Monday, November 22, 2010

Morning Note...

Futures ~40bps lower this morning as Ireland agrees to a rescue package over the weekend (meaning taxes in Ireland will probably go up and banks will be further nationalized).  Further, a front page Wall Street Journal piece on insider trading attracted negative attention over the weekend:  Europe had been higher on the formal activation by Ireland of an EU/IMF bailout of ~EU80 billion, but markets there have since drifted lower (-85bps now) as contagion fears (Portugal? Spain?) spark selling in European financials and the EURUSD is slightly lower at 1.36.  Asia mixed overnight.  Oil -10bps.  Gold flat.  USD +15bps.  In M&A news, Novell (NOVL, halted) is to be acquired by Attachmate for $2.2 billion.  In political news, this Reuters piece on “Democratic disarray over the Bush tax cuts” has sparked some concern:   Looking ahead, expect some slowdown into the U.S. Thanksgiving holiday and note that Friday will be a sparsely-attended half session (9:30am to 1pm) for stocks.  On Tuesday, the most recent FOMC minutes will be released, Wednesday brings housing data (home price index) and the first Q3 GDP revision.  The next U.S. jobs report will be Friday, December 3rd.  In other news, a bearish survey out of the National Association for Business Economics showed “the U.S. economy will fail to strengthen in 2011 as companies limit hiring and consumers curb spending.”  However, Barron’s weekend edition was positive on the U.S. consumer heading into the holiday shopping season and on the municipal bond market after recent weakness.  Barron’s was also cautious on banks over the weekend:

“Banks face another mortgage crisis” - Banks could wind up suffering losses totaling $100B thanks to repurchase demands; banks securitized some ~$2T worth of sub-prime, alt-A, and option ARM mortgages during the crisis and now the buyers of those assets are making repurchase demands onto banks.  $30B of that $100B will come from repurchase demands made by Fannie and Freddie alone.  AGO and MBI could wind up being successful recapturing some of the money lost on failed mortgages.  The Barron’s article says BAC could face losses totaling $35B while DB may see a $14B hit, GS $11B, RBS $9.4B, CS $8.9B, UBS $8.4B, MS $7.9B, C $7.8B, Barc $3.6B, and HSBC $3.5B (the article cites numbers from Compass Point).  However, it will be a long hard slog for investors in private label mortgages to make substantial claims against the banks.

Each Monday I also find the Weekend Bank Failure summary on Bloomberg interesting:

            Home BancShares Buys Florida Lender as 3 More U.S. Banks Fail 2010-11-22 10:39:26.359 GMT
Nov. 22 (Bloomberg) -- Home BancShares purchased a collapsed Florida-based lender and financial institutions in Wisconsin and Pennsylvania were also shut by regulators as 2010 U.S. bank failures rose to 149.
            * Home BancShares purchased Gulf State Community Bank, according to a statement on FDIC website
            * Home BancShares’ unit Centennial Bank has purchased 6 banks through the FDIC’s resolution process this year
            * Together, the 3 lenders closed had assets of $969.4m
Note: FDIC’s tally of “problem” banks climbed to 829 with $403b in assets at end 2Q, a 7% Q/q increase.

Also, there’s a Financial Times article out over the wknd cites Barclay’s research and predicts U.S. banks face a $100 billion shortfall against Basel III standards:

            US banks face $100bn Basel III shortfall  Published: November 21 2010 17:42 | Last updated: November 22 2010 00:10 

