Diamond Slice

Tepid Fed Remarks Create Potential For Profit

The positive durable goods report, citing new orders up 1.8% for May, fought the May new home sales numbers, below consensus at -0.6% (m/m), as conviction wavered among market movers throughout early trading Wednesday. The crux of the day's market moving news came in the form of the FOMC statement on Federal Reserve policy, where the committee unanimously decided to do... nothing. In a period where capital markets, more specifically Treasury bond traders, have been clawing for clarity, the Fed has decided to issue a statement virtually identical to the statement on April 29th. While Treasury yields have plateaued in the recent week or so, the supply issue concerning a gross $3 Trillion bond issuance over the course of 2009 amidst declining government revenues was holistically ignored.

Crude oil prices may finally be taking notes from reality as rising finished product inventories pulled prices further away from the $70/barrel high water mark amidst increases in refinery capacity and another large draw from crude inventories. The U.S. dollar index jumped higher as Treasury yields also climbed contrary to the price of crude and equity market averages. This relationship between the three suggests that the worsening economy amidst flight to quality and re-deflation trades may depict a new normal. Its natural for Treasury rates to rise until language from the U.S. government suggests a paring back of stimulus spending (unlikely given continuing demand destruction) or defines a strategy to protect the dollar. The relationship where the dollar rises alongside treasury yields will persist until inflation arrives. When this occurs, commodities and the dollar will flip flop back to their current "reflation" trade trends.

For now focus on what's simple. Demand is weak and jobs are scarce, ensuring that until we see a reversal of the price wars in the marketplace and more creative destruction, prices will remain low. The easiest thing to do here would be to go long the 10yr Treasury note rate through an ETF such as the PST which tracks the yield of 7-10 yr Treasuries. For something more exciting look into the DS Positions  which are coiled to spring. 

Support Doubly Significant, Fed Funds Hike Imminent?

On the Monday leading into a busy week of economic data and Wednesday's FOMC Federal Reserve meeting risk takers absconded from the market. The World Bank worsened it's outlook for the global economy from the March prediction for -1.7% to -2.9% growth over the course of 2009. Citing prolonged weakness among impoverished economies the bank explained that the prospects for securing aid to these countries was "bleak". While most have expected a pullback in U.S. equities on the heels of such an impressive rally, the catalyst to spur such a move has been less foreseeable than the static dates representing government decision making over the past year. The S&P 500 50 and 200 day SMA will intersect before the 100 and 200, perhaps driving home the realization of how far stock valuations have come in such short order. Ironically the point of convergence for these levels of support corresponds to the psychologically significant 900 level on the S&P 500.

The FOMC meeting on Wednesday will create a great deal of buzz as the capital markets are pricing in a 50% probability for a 50 basis point Fed Funds rate hike sometime this fall. While the statement from the meeting may remain wholeheartedly "vanilla", the minutes released in a couple weeks may give better perspective to market handicappers. The yield curve continues to steepen and could mean higher profits for banks, yet the steepening process suggests that there may be demand destruction for access to funds as the demand for real goods continues to decline. 

Expect the S&P 500 to close below the 900 level on Monday or assuredly Tuesday if the ICSC Store Sales and Existing Home Sales numbers decline month over month. The NYSE listed companies have been declining over gaining by a factor of 6 on the day. The sentiment could truly be shifting here. Be prepared to move out of long positions and investigate shorts.

Rally Triggers Misfire; Treasury Yields, US Dollar, Crude Oil

Summing up the pieces that have lead us to the strange "here and now" in global financial markets may produce a different result for each market practitioner, yet there are truths agreed upon by most worth mentioning. The purpose of this article is to identify some truths and un-truths, which will provide a fresh slice on Treasury bonds, the US dollar and crude oil assets. 

To begin talking about Treasury bonds we must first identify the balance sheet strength of the U.S. Treasury. Treasury debt issued in 2009 to pay for the current government bailouts and stimulus will total almost $2 Trillion, while financing interest on the current deficit will put the total amount of debt issued over $3 Trillion for the year. Total U.S. debt was $9.4 trillion on June 14 of 2008 and one year later is just above $11.4 trillion (21.36% yoy). Tax revenues slumping on the state and federal levels by nearly 35% makes economic growth extremely important to the future strength of U.S. credit. Still disconcerting are forecasts for GDP should to finish the year at $14 trillion for 2009, providing the optimistic outlook for no net negative growth for the remainder of the year. Similar policies abroad have quickly led Standard and Poors to downgrade the credit rating of the United Kingdom as their debt combined to nearly 100% of GDP (see Britain Solvency Questioned). 

