C.M.O. 4.13.2009

Credit Market Overview
April 13, 2009

Moves in the equity markets like the ones just experienced in the holiday shortened week bring the statisticians out of the woodwork looking at the size of the moves, how fast they happened and where things stand in relation to the oft sited benchmarks. The talking heads will be inundating you with that for most if not all of today and by doing so could well help the prophesy of a pullback become self fulfilling.

I will to spend just only the space needed here discussing those things to lay the ground work for bringing to light some hopefully not so often looked at information which will, also hopefully, allow you to come to your own conclusions as to wear things might be headed.

The S&P has rallied 26.6% since closing on March 9th at 676.53 and the closely watched VIX has fallen 30.6% since its 52.65 close on March 2nd. At 1653 the NASDAQ’s 27.7% 5 week run is the best in its entire history while the Russell 2000 has gained 33.4% in the same time period. Banks, which every monkey’s uncle has said need to participate in any turn around, are now up 80% from their lows according to Kopin Tan in Barron’s.

Andrew Burkly of Brown Brothers Harriman says the index numbers are now ahead of the moves in 1932, 1938, 1974, 1982 and 2002 which were all the start of a new bull markets.

The numbers themselves are impressive but the acceleration of the move begs the question; where to from here? Probably a good time to have a look at the tea leaves.

Barry Knapp, a strategist at Barclays Capital sees some questions of sustainability with financial stocks 26% above their 50 day moving averages, which he says, is the widest gap in two generations. On top of this, with 84% of all stocks are now above their 50DMA; “To buy the equity market at these levels implies a degree of confidence in a sharp recovery that doesn’t seem to jibe with the available evidence”, is how Barry put it. Some, however, wonder whether Barry is including the easier mark to market rules the banks now have and the Fed’s quantitative easing actions in his “available evidence.”

Louise Yamada says, “The bottom isn’t a place, it’s a process. The indexes, except for the NASDAQ, have been outperforming, but are still in a pattern of lower highs; each rally has met with selling into strength. The first step would be to get through the December peaks across the board. It is a bear-market rally until proven otherwise.”

The recent uptick in home sales and reduction in mortgage rates have been greeted with enthusiasm as was PHM’s promise to marry CTX (The next reality show is going to be the “Real Homebuilders of America”.) Ronald Temple, Lazard Asset Management’s co-director of research asks us to remember, however, that homes are among the planet’s slowest moving assets. With the jobless ranks continuing to grow and the banks being less than effusive in their lending he feels we could see another 22% - 27% to the downside from January’s levels.

The Fed’s quantitative easing once again comes into play here as Ben’s plan to buy $1TN in mortgage securities will apply downward pressure on mortgage rates. Given that each 1% decline in rates reduces monthly mortgage payments by 10% RT thinks that even at 4% there is another 16%-21%% lower to go in home prices. Ron doesn’t see home prices stabilizing this year but thinks with all the work the government is doing they “may decline at a slower pace.” Stocks won’t need to see a recovery in housing but only “smell one” to begin to recover he says.

The actual effectiveness of the Government’s quantitative easing is coming into question as the announcement to purchase $300BN of its own paper in the open market initially pushed the 10-year yield (a key rate in the mortgage market) down to 2.5% from 3%. That rate had since risen back to 2.93% as of Thursday.

One cause for this is that “the Treasury auctioned far more than the Fed bought back” last week as was observed by Gray Smith of Arbor Research. Exact numbers for the week come in at $59BN sold; $36.6BN bought. “This leads many to question what impact the necessity of funding massive projected 2009 and 2010 federal deficits will have on interest rates over the next six to nine months.” If you’re wondering where the bond vigilantes are you need only ask the little girl in front of the TV in “Poltergeist II”.

In the market, as in many areas of life, perception is, or at least can quickly become, reality (just ask the “Housewives”). The reality of which I speak here is that perceived by the 50 economic forecasters who contribute their thoughts to Blue Chip Economic Indicators, a Kansas City based business sentiment aggregator. The good news is that the group has stopped lowering their expectations. This is not the same as raising them but with “not as bad as expected” becoming the new “good” beggars can’t be choosers.

BCEI’s nifty fifty sees all of 2009’s contraction occurring in the first half of the year with real GDP falling at annual rates of 5.1% and 2.1% in the 1st and 2nd quarters respectively. Beyond that they see growth of 0.4% and 1.6% in the last two quarters of the year. A year out they see 4Q10 GDP growing at 2.7%. They expect unemployment to peak at 9.6% in 1Q10 but they don’t see an unemployment rate without a 9 handle for any part of next year.

The wealthy, who for these purposes will include investors with $500,000 or more in liquid assets, (how many of those are left?) are feeling rather upbeat at the moment according to TNS, a research firm that monitors these types of things. They say 79% of the previously defined “wealthy” expect improvements in their households’ overall financial situation in the net 6-months; that is up from 69% in October of last year. Ellen Sills-Levy, a senior vice president at TNS thinks “the market always responds worse to uncertainty than to anything definitive – positive or negative. These results show us that affluent Americans are beginning to sense a ‘shift’ in the markets’”.

Where does this all bring us? Back to the one thing we monitor more closely than anything else at Market Strategies Mgmt., credit spreads.

Justin Lahart put a feather in my cap (without even knowing it) writing in the WSJ recently saying that “corporate bonds spreads have been far better at predicting where the economy is headed than anyone thought.” He sites the widening of spreads in the fall of 2007, even as the stock indexes made all time highs. The research Mr. Lahart sited also looked at a similar period in early 2000 which, as we all know, lead to similar results.

Spreads are not only good at detecting individual companies’ ability to service their debt but can also be the canary in the coal mine when disruptions occur in credit supply. Like when banks have so many toxic assets on their books that they can’t lend anymore, widening spreads which results in a contraction of expansion.

By now everyone has heard the soprano Meredith Whitney sing the aria “Insolvenza” from the new opera “Completa Rovina Finanziaria Globale” written by Nouriel Roubini. You haven’t?! Make sure you’re not the last on your block to do so or maybe you should just make sure you’re not the last one on your block!

The findings quoted by Justin are the work of Simon Gilchrist and Vladimir Yankov at Boston University and Egon Zakrajsek at the Federal Reserve. All of their work will be included in a paper due to be published in the Journal of Monetary Economics.

Until then what you should know is that the model these gentlemen have developed predicts industrial production falling an additional 17% by the end of 2009 with 7.8MM more people out of work than the 5.1MM already unemployed.

Those are the tea leaves.

Enjoy the week.

Jim Delaney