January, Thursday 12, 2012

DOW + 21 = 12471
SPX + 3 = 1295
NAS + 13 = 2724
10 YR YLD +.03 = 1.93%
OIL –1.65 = 99.22
GOLD + 5.60 = 1649.60
SILV + .28 = 30.35
PLAT + 2.00 = 1504.00
In 2011, the market value of U.S. stocks went nowhere from the first trading day, January 3, to the last trading day, December 30. And I mean absolutely nowhere. The S&P 500 started the year at 1,257.64 and ended the year at 1,257.60.
While the market value of the S&P 500 was going absolutely nowhere, its valuation was plummeting. S&P 500 trailing 12-month earnings (through September 30, 2010) started last year at $79 a share and ended the year at $94.64 per share. That means earnings grew at nearly 20%, but prices went nowhere. In fact, prices have gone nowhere for the past 12 years. That’s not exactly true – we are pretty much where we were 12 years ago, but prices moved quite a bit in between. We get into overbought and oversold positions. The question is: where can we find opportunity?
Standard & Poor’s classifies every individual stock into one of ten primary sectors. They then publish specific indexes for each sector (as well as dozens of sub-sectors within the ten primaries). The worst performing S&P sectors for 2011 Financials (-18.4%), Materials (–11.6%), and Industrials (-2.19%). The top performers included Utilities, consumer staples, and health care. Only 3 of the ten sectors were down but the S&P 500 is capitalization weighted; that means each stock and each sector influences the overall index in proportion to its size. The bigger the stock, the bigger the influence. That means the Financial sector dragged the whole index lower. It’s worth noting that the top performers were defensive plays: utilities, consumer staples, and health care.
Now, this is not a roadmap to performance for the New Year. What it does tell us is we should watch the Financials to see if they continue to underperform or if they start to show signs of life. It also tells us that as we enter the New Year the market remains in a defensive mode. The other important thing to watch is that the S&P has climbed back from the lows of October. The world didn’t end; not yet. Europe hasn’t imploded; not yet. The US economy hasn’t fallen off a cliff and it hasn’t fully recovered; not yet. What has happened is that the economy has been recovering, very slowly but recovering. And the S&P has been recovering very slowly as well.
Mario Draghi, president of the European Central Bank says the decision to provide a massive dose of long-term liquidity to the euro area’s troubled banks is helping to stabilize euro-zone debt markets; so the ECB is moving to the sidelines to see how it all shakes out.
The president of the central bank, in his monthly news conference, didn’t suggest that banks or sovereign borrowers are out of the woods, but he noted a “significant, if not substantial,” decline in interest rates across markets. Earlier, the central bank’s governing council left its key lending rate at 1%, matching its historic low.
Let’s start with trying to figure out what’s going on with the financials; easier said than done. You might think that publicly traded companies actually might want investors to be able to understand the financial situation of the companies they invest in. Traditionally, that is a thing that many people want. Much of our system of corporate finance is dedicated to that and it mostly works okay.
A place where it breaks down a bit is in financial institutions. Because big financial institutions more or less take shareholder money, leverage it 10 or 30 times, and invest it all in a large and ever-changing mix of mark-to-market assets, or they just stick a price on it, whatever sounds good at the moment. They do this by assigning a current expected value, and then they adjust that value based upon a variance they designated, and which changes daily and which can’t be disclosed in greater detail because it would create a competitive disadvantage. And if you’re still perplexed about why financials dropped in 2011 or why there has been a miniature rally in the first few days of 2012, just abandon your fears and embrace an external source like the ratings agencies – you know, the bastions of marketplace integrity; or just take solace in the idea that the government will help make the financial institutions solvent, more or less.
So, how do you put a valuation on the banks? Vikram Pandit, the CEO of Citigroup, has an idea: Regulators should create a “benchmark” portfolio and require all financial institutions to measure risk against that benchmark. The benchmark portfolio would not actually exist on the balance sheet of any one institution. Rather, it would be a collection of real investments that stand in for the kinds of assets that most financial institutions actually hold at the time. What is more, its contents would be 100 per cent public.
Institutions would be required to produce, on a quarterly basis for that benchmark portfolio, a hypothetical loan/loss reserve level, value at risk, stress-test results and risk-weighted assets. Right now these measures are run only against an institution’s actual portfolio and only a limited number of the results are disclosed. Worse, those results have no common frame of reference. The benchmark portfolio would supply that needed frame of reference.
And the estimated time to game the benchmarks? One New York second. How do you game the benchmark? Make the benchmark portfolio look much riskier than it should, make you own portfolio look much safer than it really is.