Unfortunately, neutral estimates of 2009 GDP at $14 trillion may easily be surpassed by the federal deficit this time next year, suggesting that a downgrade of America's credit rating may be imminent. While most won't agree that the U.S. will suffer a downgrade, Treasury market yields suggest the U.S. is far less credit worthy at best. The yield curve below shows the shift which has occurred in Treasury yields in the past 30 days.

The basic assumption suggests that a steepening yield curve and higher long term Treasury Note yields ensure that inflation must be occurring in the marketplace. We have seen evidence through commodity prices rising and 10 yr Treasury yields increasing significantly as the U.S. dollar index becomes weaker.  Could we have forgotten to consider the domestic and foreign demand for American goods? The "hope" trade has catapulted the recovery into the hearts and minds of all who watch and participate in financial markets, yet the economic data theme has shifted from "green shoots" to "dead and brown" on falling demand for American goods domestically and abroad. 

The following three charts depict the cycles of the U.S. dollar index, 10 Yr Treasury yield and the WTI crude oil spot price. The current theme of treasury yields and crude oil moving higher opposite the U.S. dollar is synonymous with an economic recovery and is contrary to the relationship seen earlier this year in November. At that time fear engulfed the market and Treasury yields fell with crude prices because Treasuries represented security while crude oil became cheap in anticipation of a deep recession. The dollar was strong during the bottoming periods due to high demand for U.S. Treasuries in a time where there was "nowhere to hide".

 

Many believe the global economic recovery and suggest that China's stimulus has saved their country from collapse, causing such great domestic demand for goods that they are aggressively buying commodities. The story sounds awfully familiar to rhetoric heard during the oil bubble in July of 2008. The truth of the matter, described by consultant to the Chinese government Charles Nenner, is that China has been buying commodities as speculative investments given historically low prices. Higher energy prices due to speculation don't translate into inflated consumer prices and can't manipulate the underlying currency's value. It is important to also realize that consumer prices fluctuate based on the U.S. dollar and foreign currency exchanges as well as the demand for goods. The current account data has shown that consumer demand continues to fall for domestic and foreign goods, but that the foreign demand for American goods is falling less fast and strengthening the dollar. 

Extremely low volume and tepid buying have defined the equity trading environment throughout June and suggest that equity markets are losing momentum to top out in a slow but persistent defeat. The pain felt by consumers throughout the recession has been drastic when compared to previous lifestyles, yet the wealth of our country is so great that true pain has been forgotten. Consumer demand has dropped substantially, yet true fiscal responsibility and humility have still not been attained. Once the true destruction of inefficient firms occurs and prices stabilize, the trend seen recently in the dollar, crude oil and treasuries will make sense.

In the near term, expect for the S&P 500 to trend downward followed by crude oil while de-linking the commodities from movements in Treasury yields. Only when demand returns to the market will there be a sustained move higher in commodities. The move in the stock market suggested that the economy has turned the page and resumed growth, yet economic indicators suggest the opposite. Treasury yields will continue to rise over the long term, adding fear to the equity market, yet commodities and the dollar will de-link from the treasury yields and resume a November-esque relationship until CPI and PPI indicators confirm that inflation has arrived. Wednesday's intra-day bounce off of 905 resistance on the S&P will create more momentum for a deeper dive below these levels on Thursday or Friday. 

Poor Econ Data, Monday Movers Reel-In Positions

Kicking of the June 15-19 trading week, the Dow Jones Industrial Average and S&P 500 both sold off well over 2% and erased previous gains for the month. Should history repeat itself, U.S. equity trading this week will show marginally increased volatility and volume due to the "quadruple witching" day occurring on Friday. The significance of such a day is defined by the clearing and covering tied to the expiration of equity index options, equity index futures, stock options and single stock futures. 

