August 12, 2010 -From a Western financial professional’s perspective, South Korea has traditionally been overlooked. The most familiar big three finance hubs in the East were forged in Singapore, Hong Kong, and Tokyo. However, Korea is redefining itself as a major marketplace for a specific breed of financial product, for better or worse, broadly labeled “derivatives”. For those having flash backs to calculus at the thought of the word, don’t fret… you’re actually on the right track. Here we’ll give a crash course on derivatives and their place in financial markets, inspect their recent appearance in emerging markets, and theorize as to the effect they will have on Korea’s global financial presence and the economy as a whole.

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Sure it’s easy to love a scandal when the home team (main street) is hurting, but smearing your rival’s leading guard (GS), because he continuously posts “tripple doubles”, doesn’t necessarily bring the trophy home. Goldman Sachs has been the source of an accelerating wave of controversy over the past few weeks, due to the SEC suit against the firm for fraud, and was most recently bent over the well worn U.S. Congressional hearing desk, compliments of U.S. Senator Carl Levin, of Michigan.

There’s a lot of chatter on the blogosphere about the actual construction of the ABACUS deal and just how it went down. Most of which requires time on an investment banking desk or a masters in quantitative finance to understand. We’re going to take a stab at making it one big step simpler…

What is a CDO?

If you don’t know this then you’re already lost. A CDO is a Collateralized Debt Obligation, which means that it is a security that is priced to a certain degree of risk based on a diversified pool of a particular type of debt assets. Generally CDO’s are set up by collecting a pool of cash flow producing assets, in the case of the recent crisis many CDO’s were actually Mortgage Backed Securities, thus the term MBS. The pool of cash flow producing assets is diversified across the nation and is then divided into levels of risk, known as “tranches”. The risk levels have nothing to do with the quality of any one mortgage or borrower. Instead the risk levels are simply a pecking order of who loses, from first to last, when payments from any asset in the pool stop coming in.  See this excellent explanation of mortgage based CDO’s for a crash course.

What is a Synthetic CDO?

Now let’s try to get a grasp on synthetic CDO’s. If a normal CDO is tied to cash flow producing assets, a synthetic CDO is priced based on a portfolio of cash flow producing assets in a far more indirect manner. Synthetic CDO’s are derived by selling Credit Default Swaps (CDS) on cash flow producing assets (bonds, mortgages, etc.) in order to receive periodic interest payments that theoretically mimic the cash flows of the pool of performing loans. If CDS’s are the insurance on a pool of assets going belly up, then synthetic CDO’s are priced by extrapolating the present value of future cash flows coming out of the CDS’s of that pool. The synthetic CDO’s are then tranched from first to last loss, just like a normal CDO, where the riskiest tranche is always the highest yielding. The most common tranche categories from first loss to last, are “first-loss (FL)”, “D”, “C”, “B”, “A-2″, “A-1″, and “Super Senior (SS)”.

For Synthetic CDO’s to exist there must be a “market maker”, which is comparable to the “bookie” in a high stakes gambling circuit. These contracts and securities are generally formed and exchanged between few specific parties and organized by an investment bank, rather than a central clearing house (e.g. NYMEX, CBOE, etc.), and in the case of ABACUS the bank “making the market” was Goldman Sachs.

(Review note: FL will always be the first investor group to lose their principle, while SS will be the last. For SS to go belly up, the entire pool of assets tied to the CDS must default. When all loans are performing, CDS insurance premiums continue to roll in and Sythetic CDS’s yield large profits, mainly due to the small amount of principle required to sell the CDS’s and thus open a synthetic CDO position.)

What is ABACUS?

Abacus is a whole new breed. The idea behind this “business entity”, as it was described by its founders at GS, was to create two tranches of a synthetic CDO, which weren’t actually tied to any real cash flow producing assets at all. If a CDO is a fish in the hand, and a Synthetic CDO is a fish on the line, this baby cut the line and instead imagined the fish on the other end, basing their assumption of the fish on a bunch of other fish that had recently been caught.

Before we go any further, take a look at this illustration to get a sense of the way the ABACUS deal was structured. It’s not perfect, but it clearly shows that there are only two tranches in this mechanism, A-1 and A-2. If you are comfortable with the definition of a Synthetic CDO above, you should be asking, “how can you only have AAA and AA rated tranches if the lower tranches don’t go belly up first?” Isn’t the point of the tranches to create a pecking order of defaults? In a Synthetic CDO “yes”, in ABACUS “no”.

This is where the lines begin to blur… ABACUS Ltd. is specifically a business entity, organized and formed by Goldman for the purpose of market making. According to the SEC Goldman formed ABACUS on a request from John Paulson’s hedge fund, in order to make a market for Paulson to buy a quantity of AAA and AA rated Synthetic CDO tranches. In this way Paulson could purchase securities, designed to mimic CDS’s on AAA and AA tranches of a residential mortgage pool without having to find a buyer of the CDS’s of lower tiered tranches as with a normal or synthetic CDO contract.

The two lucky souls who ended up responding to the market making were IKB Deutche Industriebank and ACA Capital. Involved in insurance, corporate bonds, and municipal debt, these firms were clearly more than able to perform the due diligence to realize the risks of their positions, and were interested in placing a long bet on the strength of the U.S. housing market. By entering into the contract these two firms sold Paulson the securities designed to mimic AAA and AA CDS tranches, thus making themselves liable to pay the full principle of a the theoretical value of the reference portfolio in exchange for a handsome cash flow premium.

