Murdoch Wins!

An internal Dow Jones memo confirmed that the Bancroft family accepted Rupert Murdoch's offer to purchase the company late Monday evening. An official press release is expected this evening. Dow Jones is up 12% today on the news. I'll have full coverage of the details tomorrow.

Apparently the deal wasn't reached until after the 5pm deadline imposed by News Corp. Many involved were still reeling from the announcement earlier in the day that a deal was "highly unlikely." It does appear however that after a 3 month courtship a deal has been reached that will satisfy all parties.

How Far will Dow Jones Fall?

News Corp. just announced a few minutes ago that unless they started receiving more support from the Bancroft family it is "highly unlikely" they will continue their bid for the company. Almost immediately afterwords shares of Dow Jones dipped 5% and are approaching $52 after opening at $54.10. Remember the News Corp. offer for Dow Jones is at $60/share. News Corp. had set a 5pm EST deadline today for the vote.

If the deal falls apart it is certainly possible that shares in Dow Jones could drop back under $40 where they sat before the News Corp. offer was announced. This should be a high volume day for the stock.

GDP Clocks In at 3.4%

The 2Q2007 advance GDP number was released today by the Bureau of Economic Analysis. At 3.4% it was above economist expectations, but it is still subject to revision. This is definitely a stronger number than in Q1 when the BEA revised GDP down to 0.6% from 0.7%. Combined, the economy grew at an annual rate of roughly 2% during H1. This is below trend growth and definitely falls into the 'growth recession' range. Here are the important details from the report:

The price index for gross domestic purchases, which measures prices paid by U.S. residents, increased 3.9 percent in the second quarter, compared with an increase of 3.8 percent in the first. Excluding food and energy prices, the price index for gross domestic purchases increased 1.7 percent in the second quarter, compared with 3.1 percent in the first.

Real personal consumption expenditures increased 1.3 percent in the second quarter, compared with an increase of 3.7 percent in the first. Durable good increased 1.6 percent, compared with an increase of 8.8 percent. Nondurable goods decreased 0.8 percent, in contrast to an increase of 3.0 percent.

The price data was good news because core inflation appears to be moderating as the Fed expected. This may give the Fed the flexibility to squeeze in a rate cut later this year if necessary. In fact the futures markets are predicting one rate cut by December.

The Real PCE numbers and durable goods numbers were dismal however and if consumers and businesses continue to slow spending that would have a severe negative impact on the economy. Taken as a whole todays report contained mostly good news, although some, including Nouriel Roubini remain quite pessimistic about H2.

Stocks Fall, Bonds Rally on Recession Worries

Nervous investors have finally begun to step back and appraise the risks of the current market and have decided to take some profits off of the table. As of 3:00 EST all major indexes were off over 3% led by the S&P which was down 3.2%. Those dollars seems to have found a home in treasuries. Treasury prices rallied sending yields back under 4.8% for the first time since the middle of May. As many have predicted, renewed uncertainty about the direction of the market has helped the VIX volatility index reach a 13 month high at 21.95.

There are an abundance of scare factors in the current market. Just check out the list below. This is far from comprehensive but I feel it does highlight some of the main issues:

1. Housing Market Slowdown- What started as a meltdown in the subprime market, has led to tightening credit, skyrocketing foreclosures, construction layoffs, the lowest building permit numbers in a decade, rising mortgage rates, contagion spreading to the alt-A and prime markets and the risk that the housing market weakness could extend well into 2009.
2. Oil Prices - Prices have risen steadily this summer and topped $77 in trading this morning, before settling back down near $75. Even at $75 oil is up over 50% from earlier this year. We are certainly threatening the highs of last summer when crude trading into the $80's before falling in the winter.
3. Consumer Spending - The housing slowdown and rising gasoline prices are starting to eat a hole in consumer's wallets. Retailers, grocers, automobile companies and hotels will be among the first to feel the squeeze. Just this week grocer Supervalue indicated that sales have slumped in the beginning of the third quarter. If consumers clamp up it will be virtually impossible to avoid a recessionary environment. Nouriel Roubini points out that recent data on weekly chain store retail sales suggest that the softness of retail sales in June is extending to July.
   
4. High Yield Debt Market - A lower tolerance for risk among banks has led to rising yields, putting pressure on the financing of merger transactions. The credit squeeze makes private equity firms less likely to pursue major deals to keep the market rallying. Over the past two weeks Blackstone's $12 billion Chrysler financing and KKR's $10 billion Alliance Boots financing hit major snags and were postponed. Investors it seems just can't stomach any more risk in spite of low default rates. This does not bode well for the rest of the $400 billion of merger activity in the pipeline. The credit crunch isn't just effecting the major deals, in total over 32 deals have been postponed, sweetened or restructured in the past month. Meanwhile high yield credit spreads have risen 54% since the beginning of June.
   
