All Things in Moderation

Vital Statistics:

Futures are flat this morning as the market waits to see what comes out of Europe. The WSJ has a story this morning about the brightening outlook for Corporate America. It raises an interesting point regarding consumers – what they actually do can be different from what they say. Consumers can feel tapped out and miserable, but when the 10-year old car has had it, they buy a new one. Consumption can only be deferred for so long, and we have had a retrenching consumer for 3 years now.

The Obama administration is working on a new housing plan – one which eases the requirements for refinancing. Credit is so tight right now that borrowers who are current but have little or no equity are unable to refinance. This move is intended to break that dynamic. Will it prevent home prices from dropping? Probably not, as the first-time homebuyer is not really in a position to buy a house, and prices aren’t cheap enough to entice professional investors to take the liquidity risk and step into the market.

Merger Monday is back upon us with a bear hug in the pipeline space and a deal in the cloud computing space. CAT reported better than expected earnings.

No major economic data today – Case-Schiller comes out tomorrow.

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Vital Statistics:

European leaders begin a 6-day summit on Greece and the banks today. Merkel and Sarkozy are having differences over the mechanics of the European Financial Stability Facility. The WSJ has an article this morning about the exposure French banks have to Greece. While a Greek default will not make them insolvent, they will have to raise capital and de-risk. Societe Generale’s stock has been cut in half over the last 3 months. EURIBOR / OIS spreads have retreated from their peak a month ago, but are still elevated.

In earnings, Mister Softee posted better than expected sales on strong corporate demand. It is now a value stock, sporting a single digit P/E. I remember when MSFT was a growth stock in the late 90s, trading at 56x 2000 EPS of .86. Earnings have increased 10% a year to a current estimate of $2.83. Meanwhile, the stock has been cut in half over the same time period. The gulf between the perceptions of growth investors and value investors is huge. And once growth investors decide the fizz is gone, it is a long long way down until value investors get interested. AAPL investors beware.

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Initial Jobless Claims came in at 403k, slightly higher than the 400k estimate. Later this morning, we will get Leading Economic Indicators, Philly Fed, and Existing Home Sales. It will be interesting to see if the Existing Home Sales confirms some of the increase in activity we are seeing from the homebuilders. Yesterday we saw some big prints in the call options for Toll Brothers and D.R. Horton. (14,000 contracts). It looks like others are positioning themselves ahead of earnings announcements. NVR’s earnings were a mixed bag this morning. Something to keep an eye on.

Other companies reporting today / last night: PM, LLY, EBAY, NUE

Steve Wynn went on another epic rant on his earnings conference call yesterday. Here is the audio and transcript: Wynn Resorts 3Q conference call

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Thought I’d add a link to Huntsman’s WSJ op-ed on TBTF. Not being a financial guy, I was surprised by the following numbers:

More than three years after the crisis and the accompanying bailouts, the six largest American financial institutions are significantly bigger than they were before the crisis, having been encouraged to snap up Bear Stearns and other competitors at bargain prices. These banks now have assets worth over 66% of gross domestic product—at least $9.4 trillion, up from 20% of GDP in the 1990s. There is no evidence that institutions of this size add sufficient value to offset the systemic risk they pose.

The major banks’ too-big-to-fail status gives them a comparative advantage in borrowing over their competitors thanks to the federal bailout backstop. This funding subsidy amounts to roughly 50 basis points, or one-half of a percentage point in today’s market.

Huntsman on TBTF

— Mike

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Vital Statistics:

The earnings parade continues. Bank of America (BAC) posted 3Q income of 56 cents a share, mainly on one-time items and accounting gains. They continue to deleverage – they shrunk the balance sheet $42B QOQ and have increased Tier 1 capital to 8.65%. I don’t see any mention of Durbin and the dreaded $5.00 debit card fee in the press releases. Maybe they will talk about it on the conference call. The stock is up a couple of percent pre-market.

Goldman reported a loss for the quarter. Writedowns on investments drove a lot of the losses. Sales and Trading revenues were lower as well as investment banking. Given that the stock market rolled over early in the quarter, these numbers should not have been a surprise. GS is up a buck pre-open.

Other companies reporting today: JNJ, KO, MRO, UNH, EMC, CROX

In economic data, the Producer Price Index came in higher than expected. China’s GDP came in slightly lower than estimates.

The WSJ has a story this morning talking about the lack of liquidity in the equity and bond markets. Decreased liquidity is a bear-market phenomenon, as lower prices beget lower activity. Hedge funds are sitting on their hands waiting for redemption notices at the end of the month. The overall decrease in sales and trading commissions means that banks aren’t going to take risk to facilitate customer orders for all but their best customers. Perhaps we are seeing the downside of the changes made in the late 90s – the balkanization of stock exchanges, the reduction of bid/ask spreads to pennies, and the decrease in commissions. In bull markets, people can move in and out of the market with ease, and these liquidity providers (market makers, the NYSE specialist) are viewed as unnecessary costs of trading. However, in a bear market people start to miss them. IMO, the flash crash would have been an unlikely phenomenon under the old regime. Is there any chance that we go back to the days of 1/16 bid – ask spreads, 3 cent commissions, and the NYSE specialist? Probably not. But it is becoming clearer that we gave up something in order to get penny spreads and sub-penny commissions.

