Fed’s New Mortgage Rules
From Dow Jones: “The Federal Reserve proposed new rules for subprime mortgages, including a ban on low- documentation loans and limits on penalties for borrowers who prepay their debts. The plans, the Fed's biggest regulatory initiative since Chairman Ben S. Bernanke took office in February 2006, are aimed at curbing lending practices that contributed to record foreclosures. Board members unanimously voted in a hearing today to make lenders responsible for determining whether borrowers can afford their mortgages even after low starter rates expire… The proposed new rules ``were carefully crafted'' to deter ``improper lending'' without ``unduly restricting mortgage credit availability,'' he said. Bernanke is aiming to preserve the Fed's consumer-protection role after Democratic lawmakers blamed it for lax oversight and introduced legislation to set rules for mortgage lenders. Today's proposals received mixed responses from legislators, consumer advocates and finance-industry officials… Today's package covers all high-cost mortgages, which are defined as loans with rates at least 3 percentage points above a comparable Treasury security for first mortgages and 5 percentage points for second loans, or home-equity loans… The proposal also went beyond its initial scope of consideration, and recommended new disclosure rules aimed at mortgage brokers, appraisers and solicitors. The rules apply to both prime and subprime loans. Fed governors approved prohibiting lenders from paying brokers fees in excess of what the borrower initially agreed. The proposal bars coercion of appraisers, and defines seven advertising practices as misleading or deceptive.”
Interesting Discussion on Equity Market Cycles – Are we in a Bull or Bear Market?
From Merrill Lynch: “The past five years — was it a bull market or a bear market? Well, if you look strictly at “price”, it has been a classic cyclical bull market – the S&P 500 has obviously risen more than 80% from the late 2002 lows. But every inch of the way, it was earnings growth that led the bull run – though we now know looking at all the write-downs that a certain volume of this growth in the “E” was nonrecurring. The benefit of hindsight. But the P/E multiple has actually been in a bear market through the entire piece – going from 27x at the market bottom to just over 18x right now. Imagine what this cyclical bull market would have done if the multiple had expanded! But this is a key point Two-thirds of the great bull run that started in 1982 and ended in 2000 was pure multiple expansion – going from the trough of 8x to the peak of over 30x in that 18-year interval. During that time, of course, we saw the spreading technology breakthroughs, more responsible monetary policy, smaller government, deregulation, the breakdown of global trade barriers and the crumbling of Communism lead to ever-declining rates of inflation and inflation expectations and much lower bond yields and much higher “fair-value” P/E multiples. But only one-third of that great bull market was due to profit growth – the majority of the gains were in the price that investors were willing to pay for that earnings stream. But in this current cycle — it’s all been about earnings That is a good thing and a bad thing – a bad thing because we are about to go through an earnings recession with no cushion from the multiple which remains above historical norms (and no, this is not justified by “low” interest rates, which in real terms are actually right in line with long-term averages in the private sector). The P/E multiple did something it has never done before in the context of a bear market and bottomed at 27x at the late-2002 lows in the S&P 500. On average, the multiple troughs at 12x at the bear market bottom, but not in this latest cycle, and the reason for that is because the Fed had cut rates so aggressively back then that it actually took, for the first time ever, the level of the 3-month Eurodollar deposit rate below the level of the S&P 500 dividend yield. This was unheard of. Not only that, but the Fed ensured that this spread remained negative for two years (the fall of 2002 to the fall of 2004) and during that early time frame, the stock market bull run was well entrenched, with the S&P 500 appreciating 40% and breaking many key technical barriers along the way. Not until this bull market was into its third year was the level of money market rates pushed above the dividend yield – though these metrics have switched course because these 3-month eurodollar deposits now command a 310 basis point premium over the 1.9% dividend yield even with the Fed’s moves to cut the funds rate and discount rate in recent months. But the major conclusion is this - Even with the rally that was induced by negative real short-term rates by the Fed and subsequently nurtured by the strongest earnings cycle on record (some would argue financially-engineered), the P/E multiple has remained in a bear market. And if history is any guide, the fundamental low in the multiple will be closer to 12x than the current level of 18x. So the multiple has, over time, been gravitating lower and the question must be asked as to whether the Fed’s aggressive easing in 2002-03 merely delayed the inevitable compression to the traditional lows of 12x that defined so many bear market lows in the past. We had an earnings recession back in 2001-02 coupled with P/E compression and that delivered a severe bear market. Then we had a huge cyclical snapback in earnings from 2003 to 2006 that more than offset the effects of a sustained narrowing in the multiple and gave us a powerful bull market. But now we are on the precipice of an earnings recession What if we are correct at $83 on operating earnings next year and the multiple finds its way to the 12x level that would have been consistent with prior secular bull market starting points (aka real buying opportunities) – a level we may well have seen in late 2002 or early 2003 if the Fed had not so dramatically altered the relationship between the dividend/earnings yield with cash rates. That then would mean a snick below 1,000 on the S&P 500 (the “glass is half full” shows that this would still be one-third above the 2002 low and double the level prevailing in 1995). We want to stress that this is not, repeat not, a target by any stretch of the imagination. It is about generating a discussion and sparking a debate. Maybe – just maybe – we never did complete that entire bear market from 2000 to 2003 and the earnings recovery masked what was and still is a mean-reverting downward trend in the P/E multiple. But the fact that we have both cash and bonds outperforming equities with two weeks to go in the year, despite a 150 basis point cut in the discount rate, is indeed an ominous signpost. Then again, whenever the Fed has been forced to cut the discount rate this much in the past, it has generally been because the economy was heading for a hard landing, with the accompanying decline in corporate earnings, stock prices and Treasury yields.”