The volume and volatility must be lagging into the March "Quad-Witching" as the sell-off in stocks came quick and early in the day.  Bullish vigor wore thin on Monday as the June Empire State Manufacturing survey fell from -4.6 to -9.4, far below estimates, and the Housing Market Index for the same month dropped from 16 to 15, halting the prior back to back monthly gains. The green shoots are dead and markets will now have to determine whether we're going to have an "indian winter" in equity markets or a true spring renewal. Worse still, the economic winter could very well grow colder and longer. The day consisted of fear among bulls and reluctance among bears, as light volume kept major index averages within a tight range throughout the second half of the day.

President Obama will unveil his plan to increase the regulation of a wide range of financial instruments including OTC derivatives and Credit Default Swaps on Wednesday. However, markets will have plenty to ponder Tuesday as PPI, Housing Starts and Industrial production numbers could verify trouble ahead for the economy. 

Absent Sellers Float Market Higher

Undertaking a balance sheet analysis of any single TARP recipient bank seems "too much like hard work" for most investors. Post FASB revised asset values and TARP fund side effects have tainted the traditional balance sheet appraisal process. It seems that these institutions have become trading vehicles rather than investments and that current valuations of most TARP banks are expensive even after discounting an economic recovery.

On Tuesday the U.S. Treasury announced that ten of the TARP funded banks are being "allowed" to repay their combined debt of $68 billion to the government. While the news came as no surprise to many connected within the industry, the Treasury suggested that the three most disgraced banks (Bank of America (BAC), Wells Fargo (WFC) and Citigroup (C)) will not be allowed to return funds for some time. Those banks that are allowed to return TARP may gain investor confidence but will now be crippled by a weaker balance sheet and an inability to take advantage of a steepened yield curve, while the remaining TARP banks face public shame and criticism as to their ability to compete. All in all TARP repayment looks to be a net zero gain for the industry at this point.

What will influence the financial sector and U.S. equities is the Treasury yield bond curve. The 30yr yield increased today as all yields on notes of less than 30 years actually gained. Resistance on the long end of the curve reinforces the argument for mortgage rates to climb just one day prior to the weekly mortgage report set to be announced on Wednesday morning. Banks' un-leveraged lending margins are growing wider as mortgage rates rise, but will higher borrowing costs kill the consumer on which banks are profiting from?

It's interesting to note that across the blogosphere and online forums, many perma-bears have changed their tunes to jump on the bandwagon and "ride this rally" as retail sales numbers Tuesday morning from Redbook and ICSC suggest that the consumer is going into hiding rather than to the gas pump as crude prices suggest. Don't buy the hype, read the facts.

"Bond King" Insights

Bill Gross of PIMCO began his June outlook statement with the fitting quote from Abraham Lincoln stating, "You can fool some of the people all of the time, and all of the people some of the time, but you cannot fool all of the people all of the time". Perhaps there are a few more fools than visionaries these days, but the unforgiving variable of time will inevitably purge misplaced sentiment from the market consensus. Gross goes on to describe the nature of Americans endorsed most amiably over the past decade, wherein individuals have preferred to be entertained rather than informed. 

Gross adamantly defines the successful investor as one who can "anticipate the herd, ride with it for a substantial period of time, and then begin to reorient portfolios for a changing world." He cites the widening gap between headline and core CPI inflation statistics, preaching that commodity prices will continue to rise and weigh on consumers' purchasing power. While his commendations for future success include investments in commodity based assets and baskets of securities tied to developing countries, he notes that these are alternatives to the sure-fire losses to be seen in Treasury bonds (including TIPS) over the foreseable future. For the more agressive investor Bill Gross asuredly falls short of calling the next big score, yet his proverbial insights are nothing to scoff over.

Thursday offered further evidence that the equity market mentality is overwhelmingly positive, as the market ended higher despite the initial jobless claims report marginally above the consensus at 621,000. The productivity report was well recieved by investors as it suggested a 1.6% increase over the 1st quarter with the cost of labor rising 3.0% in the same period. However, this information was relatively discounted into share prices given the massive number of unemployed amassed during the period, thus relieving businesses of the fixed costs associated with full time employees. 