5. Corporate Capital Expenditure Weakness - Economists were surprised by a half point decline in durable goods orders in June. The feeling that after a dismal Q42006 and Q12007 capital expenditure would surely rebound in the second half of 2007 is beginning to look more and more like "wishful thinking." Businesses are likely looking at slow consumption growth and wondering why they should spend more money than they have to. In fact economists surveyed by the WSJ identified slow CapEx spending as the biggest threat to the US economy.
6. Recession Odds: In review, the dismal first quarter GDP number of 0.7% even when combined with a strong second quarter of 3% (a guess) still only leave us with 1.8% in H1. If the risks above term out as I expect, growth in H2 should not improve much, if at all, on the 1.8% number. If there was a 12 month recession probability index, it would have gapped up this week.

Apple Up 9.5% On Earnings

Apple announced earnings today after the bell and the news pleased investors. After getting a sneak peak at the success of the iPhone launch after AT&T announced 146,000 new subscribers last week, Apple surprised investors with better than expected iPhone sales of 270,000 units. Of course you must remember that Apple squeezed out the iPhone on June 29th, less than 30 hours before the end of the first quarter. The company expects to have sold 1 million units by the end of the third quarter and 10 million by the end of next year.

The real stars of the quarter however were the Mac and iPod businesses:

Apple said it sold 9.8 million iPods in the quarter, for $1.57 billion in sales, up from 8.1 million iPods, or $1.5 billion, in the same period a year ago.

Apple's Macintosh computer business performed even better.

The company sold more than 1.8 million Macs, for $2.53 billion in sales, up from 1.33 million Macs, or $1.87 billion in sales, during the same period the prior year.

Although Macs represent a small portion of new PC sales -- around 5% in the U.S. -- Apple executives said the 33% unit growth in the Mac business was 2½ times the world-wide unit growth rate of personal computers.

Overall Apple saw earnings jump 73% on a 24% increase in revenue. The stock was up over 9.5% after the close to $150.18, a new 52 week high. Apple is now up almost 80% on the year, after being up less than 10% in 2006.

Apple is also the star of my Equity Select Portfolio, pacing my other 4 stocks by a significant margin.

WSJ Article >> "Apple's iPhone Gives Reassuring Ring to Investors"
Nick Wingfield

Bill Gross Says Enough is Enough

It seems everybody is talking about Bill Gross' investment outlook for August 2007 entitled 'Enough is Enough.' In it Gross opines on growing income inequality in America as well as excesses in the credit markets.

If you want to stay on top of what Gross is saying I encourage you to head over to the PIMCO site and subscribe to the updates via email. (I'm still waiting for them to add a feed to the page . . . . .)

I encourage you to read "Enough is Enough" in its entirety here.

Bancroft's Divided over Murdoch's Bid for Dow Jones

So the Bancroft family had their meeting in a cozy conference room at the Hilton in Boston yesterday. Most of the family attended in person and a few conferenced in via telephone. They received a presentation from bankers, trustees and board members and then broke away to talk in private. They will now be given a few days to deliberate before a final vote will be taken. Here is a quick synopsis of the entire situation:

1. On May 1st it was announced that Rupert Murdoch and News Corp. had placed an unsolicited bid for Dow Jones at $60/share, representing a 65% premium on Dow Jones' closing price the day before of $36.33. The Bancroft family controls 64% of the voting shares of Dow Jones. Most of the remaining voting shares are for the sale. Murdoch needs slightly less than half of the Bancroft's to side with him in order to win the company.
2. Several other bids have emerged, including bids by former MySpace CEO Brad Greenspan and supermarket magnate Ron Burkle, but it is unlikely that either bid will succeed.
3. Deliberations have gone on for months now and the meeting yesterday is the last before a family-wide vote. Rupert Murdoch gave the Bancroft's a one week deadline to reach a resolution.
4. Yesterday's results via the WSJ: "Their conclusion was clear: While they viewed the offer as a substantial one that would give Dow Jones much-needed resources to expand, they acknowledged that it would be difficult to guarantee that The Wall Street Journal's editorial independence would survive a sale, even under the guidelines agreed to by Dow Jones's board and News Corp."
5. The key new piece of information: "Jane MacElree, a family trustee who votes shares totaling about 15% of Dow Jones's total shareholder power, made it clear to the family she was in the anti-Murdoch camp, people familiar said. Ms. MacElree, a member of the Cox branch, is one of the most senior Bancrofts and has been viewed as a swing vote. Her decision could put her at odds with some of her seven children, who support the deal."
6. When will we know the results? "Family members . . . will be given several days to cast their votes on the deal, and it could be next week before the results of the poll are known."

