Diamond Slice

"Swinefully" Exuberant Investors Expect Consumer Return

While the Swine Flu "epidemic" has stimulated substantial buzz among global equity markets, the lasting effects of the virus on the consumer are limited. The virus is serious and deserves appropriate responses by the WHO and individual nations but has only killed individuals in nations where timely detection and health care response is limited. Cases of the virus are popping up globally which is naturally fearful for consumers who feel helpless and threatened, regardless of their geographic whereabouts, but the disease is treateable. Experts have identified that the current strain is weaker than expected and has a relatively short lifespan as it is transmitted between hosts.

The strength seen Wednesday in U.S. equities was a direct result of the realization described above combined with hopeful projections that the consumer will increase purchases of goods and services. The positive forecast of consumer spending was founded in the Q1 2009 GDP report which cited an increase in Personal Consumption Expenditures (PCE) by a factor or 2.2%. PCE increased by by 1.0% in January but slowed to 0.2% in February according to the Income and Outlays reports thus far. The Income and Outlays report to be announced Thursday morning will be scrutinized, as a poor PCE number will suggest that the consumer spending trend is less optimistic than the three month average pop reported in the GDP report.

National GDP dropped 6.1% for the first quarter of 2009 mainly due to slashed inventories, decreased government spending, lower exports and far fewer dollars spent on construction. The report cited that fewer imports and improvements in consumer spending softened the otherwise cataclysmic results.

The economic recovery argument has become increasingly popular but ignores the forward indications of economic decay found among the crude oil inventory reports since October of 2008. Over the past six months crude inventories have risen from 290 to 375 million barrels amidst projections of yearly 2009 demand destruction from the IEA. Crude will be tethered to U.S. equities until the "hope" trade exits the market and a reasonable foundation for growth can emerge at cheaper levels.

Mortgage applications struggled to improve over the past week as incentives for cheaper home financing has puttered out. It is now apparent that the bottoming of the 30 year fixed rate near 4.6% has exhausted the "shock and awe" effect among refinancers as buyers maintain a "wait and see" approach to investing in new homes.

The S&P 500 danced around the 875 level for much of the day Wednesday, which market movers have considered resistance to the wedge shaped market over the past few weeks. The level marked a peak for the U.S. equity market on January 28 and has not since been broken. Pay particularly close attention to the March Consumer Income and Outlays report as well as the Jobless Claims report to be announced Thursday morning. These reports may boost or break confidence ahead of the looming stress test results for TARP funded banks, set to be announced Monday. 

The overbought market is founded on false promises from the government and blind hope. Investors have ignored the looming trouble ahead in the economy for far too long. Poor economic reports and the fear of stress test results will absolutely muddle any gains seen today as market movers exit long positions ahead of the uncertain weekend. 

Flirting With The VIX

The Chicago Board Options Exchange Volatility Index, commonly known as the VIX, has secured a spot in the limelight as technical traders and six o'clock news broadcasters have religiously cited the measure throughout the unfolding economic crisis. The index is sometimes referred to as the "fear gauge" as it rises during times of increased market volatility. 

While the magnitude of the VIX can parallel fear among investors in over sold markets, it also corresponds to positive sentiment in over bought market conditions. The measure is calculated by comparing the near-term to next-term options of the S&P 500 (SPX) to give a statistical measure of the potential change in the S&P 500 over the next 30 days. Dividing the VIX by the square root of 12 (representing the monthly % change) gives a rough percentage estimate of the potential change in the S&P 500 over the next 30 days. 

Trusting the VIX currently trading at 37.46 to predict the potential change in the S&P 500 over the next thirty days, one would expect the index to fluctuate by roughly 10.8%. The trouble arises when the technical analysis is factored in with the real state of the economy and the firms it encompasses. When U.S. equity valuations are high with respect to growth the rational investor would expect the fluctuation to average on the downside. However, the sentiment of the market inspires players to become more hopeful or fearful with respect to recent moves in the security prices. 

Take a look at the chart below, which compares the VIX to the S&P 500, to witness the simultaneous highs and lows of the two. While a low VIX does suggest less pessimism in the market, it can be dangerous to take an optimistic forward outlook in a market that still remains extremely volatile. 

"Bobble Head" Earnings Nod Bulls Ahead

Volatile markets ignite "animal spirits" among all participants, provoking individuals to act on emotion rather than rationality. Scroll back to Monday, April 20 (a week ago) and remember the steady relentless sell off, pulling the Dow Jones Industrial Average down roughly 300 points. The weekend trading break has been too much for markets to digest in recent weeks, where this past Saturday and Sunday saw headlines related to the global outbreak of the virus known as "Swine Flu". 