The top 35 US banks will be short of between $100bn and $150bn in equity capital after the new Basel III global bank regulations are imposed, with 90 per cent of the shortfall concentrated in the biggest six banks, according to Barclays Capital. The BarCap study assumes the banks will need to hold top-quality capital equal to 8 per cent of their total assets, adjusted for risk. This 8 per cent tier one capital ratio, a key measure of bank strength, provides a one point cushion against falling below the effective global minimum of 7 per cent set in September by the Basel Committee on Banking Supervision. The Basel III reforms will hit banks in two ways – by gradually tightening the definition of what counts as tier one capital; and by forcing banks to increase the risk adjustment for big swathes of their businesses. Banks can respond by increasing their capital through retained earnings or equity issuance or they can cut their risk-weighted assets through sell-offs and by cutting back on risky business lines. So far most analysts believe the big US banks will not be forced to raise capital just for regulatory purposes. But some people worry sharp cuts in assets could force banks to curb lending to the real economy or raise borrowing costs. “These shortfalls are entirely manageable...The more difficult question is what affect the new rules will have on the cost and availability of credit and bank profitability,” said Tom McGuire, head of the Capital Advisory Group at BarCap.
Basel III: The impact on bank capital

Regarding Europe, an outfit called High Frequency Economics is predicting a “shut down” in Greece and CDS there have widened by 36 bps:

            Greece May ‘Shut Down’ on Cash Shortage, High Frequency Says  2010-11-22 08:18:51.866 GMT
Nov. 22 (Bloomberg) -- Parts of Greece’s government may be forced to “shut down” as early as next week if the country isn’t able to cover a revenue shortfall after its EU partners delayed its next tranche of aid money, High Frequency Economics said.  Greek government bonds declined for a second day, with the 10-year yield increasing 3bp to 11.78%

Thought this was interesting from BofAMLCO this morning…something worth keeping an eye on:

We launch the BofA Merrill Lynch Global Financial Stress Index (GFSI). We believe the GFSI and its family of constituent indices represent the most comprehensive measures of stress in financial markets. The GFSI is an index encompassing three kinds of financial market stress. First, risk as indicated by cross-asset measures of volatility, solvency and liquidity (the Risk Index). Second, hedging demand implied by equity and currency option skew (the Skew Index). Third, investor risk appetite gauged by trading volumes and flows into equities and high yield bonds and out of money markets (the Flow Index). The GFSI and its 11 sub-indices can be followed daily on Bloomberg. Type GFSI . Our backtesting shows that GFSI is a better leading indicator than the VIX. Sharp rises in the GFSI have preceded sell-offs in risky assets, particularly equities. It signals market turning points. The GFSI's constituents help identify relative value across assets and cheap hedges. The GFSI's current reading is 0.15, which indicates that market stress is marginally elevated. The Flow index as of Friday close is -0.57, recently touched a 2 year low (-0.72) indicating large inflows into risky assets and out of money markets. Both the Risk (0.28) and Skew (0.36) indices remain elevated, indicating growing market stress. Buy protection is the actionable message today.

In other commentary, Mike O’Rourke of BTIG posted a nice summary of recent Ben Bernanke comments:

Ben Breaks His Silence.

Throughout August, we criticized the Federal Reserve and the Chairman for leaking major monetary policy shifts thereby fueling confusion and controversy in the financial markets.  The action was akin to the General Manager of a professional sports franchise floating trade rumors in the press to gauge what the reaction is.  In both cases, such tactics show a lack of leadership and can be unnecessarily destabilizing.  In late August, at his Jackson Hole speech, Chairman Bernanke finally provided clarity regarding the rationale for the implementation of replacement purchases of assets as the Fed's balance sheet shrunk.  It was at that point that QE2 discussions commenced.  Once again, vague details were leaked to the media but generally, the Fed Chariman remained quiet.  In his October 15th speech, the Chairman confirmed that a new round of Large Scale Asset Purchases was likely, but that was already a foregone conclusion in the market for nearly a month.  Thursday night, Chairman Bernanke provided his most comprehensive explanation of why the United States commenced a new asset purchase program. 

The Chairman addressed the global imbalances fostering the "Two Speed Global Recovery."  The Chairman mounted an extensive defense of FOMC policy in relation to the global economy.  He even took the rare step of including 9 charts to help illustrate his view.  The initial headlines regarding the speech indicated that the Fed Chairman was taking shot at China.  Such headlines fed into the key Bear themes in the financial markets today - that a currency war will escalate into a larger trade war.  As most market participants are aware, there usually aren't any winners in a trade war.  We don't interpret the Fed Chairman's statements as inflammatory rhetoric, rather, quite to the contrary, the statements are honest. 

