May 2008 - Posts

A Global Credit Market Update
23 May 08 02:00 PM | Brian Dightman

Since stock market lows in March, the S&P 500 has rallied 12%. Which leads to the question, are we through the worst of the credit market crisis? To answer that question we should look at current data on the extent of the credit crisis and how much money banks may need to raise to shore up their balance sheets.

A recent report, published by Bank of America, listed the total capital raised by 11 of the worlds largest banks at $260 billion and the estimated write-downs at $338 billion, a $78 billion dollar shortfall. The IMF estimated in their April Global Stability Report the total credit related write-downs worldwide could reach a trillion dollars. More recently, the bond rating company Fitch, estimates global credit market losses totaling somewhere between $400 & $550 billion. The variation in estimates can be attributed to the credit market addressed, when the research was conducted, the complexity of the credit market, and other factors.  It does appear additional funds will need to be raised by banks and both Fed Governor Bernanke and Treasury Secretary Paulsen echoed as much in the last week.

So far banks have been fairly successful in raising capital but they may find it more challenging in the future since they have already tapped several liquidity sources, such as sovereign wealth funds and private equity. Some of the initial deals were completed before banks disclosed the full extent of their losses. To protect the new investors, some banks agreed to compensate them if the bank sold more stock at lower prices in future deals. The end result for those banks needing to raise more capital under this condition could mean further dilution to existing shareholders. Another challenge for banks is determining the current value of certain assets. Due to the illiquid nature of the complex securities in question, which are backed by troubled loans, determining the value of some of these assets is difficult and may have caused banks to focus on shorter-term capital needs. In addition, federal regulators and rating agencies are expected to increase the capital requirements for holding certain security types and increasing disclosure on assets held.

The future is still unclear, but some themes have developed:

• Some banks are very likely to need to raise more capital
• Additional shareholder dilution might be required to raise capital
• The extent of capital needs by banks may not be fully known
• Regulators and insurers may require banks to maintain more capital if they hold certain security types
• One of the root causes of the credit crisis, falling U.S. home prices, continues

After the credit crisis climax with the Bear Stearns bailout, U.S. stocks started an upward trend and showed some resilience recently. Just last week the NASDAQ 100 led U.S. markets, up 3.6%; firmly above its 200 day moving average. The S&P 500 rose 2.7% and the Dow turned in a weekly gain of 1.9%. Market leading stocks delivered terrific performances, with the IBD 100 up 4.2%. Volume characteristics improved but still lack the conviction often found at the start of a prolonged bull-market rally. Current market action would be a lot more credible if an improved lending environment (the Ted Spread is still negative) between banks returned and the U.S. housing market stabilized. Those investors putting new money to work in the current rally appear to be focused on 1) a belief the credit market issues have been controlled 2) an overall less dismal economic environment in the U.S. 3) continued economic expansion in emerging markets 4) covering short positions.

While monetary authorities have stepped in to prevent a financial market meltdown and some credit market conditions have improved, there are still potential problems on the horizon.  For a look ahead, the price of gold may be a good indicator of more bad news. It has been known as a flight to safety asset.  In mid-March, at the height of the Bear Stearns crisis, gold traded around $1,000 an ounce but then fell to around $850 by the end of April.  So far in May it has rallied back to just over $900 an ounce.  It is important to remember that gold is influence by other factors, like inflation.

GLD = GOLD

^GSPC = S&P 500

Filed under: NASDAQ 100, IMF, Fitchs, Gold, Credit Markets, Global Banks

Commodities & Related Industry Performance
10 May 08 02:57 PM | Brian Dightman

After three straight weekly gains, it is not surprising stock markets suffered losses last week.  It still remains to be seen whether we have started a sustainable rally; how the S&P 500 moves relative to its 200 day moving average may shed light on the near term direction for U.S. stocks.  It has spent most of the year below it.

 

While many broad stock indexes are still down for the year, there are a few industries with gains.  Many of the current leading industries (mining, energy, machinery, transportation) have some exposure to the price of raw materials.  One of the current challenges for portfolio managers is the influence of commodity prices on many of these industries and the additional risk created if they are combined in a portfolio.  

 

One industry that has done well since the start of the year is precious and industrial metals.  For example, steel (SLX) is up 21%.  You can access many of these markets individually or several of them through one investment in the SPDR S&P Metals and Mining ETF (XME).  XME also includes a small amount of exposure to coal (KOL), which is also performing well in the current market.  If world demand from emerging countries for raw materials continues, these industries are likely to do well.  XME is an easy way to start a broad position in a portfolio with the potential to add DBB, DBP, GDX, or SLX for more specific exposure.  There are many other choices as well.  Make sure you understand whether your investment is an Exchange Traded Fund or Exchange Traded Note for the different risk factors associated.  Also, check with your accountant regarding tax exposure; there are specific tax characteristics to take into consideration.  There is also risk if the global economy slows, reducing demand for commodities, causing prices for metal and mining companies to decline.