As we all know, synthetic CDO’s and assuredly agreements such as ABACUS performed very poorly for the sellers of the CDS contracts (e.g. the side long the housing market), when the reference portfolios crashed towards zero and for months no market was successfully made. Many similar agreements had been made and the volume of bets surrounding the housing market far surpassed the actual amount of mortgage debt issued, further muddying the market’s perception of what these reference portfolios were even worth.

What you should know is that Goldman Sachs was not along in this levered gambling of mortgage debt. Many parties came to the table wanting to get a piece of these long housing market positions (synthetic CDO’s and ABACUS style CDO’s) which generated cash upon issuance, like a short sale, and offered the potential for profit if reference portfolios continued to appreciate.

The blame here rests solely on the greed and ignorance of a whole industry bent on better than possible returns at smaller theoretical risk. Anyone who was a part of this investment banking market making process and had access to the volume of transactions being done, could have seen the excesses in their purest forms. Goldman was hired to make a market where a new type of security could be sold. Granted, the security was bogus, but there were no lies being peddled in the process and the prospectus clearly stated the terms upon which ACA and IKB must agree in order to have this theoretical CDO exposure. Whether Paulson’s fund had a hand in developing ABACUS or not, Goldman simply offered a product to consumers ad hoc and these two banks felt that the terms were fair enough to engage. They ended up making a terrible long bet on the U.S. housing market near the end of the party. They lost. End of Story

Hat tip to Baseline Scenario, Alea Blog, and Interfluidity for their analysis of ABACUS, which helped us bring you some of the links and data that contribute to our analysis here today.

Where We’ve Been

1.) The iShares Dow Jones US Financial Sector Index (DJUSFI) ETF (IYF) has rallied 34% in the last 52 weeks, to 51.51 on February 4, 2010.

2.) The DJUSFI itself, which IYF is designed to mimic, presently totes a 61.07 trailing p/e when accounting for earnings losses.

3.) The DJUSFI’s forward p/e appears reasonable at 13.36 when accounting for positive and negative earnings, yet the expectations of future earnings, used to compute this number, are based on a full scale U.S. economic recovery.

4.) Higher p/e ratios are tolerated as upside earnings surprises have helped to keep multiples low throughout the latter half of 2009.

Consider the possibility that your view is now the byproduct of a positive feedback loop, fueled by a bias that is based on a string of positive surprises. Statistics reminds us to rely only on pertinent, non random, past data when forming hypotheses and to discard random events, disguised as oracles.

Signal Flares

Looking ahead, we see a trend forming in the very sector which plagued the economy into recession. New home sales have fallen to 342,000 units in December (just above the March 2009 low) after the initial housing stimulus expired and a new incentive package failed to pick up the slack. Simultaneously the Case-Shiller resold home price index stalled in October and November and existing home sales in December tanked to the lowest level since August. Most disconcerting was the jump in months supply of existing homes which jumped almost a full month to 7.2 months worth of housing inventory.

Where the Money Came From

Banks have profited from three factors in the latter three quarters of 2009 that could actually hurt them in 2010. (1) It’s no secret that the Federal Reserve propped up the nations largest banks through the largest liquidity campaign in the history. Mortgages are still being purchased by the Fed, but they have vowed to quit the purchases of MBS from Fannie and Freddie by the end of March. These purchases allowed potential buyers of similar assets on private balance sheets to find a market price and risk taking re-entered the market. (2) Once it was clear that banks weren’t going to fail or be nationalized the first leg of the rally carried prices from book values near .50 to levels nearer to fair value. At this point , it was still understood that the “infected” TARP banks would need some wiggle room to begin lending and get their capital requirements up to par. The answer was found in the repealing of “mark to market” accounting (FASB 157), where banks were suddenly able to keep Real Estate Owned (REO) properties, which had been foreclosed and seized by the bank, on their balance sheet at a price estimated by the bank itself. (3) The rally, which resulted from the new found faith in the financial system as a whole, carried confidence and thus risky investments into the market. This return to risk naturally benefited banks through increased fees and expenses from their brokerage arms and increased profits from proprietary trading of their own funds.

Holes in the Cheese

Just as these three factors contributed to the investment in banks in 2009, we see most bank shares at artificially high prices, supported by unsustainable multiples, and several reasons to doubt the foundations of U.S. banks. The 10-year Treasury rate and the 30 year fixed mortgage rate are at historic lows amidst a record U.S. fiscal deficit of 1.4 trillion USD in 2009, insisting that the end game will include higher rates on mortgages in the future. Taking it one step further, we see recent strength in the USD index, and an upward trend in the 10 year Treasury Note yield, forcing borrowing costs to rise in 2010 and decreasing the incentives for home owners to buy and traders to trade risky assets. This shift will be doubly negative for banks as rates chip away new found cash flows from mortgage refinances and profits from proprietary trading. Similarly, higher rates in 2010 will force 2009 refinanced payments higher, where ARM’s reset at rates above “teasers”, and fixed products will become less attractive to new buyers on the margin. The benchmark Treasury Yield (10 year note) illustrates the bottoming of the yield below.

