• Merck
• Google
• Coca-Cola
• Oracle
• Baxter, Intl.
• Microsoft
• Pepsico
• Colgate
• United Parcel Service
• Raytheon (interesting, considering who pays them)
• Norfolk Southern
• Wal-Mart Stores
• Monsanto
• Nike
• Consolidated Edison
• John Deere

Effectively, the market has appraised the risk of default for these companies and has judged them to have less credit risk than the U.S. government, which has the ability to levy taxes, confiscate things–including companies and countries.

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Below

• Correction mode continues
• Oil dynamics likely to fluctuate (deep thought by Jack Handy, that one)
• Slow week for economists

Prior Posts

• The Trouble with the Dow
• Your Federal Reserve at Work

Capital Markets Recap

Here’s a look at the correction action in the S & P 500.  It’s down just 3%, so it hardly counts as a correction.  Naturally, the pain has been more acute in individual securities.  The chart below shows a breach, yesterday, in the 50-day moving average and, today, a rebound back above it.  We’ll call yesterday’s action a whipsaw for now, a shakeout of traders who use the default settings on their fancy software.  But that support has been shown to be tenuous–notice that the action back in November/December only flirted with the 50-day moving average, validating it by not closing below it, just getting there on an intraday basis.

For now, we remain in correction mode until we start to see some higher highs in the chart above.  The market tends to make a modest bottom early in March of each year, so it may just be that seasonal dip. 

We think this will be a short-term correction within a cyclical bull market within a secular bear market, so for now we intend to weather the correction and make some buys of stocks we’re watching.  Trouble is, one never knows if the short-term will become cyclical . . .

Top Stories

 Running out o’ time on this Friday afternoon . . . bullets only.

• Dubai Stocks Tumble to World’s Cheapest as ING says Time to Buy
• Italian Stocks Cheapest Since 1993 May Signal Gain
• PIMCO’s Gross Eliminates Government Debt from Total Return Fund

The Total Return fund is the world’s largest fund of any type, stock or bond.  In his monthly dispatch, which came out last week, Bill Gross argued that the Fed’s Quantitative Easing program (aka QE2) has been a $1.5 trillion prop for risk assets and has kept interest rates low.  With itself as THE buyer of the increased debt supply–and itself exiting the pool of future bond buyers–the Bond King wonders where the next marginal buyers will come from?  In other words, how will interest rates be kept low.

• Oil Tumbles as Japanese Quake Shuts Refineries

This is a curious one, and about one economics class beyond my ken, having stopped at Econ 100.5.  The refineries will demand less oil; thus aggregate demand for oil will go down, pushing its price down.  At the same time, the supply of distillates (i.e. refined products) will go down, and that could push gas prices higher.  That’s one moving part too many.  So much for ceteris parabis.

Short of saving your soul or fixing the Mars/Venus problems, a Bloomberg terminal can do just about anything, and we sport one of the desk of each portfolio manager here.  As a matter of fact, while it can’t sort of Mars/Venus issue, in the event that Mars (or is it Venus) wants Venus (or is it Mars) to stop talking and just get to the point and ruffles feathers in the process, the Bloomberg terminal can help facilitate penance via its shopping functionality.

Anyway, here’s a look, courtesy of Bloomberg, at refinery outages worldwide.  (Click the image for super large version.) 

Here is what makes me think you’d better top off the tank, again.  We’ve lost an annualized 25% of output–O V E R N I G H T–as the chart below illustrates.

• Retail Sales in U.S Climb Most in Four Months on Car, Clothing Purchases
• Gross says U.S. will Retain its AAA Credit Rating as PIMCO culls U.S. Debt

Undoubtedly, PIMCO received a call from its close associates at the Fed (“I’ve got Bernanke on seven, your majesty,”) asking it to go on Bubblevision and reassure Joe Investor that his bonds are safe.  The credit rating is someone’s approximation of the likelihood of an investor getting his/hers principal and interest payments.  No risk there for now, no matter what Sean Hannity says. If Bill’s right the risk now seems to be that of a rise in real interest rates (who will buy the bonds? have to raise the yield) and, possibly, the inflation premium will go up, too, giving a double kicker to yields.  We advise under-emphasizing bonds in a balanced portfolio.