What is the new battleground stock these days? Green Mountain Coffee Roasters. David Einhorn (who got it right about Lehman Brothers) was at the Value Investing Congress with a 110 page presentation ripping GMCR. This is one of those classic big battles in the markets – the value-driven hedge fund manager vs mutual fund managers starved for a growth story. We have seen this battle before in major flame-outs like Krispy Kreme and Enron. I don’t have the slides, but here is the WSJ story.

Further to yesterday’s energy discussion: WSJ It’s Official: ‘Age of Shale’ Has Arrived Money quote:

“You certainly have to record the discovery and the exploitation of resources from both oil and gas shales as one of the great wealth creators in American history,” said Ralph Eads, vice-chairman of investment bank Jefferies & Co., which has advised on more than $75 billion worth of shale deals over the last three years. “It looks to be the economic equivalent to any of the big technology innovations.”

Could be. And as more and more countries eschew coal and nuclear for electricity generation, the US could be shipping LNG all over the world and not only become energy independent, but a net energy exporter. Middle East geopolitics are going to change in a big way.

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After a lull in activity, Merger Monday is back upon us. Today’s activity is in the energy space as Kinder Morgan is buying El Paso for $38 billion in cash and stock, and Norwegian Oil company Statoil is buying E&P independent Brigham Exploration. The KMI / EP deal is a bet that natural gas will continue to grow its market share of energy in the US. Barclay’s will provide $11.5 billion in financing, which is a good sign for the credit markets.

Germany poured cold water on the idea of a complete sovereign debt crisis fix at the Oct 23 summit. G20 finance ministers met over the weekend. This has all the feelings of a negotiation, not a Lehman-esque crisis.

Citigroup posted better than expected earnings this morning, while Wells Fargo missed. Citi announced they have $32.4 billion in European exposure. Lowe’s announced they will close 20 stores and lay off 2000 workers.

Robert Sameulson has a piece in this morning’s Washington Post which discusses why our children’s future doesn’t look so bright. IMO, this sort of thinking is part and parcel of recessions. If anything, I think the national mood was worse during the late 70s / early 80s, where people thought that the US would be devoured by the two headed monster of OPEC and the Japanese. It turned out that oil demand was a lot more elastic than we thought, and the Japanese were in a bubble of their own. US manufacturing rebounded smartly as US companies adopted just-in-time and adopted Deming’s quality concepts.

I remember during the early 90s recession, we were supposedly heading for a generational war as the baby boom generation took all the job opportunities from Gen X-ers. Unemployed Gen X-ers would supposedly toil away forever at temp jobs while highly paid baby boomers bid up real estate prices to unreachable levels. Instead, we got the dot-com boom, which made many Gen X-ers extremely rich.

The point is that conventional wisdom, especially in the area of economics, is usually wrong because it overreacts to what is going on at the moment and extrapolates that forever. It accounts for the Business Week “Death of Equities” cover story in August 1979 as well as Dow 36,000 which was released in Oct 1999.

While I do believe that this recession is indeed different that past Fed-driven recessions, it isn’t a permanent state of affairs. This too shall pass. Booms don’t last forever, and neither do busts. My view has been that we are on a cusp of a revolution in energy which will collapse prices and turn the US from a net importer of energy to a net exporter. And that revolution will be a true elixir – it will go a long way towards fixing our budget problems and our trade deficit. It will also directly benefit the middle class the most by increasing disposable incomes and providing jobs.

We do have some more wood to chop economically – housing has to bottom, and the imbalances that stemmed from the real estate bubble have to be corrected. The debt that accrued during the last decade has to be worked off. Fortunately, while debt levels are quite high according to historical levels, debt service levels (principal and interest payments) are on the low side because interest rates are so low. Which means the debt will be worked off faster.

In economic data, Empire Manufacturing came in lower than expected. Industrial production was .2% and Capacity Utilization is slightly lower than expected at 77.4%. Below is a chart of capacity utilization. It shows that there still is a tremendous amount of slack in the economy, which bodes well for inflationary fears.

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Economic data this morning: Import Price Index up 13.4% YOY. Advance retail sales up 1.1% for the month of September. August sales were revised higher from flat to +.3%. September’s numbers have generally been much stronger than August. The WSJ has a story this morning discussing economic volatility, and shows that economic volatility has indeed been higher than historical averages. Certainly the stock market has been more volatile, with the VIX index over 30 (even after a gigantic rally). Link: Economy in Full Swing (Watch Your Head) – WSJ

Google reported last night better than expected numbers. The stock is up over 8% premarket. So far, Alcoa and JP Morgan have sold off after their numbers (in spite of “beating” the “analyst estimate”). The initial take from JPM and AA is that Europe is going to be a problem. Last quarter, CEOs were generally constructive on 2H; it will be interesting to hear their views going forward this time around.