So there you have it. The meeting occurred. One more trustee is against the sale to Murdoch, but the key issues remain unchanged. We should know the results of the vote by next week. For its part, the street is slightly discounting the possibility of the sale going through and the stock is sitting at $53.44 off 2.3% since the meeting yesterday. While this is less than the $60 if the deal goes through it is still far above the value the stock will likely drop to if the deal falls through. The odds still seem to be in Murdoch's favor.

Via the WSJ: "New Opposition Arises to Dow Jones Deal"

China Inc. is at it Again

China's state investment company made its first big play back in March when it bought a stake in the Blackstone Group for $3 billion. That investment is still underwater, but that hasn't stemmed China's interest in investments outside the world of US Treasury's. Today it was announced that a Chinese government controlled bank and Temasek, Singapore's state-controlled investment arm, have agreed to buy a stake in Barclay's bank. That move will generate the cash that Barclay's needs to purchase ABN Amro. China's advisor on the deal? You guessed it . . . . Blackstone Advisory. Here's the story from Jason Dean at the WSJ:

BEIJING – China Development Bank's planned stake in Barclays PLC could become the largest overseas investment by a Chinese company to date, and underscores the growing role China Inc. is playing the global corporate arena.

China Development Bank, a Chinese-government controlled policy lender, and Temasek Holdings Pte. Ltd., a Singapore government investment agency, will together invest as much as €13.4 billion ($18.54 billion) in Barclays, the British financial group announced Monday.

China Development's stake will be the larger of the two: it will buy up to 2.2 billion euros of new shares in Barclays initially, amounting to a 3.1% stake, Barclays said. China Development will then buy as much as €7.6 billion worth of additional Barclays's shares, if the British bank's bid succeeds for ABN Amro Holding NV – and if the deal wins regulatory approval, Barclays said.

If the whole deal is completed, China Development would spend a total of $13.5 billion for its stake in a newly enlarged Barclays, dwarfing other overseas deals by Chinese institutions.

Earlier this year, China's government agreed to invest $3 billion of the country's foreign-exchange reserves in U.S. private-equity giant Blackstone Group. In October 2005, China National Petroleum Corp. agreed to buy PetroKazakhstan Inc. for $4.18 billion. Earlier that year, Lenovo Group Ltd. bought the personal-computer division of International Business Machines Corp. for $1.25 billion.

Chinese companies have tried for bigger deals before – and failed. In 2005, China's Cnooc Ltd. abandoned an $18.5 billion bid to acquire U.S. oil producer Unocal Corp. after a heated political firestorm that has deterred high-profile deals ever since.

China Development may seem an unlikely investor for Barclays. Set up in 1994 by China's cabinet, its primary mission is to make policy loans to support Chinese government economic policies, such as to big infrastructure projects and to rural enterprises. In its 2006 annual report, China Development states its mission as "strengthening the competitiveness of our economy and improving the living standards of our people."

However, China's government has also been pushing the country's expanded economic activities overseas. China Development's annual report also acknowledged its growing part in this effort, saying: "In answer to the call of the State to encourage domestic enterprises to 'Go Global,' the Bank engages in a wide range of international cooperative activities."

China Development said it had been advised in the deal by Blackstone Advisory, an arm of Blackstone Group.

"Barclays Stake Sale Shows Rising Role of China Inc."
Jason Dean

Blackstone's Struggles Continue

Blackstone is trading 20% below its IPO price. Fortress is back near its 52-week low. Yesterday, hedge fund giant Man Group's brokerage arm -- MF Global -- fell dramatically after its IPO after being priced underneath its offering range. In London, Daniel Loeb's Third Point LLC listed a hedge fund that raised $525 million, which was far short of the $690 million it hoped to raise. The market is bearish on anything that smells of private equity or hedge funds right now, either due to systemic risk stemming from the subprime shakeout, worries about a tax hike on carried interest or just concerns that we have reached a peak in the market.

Blackstone was off another 5% today after a miserable month. The company now trades at a PE of 9.67. Just to bring this in to perspective, Blackstone is now trading cheaper than brokerage firms like Bear Stearns and UBS. I think the market may not know how to value a management company like Blackstone. Remember this is a company that has had virtually uninterrupted growth over the last 20 years. They attract some of the top talent on the street. They sold a sizable stake to China which tells me they should have access to the Chinese market that other firms just won't have. Yet, every day the stock goes down.

The questions then become:

1. At what price does Blackstone become a buy?
2. Will Blackstone's struggles scare off Och-Ziff or KKR?
3. Are investors realizing that non-voting shares in master limited partnerships have far more risk that voting shares in public corporations?

