Daily Insight

Remember how yesterday, I said that I liked it when the market didn’t lose everything after a big gain like Tuesday’s?

Well, we didn’t quite lose it all, but markets traded lower yesterday to the tune of 224.64 points on the Dow Jones Industrial Average, to close 1.90 percent lower at 11,431.43. A much worse than forecast loss at American International Group (ticker symbol: AIG) was to blame as insurer announced that it lost $5.36 billion on mortgage-related write-downs; shares lost 18 percent of their value.

Oil took an opposite turn, gaining $1.44 per barrel to close up 1.20 percent and close at $120.02 per barrel in New York. It’s too bad, too, since I just filled my tank up today and was thinking how nice it was to be below $60 for a fill-up.

Recently, I read an economist’s take one why we pay such close attention to gas prices: we stand there with nothing to do and stare at the price. Yogurt prices have risen by the same percentage as gasoline prices over the past 18 months, but there isn’t a whole lot of uproar about it (then again, America isn’t addicted to yogurt in quite the same way).

Market Activity for August 7, 2008
This morning futures are basically flat as results from Fannie Mae (ticker symbol: FNM) are reviewed and traders consider oil futures, which are lower again this morning. Right now, oil futures are lower by $2 per barrel suggesting a barrel will trade for under $118 per barrel this morning.

This is no doubt partly a response to the sharply higher dollar, which has moved because China said that it would tighten their currency controls further (is that possible?) and it appears that the European Central Bank will not raise interest rates further. The ECB’s most recent action was to do nothing since it appears that all of Europe is on the verge of a recession/slowdown as well.

As Brent has said many times, at the point when the U.S. dollar stabilizes and begins to recover, the commodity bubble will shrink rapidly (something we have seen in July and August).

With respect to the FNM news, losses were expected and Freddie Mac had already laid the groundwork for some bad results when they posted earnings earlier this week. Therefore, it isn’t likely to have such a negative effect on trading today despite the weak results.

FNM posted a $2.3 billion loss compared to a $1.95 billion positive net income a year ago this quarter. FNM also booked $5.35 billion in credit costs by increasing loss provisions and charge-offs. They also cut their dividend by 86 percent to five cents per share that will save the company $1.9 billion through the end of 2009.

In my personal view, they should have scrapped the dividend on the common stock altogether. I don’t think it makes a whole lot of sense to continue to pay the common shareholder while the government is now officially standing by to rescue the company if they can’t raise enough money to continue independently. Certainly the stocks are so far off (another 11 percent this morning for FNM in pre-market trading) that cutting the dividend to zero wouldn’t likely kill the company. I don’t think anyone still holding the stock is in it for the dividend.

In economic news, U.S. productivity (defined as output per unit of labor) remained strong in the second quarter despite the slowing economy. Non-farm business productivity rose at an annual rate of 2.2 percent in the second quarter. Additionally, labor costs gained only 1.3 percent, below expectations.

This is an important piece of data because labor costs are the largest input in the creation of goods and services. The smaller than expected labor costs suggest that we are not in a 1970’s rerun where higher energy prices spiral into higher labor costs which spiral truly out of control.

Have a great weekend!

Dave Ott, General Partner

Daily Insight

Yesterday the kind of day that I really like: anytime you have a huge up market day like Tuesday, you really expect to give back at least half of it the very next day, so when that doesn’t happen, it feels like a gift.

Despite the far worse than expected $821 million loss for Freddie Mac (plus some write-downs in the billion dollar range), the Dow Jones Industrial Average rose 40.30 points, or 0.35 percent, to close at 11,656.07. The real stock market winner of the day was the Nasdaq, which gained 1.21 percent after Cisco Systems, Inc (ticker symbol: CSCO) announced stronger sales and net income.

Additionally, oil was lower for the third day in a row as inventory data showed that U.S. consumers are changing their driving habits in response to higher prices (kind of like what you would might remember from Econ 101: prices go higher and demand fall leading to lower prices). At the low point, oil had fallen to $117.11 per barrel.

Market Activity for August 6, 2008

At Acropolis, we have had the view that oil was overpriced. That’s the good news. The bad news is that we started saying it before it had crossed $80 per barrel so we’re still way above what we think it ought to be.

Having said that, however, oil has had such a precipitous drop just in the month of July that it does lead one to believe that oil prices are clearly not operating on fundamental factors alone.

Although the U.S. is consuming less crude, Saudi Arabia has increased their deliveries and demand growth in India and China hasn’t changed in the last 30 days. The obvious change was in trader sentiment. It is widely believed that one of the largest trades among Wall Street hedge funds is “long oil and short financials.”

