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Prieur's Perspective: Mean Markets - Emphasize Capital Preservation

"Finance is the art of passing money from hand to hand until it finally disappears," said Robert W. Sarnoff. This is certainly the way it looked last week as the fall-out of the credit crisis deepened.

Markets had investors feeling dazed and confused after another roller-coaster week amid further evidence of the deteriorating health of the US financial sector and a renewed rise in oil prices. Adding to the pain, Barron's Randall Forsyth said: "Now that the bear market has officially arrived, it may stick around and gnash its teeth for a while - until it's scared away those who remain."

Government Sponsored Enterprises (GSEs) Fannie Mae (FNM) and Freddie Mac (FRE) were the main sources of volatility for the market, as speculation was rampant that they were destined for a government bail-out despite numerous assurances from government officials and their regulator that they were adequately capitalized. Between them, these enterprises own or guarantee about half of the $12,000 billion of outstanding US home loans.

Henry Paulson, Treasury secretary, downplayed a government takeover, saying: "Today our primary focus is supporting Fannie Mae and Freddie Mac in their current form as they carry out their important mission." Describing Fannie and Freddie as "very important institutions", President George W. Bush said the nation's top economic officials would be "working this issue very hard".

A Reuters report on Friday cited a source as saying that Fed Chairman Ben Bernanke had told the GSEs they would be eligible to borrow from the Fed's discount window. However, the Fed said there had been "no discussions" with Fannie and Freddie on access to the discount window.

Separately, Bernanke suggested that the "temporary" Term Auction Facility to Wall Street might be extended into 2009. Bill King (The King Report) did not find this particularly reassuring, asking: "... isn't this evidence that there is something very wrong in the financial system and it is troubling to solons?"

This is a nasty market and, irrespective of oversold and short-covering-induced technical rallies, one's emphasis should be on the return of capital rather than on the return on capital. There is an old and appropriate saying, "I'd rather be out of the market wishing I were in than in the market wishing I were out."

GMO's Jeremy Grantham echoed that the key to surviving bear markets was capital preservation. You want to "live to fight another day. You may see amazingly cheap asset opportunities in the next couple of years as distressed pricing might become more commonplace. It would be nice to have the money to take advantage."

"... developed economies including the US, Europe and Japan are contracting moderately, while most developing economies are expanding moderately. On net, the global economy is growing, albeit barely," reported the Survey of Business Confidence of the World conducted by Moody's Economy.com. "Pricing pressures spurted higher again last week and is approaching a new record high."

Against the backdrop of what happened with GSEs, and the financial sector as a whole, US market participants paid less attention to fresh economic data. However, the past week's economic reports included the following notable releases:

  • Pending home sales for May slipped 4.7% from April. The main message is that the bottom of home sales is not here after sales of existing homes peaked in September 2005. The fact that there is a large inventory of unsold homes in the market place suggests that additional declines of home prices should follow.

  • Initial jobless claims fell by 58,000 to 346,000 during the week ended July 5. However, the sharp drop reflects the shortened week due to the July 4 holiday and distortions arising from auto retool shutdowns in the summer. The decline in initial claims is a distortion and is not an indicator of a marked improvement in labor market conditions.

  • Chain store sales rose by 4.3% in June, well ahead of expectations, thanks to the spending of tax rebates. Rising gasoline prices also played a role in the strength, lifting sales at warehouse clubs. Discounters performed particularly well as financially pressed consumers focused on necessities and lower-priced goods.

  • The nominal trade deficit narrowed to $59.8 billion in May from $60.5 billion in April. In terms of the impact on GDP, the inflation-adjusted trade deficit of goods was nearly $90 billion in the April-May period compared with a $102 billion in the first two months of the first quarter, suggesting that trade will have a positive influence on the second quarter GDP.

  • Prices of imported goods continued to advance in June, which is problematic for the Fed. The import price index rose by 2.6% in June, reflecting higher prices for petroleum and non-petroleum imports. The price index of petroleum imports moved up 7.4%, putting the overall quarterly gain at 24.4% and the year-on-year gain at 20.5%. Import prices excluding fuel rose by 0.8%, with the year-on-year gain at 6.6%.

