As we noted last quarter, this is an increasingly confusing economic environment in which to invest – both at home and abroad.  The cross-currents within the economy are formidable, with massive government stimulus clouding the underlying strength of the rebound, solid inventory restocking patiently awaiting a noticeable pickup in consumer demand, and an already weak employment picture being skewed through temporary census hiring and statistical massaging.   

Unfortunately, it’s not getting any easier.

The Slow Train Wreck that is the Economy

What is apparent is that the U.S. economy is again slowing now that much of the 2009 economic stimulus packages have worked their way through the economy.  Moving past the “cash for clunkers” program we find that new auto sales have fallen again and are now stagnant at an annual run rate of about 11 million units, when replacement demand alone should dictate sales of approximately 14 million units.

Home sales have taken another leg down following expiration of the homebuyer tax credit, with new home sales in May down to a seasonally adjusted 300k annual rate – nearly 80% below all-time highs and 32% below April’s level.  Over the past few months pricing has held but banks are becoming more aggressive in foreclosing on delinquent borrowers, and home prices look to again be on the verge of turning lower.  The national mortgage delinquency rate rose to 9.2% in May from 7.9% a year earlier, and an estimated 24% of all property owners have mortgages greater than the value of their homes. 

Employment statistics paint a sloppy picture as well.  Weekly initial unemployment claims continue to hover north of 450k, where they’ve been most of the year. Economists estimate that initial claims need to come in consistently below 400k to signal resumed growth in U.S. jobs.  The official unemployment rate rests at an uncomfortable 9.5% and the employment-to-population ratio is down to 58.5% from the mid-60’s prior to the downturn.  Businesses, while no longer shedding jobs aggressively are not hiring either, and state and local governments are only in the early stages of rightsizing their personnel.  More importantly, large numbers of unemployed are now running through their 99 weeks of un-employment insurance and a further extension of these benefits looks unlikely.  It’s going to be a long, slow road back to full employment.

Oh, and yeah, consumer credit continues to contract as well.  Revolving credit (mostly credit cards) is down more than 13% since the end of 2008.  We’re now back to levels last seen at the end of 2005.

Unfortunately, the situation in Europe isn’t any better, with the regions leaders voicing their intent to reign in spending, at the cost of growth, at the recent G20 Summit in Toronto.  With all the world’s developed countries planning to boost growth through exports – who might the buyers be?

HFT Algorithms do not a Market Make

We’d love to turn optimistic, but by our read the economic evidence is proving increasingly overcast; perhaps the economy never really rebounded in the first place.

With favorable economic data unlikely to be a catalyst for upside stock market action in the near-term, investors have largely stepped aside of the market and trading volume has collapsed.  What volume remains is increasingly controlled by short-term players –Wall Street bank proprietary traders, private independent High Frequency Trading (HFT) boutiques, and hedge funds, intent on making the next buck, not a long-term wager on any individual company’s success or failure.

As such, the structure of the global equity market has been altered, quite dramatically.  Though these changes remain largely un-noticed by the general population, the evidence is apparent to those closer to the action.  They include an overwhelming focus on “technical levels” as opposed to company specific or economic news, higher correlation amongst individual stocks, and less liquidity as market participants automatically pull bids at the slightest sign of turbulence.

We’re in a “binary” market where trends stay in tact until support or resistance levels typically turn the tide on no underlying fundamental developments.  On the S&P 500 those technical levels are 1040, 1080, 1100, 1120, etc.  Violate one and move to the next – as an example, here’s the trading pattern for Thursday July 15th.  Notice how the market trades down to 1080, holds, and then turns up - with the obligatory sprint upward at the close?

Source: Yahoo! Finance

It’s a “risk-on, risk-off” world where channels between technical levels get traversed with increasing speed and individual stocks are more likely to trade as a package driven by ETF purchases and sales instead of company specific news.  As the Wall Street Journal noted July 12th in an article entitled: The Herd Instinct Takes Over:

 

Correlation is on the rise, to the frustration of investors who are trying to analyze stocks based on their underlying strengths and weaknesses.

 

The market's flock-like behavior is one more reflection of the growing influence of investors using broad-based strategies to buy and sell large blocks of stocks. "It is an indexing market and not a market for stocks. On good days everything goes up, and on bad days everything goes down. Everyone talks about baskets or sectors," says Jeffrey Yale Rubin, research director at Birinyi Associates. "It is harder for individual investors and even for mutual-fund managers to distinguish themselves by doing individual stock picks. They might get the product right and the earnings right, but the market goes down and the stock is going to go down as well."