How to Play It

If you look through our archives you’ll see that we held a position in the ProShares Double Short Financials ETF (SKF) earlier in 2009. SKF follows the 2x inverse of the DJUSFI and has been on a wild ride over the past two years. I will be the first to tell you that we did very poorly by holding this position, as our assumption that (a) market handicappers would overstep the obvious but short term increases in profits due to the revision of accounting rules (FASB 147) and (b) that trading fees and proprietary trading gains would be short lived for financial firms, as the market topped and returned to a decline in mid summer 2009. You should know that this did not occur and we ended up closing the position in August for a considerable loss.

While we did take a loss, we see SKF as a crucial element to our financial strategy in 2010. We are bearish on blue chip financial firms in 2010, due to the ramifications of rising interest rates, widespread exposure to mortgage defaults, and a tired equity market. However, it is prudent to hedge where value lies, and in financials we found our protection in the obvious favorite.

We are playing the financial volatility with expectations for weakness, by going long Goldman Sachs (GS) and 2x short the Dow Jones U.S. Financials Index, using an equally weighted long position in SKF. Review the charts below of both names. GS is actually included in the DJUSFI, as the fifth largest holding, yet it’s 7.1 p/e and 1.39 price/book make the firm an incredible value, compared to it’s DJUSFI peers.

-GS 6 month performance-

-SKF 6 month performance-

By opening positions in both GS and SKF, with an equal share of capital in each, we are playing a sort of bear biased saddle. While we expect financials to fare badly in 2010, GS has relatively little exposure to mortgage issues and has proved that it’s innovation will prevail in any environment. The firm has missed earnings estimates only three times since Q2 of 2001, and has exhibited solid dividend yield and earnings per share growth over a 10 year period. By trading this strategy on a weekly basis, we will sell shares and capture gains from the winning position and add this capital to the other vehicle. Should our thesis prove correct, we expect that losses from goldman sachs will be limited, and that their value relative to the financial sector will support share prices in most environments this year.

Remember this is an active trading strategy and unknown market factors can always drastically change prices over short periods of time. For added protection enable loss stops on both positions to protect yourself from extensive losses.

Disclosure: Long GS, Long SKF

Fundamentals

Crude supply rose by 5 million to 330 million barrels in the past two weeks, still above average market high water mark levels. Despite a large draw from the 375 million barrel supply peak in May 2009, refiners are voicing their concern by halting production capacity just above 81%. Crack spreads are increasingly narrow as weak consumer habits choke the profitability of refiners and discourage production managers from adding to the more costly finished good stockpiles (i.e. gasoline, distillates, etc.). When crack spreads rise alongside prices, refiners benefit from higher gas prices by increasing their margins. However, stagnating crack spreads near all time lows signals weaker consumer demand for final petroleum products, forcing refiners into slowing production to keep spreads at current levels. In short, higher oil prices are hurting refiners and consumers in an environment where end demand for energy is not responsible for price gains.

Graph of brent crude oil spot price vs. European gas - oil crack spread, January 2010

International Energy Agency (IEA) World Oil Demand

The fundamental global price function of supply and demand should be respected, but IEA have recently been misstated by oil hawks. The International Energy Agency has predicted global demand for oil to begin at 86 million barrels per day (mb/d) in Q1 2010 and finish Q4 near 87 mb/d. While these estimates may have risen from earlier expectations for weaker demand, the upward price momentum has been baked into stocks.

IEA Wolrd Oil Supply 2010

The 2010 mean demand estimate of 86.3 mb/d compared to December global supply of 86.2 mb/d, on an unexpected rise of 270 kb/d, suggests that supply is gaining while demand growth, rooted in non-OECD developing Asian countries, is less than stable. Also important are upside supply surprises from the OPEC 12, which prove that there are incentives for the cartel member states to raise production levels at these prices.

Sentiment

Rooted in U.S. equity values lie traders’ economic sentiment. Crude oil prices are historically volatile during periods of uncertainty, where the commodity reflects market participants’ confidence in the economy as a whole. Bullish sentiment has been on the rise for much of the previous year, as traders have been talking up the potential for crude to hit $90 per barrel. This optimism has been rooted in the manufacturing expansion in the second half of 2009, GDP expansion in Q3 and expectations of expansion in Q4, and global demand upgrades by the IEA mentioned above. Though mainly, there is the $144 per barrel price hemorrhage of July 2008 fresh in traders’ minds and expectations for a lasting economic recovery in 2010. These factors have combined to create a short averse commodity trader’s market, where resistance levels have remained weak as rallies occur.

As you may have already guessed, we consider prices to be floating on a thick layer of froth, aided by the mentality that oil will continue a sustainable rise, despite the 130% rally from February ’09 to January ’10. The catalysts necessary to cause this confidence shift are simply the reverse arguments of price inflating factors that are now being proven overblown.

First, the manufacturing recovery has outpaced most expectations, as ISM Manufacturing Surveys show positive forward indicators of growth, inflating expectations to levels where the probability of upside surprises is greatly reduced. Second, the manufacturing sector has contributed largely to GDP expansion in Q3 and is expected to carry the U.S. economy towards +3% growth in 2010. Future disappointments from the goods producing sector would not only implicitly hurt oil, but would indirectly lower crude prices as the forecasts for broad based economic growth are revised lower. Third, the IEA estimates for Global demand for crude oil are overblown and supply is increasing more rapidly than predicted. All the while, a public announcement from China proclaimed that QE in response to the economic recession is now being reversed, causing the market’s expected rate of energy consumption to be revised lower.

