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Words from the (Investment) Wise for the Week That Was (September 1 - 7, 2008)

Investors not only returned to a shortened trading week after the Labor Day holiday on Monday, but also to a bruising on stock markets, at least for those with long equity positions.

Concerns about the global economic outlook and continued financial duress spooked bourses around the world, with a number of other factors also adding to investors' nervousness. In particular, Pimco's Bill Gross, the manager of the world's largest bond fund, said the US needed to step up and buy assets to avoid a "financial tsunami" (Bill is renowned for talking his book on occasion!), Dwight Anderson's big Ospraie commodity hedge fund closed after suffering large losses, and Russia was selling foreign currency reserves to prop up the rouble after foreign capital fled the country following Russia's invasion of Georgia.

Stock markets and commodities ended the first week of a traditionally bad September deeply in the red, but government bonds and the greenback benefited from the deleveraging and a flight to perceived safety.

An announcement by the US Treasury Department regarding the bailing out and recapitalization of collapsing home mortgage giants Fannie Mae and Freddie Mac seems to be imminent. According to The Wall Street Journal, Congressman Barney Frank, chairman of the House Financial Services Committee, confirmed on Saturday that Treasury Secretary Henry Paulson was planning government intervention to back the troubled GSEs. The detail could be announced as early as today (Sunday), prior to the Asian markets reopening.

Source: Gary Varvel, Slate

Next, a tag cloud of the text of all the articles I have read during the past week. This is a way of visualizing word frequencies at a glance. As expected, words such as "bank", "prices", "inflation" and "growth" featured prominently in my reading matter.

I have mentioned previously that the mid-July stock market lows need to be sustained in order for the summer rally and the market's base building to still be in effect. These levels - 10,963 for the Dow Jones Industrial Index and 1,215 for the S&P 500 Index - approached with unnerving speed last week.

Commenting on the current market weakness, Brett Steenbarger (TraderFeed) remarked as follows: "A number of sectors, such as consumer discretionary and even many of the financial shares, remain well above their July lows. It is not at all clear to me that this will be a fresh bear market leg down. I'm open to the idea that this may be an ultimately successful test of the July lows and part of a larger - and quite significant - bottoming process. Participation to the downside will tell the story."

From across the pond, David Fuller (Fullermoney) added: "... investors have little incentive to channel the large capital pools accumulating in money-market funds back into stock markets. Resistance near the August highs for share indices has checked the rallies. Moreover, many have broken beneath their August lows this week. We have also seen some new lows for the year, reaffirming overall downward trends. Unless stock markets can push back above their August highs, the bear will remain in charge for a while longer."

The last word goes to Richard Russell ( Dow Theory Letters): "Yesterday's [Thursday's] stock market action, according to Lowry's, was a classic 90% downside day. Normally, such days are followed by 2 to 7 days of rally (bounce), and then a continuation of the downtrend. 90% downside days often come in a series of one or more, and after each 90% downside day we look (hope for) a 90% up-day. And that's where we are now."

Before highlighting some thought-provoking news items and quotes from market commentators, let's briefly review the financial markets' movements on the basis of economic statistics and a performance round-up.

"Global business sentiment has been more or less consistent with a global economy that is near recession since the subprime financial shock hit over a year ago," according to the Survey of Business Confidence of the World conducted by Moody's Economy.com. The survey did take on a slightly more upbeat tone at the end of August as pricing pressures abated a bit, sales strengthened somewhat and hiring firmed modestly. Businesses remain most dour in the US, Europe and Japan, and most upbeat in the rest of Asia.

In the US, the September Beige Book report from the 12 Federal Reserve districts indicated slow and weak conditions across nearly all districts. Price pressures for energy and commodities continued to be a factor during July and August across nearly all districts, although pass-through to wages appeared to be minimal, giving the Fed some breathing space in terms of monetary policy for now.

The most important economic data released in the US during the past week concerned the employment situation. Non-farm payroll employment fell by 84,000 in August and the unemployment rate rose to 6.1% from 5.7% in July. Revisions to June and July job numbers tacked on another 58,000 lost jobs. In the first eight months of 2008, on average 76,000 jobs have been lost each month. The decline in payrolls and the rise in the unemployment rate were both larger than expected by consensus forecasts, fueling concerns about the pace of consumer spending in the months ahead.

Summarizing the outlook for US interest rates, Asha Bangalore (Northern Trust) said: "The question is how long before it is widely acceptable to use the 'R' word. The recent rally of the dollar and reduction in energy prices have allowed the Fed to watch and wait. That said, the Federal funds rate at 2.0% may have to be reconsidered in the near term if a turnaround is not visible. The September 16 FOMC meeting will most likely end with the Federal funds rate left unchanged at 2.0%."