Stir in the “Flash Crash” of May 6, 2010 which points to the fact that market liquidity may be more of an illusion than a reality, and it all leads investors to a general unease with regards to the stock market. 

Awash in Cash, but Still Not Cheap Enough

With regards to individual company fundamentals and their market valuations, the news is mixed.  With roughly $1.8 trillion on the balance sheets of S&P500 companies (perhaps the largest amount in history?) there is little doubt corporate America is well protected in case of a renewed downturn.  Companies have cut costs to the bone over the past few years and are, in a sense, self-insuring their financing needs through excess cash on their balance sheets.  There’s no need to deploy that capital into added industrial equipment - at 74.1%, the national capacity utilization rate remains well below its historical average.  Besides the consumer just hasn’t returned in a big way yet.

On overall market valuation, we defer to John Hussman’s always astute analysis. He’s got the data and a rigorous methodology for separating the apples from the oranges in deciphering whether valuations are cheap, or rich.  Here are his current thoughts:

“On a valuation basis, the S&P 500 remains about 40% above historical norms on the basis of normalized earnings. The disparity between our valuation assessment and the putative undervaluation being touted by Wall Street analysts is so great that a few remarks are in order. First, virtually every assessment that "stocks are cheap" here is based on the ratio of the S&P 500 to year-ahead operating earnings estimates, and often comes with a comparison of the resulting "earnings yield" with the depressed 10-year Treasury yield. What's fascinating about this is that this is the same basis on which analysts deemed stocks to be about 40% undervalued just prior to the 2007 top, following which the market plunged by more than half…

 

…When you hear analysts say that the historical average P/E ratio is about 15, you have to recognize that this is the normal P/E based on trailing 12-month earnings after subtracting all writeoffs and other charges. Forward operating earnings are invariably much higher, and it turns out that the comparable historical norm, as I discuss in that 2007 piece, is only about 12. If you exclude the late 1990's bubble valuations, you get a historical norm closer to 11.5. The 1982 and 1974 market lows occurred at about 6 times estimated forward operating earnings.

 

A final observation is crucial. Current forward operating earnings estimates assume profit margins for the S&P 500 companies that are nearly 50% above their long-term historical norms. While we did observe such profit margins for a brief shining moment in 2007, profit margins are extraordinarily cyclical. Investors will walk themselves over a cliff if they price stocks as if profit margins, going forward, will be dramatically and sustainably higher than U.S. companies achieved in all of market history. 

So, economic fundamentals deteriorating – check.  Market returns increasingly driven by short-term technicals on less volume – check.   Market indices still sufficiently over-valued relative to long-term historical levels – check.  Exactly how much faith should investors have in this environment to warrant significant stock exposure?

Icing on the cake?  Meredith Whitney, whom along with Chris Whalen we view as the most astute financial sector analysts in the industry, sees a good deal of pain for the banking sector over the next year.   Non-performing loans are ballooning; they’ve doubled within the past year at the top 4 banks and are now greater than all the mortgages that have been written off since 2005, the Bank for International Settlement’s “Basel III” accords are likely to require banks to raise substantially more capital, and the U.S. financial regulation reform bill will likely hinder earnings.  A must watch video on Meredith’s current thoughts can be found here.

While we’re finding quite a few individual stocks attractively priced at this juncture, overall we prefer to keep the volatility of client accounts low by staying nearly fully hedged here.  With yields of 8.5% or more to be found in preferred stocks, exchange-traded oil & gas transportation MLPs, and high-yield corporate debt, we’ll continue to focus on generating sustainable income as opposed to risking substantial funds on equities at this time.

Call us in a quarter, or two.

Last year we noted the ongoing debate with regards to the outlook for inflation – specifically whether we as a country are more likely to experience rapid inflation driven by aggressive Federal Reserve money printing, or deflation as an outcome of declining credit and demand, over the coming years.  This is a question one should have a view on as the ultimate answer will greatly impact the financial returns for most economic sectors.  Getting it right will matter a lot.

Recently, two individuals who’s economic and market commentary we both enjoy and respect sat down to debate the issue.  David Rosenberg argued the deflationary case, while Jim Grant sides with the inflationists.  The resulting video, “the Great Debate” of March 23, 2010 is posted on Mr. Grant's website.

