With all eyes concentrated north of the 49th parallel, towards the Olympic Games in Vancouver, investors were inundated with negative news in February, ranging from tighter liquidity restrictions in China to the tragedy unfolding in Greece.  Still, the S&P 500 index was able to prove resilient and close with a 2.9% gain over the course of the month. 

Looking at performance of the S&P 500 from 1950 to present, February is typically the second worst performing calendar month of the year, especially true over the past three years, which saw the index drop 2.0%, 3.3% and 10.7%, respectively.  The reason for this year’s atypical move may have been the strong selloff in January, one of the year’s historically strong months, allowing for investors to capitalize on a countertrend rally. 

Narrowing our focus to the past week, the news cycle was equally mixed.  Economic releases were mostly disappointing but Federal Reserve Chairman Bernanke’s testimony before Congress, where he reiterated that rates will remain low for an “extended period,” offered moderate support to the markets.   

Employment is the obvious trouble spot that is refusing to go away.  Initial unemployment claims trended higher in the past three weeks, increasing by a cumulative 53k over that time.  When all else fails, blame it on the weather.  We can see in the chart below that precipitation was higher than usual the week prior to last, potentially creating a backlog of claims that materialized last week.   

Source: Zero Hedge Blog

Friday brought about an improved GDP report, showing economic growth increased by 5.9% in the 4th quarter, rather than the earlier reported 5.7%. Inventories accounted for 3.9% of that gain with final sales adding 1.9%. As mentioned previously, an inventory led GDP bounce will be unsustainable for long, requiring consumers to eventually pick up the slack.

Source: Financial Times

On the regulatory front, the Securities and Exchange Commission (SEC) voted in favor of rules to stem aggressive short selling tactics.  In 2007, the SEC abolished the “uptick” rule, which said that a trader could not short a stock unless done above the last trade price, or once the last price was higher than the previous.  The market meltdown left many questioning whether the abandonment of the uptick rule precipitated the severity of the equity market decline.

To stem those concerns, the new SEC rules states that if a stock falls by 10% in a given trading day, an investor may only short the stock if they pay a price above the highest national bid.  That rule would carry over into the next trading day.  Goldman Sachs, likely to be one of the many parties affected by this rule, discovered that from January 2008 to February 2010, roughly 2% of the companies in the S&P 500 index would trigger that rule, equating to 11 companies over the course of the average trading day.  In the Russell 2000 index, that figure climbs to 4%, or 79 companies.  

The banking sector received its own dose of bad news in the form of the FDIC’s Quarterly Banking Profile for the period ending December 31st.  More than 700 banks with $400bln in assets were classified as “problem banks.”  Keep in mind, while this is troubling, it is still dwarfed by the 1,400+ problem banks at the peak of the saving & loan crisis.  At the same time, the FDIC closed 2 community banks, bringing the 2010 tally of failed banks to 21.

Source: Calculated Risk Blog

 Are credit default swaps the modern day trojan ho

Some in the financial press have recently likened credit default swaps (CDS) to a more sinister version of the Trojan horse that sacked Troy centuries ago.  Those pundits blaming Greece’s woes on CDS traders are high on conjecture but amazingly short on fact.

To paraphrase one author on the blogosphere, “Credit Default Swaps are driving Greece to the edge of default (name withheld to protect the uninformed).”  Ignoring the fact that Greece racked up massive amounts of debt long before CDS even existed, the overall impact of CDS on the future of Greece is miniscule.

Based on recent data from the Depository Trust & Clearing Corporation there is roughly $90bln of gross notional CDS outstanding on the Hellenic Republic (Greece).  However, on a net basis, there is only $9bln of outstanding CDS contracts. In the past several weeks, as the situation in Greece spiraled out of control, net CDS hardly moved.

Source: BNP Paribas

This tells us that an overwhelming percentage of the contracts traded are merely being used to protect positions that are already in place. 

Another claim by the previously aforementioned author states that CDS traders are incentivized to push companies/countries into bankruptcy in order to collect on a payday.  What he fails to realize is that European banks, which were stung by hundreds of billions of dollars worth of losses throughout the credit crisis, hold some $235bln worth of exposure to Greece.  With that in mind, is it truly surprising to see those banks racing to protect positions at risk of downgrade or potential default? 