Hat tip: Phil's Stock World

Data releases from the UK, continental Europe and Japan underlined rapidly worsening economies bordering on recession.

The European Central Bank (ECB) kept its main refinance rate on hold at 4.25% at its September monetary policy meeting. Interest rates are at a seven-year high as central bankers are unwilling to relax monetary policy before inflation comes down closer to the bank's 2% target.

In line with market expectations, the Bank of England (BoE) decided to keep its key repo rate steady at 5% at its September monetary policy meeting. September marks the fifth consecutive month with no change in the monetary policy rate.

Week's economic reports
Click here for the week's economy in pictures, courtesy of Jake of EconomPic Data. This is an exciting addition to "Words from the Wise" and will in future be included regularly.

Date Time (ET) Statistic For Actual Briefing Forecast Market Expects Prior
Sep 2 12:00 AM Auto Sales Aug - 4.8M NA 4.4M
Sep 2 12:00 AM Truck Sales Aug - 4.8M NA 4.6M
Sep 2 10:00 AM Construction Spending Jul -0.6% -0.3% -0.4% 0.3%
Sep 2 10:00 AM ISM Index Aug 49.9 50.2 50.0 50.0
Sep 3 12:00 AM Auto Sales Aug - 4.8M NA 4.4M
Sep 3 12:00 AM Truck Sales Aug - 4.8M NA 4.6M
Sep 3 8:15 AM ADP Employment Aug - - -19K 9K
Sep 3 10:00 AM Factory Orders Jul 1.3% 1.0% 1.0% 2.1%
Sep 3 10:35 AM Crude Inventories 08/30 - NA NA -177K
Sep 3 2:00 PM Fed's Beige Book - - - - -
Sep 4 8:15 AM ADP Employment Aug -33K - -30K 1K
Sep 4 8:30 AM Initial Claims 08/30 444K 415K 420K 429K
Sep 4 8:30 AM Productivity Rev. Q2 4.3% 3.5% 3.5% 2.2%
Sep 4 10:00 AM ISM Services Aug 50.6 50.0 49.5 49.5
Sep 4 10:35 AM Crude Inventories 08/30 -1898K NA NA -177K
Sep 5 8:30 AM Average Workweek Aug 33.7 33.7 33.6 33.7
Sep 5 8:30 AM Hourly Earnings Aug 0.4% 0.3% 0.3% 0.4%
Sep 5 8:30 AM Non-farm Payrolls Aug -84K -70K -75K -60K
Sep 5 8:30 AM Unemployment Rate Aug 6.1% 5.7% 5.7% 5.7%
Source: Yahoo Finance, September 5, 2008.

Next week's US economic highlights, courtesy of Northern Trust, include the following:

1. International Trade (September 11): The trade deficit is predicted to have widened to $58.5 billion in July from $56.8 billion in June, partly accounting for higher imported oil prices. Consensus: $59.5billion.

2. Retail Sales (September 12): Auto sales rose to 13.7 million units in August from 12.55 million in July. Gasoline prices are likely fell in August. The headline may show a small gain (+0.2%) to reflect the jump in car sales. Excluding autos, retail sales should be soft. Consensus: 0.3% versus -0.1% in July; non-auto retail sales: -0.2% versus 0.4% in July.

3. Producer Price Index (September 12): The Producer Price Index for finished goods is expected to have dropped 0.6% in August, reflecting lower energy prices. The PPI was up 1.2% in July. The core PPI is most likely to have risen by 0.1% after a 0.7% increase in July. Consensus: +0.4%, core PPI +0.2%.

4. Other reports: NFIB survey, Pending Home Sales Index (September 9), Import Prices (September 11], Inventories, Consumer Sentiment Index (September 12).

Click here for a summary of Wachovia's weekly economic and financial commentary.

A summary of the release dates of economic reports in the UK, Eurozone, Japan and China is provided here. It is important to keep an eye on growth trends in these economies for clues on, among others, the trend of the US dollar.

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, September 7, 2008.

Stock markets around the world suffered badly during the past week on the back of the deteriorating global economic outlook, with the MSCI World Index and the MSCI Emerging Markets Index plunging by 5.6% and 8.6% respectively.

Among mature markets, the worst losses were recorded by the UK FTSE 100 (-7.0%), the Canadian S&P/TSX Composite Index (-6.9%), the Japanese Nikkei 225 Average (-6.6%) and the French CAC 40 Index (-6.4%).

The carnage among emerging markets was even worse as illustrated by the declines in markets such as Russia (-10.8%), Taiwan (-10.5%), South Africa (-8.3%) and China ( 8.1%). Gains were few and far between, with Pakistan (+1.5%) and the Philippines (+1.4%) being two of the rare positive spots.

