In Focus: Retail Sales

The July retail sales data is due out tomorrow morning at 8:30am EST. A strong number will go a long way to help soothe the market. Last month retail sales decreased 0.9%, following an increase of 1.5% in May. We haven't had consecutive declines in retail sales since Sept.-Oct. 2003 and the consensus estimates are that retail sales will increase 0.2% and retail sales excluding motor vehicles will increase 0.4%.


As investors we care about retail sales because consumption is two-thirds of GDP and weakening consumption could mean that a recession is looming. If consumption remains strong worries that housing market weakness is hurting consumption will ease. If retail sales fall below the estimates look for a rough start to the morning in the markets and an increased chance that the Fed will cut rates in September.

Liquidity Injections and GRE Portfolio Caps

A lot of ink has been wasted talking about our Federal Reserve and Central Bank's around the world injecting liquidity into the market over the last few days. The WSJ had a nice breakdown of some of the activity:
Reading about these liquidity injections sounds scary, but they are not a big deal. While the Fed is currently targeting a Federal Funds rate of 5.25%, the actual rate moves with the market and the Fed must use open market operations to keep the overnight rate as close to 5.25% as possible. When it drifted up towards 6% on Thursday/Friday the Fed acted to bring it back in line. If you go to the NY Fed website you can see that this activity is very normal. The Fed has intervened 25 times since July 19th, the only difference over the last 3 days has been the increase in volume and the statement that the Fed released. All of these operations are temporary "Repo's" and represent nothing more than 3 day loans to banks at 5.25% with MBS as collateral.

The second piece of information that has been floating around is the potential to restore calm to the market by raising the GRE portfolio caps allowing Fannie Mae and Freddie Mac to buy loans above the current $417,000 conforming limit. While this is certainly an option, there is no need to jump to this conclusion now. The OFHEO has already released a statement that they have no intention of raising the caps at the present time.

At a volatile time like this in the market non-news can seem like a big deal. But, after a closer look really not be that big of a deal at all.

Hat Tip: Calculated Risk

A Slow Motion Train Wreck or a Minksy Moment?

There are a few investment professionals whose market commentary and quarterly/annual writings I read religiously in order to get a dose of perspective on the current state of the markets. Among those sages are Warren Buffett, Bill Gross and Jeremy Grantham. Due to their successful investing prowess and long track record I give their thoughts more weight than any of the market pundits and bloggers. I also enjoy reading a blog written by NYU economist Nouriel Roubini. Though not an investor himself he is very knowledgeable and good at detecting risks in the financial system.

Recently both Grantham (pictured above) and Roubini have been quite bearish. Grantham, who manages $150 billion at Grantham, Mayo, Van Otterloo & Co. LLC, describes the current market as a "slow motion train wreck" and sees the biggest opportunity in "anti-risk." Roubini sees the current market as the peak of a Minsky Credit Cycle and sees the credit crisis as worse than the LTCM meltdown. I encourage all of my readers to read both pieces. Grantham's quarterly newsletter can be read here. You may have to register to view Grantham's piece, though it should only take you a few minutes. Roubini's blog post can be read here.

Grantham's musings are quite somber. He starts out with a discussion of tax rates and excesses in private equity (much like Bill Gross did a few weeks back) but then goes on to discuss where he sees opportunity in the markets. Being a "perma-bear" it is not surprising that Grantham sees opportunity in "anti-risk," a more nuanced version of a flight to quality. Here are the highlights from his quarterly newsletter entitled "The Blackstone Peak and the Turning of the Worms":

• "What we have to worry about is whether we are reaching a broad-based level of financial metal fatigue in which bolt after bolt will fail with ultimately disastrous consequences"
• "The odds of failure rise but they probably don’t become high until October 2008. At that time, a new administration with its new broom and new taxes and new antipathy to the financial world's rich, coupled with tighter credit and credit problems, we will have a very typical time, based on history, to have a bear market, and I for one am betting on it."
• "In 40 years I believe I have been offered three obvious and extreme opportunities to make or at least save money . . . the third great opportunity is now upon us in my opinion, and that is anti-risk."
• "In 5 years I expect that at least one major “bank” (broadly defined) will have failed and that up to half the hedge funds and a substantial percentage of the private equity firms in existence today will have simply ceased to exist."
• "I have often been too bearish about the U.S. equity markets in the last 12 years (although bullish on emerging equity markets), but I think it is fair to say that my language has almost never been this dire. The feeling I have today is that of watching a very slow motion train wreck.*"
  

Roubini's (pictured to the right) blog post today is scary though perhaps a little less dire than Grantham's newsletter. Roubini predicts a "hard landing" for the economy but doesn't provide a lot of guidance for investors. Here are some highlights:

• "the current market turmoil is much worse than the liquidity crisis experienced by the US and the global economy in the 1998 LTCM episode. "
• "Today we do not have only a liquidity crisis like in 1998; we also have a insolvency/debt crisis among a variety of borrowers that overborrowed excessively during the boom phase of the latest Minsky Credit Bubble."
• "if you take a bunch of to be defaulted subprime and near prime mortgages and you repackage them into RMBS and then these RMBS are repackaged into various tranches of CDO, the rating agencies may be using magic voodoo to turn those junk BBB- mortgages into AAA tranches of CDO; but this is only voodoo as the underlying assets are going to be defaulted on."
• "The risks of a systemic crisis are rising: liquidity injections and lender of last resort bail out of insolvent borrowers - however necessary and unavoidable during a liquidity panic- will not work; it will only postpone and exacerbate the eventual and unavoidable insolvencies."