While it’s a rather long discussion, it’s highly both educational and entertaining.  We think you’ll take away more than a few ideas from Mr.’s Rosenberg and Grant.

The goal of individual retirement investors is to generate positive returns over an extended period to provide a financial base for their life in retirement.  Historically stock markets have offered the best means for achieving success in this endeavor as returns have averaged on the order of 2% better than those of the bond markets. 

This fact has been well advertised within the financial media and retirement plan participants are easily seduced to over-allocate to the sector on the premise that they can ride out any ensuing storms and will be better off in the long-term for doing so.  At no time is this strategy more alluring than in the middle of strong stock market advances – such as now, as the psychology of missing out on potential upside, in the short-term, overwhelms longer-term judgment.  Unfortunately, short-term financial market performance is dictated by mass sentiment.

Yet if one steps back and looks at the data a bit deeper it’s clear that long-term, sustainable returns are driven by starting valuations, not sentiment.  No clearer example exists for investors today than to recognize that the U.S. stock market’s return over the past twelve has been essentially zero.  Investors starting with a lump sum twelve years ago would have roughly doubled their investment by merely holding a diversified mix of bonds, stock investors would have gained nothing.

Think about this for a moment – the past dozen years have been full of dynamic changes in the way we communicate, healthcare, the source of the goods we buy, the composition of fuel that powers our cars and homes, and the very way in which we transact business day-to-day.  Yet in aggregate these changes haven’t been compensated in the financial markets; they were all fully priced in twelve years ago. 

An obvious optimal investment strategy would marry both market sentiment, to tactically position ones assets with the prevailing winds,, and valuations to strategically allocate amongst stocks and bonds. Unfortunately this is a proposition most fund managers aren’t willing to undertake – as short-term fund rankings dominate the decision making of most retail investors, and their investment dollars.  In the quest for short-term profitability most mutual fund companies have conceded to the adage of “sell the public what they want, not necessarily what is good for them”.

One manager who stands apart, and has had an enviable track record doing so, is John Hussman, manager of the Hussman Strategic Growth fund.  Where most managers are custodians shackled to the returns inherent in the sector, or sectors, in which they cast their lot, Hussman is a steward, actively balancing the short and long-term risks and rewards inherent in market sentiment and valuation.  We’ve grown quite fond of his weekly missives and feel all investors could gain markedly from his insights.

The sad truth is that investment options like the Hussman Stategic Growth fund – focused on long-term capital appreciation, even if it means dramatically altering the investment mix over time - haven’t made it into the lineups of a vast majority of retirement plans.  While plan participants would have been better off for having access to such an option, the career risk for pension consultants and benefits employees in doing so is simply too high.  Better to stick with less controversial options – the lowest cost index funds, or target date funds that systematically adjust their mix based on a pre-specified time-to-retirement approach – than to risk short-term criticism.

Our goal is to provide readers a service similar to Mr. Hussman for plan participants of select 401(k) plans and retail investors who avail themselves of the Fidelity, Schwab and TD Ameritrade brokerage platforms.  As such, we will often be uncomfortably out-of-favor over select shorter-term periods, but hopefully continue to add 3% to 5% in excess returns over a full market cycle.

Today, by our readings, the investment landscape is at an extreme – unabashedly positive short-term momentum coupled with excruciatingly high valuations.  While S&P 500 P/E ratios based on operating earning expectations of $78 per share for 2010 and $93 per share for 2011 look sanguine and seem to support the market’s enthusiasm, the estimates themselves are aggressive – up 37% in 2010 and an additional 20% in 2011.  Remember, these are operating earnings – driven solely by sales growth and margin expansion.  To us, it’s quite a stretch to think sales can grow north of 10% in aggregate in 2010 and harder to see how margin expansion can fill the gap.

The details behind the aggregate lend a disturbing tone to the quality of recent, and upcoming future, earnings.  According to David Rosenberg of Gluskin Sheff, a stunning 85% of the earnings growth since the recession lows have come from the financial sector.  The aggregate, excluding financials, is growing at a much more subdued 5%-6%.

The same financial sector that has benefited the most from the suspension of “mark to market” rules is now leading the “recovery”.  Perhaps garbage assets on the books of the too-big-to-fail banks can’t be sold, but they sure can be written up!  Japan in the 1990’s on steroids. 