Wrapping up, Q4 earnings results seem to be less positive than Q2 and Q3, where specific results from financials and transports have so far bode badly for animal spirits. Further write downs from JP Morgan (JPM) & Citi (C) on credit card defaults and foreclosures have pushed the consumer’s recovery further down the time line, while CSX Corp. (CSX) reported lower transport volume, dampening the spirits of bulls citing manufacturing growth during the period.

Technicals

While fundamental analysis and sentiment shifts are both worth pointing out, the technical support to one’s argument is always most crucial to a high conviction trade. Glance over the visual below, then we will discuss the technical signals in more detail.

West Texas Intermediate (WTI) Crude Spot Price (NYMEX Crude)

The bearish wedge pattern is a classic technical pattern, where market prices for an underlying security increase over a period of time, but growth between peaks shrinks while growth between troughs is sustained. In this cycle, the Moving Average Convergence to Divergence (MACD) graph and histogram show weakening moving average momentum, as depicted by the downward sloping trend between peaks on the MACD
sub-chart. While the wedge has been forming for some time, two further technical signals support now as the turning point for crude prices. The first signal comes from the 50 day simple moving average (sma) at $77.50, which prices broke beneath more than once in futures markets on Monday, before the WTIC closed higher at Tuesday’s close. The second and most convincing sign came when the MACD histogram broke below zero, marking a bearish cross. Had trading momentum led to higher price levels and an MACD reversal above the most recent rally peak in late October, the bearish wedge would not have formed and crude prices could have consolidated to move higher. Instead, we saw a perfect lower peaking reversal to complete the bearish wedge and seal this call.

The WTI continuous spot, charted above, closed at $79.32 on Tuesday and will allow for a better entry point for oil shorts on Wednesday. We own the PowerShares Double Short Crude Oil ETN (DTO) and added to our position at $79 dollars. The vehicle attempts to provide 2x inverse price movement compared to the WTI crude oil spot.

We are setting a price target for the WTI spot at $70, where we will take profits from our DTO position and reassess our position.

Disclosure: Long DTO

Combine the absence of economic indicating data on Friday and a hand full of releases spanning Tuesday to Thursday, and the spotlight turns squarely on the weeks earnings reports listed by day below…

Tuesday: Citigroup (C), CSX Corp. (CSX), McMoRan Exploration Co. (MMR)

Wednesday: Bank of America (BAC), Ebay (EBAY), Logitech International (LOGI), Morgan Stanley (MS), Starbucks (SBUX), U.S. Bancorp. (USB), Wells Fargo & Company (WFC)

Thursday: American Express (AXP), Burlington Northern Santa Fe (BNI), Capital One Financial (COF), Fifth Third Bancorp (FITB), Freeport-McMoRan Copper & Gold (FCX), Goldman Sachs (GS), Google (GOOG), Southwest Airlines (LUV), Union Pacific (UNP), Xerox (XRX)

Friday: BB&T (BBT), General Electric (GE), McDonalds's (MCD), Schlumberger (SLB), Suntrust (STI)

Tuesday 

The late trading week will start in a hurry Tuesday morning as C and MMR are scheduled to announce earnings before the market open. Citigroup has been plagued by sub par lending standards and may miss the expected -0.33 EPS due to higher defaults and weaker Commercial Real Estate fundamentals, cited in JP Morgan's results on Friday. MacMoRan will likely have benefited from higher oil prices over the quarter, perhaps beating the -0.26 EPS consensus, yet the forward momentum for drilling and exploration of crude oil could be dampened by the recently wavering price of the commodity. The Treasury's International Capital report will hit wires at 9:00 AM, and should give some clarity to the Treasury market that has moved inversely with equities as investors seek safety and speculators look to capitalize on future supply-demand gaps of the U.S. debt. At 1:00 PM home builders' sentiment will be judged by the results of January's Housing Market Index, which weakened from 17 to 16 in the previous month. Following the close, rail carrier CSX Corp. will announce earnings, where the estimated result stands at -0.76 EPS. 

Wednesday 

The usual weekly suspects MBA Mortgage Applications (7:00 AM), ICSC Goldman Store Sales (7:45 AM), and Redbook Sales (8:55 AM), may be overshadowed by financial earnings this Wednesday. Wells Fargo (WFC) (-0.02 EPS est.) and Morgan Stanley (MS) (0.36 EPS est.) will announce Q4 results at 8:00 AM, U.S. Bancorp (USB) (0.29 EPS est.) will release numbers before the open, and Bank of America (BAC) (-0.52 EPS est.) will keep traders guessing, but vow to show their grades by day's end. While BAC and WFC expect losses, USB has the most to lose if results miss the optimistic estimates. In a quarter where JP Morgan announced an additional $2 billion of loan loss provisions for 2010 Q1 and Q2, The financial sector may reveal some skeletons. US Bancorp. doesn't have the trading arm to profit from market movement fees like BAC, MS or JPM and share a closer fate to their loan portfolio. The PPI and Housing Starts data will cross tickers at 8:30 AM, and are expected to show virtually no change in either statistic, suggesting that any big moves from these reports will impact markets. Consumer names EBAY (0.40 EPS est.), LOGI (0.27 EPS est.) and SBUX (0.27 EPS est.) will announce and be judged in after hours trading; begging attention to after-market consumer goods, communication tech spending, and consumer discretionary outlays, respectively. 