World Bank Revises Down Size of Economies in China and India
From Barclays: “China and India’s economies are 40% smaller than previously estimated. That is one of the major findings from yesterday’s release of the 2005 International Comparison Program (ICP), an initiative led by the World Bank over 2003-2007 to estimate Purchasing Power Parities (PPPs) of 146 economies. It marks the first time China participated in the ICP, and the first time since 1985 that India has. Compared with earlier estimates, which were based on old and very limited data, China and India’s shares in global GDP have been downwardly revised from 14% and 6%, to 9% and 4% respectively. A natural implication for the global economy is that growth, both retrospectively and forward-looking, will now also have to be revised lower, given that contributions from the emerging economies of China and India would now be weighed by smaller shares. But what does this mean for commodity demand? Clearly, while the way of measuring China and India’s GDP has changed, historical levels of Chinese and Indian commodity demand have not. If anything, we see this downsize in their economic clout as presenting a positive risk to future demand growth…suggesting that growth in both economies have in fact been much more energy/metal intensive than initially thought. Re-looking at the same numbers in per capita terms, trimming Chinese GDP numbers by 40% does make sense for its energy/metal demand for a given level of income… the same level of GDP per capita is now associated with higher copper demand per head, bringing Chinese demand more in line with the path that other Asian economies have taken in their earlier years of industrialisation. The picture for oil demand depicts a very similar story. The second implication relates to the growth potential in both China and India’s economies now that they are starting from a lower base. After the revision, China’s PPP per capita is approximately 14% that of Japan and 19% that of Korea, while the same set of numbers for India are 7% and 9% respectively… China and India are only in an early phase of their industrialisation process. This, coupled with their massive economic size and potential, point to continued strong demand growth in commodities for many more years to come.”
How Much Liquidity is the Fed Really Adding?
From Hussman Econometrics Advisors: “Case in point is the ridiculously over-hyped "term auction facility" announced last week. According to that announcement, the Fed plans to auction about $40 billion of "liquidity" this week: $20 billion on Monday December 17th, which will be a 28-day repo, and another $20 billion on December 20th.
… there are currently $53 billion of repos outstanding (as of Friday), fully $39 billion that mature this week. And wouldn't you know it, the Fed is going to be "injecting" $40 billion this week too. So here's a little acid-test of whether the Fed will actually be providing new "liquidity," or whether it's just trying to brew up a tempest with what's already in that little teapot. Watch the NY Fed's listings of open market operations:
http://www.ny.frb.org/markets/omo/dmm/temp.cfm?SHOWMORE=TRUE
If the Fed is actually adding liquidity, you'll see not only the two $20 billion repos on the 17th and 20th, but additional repos to replace the $39 billion that are coming due this week ($5 billion mature on Tuesday the 18th, and fully $34 billion are set to mature on Thursday the 20th). If the Fed does nothing but those two $20 billion longer-dated repos, all it will have done is to change the maturity of its outstanding repos, without changing the amount. Now, that's not to say I believe that even if the Fed does temporarily buy $40 billion of government securities for 28 days, before selling them back out, it will do much for the solvency of the $12.7 trillion U.S. banking system, much less exotic CDOs and mortgage-backed securities. As I've emphasized in recent weeks, if you track all those daily and weekly rollovers and figure out the total quantity of Fed repos outstanding at any given time, you'll find that the Fed has only injected $18 billion in "liquidity" since March. If investors think the Fed buying up a few billion of Treasury and agency debt means a hill of beans, they might do well to remember that the U.S. government is running up annual deficits in the hundreds of billions. In fact, the U.S. Treasury will float tens of billions of new debt in December alone (most of which will be sopped up by foreigners, who have increased their holdings of Treasuries by well over $200 billion in the past year). This will be mixed in with refinancings. Last week, for example, the Treasury auctioned $21 billion in 3-month bills and $20 billion in 6-month bills. In doing so, the Treasury offset every bit of the Federal Reserve's actions this week, even if it turns out that the $40 billion "term auction facility" represents new liquidity and not just rollovers. Why aren't investors just as interested in that? When the Fed does open market operations, all it's doing is buying up (temporarily or permanently) a tiny fraction of U.S. Treasury debt and replacing it with currency and bank reserves. But every time the Federal government issues more debt to finance its deficits, the new issuance cancels out any beneficial increase in liquidity the Fed could possibly provide. So it's difficult to understand why investors would get all excited about the Fed temporarily buying up a few billion in government securities, when we've got a Federal government that's simultaneously and permanently issuing and then constantly rolling over many, many times that amount. It's an escape into dreamland to believe that Fed actions have any chance at all of providing more "liquidity" when the Federal government's deficits suck up in a matter of weeks every bit of liquidity that the Fed has provided in a year. These Fed actions are nothing but marginal tinkering around the edges of the global financial system, and investors are starting to catch on. Still, it's fun to watch when you understand what's going on. In fact, there will be all kinds of interesting things we'll get to watch this week. For instance, the Fed does its first $20 billion auction on Monday, but there's a timing disparity - only about $5 billion of expiring repos come on Tuesday, and the other $34 billion come due on Thursday. So between Monday and Thursday, we'll observe at least a temporary jump of $15-20 billion in Fed repos outstanding. There's a good chance that during that 3-day overlap, the actual Fed Funds rate will creep below the current target of 4.25% (watch the chart here: http://www.ny.frb.org/markets/openmarket.html). If that happens, you can bet that some analysts will incorrectly conclude that the Fed is doing some sort of "stealth easing." But it will be nothing more than a 3-day timing overlap between maturing and new repos.
