Economic & Market Update: February 17, 2009

“A Keynesian Experiment Unlike Any We Have Seen”

The Fortigent Investment Research Team

Last Week’s Highlights:

Trade Balance:          $39.9 bln – imports and exports falling off a cliff

Retail Sales:                     +1.0% – post-holiday bargain hunters reverse recent trends

Consumer Sentiment:       56.2 – consumers not sure what to be happy about

Stocks:                                  827 – investors perpetually disappointed by Washington 

Bonds:                                   2.9%

Oil:                                         $38

Dollar/Euro:                    $1.29 – traders undecided about which economy is worse off

Economics This Week:

Date      Item                                    Est.                     Comment

2/18      Housing Starts:             530k                    Builders lacking credit to build

2/18      FOMC Minutes                N/A                    Straight from the horse’s mouth

2/19      PPI:                                    0.2%                    Holding steady

2/20      CPI:                                     0.3%                    Consumers not overly optimistic

Washington May Kill the Markets Yet

As further evidence that the financial center of the country has moved from Wall Street, last week all eyes focused on Washington, and the markets walked away supremely disappointed with the S&P 500 index falling nearly 5%. The continued lack of clarity behind the “bad bank” plan, the passing of the fiscal “stimulus” package with no bipartisan support, and a newly announced foreclosure prevention plan gave the markets another bad case of indigestion.

Late in the week, in an attempt to prevent foreclosures, the Obama administration announced a $50 billion plan to subsidize mortgages.  Considering that 7% of residential loans are delinquent and that this program would only cover 0.5% of all mortgage debt outstanding, this plan is unlikely to have much of an impact. On the other hand, efforts by the government to directly assist struggling homeowners may give the markets confidence, which is sorely lacking these days. 

The stimulus package finally passed both houses of Congress late Friday evening. We apologize for repeating ourselves, but the lack of truly stimulative measures in the bill, the massive increase in the federal budget it will engender, the unprecedented levels of Congressional and special interest pork, and the realization that most members of Congress did not have time to read the more than 1400 pages of the final mark-up before casting their votes leaves us skeptical about its chances of actually kick-starting the economy. Provisions such as the $70 billion measure to pardon 26 million middle-income taxpayers from the Alternative Minimum Tax (representing 10% of the overall bill) may be politically popular (and may even represent good policy), but it will have little to no stimulative effect on the economy.

Voters, for now, appear to have lost confidence in free markets and in “creative destruction” capitalism. They are deeply concerned about their jobs, their mortgages, and the state of the economy, and they appear willing and ready to give good old fashioned Keynesian governmental intervention a huge try. This once-in-a-lifetime opportunity to permanently grow the baseline size and scope of government (with no questions asked and no concern about deficits) seems to have been too enticing to the members of Congress, who porked up the “stimulus” bill accordingly. [Interested readers can access http://www.recovery.gov, a website where President Obama promises to track exactly how each stimulus dollar is spent.]

Given how large a percentage of GDP that consumer spending has become, if the bill succeeds in improving depressed consumer sentiment and confidence (regardless of its actual stimulus merits) then perhaps it will do some good. But if unemployment continues on track to its anticipated 9%-10% level, consumers are going to continue to “live small,” shut their pocketbooks, and refuse to spend.  

Source: New York Times

As a consolation, we should note that the government is notoriously late in enacting stimulus measures during times of recession. We hope that trend continues and this most recent legislation marks the beginning of the end.   

Earnings Are Free Fallin’

So far, about 400 of the S&P’s 500 component companies have reported earnings for 2008 and the picture looks worse than a Jackson Pollack painting. 

The fourth quarter will mark the sixth consecutive quarter of negative growth, matching the previous record set in 1951/52. Even more remarkable is the fact that this is the first quarter of negative earnings in the history of the S&P 500. 

As it stands now, S&P earnings per share on an as-reported basis are showing a loss of $10.44 for the quarter. People will be quick to blame the financial sector but even if you strip those names out of the index, the loss would be $2.35 per share. Across the board it appears that most companies decided to purge their balance sheets at the end of 2008 in favor of starting ’09 with a clean slate. 

Source: John Mauldin

For anyone who considers stocks to be the buy of a lifetime in the near term, just consider that with the S&P closing the week at 827, stocks are trading at a trailing P/E of 28 based on 2008 full year estimates. Investors should pay close attention to this phenomenon – prices have indeed fallen precipitously, but earnings have fallen correspondingly, so seemingly attractive valuations need to be considered with the recognition that P/E ratios are not static nor dependent only on the numerator.

Do U.S. Treasuries Still Represent the “Risk-Free Rate?”

With the preface that, in our opinion, the ratings agencies don’t have a shred of credibility – but with the acknowledgement that their actions still impact market prices – we read a relatively intriguing report from Moody’s this week on the credit deterioration in AAA-rated sovereign debt. 

Moody’s divided AAA credits into three categories – resistant, resilient and vulnerable. The US and UK fell into the second tier of credits, considered to be resilient as a result of significant economic deterioration but with a greater ability to recover from the increased debt burden resulting from the current economic crisis. 

Source: Moody’s

Focusing on the US, the flight-to-safety last year was actually beneficial in that it pushed bond yields to historic lows, allowing the government to finance its numerous rescue packages at relatively inexpensive rates. That trend is reversing here in ’09, leading to concern by some that the debt burden will grow more rapidly than the US can handle.  Moody’s projects that interest payments as a percentage of government revenues would increase from 6.1% currently to well over 10% by 2011. Above that level the government will be increasingly hard-pressed to respond to future economic crises. 

The bigger concern, in our view, is that the stimulus package ultimately winds up being a spending package. It becomes exceedingly difficult to cut back on spending programs once they are implemented and an increase in future spending without a comparable increase in growth could be devastating to the US’s credit profile.

Moody’s surely recognizes that downgrading the US from a AAA rating would be political suicide but the rest of the world, especially China, is undoubtedly paying close attention to this development.

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