asks: "What if ‘extend and pretend’ within our nation’s troubled mortgage markets is actually providing a lift to consumer spending?" Jackson points to 7.4M non-current loans with most Americans who are behind on their mortgage now OVER A YEAR behind on their payments. We already know that Americans stop paying their mortgage long before they stop paying their credit card bills, auto loans, etc. because the foreclosure process is relatively slow and, of course, many consumers are waiting for the modification fairy to come and fix everything.

Jackson cites an example of a person who isn’t paying their mortgage living rent-free in the home yet spending more than the $1,880 monthly mortgage on things like tanning, nails, liquor, pay-per-view and "Over $1,700 in retail purchases, including: Best Buy, Baby Gap, Brookstone, Old Navy, Bed, Bath & Beyond, Home Depot, Macy’s, Pac Sun, Urban Behavior, Sears, Staples, and Footlocker." Jackson reasonable extrapolates this behavior to show how we could easily be looking at $3.7Bn a month in consumer spending (10%) that is simply a quirk of this in-between stage of people who have given up trying to pay for their homes but haven’t suffered the consequences - YET.

We has a great discussion in Member Chat last night on the ethics of walking away from your home - as you should any other bad investment. Are we "sticking it to the bank" or is the bank simply our partner in this home-buying venture that didn’t work out and should be sharing the pain in our mutual bad investment? However you want to slice it, the fact is that the banks are not moving to foreclose because they’d rather write off a year of missed payments than take back the home and have to write it down when it’s sold as well as having to pay taxes (also past due) and maintenance on their vacant homes as they sit unsold in a bad market. Frankly, if those 7.4M homes were actually empty, the bank would have to pay someone to mow the lawn, and keep the bugs out and prevent the property from being looted, etc.

This is how this strange situation is persisting in 2010, but don’t mistake an economic coincidence for real economic strength - it’s just another house of cards that will look nice right up until something makes it all collapse. Of course it is possible that the market does turn around and the consumers go back to paying their mortgages and the banks don’t ultimately have to write off another Trillion in bad assets but I’m just a little uncomfortable counting on that and, with the markets back at 2007 levels - that’s exactly what investors are doing.

Asia was flat today other than the Hang Seng, which gapped up 300 points at the open and finished the day up 391 (1.8%) at 21,928 - right back to our 22,000 mark after giving us a strong sell signal when they failed it way back on Jan. 13th. The Hang Seng had gone as low at 19,500, so 22,000 is a 12.5% move off the bottom and we’ll be looking for them to complete the move to 15% at 22,500 - anything less than that will be a sign of weakness in the Chinese markets.

Europe is trading down across the board by about half a point as the Euro tests new lows against the dollar. The EU economy "unexpectedly" (to the bulls) stagnated in the fourth quarter as companies cut spending more than previously estimated. Yes, I know this is the opposite of what you’ve been hearing in the MSM, and that is because this is the truth and there’s no place for that in our corporate media outlets. Data “point to a continued recovery of the world economy, albeit at variable speeds across countries and regions,” the Organization for Economic Cooperation and Development said in a report today. “A number of factors are expected to bear down on activity in the very near term.” Europe will see “a slow and bumpy recovery,” said Colin Ellis, an economist at Daiwa Capital Markets Europe Ltd. in London. “The euro area is set to rely disproportionally on trade this year and next.”

This is, of course BOOSTING our futures as it means the ECB is likely to remain on hold, which means our own Fed can keep handing out free money and we can keep pretending everything is fine for another quarter, so YAY, I guess. Greek 10-year bonds hit a record 407 basis-point spread to the German bund as that crisis gets worse again, but US investors are bored with it so we’ll pretend it doesn’t matter now. Copper briefly failed $3.60 and gold pulled back to $1,125 and that sent miners lower, but the free money story is pumping the commodity pushers back up ahead of the US open.

Today we have Greenspan testifying to Congress in day one of two days of testimony on the financial crisis starring the usual suspects. Mortgage Applications were up 0.2% last week as the 30-year climbed from 5.04% to 5.31% during the week. At 1pm we have the 10-year note auction and that can be a market-mover if it goes poorly. Midwest manufacturing tapered off in February, largely due to a decline in auto production, according to the Chicago Fed. The Midwest Manufacturing Index fell 0.8% to 82.6, paring back a 2% gain in January. Compared to a year ago, the index was -0.5% but the S&P is up 78% so this must be a good thing somehow, right?

Another "good thing" with the IYR up 160% in 12 months must be that the vacancy rates at U.S. shopping centers and malls rose to 10-year highs in Q1 according to research firm Reis, who predicted no improvement in the near future: "Until we see stabilization and recovery take root in both consumer spending and business spending and employment, we do not foresee a recovery in the retail property sector until late 2012 at the earliest." Have I mentioned how much I love cash lately?

It’s still pretty crazy out there - be careful!