This strategy was no doubt a winner for most of the year – energy prices are still high compared to Jan. 1 and financials have obviously been a disaster. However, in July, when Wells Fargo came out with better than expected earnings and increased their dividend, the trade turned upside-down as financials had a 50 percent rally from their lows, which undoubtedly forced a lot of short covering and unwinding long positions in energy.

This morning, futures are pointing lower this morning as the insurer American International Group (ticker symbol: AIG) posted a worse than expected $5.36 billion loss on even more mortgage related write-downs.

This is the third consecutive multi-billion dollar loss for the insurer related to mortgage investments. Obviously this kind of write-down, along with the news from Freddie Mac yesterday is enough to keep everyone on edge with respect to the bottom in housing.

In similar news, mortgages issues in the first part of 2007 are already going bad a much faster pace than mortgages issued in 2006. The data goes through April 30 of last year and shows that 0.91 percent of prime mortgages from those four months are seriously delinquent after 12 months, which means that they are either in foreclosure or 90 days past due. The data from 2006 shows that 0.33 percent were in serious delinquency.

The only good news on that data is that the lending really did tighten up by the end of the year, so there is some sense that there could be an end point to the lax lending standards.

In semi-related news, July same-store sales fell short of expectations for the second straight month, but discounters like Wal-Mart continued to pick up the slack. Again, this seems like Econ 101 – in tight times, it seems obvious that consumers would forgo $50 jeans at The Gap and buy $15 jeans at Wal-Mart (disclosure: I have no idea what jeans cost at either store, but you get the idea).

Initial jobless claims just came in higher than expected at 455,000. We will get into more specifics of the jobs number tomorrow, but it looks like we may give back some of the gains made in the last two days.

Have a great day!

Dave Ott, General Partner

Daily Insight

As expected, the Fed didn’t adjust their policy interest rates and the market loved it.

The Dow Jones Industrial Average closed 331.62 points higher, or 2.94 percent, to close at 11,615.77. There was only one loser in the Dow today – Chevron, which lost 0.40 percent due to oil prices.

Crude oil fell by 2.77 percent to close at 118.64 per barrel in New York. Oil has now fallen more than 18 percent since is high one month ago.

Market Activity for August 5, 2008

As we have talked about all this week, we knew that the Fed wasn’t very likely to make any changes to interest rates. The question would be what their message would be. Their assessment was towards inflation risk and the key phrase of the day was “significant concern’ regarding inflation.

Markets were strong from the start as oil prices continued their slide. When the market got the announcement, the rally pushed higher as more investors believe that the Fed will tighten later this year to curb inflation.

Right now the market believes that there is a sixty percent chance that rates will rise by either 25 or 50 basis points at the next meeting on September 9th and an 75 percent chance rates that rates will be higher by the meeting in late October. Obviously there is a lot of data that will be released between now and then, but today’s market action reflects this current thinking. In short, it is widely expected that a tightening campaign is forthcoming.


The chart above shows the dramatic shift in the Fed Funds Target rate over the past five years. It’s amazing to look at the steep declines in contrast to the measured pace of tightening in the last campaign.

I mentioned in yesterday’s email that I thought it was likely that there could be three dissenters who wanted to raise rates. Only one dissenter came through, Richard Fisher, who has dissented for the past five meetings.

Here is the statement parsing from the Wall Street Journal.


On the earnings front, Proctor & Gamble (ticker symbol: PG) earned 0.80 cents per share this quarter (on a diluted, continuing operations basis), ahead of the 0.78 cents per share Street expectation. This was a 19.40 percent gain on a year-over-year basis, demonstrating their power to push commodity price input costs along through to the consumer. Surely, this is a mark of their strong brands.

Freddie Mac (ticker symbol: FRE) reported a quarterly loss this morning that was three times wider than analysts’ estimates and wrote down another $1 billion in subprime and low quality mortgage securities. They also announced they will slash their common stock (not their preferred stock) dividend at least 80 percent to raise additional capital. CEO Richard Syron said that the company is still committed to raising $5.5, but many believe these efforts will dilute the value of their common stock. Freddie’s common stock futures are down this morning and could weigh on investor sentiment throughout the day.


Have a great day!

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Daily Insight

Markets closed lower yesterday after a see-saw ride that lifted the Dow Jones Industrial Average as high as 55.85 points (0.49 percent) and as low as -104.79 points (-0.93 percent). Ultimately, the index closed down 42.17 points (-0.37 percent) as major oil stocks fell along with oil and investors await word from the Fed.