So strategically we can either hold our noses, drink the Kool-Aid, and buy stocks aggressively at these levels, or recognize that short-term momentum is a phenomenon that typically turns on a dime without notice – in which case we remain defensively positioned.  We continue to choose the latter.

In both our Wealth Advisor and managed accounts, we’ve taken more aggressive defensive posturing, which hasn’t helped recent performance, but will notably buffer our results when sentiment inevitably shifts.

Throw out the economic playbooks – this is one confusing recovery.  A full 28 months after the downturn and nearly $2 trillion in stimulus and the U.S. economy remains mired in a listless funk. 

It’s a jobless recovery for sure.  Unemployment, officially pegged at 9.7%, but north of 16.9% when those either under-employed or so discouraged they’ve given up looking are included, has only just begun to show an anemic upturn.  The March jobs report released April 2nd showed a net increase of 162k jobs – not robust by any post-recession standard; but take out the short-term hires for the 2010 census (48k) and subtract the 81k added through the Department of Labor’s statistical massaging known as the “Birth/Death” model and we’re back to 33k in new, net long-term hires.  For a labor pool of 153 million that have lost a cumulative 8.4 million jobs during this downturn, this month’s report is a rounding error, not a recovery!

The good news behind the headline – the average hours worked extended by 0.1 hours, to 34 per week.  The bad news – average wages were down by $0.02.

Our read is that while layoffs have slowed, employers have little need or incentive to hire.  State and local governments have no funds to do so.  Companies have figured out how to run lean operations and in the process build up strong cash reserves, and the stock market continues to reward them.  No need for further hiring without more robust demand. 

Outside of employment, the consumer is again showing some signs of life.  Retail sales have notably revived the last few months rising 3.4% year-over-year for the first two months of 2010.  Yet, these gains have come at the expense of the national savings rate, which declined to 3.1% in February from 3.4% in January, and 4.0% at the end of 2009.  Couple this drawdown in savings with stagnant average hourly earnings and the fact that consumer credit continues to contract – down 4.4%, or greater than $113 billion since year-end 2008, and it’s tough to envision recent retail sales gains as sustainable.

With the U.S. stock market up 70% from the March 9, 2009 lows, historic 4-quarter P/E ratios at better than 20x earnings and forecasts for a 30-40% earnings recovery in 2010–  very high expectations are built into today’s stock prices.  30-40% earnings growth in 2010 is very unlikely considering that as of September 2009 year-over-year revenue for the S&P 500 was down 10.8%. 

In order to achieve earnings of this magnitude, either sales growth comes back strongly or companies continue to pare costs.   Strong sales growth looks increasingly unlikely after weak holiday sales (don’t be fooled by the “same-store” sales numbers – there are less stores around this year than last so total sales were weaker than the headlines reported) and only tepid inventory rebuilding to date.  The consumer makes up nearly 70% of the economy, and with savings/debt reduction the new norm (revolving credit was down better than 9% YTD through November 2009), it’s unlikely we see a big return to spending any time soon. 

So, are company’s going to continue aggressively cutting costs to generate this earnings growth?  It’s difficult to see how they could given the magnitude of jobs taken out of the economy since the downturn started nearly 2 years ago (better than 7 million) and stable to rising commodity prices.

What has held equity prices at such lofty valuations over the last three quarters has been government intervention, plain and simple.  A relaxing of reporting standards for the banking sector, incentives for home purchases, cash-for-clunkers and other short-term spending initiatives all have served to prop up the economy in the short-run, but cloud the longer-term picture.  Strong organic, or naturally occurring, growth is what is needed to sustain a recovery and that is something we don’t have, nor are likely to have, in the foreseeable future.

The one factor that could give corporate earnings growth another short-term artificial boost is the potential for write-ups in the financial sector.   To the extent that they’ve written down a lot of debt over the past few years due to bad collateral and unstable markets, might more stability in the credit markets induce banks to revalue their troubled assets upwards over the coming year? 

We certainly hope not and believe that if anything the fragility of bank balance sheets continues to be under-reported.  Yet we can’t rule such moves out.  After all, who would have thought big banks would have the audacity to repay TARP funds within months after receipt in order to pave the way for renewed executive bonus payments.  Short-term thinking continues to dominate decision-making, regardless of long-term ramifications.

So, almost needless to say, we remain defensively positioned again this quarter in both our model portfolios, and managed accounts.  While optimistic sentiment has been a formidable headwind to our views of late, the situation is eerily similar to early 2007 – the problems are staring market participants in the face, yet they refuse to acknowledge them.