This Week

As I mentioned last week, there really wasn’t much of great import on this week’s economic calendar.  The NFIB Small Business Optimism index rose to a level last seen at the end of 2007.  The index had been in decline then, but the recession that was underway hadn’t been widely accepted.  Hiring Plans, however, a component index is only back to Lehman-Crisis September 2008.  Initial Jobless Claims took an unexpected–as if anything the economist get wrong is unexpected–jump to 397,000, which was well above the consensus (376,000) and last week’s figure (368,000, which was subsequently revised up to 371,000.)  Finally, skyrocketing gas prices finally put the squeeze on the consumer’s attitude.  The drop in University of Michigan Consumer Confidence to 68.2 broke a rising trendline, which had been in place back to early 2009.

Next Week

In contrast to this week, there’s a whole slew of them next week.

Key indicators to watch

• FOMC Rate Decision - there won’t be any surprise on the rate, but following Bill Gross’s comments about QE 2 propping up the market, you can be sure this will be carefully watched.
• Producer Price Index (Wednesday) – February
• Consumer Price Index (Wednesday) – February
• Industrial Production (Thursday) – February
• Capacity Utilization (Thursday) – February
• Initial Jobless Claims (Thursday) – weekly
• Leading Economic Indicators (Thursday) – February

Housing related indicators

• NAHB Housing Market Index (Tuesday) – March
• Housing Starts (Wednesday) – February
• Building Permits (Wednesday) – February

Regional indicators

• Empire State Manufacturing index
• Philadelphia Federal Reserve 



Graig P. Stettner, CFA, CMT

Vice President & Portfolio Manager

Tower Private Advisors

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As usual, I’m a day late and five dollars (inflation) short on this subject.

Meredith Whitney made a splash late in the last decade saying Citigroup was going down the tubes.  Not having made any market-shaking calls since that call when she was employed at Oppenheimer–she left there to start up her own shop–and needing some new clients, she recently showed up in a 60 Minutes interview predicting there would be between 50 and 100 “significant” muni bond defaults in 2011, totalling “hundreds of billions” of dollars.  [Plagiarism police please note:  I lifted everything from “between” to “dollars” verbatim from the Bloomberg synopsis below the video at bottom.  She was not pressed to substantiate those claims and, thus, fear was mongered.  You can watch that video by clicking on the image below, but only if you promise to watch the one below it.

A number of folks have taken umbrage at her claims.  Their umbrage is pretty well summed up in the Bloomberg interview below.  In short, she doesn’t know what she’s talking about.  In long, unfunded pensions have been an issue for several years.

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They just hit the sell button.  (This chart goes back to the beginning of 2009.)

Where they go with proceeds is anyone’s guess, but it’s pretty tough to meet retirement goals with modest interest rates and falling bond prices.

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Here’s a quick recap:

• Economists expected a drop of (-)65,000 jobs, because those sharp folks knew that census workers would begin to be furloughed/downsized/fired/canned, but they evidently expected a pick-up in private payrolls to offset that drop.
• Instead, payrolls fell by (-)131,000.  What’s more, the June figure was revised downward, from an initial release of 125,000 jobs lost to 221,000 jobs lost.
• The Private Payrolls increase, which seemed to be sparked by an optimistic ADP’s Employment Change report of Wednesday, which only reports on private payrolls, was 71,000 instead of the hoped-for 90,000.
• The Unemployment Rate stayed at 9.5% instead of increasing to 9.6%.  The unemployment rate always goes up after a recession as the labor pool swells up as more job seekers re-enter the labor force.
• On the positive side of the ledger, Average Hourly Earnings grew by 0.2%, far better than the drop of (-)0.1% in June, and the President found hope in the increase in Manufacturing Payrolls.  They rose by 36,000, 4x the June number and far more than the hoped for 13,000.

So how does one explain the market’s performance, shown below?  The market dropped shortly after the opening, and the opening nonsense is often reversed, but there was very little positive to be found in this most important of economic reports.  Indeed, at this point in the game, it is the most important report, bar none, whatever that means.

According to a couple of sources, it was rumored that the Federal Open Markets Committee; i.e. the Fed, which is to meet tomorrow, is prepared to announce another round of monetary policy measures meant to stimulate the economy.  So far, traditional monetary policy has amounted to pushing on a string, so the market is hoping for another round of Quantitative Easing–QE to the informed.  For those of you worried about the government printing money that’s what QE is.  In this case, they wouldn’t exactly be printing money, just reinvesting principal-paydown proceeds from Mortgage Backed Securities (MBS) into . . . Treasuries or more MBS.