Crude oil dropped $3.69 per barrel or -2.95 percent to close at 121.41 in New York trading. Since the peak of 145 early last month, crude prices have dropped slightly more than 16 percent – a correction, but not yet a bear market (one that we can all enjoy). Still, oil is up more than 25 percent for the year and is only back to prices seen in May.

Market Activity for August 4, 2008

Both personal income and personal spending were higher than Wall Street expected. As noted yesterday, personal income was expected to be lower by -0.20 percent, but actually came in positive at 0.10 percent. Personal spending registered a greater than expected 0.60%, versus the anticipated 0.40 percent.

As mentioned yesterday, one of the key considerations was whether or not consumers were spending their stimulus checks and the data bore that out. I don’t know how I failed to mention it (Brent will have my head), but along with the personal income and spending data came the personal consumption expenditures (PCE) that are considered a key measure of inflation.

The PCE is an index that measures the average increase in price for all domestic personal consumption. If you thought that this would be identical to the Consumer Price Index (CPI), you would be fooled by those tricky economic data collectors.

The CPI uses one set of expenditure weights for several years, where as PCE uses expenditure data from only the current and the previous period. In short, it looks at price changes from one period to another rather than looking at the most recent period compared to some predetermined base period.

The PCE index rose by 0.80 percent in June and gained 4.10 percent from the same month one year ago. Like its ugly cousin CPI, PCE also has a less volatile ‘core’ rate that excludes food and energy. The core PCE rate rose 0.30 percent in June, or 2.3 percent for the year ending in June. The Fed would like the core PCE rate below two percent.

Brent will also be aghast that I forgot to provide any guidance on productivity – one of the favorite measures of our nation’s great fortune. Despite the economic weakness, productivity has grown at an average annual rate of 2.50 percent. For those of you who don’t remember productivity rates in the 1970’s, it was around 0.80 percent.

Set your alarm clock for 2:15 pm EST, when the Fed announces their inaction. As stated yesterday, very few people believe that there will be any change in Fed policy. The key will be the statement. It is widely expected that rates will be unchanged, but that there will also be several dissenters instead of just one. That alone is a signal that rates are headed higher later this year, but the generally fragile nature of the financial system right now is a paramount consideration.

Have a great day!

Dave Ott, General Partner

The Housing and Economic Recovery Act of 2008

The housing bill President Bush signed into law last Wednesday, officially called The Housing and Economic Recovery Act of 2008, looks more like a transcription of the Odyssey in Homeric Greek than it does an attempt to help the everyday American homeowner manage the current mortgage crisis.

However, after reading through the bill itself and listening in on multiple analyst conference calls I will attempt to explain some of the contents of the bill, where it helps the current housing environment and where it falls short.

Government Purchasing GSE Securities

• GSE’s are the Government Sponsored Enterprises, known more commonly as Fannie Mae and Freddie Mac. These organizations were created by congress but are privately owned by common stockholders. Since their inception, they have had a unique, hybrid role between the public and private sector that is at the heart of today’s crisis.
• In order to prevent a widespread deterioration of the market for Fannie Mae and Freddie Mac debt, the government has been given the ability to buy any GSE security issue, whether it is debt or equity, by either agency.
• This announcement has shored up the market prices of the senior debt of both agencies and increased the confidence in their subordinated debt.
• If the government takes an equity stake in either company, it is unclear what effect this will have on the existing common and preferred shareholders.
• Treasury Secretary Paulson has said many times that he orchestrated the purchase plan as a confidence booster and doesn’t foresee the need to use it in the future.

Rising Rate of Foreclosures

• If a particular homeowner is at serious risk of default, they can apply for participation in the refinance program with the Federal Housing Administration (FHA).
• The FHA will refinance the home up to 85 percent of the newly appraised value as long as the current loan servicer agrees to forgive the outstanding principle balance above and beyond the FHA refinance.
• To qualify as seriously delinquent, the homeowner must prove that at least 31 percent of gross income is allocated to servicing mortgage debt and loan-to-value (LTV) must be greater than 90 percent.
• The FHA underwriting standards will remain strict. Therefore, jumbo loans and homeowners who cannot prove the proper documentation of income will not qualify for this program.
• By participating in the FHA program, the homeowner will sacrifice a portion of the future appreciation of the home, up to 50 percent in certain cases. This, along with a fee paid by Fannie Mae and Freddie Mac on the new securitization business, leaves some hope for this portion of the program to pay for itself.