Google Misses Earnings, Drops 7.5% After Hours

After missing earnings today after the bell Google is trading down almost 8% in after hours trading. Google could trade tomorrow back in the 400's . . . . territory it hasn't visited since the end of May. This is only the second time Google has missed earnings and obviously the market was not impressed with Google's 28% profit growth. The 7.5% drop washed away roughly $13 billion of market value.

Crude Approaches $76 a Barrel

Light sweet crude is approaching $76 a barrel after dipping as low as $55 earlier in the year. That's a 38% increase for those of you counting at home. We now look poised to explore the highs from last summer. The good news is the stock market seems to totally ignore crude oil prices these days . . .

Opening Day at the Races in Del Mar

I will be at the Del Mar Racetrack today for the opening day festivities. I'll be back at it tomorrow.

In the meantime you can debate whether or not the Bancroft family will vote to sell Dow Jones to Rupert Murdoch now that the Board has approved the sale.

Is the Credit Meltdown Finally Here?

The trickle of disturbing data about the credit market has reached a veritable flood in the last few weeks. We are seeing the subprime meltdown continue as well as problems in the high yield debt market. Here are a few of the highlights from the last week:

1. According to Bloomberg there have been over 20 postponed or restructured financing deals in recent weeks and more on the horizon.
   
2. High yield spreads have widened 27% since June 1st, yet still remain at historic lows. I am inclined to think that once a major LBO collapses we could see spreads widen substantially in the weeks and months ahead.(Hat Tip:Bespoke Investment Group)
3. Cerberus announced today that the tighter credit markets forced them to sweeten their Chrysler financing from 3.25% above LIBOR to 3.75% above LIBOR. I expect similar changes on almost every other major deal (yes First Data, I mean you) still out there . . . of which there are about $200 billion.
4. I'm scared everyday when I go online and check the Markit indices because everyday I am shocked and awed by the declines. Today was no different. The LCDX Index that tracks bank loans is approaching 96 with a spread of 229:

   Time / Date	Price	Spread
   4pm Close (17Jul07)	96.14	229.1
   Midday (17Jul07)	96.60	214.7
   4pm Close (16Jul07)	97.06	200.9
   Midday (16Jul07)	97.42	190.4

5. In the subprime world, investors in the troubled Bear Stearns hedge funds were told today that: "preliminary estimates show there is effectively no value left for the investors in the Enhanced Leverage Fund and very little value left for investors in the High-GradeFund as of June 30th." That is scary news.
6. The Markit ABX Index continues a plunge that the WSJ market blog calls a "bloodbath". The BBB index is down to 45 from 97 in January, the A index is at 68 from 100, the AA index is at 88 from 100 and the AAA is at 95 from 100. Clearly every credit quality is getting hurt, not just subprime. But I have to admit this BBB chart is by far the ugliest:

So what is an investor to do?

• If you have a bond portfolio I would recommend two actions: 1) focus on high credit quality, 2) shorten your duration.
  
• If you are very ambitious you can look into buying an ETF or mutual fund that tracks the inverse of the junk bond market. Check out this article from the Wall Street Journal from a fund that was launched 2 years ago.
• You may want to stay away from Blackstone and Fortress for a while in case investors flee quickly out of fear that PE management companies aren't where you want to be if the market dries up.
• Don't ditch your long term asset allocation, but you may want to focus on large cap equities and blue chip stocks for the time being as their borrowing costs will stay lower during a swoon in the credit market.
  

The Fed and Energy Prices

There has been a simmering debate about whether the Fed is focusing on the right measurement of inflation. The Fed prefers to use core Personal Consumption Expenditure (PCE) in its Taylor Rule. Economists use core PCE to eliminate "noise" from the data. They do this by stripping out volatile food and energy prices, which the Fed has no control over. Critics like Barry Ritholtz like to call this "inflation ex-inflation", since the headline inflation numbers which include food and energy have shown higher inflation. Thus in the great inflation debate you argue either for the core or the headline inflation data. The key questions are:

Should a central bank accomodate energy price shocks? Should the central bank use core inflation or headline inflation with the volatile energy component in its Taylor rule?

These are the questions that two economists -- Rajeev Dhawan and Karsten Jeske -- at the Federal Reserve Bank of Atlanta set out to answer, most likely in response to clamoring in the media that the the Fed was ignoring the average American consumer by ignoring food and energy prices. So what did Dhawan and Jeske conclude in their paper entitled "Taylor Rules with Headline Inflation: A Bad Idea." (I guess the title kind of gives it away . . .)

