August - 2009 Economic Brief

From July 10 through July 23 the S&P 500 index gained 11.1 percent and we are still rolling, but on just exactly what is not so clear; what's clear is it certainly is not earnings, they are way down.

Earnings declined over 98% since peaking in Q3 2007, making this by far the largest decline on record (the data goes back to 1936). In fact, real earnings have dropped to a record low and if current estimates hold, Q3 2009 will see the first 12-month period during which S&P 500 earnings are negative.”

As you may note, materials, consumer discretionary, and information technology were the three biggest sector winners.

Note that all three of these sectors are highly cyclical. In other words, they do well when the economy is strong and poorly when the economy is weak.

The fact that these three continue posting strong gains means investors are betting on a quick economic recovery.

But even if things are now less worse ... and possibly even bottoming ... is such an optimistic rotation into these riskier stocks warranted?

Case in point, even after announcing a poor quarterly earnings report, shares of Google posted a new yearly high, go figure!

Consider too what we heard from Microsoft in July. The firm said profits sunk 29 percent in the second quarter of 2009 vs. the same period a year earlier.
What about the financials and their bogus profits?

According to Bloomberg.com,

Goldman Sachs’ current record $3.44 billion earnings from their free or low cost capital supplied by broke American taxpayers has led the firm to decide to boost compensation and benefits by 33 percent. On an annual basis, this comes to compensation of $773,000 per employee.

As Eliot Spitzer said, the banks made a “bloody fortune” with US aid. And now, Goldman is taking the most trading risk in the firm's history.

Yes, it's true, Goldman generated record profits in the second quarter. Now it's also true that it doing so by taking the most trading risk in the firm's history, with money it, heretofore, never had access to until it' s new partner showed up, the US government with money from the Federal Reserve.

Yet presently, the banks have more than a $1 trillion in toxic assets on their balance sheets and the wholesale credit markets (securitization) are in a shambles. Nothing has been done to separate commercial from investment banks, force all derivatives onto regulated platforms, unwind insolvent financial institutions, establish prices for complex securities, increase capital requirements, or put an end to off-balance sheet operations. In short, we are not fixing the problem are we? The next bubble is already here. This time it’s government spending, fiscal deficits and increasing risk...

The point being... Beware of the Bear Trap

Here are my reasons:

1)
The sheer size of the derivatives market.
In 2006 the global market for derivatives was $285 trillion. Now it's $592 trillion. Its six-year compound rate of growth: A shocking 34.5 percent per year!

Despite all the talk of reducing risk and reforming the financial system, U.S. commercial banks still hold record amounts of high risk derivatives. The latest tally: $202 TRILLION in notional value derivatives. And even that pales in comparison to the global tally by the Bank of International Settlements, now at $592 trillion.

Bank of America has total credit risk to derivatives to the tune 169 percent of its capital; Citibank, 216 percent; JPMorgan Chase, 323 percent; HSBC Bank USA, 475 percent; Goldman Sachs, a whopping 1,048 percent, or over TEN times its capital

2)
The Lack of Transparency.
We railed against over-the-counter (OTC) derivatives, representing 96 percent of all derivatives held by U.S. commercial banks. No one but the parties involved knows precisely what the contracts are, or what their value really is.

Now, in Senate Banking Testimony, SEC Chairman Mary Schapiro has openly admitted that
"OTC derivatives are largely excluded from the securities regulatory framework by the Commodity Futures Modernization Act of 2000. In a recent study on a type of securities-related OTC derivative known as a credit default swap, or CDS, the Government Accountability Office found that 'comprehensive and consistent data on the overall market have not been readily available,' that 'authoritative information about the actual size of the CDS market is generally not available,' and that regulators currently are unable 'to monitor activities across the market.'"

3)
Too much in the hands of too few.
Back in 2006, there are close to 9,000 commercial and savings banks in the U.S. But... 97% of the bank-held derivatives in the U.S. are concentrated in the hands of just five banks. Today, 3 years later, virtually nothing has changed. And if you include the recent shotgun mergers and restructurings, such as Bank of America's acquisition of Merrill Lynch, the concentration of risk today is even greater.

4)
Cancerous growth in Credit Default Swaps (CDS).
It was just $180 billion in 1996. That grew to $893 billion in 2000 ... $1.95 trillion in 2002 ... and a stunning $20 trillion in 2006. It's hard to believe. That's a 111-fold expansion in just a decade! CDS are just one of the derivatives in a larger $592 TRILLION market of all different kinds of derivatives controlled by U.S. commercial banks. It’s the derivative that relates to the insurance-for-insurance for home mortgages through Fanny Mae and Fredy Mac.