More interesting is to watch what happens on Thursday. That's when we get $34 billion of repos coming due. If the Fed does little more than $20 billion through its "term auction facility," that will put the total for the week at $40 billion, versus $39 billion expiring, and it will be clear that this whole maneuver is simply a way for the Fed to temporarily refinance its expiring repos using a slightly longer 28-day maturity, rather than any effort to actually increase the amount of reserves. In any event, banking conditions aren't likely to change even if $40 billion in additional 28-day repos actually materialize. Indeed, a Bloomberg report noted "A Fed official told reporters that the U.S. central bank's efforts won't add net liquidity to the banking system. The plans are aimed at buttressing so-called term funding markets, such as for one-month loans, rather than overnight cash." Should be interesting. Finally, it's worth repeating that the total amount of outstanding repos has increased by only $18 billion since March, nearly all of which has been drawn out as currency in circulation. Most likely, the Fed will enter a "permanent" open market operation on the order of $10-20 billion at some point in the coming weeks to formalize that increase in outstanding currency. That move will probably be met by ridiculously over-hyped reporting as well. But it's entirely predictable. In short, Wall Street analysts aren't paying attention to the data if they believe that the Fed is "pumping" hundreds of billions into the economy to provide some kind of "safety net" for the banking system or the mortgage market. Is it really too much to ask that they make some attempt to understand the subject about which they opine incessantly? As for the Fed itself, it's a great gift to offer people hope, but a great disservice to offer people false hope, and I think that's what the Fed is doing. What's going on in the mortgage market is not a crisis of confidence that we can talk ourselves out of - it's a problem of structural insolvency, where many borrowers literally don't have the means to service their debt over the long-term, because many of them were counting on rising home prices over the short-term. By acting as if a few billion in repos will substantially change this equation, the Fed is raising hopes, and setting the markets and the economy up for disappointment that will be far worse as a result. Bernanke would be better off admitting that the Fed has no chance of providing meaningful "liquidity" when the Federal government is issuing Treasuries at ten times the rate the Fed can absorb them. At that point, Americans would see better that the resources we need to invest, compete and become a financially sound nation are being hoarded by the Federal government and sent up in flames.”
MISC
From Bloomberg: “Money market rates tumbled after the European Central Bank injected an unprecedented $500 billion into the banking system as part of a global effort to ease gridlock in the credit market. The amount banks charge each other for two-week loans in euros dropped a record 50 basis points to 4.45 percent, after climbing 83 basis points in the past two weeks, the European Banking Federation said today. The decline is the first sign attempts by policy makers to revive interbank lending are succeeding.”
From CNN: “Gasoline demand has fallen for the first time in years as drivers appear to recoil from near-record prices, throwing doubt on America's seemingly insatiable thirst for fuel. Growth in gasoline demand has been slowing all year. In five of the last seven weeks, the amount of gas that Americans consume has actually fallen compared to the same time last year…In some weeks demand has fallen by as much as 3 percent…Gasoline is one of those items that some economists consider "inelastic," that is, people will buy it no matter what the cost. But the recent drop in demand puts that into question, and suggest people will cut out unnecessary trips if they are too expensive.”
From Bank of Montreal: “For only the second time since the bad old days of the early 1980s, headline U.S. CPI inflation is now higher than the 10-year Treasury yield (4.3% versus just over 4.1%). The other time was when CPI temporarily spiked after Hurricane Katrina…Not good. The last time this occurred for a prolonged period was in two episodes in the 1970s --- both of which were followed by an economic downturn.”
From Morgan Stanley: “The current account deficit fell to $178.5 billion in Q3 from $188.9 billion in Q2. As a share of GDP this represented a decline to 5.1% from 5.5%, low since 2004Q1 and down from the peak of 6.6% in 2006Q3. The goods and services trade balance improved to -$173.2B from -$178.4B, as previously reported in the monthly trade figures, while the income balance jumped to $20.5B from $12.7B, a record high, on significant increases in interest and dividend payments on U.S. owned foreign assets and a sizable rise in receipts on direct investments abroad.”
From Barclays: “Disappointment about the super-SIV plan, the Paulson rate freeze plan, and the TAF should all drive home the point that policy measures can only do so much in solving both the liquidity issues and the subprime problem. The possibility of more write-downs by banks and brokers, as well as year-end funding issues, should also help the curve to bull steepen into year-end.”
From Deutsche Bank: “Clearly, the housing figures have been abysmal this year, however we think we may be seeing early signs of a bottom-after all, housing activity can only fall so far, and the construction figures are already the lowest since the housing recession in the early 1990s. Case in point, homebuilders' sentiment appears to have hit bottom, it has held steady at an index level of 19 for the last three months. Residential investment is likely to subtract about 1% from GDP both in the current quarter and Q1 of 2008. However, by Q2 of next year we project the residential investment share of GDP will fall to a record low, which means its negative effect on growth should trail off. However, significant negative second-order effects on the economy are likely to remain as a result of elevated inventories and potential further declines in house prices.”
From Merrill Lynch: “The Dow closed down 172 points, which was the first time we have seen back-to-back triple-digit losses since the onset of the credit crunch in mid-August (before the Fed began to ease). There were 5 decliners for every gainer on the Big Board – talk about bad breadth. And all ten S&P 500 sectors were down, but leading the decliners this time were not the usual culprits (financials, consumer discretionary) but rather 2%+ slides in the seemingly impenetrable ‘decoupling’ groups such as materials, tech and energy…It could just be that the market is starting to price in the earnings recession that began in earnest a quarter ago.”