Thursday 

While Jobless Claims will demand an audience at 8:30 AM, following an unexpected 11,000 jump in initial claims to 444,000 last week, earnings reports will steal the pre-market show. First by Fifth Third Bancorp (FITB) (-0.31 EPS est.) at 6:00 AM, second with Xerox (XRX) (0.22 EPS est.) at 7:00 AM, and accompanied by Goldman Sachs (GS) (5.19 EPS est.) and Union Pacific (UNP) (1.04 EPS est.) some time before the opening bell. FITB will add clarity to consumer lending and commercial real estate, XRX will mirror businesses investment, GS will tell how well the best traders on the planet fared, and UNP will keep tabs on the manufacturing sector's recovery via transportation of goods. 

The Leading Indicators report, due at 10:00 AM, is expected to ease from the 0.9% November growth to 0.7% growth in December but may be weakened by recent negative surprises from labor and spending in the tail end of 2009. Simultaneously the Philadelphia Fed will release their survey of economic conditions within their respective district, which is also expected to show decelerating growth as the indicator drops from the previous high of 20.4 in December, to 18.0 in January. The EIA Petroleum Status report has been pushed from Wednesday to Thursday this week, and will be closely watched for total supply changes (currently 330 million barrels) as well as distillate stock draws and refinery capacity rates.

Reporting after the close are Burlington Northern Santa Fe (BNI) (1.22 EPS) at 4:00 PM and Capital One Financial (COF) (0.45 EPS est.) at 4:05 PM, while American Express (AXP) (0.55 EPS est.) and Google (GOOG) (6.43 EPS est.) will release earnings sometime after the bell. BNI will be an interesting post-close story to compare to UNP as traders look for moves in the transport sector, just before Capital One walks investors through an average U.S. credit portfolio. Amex will unveil the strength of their high end consumer credit book and small business arm, while Google will most definitely stomp estimates, as on-line advertising continues to gain traction. Finally, Southwest Airlines (LUV) (0.06 EPS est.) will announce results at an unknown time; a testament to consumers' marginal propensity to fly rather than drive.

Friday

On a day where there is literally no economic data to be released, Friday's market action will be acutely focused on earnings. Before the market open BB&T (BBT) (0.21 EPS est.), General Electric (GE) (0.27 EPS est.), McDonald's (MCD) (1.02 EPS est.), and SunTrust (STI) (-0.69 EPS est) will make highlights. Most of the banking sector will have reported at this stage, however results from BB&T and SunTrust will reflect loan quality and economic activity in the South Eastern states where these banks have a dominant presence. Similarly, GE and MCD will boast or bleed by changes in consumer demand for household appliances and premium priced meals at fast food restaurants. Capping off the list of noteworthy market moving events, Schlumberger (SLB) (0.63 EPS est.) will announce their Q4 2009 earnings as the only scheduled release on Friday, while it happens to be the earliest at 6:00 AM. The strength of the offshore oil explorer and driller will be influenced by spiking crude prices throughout the quarter, yet expectations for the price/barrel moving forward could have a greater effect on the stock than the corporate track record. 

Keep a close eye on earnings and economic data in this short yet furious week of market moving events. Oil is moving lower and the MACD is showing a bearish cross, leading us to make a high conviction call in our next piece that you won't want to miss. 

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Thank you and as always… Happy Trading

The oil issue has been speculative to this point. It's hard to argue against 90 dollar oil when we saw 145 in July 2008, but the fundamentals aren't congruent with the price growth we've seen and this trader finds it easier to argue FOR $60/ barrel oil. Crude supply in the U.S. remains high, at 330 million barrels, while gasoline demand remains week and imports are rising. Crack spreads for refiners are reflected in their output averse management of facilities, where capacity utilization rates have stagnated at 81.3%. Refiners are the effective buyers of crude and the capacity numbers are sending signals of distress. The IEA's world demand predictions for 2010 were recently raised from the current 2009 level of 84.9 Million Barrels / Day (mb/d) to nearly 87 mb/d by 2010 Q4. (It should be noted that predictions for Q4 2009 global demand at 85.5 mb/d overshot the actual level of 84.9.) Rate hikes in China this week will calm the giant and should increase the likelihood of U.S. rate hikes in the first half of 2010.

Rate hikes will cool speculative trades and pull a significant amount of upward speculation out of Crude, as they increase capital holding costs and the risk of trading on margin. Softening Chinese growth will also cool global supply and demand speculation, with respect to crude, in an equally bearish development for the commodity.

The Consumer

Earnings season may present upside risk to short positions, which is why our stops have been tightened on our SDS and SCC positions. SPX might make it's way to 1200 where a lot of traders are calling the next Fibonacci resistance level, but momentum seems to be sputtering as earnings have begun.

The December Retail Sales report showed -0.3% growth combined with the revised higher 1.8% November rate, and makes it difficult to gauge buying sentiment moving into 2010. However the negative growth in the month of Christmas will leave many scratching their heads, and suggest that energy prices are playing a bigger role in retail sales than previously thought.

All in all, crude seems to be weakening, even on the backs of solid earnings from Intel, which should have been interpreted as positive to the overall economy. In after hours trading Intel traded up around 0.8% on a 0.55 EPS report vs. 0.34 EPS expected. Granted the day saw some sour economic fundamental data from the previous mentioned reports, but the market response was weak for a 62% profit beat.

