With earnings season now fully underway, bulls and bears alike have been treated to a range bound equity market over the past few weeks with a low end of the range at 875 on the S and P 500 and resistance in the 950 area. After trading down for almost a month, equity markets across the globe cheered as Goldman Sachs and Intel beat analyst estimates. Major indexes now sit firmly within their ranges as summer trading continues with low to moderate volume. Market volatility, as measured by the VIX index, is now at or near one year lows, giving some traders and economists hope that the worst is finally behind us. For the contrarian trader however, a low reading on the VIX is a warning signal that caution should be warranted in the next weeks or months as market participants have become complacent. Whether or not this proves to be the case this time is yet to be seen. Since the beginning of the equity rally in early March, the media and some perma- bull analysts have proclaimed that we were witnessing “green shoots” of economic growth in the US and global economies and that a recovery should be expected by early 2010. We would caution investors that trying to figure out a trend in equities during low volume summer trading is a fool’s game especially in a market that has just come off of a major bottom. What we do know for sure is that the Federal Government will now essentially provide a backstop for the equity markets and will add a second stimulus package if markets begin to fall again. This was especially true over the past few weeks as the market traded down and major players in the Obama Administration (as echoed by the media) began making the case for another shot of fake confetti stimulus dollars to boost the economy. Where this money is going to come from is anyone’s guess but apparently it is available. As we have stated here before, the US is probably going to have to get used to a slower rate of economic growth for the next 5-10 years, mainly due to the actions taken by the Federal Reserve and Congress. In our opinion, the “green shoots” that people are proclaiming are little more than a replenishment of inventory after the consumer pretty much stopped spending last fall due to the financial crisis, and we are at least a year away before we start seeing any sort of real growth in the economy.
With the number of foreclosures still rising and unemployment not improving, the consumer is still in very bad shape. Industry reports are now showing that as many as one in eight American are now delinquent on their mortgage payment or already in foreclosure. And with as many 3/4 of payment option adjustable rate mortgages due to adjust higher in 2010 and 2011 these charges will hit banks’ balance sheets at precisely the time the consumer will need financing available. Nationwide housing prices are down 32% and most likely will continue to soften further in the coming months as markets tend to overshoot to the downside especially after bubbles of the magnitude we had in housing. While housing sales have started to pickup, most of those sales have been at deep discounts or foreclosed properties. Due to the long period of overbuilding, housing inventories are approximately 2 million higher than normal. These numbers will have to improve before we see growth return to the economy and this will take some time. (Please see my previous post for our current real estate market outlook)
And with another wave of foreclosures set to next year, we should also expect to see more credit card charge offs at the major banks. JP Morgan and Bank of America have already stated that they are preparing for further credit defaults. JP Morgan alone lost $433 million in the second quarter on credit card loans that have defaulted. Analysts are particularly concerned that early stage delinquencies, or loans that are overdue 30 to 59 days at JP Morgan. Similarly, Bank of America, said that June charge offs were as high as 13.86 percent. As bankruptcies continue to rise in the US due to a weak labor market and rising foreclosures, we should expect similar numbers from the other major credit card issuers. Whether or not the banks have set aside enough capital to absorb these losses is yet to be seen, but we all know now that the Federal Reserve and Treasury will do whatever it takes to save the major banks from collapse. Hopefully we have finally seen a line drawn in the sand in regards to bailouts for failed institutions with the Treasury’s decision to not give capital to CIT, which is unfortunately one of the nation’s biggest lenders to small businesses. The ripple effect from this decision, and if and when CIT finally declares bankruptcy, will be felt temporarily but like the GM and Chrysler bankruptcies, there will similarly be buyers to pick up the pieces from the failed company. Every stimulus package, bailout, and credit program changes the nature of the marketplace. For example, by denying CIT access to the same credit programs that were given to the major US Banks, lenders in a similar position to CIT’s, and more importantly their investors, now understand that they should not expect to have access to the same credit facilities available to them. Perhaps if CIT would have had enough exposure to Goldman Sachs, or enough ex CIT employees were now working at the Treasury, we would have seen a different decision handed out to the lender. By denying access to CIT, the Treasury closed the door to an entire business model, (in this case lenders to small and medium size business) and depending on the individual companies’ current financial position, the Treasury may have just made things far worse for an entire industry. We should expect to see more failures of companies that are in a similar position to CIT’s, where the liquidity needed to refinance its debt has simply dried up.
One of the biggest challenges that the US economy faces now is that it doesn’t let itself slide into an extended period of slow growth and rising prices. Unfortunately, with the government intervening in almost every aspect of our economy now, it seems like a reasonable probability that we are going to enter into such a scenario. Another problem with government intervention, (besides the fact that eventually one entity or person will be left out as with the case of CIT), is that at some point someone is going to have to take away the punch bowl. The Federal Reserve has pumped $1 trillion into the banking system over the past year through bond purchases and emergency loans. As of now, we still haven’t heard when or how they are going to take away this excess liquidity. With unemployment expected to stay high for an extended period of time, the Fed risks damaging the economy further if they take away the liquidity too soon. On the other hand if they don’t act soon enough the Fed risks losing control of interest rates which will pretty much negate all the programs and central planning they have done so far. If history is any guide, unfortunately the Fed will not be able to walk this tight rope as there are simply too many variables to try to control. Whether the end result will be years of slow growth or an extreme case of inflation is yet to be seen. While the Fed may have been able to save some of the banks for now, the economy as a whole is still in bad shape.
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