Capital Spending Whoas

Lately, I have been writing about the market’s latest push toward the highs as a false rally. Maybe it’s just my nature to scrounge around looking for evidence to support my contrarian views, but I am adamant about backing up my opinions. Most recently I said the reaction to the FOMC policy statement was overblown as traders and investors misread the policy to the effect they saw a rate-cut in the near future. To the contrary, the statement had obviously stated that it plans to maintain the current fed funds rate at 5.25%. The markets react and anticipate, yet sometimes they anticipate incorrectly. This is why we are so fascinated with financial markets and this is why things can become ugly in a hurry.

I don’t believe things will get ugly, but I do think the markets have been overlooking certain aspects of the economy that are suggesting weakness, yet are captivated by other aspects in order to keep the “Goldilocks Scenario” alive. Eventually, according to efficient market theory, all information will be accounted for and the market will price accordingly. That said, the markets should currently be pricing in a modest economic growth of 2-2.5%, slower corporate earnings, higher energy prices, a slowing housing economy (which by the way pushed economic growth for the past several years) and a federal funds rate of 5.25%. However, I don’t think we have seen this. The market is sitting within 1-2% of their 6 year highs and nothing is being discounted. An extremely optimistic market will sooner or later catch up with the real information being released leading to less optimistic markets with a sense of risk.

One of the aspects of the economy the market has simply overlooked is the slowdown in capital spending. Capital spending is the capital spent to acquire or upgrade assets. Think buildings, computers, planes, trucks, equipment and other machinery. Before providing the numbers, let me explain why capital spending is important. When businesses are growing (and the economy expanding), they need equipment and machinery to let their business flourish. Orders are placed with vendors to provide the products and then the businesses begin producing their goods for consumers. If they decide to not invest in their infrastructure then they are not producing more goods; therefore, the economy has fewer goods on the market and it slows the overall business cycle. This is an elementary crude explanation, but it should do for now. On to the numbers.

This morning, the numbers for February factory orders were released. They did nothing to make me believe that the downtrend will be interrupted by a sudden surge of new orders being placed. The first quarterly decline in capital spending in nearly four years was posted in the fourth quarter of 2006, but it passed with hardly a mention. Although Feb. orders were up 1.0%, this was well below the consensus estimate of a 1.9% gain following a -5.7% drop in January orders.

This doesn’t bode well for the overall expansion of businesses growth. Take a look at the chart below. You can see that the drop has the look of the drop in orders from the last recession in 2000.

Factory orders consist of durable and non-durable goods. Non-durable goods
include items like food, clothing, and tobacco products. Durable goods are
products that maintain non-durable goods such as washers and dryers, computers
and machinery.

The drop in capital spending is happening at a time of near-record corporate profits. It has been known for some time that CEOs remained cautious in their spending plans, yet they have spending all those profits on share buybacks. That creates some shareholder value, but how does that help an economy that is beginning to show more signs of weakness?
Ben Bernanke has taken notice of the lack of spending by businesses hoarding cash as he gave his testimony to the congress last week adding that there was “an additional downside risk” to the economy if the weakness in business investment continued. I know we have ignored some weaker data points along the way to these multi year highs, but this is not something that we want to ignore.

The lack of spending may have similar effects on the economy as a weaker housing market. It will take some time to see, but as early as next month more capital spending data will be released. Another quarterly decline would mean two consecutive quarterly declines in capital spending at the same time the economy is modestly expanding. Take note that the market has yet to account for this and it again overlooks a vital piece of forward-looking information reflecting the state of the economy. I have not forgotten the 6.5% drop near the beginning of March; however, it took the market no more than ten trading days to recover almost all that was lost during that “correction”. That is not convincing enough for me and the wall of worries is continuing to grow. Maybe I am overly cautious, but I doubt it.

Friday Slough

It is Friday afternoon and the market's have again been very volatile. It was a strong start this morning as the marktes received a deluge of solid data; consumer spending defies the economic slowdown, incomes are up, and the Chicago PMI set a whopping record, jumping from 47 to 63 (largest historical monthly jump); however, inflation (Core PCE) was up 0.3%, or 2.4% yoy (about as expected).

