Band of Analysts'  Instablog

The Paris-based Organization for Economic Cooperation and Development (OECD) revised its growth expectations for developing countries twofold: it expects that the US economy will grow 2.5% in 2010, up from the previous expectation of a 0.9% growth rate established in June.  In comparison, the Euro region was expected to stagnate in 2010 but is now expected to grow 0.9%.  These revisions were supported by signs of a recovery, the primary of which is the recent growth seen in developing countries. 

Nevertheless, the positive outlook was overshadowed by cautious commentary that the recovery is going to be tepid because businesses and households still have to mend their finances and as a result unemployment will continue to rise.  More job losses means lower spending, more home foreclosures, more losses at banks, and less credit.  The economy has to break that vicious cycles, and unfortunately all the stimulus that the governments have been pouring into the system hasn’t proven enough.

Stocks have been rallying because of a consensus technical rally into year-end (so that hedge fund profits will inflate and paydays will be higher) and because investors have been getting more comfortable with adding risk and beta to their portfolio in order to participate in the economic recovery.  The market arguably prices in a faster recovery than what the OECD expects, but then again the organization had to revise its growth estimates much higher in the short span of a few months, so that can easily happen again.  Still, the market is probably slightly dislocated from the reality of the fundamental economic data and the futures are pointing to a weak open.

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The market seems to be taking a breather after yesterday’s rally, fuelled by stronger-than-expected retail sales data (boosted by strength in the auto industry, offset partially by weakness in housing-related sectors) and dollar weakness.  Despite signs of an economic recovery by the former, the latter reflected expectations of continued low interest rates.  The reaction followed Bernanke’s warnings of a weak recovery, which gave confidence to investors that the Fed will keep interest rates low. 

Low interest rates can give more time for the financial system to heal, but they also result in a weaker dollar because of excess liquidity, a larger supply of dollars in the market, and future inflationary pressures.  The weaker dollar in turn can help the economy by making US exports cheaper.  The paradox is that the market rallied on news that the economy is doing worse, simply because worse economic data mean that interest rates will stay low.  One explanation of this market reaction is that investors already know that the economy is doing poorly, but they lack the confidence that the government knows that and that it understands the importance of extending low interest rates.

Credit reporting agency TransUnion reported that a record 6.25% of all US mortgages were 60 days or more past due as of Sept 30.  Getting 2 months behind on mortgage payments is a significant milestone towards going into foreclosure proceedings, i.e., there is a high “roll-rate” forward to foreclosures from that bucket.  The silver lining in the report was that the 60+ day delinquency rate increased at a slower pace than it has been rising in the past few quarters, growing at 7.6% from June, which showed an 11.3% rise since March, which in turn jumped 14% since December. 

The slowdown is good news, but the fact that delinquencies are still increasing indicates that there could be a lot more pain in mortgages going forward.  For one thing, banks have been telling their investors that they will stop building reserves in the next couple of quarters; however, if delinquencies keep rising, they cannot stop building reserves.  This delinquency rate will be a key metric to follow before an investor can believe banks’ optimism.

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This is a heavy week of macro news: retail sales and manufacturing survey are out before the Monday market open, the PPI and industrial production are out Tuesday, the CPI and housing starts are out Wednesday, and jobless claims and leading indicators are out on Thursday.

Retail sales were expected to grow 0.9% over the prior month, but actually grew a better 1.4%, which started fueling the market before the open.  Excluding autos and gasoline though, results were mixed, with the losers concentrated in housing-related sectors, e.g., building materials.  The Empire State manufacturing index shows the state of general business conditions in the NY area.  Economists expected a 29 reading, but the actual number was a disappointing 23.  A reading greater than zero still indicates growth in the manufacturing sector represented by the area, but it was weaker than anticipated.  Overall, the results are generally positive, but not as robust as the market perhaps had hoped for.  Thursday's economic data are probably going to be the focal point for the market's reaction to trends in the underlying fundamentals.

Two of the most prominent investors disclosed some of their thinking last week.  John Paulson is betting on financials and hotels -- or, at least that's what he was doing up until Sept. 30 -- while Sam Zell sayd there will be a lot more pain in commercial real estate before he gets back in the game.  Paulson is betting on an earlier recovery, while Zell waits.  Two weeks ago, Warren Buffett signaled his faith in the US economy by offering to buy out Burlington Northern and making an "all-in" kind of bet.  That said, the latter has a much longer time horizon than any other institutional investor, and he can afford to weather some storms in the near term.

Paulson's 13F came out after the market close this past Friday.  It showed that it started substantial new positions in Citigroup (300 million shares) and a number of hotel/lodging companies.  The Citigroup position was most likely the result of owning Citigroup preferred shares and participating in their exchange into common, which was completed in this quarter.  This is a very contrarian bet on a very weak sector.  Hotels have suffered the most of commercial real estate as clients have cut back on traveling, conventions, etc.  However, a business recovery would produce more travelers.  Maybe Paulson thinks of this as a levered play of an economic recovery.  For both his Citigroup and the lodging holdings, it may be the case that he has unloaded a large portion of them.  Unfortunately, the 13F data are stale by 45 days, so the filing is not all that helpful other than looking back into 3Q price movements and seeing how the investor thinks.  It doesn't necessarily mean that Paulson is still holding on to his Citigroup shares.  Nevertheless, the market saw the filing and interpreted the (stale) position as a vote for confidence, sending Citigroup up more than 3% after the market close on Friday and holding on to these gains on Monday morning.  Other new positions included: CNO, FCH, HIG, SHO, STWD.  Paulson decreased his position in JPM significantly from 7 to 2 million shares, and he got out of GS completely (he owned 2 million shares).  The decrease in his BAC position was immaterial (from 168 to 160 million shares).  His biggest position is still in gold.  Paulson was the most successful hedge fund in capitalizing on the short investment theme on US housing and he now commands one of the largest hedge funds, so everyone is monitoring what he's up to.

Another great investor, Sam Zell (a.k.a. the "grave dancer"), spoke last week to investors in a conference in Chicago about commercial real estate.  He earned his nickname through his well-timed vulture investing activities in the space.  This time around, everyone is waiting to see when he is going to pounce, which presumably will signal that the commercial real estate space will be near a bottom.  However, Zell warned investors that the time is not right yet, because existing holders of commercial real estate are completely detached from reality.  The space is suffering and fundamentals are deteriorating as everyone witnesses declining occupancy rates and rents.  Nevertheless, owners are holding on and hoping for a V-shaped recovery to bail them out.  They are banking on an inflection point in occupancy rates because there hasn't been much building going on this time around (as opposed to the over-building of the late 80s - early 90s).  Zell concedes to that point, but argues that rents are going to drop in the order of 30% before that inflection point arrives.  The result will be very painful restructurings, and whoever jumps the gun is going to do better than the rest.  This is the same argument that investors and analysts used to urge banks to purge their real estate books before everyone else hit the market.  Those that were more proactive indeed fared better than the rest.  The bottom line is that it doesn't pay to be early in the cycle, so the recent optimism in the hotel / lodging / gaming sectors may be somewhat misplaced.

Disclosure: No positions