 

With political instability in several oil producing nations on the rise, many people are wondering where the price of oil is headed.  Investors Business Daily just published an Oil and Gas Exploration and Production industry review that touched on the wide ranging views by companies and oil experts.  The article listed prices as low as $65 a barrel to as high as $200, with many smaller producers using $75 as their yardstick.  If you own a broad commodity index like DBC or DJP, you already have exposure to the price of crude oil, which is closely tied to the performance of Oil and Gas Exploration and Production companies.  For industry specific exposure take a look at XOP.  Owning both a broad commodity index and XOP may expose your portfolio to additional risk related to price sensitivity to crude oil.  While political instability can change quickly, many experts agree, remaining oil and gas reserves are becoming more difficult to find and develop.  Increasing demand in places like China and India, and some resource-bearing nations moving to take control of their assets, is shifting power.  In short, operating complexities have increased for the industry.  There is also risk a global recession could dampen demand and lead to excess supply.

Filed under: Commodities, Exchange Traded Funds, India, Oil and Gas Exploration and Production, Energy, Exchange Traded Notes, Industrial Metals, S&P 500, IBD, Coal, Crude Oil, China, Steel, Investors Business Daily

Temporarily Conflicted
02 May 08 09:19 AM | Brian Dightman

As an investment manager, I am constantly monitoring multiple data points in my decision making process. There is no such thing as a perfect investment environment. When risk management is a good part of your job, there is always some piece of information to sway your decision. I remember when Operation Iraqi Freedom launched in the middle of March, 2003. U.S. markets had seen 3 years of bear market declines and many investors were in no mood to talk about stocks, still suffering from brutal declines in their wealth. The stock market, however, had been rallying for months and combined with other economic develops underway at the time, I encouraged clients to get into stocks. 2003 turned out to be a great year for stock investors.

I believe in highly diversified portfolios. There’s a never ending set of variables to consider when managing portfolios and diversification helps you maintain exposure in an environment of contradictions. Investors can't afford to go completely to cash when the environment gets ugly. But I do think you can over and underweight different asset classes to create a more offensive and defensive position to accommodate market conditions. At present, I have incorporated a defensive bias in many portfolios, which has worked well in the most recent market downturn.

Since mid-March the markets have rallied and I must now re-evaluate my exposure to U.S. stocks. After yesterdays big run I considered adding the NASDAQ 100 to some portfolios. Compared to the S&P 500 and DJ 30, the NASDAQ 100 has seen more trading above its average volume on up days and very little increased selling on down days since the rally started over a month ago. It includes many global companies, (Apple, Microsoft, Google, Cisco, Intel, and Oracle). Outside of information technology, which represents around 64% of the index, it includes health care (14%), consumer discretionary (13%), Industrials (5%), and a small allocation to a few other industries. The NASDAQ 100 has also performed on par with emerging market stocks since the rally kicked off in March.

The challenge is determining if the current rally is sustainable or simply a rally within a market headed for more declines. To finalize my decision I reviewed the current climate and what do you know, the Fed came out with a brand new liquidity program to help banks (you mean they need more help? Isn't everything all rosy now that they have written down some debt and raised liquidity with new financing?). The Fed is now willing to take credit card and auto loans as collateral for Treasuries in an effort to expand liquidity. The Fed even convinced the European Central Bank and the Swiss National Bank to joint in. Sounds like a party, but it points to a very serious problem facing world markets. For more details see the following MarketWatch article. Banks are still holding troubled debt and as a result they are unwilling to make loans to each other. I have posted on the trouble with the TED Spread previously and the latest action by world monetary authorities is targeted at that specific problem. A low interest rate environment by itself does little to stimulate the economy. The economy needs a vibrant loan market so businesses and consumers (mostly consumers) can spend money (isn’t that what got us into this problem to begin with?) which helps drive corporate profits. Which brings me to another important concern: corporate profits (as measured by Y/Y % change) have been very strong over the last 5 years and are considered by many analysts to be at unsustainable levels. Q1 '08 earnings were far from a disaster and international strength helped many companies turn in reasonably good numbers, but profit growth remains in negative territory, a trend started in Q3 ’07. At current valuations, the expectations for profit growth are considered by some to be lofty. If the current profit slowdown in financials spreads to other industries, it is going to be hard for stocks to maintain current valuations. Of course, globalization may help U.S. corporations deliver positive profit growth later in ’08, as many expect. Even so, it is not uncommon for stock prices to lag profit increases, as we saw 2002-2003 for 5 straight quarters. In 2006-2007, we saw the exact opposite: growth in stock prices exceed profit growth for 5 straight quarters.

It is hard to watch the NASDAQ 100 move over 18% (since March 10th through today’s close) and not feel like better days are right around the corner for U.S. stocks. After my review, however, I feel as through there are more obstacles to over come then sustainable drivers that can push stocks higher. I would not be surprised if short covering has helped facilitate the current rally and I continue to remain cautious on U.S. stocks.

Filed under: TED SPREAD, NASDAQ 100