From RBSGC: “…intriguing story in the WSJ where Greg Ip writes about a discussion within the FOMC that about the balance of risk assessment. He interviews Plosser (a hawk) who said the assessment may convey too much confidence about the direction of rates -- and offered that inflation pressure is spreading beyond energy. This is one man's opinion, and a leading hawk's at that, but still sheds some light on the internal debate within the Fed and suggests that their own struggle/confusion over the balance of risks mirrors the markets.”
From Dow Jones: “Fitch Ratings said it would set a ceiling for ratings on certain structured investments, while also implementing stricter requirements. The move comes as issuance and trading in these markets have ground to a halt with spooked investors retreating to the sidelines amid the ongoing credit crunch - forcing rating companies to reassess their methodology and also take into consideration the ease with which these securities trade. “Credit ratings really aren’t designed to measure liquidity. They measure credit performance as defined by the probability of default and ratings migration,”…”
From Merrill Lynch: “The Baltic Dry index continues its march downward, falling 0.3% on Friday to a level of 9918, which is the lowest since October 7. For the week, the index is down 1.5% and, since hitting an all-time peak back in mid November, the measure of global dry bulk commodity shipping rates has fallen by 10.1%. Could this be fore-shadowing a moderation in the commodity complex? The CRB index hit its peak on November 6, and since then, the index is down 2.4%.”
From Morgan Stanley: “Congressional wrangling over the Alternative Minimum Tax (AMT) appears likely to lead to an unprecedented delay to the start of the tax filing season. This could have a significant impact on the volume of tax refunds that will be pumped into the economy in early 2008 and represents yet another potentially important headwind for the US consumer…The IRS cannot process tax returns until all of its systems conform to current tax law. Normally, all tax legislation is completed by early-November and the IRS is ready to start processing returns by mid-January or so. At present, the IRS estimates that it will take seven weeks after the bill is signed before they can start processing returns. So, even under a best case scenario, the IRS probably will not be able to begin mailing refund checks until mid-February…it seems likely that the refund delay could -- at least temporarily -- take a significant chunk out of discretionary spending in early 2008, adding to the near term downside risks confronting the US economy.”
From Bloomberg: “The light bulbs in almost every U.S. home and the gasoline in many cars will be altered by energy legislation that the U.S. House of Representatives passed today…The measure, approved 314-100, slashes U.S. energy use 8 percent by 2030, environmentalists say. It contains the first new vehicle fuel economy law in 32 years and mandates a fourfold increase in the use of biofuels. The bill, already approved by the Senate, phases out incandescent light bulbs, which have been in use for a century, and places the first limits on the amount of water used in new washing machines and dishwashers…``Literally, the amount of energy that's being saved by the light-bulb standard alone is more than has been achieved since 1986 for all appliances combined.''”
From Dow Jones: “President George W. Bush will sign mortgage-tax relief legislation
later this week if it passes the House as expected. White House spokeswoman Dana Perino lauded the measure, which would let homeowners avoid income tax on mortgage debt forgiven through refinancing. “This will protect homeowners from having to pay extra taxes when they refinance their mortgages on the difference,” Perino said. Bush “believes it is good policy.””
From Bloomberg: “Bill Gross, manager of the world's biggest bond fund, said the U.S. is headed for a ``mild'' recession in 2008 amid the worst housing slump in 16 years.”
Bank of America: “Corporate tax receipts at the Treasury recovered from their weakness in September. Comparing tax receipts on the day of the deadline, December receipts fell -3% year-over-year (yoy) versus a -13% decline in September.”
From Dow Jones: “Prices for most types of property and casualty insurance are expected to decline in 2008 for the first time since World War II, as a weakening economy and heightened competition hold prices down everywhere except along coastal areas that are exposed to hurricanes.”
End-of-Day Market Update
From UBS: “Treasuries rallied right out of the gate, rising almost non-stop until noon, after which they gave back a portion of their gains…swap spreads to narrow across the board. Agencies had light flows, with the front end underperforming versus Libor. Mortgages had a quiet day, with higher coupons lagging lower coupons. MBS ended 7 ticks tighter to Treasuries and 2+ to swaps.”
From Dow Jones: “U.S. Treasurys were higher Tuesday morning on the heels of an aggressive overnight move by the European Central Bank to ease liquidity pressures, which reawakened investors’ year-end liquidity concerns. The ECB Tuesday saw robust demand from banks for its offer of unlimited two-week funds at a fixed rate, lending around $500 billion in such funds to help ease strained money markets and boost liquidity into year-end. The add dwarfed the size of the Federal Reserve’s $20 billion sale Monday, the first offering in its Term Auction Facility program also designed to ensure liquidity through year-end, and raised worries that the Fed offering may not be enough…The dollar rose a bit against the yen Tuesday as a modest rise in US stocks swayed investors to take on more risk by selling the low-yielding yen and buying higher-yielders. But ranges remained tight and the greenback showed little reaction to yet another weak US housing report as markets downshift gears as the year winds down. Wednesday could be another dull session, with no important data slated for release…The market seemed unable to make up its mind Tuesday, as stocks dipped early in the afternoon and then moved back to positive territory.”
Three month T-Bill yield fell 1 bp to 3.03%.