With the exception of the Nasdaq Composite Index (-4.7%; YTD -14.9%), the US stock markets fell by somewhat less than most other bourses as shown by the major index movements: Dow Jones -2.8%% (YTD -15.4%), S&P 500 Index -3.2% (YTD -15.4%) and Russell 2000 Index -2.8% (YTD 6.2%).

Factoring in the past week's performance, an interesting picture regarding bear market declines emerged, as summarized by Bespoke: "After declining 4.25% on Wednesday, 3.94% yesterday, and 3.75% today, Russia's RTS Index is now 41.19% below its 52-week high. These declines put it second to last behind China when looking at recent equity market returns for 22 major countries. As shown, China has fallen 64% from its 52-week high last October!

"The declines recently in global equity markets have really been astounding. Japan, Spain, Brazil, India, Italy, South Korea, Singapore, Sweden, Taiwan, and Hong Kong all join China and Russia with equity markets off at least 30% from their 52-week highs. North American countries rank 1, 2, 3 as countries holding up the best. International exposure has never hurt so bad."

The past week's sell-off has resulted in all the major US indices trading below their respective 50- and 200-day moving averages, with the exception of the Russell 2000 Index which is still marginally above the 200-day line. Some comfort for the bulls is that the key mid-July lows have not yet been breached by any of the indices.

Click here or on the thumbnail below for a market map, courtesy of Finviz.com, providing a quick overview of the performance of the various segments of the S&P 500 Index over the week.

The major trend in the market last week was a sell-off in many commodity-related groups - oil and gas, gold, aluminum, steel, coal and copper. The drivers of these declines were lower commodity prices and growing investor concern over a global economic slowdown. The diversified metals and mining group was the worst-performing group for the week, declining by 17%. Its single member, Freeport-McMoran (FCX), sold off as the prices of copper and gold declined.

The construction and engineering group (-16%) was the second-worst performer, negatively impacted by economic woes and the fact that many companies in this group have exposure to energy commodity prices.

The regional bank group (+7%) was the best-performing group for the week. As oil and other commodity-related groups declined, there was an apparent rotation into several financial groups, including regional banks.

The home improvement retail group also outperformed, rising by 5%. The group was led higher by its two largest members, Home Depot (HD) and Lowe's Companies (LOW). An analyst report said that economic forces weighing on home improvement chains were nearing the end of their "trough-like levels" and the early stages of improvement could begin sometime next year.

Fixed-interest instruments
Increasing risk aversion and a flight to safety pushed global government bond yields sharply lower during the past week.

The ten-year US Treasury Note declined by 18 basis points to 3.65%, the UK ten-year Gilt yield by 10 basis points to 4.38% and the German ten-year Bund yield by 14 basis points to 4.03%.

Bond yields are increasingly taking their cue from investors' worries about a global economic recession, whereas the threat of inflation is subsiding as shown by the declining trend since March in the Lehman US Treasury Inflation Protected Securities ETF (TIP).

Emphasizing the importance of the direction of bonds, Richard Russell (Dow Theory Letters) said: "... I'm watching the bond action intently. If the bonds believe 'things are getting better', they'll head down. If bond investors continue to be worried about the outlook, they'll buy the currently low-yielding Treasuries, with 10-year notes now yielding only 3.66%."

The US dollar maintained its upward path during the past week, supported by the view that interest rate differentials may increasingly favor the greenback as data from the UK, continental Europe and Japan are weakening relative to the US.

The past week saw the US dollar rising against the euro (+3.2% - an eleven-month high), the British pound (+3.6%), the Swiss franc (+1.7%), the Australian dollar (+1.2%) and the Canadian dollar (+0.5%).

However, the US currency declined by 1.9% against the Japanese yen as risk aversion triggered the unwinding of carry trade transactions funded by the low-yielding yen.

The currencies of commodities producers came under strong selling pressure as commodities slipped further. Examples include the Australian and New Zealand dollars that declined by 5.5% and 4.9% respectively against their US counterpart. The Aussie dollar was also weakened by the Reserve Bank of Australia lowering its key interest rate by 25 basis points to 7.0% - the first cut in seven years.

The histogram below shows the performance of a number of currencies since the beginning of 2008, indicating the US currency is now in positive territory after a gain of 3.0% YTD.

The continued unwinding of commodity positions savaged the Reuters/Jeffries CRB Index, shown by the week's 6.5% plunge. 22.4% of the Index's value has been wiped out since its record peak of July 2 - just more than two months ago.

