Friday, May 08, 2009

The "Green Shoots" Thing

This morning, on CNBC, BofA CEO Ken Lewis gave an extended interview covering many topics.

Of particular interest was his contention that some sort of economic bottom has been reached, and that we can believe that the recession should be nearing an end.

If only.

This "green shoots" thing has been played up to nauseating levels by CNBC for a month or more. Larry Kudlow openly cried "the recession is over" yesterday.

Am I the only person who feels that Lewis has credibility issues? He's responsible for:

-buying a failed mortgage bank, Countrywide, at an inflated price;
-buying a failed broker, Merrill Lynch, at an inflated price; and
-being strong-armed by the Feds to complete the latter purchase and violate Sarbanes-Oxley, to the detriment of his own shareholders.

So why do we trust the economic judgement of a guy who thought he was getting a great deal on Countrywide, and then was totally blindsided by the financial meltdown?

Further, various economic pundits and administration spokespeople have been on all morning extolling the cessation of increasingly bad sales, unemployment and other economic indicators.

Fine. The pace of the recession's economic deterioration has declined. That is nothing remotely the same as saying we are in a recovery.

What we probably are in is a period of lower economic activity and continuing weakening, at a steady pace, due to the continuing effect of a massive financial deleveraging on top of a normal, but bad, economic recession.

Here's a series of S&P500 Index monthly returns from July 2001- April 2003. The green-highlighted values represent the positive return months which led to the early 2002 feeling of a recovery. The red-highlighted values represent the significantly negative monthly S&P returns following that false spring's 'green shoots' rally.

Jul-01 -0.010
Aug-01 -0.063
Sep-01 -0.081
Oct-01 0.019
Nov-01 0.077
Dec-01 0.009
Jan-02 -0.015
Feb-02 -0.019
Mar-02 0.038
Apr-02 -0.061
May-02 -0.001

Jun-02 -0.071
Jul-02 -0.078
Aug-02 0.007
Sep-02 -0.109
Oct-02 0.088
Nov-02 0.059
Dec-02 -0.059
Jan-03 -0.026
Feb-03 -0.015
Mar-03 0.010
Apr-03 0.081

On April 30th, I wrote in this post,

"Having patiently watched our recent put portfolios steadily decline in value, I reviewed equity market performance in the spring of 2002. By that season, the S&P had posted some good positive monthly returns, along with mild negative returns, resulting in my equity allocation signal indicating a re-entry into long positions. That only lasted for a month, though, as July and September saw the S&P post -8% and -11% returns, respectively.

It was not until spring of the next year that my signals correctly indicated the sustained recovery in the equity market. That spring, 2002 indication was a false positive.

Perhaps this recent 20+% rise in the S&P is another equity market head fake. The 2002 incident was accompanied by a decline in volatility to a point that corroborated a move to long allocations in equities, and puts in options."

It took another six months following September's -11% S&P return for a string of positive returns to signal the genuine end of the market decline.

The recent equity rally has now topped +30% since the March bottom. But based on what?

The retail spending rate of decline easing was primarily in discount stores- Wal-Mart and some drug chains. The Wall Street Journal article discussing the reports noted that mid-priced and high-end retailers are still mired in difficulty.

I just don't buy this cock-eyed optimism suddenly appearing everywhere.

Holman Jenkins On Chrysler/Fiat

Holman Jenkins, Jr., wrote another piece in his Wall Street Journal column on Wednesday of this week that is scathing in its assessment of the current US administration's approach to the two US-based auto makers which are in or near bankruptcy. Continuing his outright mockery of the president, Jenkins pokes fun at the tangled, mixed-up, illogical positions in which the current administration, and Congress, now find themselves.

For example, he begins with,

"When you buy a car, I hope it will be a Democratic car."

Oops. We have misquoted the president. He said last week he hoped you would buy an "American car" -- though apparently not one built in a red state in a plant owned by Japanese or German investors. He meant a car built by a company headquartered in Detroit, even if the car itself is assembled in Mexico or Canada. How confusing.

Hundreds of shoppers certainly understood him to mean a Chrysler car. They rushed into dealerships last weekend. Never mind that Chrysler isn't technically making cars in the U.S. at the moment -- it shut down its factories -- and when it reopens it will be on a path to ownership by a company based in Turin, Italy."