According to some of those same sources, those hopes are likely to be dashed.  As we like to say–and like most things, it’s not original to us–hope is not an investment strategy.  It is, however, a decent speculation strategy, so long as you can sell the idea (and your securities) to a greater fool.

If the Fed does not announce new measures, the market tanks.

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Our concerns arose from a couple of items that the Williams Inference Service folks raised.  Here’s a recap.

Fourth quarter of 2005 – file titled, “Local Debt” – featured rising local taxes and efforts to cap them.  Finished with excerpt from Money Chronicles: 

“[b]ut the really serious local debt crisis nobody is talking about yet is . . . local government debt . . . Take the states.  Out of 50, 43 of them are close to bankruptcy.” 

Alarmist? sure, but it caught one’s attention.

Fourth quarter  of 2008 – file titled, “Main Street” – talked about the pension issue (“perhaps the bigggest time bomb of all is something that remains a secret . . . “), declining sales tax revenues (“And states, unlike households and business, have few reserves set aside for a rainy day.”)

First quarter of 2009 – file titled, “Firemen’s Pensions”

“Thee Federal government is focused on the bailout package . . . This leaves pension obligations as an afterthought.  This ticking time bomb will have repercussions far into the next decade.”

Between and since these events stories about municipality troubles have begun migrating from page 16 to page 1, the point at which the problems should be widely discounted and the end of the trend may be near.  Well, you can’t get more page 1 than a TIME magazine cover story like this one.

Meanwhile, our Strategas service recently pointed out several datapoints that are bullish for municipal finance in a report titled, “STATE(S) OF CONFUSION: DISPELLING THE MYTHS ABOUT STATE & LOCAL GOVERNMENT FINANCES.”

An ideal situation would have been for municipal bond yields to have risen over this period.  Then we could look for a peak and an opportunity to back up the truck, as they say, and buy muni bonds.  In fact, yields have largely declined over this period, as can be seen below.  Also on display is the breakout through the downtrend in yields, so yields are on the rise.

While rising yields aren’t evidencing the increased fear/awareness, what might be is the way municipal bonds have lagged the rally in Treasuries.  If the fears are at a peak it might suggest that munis have some catching up to do.  Even without the ultra-low yield on display in Treasuries, it makes sense to sell Treasuries and buy munis.

Make no mistake:  there will be trouble with municipalities.  They’ll include communities affected by the oil spill and those in trouble with pensions.  You’ll read stories like this one:

Tough times: The city of Maywood, California, is laying off all city employees and hiring contractors for police work and all other essential business, the Los Angeles Times reports. Having been bankrupted by financial incompetence, the City Council decided to fire all 100 city workers. It will contract police services from the LA County Sheriff’s Department and get street maintenance, finance, and administrative services from a neighboring city.  Full story here.

These anecdotes, however, shouldn’t be used to paint an entire asset class, and, indeed, with the press featuring such a story on the front page, it suggests the fever pitch should be approaching an end.  We would use any yield spikes as an opportunity to buy solid municipal bonds.

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Some Trilateral Commission/conspiracy types, however, were skeptical since it left the fox guarding the hen house.  The principal amount of a TIPS is adjusted each month for the change in [__]flation–”in” or “de,” and the interest payment goes up or down, accordingly.  The Consumer Price Index for all items–doesn’t exclude energy and food prices–is used for the inflation adjustment.  So Uncle Sam calculates the factor that determines the interest payment and the maturity value of the security, and it’s on the hook for the potential increase.  Suffice it to say, for the cynic there’s plenty of reason for the government to prefer deflation as it relates to TIPS.

Never happen, right?  ‘Government’s wouldn’t do that, would they.

You’ll have to decide that for yourself, but the following might help. 

I’m lifting the following directly from John Mauldin’s Thoughts from the Frontline weekly newsletter (available here) dated 18 September 2009 (available here.)  The emphasis mine, other than the title.

Outrageous! – Artificial Deflation!