Optimistic anticipation that the Friday announcement of unemployed workers in May would come in below estimates drove markets higher on Thursday. The consumer credit number should be extremely interesting to watchful traders on Friday and will weigh heavily on the handicaps of banks and consumer descersionary stocks. Gross may be on to something here, as investors and money managers seem to be largely entertained by recent stock market returns rather than informed by top down analysis of the economy. As the S&P 500 flirts above it's 200 day SMA the ability of equity shares to maintain current valuations is more difficult than ever. 

Buyers beware... Sellers keep contact with the trigger...

The Bernanke Backfire

The genre of investing known as "fixed income" has been written off by most investors over the past decade as uninteresting, largely due to the seemingly dry nature of the bond market. Returns on bonds are more stable compared to stocks but generally lag profits made by the basket of S&P 500 equity shares amidst periods of growth. Prudent money managers however, keep ears to the ground as bond yields tend to foreshadow trouble ahead and represent the levels of risk in entities they represent. To individuals and cowboy traders these warnings have been either misunderstood or ignored to various degrees of magnitude. Debt obligations tied to the credit of the "strongest economy in the world" seem to be followed only by eyes behind thick rimmed spectacles in dark closets during booming economic growth, due to their comparatively low yields, yet this was the old norm... not the new.

Recently even Joe the plumber could take a hint from bond rates, as the 30-yr fixed rate mortgage has jumped from its low near 4.75% to 5.36% today, parallel to the increase in 30 year Treasury notes over the same period of time. The Fed and Treasury have both gone on record stating that the path by which the United States emerges from recession must include fixing the housing market, specifically by keeping interest rates low and providing tax incentives for potential buyers to make the leap into ownership. Unfortunately U.S. regulators are playing a game which may be rigged against them as they have exhausted ALL conventional means of quantitative easing with the Federal Funds rate near 0.25% and the discount rate around 0.5%. Simultaneous to Bernanke running out of machine gun rounds, General Obama called for a spending spree of $2 trillion to pay for social programs and incentives to help consumers return to the market place. All the while the acceleration of unemployment is predicted to rise faster in May than in April by the ADP report, which will ensure that government revenues continue to deteriorate.

The last move for the Fed is to decide how much of the $2 trillion of new treasury debt to buy over the course of 2009. If Bernanke chooses to buy more than the promised $300 billion of long term debt, the short term effect may drive down mortgage rates but will also signal to the rest of the world that there is something rotting on our side of the pond. The UK has already suffered a cut by S&P, losing their AAA+ rating, perhaps signaling a similar fate down the line for the United States. The total amount of U.S. debt to be issued in 2009 is actually greater than $3 trillion, when accounting for financing the previous deficit, adding weight to the ballancing act ahead for Bernanke and Co.. 

The unavoidable outcome is a drastic increase in long term bond rates and thus mortgage rates over the next five years, combined with relatively high levels of inflation in hard and soft commodities. While a future "new low" in the global equity market is uncertain, it is ominously concrete that consumers will pay higher prices for the goods they consume at higher borrowing rates. Should the bets made by the U.S. government not trigger a private sector recovery and allow the U.S. to solidify the trust of its global financiers, Treasury rates will continue to climb and drag down the buying power of consumers. 

A Fresh Look At Shorting

A modest trader is a sharp trader and we at Diamond Slice maintain our short strategy, despite the rally extension in U.S. equities . Fundamental economic data continues to show that the broad economy continues to decline despite government stimulus efforts to increase consumers' ability to purchase goods. The home purchase program is extremely attractive and will have soon run it's course, creating short term demand for depressed prices on real estate as first time buyers drudge into the market. The moratorium of foreclosures has ended and all data points to sharp increases in foreclosures throughout the 2009 summer as unemployment continues to rise with no end in sight. 

At Diamond Slice we maintain that a convicted and objective trader will be rewarded for ignoring irrational market movements and allowing time for the combined factors in a winning strategy to take hold. 

Stay informed, objective and diligent while embracing criticism. Happy hunting...

Stimulus Effects Not Yet Seen In Econ Data

U.S. equity averages roared higher Monday on better than expected results from economic indicators including Income, ISM Manufacturing, and Construction Spending reports. Income rose, manufactured new orders popped above 50 for the first time since November, and construction spending surprised higher by 0.8% compared to the expected -0.8%. The average investor heeded positive headlines and bought everything synonymous with a boisterous recovery, from consumer discretionary to industrial transport shares. 

