Thursday, August 11, 2011

It's been almost a year!

We realize that we haven't published since Aug. '10. Late Wednesday night (and early Thursday morning) we thought we might as well share our thoughts. We weren't just sitting on our you-know-what during the last 12 months. We have been trying to enlighten ourselves by studying financial engineering at University of Michigan. We loved the academic environment so much that we decided to pursue another graduate degree, master of applied economics. Whether we'll realize substantial return on these investments remains to be seen.

Until then, we thought it may be time to review what we had mentioned up to last year.

First, let's start with a simple comparison that we made last year. The table below is self-explanatory. We note that yes, the recent volatility of and semi-correction within the equity market have certainly helped. But even before the latest equity market's dip, gold was and remains ... golden.

Here is some additional data: S&P 500 is down 6.2% during the last ten years, while VIX is up 104.5%.

Second, after reviewing most of our posts, we realized that we were pessimistic when it came to the state of employment; not just ours, but also that of the rest of the country. Well, the picture hasn't improved much since last year.

The 'official' July '10 unemployment rate of 9.5% was only slightly higher than last month's 9.1% rate. July’s U-6 unemployment rate which includes PT workers and the “marginally attached” employed, came in at 16.1%, down about 70bps from the year before. Many, including us, question the methodology used in calculating the official unemployment rate. So let's look at the non-farm payroll figures. Jan. ‘08’s annualized total non-farm count was 137.996MM; last July’s annualized figure was 131.190MM. The private figures for the same periods were 115.610MM and 109.156MM, respectively. We must highlight the fact that 1.258MM and 1.805MM non-farm and private jobs have been added during the last 12 months. However, those figures have been far below expectations.

What about wages? One of the potential impacts of monetary easing that we continued to highlight was that although it may inflate asset prices ('artificially' in our opinion), it will not "trickle down" (as one of our former Presidents used to say) to most Americans in form of cash (higher wages) or jobs. Well, it hasn't trickled down. With inflated asset prices, companies went on a shopping spree for a while, which actually led to more payroll cuts. We discussed most of this in a bit more detail in CEOs Explain Why They're Not Hiring Despite Cash, Rising Profit. In addition to lack of enough job and wage growth, unemployment benefits for many are expiring and many states have not only ended extended unemployment benefits, but have also actually cut the 'default' 26-week benefits.

We also continued to use what we view as leading indicators of the state of employment, weekly initial claims and monthly capacity utilization, to support our belief that the equity market was too far ahead of the economy and the state of employment (thanks to monetary easing). Initial claims disappointed more times than not, and capacity utilization has remained well below the 80.4% average of 1972 - 2010.

Third, we had some doubts regarding the housing market. It appears that we were on the right track. Many housing numbers indicate that we either already have or are well on our way to hitting a double-dip. June’s annualized existing home sales data was 8.8% below last year’s data. Inventory also didn’t look great as the months’ supply went up 4.4% sequentially and 6.7% Y/Y. Other data and charts providing more color on the real-estate market are provided below.

We must say that some regions have seen signs of recovery, but then again, Washington, D.C.; Santa Monica, CA (including Brentwood); San Francisco, CA; Manhattan, NY; Bethesda, MD and other similar regions were not hit nearly as hard as many other areas. We'll take a political risk here and say that the 'rich' areas recovered somewhat and the other areas got hit again; not much is trickling down. One last thing regarding housing - it is obvious that lower rates are not bringing the buyers out of the woodwork. The MBA Mortgage Index has been increasing but mainly driven by refi's and not purchases. So much for that incentive that the government provided to induce people to buy homes.

What has been the benefits of all of this monetary easing (third of which is likely around the corner)? In our opinion, nothing much besides a short-term 'high' for the equity market and some 'artificial turf' instead of the good 'ol 'green shoots' that Bernanke kept talking about. And now the market is getting some turf burns. While the rally of the stock market may have benefited a few, that was just it, only a few.

We are not being political or ideological. We simply believe that the politicians' yearning for power, which translates into thinking about getting re-elected 24/7, combined with the Street's hangover from the stock and housing market bubbles, drove them to push through short-term quick fixes, while ignoring the long-term negative impacts. Many should be familiar with this phrase these days - 'kicking the can down the road.'