The financial markets continued to heal during the final quarter of 2009, with the broad U.S. stock market gaining an additional 5.9% - as defined by the Russell 3000 stock market index.  Corporate spreads tightened aggressively and riskier credits are once again borrowing; signaling a sense of normalcy, or perhaps even complacency, returning to the investment world.

As is usual coming out of a recession, and has been the case since this rebound commenced in March 2009, growth stocks generally continued to fare far better than their value-oriented counterparts across the capitalization spectrum (as seen in the table below).  On the growth side of the spectrum, the larger the capitalization of the company, the better it generally performed in Q4, as larger companies are viewed as having more exposure to foreign markets and with the dollar depreciating their foreign currency revenues translate into more U.S. dollars.  Conversely, small and micro-cap stocks continued to struggle, probably owing to both all-domestic revenue exposure, and poorer propects for credit.

(Sidenote Commentary: It’s a true tragedy that in times of economic turmoil small companies (which are the engine of economic growth over the long-term) are both crowded out of the financial system and treated as second-class citizens when it comes to economic stimulus.)

From a dollar perspective, developed foreign markets struggled to keep pace with their U.S. contemporaries during the quarter but emerging markets continued to tack on excess gains (most are pegged to the dollar in some way) with the Vanguard Emerging Markets Index fund up 8.31%.

Natural resource shares held a strong bid throughout the quarter as purchases from China highlighted demand and gold sped higher on enthusiasm over central bank buying.  We have a hunch precious metals will continue to be well-bid throughout the coming years, as paper money continues to devalue against hard assets.

Mirroring stocks, bond credit risk was well compensated throughout the quarter with corporate spreads collapsing in both the high-grade and high-yield sectors.  The easy money has been made here – though a strong argument can be made for continued investment.

Economically real U.S. GDP came in at 2.2% (final revision) in Q3, 2009, much below the historical 7% average recession rebound.  Of the third-quarter total, most analysts conclude that better than 90% was government induced – cash for clunkers, first-time homebuyers, and public work projects.  As reinforced by recent jobs data, this is a slow, slow recovery and there should be plenty of concerns remaining over its buoyancy once stimulus begins being withdrawn – yet that doesn’t seem to be the case with the markets.

Financial markets continued to move steadfastly higher throughout the quarter with only brief pullbacks to punctuate the advance.  Analyst upgrades set the tone while better than expected headline economic data often masked continued deterioration below the surface, yet was given the benefit of a doubt.  Worse than expected data was either completely ignored or cast in a positive light – typically that the Fed would refrain from tightening rates for an extended period.

Notably, as the market has moved higher, far beyond what we perceive as fair value, technical trading has come to the fore as traders and investors alike become enamored with support and resistance levels, channels, and moving averages.  Trading technicals is all nice and good, but highlights the short-term confusion amongst participants.  “I don’t want to miss out on possible upside here, but I’m not real convinced of the longer-term value proposition at these levels…I know I’ll just go along with the others.  Unfortunately, the end result once again is an unsustainable rise in asset class correlations.  Dollar down, gold prices higher, bond prices higher, equities prices higher.  Rinse and repeat.  Of course again it will end badly – the question is when.  ‘Nuff said.

Well my friends, after six and a half long years and a lot of nail-biting along the way, the time has come for a major change of positioning based on our operating earnings model for the S&P 500 index.  This quarter we’re initiating a “sell” rating on the broad market with a buy target of 724, a full 30% lower than current levels.

If you recall our model is predicated on the belief that a good indicator of market value can be derived from the latest four quarters of operating earnings, lagged a quarter – so today’s valuations stem from earnings released for Q1 2009.  Contrary to popular opinion, our historical backtests show that the market doesn’t typically price in earnings until one full quarter after they’re released. Standard opinion remains that the market is forward looking, digesting news before it’s released.  We haven’t found evidence of that.

Based on 20+ years of quarterly data, our model suggests that operating earnings, lagged one quarter, explain roughly 74% of the broad stock market level with a standard error of just shy of 200 points.

From early 2003 through the end of 2008, the model seemed to have broken down as reported operating earnings suggested much higher levels for the market than we were able to achieve.  In hindsight, our interpretation is that market participants were not drawn in by what may be found to be artificially high operating margins during the period – inflated by an unstable amount of leverage in the system.  Instead, they skeptically discounted these margins, keeping a lid on market appreciation.