Today’s Washington Post discusses the prospect of a double dip recession, (link) and makes the point that the typical drivers of a recession – construction and auto inventories – are already flat on their back, so there isn’t any excess to work off. That is a fair-enough observation, although I would point out that this isn’t the typical inventory-driven recession. This is a recession in the aftermath of an asset bubble, and those recoveries are slower, more fickle, and a lot of the levers that government has to fix things (monetary and fiscal policy) don’t work very well. To give you an idea of how depressed housing is (and why this recession is different), look at the chart below regarding housing starts.

Housing and construction typically leads the economy out of a recession. This time, it is not because there is a massive inventory of unsold homes. In addition, household formation has been depressed as a) immigration has been slowing, and b) unemployed college graduates move back in with their parents. A bottom in housing is a necessary, but not sufficient, condition for an economic rebound.

The WSJ has a depressing piece on how median incomes have fallen during the 2000s. Again, this is typical post-bubble behavior. The equity bubble burst in 2000, and the only thing that provided the economy any real energy was the housing bubble. Although people have the perception that the housing bubble inflated in 05-06, if you look at housing’s historical relationship with incomes, the bubble actually started in 2000, when the equity bubble burst. Guys like Krugman have been advocating inflation as a way out of this mess; so far, the Fed has only succeeded in commodity price inflation. If the “wage” side of the wage / price spiral don’t cooperate, the Fed only succeeds in crimping disposable incomes further, which is a recipe for the dreaded misery index.

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FYI, I do one of these on my other blog. It is easy enough to just copy it over here. Let me know if you find this worthwhile or not. Sold2u.

Vital Statistics: S&P futures -4, Eurostoxx – 1.5%, 10 year bond yield 2.18%, US dollar +21bp, Oil down 1.10 to 84.48, EURIBOR / OIS + 1.7bp.

JP Morgan reported earnings this morning. EPS and revenues were better than estimates, but the stock is down slightly based on earnings quality issues. They expect the Durbin rule to reduce consumer banking net by $600MM. They are very cautious about 2012 investment banking revenue, and headcount continues to fall. Euro exposure is about $15 billion, of which 65% is sovereigns. Tier 1 (Basel III) was 9.9%. Mortgage origination was $37B. Refis will drive business for the near future.

Harrisburg, PA filed for bankruptcy yesterday, mainly due to an ill-advised incinerator project that dwarfs the city’s budget. Harrisburg’s munis have been in the doghouse for a while, and this is not a surprise. Most are insured at any rate. The state will probably end up taking over the city’s finances. While the downturn has caused fiscal issues for many localities, we have not seen the mass bankruptcies / muni bloodbath that Meredith Whitney has been predicting.

Martin Feldstein has an editorial in today’s NYT link: How to Stop the Drop in Home Values discussing yet another plan to halt the decline in house prices by intervening in the market. This one involves reducing principal to 110% of the value of the house, and making the new mortgage full recourse – in other words, the bank can go after the other assets of the homeowner. The government and the banks would split the costs of the principal reduction. Washington seems fixated on this idea that foreclosures are reason why house prices are falling, and if we just stop the foreclosures, prices will stop falling. As I have argued in another post Robert Samuelson: The only thing we have to fear is fear itself this is premised on the idea that house prices are too low at the moment. Which is nonsense. If anything prices are sort of back in their historical relationship with incomes, but since incomes are falling, so should housing.

The magical thinking is on full display here: “

Without a program to stop mortgage defaults, there is no way to know how much further house prices might fall. Although house prices in some areas are already very low, potential buyers continue to wait because they anticipate even lower prices in the future.

Before the housing bubble burst in 2006, the level of house prices had risen nearly 60 percent above the long-term price path. So there is no knowing how far prices may fall below the long-term path before they begin to recover.”

Martin’s underlying assumption is that buyers are stupid. They aren’t. They won’t believe the government has the ability to support the housing market. And they aren’t going to start paying up for “fairly priced” property. For that matter, underwater homeowners need buyers to bid property back into “overvalued” territory. Anyone who has spent any time in the financial markets as a professional understands that markets don’t work that way, especially ones where underwater sellers dominate.

The low lending standards of the bubble years allowed first time homebuyers to purchase property without a downpayment. Essentially, the housing market “borrowed” first time homebuyers form the future. The only buyers left in this market are pros and the very young first time homebuyer. The very young first time homebuyer is lucky to have a job and is saddled with student loan debt. They are years away from amassing the downpayment that is needed in this tight credit environment. That leaves the pros. And they aren’t going to pay up for a fairly priced (at best) asset. Though some are moving into the MBS market, they are more or less front-running the Fed.

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