Regarding the outlook for crude oil, David Fuller (Fullermoney) said: "Today, I see no evidence that crude oil has bottomed in what I regard as a lengthy medium-term correction, meaning a minimum of several months and up to two or possibly even three years. ... we could easily see a retest of $100 this year, with an outside chance of a temporary overshoot, taking us close to $80."

The chart below shows the damage of the past week's movements for various commodities:

Now for a few news items and some words and charts from the investment wise that will hopefully assist with navigating our portfolios through the treacherous investment waters. But always remember Earl Nightingale's words: "Wherever there is danger, there lurks opportunity; whenever there is opportunity, there lurks danger. The two are inseparable. They go together." (Hat tip: The Kirk Report.)

Source: McClatchy

The New York Times: US rescue seen at hand for two mortgage giants
"Senior officials from the Bush administration and the Federal Reserve on Friday called in top executives of Fannie Mae and Freddie Mac, the mortgage finance giants, and told them that the government was preparing to place the two companies under federal control, officials and company executives briefed on the discussions said.

"The plan, which would place the companies into a conservatorship, was outlined in separate meetings with the chief executives at the office of the companies' new regulator. The executives were told that, under the plan, they and their boards would be replaced and shareholders would be virtually wiped out, but that the companies would be able to continue functioning with the government generally standing behind their debt, people briefed on the discussions said.

"It is not possible to calculate the cost of any government bailout, but the huge potential liabilities of the companies could cost taxpayers tens of billions of dollars and make any rescue among the largest in the nation's history.

"Under a conservatorship, the common and preferred shares of Fannie and Freddie would be reduced to little or nothing, and any losses on mortgages they own or guarantee could be paid by taxpayers. Shareholders have already lost billions of dollars as the stocks have plunged more than 80 percent this year.

"A conservatorship would operate much like a pre-packaged bankruptcy, similar to what smaller companies use to clean up their books and then emerge with stronger balance sheets. It would allow for uninterrupted operation of the companies, crucial players in the diminished mortgage market, where they are now responsible for nearly 70 percent of new loans.

"The executives were told that the government had been planning to announce the decision as early as Sunday, before the Asian markets reopen, the officials said."

Source: Stephen Labaton and Andrew Ross Sorkin, The New York Times, September 6, 2008.

Bloomberg: Volcker says finance system "broken", losses may rise
"Former Federal Reserve Chairman Paul Volcker said the US financial system, dependent upon securitization rather than traditional bank loans, is broken, and may contribute to the weakest expansion since the 1930s.

"'This bright new system, this practice in the United States, this practice in the United Kingdom and elsewhere, has broken down,' Volcker said today at a banking conference in Calgary. 'Growth in the economy in this decade will be the slowest of any decade since the Great Depression, right in the middle of all this financial innovation.'

"The former Fed chief projected 'a lot' more losses from the collapse in the mortgage-backed debt market, after the more than $500 billion tallied so far, should the US, European and Japanese economies fail to pick up. He urged changes in financial regulations, echoing calls among sitting officials and legislators.

"'It is the most complicated financial crisis I have ever experienced, and I have experienced a few,' said Volcker.

"'Changes are going to have to be made' to the global financial system, Volcker said. Banks three decades ago accounted for about 60% of US credit; that later declined to about 30% as securitization - where financial firms package assets into bonds and other instruments and sell them on to investors and other companies - spread."

Source: Doug Alexander and Steve Matthews, Bloomberg, September 5, 2008.

Paul Kedrosky (Infectious Greed): RNC/DNC: Crisis? What crisis?
"What continues to amaze me is the not-so-benign neglect being accorded by politicians to the current financial crisis in the US. Granted, it's usually better being ignored by such people; and granted, the current debacle is more complicated than saying 'Ken Lay is a bad man'. But if you had watched the just-completed Democratic and Republican National Conventions, you wouldn't have known the US is stumbling through the worst financial crisis since the Great Depression. Nor would you have known, of course, that we're queuing up for a bill that could exceed total Iraq War expenditures.

"To prove the point to my own satisfaction, I combined the Palin/McCain acceptance speeches in one block of text, and the Obama/Biden speeches in another. I then set up some keywords to compare across the text blocks. The following summary table shows keywords in the left column, and then respective keywords counts for each party' slate in the appropriate DNC or RNC column. This isn't the usual exercise in cute tag clouds, but an attempt to understand whether important language concerning the current financial crisis penetrated the political radar over the last few weeks.

"And it hasn't - unless, of course, the repeated utterance of the word 'God' came in a context more like 'Oh God, we're screwed!' than I think it did."

Source: Paul Kedrosky, Infectious Greed, September 6, 2008.