Two year T-Note yield rose 1.5 bp to 3.19%
Ten year T-Note yield fell 2 bp to 4.12%
Dow rose 65 to 13,232
S&P 500 rose 9 to 1455
Dollar index rose .03 to 77.43
Gold rose $10 to $803
Oil fell $.14 to $90.5
*All prices as of 4:35pm
From Dow Jones: “The Federal Reserve proposed new rules for subprime mortgages, including a ban on low- documentation loans and limits on penalties for borrowers who prepay their debts. The plans, the Fed's biggest regulatory initiative since Chairman Ben S. Bernanke took office in February 2006, are aimed at curbing lending practices that contributed to record foreclosures. Board members unanimously voted in a hearing today to make lenders responsible for determining whether borrowers can afford their mortgages even after low starter rates expire… The proposed new rules ``were carefully crafted'' to deter ``improper lending'' without ``unduly restricting mortgage credit availability,'' he said. Bernanke is aiming to preserve the Fed's consumer-protection role after Democratic lawmakers blamed it for lax oversight and introduced legislation to set rules for mortgage lenders. Today's proposals received mixed responses from legislators, consumer advocates and finance-industry officials… Today's package covers all high-cost mortgages, which are defined as loans with rates at least 3 percentage points above a comparable Treasury security for first mortgages and 5 percentage points for second loans, or home-equity loans… The proposal also went beyond its initial scope of consideration, and recommended new disclosure rules aimed at mortgage brokers, appraisers and solicitors. The rules apply to both prime and subprime loans. Fed governors approved prohibiting lenders from paying brokers fees in excess of what the borrower initially agreed. The proposal bars coercion of appraisers, and defines seven advertising practices as misleading or deceptive.”
Interesting Discussion on Equity Market Cycles – Are we in a Bull or Bear Market?
From Merrill Lynch: “The past five years — was it a bull market or a bear market? Well, if you look strictly at “price”, it has been a classic cyclical bull market – the S&P 500 has obviously risen more than 80% from the late 2002 lows. But every inch of the way, it was earnings growth that led the bull run – though we now know looking at all the write-downs that a certain volume of this growth in the “E” was nonrecurring. The benefit of hindsight. But the P/E multiple has actually been in a bear market through the entire piece – going from 27x at the market bottom to just over 18x right now. Imagine what this cyclical bull market would have done if the multiple had expanded! But this is a key point Two-thirds of the great bull run that started in 1982 and ended in 2000 was pure multiple expansion – going from the trough of 8x to the peak of over 30x in that 18-year interval. During that time, of course, we saw the spreading technology breakthroughs, more responsible monetary policy, smaller government, deregulation, the breakdown of global trade barriers and the crumbling of Communism lead to ever-declining rates of inflation and inflation expectations and much lower bond yields and much higher “fair-value” P/E multiples. But only one-third of that great bull market was due to profit growth – the majority of the gains were in the price that investors were willing to pay for that earnings stream. But in this current cycle — it’s all been about earnings That is a good thing and a bad thing – a bad thing because we are about to go through an earnings recession with no cushion from the multiple which remains above historical norms (and no, this is not justified by “low” interest rates, which in real terms are actually right in line with long-term averages in the private sector). The P/E multiple did something it has never done before in the context of a bear market and bottomed at 27x at the late-2002 lows in the S&P 500. On average, the multiple troughs at 12x at the bear market bottom, but not in this latest cycle, and the reason for that is because the Fed had cut rates so aggressively back then that it actually took, for the first time ever, the level of the 3-month Eurodollar deposit rate below the level of the S&P 500 dividend yield. This was unheard of. Not only that, but the Fed ensured that this spread remained negative for two years (the fall of 2002 to the fall of 2004) and during that early time frame, the stock market bull run was well entrenched, with the S&P 500 appreciating 40% and breaking many key technical barriers along the way. Not until this bull market was into its third year was the level of money market rates pushed above the dividend yield – though these metrics have switched course because these 3-month eurodollar deposits now command a 310 basis point premium over the 1.9% dividend yield even with the Fed’s moves to cut the funds rate and discount rate in recent months. But the major conclusion is this - Even with the rally that was induced by negative real short-term rates by the Fed and subsequently nurtured by the strongest earnings cycle on record (some would argue financially-engineered), the P/E multiple has remained in a bear market. And if history is any guide, the fundamental low in the multiple will be closer to 12x than the current level of 18x. So the multiple has, over time, been gravitating lower and the question must be asked as to whether the Fed’s aggressive easing in 2002-03 merely delayed the inevitable compression to the traditional lows of 12x that defined so many bear market lows in the past. We had an earnings recession back in 2001-02 coupled with P/E compression and that delivered a severe bear market. Then we had a huge cyclical snapback in earnings from 2003 to 2006 that more than offset the effects of a sustained narrowing in the multiple and gave us a powerful bull market. But now we are on the precipice of an earnings recession What if we are correct at $83 on operating earnings next year and the multiple finds its way to the 12x level that would have been consistent with prior secular bull market starting points (aka real buying opportunities) – a level we may well have seen in late 2002 or early 2003 if the Fed had not so dramatically altered the relationship between the dividend/earnings yield with cash rates. That then would mean a snick below 1,000 on the S&P 500 (the “glass is half full” shows that this would still be one-third above the 2002 low and double the level prevailing in 1995). We want to stress that this is not, repeat not, a target by any stretch of the imagination. It is about generating a discussion and sparking a debate. Maybe – just maybe – we never did complete that entire bear market from 2000 to 2003 and the earnings recovery masked what was and still is a mean-reverting downward trend in the P/E multiple. But the fact that we have both cash and bonds outperforming equities with two weeks to go in the year, despite a 150 basis point cut in the discount rate, is indeed an ominous signpost. Then again, whenever the Fed has been forced to cut the discount rate this much in the past, it has generally been because the economy was heading for a hard landing, with the accompanying decline in corporate earnings, stock prices and Treasury yields.”