Financials

Markets are becoming tougher to surprise at these levels and we could see more weakness from the banks. Soc Generale (SCGLY.PK) had an awful quarter in France and the U.S. regional First Midwest Bancorp (FMBI) missed the -0.07 EPS consensus by 76 cents, at -0.83 EPS. If regional financial problems due to MBS and the potential for more mortgage pain continue to show their fangs, financials could sell off through earnings.

Financials are the guts of the recession and will surprise many at how fast they can lower the tide for all. JP Morgan (JPM) will answer questions in this category on Friday, where weakness from the best in breed lending giant would create malignant concern in the banking sector at large. 

Disclosure: Long SDS, Long SCC, Long DTO (see: DS Portfolio)

While Alcoa is only one company, the firm is symbolic of the U.S. manufacturing sector as a whole and it’s profits are directly affected by the prices of input commodities, primarily petroleum products and aluminum ore.  Below is a 1-year chart of the S&P 500, annotated according to AA earnings results vs. estimates. (Click chart to expand in a new window)

As shown above, the S&P 500 has rallied from the announcement of AA earnings following each of the past three quarterly announcements. The once discarded industrial giant has found new importance over the past year in financial markets as it foreshadows the industrial earning power of the U.S. The recent two quarterly results beat estimates, while the Q1 2009 results were very near the street’s consensus at the end of a period wrought with massive earnings let downs. All in all we see the first three AA quarterly results of 2009 as better than expected.

Naturally, Alcoa can’t dictate the earnings of an entire economy, but the two factors causing the firm to miss earnings will be applied to bottom lines as earnings season picks up in the following weeks. These factors were higher energy and aluminum ore costs combined a weaker U.S. Dollar. The macro economic message heard on Wall Street highlights real revenue destruction from a weaker domestic currency and the negative cost effects of higher oil.

The following two charts show the trend of these two factors of production below in the form of the USD index and the WTI Continuous contract.

Referring to the charts, the cost of petroleum based inputs to production and the devaluing of the U.S. dollar during the months of October to December 2009 are both evident. Immediately, traders and investors have begun applying heavier weights to these parameters when running their earnings models. Will this trend be the thorn in the side of earnings to bring the first season of the recovery where earnings miss more than beat estimates?

In our opinion the dollar has held it’s ground fairly well over the past month and may see a short term appreciation on interest rate concerns, while we view crude oil as overbought and due for a pullback. We follow the Moving Average Convergence Divergence technical series, as it has been highly predictive of price cycles in the many securities, mainly crude oil, over the course of the recovery, and see crude oil particularly overbought with respect to this statistic.

Whether earnings season is a make or a break for stocks relies on more than the results of just one firm, yet the manufacturing recovery story has remained the golden goose of 2009 and will not benefit from the implications derived from a negative AA earnings card.

Disclosure:

Currently we are short Crude Oil (DTO), short Consumer Services (SCC), and short the S&P 500 Index (SDS).

(By Clicking on the DS Portfolio tab in the navigation bar above, readers can follow the current portfolio held by Diamond Slice partners in real time.)

The consumption of manufactured goods represented 1.59%of the revised 2.2% U.S. GDP growth in Q3 2009 and thus remains the center point of the economic recovery as we have known it thus far. The growth indicative ISM report booned U.S. markets in the first 2010 trading session, as the seemingly unbeatable 60.3 November New Orders component was crushed by a 65.5 stat in December. New Orders are the single most telling economic reading of future conditions in Manufacturing, perhaps making this month’s strength unbeatable in January and ironically a curse on the effects of less positive results moving forward. Less discussed but also important, are increasingly slower deliver times that, if sustainable, should have positive effects on both transportation carriers’ top lines and jobs in the industry.

Standing on the shoulders of a massive rally to start 2010, it’s safe to say that the environment is still a wash of confusion. Inventory numbers from the report show that clients of manufacturers are becoming increasingly skeptical, where the Customers’ Inventories number at 35 perpetuated a nine month trend of contraction during one of the highest consumer demand months of the year. These results suggest that inventory rebuilding hasn’t occurred on par with headlines, and that instead the entire production chain has become extremely lean and risk averse. Should confidence return and consumers loosen their wallets, this would be a prime area of growth in the new year, but headwinds to such spending remain significant and could intensify. Partly frightening, is the component of higher input prices, continuing a six month trend of appreciation that is reflective of the commodity rally and U.S. Dollar weakness. While input prices have helped to raise the ISM headline number in recent months, U.S. Dollar strength will be discounted as having a negative effect on future reports.

Kicking the mud from our boots, let us shed the stats from our purview and think logically about the chances for economic success in the U.S. over the next year. 2010 estimates for U.S. GDP growth are floating in the mid 3% range, but where can we expect to find growth summing up to this handsome rate of expansion?

In the U.S. 24% of annual GDP dollars are rooted in manufactured goods, while the service industry brings in nearly twice that figure. In Q3 of 2009 we lost about 3% to our trade deficit, which should grow if consumers spend more, and the remaining 30% is split into one part domestic investment, two parts government expenditures. We can expect that the government isn’t going to muster much more growth in 2010, due to it’s bureaucratic inefficiencies and the Q3 2009 0.5% annual contributed GDP growth, despite $700 billion (5.3% x GDP) of stimulus.