Asha Bangalore (Northern Trust): Employment situation confirms recession is underway
"Civilian Unemployment Rate: 6.1% in August vs. 5.7% in July; cycle low is 4.4% in March 2007
Payroll Employment: -84,000 in July vs. -60,000 in July, net loss of 58,000 jobs after revisions of payroll estimates for June and July.
Hourly earnings: +7 cents to $18.14, 3.6% yoy change vs. 3.4% yoy change in July; cycle high is 4.28% yoy change in Dec. 2006.

"The jobless rate has risen 1.3 percentage points in a six-month span. Similar gains in a short time period last occurred in the 1982-82 recession. The recessions of 1990-91 and 2001 registered smaller increases in a six-month period. The question is how long before it is widely acceptable to use the 'R' word?

"At first blush, a sharp increase in the unemployment rate points to the possibility/necessity of a lower federal funds rate. However, the unemployment rate is a lagging indicator and historically a large part of easing of monetary policy is done prior to the establishment of a peak for the jobless rate, which the current FOMC has carried out between September 2007 and April 2008 by lowering the federal funds rate 375 bps. The complete lagged impact of this action will be evident by year-end.

"The recent rally of the dollar and reduction in energy prices have allowed the Fed to watch and wait. That said, the federal funds rate at 2.00% may have to be reconsidered in the near term if a turnaround is not visible. The September 16 FOMC meeting will most likely end with the federal funds rate left unchanged at 2.00%."

Source: Asha Bangalore, Northern Trust - Daily Global Commentary, September 5, 2008.

Asha Bangalore (Northern Trust): ISM non-manufacturing survey -export orders drop to cycle low
"The ISM Non-Manufacturing Survey results for August show a small improvement in the composite index. In August, the index moved up to 50.6 from 48.5 in July. The largest positive contribution was from supplier deliveries (55.5 vs. 53.5 in July). The new orders index (49.7 vs. 47.9 in July) and the employment index (45.5 vs. 47.1 in July) remain below 50.0, while the business activity index (51.6 vs. 49.6 in July) rose above 50.0. Readings above 50.0 denote an expansion in activity."

Source: Asha Bangalore, Northern Trust - Daily Global Commentary, September 4, 2008.

Asha Bangalore (Northern Trust): ISM manufacturing index - factory sector in slump
"The ISM manufacturing composite index has moved between 50.7 and 48.4 since September 2007. During the twelve months ended August 2008, this index posted readings above 50.0 for six months, ranging between a high of 50.7 in January 2008 and a low of 50.0 in October 2007 and July 2008. During the six months in which it held below 50.0, it has hovered between 48.4 and 49.9. In other words, the composite index suggests that the factory sector has been moving around insignificant growth and contraction for a period of twelve months. The composite index for August is 49.9."

Source: Asha Bangalore, Northern Trust - Daily Global Commentary, September 2, 2008.

Bespoke: Mortgage rates show decline
"A couple of weeks ago, credit crisis watchers were focused on rapidly rising 30-year fixed mortgage rates as well as the spiking cost to insure against corporate debt default. As shown in the charts below, default risk still remains extremely elevated, but at least the 30-year fixed mortgage rate has come down from the 6.5% level to about 6.2% over the last few weeks."

Source: Bespoke: September 4, 2008.

GaveKal: Ten-year US bond yields too low
"In recent weeks, we have seen 10-year bond yields in the US grind lower every day, to reach the current 3.7%, i.e. a level last seen in the midst of the Bear Stearns implosion. Meanwhile, real rates have now plumbed depths that we have never witnessed in our career. And interestingly, this pullback in bond yields has occurred while most of the US economic data actually surprised on the upside (i.e. yesterday's US factory orders that came out better than expected). So why are bond yields pulling back when, increasingly, the US recession looks like The Recession That Never Was?

"1) The first possible explanation is that, with the US$ strengthening and commodities pulling back, the Fed will be under a lot less pressure to raise interest rates anytime soon. In turn, this probably gives US commercial banks more confidence to borrow at the short end to lend at the long end, making the most out of the steep US yield curve.

2) The second possible explanation is that we are of course in the midst of a financial panic with tremendous volatility across all asset classes (commodities, real estate, corporate bonds, equities and foreign exchange). At such times, the natural inclination of investors is to seek refuge in government bonds.

3) The third possible explanation is that most market participants are coming around to the view that inflation will not wreak as much havoc as some feared just a few months ago. Instead, the risk remains one of lackluster economic growth (though we have to wonder how high that risk is for the US given the steepness of the yield curve and the record low real rates).