Neither of these articles hold good news, particularly if you are still bullish. But, remember that it is incredibly healthy as an investor to have a healthy dose of fear. There is a reason that Warren Buffett's search for an investor to replace himself starts and ends with being aware of risk:

"Over time, markets will do extraordinary, even bizarre, things. A single, big mistake could wipe out a long string of successes. We therefore need someone genetically programmed to recognize and avoid serious risks, including those never before encountered. Certain perils that lurk in investment strategies cannot be spotted by use of the models commonly employed today by financial institutions."

Successful investing is as much about avoiding serious risks as it is about spotting serious opportunities. Such advice is timely right now as we watch some incredibly skilled investors and the black box models they create get "blind-sided" by current market gyrations.

Bargain Hunting In Financials (and Energy)

If you were looking for the right time to buy some of your favorite financial stocks, the day may soon be approaching. A cloud of worry hangs over the sector due to the subprime mortgage fallout and many of the top names have been crushed. When was the last time you could have picked up Morgan Stanley at 7.56 times earnings or Lehman Brothers at 7.67 times earnings? In fact only two of the top 25 S&P 500 stocks with the lowest P/E ratios are not in the financial or energy sectors. A full 2/3rds of this list are financial companies, and many of them are officially on sale.

By the way Valero Energy is the largest refiner in the US and is a screaming buy at 7.88 times earnings. It seems some people have caught on to Valero's deep discount and started buying a few days ago on the dip . .

Fed isn't spooked by Credit Market Woes

I thought that the text of the Fed's release today was exactly what the market needed. The statement acknowledged all of the fears that investors have -- housing downturn, market volatility, credit conditions -- but stuck to its guns on inflation. What the Fed was essentially saying is that all the other concerns are important but are more transitory in nature and don't pose a significant enough threat for the Fed to change its bias. After a brief dip following the release of the statement, the S&P 500 took the encouraging words to heart and finished the day up over half a percent. Here is the text:

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 5-1/4 percent.

Economic growth was moderate during the first half of the year. Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy.

Readings on core inflation have improved modestly in recent months. However, a sustained moderation in inflation pressures has yet to be convincingly demonstrated. Moreover, the high level of resource utilization has the potential to sustain those pressures.

Although the downside risks to growth have increased somewhat, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the outlook for both inflation and economic growth, as implied by incoming information.

I couldn't have said it better myself. The credit crunch and the housing downturn make a lot of news and grab a lot of headlines but there is still no substantial evidence of significant contagion. While I agree with this view, I think Jim Cramer may be a little bit disappointed with the Fed's take.

Yield Curve Inversion Persists

The two months of a normal yield curve we experienced from May 18th- July 20th are now long gone. As of this morning the yield on the 1-month T-bill is 4.946% and the yield on the 30 Year bond is 4.903%.

Hat Tip: Bespoke Investment Group

Unemployment Rate Rises to 4.6%

Job losses in the manufacturing and construction sectors caused the US unemployment rate to tick up from 4.5% to 4.6% in the July BLS data. Wage growth was also largely contained. To economists slowing wage growth and a rise in unemployment may actually be good news. As the economy has cooled in the last few quarters the Fed has held the benchmark federal funds rate stable at 5.25% pointing to above target core inflation as its chief concern. A tight labor market, rising wages and slowing productivity led them to believe that a lack of slack in payrolls could lead to increased inflation as companies would offset their high labor costs with higher prices. A slowly rising unemployment rate and low wage growth could ease those concerns, giving the Fed more flexibility moving forward.

When the Fed meets next week I expect them to again hold rates steady at 5.25%. Bernanke will still list inflation as the chief threat to the economy. But somewhere in the back of his mind slowing growth, core inflation below 2% and a small uptick in unemployment are easing his inflation concerns. If all three trends continue, Fed reports by the end of the year should indicate a neutral stance between growth and inflation, though I do not expect a rate cut this year.

Who Will Subprime Get Next?

The big game in the market these days is figuring out which company or hedge fund will be stung next as a result of fallout from the housing market and the 'too loose for too long' mortgage lending market. First it was the borrowers themselves. After all none of this would be a problem if borrowers weren't defaulting on their home loans. Here's a shocking statistic: foreclosures are now up over 800% year over year. Yes, its safe to say subprime borrowers were the first and hardest hit by the housing slowdown.

Next came the monoline subprime lenders like Accredited Lenders, New Century Financial, Fremont Investment, NovaStar Financial etc. Those firms were hit hard in early March as banks noticed the high default rates and pulled financing. Many ceased operations within weeks and many are no longer 'going concerns'. Subprime lending as we knew it from 2003 - 2006 is almost completely gone.

Next came the homebuilders and the first wave of hedge funds. These hedge funds held either the stocks of subprime lenders or those who held subprime debt, including Thomas K. Brown's Second Curve fund which I wrote about several times back in March.

There are more subprime casualties coming to light every day: almost every single major bank and financial firms has been hurt badly and a small army of hedge funds including Sowood Capital, several Bear Stearns funds and hedge fund legend Paul Tudor Jones' (pictured above) Raptor Fund.

So who will be next? I think there are three areas of interest. First, the banks that did all of the pier lending (a bridge to nowhere) on private equity deals that haven't yet closed. They could be in for a big surprise if the credit markets don't clear up. Second, hedge funds and financial firms that are still marking their subprime debt holdings to model. Once more of this stuff starts hitting the market more and more blow-ups should be uncovered. Finally, foreign investors, governments and insurance companies should get hit very hard. If you check out the graph below you will see that they are some of the biggest buyers of agency mortgage backed securities. We can also presume that they also make up a large portion of private ABS securitizations.
Graph courtesy of Credit Suisse.