It is pretty riotous to hear the president fumble with his call to 'buy American,' when that really means cars assembled outside the US, by a firm which will now be owned by foreigners. Does he ever mention that American workers in South Carolina and nearby states assembling cars for Mercedes, Toyota,

Jenkins then observes how astute the Germans at Daimler were to quickly dump Chrysler a few years ago.

"Daimler, its previous parent, certainly had no desire to fund such profitless extravagance. The Germans took a lot of guff but they're the ones laughing now. They sold their majority stake in Chrysler just months after Democrats took over Congress, and just weeks after President Bush began blathering about "oil addiction" and echoing Democratic demands for stringent new fuel-mileage rules (after opposing them for years).

It's no exaggeration to say the rest of the story is told in Chrysler's bankruptcy filing. In search of a partner to underwrite development of fuel-sipping hybrids and electric cars that would be almost certain to lose money in the U.S. marketplace, Chrysler's Tom LaSorda spent two years seeking alliances with Nissan, GM, Volkswagen, Tata, Magna, GAZ, Hyundai, Honda, Toyota, Beijing Auto and others -- efforts that were "uniformly without success." Fiat, he said in an affidavit, was "Chrysler's last best hope."

A stunning rebuke to this whole notion that anyone with brains and money believed that Chyrsler can return to profitability by building cars that the green crowd in America demand. Jenkins then mentions the ill-famed car of the editorial's title,

"Not since Renault teamed up with AMC to bring you Le Car has an odder pairing been seen -- or a less promising one.

Unless gasoline prices go to $5 a gallon, Mr. Marchionne certainly is not so foolish to believe making and selling teensy eurocars in the U.S. is anybody's route to salvation.
Even in Europe, he has noted, a move to bigger, more powerful cars is underway. Motorists are getting fatter and older -- and unwilling to contort themselves to get in and out of a car.

He also understands that trying to beat Toyota at its own game is a nonstarter. Toyota sets a standard of quality and technology that all must meet -- that's the price of admission. But "what we have that Toyota does not have -- and I say this with all modesty -- is the great historical heritage of the brands." "

This is pretty funny. A collection of largely has-been brands, with the possible exception of Jeep, which, of course, has bloated into a non-eco-friendly car line. And this is what taxpayer money is funding to take on the world's best auto manufacturer?

Then Mr. Jenkins notes how the head of Fiat is aiming to build a car maker with sufficient scale to survive the coming thinning of the vehicle-manufacturing herd,

"He's already turned his attention to Opel, GM's European arm, which is on the market. Notice, though, that he's committed no money to Chrysler, only a promise of vehicle technology. As a New York Times story recently trailed off, ". . . at some point, some [Obama auto] task force members acknowledge, the drive for profitability is likely to collide with Mr. Obama's fuel-efficiency and low-emission goals."

Yup. Mr. Marchionne has kept his skin out of the game for a reason. Don't expect him to reach for Fiat's modest checkbook until Team Obama can explain exactly how Chrysler is supposed to make money building the "green cars" Mr. Obama wants it to build. But you already know the answer: You, the taxpayer, have not finished chipping in to keep Fiat-Chrysler alive."

As usual, Jenkins pulls no punches. He correctly concludes that you, the US taxpayer, will now continue to fund this Don Quixote-like dream of profitably building green cars in America. From a failed manufacturer.

Everyone in power over the past few years in Washington is guilty on this one. And, as Jenkins sadly notes, we're nowhere near finished with this travesty yet.

Thursday, May 07, 2009

More Punditry On Next Steps for US Banks

The Wall Street Journal carried two editorials this week concerning the ongoing difficulties of the larger US banks. Specifically, Nouriel Roubini and Matthew Richardson, both of NYU, wrote on Tuesday that, at some point, "government has to show it can handle major insolvencies."

They also made the point that, thanks to overly-generous bailouts of equity investors in the past six months,

"The government has got to come up with a plan to deal with these institutions that does not involve a bottomless pit of taxpayer money. This means it will have the unenviable tasks of managing the systemic risk resulting from the failure of these institutions and then managing it in receivership. But it will also mean transferring risk from taxpayers to creditors."