The problem: Now, hedge funds and other investors are using these derivatives to spin the roulette wheel. In fact, the hedge fund industry now holds 32% of the credit default swaps, up from 15% two years ago. Think about that for a minute:
Thinly capitalized, gun-slinging hedge funds are now essentially taking on the responsibility for insuring billions of dollars in bonds.

5)
Outstanding derivatives dwarf the trading in the underlying securities.
The sheer volume of total derivatives outstanding (not just CDSs) ... is dwarfing the amount of underlying debt securities. In other words, the sheer volume of derivatives outstanding ... is dwarfing the amount of original debt in the underlying debt securities or the amount of debt the specified company owes. That's causing major market distortions.

6)
The Baltic Dry Index,
which measures the freight rates for dry cargo traveling by ship, hit an all time high of 11,793 on May 5, 2008. Then it plunged to 663 on December 5, a decline of 94.4 percent. It was as if trade was coming to a standstill. However, freight rates soon started to recover...

Since its December low, the index is up to approximately 4,000 for a whopping gain of some 500 percent! And the "green shoot" crowd is pointing to this surge as proof of the revival in world trade, even though the index is still down 68.6 percent from its May 2008 high.

7)
Container vessels reflect the movements of goods instead of raw materials. So their behavior is more representative of what's going on with sales of finished goods. And they exclude any possible commodity speculations.

According to Germany's Commerzbank, freight rates of container vessels are down 75 percent from early 2008. More importantly, they declined by almost 30 percent this year and hit a new low in June.

Association of American Railroads reports that total traffic for the major players fell 21% in Q2 vs a 16% decline in Q1, which means business inventories are not getting replenished.

8)
The Chinese stock market is up 78 percent from its November low. But even so, it's still down 50 percent from its October 2007 high.

9)
The secular credit expansion has reversed, both consumers and banks are deleveraging and companies in the middle are downsizing to accommodate a leaner business model going forward: the "new normal." The asset boom was driven by liquidity and liquidity was driven by easy credit. Whether you wanted to buy a car, a condo, a corporation or a Collateralized Debt Obligation, financing could easily be arranged. Things are different now.

This rally is celebrating the fantasy that the old normal can be revived. Dreams die hard and these developments do not bode well for world trade.

Meanwhile, the Fed is stealthily tightening, not by raising rates, but by withdrawing funds from the money supply and extending time periods for short-term bond offerings! And it is a good thing to because according to the U.S. Federal Reserve, seasonally adjusted M2 has gone from $7.25 trillion in July of 2007 – to over $8.37 trillion today.

(Note: M2 is calculated by totaling up the value of cash held by the public, checkable deposits, household savings deposits, small time deposits, and money market mutual funds. M2 is an important economic indicator used to forecast inflation. If you have too much money or M2 awash in the economy chasing too few goods and services, the result is higher inflation.)

That’s 15.44% more money circulating around the economy in just two years, a colossal $1.12 trillion increase. This large injection of currency into our economy will certainly lead to higher inflation, which will be further amplified due to our fractional reserve banking system. In a fractional-reserve banking system a new sum of money is created whenever a bank gives out a loan.

Unless backed into a corner (do I hear China?) the Fed won’t increase rates as it could cause interest payments on the government’s debt to double, it would be better to devalue the currency than to make still larger payments; today payments are slightly below $500 billion annually. Year over year M2 growth (actual currency in circulation and key economic indicator used to forecast inflation) was 9.3% in June and has only increased 2.5% year to date. Banks have increased their cash reserves by more than 25% in the last year, but lending is not increasing.

Money pumped into financial system not reaching broader economy

Central banks worldwide have frantically poured money into the financial system to cope with the credit crunch, but that liquidity does not appear to be reaching the broader economy. Central bankers are encouraging financial institutions to use the funds to bolster lending, but banks are concerned about their balance sheets and potential losses on loans. (Financial Times tiered subscription model) (21 Jul.)

Instead, the velocity of money, (See March – 2009 Economic Brief for an explanation of monetary velocity), in the U.S. financial system is slowing as banks hold on to capital for a rainy day. And not just banks; consumers, too, the U.S. savings rate is now approaching 7%, having been near zero two years ago.

In fact, just about everything in the U.S. seems to be slowing down. For example, the country is experiencing the longest and steepest decline in driving since the invention of the automobile.

10)
According to the latest data from Standard & Poor's, the second quarter of 2009 saw just 233 dividend increases.

How does that stack up historically?

Well, it's the worst second quarter on record since 1958! This year might just go down in history as the worst year ever for dividends. In the first quarter of 2009, companies cut $40.8 billion in dividends, more than were eliminated in all of 2008.