Time will tell, as at current levels, the market is now implicitly pricing in a resumption in these historically high margins.  Funny how that works.

A couple of side notes – if we do happen to achieve the current level of earnings being proffered by Wall Street analysts, fair value six months forward would be close to 1300 – a better than 20% leap from current market levels.  Yet at today’s valuation we’re pricing in about $46 of rolling operating earnings – again about 20% higher than realized earnings of $39.79. 

We know for certain that next quarter’s input to our model is $38.30, so one thing’s for sure - the next few quarters of earnings announcement will be crucial in determining future direction; and a lot of growth is already baked in the cake.

Proprietary Valuation Model Says "Buy" - but be Cautious

We haven’t updated readers on the recommendations gleaned from our S&P 500 valuation model since the first quarter of 2008.  A lot has changed since that time and we thought it appropriate to visit this gauge once again.

A bit of background is in order first.  We’ve developed a “fair value” estimate of the S&P 500 using historical operating earnings going back to 1988.  At the time the model was constructed we also tested “as reported” earnings but found that operating earnings, lagged one quarter, explained more of the current level of S&P 500 index values.  When the market moves lower than one standard deviation below current “fair value” our model flashes a buy rating.  When the market moves more than one standard deviation above fair value, the model signals a sell rating.

As shown in the graph above, over the long-term our model has had notable success in signaling appropriate times to move into, and out of, the broad stock market.  It suggested a purchase in late 1995 and a subsequent sale in early 1999 – avoiding much of the tail end of the internet bubble and subsequent bust.

Yet the last five years have been frustrating, as our approximation of fair value ran far, far ahead of the market.  Our model has had a buy rating on stocks now since early 2003.  Even the sharp downturn in earnings to date has not triggered a sell signal.   What’s been at work here?

Others have noted the elevated profit margins of recent years amongst the companies that make up the S&P 500 index.  Historically (back to 1948 or so) these margins have averaged between 6.5% and 7%.  However, from 2003 into 2008 these margins expanded from 8% to 11%.  In hindsight, the lagging index values were likely telling us that these operating margins were unsustainable – hence stocks weren’t accorded full value for the earnings they were generating.

As we move our way through a severe credit contraction one can most assuredly state that profit margins will diminish going forward.  So, it’s likely our valuation model will begin to display better results in the future.

At present our model estimates fair value for the S&P 500 at about 965 likely decaying to 885 next quarter and 860 by the end of the year, based on current consensus future earnings estimates.  From there analysts expect a strong rebound in earnings, roughly 50% year-over-year for next June.  Though the recent rally has likely priced this profit rebound in, we’re skeptical of the magnitude and would remain defensively biased until trailing four-quarter earnings actually begin to turn up.

To be clear, if earnings come in as expected, our model will not flash a sell rating over the next two quarters.  However further downward revisions to future earnings expectations, which in our opinion are likely, will cause our model to move to a sell rating.  In our opinion, a cautious stance is warranted at this time.

The U.S. Treasury Department’s recently unveiled Public Private Partnership Investment Program for Legacy Assets offers a unique approach to helping rid bank balance sheets of “toxic” assets, but am I missing something?  It looks like a recipe for almost certain future taxpayer losses – borne by the FDIC.

Here’s how the Treasury lays out the process for Legacy Loans:

Sample Investment Under the Legacy Loans Program

Step 1: If a bank has a pool of residential mortgages with $100 face value that it is seeking to divest, the bank would approach the FDIC.
Step 2: The FDIC would determine, according to the above process, that they would be willing to leverage the pool at a 6-to-1 debt-to-equity ratio.
Step 3: The pool would then be auctioned by the FDIC, with several private sector bidders submitting bids. The highest bid from the private sector – in this example, $84 – would be the winner and would form a Public-Private Investment Fund to purchase the pool of mortgages.
Step 4: Of this $84 purchase price, the FDIC would provide guarantees for $72 of financing, leaving $12 of equity.
Step 5: The Treasury would then provide 50% of the equity funding required on a side-by-side basis with the investor. In this example, Treasury would invest approximately $6, with the private investor contributing $6.
Step 6: The private investor would then manage the servicing of the asset pool and the timing of its disposition on an ongoing basis – using asset managers approved and subject to oversight by the FDIC.