It is no secret that many Asian nations manage their currency.  In doing so, they shut the release valve that would moderate capital inflows from becoming too hot, thus creating asset bubbles and overheating their economies.  Bernanke explains how the proper exchange rate process should work, "This currency appreciation would in turn tend to reduce net exports and current account surpluses in the emerging markets, thus helping cool these rapidly growing economies while adding to demand in the advanced economies.  Moreover, currency appreciation would help shift a greater proportion of domestic output toward satisfying domestic needs in emerging markets.  The net result would be more balanced and sustainable global economic growth." None of this is new.  Even pre-crisis, the U.S. and China have created an unhealthy environment of codependency where the U.S. purchases China's inexpensive products and China buys America's expensive bonds.  The Fed believes that asset purchases are the best viable policy option to promote the growth in the U.S. economy while operating within the currency constraints of the global economy.  Bernanke also highlighted the important point that despite private capital has been flowing to emerging markets at the same torrid pace as it did pre-crisis reserve capital is flowing back into developed economies.  He explained that "…current account deficit of the United States implies that it experienced net capital inflows exceeding 3 percent of GDP in the first half of this year.  A key driver of this "uphill" flow of capital is official reserve accumulation in the emerging market economies that exceeds private capital inflows to these economies."  We would interpret that as an additional sign that the Dollar's demise will continue to be delayed while these imbalances exist.  On that note, despite all of the criticism of the Dollar in recent months, not only did the Dollar index not break its 2009 lows, it has not broken its 2008 lows either.  Additionally, Bernanke's 8th chart indicates that the currencies in both Taiwan and Hong Kong have devalued versus the Dollar in the 12 months ending September, thus leading to more dramatic reserve builds relative to GDP than China.  Those points are certainly not shots at Mainland China

If one really wanted to heat up the anti-China rhetoric, one need only call into question China's demand for more IMF influence despite having the world's largest manipulated currency.  If you want a seat at the table, you should be eating the same food.  In fact, the Chairman was fairly forgiving in his speech, noting that "In the near term, a shift of the international regime toward one in which exchange rates respond flexibly to market forces is, unfortunately, probably not practical for all economies.  Some emerging market economies do not have the infrastructure to support a fully convertible, internationally traded currency and to allow unrestricted capital flows.  Moreover, the internal rebalancing associated with exchange rate appreciation--that is, the shifting of resources and productive capacity from production for external markets to production for the domestic market--takes time."  While we still do not agree with the Fed's policy, Chairman Bernanke did a good job of clarifying for the global community the factors behind the Federal Reserve's decision to commence a new round of asset purchases. 

GMCR higher on earnings restatement and BCAP upgrade.  CIEN upgrade at BCAP.  CITI ups AMKR, TER.  FBRC ups AGII.  JEFF ups CRUS.  MSCO ups TSO.  BARD ups SNDK.  CITI cuts YGE.  CSFB cuts SPP.  FBRC cust MEE.  MSCO cuts DE.  WEFA cuts ATW.  CSFB positive T, VZ.  CIEN rated new EW at MSCO. 

S&P 500 PreMarket 8:30am (last/% change prior close/volume): 

Today’s Trivia:  What sea creature boasts the largest eyes in the animal kingdom?
Yesterday’s Question: Who does Rocky fight in Rocky III?  How about Rocky IV?

Yesterday's Answer:  Rocky fought Clubber Lang in Rocky III and Ivan Drago in Rocky IV. 