11)
The number of states that have exhausted their unemployment insurance fund and now must borrow from the federal government to meet weekly payment obligations continues to rise. So far, 18 states have tapped the feds for a total of $12 billion.

And all this pales in comparison to California’s fiscal disaster — the nation's most populous state, with the largest GDP and the greatest impact on the entire U.S. economy — collapsing.

Remember: California has a GDP of $1.8 trillion, larger than the economies of Russia, Brazil, Canada and India.

12)
And U.S. employers have just slashed another 540,000 jobs in June vs a 322,000 loss in May, driving the official U.S. unemployment rate to 9.5 percent, its worst level in 26 years. If you include part-time and discouraged workers, 16.5 percent of America’s work force is now jobless! Every single job created after the prior recession has been wiped out.

Unemployment remains a major hurdle, Treasury official says

The U.S. Treasury is concerned that 40% of those unemployed describe themselves as "permanent job losers," a much higher percentage than in previous recessions, said Alan Krueger, assistant Treasury secretary for economic policy. Employment will continue lagging behind production, he said, and the weak job market "poses severe challenges" for economic recovery. Reuters (20 Jul.)

Unemployment claims reach 554,000 in U.S.

The number of initial claims for unemployment benefits in the U.S. climbed by 30,000 last week, bringing the total to a seasonally adjusted 554,000, the Labor Department reported. A government official said the increase was slightly exaggerated by an unusual pattern in auto-industry layoffs. The New York Times/Reuters (23 Jul.)

Job worries undercut U.S. consumer optimism

Consumer confidence in the U.S. declined for the second month in a row in July, The Conference Board said. The research group's Consumer Confidence Index slid from 49.3 in June to 46.6 this month. "Consumer confidence, which had rebounded strongly in late spring, has faded," said Lynn Franco, director of The Conference Board Consumer Research Center. USA TODAY/The Associated Press (28 Jul.)

13)
Consumer confidence unexpectedly plunged by nearly 10 percent last month The consumers whose spending used to account for 70 percent of the entire U.S. economy. And with 70% of our economy dependent on consumer spending, where is the recovery going to come from?

Let’s take a quick look at what is really happening out there for the consumer... in the first three months of 2009, delinquencies on home equity loans, home equity line of credit and credit cards exploded to new, all-time record highs — and delinquencies on auto loans surged a mind-numbing 48 percent from the end of 2008. As a reflection of consumer confidence you can also factor in that retail sales dropped 4.9% in June, due in part to deep discounting. That headline figure may not sound too bad, but double- digit sales declines were common among many.

All department stores that reported June sales posted declines. The new frugality is affecting the entire retail spectrum, from low-end Target (down 6.2%) to high-end Neiman Marcus, where sales were off 20%. Interestingly, sales of televisions were up 50% year-over-year, suggesting the return of the cocooning phenomenon.

Meanwhile, the “consumer effect” on the default rate on Corporate “junk” bonds has almost quadrupled to 9.5 percent from 2.4 percent a year earlier, according to Fitch Ratings.

Banks continue to struggle with troubled loans

Results from Wells Fargo, U.S. Bancorp, KeyCorp and SunTrust Banks show that while they are performing well in some areas, they are still struggling with increases in troubled loans to businesses and consumers. All four banks reported steep increases in loan losses. The reports indicate the financial industry is not done working through issues related to the financial crisis. The Wall Street Journal (23 Jul.)

U.S. household leverage, as measured by the ratio of debt to personal disposable income, increased modestly from 55% in 1960 to 65% by the mid-1980s. Then, over the next two decades, leverage proceeded to more than double, reaching an all-time high of 133% in 2007. That dramatic rise in debt was accompanied by a steady decline in the personal saving rate. The combination of higher debt and lower saving enabled personal consumption expenditures to grow faster than disposable income, providing a significant boost to U.S. economic growth over the period. In the long-run, however, consumption cannot grow faster than income because there is an upper limit to how much debt households can service, based on their incomes.

Beginning in 2000, however, the pace of debt accumulation accelerated dramatically... Between 2000 and 2007 the total U.S. credit market debt increased at five times the rate of nominal gross domestic product. Rising debt levels were accompanied by rising wealth.

In the last 18 months, the ratio of debt to disposable income has only eased to 128%, which means that it will take at least a decade to rebuild balance sheets enough to resume spending at pre-crisis levels. It's going to be a long hard slog even if the stimulus works according to plan. The full brunt of the credit collapse may be behind us, but please, the other two shocks, namely deflating labor markets and deflating home prices, are very much still front and center.