While treading carefully to avoid any politically correct toes, there are interesting parallels to be drawn between the fear of Swine Flu and that of a crumbling financial system. Last weekend language from the president, regulators, and industry CEO's threatened the banking system. Headlines were speculative of future problems such as credit card defaults, government conversion of preferred to common equity, and rates of mortgage default. Similarly, the Swine Flu scare diluted market optimism as the trading week began. 

Speculators placed bets against disease fearful consumers during pre-market trading but confidence re-emerged as markets opened and earnings from Humana (HUM), Whirlpool (WHR) and Corning (GLW) beat estimates. Predictions from most corporations and analysts leading into 2009 Q1 were unrealistically low, causing many firms to beat estimates this earnings season. Each time a major corporation reports another "earnings beat" the confidence of bulls increases parallel to the complacency of bears.

The battle between "top down" and "bottom up" analysis wages on as both sides tread for a solid foundation to their arguments. Top down analysts cite macro economic data as evidence while making cases for an improving or declining economy, yet most currently endorse a "glass half empty" sentiment leading forward. The bottom up school of thought emphasizes firms, industries and countries, making inferences about the global economy as a sum of smaller parts. This approach can be very useful to traders and investors, but only if the strength of firms is analyzed honestly and objectively.

Imagine a scenario where the market had been less pessimistic leading into U.S. Q1 results, but that firms actually performed the same over the three month period. Assuming that profit estimates for firms were higher than actual results, the market would be selling off and citing the majority of negative economic data as proof. Instead the outlook prior to earnings overshot the negative results from U.S. firms and has caused an abundant frothy chatter as each firm reports "better than expected" results. 

Those who are short the market understand this and aren't foolish enough to push further capital in front of firms as they beat earnings while sheepish investors build strategies around the hype. As earnings finish clocking in, the ball must bounce back into the court of the "top down" boys who have dominated downward trends from short positions.

Will the HPI come in much better than expected or store sales find a joyful pop? Perhaps consumer confidence will remain low for April and mortgage refinancing will run out of steam. Optimistic investors will hope for a down trend in initial jobless claims and a pop in personal income/outlays. But will Friday's manufacturing index and factory orders be the dark chocolate icing on a sluggish economic cake?

The proof may be in the pudding but the pudding isn't earnings season... The equity market will show its true colors as it faces hard economic data without "better than expected earnings" contributing to the euphoric aura surrounding current market projections.

Stress Test... What Stress Test?

The specifications of the stress test were released Friday afternoon, but failed to specify what tangible equity requirements banks must keep on their balance sheets. The regulators have specified that they are adding more stringent parameters to the test that will take into account a 22% decrease in home prices throughout 2009 and an additional 7% decline in 2010.

The general consensus following the report, affirmed by language from regulators, is that banks are going to be required to raise more capital. Whether firms will raise capital through the private market or take on more government money is unclear. It seems unfathomable that investors would flock to banks that are taking on additional government money. Likewise, the prospect of the government converting preferred shares to common equity in TARP banks is unfavorable to the average shareholder. 

All in all the future of the TARP debacle is unclear, but the potential for banks to return funds to the government is becoming increasingly smaller. While strong banks would like to repay funds and weaker players hope they won't, the potential for profit growth in the sector is completely dependent on the strength of the consumer. Most corporations have announced extensive plans to cut jobs throughout the rest of the year, making consumer strength increasingly difficult moving forward. 

It's hard to find a solid argument for investing in U.S. stocks, given the current environment, yet buying seems to be "all the rage" right now. Insiders and hedge funds have seen losses throughout the "suckers rally", as some refer to the recent gains, and will be unlikely to chase the increases in equities. Instead it is more likely that the current rally is extremely over-bought. In the five seconds it takes to pull up the Monday intra-day chart of the S&P 500, one can witness how weak the market truly is when selling begins.

Worsening Economy Drowned by Earnings

The Jobless Claims and Existing Home Sales data released Thursday morning affirmed bearish calls for the U.S. economy to worsen. New jobless claims jumped to 640,000 for the week ending 4/18 while continuing claims rose again, this time by 93,000, setting the tally at 6,137,000 unemployed. Existing home sales fell to a rate 4,570,000 homes during March, compared to consensus estimates of 4.7 million, as the supply of existing homes on the market also rose to 9.8 months vs. 9.7 in February. 

Stocks are clinging to good news rather than bad as they made up their losses on the day. The S&P 500 closed nearly one percent higher on the day as optimism concerning banking and consumer strength managed to hold a foundation.

