Daily Insight

U.S. stocks jumped yesterday on very positive news out of Citigroup and comments from policymakers the uptick rule will be reinstated and mark-to-market may be modified. The rally was powerful, marking the best one-day advance since back-to-back 6% days back in late November. Still, because of the damage done over the past couple of months, not to mention the last six, only gets us to 720 on the S&P 500 and just over 6900 on the Dow.

Financials led the advance, jumping 15.6% on the uptick and accounting comments. Sure Citigroup’s news helped the rally as well – the firm stated they will achieve an operating profit this quarter, which would be the first since the third quarter of 2007. Still, I’m a bit skeptical that this portends a reversal for the industry in general – I’ll explain why below.

Industrial and information technology shares – two of our favorites for the next decade – also outperformed, up 8.50% and 7.42% respectively.

The key for now is for policymakers to get it done with regard to uptick and mark-to-market. We can’t have more of this talk, only to see no additional comment or action on these topics for a couple of months like everything else they’ve been in involved with lately. There are few reasons for short sellers to run for cover (of course it occurs on days like yesterday, but we need several days of this to get them truly scared and dropping the ball on the reasons the shorts feel safe will prove a huge mistake.

Back to this Citigroup news for a moment, the reason I remain skeptical the industry is not yet ready for a relatively sustained earnings rebound is because there is no sign yet in the coincident indicators that the economy has bottomed, and bank losses generally lag the economy. I find it hard to believe the credit-card side of the business has bottomed since monthly job losses remain large.

Nevertheless, the core business side of the banking industry is looking pretty good – if we can get some work done on mark-to-market banks will begin to lend more freely as they will not be worried about taking on more assets that then will have to be marked to distressed prices and thereby affect their regulatory capital.

If regulators are not going to abolish the accounting standard, they must break the link between mark-to-market and regulatory capital. They can do this by allowing banks to remove these assets from their trading accounts and into their held to maturity accounts. Banks’ core business is essentially a carry trade, borrow low and lend higher, and the strongly positive yield curve makes this possible, but we must at least get the accounting rule modified. Then reinstate the uptick rule, call it a day and watch the market explode to the upside.

Market Activity for March 10, 2009


The Rally

Yesterday we touched on the potential for a market rally from these levels – yesterday’s move was helpful but one day doesn’t matter right now, we need a trend. You can sort of feel a bounce is coming for the following reasons: we’ve been down for 2 ½ weeks straight (and the degree of decline has been harsh); the mood is very dire (and generally when you least expect it, expect it); and again, more and more people (including Bernanke yesterday) are talking about the pernicious aspects of mark-to-market accounting with regard to capital requirements. It’s a start.

Further, there is talk that CDS (credit default swaps -- essentially insurance on default risk) will be required to post margin; amazingly this was not the case heretofore, but then problems generally are not addressed until…well, they become problems. Also, from what I read, the SEC is establishing a futures exchange (the CME and ICE are bidding on the business). This is a big step that will bring transparency and hopefully more appropriate values.

CDS fundamentals seem very much out of line right now as CDS on AAA firms such as Berkshire and GE are trading as if these are non-investment grade firms. This is exacerbating the decline in stock prices – CDS amplify the downside. Say a hedge fund or bank sold CDS eight months back when things were more normal. They are now buying CDS to offset this risk or simply, and more likely, shorting the name for which they sold CDS on. This is why CDS amplifies the downside. Add in pro-cyclical accounting measures (mark-to-market), and we’ve got ourselves two very big issues that are pushing stocks lower than they would likely otherwise have declined. It about time we’re getting the ball rolling on these fronts, now don’t drop the damn thing. (Ok, I promise not to bring mark-to-market up again until they actual take action on it, you must be tired of me brining it up.)

In terms of a rally that turns into a trend, we may have to get around another spate of credit-market fear first. You can see it in the way the corporate-bond ETFs are behaving of late. An investment grade ETF (exchange-traded fund) is down 11% over the past seven weeks and a high-yield ETF is off by 20% over the same period. Outside of the policy front, this is the main impediment to a near-term stock market bounce. If credit spreads widen you can probably forget about any one-two day rally having legs.


The Economy

The Commerce Department reported wholesale inventories fell for the fifth-straight month in January, down another 0.7%.

Sales have been crushed since September, the month everything changed, and they took another beating for January, down 2.9%. This follows large declines over the previous five months – down 2.1% in September, crushed by 4.5% in October, sandblasted by 7.3% in November and creamed by 3.7% in December. This marks the most severe contraction for merchant wholesaler sales since records began in 1967, illustrating businesses went into full-blown survival mode due to the credit chaos that followed the Lehman and AIG collapses.

Most of the damage done to the figure over the past several months has been the collapse in auto sales. Of late though, machinery sales have really plunged – down 3.3% in November, 2.8% in December and a huge 10.8% in January.

The inventory-to-sales ratio, due mostly to the plunge in sales, has moved from just above the record low to just above the average of the past 15 years all in six months time. Inventories in general are not out of control though, much lower than most periods in which the economy has deteriorated to recessionary level. When we do get a bounce back in sales, this inventory-to-sales ratio will come down fast, but we need a rebound in confidence to foment a sales bounce.

This is why we’ve harped on a tax-rate response since the credit crisis began in September. We know it has zero chance due to the make-up of Washington, but that doesn’t mean you stop talking about what best delivers confidence about the future. And that is exactly what we need.

In a separate report, the National Federation of Independent Business (NFIB) released its small business survey for February showing optimism weakened to 82.6 – a record low. The figure posted a reading of 84.1 in January.

The net percentage of firms planning to hire rose to -3% from -6% in January, some improvement there. Amazingly, even in this significantly poor labor-market environment 11% of small businesses surveyed stated jobs as being “hard to fill.” This illustrates the shortage of skilled labor. You wouldn’t think there to be any problem filling positions in this scenario.

Overall, this is a very weak reading from NFIB. “Poor sales” was cited as the single-biggest problem for small business, with taxes running second. I’ll bet 12-18 months out taxes will be the single-biggest problem cited.

The survey showed small firms continue to expect to cut jobs over the near term, but at a slower pace.

Have a great day!


Brent Vondera, Senior Analyst