Market Bears Back in Business

The past week started on a seemingly strong note, with the positive sentiment witnessed towards the end of last Friday (February 22) carrying forward on Monday, after S&P reiterated its top rating for Ambac Financial (ABK) and took MBIA (MBI) off its credit watch list. The front-line indexes held on to their gains over the following two trading sessions, managing to shrug off the weak economic data on the back of the announcement of a repurchase program by IBM (IBM) and optimism over additional Fed rate cuts. Heightened fears of a recession gripped the minds of investors towards the end of the week, and the front-line indexes squared the week with losses ranging between 0.9 percent - 1.7 percent.

In our previous report, we had likened the price action since January's panic lows to a bearish pennant pattern on the DJI (DIA) and the S&P 500 (SPY) indexes. Though the gains witnessed in the early part of the week rendered the pattern invalid, the DJIA retreated from the resistance at 12740 levels and the S&P 500 resumed the decline from around 1395 levels. The front-line indexes appear poised to decline further to the January panic lows.

click charts to enlarge

This week we take a look at the news on the economic front, provide an update on the continuing turmoil in the auction rate securities market and take a look at Ben Bernanke's semi-annual testimony before the Congress.

More Signs Of Deterioration

As has been the norm over the past few weeks, fresh economic data that flowed in from various fronts over the past week remained starkly negative. On the housing front, data showed that sales of new single-family home sales at 588,000 units fell 2.8 percent in January, its lowest rate since February 1995. Median prices also plunged 15.1 percent on a year over year basis. The number of homes facing foreclosure jumped to 57 percent in January compared to a year ago, as lenders are forced to take possession of homes they could not unload at auctions.

The S&P Case Shiller report showed that home prices continued to journey south in December, hallmarking an entire year of decline. The quarterly National Home Price index fell 8.9 percent in Q4 2007, to the lowest in its 20 year history. The 20-City Composite recorded a 9.1 percent annual drop, while the 10-City Composite fell to its lowest level ever, since inception and plunged 9.8 percent over the year.

The National Association of Purchasing Managers-Chicago said its index of regional business conditions showed a sharp contraction and dived to 44.5 in February, its lowest since December 2001, from 51.5 in January. The NAPM-Chicago PMI that is widely considered to be barometer of manufacturing activity, showed that even regions in the country seen to be the least affected by the housing cycle are being adversely impacted by the crisis. This release, precedes the ISM manufacturing survey (scheduled to be released in the forthcoming week) and has spurred expectations that the latter will also show a contraction. As seen in the chart below, the ISM manufacturing index has invariably followed the NAPM, whenever it has historically dropped below the neutral 50 levels.

The Commerce Department, after having confirmed that the economy grew a meager 0.6 percent in the fourth quarter, said that personal spending rose 0.4 percent in January, while personal income increased by 0.3 percent. On the face of it, this data suggests that spending ticked up in January, and at a pace greater than a rise in income. Inflation adjusted spending data, however, shows that spending remained unchanged, implying rising food and energy costs. This coupled with a 5.3 percent decline in durable goods orders provides clear evidence that 2008 began on a weak note for consumers, and does not bode well for the economy as consumer spending accounts for two-thirds of total economic activity. The Conference Board's Consumer Confidence Index plunged in February to 75.0 from a revised 87.3 in January, its lowest since February 2003, right before the start of the Iraq War.

The Labor Department's report indicated that another indicator of inflation, wholesale prices rose 1 percent last month. Over the past year wholesale prices surged a whopping 7.5 percent, its fastest pace since October 1981. The personal consumption expenditure price index is the most widely watched inflation gauge, given that it is the Fed's preferred inflation gauge. This index gained 0.4 percent on the month in January and 3.75 percent on the year. Core personal consumption expenditure price index, that excludes the volatile food and energy prices rose 2.2 percent year-over-year and was marginally above the Fed's perceived comfort zone that lies between 1 percent and 2 percent. Hence the economic data increasingly points that the US economy is faced with stagflation like scenario.

Municipal Bond Woes

We had earlier noted that the auction-rate securities market, where local governmental or quasi-governmental authorities borrowed long-term funds at short-term rates had begun to freeze. The failure of these auctions highlight the reluctance of the investment banks that have been bitten by the sub-prime crisis to support this market, that has resulted in the automatic resetting of interest rates at higher levels. In order to escape the backlash of rising re-sets, many bond issuers intend to convert these securities to long-term debt with fixed interest rates. This has led to an alarming concern that the sudden spurt in the supply of municipal bonds (whose quality is next only to the U.S. Treasury) will outstrip the already sparse demand from hedge funds and banks. The yields on 30-year top-rated, fixed-rate bonds climbed to 4.99 percent, its highest since August 2004, according to Municipal Market Advisors. The iShares S&P National Municipal Bond Index ETF (MUB) tracks the performance of the municipal bond market. As depicted below, prices have plunged 5.5 percent over the past three weeks, reflecting these very concerns.

Bernanke's Balancing Act

In his testimony before the Committee on Financial Services, the Federal Reserve Chief, Mr. Ben Bernanke, stated that "the economic situation has become distinctly less favorable" since July. Further, he pointed out the housing market is likely to continue to weigh down economic activity in coming quarters. Bernanke admitted that:

Further increases in the prices of energy and other commodities in recent weeks, together with the latest data on consumer prices, suggest slightly greater upside risks to the projections of both overall and core inflation than we saw last month.

While conceding that the economic data pointed towards sluggish economic activity in the near-term, he remained optimistic that PCE inflation would moderate significantly in 2008, assuming flattening out of energy and food prices, chief contributors to the climbing inflation. The Fed chief noted that there is a time lag between the implementation of remedial measures (monetary and fiscal) and tangible effects of these initiatives and anticipated that the benefits emanating from the fiscal stimulus package will trickle in by the second half of 2008.

He also said that:

Any tendency of inflation expectations to become unmoored or for the Fed's inflation-fighting credibility to be eroded could greatly complicate the task of sustaining price stability and could reduce the flexibility of the FOMC to counter shortfalls in growth in the future.

These statements indicate that downside risks to growth continue to clearly remain on top of the Fed's priority list for now, but growing concerns of a rising inflation is beginning to take a seat on the back of the Fed's mind. After this speech, the probability of a 75 bps cut in rates at the upcoming Fed meeting on March 18 shot up to 70 percent from a minuscule 2 percent a week ago.

Comments

[Leonard:]

Thank you for the summation. I have shorted most of Feb. and I don't see any reason to change my mind.

2008 Mar 03 11:54 AM