For all intensive purposes we’re left with the manufacturing and service industries to get us most of the way to 3% growth. “We did it in 2003, so it’s just a matter of animal spirits… right?” Unfortunately, in our opinion, the game has changed significantly, making 2009 anything but 2003 . First, there is not an abundant supply of new homes, and the supply we have aren’t being bought, so the big new houses of Super Sized Suburbia30 miles from town won’t have the same magnetic effects on consumption as were present in 2003-2006. Instead we’re seeing strength in existing home sales and less confident buildersrealizing that bigger isn’t better. Second, unemployment is expected to average 10% in 2010, according to Bloomberg economists, landing well above the worst case scenario for financial institutions outlined under the Stress Tests in April of 2009 and crippling to the financial strength of the government, as Washington continues to roll over benefits and pay to jobless individual. Third, the shadow inventory of homes, as described by Robert Shiller, will flood the market with more defaults as teaser rates reset higher, even as rates are low, while weakening bonds will inevitably send mortgage rates higher.

Some of the smartest guys in the room are beginning to make calls that hold viral ramifications for the economy. Robert Shiller is predicting higher rates of defaults in the prime mortgage category, while Bill Gross is liquidating most of his exposure to bonds, and still many see this scenario as a victory on il-applied grounds of historical market recoveries. Perhaps confident retailers and mid-chain distributors could lift inventory levels as consumers spend more of what they’ve saved, but there must be widespread consumer spending on services as well as goods, at magnitudes congruent with a boisterous labor market, for 3% GDP to become a reality. At minimal, do your homework before placing your bets on a recovery founded in manufacturing, and at best keep limber to capitalize on the self fulfilling prophecy that equity markets have become when sentiment changes yet again.

Since October 23, BVN has moved from $36.97 to the Friday December 4, 2009 closing price of $39.84, capturing a 7.8% gain. Continuous spot prices for gold are near 1145 this morning, while S&P 500 futures are also down 5 points at 1102, suggesting that BVN will open lower as the December 7, 2009 trading day begins.

We like the company for a long term investment strategy of 5 or more years at these prices, given their promising new La Zanja and Tantahuatay mines. La Zanja is set to come on line in early 2010 and is projected to put out 100,000 ounces of gold per year, while Tantahuatay will come on line in 2011 and should also tack on an additional 100,000 ounces of production. BVN does not hedge their gold prices, so any changes in the price of gold directly effect the bottom line of the firm. The firm is located in Peru, where labor is cheap and the currency is highly tied to the price of precious metals, making the firm an attractive company to own in a high U.S. inflationary environment.

All said we see a shifting sentiment concerning U.S. interest rate policy (markets are beginning to anticipate earlier than expected quantitative tightening by the Fed) and a separately high technical probability that global equities will pull back from current levels.

We suspect there will be a short term pullback of the stock along with the price of gold as the dollar strengthens temporarily, yet we endorse the company as a good investment for medium and long term investors.

Diamond Slice is acting on these signals and closing BVN positions for a profit. The stock will continue to be followed and any positions regarding the stock on our behalf will be fully disclosed to our readers.

Price To Earnings

Twenty four months spanned between the peak 6.5% Federal Funds Rate mid summer 2000 and the screeching halt to 1% in December 2003, where rates would would hover through Independence Day of the following year. Prior to new millennium S&P 500 P/Es in the forties and the ensuing share price slashing, one must scroll back to 1961 to sight a Fed Funds Target below 2% and further to 1954 to find the over night rate below 1%. Similarly, we forget that prior to 1995 the S&P 500 last carried a P/E ratio greater than 25 in 1930, yet this fundamental statistic remained above 20 for the duration of the previous recession and until October of 2008.

The American Dream Home

Prior to the 2001 downturn there had been sweeping legislation to extend the "American Dream" of owning one's own home to those in lower incomes. Mortgages were generally originated by third party shops and purchased by the GSE Fannie Mae and Freddie Mac mortgage strongholds. Beginning in 1996, the United States Department of Housing and Urban Development (HUD) policy mandated that a minimum percentage of the loan portfolios at Fannie and Freddie be sub-median income products, totaling 52% of all GSE guaranteed mortgages by 2003. The appearance of Alt-A, interest-only, and ARM mortgage products became the bread and butter of "lip-smacking" originators, then passed on and digested into fortune 500 banks' balance sheets, as a Moody's/S&P rated package (i.e. CDS & MBS instruments). 

Housing Recovery 1.0

The first time around, households stopped short of buying new homes until 30-yr fixed rates ratcheted below 6% in January 2003 and remained there, tethered to near 1% Fed Funds rates, until October of 2005. Prior to 2003 30-yr fixed rates were last seen near 5.71% before 1971, where the Freddie Mac data stops, while the New York Times vouched that such low rates hadn't been seen since the early 1960's. Ensuing asset price inflation derived from cheap money and an unquenchable demand for homes brought the economy out of recession with a booming pace, as the resultant vector of growth came founded on consumer spending.

Fannie and Freddie

The mortgages purchased by the GSE Fannie Mae and Freddie Mac strongholds, facilitated "zero down" financing to less wealthy individuals wishing to own a home and strong propaganda to hopeful politicians. Barney Frank went on record supporting the HUD policies for riskier mortgages carried by the GSEs and continued to support Fannie and Freddie even as the CEOs endorsed the addition of "Alt-A" products as a major part of their business. Last week the total tally of Government capital infusions at Freddie capped the $60 billion mark, as Paul Miller of FBR Capital claimed "they are going to need [all] $200 billion in capital" promised to the firm by the Treasury.