4) Finally, the last possible explanation is that we are currently going through a sea-change in the investment environment. Instead of an environment of a continuously falling US$, which favors emerging markets, commodities and increasing leverage, we are now in an environment of a rising US$ and thus a lot of the trends that we have experienced in recent years are reversing. As this happens, and the outlook becomes more uncertain, investors are probably seeking refuge in the shelter of US Treasuries.

"Nevertheless, with yields at 3.7% it seems to us that US Treasuries are increasingly becoming a 'limited upside and large possible downside' asset class. As the new investment environment unfolds, and as investors realize that, outside of financials and materials/energy, the rest of the OECD equity markets are holding up decently, we would expect equities to once again start outperforming bonds, and this especially in the US and in Japan."

Source: GaveKal - Checking the Boxes, September 4, 2008.

Bill King (The King Report): Albert Edwards - economic and equity market meltdown imminent
"Last week saw the publication of Q2 US whole economy profits data. They were shockingly bad. Core measures of profitability are in free-fall and have now reached a tipping point, where corporate activity could easily implode. We have also reached the point where companies give up 'manipulating' their profits higher and admit they are actually in free-fall. A combination of economic and reported profits slumping will catalyse the next equity downleg."

Source: Bill King, The King Report, September 5, 2008.

Bespoke: International revenues playing a role in the rally
"With the US dollar up sharply since the S&P 500 made its recent low on July 15th, we wanted to see how much the move might be impacting equities. As the dollar has declined over the last few years, US exports have risen sharply, and US companies with large international revenue exposure have benefited. But as the dollar has bounced off its lows recently, the international revenues play has reversed.

"Below we highlight the average performance since July 15th of stocks with no international revenues and stocks with more than 50% international revenues. As shown, S&P 500 stocks with no overseas exposure (148 stocks) are up an average of 20%, while those with more than 50% (106 stocks) are up 2.84%. The S&P 500 as a whole is up 4.94%. If the dollar continues to rally, this trend should stay in place."

Source: Bespoke, September 3, 2008.

John Authers (Financial Times): US summer rally to be put to test

Click here for the full article.

Source: John Authers, Financial Times, September 2, 2008.

Bill King (The King Report): Merrill's Bernstein - valuations at historical extremes
"When one accounts for the headline CPI, equity valuations appear at historical extremes. By historical extremes, we mean similar to those seen in August 1987 or March 2000. In fact, the present combination of 5.6% headline inflation and S&P 500 trailing PE of roughly 25 has NEVER before occurred in the 44-year history of our data ...

"Inflation expectations are literally imploding, and that is good for equities. Unfortunately, earnings estimates have yet to react, and that is worrisome. Thus, unless one believes in an immense productivity miracle, the S&P 500's PE multiple must substantially decrease because of rising inflation and nominal growth or earnings are likely to be very disappointing because of disinflation/deflation."

Source: Bill King, The King Report, September 4, 2008.

Bloomberg: US stocks at 25.8 times profit means rally may end
"The best may already be over for the US stock market this year.

"The Standard & Poor's 500 Index, which had the worst first half since 2002, added 0.2% this quarter, the only gain among the world's 10 biggest markets in dollar terms. Shares in the benchmark index for American equity climbed to an average 25.8 times reported profits, the highest valuation in five years. The last time that happened, the S&P 500 fell 38%.

"Money managers at Federated Investors, Russell Investments and Morgan Asset Management, which oversee a combined $600 billion, said the gains won't last because corporate profits will fail to meet analysts' estimates. Wall Street forecasters, who were too optimistic about earnings for the past four quarters, predict income at America's biggest companies will grow by a record 62% in the final three months of 2008, according to data compiled by S&P.

"'The market is pricing in the expectation of a good quarter, but we just don't see it,' said Philip Orlando, who helps manage $350 billion as chief equity market strategist at Federated in New York. 'The fundamentals are going to be poor, earnings are going to be bad, and there are going to be more huge writedowns. We think stocks probably need to work 5% to 10% lower over the next month or two.'

"The index's price-earnings ratio rose above 25 three times in the last five decades, data compiled by Bloomberg show. The last was in 2001, during the bear market that followed the bursting of the dot-com bubble. The increase in valuations preceded a plunge that helped erase about half the market value of US companies.

"The ratio is being propped up now by analyst forecasts that call for the end of four quarters of slumping profits, the longest streak in seven years."

Source: Michael Tsang and Jeff Kearns, Bloomberg, September 2, 2008.

Bespoke: Most overbought US ETF's
"We recently analyzed the 800+ US ETFs to see which ones were the most overbought relative to their 50-day moving averages. As shown below, four double short commodity ETFs top the most overbought list, with the homebuilder ETF (XHB) ranking fifth. Other notables on the overbought list include KRE and IAT (regional banks), DUG (inverse oil & gas stocks), XRT (retailers), KBE and PJB (banks), and DGZ (inverse gold)."