And we are referring to nearly all politicians out there on Capitol Hill and in the White House, and in the Treasury and the Fed. Lower interest rates created some liquidity which was desperately needed, but the Fed should know when to say when. We mentioned this a couple of years ago - "What we are looking for is a combination of deleveraging, higher savings rates followed by stabilization in unemployment, all of which represent a slow recovery" - hasn't yet taken place. The deleveraging basically slowed down or stopped when the job and housing markets refused to show recovery. June’s consumer credit ballooned to $15.5bil, nearly 3x the previous month. On top of that, consumer confidence has been declining gradually during the last few months. We still wonder why the government and the Fed wanted to see consumers jump on the back of those credit cards again? After the return of some liquidity, we believe rates should have inched up a bit to induce consumers to save, which in turn would create 'organic' capital for banks to utilize in order to resume lending to qualified individuals and small businesses. Of course this takes a couple of years and that is just too much time for the politicians. They need to continue to provide those quick fixes to keep their voters happy for the time being. It’s pretty disappointing.

In terms of what we would do now, well, that is tough to say. Gold, or the GLD ETF, has treated us well, but we may see a small correction in the short-term given how quickly and significantly the Gold Volatility Index (GVZ) has shot up. We note that the two are somewhat negatively correlated. For this reason, given that GVZ more than doubled during the last month, we believe the GLD upsurge may take a breather. However, we remain bullish on gold for the long-run given that a QE3 is becoming more likely (who could have imagined this!). With regards to the S&P 500, besides a few dead-cat bounces (one which may take place on Thursday as the stock market futures are up at the time that we are writing this piece), we don't think it will recover until it bottoms out which we believe is around the 1,100 level; and is not too far below from where it closed on Wednesday (8/10). Buying some OTM puts on the VIX (Oct. or Nov.) is becoming more and more attractive; then again, the upside for the VIX may be unlimited. But we think that by late Oct. or early Nov. the deficit-reduction 'super-duper' committee will likely tell the markets what they want to hear. If not, the Fed will come to the rescue, which could push the market up in the short-term, pushing VIX down. We note that although VIX has hit new 52-week highs and surpassed the 2010 high, it would have to nearly double to match its 'performance' of 2008.

Given the increasing chances of another recession, sector rotation may be a good move (what a bright idea! :) ). XLP and XLU are attractive ETFs representing the consumer staples and utility sectors, respectively. While these sectors may not bounce back as significantly as some other sectors, their downside risk is also lower than the other sectors. Overall, we’d recommend highly liquid large-cap stocks with strong balance sheets, low betas and high dividend yields. Believe it or not, investment decisions based on fundamentals may pay off. We must say that although the S&P may look attractive from a P/E valuation standpoint, the majority of earnings estimates have not yet been adjusted to account for lower GDP growth (if any) in the 2nd half of CY ’11.  Lastly, although a dead-cat bounce might seem certain on Thursday, we note that the market does react to the initial claims results.  The consensus for that indicator (seasonally adjusted) is 409K, which means the non-adjusted figure has to be around 360K or approx. 20K higher than the prior week.


  1. Great post and glad to see you back. I think it is great how you combine the political reality with real financial analytics.

    One comment about wage increases though: you mentioned you do not believe we are seeing that, but you mention payroll cuts which I believe refers more directly to actual loss of jobs. Wages on the otherhand, for the people who are employed at least, seem to be doing OK and there are people getting raises and companies are not any longer freezing pay. This is mostly conjecture on my part, along with informal talks, and I do not have, nor know where to look, for more formal review of this. If I am right, then this goes more to what you were saying about the rich being OK and the poor not so (what's new). For a parallel in stocks, look at Wholefoods v. Wal-mart.

    thanks and looking forward to more

  2. Bickster, thanks for the kind words bud.

    Regarding your points about wages ... yup, payrolls are basically # of people employed. What I was saying was that with inflated assets, not much was passed down in form of higher wages ... in fact, jobs were cut (cut payrolls) as the combined companies tried to become leaner and meaner :)

    I'll post some data regarding growth in wages in a few. thanks again.