The market has staged an impressive rally since breaking through its 12 year low on March 6th. The S&P 500 index (SPY- S&P 500 SPDR) is up nearly 24% as of Friday’s close, while the Nasdaq (QQQQ- PowerShares- Nasdaq-100) and Dow Jones Industrial Average (DIA- DIAMONDS Trust ) up 28% and 24%, respectively. With a sense of optimism coming out of the G-20 Summit in London, relief that jobless numbers were not as bad as they could be, recent talk of the appearance of “green shoots” and predictions of economic recovery towards the end of 2009 (one bank economist is even predicting positive second quarter growth!), we’re not buying it. We still see the economy in a very tenuous and weak state and expect another fall from these levels.
It Begins and Ends With Financials
The banking system in the United States, to put it mildly, is still weak. Much has been made of Citigroup (NYSE: C) and Bank of America (NYSE: BAC) proclaiming operating profits for the first quarter of 2009. While slightly encouraging, it is hardly satisfying as it fails to account for balance sheets, the heart of the problem since the beginning of this crisis. The Federal Reserve and Treasury have gone to extraordinary and unprecedented lengths to create an environment in which banks can earn operating profits; borrow at the short end of the curve for practically nothing and lend out at a higher rate. Frankly, if you cannot earn a profit in this environment, you should close your doors for good. There is still pain ahead for the bank’s balance sheets. As home prices continue to fall and job losses keep mounting, the bank’s bad loans will continue to deteriorate. Bloomberg reported on Friday, April 3 that federal regulators may force at least a dozen of the nation’s biggest financial institutions to write down as much as $1 trillion in loans, twice the amount already recorded. Treasury Secretary Geithner is pushing for fast-tracked Congressional approval of a law that will allow the takeover of important institutions and bank holding companies, which should signal that risk to the system is still great. Additionally, there is a great deal of speculation as to whether PPIP will be a benefit to ailing banks. Selling troubled assets will likely mean realizing a large amount of previously unrecognized losses. We see the recent rally in the Financials (XLF-Financial Select Sector SPDR) as an opportunity to sell this overconfidence in the banking system.
Taking Cues from Credit and Commercial Real Estate
As we have witnessed in previous bear rallies, the credit and equity markets are telling us two different stories. Corporate debt is still pricing for disaster, as investment-grade corporate bonds are pricing in a five-year default rate of 40%, according to Deutsche Bank. Moody’s recently downgraded $1.76 trillion in Corporate debt, signaling the approach of the worst defaults rates since the Great Depression. Moody’s chief economist John Lonski adds that “the most prominent new driving force behind credit rating reductions would be deterioration of commercial real estate.” Commercial real estate values are still in the midst of a free fall, defaults and delinquencies are mounting, rents are falling, vacancy rates accelerating, and refinancing is tight at best and at worst non-existent. As evidenced by the CMBX index, CMBS spreads are still at highly distressed levels. All but AAA spreads remain at or near all-time highs. While there has been some spread tightening in CMBS/RMBS AAAs since Geithner’s PPIP announcement, take that with a grain of salt, AAA spreads are compressing from previously unimaginable levels. A recent article from Bloomberg notes that the country’s 10 largest banks have $327.6 billion in exposure to commercial real estate, half of which are owned by Wells Fargo and Bank of America. As the economy is still shedding jobs at an alarming rate, commercial real estate will continue to deteriorate. There is still another shoe to drop.
The United States is Not an Island unto Itself
It is also important to remember that the United States is not alone in this crisis, and it cannot fully recover without the rest of the world following suit. Although it seems we are going by the FIFO method of economic recessions, First In First Out, it seems highly unlikely that a recovery can take hold without some signs from the rest of the world. From a global perspective, the world economy is very much still in the throes of a very serious and deep recession. The Eurozone, and especially Japan, are showing no signs of relief. In fact, Japan’s economic situation seems to be continually deteriorating, with Prime Minister Aso calling for another large economic stimulus package to be compiled this month. The United States’ third largest trading partner and southern neighbor asked for a $40 billion loan from the IMF just this week. Given its shaky economy and the increasingly difficult task of saving itself from narco-statehood, Mexico seems volatile. Additionally, the recent announcement out of the G-20 to raise the IMF’s reserves to $1 trillion, raises some serious issues with us. The need for additional funds at the IMF signals that there are crises looming for many weak and battered countries. Although, it should not come as a surprise in this climate that the IMF will have to step in and help weak economies, what are the chances that the IMF can execute flawlessly on all of them? If their past performance is any indicator, it would seem highly unlikely.
Due to our expectations of continued weakness in the financial sector, the looming deterioration of commercial real estate, the credit markets tepid backing of the equity rally, and the still very shaky and highly volatile global economy, we think the recent run-up in stocks is unwarranted and presents an overly optimistic view of the months ahead. We believe investors should consider taking short term profits or use the recent run to reduce equity exposure they are weary of. We also believe investment grade debt (LQD- iShares iBoxx $ InvesTop Investment Grade Corporate Bond Fund) represents an opportunity for investors seeking beaten down prices without the downside volatility of equities.
Disclosure: no positions