• While the central bank cannot completely shield the economy from an energy price spike, a monetary policy that responds to core inflation does better than one that responds to headline (total) inflation.
• The less weight given to energy inflation, the lower the impact of an energy price shock on GDP and subsequent inflation. In fact, the central bank can lessen the impact of such a shock by assigning a negative weight to energy inflation, so long as it remains vigilant on core inflation.
• Rebalancing between durable goods and fixed capital investment is key in explaining this unconventional wisdom.
• Results vindicate the claim of Bernanke, Gertler and Watson (1997) that a less aggressive response by the Federal Reserve to the energy price increases of the 1970s would have stabilized inflation without harming economic growth.

It seems the academics are not flinching from their stance that the core numbers are the more important numbers to focus on. Take that Barry Ritholtz! (Hat Tip: CXO Advisory)

Currency Harvest ETF Looks Promising

The Powershares G10 Currency Harvest Fund (DBV - PDF Fact Sheet) has steadily gathered assets and has performed very well so far this year with a YTD return of 13.22%.


Here's the definition of what the fund does from the PowerShares website:

The Index is comprised of currency futures contracts on certain G10 currencies and is designed to exploit the trend that currencies associated with relatively high interest rates, on average, tend to rise in value relative to currencies associated with relatively low interest rates. The G10 currency universe from which the index selects currently includes U.S. Dollars, Euros, Japanese Yen, Canadian Dollars, Swiss Francs, British Pounds, Australian Dollars, New Zealand Dollars, Norwegian Krone and Swedish Krona.

The current portfolio is long the Aussie Dollar, New Zealand Dollar and British Pound and short the Japanese Yen, Swedish Krona and Swiss Franc:
Throughout the year, the weightings of each commodity component in the Index will naturally change based on changes in the underlying futures prices. The Fund's underlying holdings are rebalanced to the Index's base weights.

What I find particularly attractive about the index performance is that it has performed very well in tough years for the stock market and it only has one negative year on its record:


We are continually evaluating new ETF offerings, and this is another example of a fund that appears to offer good currency exposure for buy and hold investors with limited tolerance for volatility.

Equity Select Portfolio, 21.4% YTD

The five equities I track for fun as part of my "Equity Select Portfolio" have delivered a total return YTD of 21.4%, scorching the S&P 500 by 11.75%. I do not actually have any of my own money invested in this portfolio. It is used solely as a research tool.


I will continue to track them to see how they do in the second half with an occasional update. The holdings are:

1. Goldman Sachs (GS)- My Top Pick at the beginning of the year. It has performed admirably but has been bogged down recently by concerns about subprime contagion. This stock is a long term hold.
   
2. Affiliated Managers Group (AMG) - My Second Pick at the beginning of the year. This is a play on the continued boom in boutique asset management firms. This stock is a long term hold.
3. Google (GOOG) - My third pick at the beginning of the year. While I had some concerns about valuation I think Google is well positioned to prosper for the foreseeable future as online ad revenue continues to skyrocket. I have also been impressed at their ability to attract talented employees. This is another long term hold.
   
4. Apple (AAPL) - My fourth pick at the beginning of the year. In spite of its phenomenal outperformance I have been nervous about this stock all year. I even encouraged a bit of profit taking leading up to the iPhone release. Apple is an innovation machine and we are all along for the ride. While I sleep well with my top three selections, Apple does make me nervous.
   
5. BHP Billiton (BHP) - BHP was purchased on July 11th with the proceeds from the sale of Sears Holdings, which was removed from the list. BHP was promoted off of my Best Ideas list after a strong outperformance in the first half. I am very nervous about this stock going forward given its sensitivity to commodity prices but it has the best story from my Best Ideas List. The other stock that almost took its place was Fortress Investment Group (FIG). However, I am comfortably exposed to private equity and hedge funds through GS and AMG and don't see the need to overexpose myself. BHP is also the only foreign stock I hold. The other options on my Best Ideas list included BIDU, RIG and CVS.
   

CHANGES: Sears Holdings was the latest casualty from the list. While I do believe that Eddie Lampert will find a way to right this ship the company faces intense headwinds from a weakened consumer and stiff competition. I'd rather put money into ESL than dump it into SHLD.

Beckham, Cuban, Whole Foods and More

Here is some light weekend reading.

1. David Beckham has arrived in LA to try to make footb . . . . I mean soccer, as popular here as in the rest of the world. While this is clearly an uphill battle, I think at least among women he may make some headway.
2. Mark Cuban has spoken about buying the Cubs for years, but it looks like he has finally made his move. Unfortunately for him actually landing the team may be an uphill battle. Lets just say his $1.5 million of NBA fines may work against him . . .
   
3. Whole Foods CEO John Mackey bragged about his company for years on the Yahoo Finance message boards. Now the SEC is sniffing around. A word to the wise; never write anything that could some day come around to bite you in the . . . .