Roubini and Richardson also note that current levels of several factors, unemployment being one, are already higher in actuality than in the stress test. So, what assurance do we have that these so-called 'stress tests' are really using stressful assumptions in the first place?

Wednesday's Journal contains an editorial by economist Glenn Hubbard and colleagues which argues the same point. They phrase it as a surfeit of carrots and a lack of sticks for bankers. Hubbard's piece follows with a fairly complex and unwieldy formulation of old banks, new banks, good banks, bad banks, and debt and equity holders swapping places in the various banks.

Contrary to Hubbard's contention that there is nobody left to buy a seized large, failed bank, I have argued in prior posts that such a contraction of existing, inept lending expertise should draw forth new, better-managed capacity from the likes of private equity and hedge funds. By purchasing problem assets on the cheap, buying branch systems and inheriting deposit bases, these new entrants would represent the first significant new capital to set up shop as large commercial banks in quite some time.

But what drew my attention, of course, is that both pieces begin by bemoaning the lack of bank closures, and too much risk being taken by the federal government on behalf of taxpayers.

It seems that more observers are concluding that the path on which our financial sector was placed last fall, beginning with the ill-conceived TARP program, has resulted in no normative measures by which to navigate subsequent developments. No banks apparently will be allowed to fail. Could this be why the market prices of so many bank equities have recently skyrocketed?

The implications are fairly clear. Even if the current administration continues to verbalize a reluctance to nationalize banks, its actions contribute to that effective result. No large commercial bank is seen as vulnerable to failure. Short-term trading as speculation is relatively safe.

By altering the normal path for failed banks, last used, or threatened, in the case of Wachovia, government has indicated that it sees bank insolvency as a temporary valuation mismatch, not a sign of ineptitude. Reality is being held at arms length by newly-improvised programs, tests and procedures so that no more large financial entities will be judged bankrupt.

Even if they actually are.

Somehow, this seems a recipe for disaster on a large scale. Rather like the Japanese approach to banking at the start of its infamous 'lost decade.'

Freely-trading capital markets are all about discovery of information and the accurate pricing thereof. How are markets to do that job when several large remaining banks are suspect of really being insolvent?

Wednesday, May 06, 2009

The Bank Stress Tests

While working earlier this morning, I listened to a couple of guests on CNBC debate the consequences of the federal government's bank stress tests.

The overall sentiment was that these tests were politically motivated to begin with, a bad idea, and a poor substitute for proper, existing and regular bank examinations.

I concur.

Is it really a shock that the feds want banks to raise capital? And, of course, they would love the convenience of the banks, such as BofA and Wells Fargo, begging to be allowed to convert federal preferred stakes into common equity. What a rich irony.

In truth, though, the federal government is subverting the capital markets. Left to their own devices, investors would, though trading, establish objectively-determined prices for these banks' equities.

Maybe it's me, but won't it be more difficult and expensive for banks painted with a federally-applied big red "I," for 'inadequate capital,' to issue additional equity? Isn't it almost a self-fulfilling prophecy putting these banks on the road to higher levels of government ownership?

I can't see a single positive aspect of the so-called stress tests for banks, other than another tool for government to coerce and intimidate private sector firms.

Tuesday, May 05, 2009

Chrysler's Profit Projections

I read this morning's headline in the Wall Street Journal's Marketplace section. It's chilling-

"Chrysler Forecasts Profit- In 2012"

Followed by this in smaller, italicised type,

"Auto Maker Lost About $17 Billion in 2008; Some Secured Lenders Seek to Block Sale of Assets to Fiat."

What investor in his right mind would be sitting still for a profit forecast that showed, for 2008-2012, a net loss? Judging by the chart accompanying the article, Chrysler forecasts about $3B in profit in 2012.

We're clearly not talking about a borderline-profitable business going through a temporary problem. Chrysler should be dead. It's a failed business enterprise. Its business model didn't work.

It didn't work alone. It didn't work with Daimler-Benz. It hasn't worked under private equity ownership, which is generally the last stop on the way to total failure.

If the hardnosed, flinty capitalists who run Cerebrus couldn't make Chrysler profitable, are we supposed to believe that the guiding hand of the US federal government is going to succeed?