So in the case of the private investor, he’s putting up about 7% of the capital and receiving 50% of the profit.  This serves to generate more interest in the program from private investors, but also has the “benefit” of inflating bids on what are likely to be poor quality assets – after all perhaps I can afford to bid a bit higher since I only need to put up $6 today. 

Isn’t that what got us into the housing crisis in the first place - terms that were too easy for the buyer and thereby incentivized speculation? Did our leaders learn nothing, or is this program meant to intentionally deceive the general public into believing that there is a profitable way of providing aid to the banking system?

More importantly, when has it ever been sound business judgment as a creditor (which banks were in the case of the housing crisis and the FDIC is in the case of the PPPIP) to lend money on a highly leveraged basis to fund a really risky investment?

From an implementation perspective it looks like there are also plenty of ways to game this from the seller’s perspective by either setting up a private entity to bid on your own assets or encouraging interested parties to do so.  Let’s walk through an example. 

Let’s assume a “legacy asset” is on the bank’s books for $0.50.  The bank sets up a partnership and bids $0.84 for the assets in question.  The bank puts up $0.06, government puts up $0.06 and FDIC insures $0.72.  So effectively the interested party has:

1.      Taken toxic assets off the bank’s balance sheet for a cash outlay 12% of what they’re currently on the books at.

2.      Enabled the bank to write the value back up from $0.50 to $0.84 on their balance sheet.

3.      Retained ½ any future upside in value

4.      Have downside limited to the $0.06 put up.

Mark our words, the PPPIP will end in another tragic loss for taxpayers.

We haven’t had a chance to post in awhile, but I wanted to convey my sentiment and thoughts on current events in the markets and economy as a whole.

Economy

·        Jobless claims - released today and came in at a loss of 524,000 jobs in December.  That translated into a national unemployment rate of 7.2%, the highest level in 16 years, but neglects those prospective employees who “want a job but have stopped looking” (the Augmented Unemployment Rate) which rose to 10.4%. The job losses were widely spread across industry sectors and the hours worked component fell to 33.3 hours/week – the lowest level since the early 1960’s.  The bigger story in our opinion is the continued downward revisions to prior months.  All this suggests continued deterioration in the months ahead.

·        Other Economic Statistics – uniformly terrible and getting worse, except statistics that are being driven more by short-term commodity price movements.    

·        Auto Bailout – bad idea and sets a terrible precedent.  These are companies and unions which have been apprised of their un-competitiveness for years and have either chosen not to make the tough decisions, or didn’t recognize the severity of their plight – either case is unforgiveable.  Let them go – that’s what bankruptcy courts are for.  Do we think there will be a bigger bailout coming? – almost certainly.

·        GMAC - was given “bank” status a few weeks back in order to be able to accept funds under the TARP program.  They received a loan at 8%.  The next day they offered a promotion offering 0% interest to auto buyers.  So now the government is subsidizing car & truck purchases.  Nice.

Markets

·        Difficult First Half, At Least – just don’t see how the market can make an exerted rally in the face of an economy in free-fall and precipitously falling earnings expectations.  The wall of worries is just too high at this time.

·        Stocks Not Cheap – with 2009 earnings expectations for the S&P 500 falling to roughly $42/share based on analyst “top-down” forecasts, at current levels of 900 the S&P is trading at a p/e of roughly 21.  This is by no means cheap.  Historically the market has bottomed in the range of 15 times earnings which suggests further possible downside to maybe 630, some 30% below today.  We’ll be the first to recognize that we may not need to test these levels, but we’d place the odds of the market dropping 30% substantially higher than those of it rising 30%.

·        Own Some Gold and Hard Assets – printing loads of money has always been inflationary and with countries around the world all likely to behave similarly the best hedge against losing value is to own gold and other hard assets such as long-lived commodities (metals, energy, timber).

·        The Opportunities are In the Credit Market – when one ponders bonds and credit instruments as investments the thought typically turns to low risk and low returns.  Yet venturing into these areas - corporate bonds, preferred stocks, and virtually any sector other than treasuries, agencies, and mortgages - might be well worth the effort.  Back of the envelope, today's opportunities look to be in the range of 15-20%+ annual returns over the coming 5-10 years, probably greater than stocks.  At this time we’re moving up the corporate credit structure (away from stocks and into credit instruments – both senior and subordinated).

·        Municipal Markets – not a fan.  This slowdown is going to wreak havoc on municipalities.  Not only are tax receipts likely to be down, the ability to refinance credit has been severely impaired.  Look for federal bailouts here as well.