July 19, 2009
This article is mainly derived from e-mails in more real-time from the previous week.
Goldman, Intel, China Trigger Last Week’s Rally
Something obviously changed last week, as global markets last Monday went overnight from obsessing about breaking down through head-and-shoulder necklines at 875 on the S&P, to celebrating a few select earnings reports and economic data, especially from Goldman (which Meredith Whitney stepped in front of on CNBC), Intel and China.
The market focused on the former two financial and tech bellwethers as second-quarter earnings season hit full stride, and the latter as China, and more generally emerging markets, have so far been one of the main “feel good” stories of 2009, along with the U.S. presumably escaping Great Depression II for now, though the financial crisis has caused widespread great hardship.
A key issue with all three of these market catalysts was whether traders were right this week in extrapolating their better-than-expected news to overall global markets and economies, with SPY up 7.0% and EEM up 8.6%, and the cyclical, high-beta “usual suspects” up much more, for example UYM up 24.0%.
Traders will be focused this week on follow-through of the market’s obvious desire last week to extrapolate from leaders (among corporations and national economies), and whether that decisively breaks the S&P out of a trading range since early May bounded by the June 11th high of 956 and 875. Breaking out to the upside will pressure pm’s who can’t afford career-wise to lag a rising market to scramble further.
Whether you view the two-month trading range as a bullish or bearish consolidation, after the biggest rally since 1937-38, seems to depend on your market bias. E.g., the conviction of bearish technical analysts, concerned about things like low volume and Lowry’s low Buying Power, who believe that the market exceeding resistance might be a huge “bull trap,” may have been tested somewhat last week.
China’s Strong 2nd Quarter GDP on Infrastructure, Property Growth
Thursday China announced second quarter growth of 7.9%, up from 6.1% in the first quarter. Following that, bank economists upped their forecast of 2009 growth to north of 8%, and 2010 toward 10%, with peak quarterly year-to-year growth well over that by early 2010.
China’s infrastructure spending, much of it directed by its large government stimulus program to booming non-coastal provinces and cities, is expected to be up about 50% this year, giving a huge boost, about a positive swing of four percentage points, to its 2009 GDP growth, offsetting a weakening external balance, which is actually a negative contributor to growth this year, as export growth has lagged import. (There is some debate about how advanced invoicing late last year may be underestimating the former now.)
The hope of China bulls, most of Wall Street and retail investors, is that export growth will now pick up in the second half, which is predicated on U.S. consumption growth, which still remains weak, e.g., last week’s retail sales data. In the meantime, a strong state-sponsored rebound in China’s property sector (as in the U.S. with the Fed, though with much less impressive results so far here) has been helping to fuel its domestic consumption, e.g., annualized vehicle sales over 11 million versus less than 10 million in the U.S.
All this China growth, and speculation, is being financed by money supply and credit annual growth rates now at 28-34%, which of course has raised concerns as to whether this is another Chinese market bubble, and about China’s own stimulus “exit strategy,” e.g., in recent weeks little concerns about weaker-than-expected China government bill sales. (“Exit strategy” concerns have recently diminished regarding the Fed, as the 10-year T-bond rate fell from about 4%, the issue may be raised in Bernanke’s monetary policy testimony this week).
With the Shanghai composite on a daily march straight up the past month, now over half way towards its previous peak, bubble-type investor behavior seems to be increasing in China, e.g., its first newly approved IPO’s in quite some time were over-subscribed 500-600%. Andy Xie, the former MS chief Asian economist, is, as expected, a well-known proponent of the bubble view, in his typically very thought-provoking articles on Caijing.com.cn.
If China is becoming a bubble, the trick, as always, for those playing that game will be to not to get caught without a seat when the music stops, as Citigroup’s Chuck Prince failed to do in 2007.
Traders Start Extrapolating “Better-than-Expected” Earnings
Intel had upside surprises on both the top and operating margin lines, the latter driven by the former in a high fixed-cost business. This upside surprise always seems to occur at turns in the semiconductor inventory cycle, and it is always seems to be underestimated by Wall Street analysts, so I wouldn’t read too much into it just yet.
