Tech shares have put together nice back-to-back gains as more people may be seeing this area of the market will lead the way, along with industrials in our view. Merck shares helped the health-care sector post are strong 2.44% rise yesterday after the company beat profit expectations.
The broad S&P 500 index rallied a solid 1.58% after a rough couple of sessions; nine of the 10 major industry groups gained ground – the financial sector was the sole loser.
Market Activity for February 3, 2009
It was reported the market also received a boost as Treasury Secretary Tim Geithner stated the government will step up efforts to fight recession. We’ll see if their actions actually help things. Based on what we’ve seen from the stimulus program there’s zero chance the economy will respond kindly – it will have to be completely re-worked. I’ve got a feeling Geithner may have be referring to proposed program that brings mortgage rates down to 4.00%-4.50%.
Geithner also mentioned, after watching Japan sink in the 1990s if there is one thing he learned it is not to dither. This is what was learned? What he should have come away with is throwing money (for a full decade) at the problem does nothing but leave a nation with many more government programs and massively in debt. They don’t call it the “lost decade” for nothing. But our Treasury Secretary learned not to dither; that’s nice.
Pending Home Sales
The National Association of Realtors announced pending home sales rose 6.3% in December -- the first increase since August. On an unadjusted basis, pending sales are 6.0% above the year-ago levels; seasonally adjusted, pending sales are 2.1% above the December 2007 level.
By region, pending home sales rose 1.7% in the Northeast (down 14.5% YOY), jumped 12.8% in the Midwest (down 1.2% YOY), up a similar 13% in the South (up 1.6% YOY) and fell 3.7% in the West (up 17.5% YOY). So, despite the decline for the month, you can see things have stabilized nicely in the West region.
As a result of the rise, we’ve got a pretty good indication existing home sales will show an increase when the January data is released at the end of the month. That will be nice, but we’ll have to see some easing in job-market losses before a sustained rebound in home sales presents itself.
That said, you can see the desire building for some sort of government action with regard to mortgage rates. The Fed is certainly engaged, buying roughly $15 billion per week in mortgage-backed securities. This has done a lot to narrow spreads, now much closer to the historic average of 180 basis points – the spread between the 30-year fixed mortgage rate and the 10-year Treasury had hit 290 basis points back in November. But the Treasury may begin to issue Treasury debt, yes on top of the rest, and use Fannie and Freddie to bring fixed rates down to 4.00%-4.50%. That would provide a huge boost to both refis and purchases – with the 30-year Treasury priced at a yield of 2.82% this is certainly doable; the question is how long that window will remain open. There’s also talk the Senate may propose a $15,000 tax credit for new home buyers.
Earnings, Valuations and Policy
Fourth quarter earnings season is shaping up pretty much as we figured. Overall S&P 500 profits have been crushed due to a massive 340% decline within the financial sector. You may ask how something can fall by more than 100%. Huge losses make it possible, and the collapse will continue so long as pro-cyclical accounting rules remain in place.
Digressing for a moment, with each new loan the industry makes, they take on additional assets that must be marked down to distressed-market prices – regardless of whether principal and interest payments remain uninterrupted. This also of course ignores the fact that there is underlying collateral – a house and land with regard to mortgage-backed assets. Give me a break. Say you have an asset that is actually in default and it is already marked down to 40 cents on the dollar. In most cases, the house and land, even if the bank needed to sell that asset within a month, is worth more than that. And we wonder why lending activity is stagnant? It is no wonder spreads became prohibitively wide.
I was unaware that we’ve used market value accounting before this stint, but after reading comments from former FDIC chairman William Isaac last night learned we had. The period was the 1930s and it took eight tortuous years before it was abolished for historical-cost accounting. Let’s hope it doesn’t take so long this time – at the current pace of financial-sector deterioration it won’t, if you know what I mean
Anyway, we had no idea how badly financial sector earnings would deteriorate last quarter, but our assumption of mid-$40 per share for trough earnings on the S&P 500 was not terribly far off. The actual number is $42.05 per share with 60% of firms reporting.
The ex-financial figure, which is the one to watch as the 15-month accounting regime greatly exacerbates financial sector results, is down 15.5% for the quarter, which is in line with our expectation. This shows that profits deteriorated substantially last quarter, but it certainly is not the collapse that justifies the decline in the market, in my opinion. A decline of 30% on the S&P 500 from the peak seems justified (which would result in a trailing earnings P/E of 25 times – pretty normal if not a bit on the low side for a trough earnings multiple, currently it’s very low at 19 times) but the 47% plunge that has occurred seems quite gratuitous.
Surely, the deleveraging event and uncertainty regarding the whims of Washington are playing a role here. The forward P/E sits at a low 12.5 times expectations. Even if profits bounce just two-thirds the normal rebound coming out of trough results you’re still looking at a forward market multiple of 16.5 times expectations (and the index carries a 3.40% to boot).
But think about it, and I’m certainly not saying we’re headed for a sustained rally as the level of uncertainty over government responses weighs heavily on investor sentiment, what if policymakers get a clue and demand regulators return us to the old accounting standard, or a net-present value accounting that takes into account cash-flows? You will see financial earnings flatten out, thus no longer weighing upon overall S&P 500 earnings per share, and suddenly the already low market multiple will be pushed even lower. If it is not, it means stock prices have bounced meaningfully from current levels, and indeed I would think stocks rally hard if mark-to-destruction is abolished.
And this is the point, policymakers don’t have to do much to spark a rally. They just need to engage in some common sense and refrain from programs that do nothing but leave us further in debt two years down the road. This is quite a lot to ask from Washington I grant you, but it’s possible. One thing I am confident of is the current accounting rule is making things appear far worse than they actually are.
Have a great day!
Brent Vondera, Senior Analyst
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