Now for the heavy weekend reading (proceed with caution):

1. Barry Ritholtz has been angry with the Federal Reserve for using core inflation instead of headline inflation. I think some of his rants make sense. He is also mad at the people who calculate the unemployment rate -- he seems to think the real number is higher than 4.5%. I tend to agree.
2. Stephen Schwarzman has found a way to pay much less in taxes from the proceeds of Blackstone's IPO. Which may explain why Hillary Clinton wants Schwarzman to pay a higher tax rate on his carried interest . . . . Is this Hillary's strategy to win over big business? (if you really want to understand carried interest, read this)
   
3. This blog post by Brad Setser explains why I am not worried about the amazing reserve growth of BRIC countries, which he estimates will grow by $800bb this year.
   

Tracking Commercial Real Estate with the CMBX Indices

It was through NYU economist Nouriel Roubini that I first learned about Markit's series of ABX indices that track subprime mortgage debt. So it is no surprise that it is through Roubini that I learned about Markit's CMBX indices. The CMBX Indices track the Commercial Mortgage backed securities market, which is the commercial equivalent of the residential mortgage backed securities market (RMBS).

I've written about the potential for weakness in commercial paper before. In fact I wrote a post back on May 2nd entitled "Froth in Commercial Real Estate." In that post I described how lenders were using insanely high rent growth projections in order to justify loans. The scary thing is the way the commercial market is unraveling is eerily similar to the subprime problem on the residential side.

1. First the lenders tighten up or disappear. This step is already happening. This is from the Wall Street Journal: "In the last three months, lenders have pulled back somewhat, tightened covenants and required borrowers to put up more cash. " While this is obviously different than say what happened to New Century Financial on the residential side, it is clear that lenders are at least starting to tighten up.
2. Investors price in the risk and the Markit indices show the change. This is already occurring. The CMBX index for the riskiest commercial loans has already widened considerably. See below:
3. Finally, the existing debt gets crushed in the secondary market as more and more borrowers default. This hasn't yet happened on the commercial side. In fact defaults are still at a low point historically. But, the rating agencies are calling for rising defaults in the months to come.

Is the commercial mortgage market the next shoe to drop? Nouriel Roubini thinks so, and he sure did call the subprime meltdown.

Foreclosures Jump 87%

I mentioned yesterday in a post on the subprime meltdown that I thought the next round of foreclosure data would be particularly brutal. Well it is. But before we dive into the numbers please check out this "foreclosure heat map" courtesy of Barry Ritholtz. I think its safe to say things are going to be getting a lot hotter as the summer goes on.

Okay, now on to the numbers. This morning Bloomberg reported that US foreclosures increased 87% in June:

There were 164,644 loan default notices, scheduled auctions and bank repossessions in June, led by filings in California and Florida, where home prices have plummeted, and Ohio and Michigan, where automotive-related businesses have fired workers. Those four states accounted for half the national total, RealtyTrac, a seller of foreclosure data, said today in a statement.

Foreclosures are soaring amid a glut of properties and as interest rates close to an 11-month high make it more difficult for borrowers to refinance. Defaults may rise further as owners with adjustable rates see their payments soar. The share of people taking out all types of adjustable-rate home loans averaged 29 percent during the past three years, compared with the 17 percent average of the prior three years, according to Freddie Mac data.

RealtyTrac also said that 58% of the foreclosures are from subprime borrowers. What does this mean? It means that the lower end of the real estate market will be hit the hardest. Which states are the worst? You guessed it, the two states with perhaps more subprime lending than any other:

Nevada had the highest foreclosure rate in June with one filing for every 175 households, more than four times the national average of one per 704, RealtyTrac said. Nevada had 4,722 foreclosure filings, more than three times its total a year ago.

California had the second-highest rate, with one filing per 315 households, and the most filings overall, 38,801, for the sixth month in a row. Foreclosures in California, the most populous state, increased almost three-fold over a year ago.

Why am I so sure that foreclosures will continue to pick up? I hate to beat a dead horse, but if you look at the chart below we are just now entering a huge wave of resetting subprime loans. There really won't be much relief for the next 16 months. (Click to Enlarge)

This alone wouldn't be a huge deal if it weren't for the following three things that will lead many of these borrowers into foreclosure:

1. Tighter Lending Standards - There is virtually no subprime lending going on right now.
   
2. Lower Home Prices - Many if not most of these borrowers are underwater.
3. Higher mortgage rates - See graph below - We are at a 5 year high!

BHP Billiton: A Great Commodity Play

BHP is the world's largest diversified resource company and is dual listed on the London and Australian stock exchanges. Its roots date back to the 1800's but it has existed as BHP Billiton since 2001 following the merger of BHP with Billiton. The company maintains its headquarters in Melbourne, Australia. BHP explores for, mines or produces the following commodities: Petroleum, Aluminum, Base Metals (silver, zinc, lead, uranium etc.), Carbon Steel Materials, Diamonds, Energy Coal and Stainless Steel Materials.