Best Quotes:  Interesting Bloomberg story…

Greed Beats Fear With Stock-Bond Correlation Falling 2010-11-22 08:51:12.529 GMT

By Whitney Kisling
     Nov. 22 (Bloomberg) -- For the first time since the financial crisis started, U.S. shares are moving independently of the bond market, a sign that profits and valuations are guiding investors more than concern about the economy.
     The 30-day correlation coefficient measuring how often the Standard & Poor’s 500 Index moves in tandem with 10-year Treasury yields fell to minus 0.42 from a record 0.89 in June, data compiled by Bloomberg show. Readings of 1 indicate prices are moving together, while zero shows no link and minus 1 means they are going in opposite directions. Stocks and debt are ending a lockstep relationship that began in July 2007 and lasted through the worst recession since the 1930s.
     Pioneer Investments, Security Global Investors and Citigroup Inc. say the broken connection is bullish as the greatest number of S&P 500 companies in a decade post earnings growth. During the bull market from 2002 to 2007 when the S&P 500’s price and profits doubled, the correlation averaged 0.15, data compiled by Bloomberg show.
     “I prefer days when companies are rewarded or punished based on their performance,” said John Carey, a Boston-based money manager at Pioneer, which oversees about $250 billion.
Before, “people were worried that some large events over which they had no control would influence the direction of the market and investment results,” he said.

                        Bernanke’s Pledge

     The S&P 500 rose less than 0.1 percent to 1,199.73 last week as China took steps to curb inflation. The index has advanced 13 percent since Federal Reserve Chairman Ben S.
Bernanke hinted on Aug. 27 in Jackson Hole, Wyoming, that he would use a strategy known as quantitative easing to boost the economy. The relationship between the 500 stocks and the benchmark index fell to 0.55 on Nov. 11, the lowest since May 3, according to Birinyi Associates Inc. data on 50-day correlation.
     Futures on the S&P 500 expiring in December rose 0.5 percent to 1,204.4 at 8:48 a.m. today in London.
     The relationship using 30 days of data between the S&P 500 and 10-year Treasury yields was last negative in July 2007. It jumped to 0.79 on Aug. 14, 2007, five days after Paris-based BNP Paribas SA halted withdrawals from three investment funds because it couldn’t value their holdings as U.S. subprime mortgage losses roiled credit markets. The stocks-bonds relationship never turned negative in 2008.
     The S&P 500 plunged 4.7 percent and yields on 10-year Treasuries tumbled 33 basis points, or 0.33 percentage point, on Sept. 15, 2008, after New York-based Lehman Brothers Holdings Inc. filed for bankruptcy. The correlation jumped to 0.83 on Oct. 6, 2008, as the financial crisis intensified, reaching the highest level since a month after the Iraq War began in 2003, data compiled by Bloomberg data show.

                       Profits, Takeovers

     Bernanke’s Aug. 27 comments helped end the lockstep moves.
Weaker connections among assets mean profits, takeovers and valuation will drive returns, Security Global’s Mark Bronzo said. The S&P 500 climbed to a two-year high on Nov. 5 and the rate on 10-year Treasuries dropped to the lowest level since
2009 on Oct. 8.
     While Howard Ward of Mario Gabelli’s Gamco Investors Inc.
says stocks are likely to rally, loosening correlations aren’t fueling his optimism.
     “The correlation is moving lower because of what’s now a real perceived difference in the return potential for stocks versus bonds,” said Ward, whose firm oversees $26 billion in Rye, New York. “I understand people are very anxious about stocks because of volatility, because of economic uncertainties and because they didn’t do well for the last 10 years, but buying bonds today is like buying stocks in 1999,” before the S&P 500 plunged 49 percent, he said.

                        First Decade Loss

     Treasuries returned 81 percent between 1999 and 2009 while the S&P 500 dropped 9.1 percent, including dividends, for its first loss over the course of a decade, according to data compiled by Bank of America Corp.’s Merrill Lynch and Bloomberg.
     As correlations break down, quarterly financial results are swaying share prices more than at any time since 2007. S&P 500 companies that beat the average analyst profit forecast gained
0.1 percent since reporting results, while those that missed declined 3.3 percent, according to data compiled through Nov. 16 by Westport, Connecticut-based Birinyi. That’s the first time in three years companies beating estimates rallied and those that missed fell on average.
     “There are those individual names that will produce stronger earnings and profit margins, and will be rewarded for that,” said Bronzo, a money manager in Irvington, New York, whose firm oversees $22 billion. “We’re returning to a more normal economic environment as we’re moving past the financial crisis. So where the market traded all as a group, there’ll be more of a distinction between sectors and names.”