World Bank Revises Down Size of Economies in China and India
From Barclays: “China and India’s economies are 40% smaller than previously estimated. That is one of the major findings from yesterday’s release of the 2005 International Comparison Program (ICP), an initiative led by the World Bank over 2003-2007 to estimate Purchasing Power Parities (PPPs) of 146 economies. It marks the first time China participated in the ICP, and the first time since 1985 that India has. Compared with earlier estimates, which were based on old and very limited data, China and India’s shares in global GDP have been downwardly revised from 14% and 6%, to 9% and 4% respectively. A natural implication for the global economy is that growth, both retrospectively and forward-looking, will now also have to be revised lower, given that contributions from the emerging economies of China and India would now be weighed by smaller shares. But what does this mean for commodity demand? Clearly, while the way of measuring China and India’s GDP has changed, historical levels of Chinese and Indian commodity demand have not. If anything, we see this downsize in their economic clout as presenting a positive risk to future demand growth…suggesting that growth in both economies have in fact been much more energy/metal intensive than initially thought. Re-looking at the same numbers in per capita terms, trimming Chinese GDP numbers by 40% does make sense for its energy/metal demand for a given level of income… the same level of GDP per capita is now associated with higher copper demand per head, bringing Chinese demand more in line with the path that other Asian economies have taken in their earlier years of industrialisation. The picture for oil demand depicts a very similar story. The second implication relates to the growth potential in both China and India’s economies now that they are starting from a lower base. After the revision, China’s PPP per capita is approximately 14% that of Japan and 19% that of Korea, while the same set of numbers for India are 7% and 9% respectively… China and India are only in an early phase of their industrialisation process. This, coupled with their massive economic size and potential, point to continued strong demand growth in commodities for many more years to come.”
How Much Liquidity is the Fed Really Adding?
From Hussman Econometrics Advisors: “Case in point is the ridiculously over-hyped "term auction facility" announced last week. According to that announcement, the Fed plans to auction about $40 billion of "liquidity" this week: $20 billion on Monday December 17th, which will be a 28-day repo, and another $20 billion on December 20th.
… there are currently $53 billion of repos outstanding (as of Friday), fully $39 billion that mature this week. And wouldn't you know it, the Fed is going to be "injecting" $40 billion this week too. So here's a little acid-test of whether the Fed will actually be providing new "liquidity," or whether it's just trying to brew up a tempest with what's already in that little teapot. Watch the NY Fed's listings of open market operations:
http://www.ny.frb.org/markets/omo/dmm/temp.cfm?SHOWMORE=TRUE
If the Fed is actually adding liquidity, you'll see not only the two $20 billion repos on the 17th and 20th, but additional repos to replace the $39 billion that are coming due this week ($5 billion mature on Tuesday the 18th, and fully $34 billion are set to mature on Thursday the 20th). If the Fed does nothing but those two $20 billion longer-dated repos, all it will have done is to change the maturity of its outstanding repos, without changing the amount. Now, that's not to say I believe that even if the Fed does temporarily buy $40 billion of government securities for 28 days, before selling them back out, it will do much for the solvency of the $12.7 trillion U.S. banking system, much less exotic CDOs and mortgage-backed securities. As I've emphasized in recent weeks, if you track all those daily and weekly rollovers and figure out the total quantity of Fed repos outstanding at any given time, you'll find that the Fed has only injected $18 billion in "liquidity" since March. If investors think the Fed buying up a few billion of Treasury and agency debt means a hill of beans, they might do well to remember that the U.S. government is running up annual deficits in the hundreds of billions. In fact, the U.S. Treasury will float tens of billions of new debt in December alone (most of which will be sopped up by foreigners, who have increased their holdings of Treasuries by well over $200 billion in the past year). This will be mixed in with refinancings. Last week, for example, the Treasury auctioned $21 billion in 3-month bills and $20 billion in 6-month bills. In doing so, the Treasury offset every bit of the Federal Reserve's actions this week, even if it turns out that the $40 billion "term auction facility" represents new liquidity and not just rollovers. Why aren't investors just as interested in that? When the Fed does open market operations, all it's doing is buying up (temporarily or permanently) a tiny fraction of U.S. Treasury debt and replacing it with currency and bank reserves. But every time the Federal government issues more debt to finance its deficits, the new issuance cancels out any beneficial increase in liquidity the Fed could possibly provide. So it's difficult to understand why investors would get all excited about the Fed temporarily buying up a few billion in government securities, when we've got a Federal government that's simultaneously and permanently issuing and then constantly rolling over many, many times that amount. It's an escape into dreamland to believe that Fed actions have any chance at all of providing more "liquidity" when the Federal government's deficits suck up in a matter of weeks every bit of liquidity that the Fed has provided in a year. These Fed actions are nothing but marginal tinkering around the edges of the global financial system, and investors are starting to catch on. Still, it's fun to watch when you understand what's going on. In fact, there will be all kinds of interesting things we'll get to watch this week. For instance, the Fed does its first $20 billion auction on Monday, but there's a timing disparity - only about $5 billion of expiring repos come on Tuesday, and the other $34 billion come due on Thursday. So between Monday and Thursday, we'll observe at least a temporary jump of $15-20 billion in Fed repos outstanding. There's a good chance that during that 3-day overlap, the actual Fed Funds rate will creep below the current target of 4.25% (watch the chart here: http://www.ny.frb.org/markets/openmarket.html). If that happens, you can bet that some analysts will incorrectly conclude that the Fed is doing some sort of "stealth easing." But it will be nothing more than a 3-day timing overlap between maturing and new repos.