The company has benefited greatly in recent years from rising commodity prices and will in all likelihood continue to do so in the future. While I do like some of BHP's rivals, namely Anglo-American (AAUK) and Rio Tinto (RTP), I think BHP is the best of the bunch. The company has fatter margins than its rivals and trades at a forward PE of 15 even after its dramatic rise over the last 5 years, when it has been up 488%. While I prefer using commodity futures to get direct commodity exposure, a company like BHP can get similar exposure with some idiosyncratic risk.
BHP is up over 72% this year, RTP is up 45% and AAUK us up over 32%. It has been a hot sector, which makes me a little bit nervous. But, I still think rising demand for commodities from China, India and elsewhere make the sector a good value even at these prices.

Subprime is Officially Melting Down

Those of us who have been saying for a while that our subprime problems are far from done have been feeling validated over the past few weeks. Here's why:

• Two weeks ago a Bear Stearns hedge fund blew up forcing Bear into a $1.6 billion bailout. That sent Bear's stock tumbling and Bear's CEO James Cayne to the golf course? Yes, that's right Mr. Cayne dealt with a tough situation by pulling out his driver. Check out his scores over the past few weeks below: If you look at Cayne's scorecard you will notice that on June 21st, the day several big lenders were pressuring Bear to increase collateral, Cayne shot a 98. On the 22nd when Bear announced what was then a $2 billion bailout, Cayne shot a 97. How he found 8 hours over those two days to play golf is incredible! I have to admit I admire his persistence, even after this story appeared in the press Cayne has continued golfing and his scores are actually improving!
  
• The ABX BBB Index has fallen consistently from its highs in the 90's at the beginning of the year and is now trading in the 40's with no signs of stopping. No one wants to hang on to subprime debt . . .
• Moody's and S&P completely missed the subprime fiasco, and they are now furiously downgrading subprime bonds and the CDO's that hold them. Moody's said today they are going to cut the credit rating on slices of $5 billion worth of CDO's. This a day after S&P decided to cut ratings on $12 billion of bonds and revamp their entire rating methodology. Fitch also sounded an alarm today about commercial real estate, predicting rising defaults in the months to come. Below is a graph of the number of bonds Moody's has downgraded over the years. Too little too late if you ask me:
• The National Association of Realtors is lowering its 2007 sales predictions again! What good is a prediction if you lower it every single month?
  

Yes folks this subprime thing isn't over yet. The foreclosure statistics for June come out this week and as of two weeks into the month San Diego was on pace for a 36% rise in foreclosures from an already elevated number. Yes, folks, the bottom is falling out of the housing market.

Emerging Market ETF Options

Vanguard's Emerging Markets ETF (VWO) is beatings its iShares rival (EEM) by 3.18% YTD. Vanguard's VWO is up 23.87% on the year, the MSCI EM Index is up 22.31% and EEM is up 20.89%. Since both funds supposedly track the same index -- the MSCI Emerging Markets Free index -- the high tracking error is bad news for both companies, but is particularly bad for iShares as investors typically are more accomodative if the tracking error leaves them ahead. The Vanguard fund has one other advantage, its expense ratio is 0.30% vs. 0.75% for the iShares fund. But, in spite of these apparent advantages the iShares fund is still 9.5 times larger than the Vanguard fund, proving once again that it is notoriously hard for ETF providers to make up ground on the market leader. We were early adopters of the iShares EEM ETF but are currently looking at VWO as a viable alternative.

The source of the difference may well be the allocation of each ETF to each emerging market country. If you look at the Vanguard fund you will notice that it has slightly more exposure to India, Russia, Brazil, Taiwan and South Korea and less exposure to Mexico, South Africa and China.


While I don't think that the VWO outperformance will necessarily persist, its low expense ratio is attractive. The iShares fund has to beat Vanguard's VWO by 45 basis points a year in order to overcome the difference. That alone may be a good reason for the switch. Since we usually supplement our MSCI EM exposure with country specific ETF's the specific country allocations become less important and the need to obtain cheap beta more important.

San Diego Gas Price Convergence

Gas prices in San Diego are typically 20-40 cents above the national average. However, in the past 3 months prices in San Diego have converged upon the national price. The last time the prices converged was briefly in late 2005. If anyone has any explanation for why this has occurred I am all ears. Oh, and I do anticipate that prices have one more upward spike in them during late summer before retreating back under $3 in November/December.

Asset Allocation with Commodities and TIPs

In a post from June 8th about Bill Gross I discussed the importance of commodity and TIPS exposure in a portfolio. Today's market provided a brilliant example of why commodities and TIPS work as diversifiers. In a day where most equity indexes were down over 1% two ETF's performed quite well: the Powershares DB Commodity Index (DBC) and iShares TIPS (TIP).