David Rosenberg, Merrill Lynch's chief North American economist, warned in a research report that the US remained firmly in an economic recession in spite of economic growth figures to the contrary. Pointing to last week's news that employment has now declined for six months in a row, he said that "at no time in the past 50 years has this happened without the economy being in an official recession".

Elsewhere in the world, the Bank of England's Monetary Policy Committee left the repo rate unchanged at 5.0% in the light of conflicting risks of rising inflation and slowing economic activity. The UK's annual rate of inflation hit 3.3% in May, whereas the Halifax House Price Index was down 9.6% since August 2007.

The economic slowdown under way in the Eurozone was highlighted by steep declines in industrial production across the 15-country region, raising the risk of technical recessions in at least some member countries.

Further afield, Japanese consumer confidence fell to an all-time low in June, reinforcing expectations that the Bank of Japan will announce an unchanged target interest rate on July 15.


Date Time (ET) Statistic For Actual Briefing Forecast Market Expects Prior
Jul 8 10:00 AM Pending Home Sales May -4.7% - -2.8% 7.1%
Jul 8 10:00 AM Wholesale Inventories May 0.8% 0.7% 0.6% 1.4%
Jul 8 3:00 PM Consumer Credit May $7.8B $5.0B $7.0B $7.8B
Jul 9 10:30 AM Crude Inventories 07/05 -5840K NA NA -1982K
Jul 10 8:30 AM Initial Claims 07/05 346K 395K 395K 404K
Jul 11 8:30 AM Export Prices ex-ag. Jun 0.9% NA NA 0.3%
Jul 11 8:30 AM Import Prices ex-oil Jun 0.9% NA NA 0.7%
Jul 11 8:30 AM Trade Balance May -59.8B -$61.0B -$62.2B -60.5B
Jul 11 10:00 AM Mich Sentiment-Prel. Jul 56.6 55.0 55.5 56.4
Jul 11 2:00 PM Treasury Budget Jun $50.7B NA $34.0B $27.5B
Source: Yahoo Finance, July 11, 2008.

In addition to the release of the minutes of the FOMC's meeting of June 24 and 25 (July 16) and Fed Chairman Bernanke's semi-annual monetary policy testimony in Washington (July 15 and 16), next week's economic highlights, courtesy of Northern Trust, include the following:

1. Retail Sales (July 15): Auto sales declined to an annual rate of 13.6 million units in June from 14.3 million in May. Price-related gains in food and gasoline will dominate the non-auto retail component of retail sales in June. Overall retail sales should post a 0.4% increase while non-auto retail sales should be stronger, mostly due to higher prices. Consensus: 0.5% versus 1.0% in May; non-auto retail sales: 1.0% versus 1.2% in May.

2. Producer Price Index (July 15): The Producer Price Index for Finished Goods is expected to have risen by 0.9% in June, reflecting higher food and energy prices. The core PPI is most likely to have risen by 0.2% after a similar gain in May. Consensus: +1.4%, core PPI +0.3%.

3. Consumer Price Index (July 16): A 0.4% increase in the CPI is predicted for June following a 0.6% gain in May. Once again a food and energy story is expected in June. The core CPI is expected to have moved up 0.2%, matching the gain reported in May. Consensus: +0.6%, core CPI +0.3%.

4. Industrial Production (July 16): The 0.5% drop in the manufacturing man-hours index in June points to a soft industrial production report in June. A reversal of four monthly declines in utilities production could raise the headline but the fundamentals remain weak. Consensus: 0.0%; Capacity Utilization: 79.3 versus 79.4 in May.

5. Housing Starts (July 17): Permit extensions for new single-family homes fell by 2.2% in May. The weakness in permits and inventories of unsold new homes are indicative of fewer housing starts in June (955,000 versus 975,000 in May). Consensus: 960,000.

6. Other reports: Inventories (July 15), NAHB Survey (July 16) and factory survey of the Federal Reserve Bank of Philadelphia (July 17).

The performance chart obtained from the Wall Street Journal Online shows how different global markets performed during the past week.

Source: Wall Street Journal Online, Julie 13, 2008.