Speaking of deflation, let me mention something I find totally outrageous. Normally, I actually take up for the bureaucrats who are stuck with the task of trying to monitor inflation. It is a tough job, and like Monday-morning quarterbacks, everybody thinks you should have done it differently. I can understand the rationale for hedonic measurements [GPS: adjustments for quality, like increased computer speeds, etc.], housing rent equivalents, etc., even if I don’t agree with them. You have to set some rules and live with them. But the latest imbroglio is disgraceful.

It seems the US Bureau of Labor Statistics, in the CPI next week, will treat the subsidy received by those 800,000 car buyers who bought a car in the “Cash for Clunkers” program as if the price of a car fell by $4,500. Really? My tax dollars account for nothing?

This does several things. It will decrease the inflation used to adjust the GDP for this quarter. Not the end of the world, but annoying But what really matters is that the CPI is used to calculate Social Security increases and interest paid on TIPS.

If I tried to defraud one of my clients using such accounting legerdemain, I would be shut down, sued, and taken to court (at the minimum) by the host of regulators who look over my shoulder. And I should be! You don’t make such changes in the rules to your own benefit. But that is what the BLS did. This policy should be overruled immediately. There are enough deflationary forces in the world without having to artificially create some more. OK, off the soapbox and onto the banking system.

If you’re interested in inflation-protected securities, there are a few routes.  First, there are these TIPS, issued by the Treasury.  Second, there are inflation-linked securities issued by corporations.  Third, there are inflation-linked securities issued outside the U.S., which add an element of currency fluctuation to the mix.

There are, however, tax implications that argue for using mutual and or exchange-traded funds to get exposure to this asset class if they’re to be used in a taxable account (i.e. not an IRA).  The principal adjustment from inflation is taxable every year, whereas you don’t receive that compensation–other than in the market price–until maturity.  Probably not a huge tax issue, but one that’s easily avoided by investing in a fund of inflation-linked securities.

Oh, and you might recall from prior dispatches, that we’re not terribly concerned about inflation for the next couple of years, although the man/woman on the street probably is.  We don’t mind thinking differently from him/her.  Kinda makes us feel smart.

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It’s a wonder that municipal bonds are still largely tax free.  Some states tax residents for income generated on other states’ bonds, while others further attempt to funnel funds by only exempting home-state bonds from state tax if they’re from certain types of municipalities.  Still, the big tax savings comes from the bonds being exempt from taxes at the Federal level.

Bloomberg featured a story (below) on a CBO proposal to capture some tax revenues that might be had were the bonds taxable.  Here would be the results:

1. Higher borrowing costs for municipalities, which means . . .
2. Higher taxes to cover the borrowing costs; and
3. More tax revenues from that favored target demograpic, “bondholders in higher tax brackets,” because they receive gains, “that [exceed] the investment return necessary to induce them to buy the bonds.”

Let’s Kill the Tax-Exempt Municipal Bond Market: Chart of Day

2009-08-19 10:00:00.0 GMT

 By Joe Mysak

Aug. 19 (Bloomberg) — The tax-exempt bond market costs the U.S. government $36 billion a year in forgone taxes. Replace the exemption with a credit and the government would lose less.

That’s the contention of the Congressional Budget Office, which suggested the change in its latest volume of options for altering federal spending and revenue.

Taxable interest payments would be offset by a federal tax credit, whose amount would be determined by the Treasury. The credit would change with the type of bond “on the basis of its perceived benefit to the public,” the CBO said in its report, whose options derive from a variety of sources, including legislative proposals and the president’s budget.

The tax credit might yield a smaller reduction in federal revenue than the current system. Opponents maintain that it could “raise the interest rates that state and local governments pay on borrowed funds,” the budget office said.

Earlier this year, the government introduced the Build America Bonds program, which pays municipal issuers 35 percent of the interest cost if they sell taxable rather than tax-exempt debt. The federal subsidy results in borrowing costs to the issuer even lower than those available in the tax-exempt market.

Since April, $22.6 billion in Build America Bonds have been sold as against $202.5 billion in tax-exempt bonds.

 

If you’re so inclined, you can click here to read the CBO’s 284-page, Budget Options Volume 2, August 2009.  Skip over to page 229 for more on the muni bond revenue scheme.  On second thought, I wouldn’t suggest looking at this tome unless you’re into nightmares.

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