Source: Bespoke, September 3, 2008.

Doug Kass (TheStreet.com): This is what bottoms look like
"... I am beginning to see some light at the end of the market's tunnel.

"I have long said that relative to intermediate- and long-term interest rates, stocks are not expensive - nor have equities, in the main, ever been taken to speculative extremes, though the same can't be said for residential real estate, commodities, derivatives or private equity deals.

"Several recent developments have conspired to elevate the chances of moving out of this summer's trading range to the upside. Some of the more positive catalysts include:

• A sharp drop in the price of most commodities (especially of an energy kind) will serve as a tax cut to the consumer and even stem the tide of lower disposable incomes that has been so apparent over the last few years.

• The aforementioned reduction in cost pressures (if sustained) decreases the vulnerability of corporate profit margins. A compression in profitability had previously been the source of my concern over the last two years. Alleviating this concern is an important market tailwind.

• With raw costs dropping and wage inflation nonexistent, inflation has probably peaked in this economic cycle. Indeed, it may now have become the battle past.

• The insular, mainstream media may have underestimated Republican Vice Presidential candidate Sarah Palin and her potential impact on the McCain ticket in the November election. She hit a home run last night in a remarkably wise, poised, scorching and sassy speech.

• Regardless of the election's outcome, given the gravitas of the economic downturn, both Presidential candidates will now likely reduce individual tax rates to the middle class and introduce an additional fiscal stimulus package.

• The housing markets, which are at the epicenter of our credit problems, show preliminary signs that the bottom in activity and price declines may be only six to nine months away, even though the magnitude of the recovery remains an ongoing issue. The same may be true for the automobile industry.

• A continuing high (and increasing) level of investor pessimism is reflected in the multiyear lows in the net long positions of the hedge fund community.

"Importantly, I have long written this summer that, given the complexity of today's investment issues, I will let the market tell me its story, and Mr. Market is telling a clear disinflationary tale based on the classic relative strength and revival of early cycle sectors (homebuilding, finance and retailing).

"This is what market bottoms look like."

Source: Doug Kass, The Street.com, September 4, 2008.

John Authers (Financial Times): Emerging markets - bargains ahead

"If you want to buy emerging markets stocks, you no longer need to pay a premium.

"For several months last year, the MSCI emerging markets index traded at a higher multiple of earnings than its world index of developed world stocks.

"But this gap began to narrow after the world index peaked in October. Now, emerging markets are trading once more at a significant discount.

"There are some good reasons for this. The turmoil in states bordering Russia suggests a rise in political risk. For example, stocks in the Ukraine doubled in barely 18 months, but since January they have halved.

"This year, the extra spreads payable on emerging market bonds have widened, according to JPMorgan. But bond markets suggest risk is lower than in March this year, while emerging market stock valuations have eroded sharply since then.

"Another 'good' reason to sell emerging markets stocks is inflation, a serious problem for several big emerging economies.

"But above all, valuations seem to be driven by the developed world. A graph of the emerging p/e relative to the world p/e over time looks identical to a graph of the world index itself. The better world stocks are doing, the more of a premium emerging markets command. When developed world prices fall, the more of a discount traders require to buy emerging market stocks.

"Under the once-popular 'decoupling' argument - that emerging markets could grow independent of the developed world - the emerging market premium should rise when there are problems for the US and Europe, not fall.

"Swings of fear and greed in the developed world will work against emerging markets for a while. But in the longer term, decoupling has a kernel of truth. When developed markets hit bottom, emerging markets are likely to trade at a big discount - and be a bargain."

Source: John Authers, Financial Times, September 3, 2008.

David Fuller (Fullermoney): China - a buyer's market
"Economics 101 on fiscal prudence would suggest that countries save during the boom years, so that they are in a strong position to stimulate GDP growth in the next slowdown. This is exactly what China has done, while also deflating speculative bubbles in its housing and stock markets.

"Inevitably, China's export sector was going to suffer as the economies of OECD countries skirted close to recession, but the PRC is in an enviable position to boost growth as required. My guess is that China's economy has continued to slow in the current quarter, in line with the global trend and also due to its own additional lull during the Olympics.

"Interestingly, China's stock market has not yet responded to talk of economic stimulus, beyond the occasional one-off upward dynamic as last seen on 20th August, but these rebounds have not been maintained.

"This may be because officials have yet to implement tax cuts, reductions in bank reserve requirements or other confidence boosting measures mentioned in recent weeks. Therefore inflating fighting policies remain largely in place. Also, China's stock market did not perform in the last cycle, until it was actively targeted by the government in 2005. The current drift may actually suit China's SWFs, should they wish to invest at home.