Intel had strong growth in Asia (up over 20%, again the China story), with consumers driving demand, enterprise spending is not yet picking up. Guidance for the second half seasonal build and gross margins, bulls hoping ultimately back up toward 60%, 46% was the consensus for second quarter, was strong, lessening for now concern about the secular trend to lower-priced netbooks, with bulls hoping for upside from enterprise customers and the Windows 7 product cycle kicking in.
In other technology stock quarterly reports, IBM’s was an example of better-than-expected margins but mediocre revenues, which was enough for bulls. Nokia’s quarter was a reminder of how brutal competition is without the very hottest products in consumer electronics markets, especially in Asia, and Google’s that the consumer and hence advertising is still weak in the U.S. But for last week, the market sloughed off individual disappointments, and the technology heavy QQQQ continued its market leadership role.
As for Goldman’s blow-out second quarter, $22-23 b. is what the Street now expects for its fixed income, currency, commodities (FICC) sales and trading segment, up from a mere $3.7 b. last year, and $14.0 b. and $16.1 b. in the credit bubble fiscal years of 2006 and 2007.
GS trading and principal investments, which are expected to account for about 86% of its net revenue in fiscal 2009, is obviously back, stronger than ever due to weaker competition and less encumbered by the mortgage, consumer, commercial real estate (though GS had write-downs there) and other debt hurting most other financials, including even JPM, as shown in its report later in the week, and those of BAC and C, less successful than GS in trading.
One obvious question, which I asked in an e-mail Wednesday morning and Krugman did in his Friday New York Times Op-Ed, is whether what is good for Goldman is good for America. Wasn’t that premise the rationale for the Fed/Treasury bail-outs and industry consolidation favoring the select few too big to fail financial institutions?
Up until two years ago, the burden of proof in answering that question would have been overwhelmingly on the skeptics. That's because the then prevailing economic ideology assumed that investors were "rational," and markets were "efficient" and liquid, and that trading and speculating helped to make them so. Presumably after the collapse of the largest credit bubble in history, those assumptions would no longer have much credibility (even though they had previously survived the tech bubble fiasco and the 1987 stock market crash).
So you'd think the onus might now be on the presumably chastened "free market" bailout types to prove the social economic benefit of Goldman's trading, but it isn’t, at least on Wall Street and the mass media, where, to the best of my knowledge, no one has yet clearly explained how Goldman’s huge trading profits contribute to strengthening the economy, other than for NYC metro area real estate and luxury goods. Its traditional investment banking business raising and re-structuring capital for the Global 1000, which has some relationship to the real economy, is still expected to be flat, maybe down, this fiscal year.
One possible problem is that, in seeking to emulate Goldman’s secret sauce, others might once again be tempted to take unwise risks. Goldman envy happened when its profits coming out of the last recession blew away the competition in 2003-2004, with the Federal government then in 2004 giving the green light for the investment banks to lever up, oftentimes to 30:1 or more.
Goldman, now as a regulated bank for its convenience, is “only” at 14:1 right now, I’m not exactly sure how it is making so much money, but once that becomes more obvious, others may try to follow once again. And I highly doubt that Obama’s proposed financial regulations are going to prevent that.
Two Key Market Questions Left Unanswered Last Week
A basic issue for bulls projecting strong earning growth is that non-financial margins have remained high by historical standards, due to cost cutting, resulting in high unemployment and low incomes, which previously had not grown much even during the 2000s expansion.
To compensate back then, America’s middle class relied on “paper wealth” equity gains from an unprecedented real estate bubble. So if corporate costs are kept down again, expanding margins but holding back employment and income gains, and household savings are rising on top of that, what’s going to be the next Fed-created asset bubble this time around to drive an expansion?
As everyone knows, despite all the post March 9 rally euphoria over “green shoots,” “second derivatives,” “golden crosses,” etc., the S&P still has been unable so far to hold above its Jan 6th high, unlike emerging markets.
This has raised the questions of: 1) whether the emerging markets, with its large inflows of funds (which have flattened out the past couple of weeks), are either decoupled, or in a new bubble, especially China (see section above), or both, which is quite possible but less often considered; and 2) what is still holding back SPX from making new post March 9th highs.
Regarding the latter, composite indexes of financial conditions taking into account both credit and equity markets, e.g., from Bloomberg (BFCIUS:IND), have recovered all the ground, and then some, that they lost immediately following Lehman’s September 15th bankruptcy. One such index is now back to where it was before the global financial disaster about to strike first finally started to become obvious to many in July-August 2007.