A bunch of appointed, unelected bureaucrats are going to succeed where the most self-interested, cloaked-from-public-view turnaround veterans failed?

Joseph Schumpeter must be spinning in his grave. The Chrysler bailout out, as well as that of GM, is precisely the sort of roadblock to recycling business resources that he would have abhorred.

At least the Fiat move resembles Schumpeter's notion of salvaging the pieces of failed companies to use in better, more profitable applications by someone else. Granted, the senior secured lenders have the right to block the sale of parts of Chrysler to Fiat, if their rights are being subverted. But all of this would have already been in process months ago, had the Bush administration had the backbone to just say 'no' to the two auto makers headed for Chapter 11.

As it is, we have the ludicrous display of a failed car maker seriously projecting net cumulative losses through 2012, and apparently believing this is reason to continue to fund its existence.

Monday, May 04, 2009

The Puzzling Equity Market Rally

The recent US equity market rally continues to puzzle me. The nearly 30% rise since the S&P500 Index's most recent bottom of March 9th seems to be floating on air, given the current recessionary economic environment.

Of course, many pundits are claiming that, given a market rally, economic recovery must be around the corner. Such reasoning seems backward to me, but, that's the $64,000 question, is it not?

The Economist's April 25th edition's lead editorial, entitled "A glimmer of hope?" addresses these matters directly. The essentials of this excellent piece are distilled in this passage,

"But, welcome as it is, optimism contains two traps, one obvious, the other more subtle. The obvious trap is that confidence proves misplaced- that the glimmers of hope are misinterpreted as the beginnings of a strong recovery when all they really show is that the rate of decline is slowing. The subtler trap, particularly for politicians, is that confidence and better news create ruinous complacency. Optimism is one thing, but hubris that the world economy is returning to normal could hinder recovery and block policies to protect against a further plunge into the depths."

The remainder of the two-page editorial examines these points, and their consequences, in great and credible detail.

Personally, I do believe the first point of the passage. While current economic decline may have slowed from the past few months, I don't think it marks a turning point.

As I related to a colleague recently, several pundits have reminded us that, unlike last September, major financial institutions are not failing or being rescued each month. In that sense, the financial sector's failures effects on the economy have abated, for now.

But there is a complacency with respect to that, as well. Many government officials and financial analyst continue to cry that the nexus of our problems are financial sector health. If only risk premiums decline, and various debt spreads contract to 'normal' levels, all will be well.

Unfortunately, that's not quite true. The financial sector is a transmission device, not the originator of economic activity. In this respect, many talking heads have it wrong.

Who actually wants to borrow money right now? Where is the burgeoning demand that needs to be fueled by new debt and investment?

The bulk of the federal government's cash infusions into large US financial institutions went to simply fill holes in balance sheets created by the evaporation of equity from bad mortgage-related assets. That capital didn't, per se, add to net financial capital stocks from, say, late 2007.

Housing values are down, monthly new job losses remain high, credit card lines are being cut, new rounds of commercial real estate defaults are expected, and, as my friend B noted a few weeks ago, several major banks, including Wells Fargo, are soon to experience more residential mortgage defaults as a new wave of ARMs adjust.

I just don't see the long term sustainability of this most recent equity market rise.

From January 5th to March 9th of this year, the S&P500 fell by 27%. The recent 30% rise thus has not actually returned us to that January 5th high of 927. Close, but, thanks to the magic of percentage change, a market that rises and falls continually by the same amount is, over time, going down. For this last cycle of market tops, bottoms and new tops, a +37% gain would be required to return the S&P to it's early January peak. That's a huge gain. Over three times the average long run S&P annual return.

The Economist piece notes, further on,

"Between 1929 and 1932, the Dow Jones Industrial Average soared by more than 20% four times, only to fall back below its previous lows. Today's crisis has seen five separate rallies in which share prices rose more than 10% only to subside again."

Given today's market's greater efficiencies and liquidities, even more volatility and accentuated highs and lows than those seen in the 1930s are not surprising. We've seen two +20% S&P rallies just since November of last year.

The other major point of The Economist's editorial is food for another, later post. But, for now, I am unfortunately comforted by that magazine's concordance with my own view that this recent, fast and steep equity market rally is unlikely to last, and likely to see a rollercoaster ride back down to new lows in the months ahead.