What The Data Says

GDP data tells us that residential investment increased by an average of 7.35% per year for four full years until leveling off in the fourth quarter of 2005. The mass of capital which flooded the residential real estate market 2002 to 2006 was so great that the four year average residential investment figure jumped 22% from the prior four years, a move of an additional $126 billion/year, while since 2006  residential investment by consumers is down an average of 20% per year.

The yarn of the previous crumbling housing market isn't alone prophetical, but through inspecting recent history we can infer what contribution a recovering housing market could have on GDP, deriving it's effect on the U.S. economy as a whole. 

Fed Quantitative Easing (QE)

Concluding that the only answer to such an indebted private market was to shift the burden of current debt from private to public balance sheets, the U.S. assumed effectively all risk which had caused the large banks to be shorted in the first place. When the overnight target rate for banks to borrow among themselves crashed at 0% and LIBOR (London Inter Bank Overnight Rate) remained high, the Fed resorted to physically buying and insuring the toxic debt which is still defaulting to this day, simply on the public rather than private watch. When the Fed had thrown the proverbial kitchen sink of QE at the problem and the green Obama administration announced banks' shares would remain private, the financial stocks recovered and the broader indexes followed.

Main Street Stimulus

Shell shocked lenders left a shrapnel economy in their wake, claiming 700,000 initial jobless claims at peak and awful consumer confidence numbers. Along came the Obama $700 billion stimulus, said to be designed with shovel ready projects and job creation strategies in mind, but once congress dissected and reconstructed the bill it had that same old pork barrel stink. Obama's C.A.R.S. (Car Allowance Rebate System) program was an effective durable goods stimulus on par with those of China and Brazil, known as "cash for clunkers", which drove new car sales statistics above 10 million units per year for the first time since a year prior in August 2008. 

Housing Stimulus

The "First Time Home Buyer" tax credit, initially announced in 2008 to buoy the falling demand for new homes, was designed as a no interest loan to be paid back over 15 years. When the plan failed to stick, the administration altered the plan to where buyers never had to repay the tax credit and it was increased to a maximum of $8000. As the tax credit was set to expire in December of 2009, congress rushed through a six month extension of the credit, through June 2010. Additionally, the tax credit applies to a much higher tax bracket and to any person wishing to buy a primary residence. Keynes would argue that the expectations of consumers for the tax credit to end would have flushed all first time buyers out of the system thus far but that perhaps second or third time buyers would flock to the offer. The program seems to be working in the short term as the following chart depicts in the bottoming of home prices in the largest 10 and 20 city composite indexes, composed by comparing repeat sales of homes.

The Bottom In Housing

It's plainly obvious that homes prices have stabilized in dollar terms from the chart above, combining with the seasonally adjusted existing home sales increase of 9.2% in September 2009 from a year earlier, thus making a "bottom in housing" a technical victory. Doubly encouraging are the "months of supply" of homes on the market has decreased to 7.8 months from the peak of 11 months in November of 2008. The above data is uplifting and potentially foreshadows a prosperity founded on yet another housing recovery, yet it's equally likely that the devalued U.S. dollar accounts for much of the shift in prices and that stimulus takes recognition for sales. Indeed we would argue that there remains the possibility for home prices to dip lower should the U.S. Dollar gain strength or stimulus effects on sales run their course and resume the previous demand vacum, potentially creating an inflation discounted "real price" which continues to fall.

(Note: Remaining GDP Component growth normally a driving force in the growth and recession of the economy (dark blue), yet in Q3 of 2009 these remaining components accounted for marginally positive growth. Instead stimulus induced Durable Goods (CARS), Residential (1st Home Credit), and Government Spending components carried the growth with an additional boost from inventory restocking.)

China's Role In U.S. Recovery

A recent article in the Economist explains how a similar recovery of asset appreciation tied to exports may result in frothy demand, should domestic consumers begin consuming Chinese services in addition to goods. It would be possible for China to accomplish such a task only if the G20 succeeds in convincing the nation to float its Renminbi currency and increase the purchasing power of it's consumer base, contrary to the export heavy interests of the BRIC leader's central government. How then would an asset appreciation recovery in China effect America's economy, when assets here are only appreciating in dollar terms but remaining flat in foreign currencies (the case in recent months)? We would argue that it would effect America quite badly, and only cause an asset appreciation bubble in China and nations with high enough savings and stimulus to kick start private spending or economies tied closely to commodity production.

Whatever the role housing played in the previous recovery, it's unlikely that early signs of a bottom in the industry will spur favorable growth in the medium term (1-3 years), and that instead this recovery will need to be based in an industry coiled more tightly to spring into production, of which there are no real studs. Perhaps most important is the ability for the global market to truly account for the over-exuberant lifestyles of consumption and greed which led to such hardships, manifested through all forms of global commerce. It was not one flawed industry, cracks in regulation or the failure of markets but instead the failure of self regulation and self inspection at every level, which brought us to the seemingly unanswerable decision between more spending or more pain. 

Standing on the pivot, one might see alternate paths to prosperity or destruction given random series of events and outcomes… What will chance hold for the future of global commerce and markets this time? While a sensibly true recovery may be real for some, the exodus of toxic material from financial balance sheets at every level must come to pass for a harmonious global economic balance of growth to sustain over time.