Stocks are acting unrationally and may not heed warnings from macro data until the hype and CEO comments have worn off. The market is in a pivotal point here and will need some more positive data to keep the wind in its sails. 

Mortgage Purchases, Oil Inventories, Earnings

Mortgage purchase applications are much lower for the week ending April 17, reporting a 4.2% decline, even as mortgage rates remain near 4.75% for prime borrowers. The drop in mortgage rates inspired an initial pop of buyers into the market, but it seems that those who had the means to buy at a low rate already have.

Oil inventories influenced commodity traders as well as equity players Wednesday. Crude normally lags the equity market, but recent ballooning of inventory proved bearish to all market movers, inferring decreased broad economic activity. The rise of Crude inventories, reported by the EIA, exceeded the street's estimates and should keep spot prices sluggish.

U.S. equities inched higher in early Wednesday trading as the market digested earnings reports from Yahoo (YHOO), AT&T (T), Wells Fargo (WFC) and McDonalds (MCD). Stocks are claw for footing as the indices aspire to close in the green. Apple (AAPL) may buoy the market, as computer sales stabilization coupled with positive iPhone handheld sentiment would make a positive mark on the broader tech sector. A "miss" from Apple would surely send U.S. equities and hopes down from mid day levels.

Crude Strength Tied to Stocks

Dow components Caterpillar (CAT) and DuPont (DD) are draining the will of investors to remain vested shareholders, as CAT posted its first loss since 1992 and Dupont lowered its 2009 guidance. U.S. stocks weren't the only misfortuned securities Tuesday morning, as crude oil future prices for May and June delivery felt immense downward pressure below $45/ barrel in early trading. Reports continue to roll tape, reporting crude inventories' sustained rise to record levels, amidst the sharp sentiment change with respect to U.S. equities and the derived prospect of a global economic turnaround.

While fundamental issues and speculation are affecting NYMEX and WTI crude spots, the real squeeze Tuesday morning was the result of the short term glut between monthly prices, known as "contango". Contango is broadly defined as the upward sloping curve of future contract prices over time. As contracts approach the trading termination date, the price of the contract becomes volatile. In bull markets, the steepness of the futures curve can pull the contract nearing termination higher, while bear markets allow price decay in near term contracts to drag down longer term future values.

100 million barrels worth of crude tankers floating off the U.S. coast, the EIA estimate of crude inventories nearing a record 370 million barrels and the recent predictions that demand for petroleum based products will deteriorate throughout 2009, set the stage for the oil sell off on Monday. Tuesday morning trading accounted for poor U.S. corporate guidance, futures termination, and the harsh crude fundamentals previously identified, causing May contracts to crash below $45/ barrel. 

Throughout the day Tuesday, crude oil futures recovered and May delivery contracts appreciated towards June prices. The oil futures curve actually remained relatively unchanged, upon May future expiration, as U.S. equities improved, however the true colors of crude trading sentiment were shown in the early hours. The market opened Tuesday as if the bottom had fallen out, as a vicious decline in NYMEX crude spot prices resulted from May delivery contracts falling simultaneous to price decay in future contracts four to six months out. One would expect near term oil futures to react to investors' sentiment but not for the futures curve to maintain its slope and drop in tandem with short term contracts. This reaction of long term contract prices signals the timid lack of confidence among commodity traders and solidifies the argument that crude oil is now reactionary to the U.S. equity market in the short term.

The potential for crude oil to fall steeply from its current level to spot prices closer to $40/barrel in coming weeks is high. Pay close attention to the EIA Petroleum Status inventory levels, mortgage applications and U.S. equity strength on Wednesday. If you subscribe to the theory that equities are due for a pull back, expect to make generous profits shorting crude with an entry point around $47.50.

Disclosure: Short USO

Lewis, Stag in Headlights Upon BAC Sell Off

None were bold enough to put money to work on Monday following the dire Bank of America (BAC) outlook concerning credit cards, mortgage defaults, and capital reserve ratios. The S&P 500 fell more than 4% as equities saw linear destruction across the board.

Financial stocks lead the market lower, signaling the shift in disposition from optimistic to fearful. In an interview towards the end of trading, Ken Lewis relented several truths concerning Bank of America and the financial sector as a whole. In contrast to recent calls for bank loan loss reserves to top out in the near future, Lewis went on record stating that reserves wouldn't recede until the end of 2009. 