The income report showed slightly decreased consumer spending (-0.1%) and increased income (0.5%) in April, largely due to the temporary stimulus supported increases in unemployment benefits. Construction spending continues to bounce along the bottom, where the month to month April increase in total spending of 0.8% can be deceivingly optimistic. Dissecting the report shows that commercial construction spending actually fell 2.6% (-24.4% yoy) in April while private residential spending remains depressed by 34.4% compared to a year ago. The report is by no means a victory for the Obama administration, which has dumped $850 billion dollars into the economy. The administration has assured taxpayers that much of the money went to "shovel ready" public projects to create jobs, yet only $62.3 billion of the total package has been appropriated to housing, transportation and urban development. More discomfort comes from comparing highway construction spending as shown in the graph of stimulus appropriations below to the actual change in national highway projects. 

According to the graph provided by recovery.org there was $1.6 billion, $12.7 billion and $6.5 billion appropriated to highway construction in the months of February to April. According to the census bureau the change in monthly highway construction spending was $273 million, $2.023 billion, and $-666 million in the same three months. How can investors endorse a temporary stimulus that is unable to keep certain sectors of the economy at a net zero change after $62 billion dollars have been injected to save it?

While the S&P 500 index charged higher to slightly above 940 (200 day SMA), the rise on light volume puttered out around 945. Buyers are flocking into many large cap stocks as more and more managers fear missing the recovery, yet the statistically relevant economic data doesn't fit the move in corporate share valuations. It is a relevant and cleansing exercise to read full economic reports and legislative bills (i.e. the Stimulus Bill) to gain a broad perspective of recent events, yet most have skipped this crucial step and "jumped on the caboose" while the proverbial train began leaving the station on March 9. This is a signal for savvy investors to take a step back at a minimum and to investigate contrarion views during this crucial period.

GM Bankruptcy, Automakers In Focus

While the automotive manufacturing business is a relatively un-complicated process, the logistics of compiling inputs to create a finished product has become more complicated in recent years. Most significant to U.S. investors are the "big three" automakers Ford (F), General Motors (GM), and Chrysler, all of which are finding different degrees of strife in the current downturn. Ford had taken the lead as the gas guzzling brand in the late 90's, releasing the Excursion model that was larger than the quarter-ton GM Suburban chassis yet with no additional seats. However, the rise in gasoline prices from $0.65/gallon on Jan 1, 2000 to $3.41/gallon on July 14, 2008 combined with increased awareness of the effects of greenhouse gasses catalyzed the widespread social stigma against inefficient vehicles. 

Whether Asian automakers Toyota, Honda and Nissan had foreseen the trend towards efficient transportation or simply maintained their strategy of building the best automobiles in the world, Japanese brands took the lead as the largest producers of automobiles in the United States in 2008. Many argue that the UAW (Auto Worker's Union) disabled American companies from competing, yet the responsibility for a crippled U.S. auto industry lies with management. Thankfully Ford employed a CEO from outside the family, breaking the trend since Henry Ford pioneered the assembly line in the early 20th century. Alan Mulally, accredited with turning around Boeing before taking the reigns as Chief Executive at Ford, "set the wheels in motion" to streamline the production process across brands and lines prior to the economic downturn, allowing the company to avoid government assistance. 

Rick Wagoner wasn't so skilled or lucky (see Captain Wagoner Walks the Plank), ultimately failing the company and landing it in bankruptcy to be followed by 60% U.S. and 12% Canadian government stakes in the company. Seemingly similar to the French/German government ownership of the Airplane maker Airbus, the automaker won't see pure private ownership for some time. The bill to tax payers looks to clock in above $50 billion in loans to the GM after nearly $20 billion was provided to Chrysler before Italian Fiat bought the company. 

While GM and Toyota produce nearly the same number of unites per year, Volkswagen outproduces Ford globally, followed closely by South Korean manufacturer Hyundai/KIA. The UAW, corporate leadership and governments involved with the Chrysler and now GM bankruptcies have all made concessions to keep the corporations as stable as possible throughout their transition, job losses and adverse consumer reactions could create more obstacles ahead.