More interesting is to watch what happens on Thursday. That's when we get $34 billion of repos coming due. If the Fed does little more than $20 billion through its "term auction facility," that will put the total for the week at $40 billion, versus $39 billion expiring, and it will be clear that this whole maneuver is simply a way for the Fed to temporarily refinance its expiring repos using a slightly longer 28-day maturity, rather than any effort to actually increase the amount of reserves. In any event, banking conditions aren't likely to change even if $40 billion in additional 28-day repos actually materialize. Indeed, a Bloomberg report noted "A Fed official told reporters that the U.S. central bank's efforts won't add net liquidity to the banking system. The plans are aimed at buttressing so-called term funding markets, such as for one-month loans, rather than overnight cash." Should be interesting. Finally, it's worth repeating that the total amount of outstanding repos has increased by only $18 billion since March, nearly all of which has been drawn out as currency in circulation. Most likely, the Fed will enter a "permanent" open market operation on the order of $10-20 billion at some point in the coming weeks to formalize that increase in outstanding currency. That move will probably be met by ridiculously over-hyped reporting as well. But it's entirely predictable. In short, Wall Street analysts aren't paying attention to the data if they believe that the Fed is "pumping" hundreds of billions into the economy to provide some kind of "safety net" for the banking system or the mortgage market. Is it really too much to ask that they make some attempt to understand the subject about which they opine incessantly? As for the Fed itself, it's a great gift to offer people hope, but a great disservice to offer people false hope, and I think that's what the Fed is doing. What's going on in the mortgage market is not a crisis of confidence that we can talk ourselves out of - it's a problem of structural insolvency, where many borrowers literally don't have the means to service their debt over the long-term, because many of them were counting on rising home prices over the short-term. By acting as if a few billion in repos will substantially change this equation, the Fed is raising hopes, and setting the markets and the economy up for disappointment that will be far worse as a result. Bernanke would be better off admitting that the Fed has no chance of providing meaningful "liquidity" when the Federal government is issuing Treasuries at ten times the rate the Fed can absorb them. At that point, Americans would see better that the resources we need to invest, compete and become a financially sound nation are being hoarded by the Federal government and sent up in flames.”
MISC
From Bloomberg: “Money market rates tumbled after the European Central Bank injected an unprecedented $500 billion into the banking system as part of a global effort to ease gridlock in the credit market. The amount banks charge each other for two-week loans in euros dropped a record 50 basis points to 4.45 percent, after climbing 83 basis points in the past two weeks, the European Banking Federation said today. The decline is the first sign attempts by policy makers to revive interbank lending are succeeding.”
From CNN: “Gasoline demand has fallen for the first time in years as drivers appear to recoil from near-record prices, throwing doubt on America's seemingly insatiable thirst for fuel. Growth in gasoline demand has been slowing all year. In five of the last seven weeks, the amount of gas that Americans consume has actually fallen compared to the same time last year…In some weeks demand has fallen by as much as 3 percent…Gasoline is one of those items that some economists consider "inelastic," that is, people will buy it no matter what the cost. But the recent drop in demand puts that into question, and suggest people will cut out unnecessary trips if they are too expensive.”
From Bank of Montreal: “For only the second time since the bad old days of the early 1980s, headline U.S. CPI inflation is now higher than the 10-year Treasury yield (4.3% versus just over 4.1%). The other time was when CPI temporarily spiked after Hurricane Katrina…Not good. The last time this occurred for a prolonged period was in two episodes in the 1970s --- both of which were followed by an economic downturn.”
From Morgan Stanley: “The current account deficit fell to $178.5 billion in Q3 from $188.9 billion in Q2. As a share of GDP this represented a decline to 5.1% from 5.5%, low since 2004Q1 and down from the peak of 6.6% in 2006Q3. The goods and services trade balance improved to -$173.2B from -$178.4B, as previously reported in the monthly trade figures, while the income balance jumped to $20.5B from $12.7B, a record high, on significant increases in interest and dividend payments on U.S. owned foreign assets and a sizable rise in receipts on direct investments abroad.”
From Barclays: “Disappointment about the super-SIV plan, the Paulson rate freeze plan, and the TAF should all drive home the point that policy measures can only do so much in solving both the liquidity issues and the subprime problem. The possibility of more write-downs by banks and brokers, as well as year-end funding issues, should also help the curve to bull steepen into year-end.”
From Deutsche Bank: “Clearly, the housing figures have been abysmal this year, however we think we may be seeing early signs of a bottom-after all, housing activity can only fall so far, and the construction figures are already the lowest since the housing recession in the early 1990s. Case in point, homebuilders' sentiment appears to have hit bottom, it has held steady at an index level of 19 for the last three months. Residential investment is likely to subtract about 1% from GDP both in the current quarter and Q1 of 2008. However, by Q2 of next year we project the residential investment share of GDP will fall to a record low, which means its negative effect on growth should trail off. However, significant negative second-order effects on the economy are likely to remain as a result of elevated inventories and potential further declines in house prices.”
From Merrill Lynch: “The Dow closed down 172 points, which was the first time we have seen back-to-back triple-digit losses since the onset of the credit crunch in mid-August (before the Fed began to ease). There were 5 decliners for every gainer on the Big Board – talk about bad breadth. And all ten S&P 500 sectors were down, but leading the decliners this time were not the usual culprits (financials, consumer discretionary) but rather 2%+ slides in the seemingly impenetrable ‘decoupling’ groups such as materials, tech and energy…It could just be that the market is starting to price in the earnings recession that began in earnest a quarter ago.”