The problem is that any method to value financial institutions can be gamed. The ratings agencies can be bribed; the regulators don’t have the resources to evaluate valuations. Nobody knows the real valuations, and this is why there has been a problem in Europe. The bankers don’t know what the other bankers have on their books.  It turns out that the only solution to valuation is to rely on the government to insure the financial institutions will remain solvent. And what we have seen over the past few months is an implicit guarantee from the ECB, from the Fed, from the various governments. They have said, in not so many words, that they will cover the financial institutions. I know this isn’t a satisfying way to value a vital sector of the market, but it really is the accurate valuation methodology. It’s an imperfect valuation, but it was extremely effective in 2009, and there is every reason to believe it will be effective today – as long as we don’t do something to screw up some other part of the economy.
Now, what could throw a monkey wrench in all the well-made plans? How about a kerfuffle in the Strait of Hormuz that blocks the global flow of oil, even if for a few brief moments. Oil prices have been lingering just above the $100 mark. Any significant move higher would tip the balance in the US and Europe. On January 23rd, The European Union is expected to agree on a ban on imports of Iranian crude oil. As that date approaches the bluster withers. Now, the EU says we might expect to see a slow and gradual implementation of what will eventually become a full embargo. Oh sure, they’re going to get tough on Iran, eventually. And Iran knows this and this is why Iran acts tough. So the race is on to see whether Iran can develop a nuclear program faster than Europe and the United States can develop a solar program.
“Shadow inventory,” the number of homes that are either in foreclosure or are likely to end up in foreclosure, creates substantial but hidden pressure on housing prices and potential losses to banks and investors. This is a critical figure for policymakers and financial services industry executives, since if the number is manageable, that means waiting for the market to digest the overhang might not be such a terrible option. But if shadow inventory is large, housing prices have a good bit further to go before they hit bottom, which has dire consequences for communities, homeowners, and the broader economy.
Yet estimates of shadow inventory, and even the definition of what constitutes shadow inventory property, vary widely. For example, the Wall Street Journal published an article that guesses shadow inventory is between 1.6 million (CoreLogic), to “about 3 million” (Barclays Capital), to 4 million (LPS Applied Analytic), to 4.3 million (Capital Economics), to LPS Applied Analytics, to between 8.2 million and 10.3 million (Laurie Goodman, Amherst Securities), and 9.4 million according to Michael Olenick (of Legalprise).
My guess is that it is probably at the higher end – close to 9 million or so. I’ve looked at the methodology for calculating the estimates, and I won’t bore you with that, but I will give you some anecdotal evidence. One of the most bizarre things is that banks don’t seem to want to recognize shadow inventory; there was a sharp drop in foreclosure filings in 2011 – and it can’t all be attributed to the robo-signing scandal. Banks just don’t seem to want to move foreclosures through the system. They file, they let the case linger, they don’t take possession. There are many examples where banks haven’t taken title to a home even after the judgment is over a year old. Foreclosure defense lawyers have clients who have not paid their mortgage in years, but face neither a foreclosure nor even a negative mark on their credit report. In California, the problem is clogging the courts. After three delays, both parties must approve further delays. Further, there is an incredible tendency for servicers to lose paperwork. A bank may be able to track the purchase of a cup of coffee halfway around the world but they can’t keep track of a mortgage – really? It’s nothing but a delay tactic.
But the big reason to suspect the foreclosure problem is bigger than reported. The Federal Reserve recently got in on the act. Better late than never, Bernanke acknowledged, “Restoring the health of the housing market is a necessary part of a broader strategy for recovery.” And with that, the Fed issued a white paper entitled “The U.S. Housing Market: Current Conditions and Policy Considerations”. After years of completely ignoring the housing crash, the government has revised its HARP refinancing pan, and this time it actually might work, if they can get around to getting the software in order.
And Bernanke is doubling down on the Fed mortgage bet. Since the Fed started buying $1.25 trillion worth of mortgage bonds in January 2009, the value of housing has dropped 4 percent, and is down 32 percent form the 2006 peak. The Fed is poised to buy about $200 billion this year, or more than 20 percent of new loans – part of that is reinvesting debt that’s being paid off, but the figure could jump to $750 billion. The Fed has effectively cranked up a QE 3 stimulus plan – kind of a back door stimulus plan with the use of “Operation Twist”.
That is some serious firepower. And that’s why I’m convinced the problem is more serious than you might be led to believe. You don’t use a bazooka to swat a mosquito.
And guess what? It’s working. Mortgage rates hit a record low this week; a 30-year fixed-rate dropped to 3.89%, and a 15-year fixed-rate averaged 3.16%.
European sovereign debt, the financial institutions, and the housing market – all being artificially supported by the Federal Reserve and the government. It is a crazy way to value the market, but it would be crazier still to fight the trend.
I hope everyone is happy in your head – we’re all doing pretty good in mine.
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