Government Buying Homes

• A large amount of funds, about $4 billion, will go to purchasing the glut of already foreclosed homes that currently sit unoccupied.
• The future for the homes purchased by the government is still unclear. Most home purchases will be in urban areas and will most likely be refurbished and turned into government subsidized housing or simply bulldozed.

First Time Homebuyer Credit

• A credit for first time homebuyers of ten percent of the value of the home, up to $7,500, will be offered until the end of 2009.
• Although called a credit, it can be more accurately described as an interest free 15 year amortizing loan.
• For example, a $7,500 credit will be repaid with $500 added to the homebuyer’s federal tax bill every year for the next 15 years. This can be considered a small incentive at best.

New GSE Regulator

• In order to police Fannie Mae and Freddie Mac, the government has created a new regulator, The Federal Housing Finance Agency.
• In addition to assuming all of the responsibilities of its predecessor, the Federal Housing Finance Agency will have fairly open ended discretion over dividend payments, executive compensation and various other aspects of the business.

Problems and Risks with Plan

• Participation in this program is voluntary. The potential problem with this deals with the shocking number of homeowners that simply walk away from their mortgage without a single call to the lender. The lack of participation in programs for distressed borrowers that already exist poses a challenge for this new program.
• It will be important to see the principle amounts that loan servicers are willing to forgive. If they are too stringent it may be hard for this plan to get off the ground. It is the responsibility of the loan servicer to maximize the present value of the loan so this will be a difficult decision on their part. It is scary to think that 30 to 40 percent or more principle forgiveness is needed for some borrowers to qualify for this program.
• Although $4 billion will go towards converting foreclosed property to government subsidized housing, the bulk of the problem lies in suburban homes that are much larger and were purchased by people who couldn’t afford the homes and relied too much on the expectation of continued appreciation. These borrowers won’t qualify for the FHA refinance program because their home value exceeds the limit or they can’t document the level of income needed (or both).

The Long and the Short

The Housing and Economic Recovery Act of 2008 should not be looked at as a “cure all” for the problems that plague the current housing market. If participation in the program goes well it could help to create a bottom for declining home values and reinstate traditional liquidity in housing.

How do currency differences affect investing?

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Daily Insight

Markets ended the day lower Friday on the larger than expected losses from General Motors (ticker symbol: GM) and rising oil prices. The employment data was relatively mixed and was generally greeted with a sigh of relief even though the headline number went up by one tenth of one percent.

For the day, the Dow Junes Industrial Average (DJIA) closed down 51.70 points to close at 11,326.32, or -0.45 percent. For the week, the Dow lost 0.40 percent, but you would hardly know it as the gyrations were wild – at least 185 points one way or another each day through Thursday.

Crude prices went up by $1.02 per barrel, or 0.80 percent to close at $125.10 in New York. For the week, oil gained 1.50 percent, the first rise over a week for three weeks.

Market Activity for July 31, 2008

Today, we have June Personal Income and spending data at the market open and June Factory Orders at 10:00 a.m. Eastern Standard Time. Personal income is expected to be -0.30 percent and personal spending is expected to be +0.50 percent. The big question will be whether not there is a continued boost from the stimulus checks.

The big story this week will be tomorrow, when the Federal Reserve Open Market Committee (FOMC) announces their Fed Funds Rate and the Discount Rate. The Fed Funds Rate is the interest rate that banks charge each other for overnight loans. The current rate is 2.00 percent. The Discount Rate is the rate that the Fed charges for lending directly to banks and other depository institutions. The current discount rate is 2.25 percent.

Right now, the market expects no change in actual interest rate policy. Any major news will come from their position and comments. Their position refers to the statement that accompanies the interest rate policy decision that describes gives the Fed view on which is worse: inflation or general economic weakness (we long for the days of the third option: a balanced view).

Parsing the statements is a favorite Wall Street pastime. The image may be hard to read, but below is a copy of the most recent statement along with comments about what changed and what stayed the same from statement to statement.

Generally, the Street picks out a few key words to focus on. Last time, for example, when the Fed kept steady for the first time since the credit crunch began, The Street focused on the use of the phrase “uncertainty remains high” when the Fed referred to inflation.

These statements will give clues about whether or not the Fed will begin raising rates by the end of the year. Currently, markets believe that there is a 50/50 chance of a rate hike in October, but those numbers could change quickly depending on what happens tomorrow.

Have a great day!

David Ott, General Partner