The MSCI World Stock Index experienced a full-house of down days and declined by 1.3% during the past week as concerns about further credit-related trouble, surging inflation and deteriorating corporate earnings intensified. The MSCI has declined by 20.1% since its high on October 31, 2007, thereby meeting the "official" bear market definition of a drop in excess of 20%.

Emerging markets (+1.2%) fared relatively well as a result of strong performances from the Shanghai Composite Index (+7.0%) and the Hong Kong Hang Seng Index (+3.6%). The MSCI Emerging Markets Index has given up 22.1% since its high on October 29, 2007, resulting in sideways relative performance compared with developed markets since October last year.

The US stock markets all declined on expanding volume. The major index movements were as follows: Dow Jones Industrial Index -1.7% (YTD -16.3%), S&P 500 Index -1.9% (YTD -15.6%), Nasdaq Composite Index -0.3% (YTD -15.6%) and Russell 2000 Index +1.4% (YTD -11.9%).

The best-performing industry group was the Dow Jones Platinum & Precious Metals Index (+12.6%), whereas the DJ Mortgage Finance Index (-41.2%) performed catastrophically on the back of the Fannie Mae (FNM)/Freddie Mac (FRE) saga.

Dow components Alcoa (AA) and General Electric (GE) officially kicked off the second-quarter earnings reporting season with as-expected profit reports. The reporting season will kick up several notches next week with reports from a number of major financial and technology companies.

The final word on equities comes from Bill King (The King Report): "Stocks are grossly oversold on a short-term basis. But ... in a bear market with a negatively charged environment, grossly oversold means the conditions are right for a major storm. Ergo, the stock market needs some grand act of capitulation to generate a significant rally. ... the earnings reporting season might be the catalyst for capitulation. So for the time being, sit tight and wait for 'blood in the streets' for a buy opportunity."

Fixed-interest instruments
Government bonds around the globe ended the week little changed from the previous Friday's levels, although US yields kicked up on Friday as investors agonized about the prospect of increased bond issuance should the US government bring the GSEs onto the federal balance sheet.

The perceived safety of three-month US Treasury Bills resulted in rates falling sharply by 24 basis points to 1.57%. On the longer end, the ten-year US Treasury Note dropped by 5 basis points during the week to close at 3.94%. Similarly, the UK ten-year Gilt yield declined by 7 basis points to 4.90% and the German ten-year Bund yield by 4 basis points to 4.46%.

Mounting economic woes in New Zealand resulted in three-year bond yields declining by 35 basis points to 6.10% and nine-year yields by 22 basis points to 6.14%. (The All Blacks' rugby defeat against the Springboks on Saturday happened after close of trade!)

Concerns about the US financial sector and the realization that the Fed would not be able to raise interest rates any time soon put pressure on the dollar, causing the greenback to decline by 1.3% over the week against the euro, 0.4% against the British pound, 0.7% against the Swiss franc and 0.7% against the Japanese yen.

Efforts by the South Korean central bank to support the won resulted in the currency's biggest rise in ten years. The Bank of Korea said it would use its $258 billion of foreign exchange reserves to defend the won in an attempt to fight escalating inflation.

Robert Barbera, the chief economist of ITG, said in an article in The New York Times: "Recession, we believe, is firmly in place in the US and is taking hold in Europe. And recession for developed world economies will burst the bubble for commodity prices."

The performance of commodities was a mixed bag during the past week with agricultural commodities retreating from recent highs, industrial metals (with the exception of copper) moving higher, precious metals benefiting from safe-haven buying, and oil prices challenging $150 a barrel.

US dollar weakness, together with financial and geopolitical worries, resulted in gold bullion rising by 3.0% on the week, silver by 2.5% and platinum by 0.8%.

Oil prices experienced wide swings, with West Texas Intermediate crude touching $135.14 a barrel at its low on Tuesday before rallying back to a new record high of $147.27 on Friday. The price eventually settled for the week at $145.66 - little changed from its close the previous Friday. Reports discussing military posturing on the part of Iran and Israel, coupled with ongoing supply concerns, were at the heart of last week's trading action.

In short, it's best to remain cool and collected about these markets, and not take unnecessary risks.

Click here for some thought-provoking news items and more quotes from market commentators.

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Hat tip: Barry Ritholtz's The Big Picture


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