1. iShares TIPS (TIP) +0.79%
2. Powershares DB Commodity (DBC) +0.68%
   
3. Dow -1.09%
4. NASD -1.15%
5. S&P 500 -1.41%

Moody's Is Resilient

The feature article in the Money & Investing section of the Wall Street Journal this morning pointed the spotlight on Moody's Corp (MCO). The gist of the article is that Moody's and the other credit ratings agencies are taking heat for "missing" the subprime debt meltdown and short sellers are betting they will lose clients and revenue. Moody's (MCO) traded down all day on the news, closing down 1.11 to 60.39, a loss of 1.8%. In after hours trading it has dropped another 9 cents.

Personally I would be surprised if Moody's traded significantly below $60/share without the help of broader market declines. Why? Well, Moody's has been through this before. They took a lot of flak when they "missed" the problems at Enron and Worldcom; certainly this is no different. The stock may have already priced in future declines as it is already nearly 20% off of its 52-week moving average. On top of those factors Moody's is a resilient company. It has fat margins, rich clients and very little serious competition. I would watch this one closely in the days in months to come. Don't be surprised if Warren Buffett ups his 17.5% stake in the company if the stock dips into the 50's.

Clean Energy and Water

Two ETF offerings from PowerShares -- PBW and PHO -- have been core parts of the commodity allocation of our portfolios over the past 12 months and have performed very well.

We started buying the Powershares WilderHill Clean Energy ETF (PBW) around this time last year when the fund was trading in the 17's. At the time the fund had retreated almost 40% from its high on the year. It is up 28% so far YTD and we continue to feel that it is still well positioned to take advantage of investor interest in clean energy technology. It has accumulated roughly $900 million of investor money.

We started buying the Powershares Water Resources ETF (PHO) in 2006 as well, accumulating when PHO was trading under $19. The fund is up almost 16% YTD and has accumulated $1.54 billion of assets.

We still like PHO but we are currently analyzing a new Powershares ETF called the Global Water Portfolio (PIO). The fund just launched and only has $47.79MM of assets but due to its global slant it may be more attractive in the long run than PHO. The two ETF's are actually very similar and share 13 of the same holdings, which is about a third of each fund. (Shared holdings are highlighted, click to enlarge.)

The main advantage of PIO is that it offers broader international exposure. It has holding in Japan, the UK, Singapore, Canada, China, Austria, Germany, France and Finland as seen below:
I wouldn't be surprised that if PIO attracts enough assets it will show up in our portfolios sometime later this year. We have also looked at the Claymore Global Water ETF (CGW) and the First Trust ISE Water Index ETF (FIW).

Presidential (Un)Popularity and the Electronic Futures Markets

President George W. Bush's approval rating has been under 40% for quite some time now. This is not a good sign for Bush or for the Republican's in the next election. However, if you look at all the Presidents since Truman, each one -- with the notable exception of Dwight Eisenhower -- has spent at least part of their term with a rating near 40%. The one thing that is interesting about W however is the fact that since 9/11 he has been on a very steady downward slide. Thank you to the Wall Street Journal for the interesting analysis. (Hat Tip: Barry Ritholtz) Click the photo to enlarge.So who is lining up to replace W? For the Donkeys Hillary Clinton and Barack Obama are in a dead heat on InTrade, the political futures trading website:

For the Elephants it looks like Rudy Giuliani and late entrant Fred Thompson are racing neck in neck:

Add Hank Paulson to the Bottom Callers Casualty List

The latest victim of calling the housing bottom is Treasury Secretary Hank Paulson. It's a real shame too because I really do like Hank. But, earlier today Paulson repeated comments he made way back in April:

"In terms of looking at housing, most of us believe that it's at or near the bottom," he told Reuters. "It's had a significant impact on the economy. No one is forecasting when, with any degree of clarity, that the upturn is going to come other than it's at or near the bottom."

Well, its been 3 months since April and there hasn't been a single good data point on the housing market other than the strong employment numbers. In fact the crucial numbers like excess inventory and prices are still looking worse and worse. Check out this graph below which shows excess inventory and housing starts (click to enlarge).

Basically, until inventory drops housing starts will probably continue to fall which puts increased downward pressure on prices and GDP. If you ask me calling the bottom of home prices now could pose a serious threat to the integrity of one's professional opinion. I know I wouldn't do it! But of course I'm in a win-win position. If I'm right, I'll be right, which is gratifying. If I'm wrong, and housing is at the bottom then that is great for the economy, great for all you homeowners and great for all of our investments! (Hat Tip: Calculated Risk)