"Meanwhile, subscribers with investments in China may have to be patient for a while longer. Those contemplating investing in China are dealing with a 'buyer's market' in which they can either wait more evidence of a bottom or nibble incrementally on weakness. Taking the long view, we can probably expect last year's high to be exceeded on the next bull trend, possibly by a significant margin."

Source: David Fuller, Fullermoney, September 1, 2008.

GaveKal: Thailand - buy when the cannons are sounding

"... while we acknowledge that the situation in Thailand is currently very touch-and-go, we think the current sell-off warrants a reminder about some of the country's positives:

• The market is cheap. The SET is trading at 9.6x earnings with a 4.6% dividend. Moreover, many small caps are trading at dirt cheap PEs with even better yields. In the property sector, for example, some companies are trading on nearly double-digit yields, even though the coming year's earnings are already locked in through pre-sales (and default rates are very low in Thailand).

• Strong balance sheets. Leverage has been very low in Thailand since the Asian crisis. More crucially, there has not been a US$ debt binge, contrary to many other Asian countries (which are now getting squeezed as the US$ carry trade reverses).

• The currency is cheap. The Baht remains dramatically undervalued on a PPP basis.

• Economic growth rate of 4.8% to 5.8%. Thailand's manufacturing base has been expanding, with double-digit industrial output growth rates for much of the past two years. Exports have been sizzling - they rose 44% YoY in July, to a record US$17.8bn (one caveat here: agricultural products was one of the drivers, and commodities have obviously corrected some since July). Consumer and business confidence is much stronger in Thailand than in some other Asian nations (Vietnam, India, Philippines).

"No doubt, these positives are set against a number of negatives - liquidity in Thai stocks can be spotty; the trade balance is negative; Thai leading indicators have been falling for several months ... But there is a price for everything ... and sometimes you get a better price if you buy when the cannons are sounding."

Source: GaveKal - Checking the Boxes, September 1, 2008.

CNBC: Merrill's Bernstein on the strong US dollar
Insight on whether the strengthening the dollar is really all it is cracked up to be, with Richard Bernstein, Merrill Lynch's chief investment strategist.

Source: CNBC, September 5, 2008.

Bespoke: US dollar's golden cross
"The US dollar index has made a 'golden cross' today, as its 50-day moving average has crossed above its 200-day moving average as both are rising. The 'golden cross' is viewed as a positive by market technicians, as it is thought to signal a significant favorable turning point. Regardless of your thoughts on technical analysis, the chart below highlights a clear shift in the dollar over the last few weeks."

Source: Bespoke, September 3, 2008.

Ulrich Leuchtmann (Commerzbank): Russian rouble depreciating swiftly
"The inability of the Russian central bank (CBR) to stem the rouble's latest bout of weakness is a bad signal for the currency, says Ulrich Leuchtmann, analyst at Commerzbank.

"He notes the CBR failed to stabilise the rouble this week when it fell past the level at which it intervened at the height of the Georgia conflict last month, even though data show the bank's reserves are still at a comfortably high level.

"'The CBR's motivation to refrain from more effective interventions might be that they do not want to waste reserves but expect the market to normalise soon,' Mr Leuchtmann says. 'Such a gamble could fail.'

"He says the arguments to sell the rouble stretch far beyond the Georgia crisis and therefore might persist for some time. 'Falling oil prices have triggered speculation about the future path of Russia's current account. The bulk of Russia's exports are commodity-related, and its oil-production costs are among the highest in the world. That means any fall in the oil price hits Russia's export margin and therefore the current account.'

"He says it is also possible that the CBR finds some degree of rouble weakness welcome, given the risk factors that stem from falling oil prices and the new scepticism of foreign investors. 'This strategy is also risky. The recent swift depreciation has opened a Pandora's box which might be difficult, and costly, to close at a future point when the CBR decides the depreciation is sufficient.'"

Source: Ulrich Leuchtmann, Commerzbank (via Financial Times), September 4, 2008.

CNBC: Templeton's Mobius - bullish on commodities, China

Source: CNBC, September 2, 2008.

US Global Investors: Commodities supercycle has many years to go
"This chart from Morgan Stanley goes back more than 200 years to show cyclical trends in commodities prices. What you see here is that the upswings tend to be sustained for long periods of time before retreating. These commodities supercycles often last 20 to 25 years, according to Morgan Stanley's research, and if this one follows the pattern, we have many years to go before it plays out. The key drivers are the rapid economic growth in China and infrastructure spending in other large emerging markets."

Source: US Global Investors - Weekly Investor Alert, September 5, 2008.


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