From RBSGC: “…intriguing story in the WSJ where Greg Ip writes about a discussion within the FOMC that about the balance of risk assessment. He interviews Plosser (a hawk) who said the assessment may convey too much confidence about the direction of rates -- and offered that inflation pressure is spreading beyond energy. This is one man's opinion, and a leading hawk's at that, but still sheds some light on the internal debate within the Fed and suggests that their own struggle/confusion over the balance of risks mirrors the markets.”
From Dow Jones: “Fitch Ratings said it would set a ceiling for ratings on certain structured investments, while also implementing stricter requirements. The move comes as issuance and trading in these markets have ground to a halt with spooked investors retreating to the sidelines amid the ongoing credit crunch - forcing rating companies to reassess their methodology and also take into consideration the ease with which these securities trade. “Credit ratings really aren’t designed to measure liquidity. They measure credit performance as defined by the probability of default and ratings migration,”…”
From Merrill Lynch: “The Baltic Dry index continues its march downward, falling 0.3% on Friday to a level of 9918, which is the lowest since October 7. For the week, the index is down 1.5% and, since hitting an all-time peak back in mid November, the measure of global dry bulk commodity shipping rates has fallen by 10.1%. Could this be fore-shadowing a moderation in the commodity complex? The CRB index hit its peak on November 6, and since then, the index is down 2.4%.”
From Morgan Stanley: “Congressional wrangling over the Alternative Minimum Tax (AMT) appears likely to lead to an unprecedented delay to the start of the tax filing season. This could have a significant impact on the volume of tax refunds that will be pumped into the economy in early 2008 and represents yet another potentially important headwind for the US consumer…The IRS cannot process tax returns until all of its systems conform to current tax law. Normally, all tax legislation is completed by early-November and the IRS is ready to start processing returns by mid-January or so. At present, the IRS estimates that it will take seven weeks after the bill is signed before they can start processing returns. So, even under a best case scenario, the IRS probably will not be able to begin mailing refund checks until mid-February…it seems likely that the refund delay could -- at least temporarily -- take a significant chunk out of discretionary spending in early 2008, adding to the near term downside risks confronting the US economy.”
From Bloomberg: “The light bulbs in almost every U.S. home and the gasoline in many cars will be altered by energy legislation that the U.S. House of Representatives passed today…The measure, approved 314-100, slashes U.S. energy use 8 percent by 2030, environmentalists say. It contains the first new vehicle fuel economy law in 32 years and mandates a fourfold increase in the use of biofuels. The bill, already approved by the Senate, phases out incandescent light bulbs, which have been in use for a century, and places the first limits on the amount of water used in new washing machines and dishwashers…``Literally, the amount of energy that's being saved by the light-bulb standard alone is more than has been achieved since 1986 for all appliances combined.''”
From Dow Jones: “President George W. Bush will sign mortgage-tax relief legislation
later this week if it passes the House as expected. White House spokeswoman Dana Perino lauded the measure, which would let homeowners avoid income tax on mortgage debt forgiven through refinancing. “This will protect homeowners from having to pay extra taxes when they refinance their mortgages on the difference,” Perino said. Bush “believes it is good policy.””
From Bloomberg: “Bill Gross, manager of the world's biggest bond fund, said the U.S. is headed for a ``mild'' recession in 2008 amid the worst housing slump in 16 years.”
Bank of America: “Corporate tax receipts at the Treasury recovered from their weakness in September. Comparing tax receipts on the day of the deadline, December receipts fell -3% year-over-year (yoy) versus a -13% decline in September.”
From Dow Jones: “Prices for most types of property and casualty insurance are expected to decline in 2008 for the first time since World War II, as a weakening economy and heightened competition hold prices down everywhere except along coastal areas that are exposed to hurricanes.”
End-of-Day Market Update
From UBS: “Treasuries rallied right out of the gate, rising almost non-stop until noon, after which they gave back a portion of their gains…swap spreads to narrow across the board. Agencies had light flows, with the front end underperforming versus Libor. Mortgages had a quiet day, with higher coupons lagging lower coupons. MBS ended 7 ticks tighter to Treasuries and 2+ to swaps.”
From Dow Jones: “U.S. Treasurys were higher Tuesday morning on the heels of an aggressive overnight move by the European Central Bank to ease liquidity pressures, which reawakened investors’ year-end liquidity concerns. The ECB Tuesday saw robust demand from banks for its offer of unlimited two-week funds at a fixed rate, lending around $500 billion in such funds to help ease strained money markets and boost liquidity into year-end. The add dwarfed the size of the Federal Reserve’s $20 billion sale Monday, the first offering in its Term Auction Facility program also designed to ensure liquidity through year-end, and raised worries that the Fed offering may not be enough…The dollar rose a bit against the yen Tuesday as a modest rise in US stocks swayed investors to take on more risk by selling the low-yielding yen and buying higher-yielders. But ranges remained tight and the greenback showed little reaction to yet another weak US housing report as markets downshift gears as the year winds down. Wednesday could be another dull session, with no important data slated for release…The market seemed unable to make up its mind Tuesday, as stocks dipped early in the afternoon and then moved back to positive territory.”
Three month T-Bill yield fell 1 bp to 3.03%.
Two year T-Note yield rose 1.5 bp to 3.19%
Ten year T-Note yield fell 2 bp to 4.12%
Dow rose 65 to 13,232
S&P 500 rose 9 to 1455
Dollar index rose .03 to 77.43
Gold rose $10 to $803
Oil fell $.14 to $90.5
*All prices as of 4:35pm
No comments:
Post a Comment