Most concerning to financial stocks were the B of A CEO's comments towards the prospect of the government converting their preferred stakes in the TARP banks to common equity shares. The government currently owns almost 40% of Citigroup through preferred shares, taking the option of bankruptcy off the table given further hardship and increasing the likelihood of nationalization. Lewis stated that he would "prefer to pay back TARP, but that [it is] now in the hands of regulators"; a terrifying prospect for all TARP recipients. 

The next leg of the debacle in the form of credit card defaults, has been put on a shelf in recent weeks, but Lewis' statements directed at the industry are worrisome at best. Responding to rumors of potential Federal caps on credit card interest rates, Lewis suggested banks "may have to go a little more upscale to take that into effect, and that wouldn't be good for the country". Deciphering his words, market movers sold off bank shares into the closing bell as the prospect of further consumer credit restrictions and bank write-downs muddled confidence in the system.

Weekend Wanes Momentum

Following the pre-market release of earnings from Bank of America (BAC) on Monday, U.S. equity futures were down sharply across the board. BAC reported 2009 Q1 earnings of $0.44 per share compared to $0.23 per share a year earlier and analysts expectations of $0.04. B of A will present the firm's financial situation in a 9:30 AM conference call, which investors anxiously anticipate may offer clarification of the earnings and revenue numbers. Increased loan loss previsions, discussion of TARP payments and warrants, and foreward looking language concerning the economy will give the market more to chew on throughout the day. 

Oracle (ORCL) plans to buy Sun Microsystems (JAVA) for 42% more than it's closing share price on Friday, valuing Sun at $7.4 billion ($5.6 billion in cash) and boastfully expects the deal to contribute $0.15 per share to Oracle's bottom line in the first year.

Crude Oil dove through the floor Monday morning on harsh U.S. equity futures and negative rhetoric from EU central bankers, citing worsening situations in Germany, Spain and other members. EU unemployment is worsening to levels of 14% in Spain with a glut of temporary and part time workers straining the average consumer. Germany, the Union's industrial leader, forecasts steeper declines in demand for goods and sees the recession as far from over.

Investors are clearly skeptical that the global economy is recovering as positive earnings from BAC and a cash deal between ORCL and JAVA fail to stick. The vicious run enjoyed by U.S. stocks into Friday's closing bell proves "overdone", as market movers leave the table and enjoy their fill ahead of an uncertain earnings week.

Despite Fed, Money Supply Contracts

Deciphering strength among bank stocks ahead of Citi Group (C) Q1 earnings on Friday can be complicated. The sector has increased 45% over the past five weeks inspiring some to call for financials to pull back. Positive earnings news from WFC, GS and JPM have maintained positive sentiment amidst rhetoric from CEO's suggesting further pain ahead on hope that consumers are stronger than expected. 

The real issue for the economy isn't the profitability of financial companies themselves, but instead the functionality of banks to provide credit to consumers and firms, renewing the healthy churn of money through the market. It is no mystery that a drastic deleveraging process has begun, spreading from banks, to firms, to consumers and sparking fears of deflation. 

Deflation is misunderstood by many, since it has rarely emerged during recessionary periods, but the risks of price decay are very real. The M2 money supply which includes all cash changing hands throughout the economy plus savings deposits, CD's and money market accounts is actually falling at an unexpected rate. 

Normally M2 levels are irrelevant to markets because the Federal Funds rate allows the Federal Reserve to dictate the amount of money in circulation. In the current reality, the Federal Funds Rate is at 0.14% (as of April 10) and the Discount Window is open at a rate of .50%, allowing banks and other firms to borrow from the government and each other at extremely low premiums. A flood of liquidity and lending would be the natural result of such policies, yet the weekly M2 data reveals that the 4 week average of money supply peaked in mid march and the rate of decrease is accelerating into April. The data suggests that the effects of most recent Federal Reserve actions are wearing thin ahead of the FOMC meeting in two weeks.

While several phenomena could be stimulating the decline, the real reason for M2 shrinkage is not yet clear. The fall in M2 could be the result of a healthy deleveraging process as banks shore up balance sheets by increasing loan loss provisions and capital rations. A more dismal vantage point may suggest that banks realize they will need to foreclose on more homes as defaults continue to rise and the moratorium on conforming loan foreclosures is expiring. Banks are presently holding many foreclosed properties hoping for better prices and attempting to cash out of these undervalued positions gradually to avoid drowning down the value of performing loans. If banks begin liquidating "legacy" (toxic) assets held on banks balance sheets, they must write down the value of the assets and the loss is recorded as a loss for M2.

Money supply is important to economists as well as traders in this environment, as the pivoting arguments between inflationary and deflationary risks are moving markets. Getting it right could secure the competitive edge to a winning strategy.