Source: BCA Research

Even more to the point, research from Bloomberg found there was $108bln net notional CDS outstanding on 10 of the most common European sovereign entities.  Relative to the $11trln of debt outstanding for those combined countries, it can hardly be hypothesized that the 0.98% impact of the CDS markets would hold the power to push an issuer into default.

Source: Bloomberg

Perhaps the author should pay more attention to the growing negative sentiment in the currency markets, where institutional investors hold a net 71k contracts betting on further declines in the Euro.  With $12bln on the line in that market, don’t currency traders share in the blame?

Those bets against Greeece and the Euro may not be so far fetched when one recognizes that Greece alone needs to raise some $74bln this year.  Throw in the financing needs of Italy, Spain and Portugal and the four weak links of the Eurozone offer the potential to drag the Euro further into the mud. 

Source: Barclays Capital

As a final point of reference, there was $400bln in outstanding CDS contracts on Lehman Brothers at the time of its bankruptcy filing.  In that case, the recovery value was deemed to be less than 9 cents on the dollar (a far cry from what any country would offer), due to the $613bln of total debt held by the firm.  Despite the $400bln in outstanding contracts, less than $10bln ultimately wound up changing hands.

Throughout the ages it has always been easier to persecute what we fail to understand.  This time around, blaming Greece’s problems on credit default swaps is an argument that holds very little merit.  General George S. Patton Jr. once said “If everybody is thinking alike somebody isn’t thinking.”

 Housing Shows its true colors

The housing markets faced a number of unpleasant announcements last week.  Kick starting the week was news of a 0.32% month-over-month increase in the Case-Shiller Homer Price Index.  That index is now down 30% from its peak with several cities (Dallas and Denver, notably) faring considerably better than others (see: Las Vegas).

Source: Standard & Poor’s

That more or less covers all the positive housing news for the week.  Weekly Mortgage Applications fell by 7.3%, reaching the lowest level since 1997.  With the rate on 30-year mortgages inching back above 5.0%, applications for refinancing dropped almost 9%.  Again, weather could share some of the blame, but the purchase applications index has steadily fallen since late last fall, suggesting the weather is hardly the crux of the problem. 

Tuesday brought research from First American CoreLogic showing that 24% of residential property owners were upside down on their mortgage in the 4th quarter, representing 11.3mln properties.  This was up from 23% and 10.7mln properties in the prior quarter.  Again, states such as Nevada are bearing the brunt of the pain, with 70% of all property owners owing more on their mortgage than the property is worth.  According to the report, once loan-to-value reaches 120%, the foreclosure rate spikes considerably. 

Keeping in the foreclosure vein, Charles Haldeman, Jr., CEO of Freddie Mac, warned shareholders last week that “the housing recovery remains fragile, with significant

downside risk posed by high unemployment and a potential large wave of foreclosures.”  Freddie Mac, which lost $7.8bln last quarter, avoided begging at the trough of Uncle Sam, however, its counterpart, Fannie Mae, is racing back to the government to seek another $15.3bln in aid, following a $16.3bln fourth quarter loss.

When combined, all of this is causing the Obama Administration to reconsider the way it “manages” the housing markets.  New proposals from the administration are contemplating a moratorium on foreclosures until a homeowner has an opportunity to request eligibility under the government Home Affordable Modification Program.  This is creating a growing number of homeowners (2.9mln) who are 90 days or more behind on their payments, with the average household nine months behind. 

Any discussion of the housing markets is almost futile at this juncture, though, considering the uncertain future of government intervention.  Should those programs not be extended into the summer months, the housing markets will be more apt to show its true colors.     

 The week ahead

The economic calendar shows no signs of reprieve this week.  February’s employment report, released on Friday, will be the most talked about and dissected release of the week.  Disruptive snow storms during the month might delay some hiring into March. 

Light vehicle sales are due for release on Tuesday.  Analysts are interested to see how consumers are reacting to the recent Toyota recall, but early indications point to consumers foregoing purchases rather than switching brands.

The Federal Reserve’s beige book will provide a snapshot of regional economic activity on Wednesday.  On Friday afternoon, after the release of the employment report, consumer credit for the month of January will be announced. Expectations are for another $3.8bln contraction as consumers reposition their balance sheets.  

Copper markets should experience volatile trading early in the week on account of the earthquake in Chile, which comprises 35% of global copper production.  Some 20% of production was suspended in the country, but much of that is expected to be back on line within several days.  Highways destroyed during the quake could provide a greater headache when it comes time to transport that copper.  

(c) Fortigent

www.fortigent.com

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