Yet SPX is still about 26% below where it was just before Lehman-AIG in mid-Sep 2008, around 1275. Raising the obvious question as to why?
One answer, associated with people such as Merrill’s former chief North American economist David Rosenberg and Nouriel Roubini, seems to be that positive “second derivatives” and inventory cycle recoveries are one thing, but strong, durable, investment-led, self-sustaining, employment and income-generating expansions are another.
And despite last week’s strong rally, as far as the market is concerned, the jury still seems to be out on the latter, due to the very well-known “headwinds” of household and financial sector deleveraging and burgeoning government deficits and perhaps regulation. Deleveraging still has a long way to go, how far depends on whether you think it has to correct post-2003 cyclical excesses, or even go all the way back to post-1971 secular ones.
For now, Pimco’s El-Erian’s “New Normal” captures the current market consensus, though the latter is now edging up. E.g., both Roubini and GS are forecasting a mere 1% or so U.S. GDP growth in 2010. Those banker economists who have recently upped their forecast into the 2.5%-3% range have done so mainly on the basis of an inventory cycle swing, with weak final sales still well below 2% growth.
ECRI vs Roubini, Second Time Around
If I recall, Cramer and Roubini had a small tiff a little while ago. On Friday ECRI published an article picked up by Cramer’s Realmoney.com with a little swipe at those who missed the “second derivatives” rally. (Roubini’s views were mis-reported on CNBC and elsewhere on Thursday, the day before options expirations.)
I’ve been sending out e-mails on ECRI’s WLI every Friday since last fall, chronicling its turn. My little spreadsheet shows a simple second derivative, which is still quite high and positive, though declining the past three weeks, as is the four-week change of WLI’s four-week moving average over the past two weeks. I wouldn’t read much into that as of yet, given the strength of WLI’s annualized growth rate (first derivative), now at a five-year high.
This isn’t the first time Roubini and ECRI have disagreed. If I recall correctly, back around October 2006, the two appeared at an IMF seminar, with ECRI claiming Roubini was too early on his recession call.
In my opinion, both were right then, and both may be right now. Roubini was early on his 2006 call, my guess being that as an academic macroeconomist (Ph.D. Harvard) he was mainly oriented back then toward giving policymakers enough lead time warning to act. (Roubini had been Geithner’s advisor in Summer’s Treasury Dept in 2000.) Needless to say, they didn’t.
Yet for equity investors, there was still money to be made on the long side during the first half of 2007, especially in emerging markets, as they were simply oblivious to what was going wrong in the credit markets, readily apparent just by reading Bloomberg and the FT.
Uniquely Massive Response to Crisis, Who Knows the Outcome?
In 2009, the “second derivatives” of leading indicators fanned the huge post-March 9th rally initiated by the realization that the financial system had escaped complete collapse at that time, due to massive government intervention.
That’s now old news, the big issues that the market has been wrestling with since its consolidation began in early May are: what will be the shape of the recovery, L, U, W, inverted square root, etc; and what impact that will have on corporate profits, interest rates, the dollar and other key financial metrics..
Some people, from wildly different perspectives, helped throw badly needed light on the impending financial crisis.
These include more mainstream ones, such as Roubini, Achuthan, Rosenberg, Krugman, Stiglitz, Xie, Roach, Galbraith, Shiller, Rosner, Whalen, Faber, Kass, Hussman, Rogers, Gross, Schiff, Tett, Wolf, Tavakoli, Bookstaber, and others, and those not as in the mainstream, e.g., on the web, such as Janszen, Noland, to mention just a couple.
Do any know with strong conviction what will be the shape and strength of a recovery? Do Blankfein, Dimon, Lewis, Buffett, Ross, etc, or Bernanke, Summers, Geithner, Romer, Obama. This situation has never happened before. There have been huge financial crises, but never one met with such massive government response.
This week, more corporate earnings, AAPL, AMZN, MSFT, TXN, CAT among them, more economic news, South Korea’s GDP, Germany’s IFO, Eurozone PMI, U.S. Conference Board leading indicators and existing home sales, Bernanke’s monetary policy report, etc. The dollar index near 79 remains just above important support.
Thanks for reading, I appreciate feedback, should you wish to do so privately, please e-mail me at jf09sa@gmail.com.
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