March 9, 2009
Good morning. Yet another horrible week for the market, as the SPY continued its seemingly relentless slide lower. The SPY finished the week at $68.92, down 6.8% for the week, bringing the yearly carnage to 23.7%. These numbers are despite a fairly substantial closing rally last Friday that had the SPY close 2.7% above its low print, and actually finish up slightly on the day. This morning, early, we are seeing another 10 point decline in the S&P Futures, despite a huge merger being announced between MRK and SGP at a 34% premium to SGP’s closing price of last Friday. It appears that a late severe sell-off in the shares of Britain’s HSBC in Hong Kong has sent the world markets lower, after leaving the Hang Seng Index down 4.8% on the day.
Are we headed for something far worse than your normal recession? The standard definition of a recession is two quarters of negative GNP, and it sure seems like that is a lock, especially after the revised fourth quarter numbers showed an annual decline of 6.2%. The “new” definition of a recession that some Economists would like to see, since the old way only lets you know for sure after you actually had been in one, a new definition that defines a recession as the entire peak to trough move in the “normal” business cycle. A depression has always been defined as an economic contraction of greater than 10%. Using that definition the U.S. has had two depressions, even though most of us think of it as only one. There was a very severe one from August 1929-March 1933 where real GDP declined almost 33%, a period of recovery, then a milder one from May 1937-June 1938. The worst recession was from Nov. 1972-March 1975 where real GDP declined by 4.9%. You certainly can see how people are starting to see that we may be heading for worse than the early 70’s fiasco. (Statistics courtesy of About.com Economics) I will make a prediction that we do not go into a depression, but we get really close. I suspect we will have a contraction in the 8.5-9% range at our worst point, and I think we might be very close to that already. I also think the market has discounted at least that, and maybe worse.
Now that we are clear on the terms, where are we? Lost? Searching? I think we are some combination of both lost and searching. We are looking for political solutions to complex problems from people whom, to be fair, have little training in those things that they are now asked to address. Politically any proposed solution “has” to be opposed on principal by the opposing party, and that is a problem. The greater problem, in my opinion, is that the average politician still has no real grasp of the complexities or the fragility, never mind the depth, of our current situation. I listened to two well-respected (in their own minds) politicians this weekend, one a powerful man in Washington (R. Richard Shelby, ranking member of the Banking Committee) and the other a powerful man in Illinois (D. John Cullerton, majority leader of the State Senate). Senator Shelby was all over the news waves calling for the government to just let some big banks go bust, just like that. “We’ve got to bury some big ones and send a strong message to the market.” Interesting. I know this really plays in a lot of places, the “Why should anyone get ‘bailed out’, I am not getting bailed out?” crowd, and it certainly connects on some level with all of us. The last time I checked, however, Senator, the combined balance sheets of Citigroup, Bank of America, AIG, and JP Morgan, was around $7 Trillion (yes, trillion with a T). Those of you that have listened to me through the years know that probably no one is more critical of the political policies that allowed a small number of banks to become way too large with way too little capital behind them (along with the political power that size generated). However, blowing up places of that magnitude ($7 T is roughly three full years of all tax collections of the U.S. government) and just hoping things land all right borders on insanity. Everyone should support some kind of goal of an orderly wind-down, and greater capital requirements going forward. To suggest closing them tomorrow and just hoping for the best, get the man off TV and out of the Senate.
The same is true of Mr. Cullerton. The State of Illinois, maybe the second most crooked in the country (behind Louisiana) has mismanaged its way to a $9 Billion deficit, most of which occurred in good times. We are talking about a State with a balanced budget mandate, but one that decides to get around the mandate with a cash based accounting system. For those who do not know what that means, it means that you count your expenses when you pay them, not when they are due. So if you do not pay any bills the last month of the year they do not count towards the current year, meaning you could be “balanced” even though you still owe and intend to pay the next year. Anyway, Mr. Cullerton was on the radio Saturday talking about how an increase in taxes surely needs to be a part of the solution, and how if it is just explained properly people will understand the money is genuinely needed and not being wasted. The problem is that everyone knows a real lot of State money is indeed being wasted, and that those people losing jobs, housing values, and retirement fund values simply do not have it to give. Remember that most of the property tax levies are still being based on the fictitious prices of a few years ago. In the words of my Irish ancestors “You can’t get blood out of a turnip.” They seem to think that the electorate will always remain sheep. Will we, I ask? Thank you sir, may I have another?
OK, Where does that leave us, other than in an economic quagmire with very questionable political leaders and the 21st Century version of Local 12 (Villains, thieves, and scoundrels union) running a lot of the major firms? Can it be fixed, and do the rest of us have the collective will to fix it? What does the market say? The market (as I mentioned earlier) seems to be discounting the worst. As of Friday, the cost of a Credit Default Swap on General Electric and Berkshire Hathaway (both still AAA rated firms) was roughly the same as a similar contract on KB Homes, a homebuilder that has lost money for seven consecutive quarters (courtesy of Bloomberg). How can that be? Either we are literally throwing out the baby with the bathwater or the current rating system is beyond laughable. For you to insure a $10 Million obligation with GE, the Credit Default “gentleman” are demanding $1.65 Million up front and $500,000 additional per year. Does that make any sense to anyone? What the bleep?
You know what? I think these Credit Default numbers are nuts. I think Shelby and Cullerton need a cold slap in the face. I think we might just find that GE was a real buy under $6 and BAC under $4. My clients have been mostly protected during this whole mess, and most also have between 10-50% in cash. We did this because we were unsure of the market and wanted to have the means to buy in lower if our worst fears actually were realized. It sure seem like our worst fears are in the process of being realized. The question is, should we commit some more capital to the market at this level? To be honest, it does not feel so good and everything is so negative it feels like we will never break the trend. I will say that on the morning of August 16, 1982 (yes, I was on the CBOE floor) it sure looked awful with the Dow around 800, but that was the day a huge bull market started. Are we getting close to not necessarily another bull market, but at least the end of the skid? All we need, with the option volatilities as they are, to start producing some real returns is for the market to stabilize somewhat and us to sell calls at these levels. I think we are very close, and would welcome your comments.