                        Beating Forecasts

     Third-quarter earnings surpassed analyst projections by 6.6 percent for the 457 companies that have reported since Oct. 7, Bloomberg data show. It was the sixth straight period in which more than 70 percent of companies beat forecasts, the longest stretch since at least 1993, according to Bloomberg.
     Analysts forecast 87 percent of S&P 500 companies will post higher earnings next year. That would be the most since at least 2000, estimates from more than 10,000 analysts compiled by Bloomberg show.
     “There’s a better chance for active managers to outperform,” said Eric Teal, chief investment officer at First Citizens BancShares Inc. in Raleigh, North Carolina, which manages $5 billion. “Over the past few years, many of the macro forces have driven the stock market returns and now more fundamentals are starting to drive the market.”

                       Stocks, Junk Bonds

     Stocks that trade at below-average price-earnings ratios and that trailed benchmark indexes in 2010 -- such as Hewlett- Packard Co. and Merck & Co. -- should benefit as equity returns diverge, Carey said. MFS Investment Management’s James Swanson recommends technology companies because they have money to return to shareholders.
     Hewlett-Packard has almost $15 billion in cash, the 12th- highest amount in the S&P 500. While at least 28 of 38 analysts covering the Palo Alto, California-based company recommend investing in the world’s largest computer maker, the stock has fallen 18 percent this year, pushing the valuation down to 8.3 times 2011 estimated profit.
     Merck, the world’s second-largest drugmaker, has a price- earnings ratio of 9.2 times next year’s forecasts, Bloomberg data show. The Whitehouse Station, New Jersey-based company is down 3.3 percent this year, compared with the S&P 500’s 7.6 percent gain, even as per-share earnings excluding some items are projected to expand 13 percent next year, the best annual growth since 2007, according to the analyst average.

                          ‘My Goodness’

     “My goodness, these are very good prices for these stocks,” Carey said of health-care companies. The 51 pharmaceutical producers, device makers and health insurers in the S&P 500 trade for 12 times annual earnings, compared with a 10-year average of 19.2, data compiled by Bloomberg show.
     While the benchmark index for American shares has rallied
77 percent since reaching a 12-year low on March 9, 2009, prices relative to earnings remain below historical levels. More than
88 percent of S&P 500 stocks are cheaper than their average since 2005, based on next year’s forecasts, compared with the decade’s 66 percent mean, data compiled by Bloomberg show.
     Takeovers picked up this year, with $651 billion worth of U.S. deals announced since January, compared with $635.8 billion for all of last year, according to data compiled by Bloomberg.

                      Similar Performance

     Stronger correlations made it more difficult for mutual funds to distinguish themselves. The standard deviation, or variation in returns, for funds invested in the biggest U.S.
companies declined to 4.1 percent in the second quarter, data compiled by Lipper and Bloomberg show. That was the lowest since at least 2000. The figure climbed to 9.8 percent last quarter as correlations weakened.
     Returns among money managers mirrored one another regardless of strategy. An index of hedge funds focused on bonds of distressed companies has returned 8.5 percent this year, according to data compiled by Bloomberg and Chicago-based Hedge Fund Research Inc. Over the same period, a gauge of Latin America funds returned 7.1 percent. The correlation between the two has climbed to about 0.28 point more than the 12-year average, Bloomberg data show.
     “More focused investing may be in the process of developing,” Tobias Levkovich, Citigroup’s chief U.S. equity strategist in New York, wrote in a report this month. “As returns begin to diverge, investors arguably can be well-served by buying those stocks they deem attractive without worrying about macro conditions that can swing entire groups.”