Belt-tightening consumers slash discretionary spending

Companies that make and sell consumer discretionary items such as toys and motorcycles are taking a particularly harsh beating as unemployment continues to rise. Analysts said sales cannot go up as long as consumers' income is going down. BusinessWeek (19 Jul.)

14)
U.S. deficit reaches record $1 trillion and counting

With three months left to go in the budget year, the U.S. government's deficit has hit an all-time high of $1 trillion. The Congressional Budget Office predicted that by the end of the year, the deficit will be 13% of the country's GDP. That compares with a recent high of 6% of GDP in 1983 during the Reagan administration and 30.3% in 1943, when the U.S. spent a huge amount of money to fight World War II. The Associated Press (13 Jul.)

Here are some key statistics regarding the debt burden of the US:

 US official debt is $11.3 trillion. This represents an astronomical 80% of our 14 trillion GDP.

 Unfunded national debt that is not accounted for is well north of $50 trillion. That includes $10.5 trillion for Social Security promises, $39.5 trillion for Medicare and Medicaid promises and $8.4 trillion for prescription drug coverage.

 Household debt is over 100% of US GDP. It was only 40% in the severe recession in the mid 70s.

 Alarms go off when nations have budget deficits that exceed 5% of their GDP. The US is heading towards a 13% deficit for fiscal 2009. Perennial defaulters like Mexico and Argentina have 2.9% and 3.6% deficits respectively. This is a good point to remind you that US GDP as well as tax receipts are plummeting.

 More than half of this year’s national budget has to be borrowed. A choking $1.85 trillion is on the auction block.

 The global demand for US debt instruments has fallen off a cliff. The Fed-Treasury complex is now buying our own debt in a desperate end game strategy.

 Rising interest rates will make government sponsored debt even more impossible to pay.

That means that when the music stops on this Fed orchestrated mythical musical ride, the downside momentum could be dramatic. Keep your powder dry because the stimulus still isn’t enough.

Have you heard that:

U.S. House leader requests an open mind about second stimulus

Though he agreed that it is too early to give up on the original economic stimulus, and that U.S. House Majority Leader Steny Hoyer said the nation should be open to another round. The increase in unemployment is slowing down, but "it's not where it ought to be," he said. Reuters (07 Jul.)

That's a tacit admission that the $787-billion package enacted in February is failing to get the job done.


Out of the blue:

Food stamp bonanza: Over 10% of America now enrolled
Nationwide, enrollment in the program surged in March to about 33.2 million people, up by nearly one million since January and by more than five million from March 2008. In a recent research report, Pali Capital Inc. estimated that food-stamp spending will increase between $10 billion and $12 billion this year from $34.6 billion in 2008.



Quotes of the month:

One,
Bill Gross, managing director at the giant bond investment firm Pimco, used his own colorful language to describe the recent past — and provide a vision of the future:

"U.S. and many global consumers gorged themselves on Big Macs of all varieties: burgers to be sure, but also McHouses, McHummers, and McFlatscreens, all financed with excessive amounts of McCredit created under the mistaken assumption that the asset prices securitizing them could never go down. What a colossal McStake that turned out to be...

The fact is that American consumers have suffered a collapse in wealth of at least $15 trillion since early 2007.

Two,
TARP Special Inspector General Neil Barofsky is unhappy with Treasury Secretary Geithner. In testimony before the House Committee on Oversight and Government Reform, Mr. Barofsky criticized the Treasury for lack of transparency and offered a headline grabbing estimate of the U.S. government's potential maximum cost from the financial crisis: $23.7 trillion.

Three:
"We want to get to the bottom of what the Federal Reserve's been doing, and what they're getting away with." And, "It's a real contest between those of us in America who believe in freedom and the free market versus those who would socialize our country." – Ron Paul



Facts of the month:

“In 20 years, China’s cities will have added 350 million people—more than the entire population of the United States today.” - by McKinsey Global Institute

50 million Americans are already on antidepressants!

Note to readers:
One may wonder how it is that I accumulate such a mass of information, let alone have the time for this blog. First, it is purely self-interest as I too have to navigate these markets and since I am making the time to do the reading and discovery, why not share it with a larger audience, and so I do. Second, my sources are many and varied and what I do is take the best of the best, cut and paste, and string together a somewhat coherent thesis. In reference to my sources this month, they include in no particular order: Gregory Spear's Market Commentary; DailyWealth Reader; Tom Dyson/The Daily Crux; Money and Markets/Claus Vogt, Nilus Mative, Martin Weiss, Mike Larsen; Investorsdailyedge.com; Bloomberg; Reuters; The Wall Street Journal; Russell McDougal, DDS; Mike Whitney; Doug Casey; Ted Peroulakis; Financial Times; Reuters; and Business Week.