The Chicago PMI number is what is surprising. How does the manufacturing index jump so much in a single month? Was it extremely warm in Chicago in March? Possibly, but we still don't know why this came out so hot.

The morning news crossed the wires and the selling began shortly thereafter when the US government posed tarriffs on Chineses importing paper goods (10-20%). That will mean higher prices for Chinese importers, yet it also means that we are trying to cut into the trade deficit with China. In fact it is interesting to note:

"The action reverses 23 years of U.S. trade policy by treating China, which is
classified as a nonmarket economy, in the same way that other U.S. trading
partners are treated in disputes involving government subsidies."

Oh well, life goes on for the Chinese. Life goes on in America. As the markets are holding steady near the breakeven point, I don't see a whole lot of change happening near the end of the day, unless of course traders decide they don't want to hold on to any long positions over the weekend (could be likely) with geopolitical tensions as they are and oil prices continuing to hover near YTD highs.

That's it for today and I hope everyone enjoys the weekend. I am headed off on a six hour drive to southwest CO to Silverton, CO. I'll leave you with this.

"One Lift Servicing Heaven" Silverton, CO (www.silvertonmountain.com)

Rocking Wall Street

Gary Marks is by no means average, let alone another average hedge fund manager। Marks is a successful musician, and you can see the unique approach he has to the investment industry when he shows up to give market commentary to CNBC while wearing a blue bandanna. In fact, from the pictures that i’ve seen, he looks like he’d fit in quite well in Sturgis. He has taken his music background and developed a unique approach to the hedge fund industry since 1999. As incomparable as Marks is to anyone else in the industry, when I was recommended by “the humble analyst” John Mauldin to read “Rocking Wall Street” written by Gary, I had to jump in and immerse myself into the book.

”Rocking Wall Street” is not for the average reader, no investor। It is directed toward the high net worth individual who is not conecrned with fickle everyday purchases. Instead these individuals are looking to generate returns with their capital for retirement and even looking for capital preservation for generations to come.

First, a little bio on Gary Marks। Marks is highly regarded in the investment industry. In 1999, he began a hedge fund of funds firm called Sky Bell Asset Management which he still runs as CEO. Today, he is a multi-manager specialist and has assets under management of over $300 million, a respectable size, but still small compared to some behemoths. He has also excelled in the music industry, most recently releasing his 10th CD, “A Whisper Can Change the World” in February 2007. He has taken his lessons in the music industry and transposed them to the hedge fund industry by creating a unique approach to preserving capital and investing with other managers.

His book is written in an extremely one-on-one manner as he provides insight from his daily routines and interaction with clients। The book is based on four main strategies:

1. Emotional Controls
2. Knowing the Difference Between Market Stats and Market Hype
3. Hedged Portfolio Construction
4. Planning for the Future and Seeking “The End Game”

Throughout the book, Marks uses his personal experiences with clients and combines a narrative over these conversations. His explanations on each interaction with clients provide a real-life insight into what goes on behind closed doors of a fund of funds manager and how intricate the process can be due to personality differences in client-manager relationships. Marks walks the reader through hedge fund definitions, diversification, and portfolio construction for the high net worth individual (although this can be transferred to the everyday investor if you read between the lines). One of the most effective “scared straight” tactics he uses throughout the book is the debilitating effects of losses vs. gains.

For example, if you return 50% on $100,000 you have $150,000. But if you
lose that same amount (50%), all of a sudden you are left with $75,000 or a 25%
loss even though the percentages never changed. Losses are difficult to
overcome, yet that is the nature of the business.

As marks continues to educate the reader delicately, he leads us to “The End Game”। Essentially, this is when an individual has reached a point in his/her life where they have enough capital to live a very high standard of life. They have enough capital to not take certain risks even though a loss of X amount of capital or a double up of X amount of capital would not change their lifestyle. This individual has reached “The End Game”. At this point, the individual should be looking for capital preservation and to provide for generations to come (if that is the choice the individual makes). It is an interesting point and one that is too often overlooked as we see American’s trying to keep up with the Joneses.

Gary Marks continues to excel wherever he puts his mind to work. Whether it be managing client’s capital creating musical works of art or even writing though-provoking books. He has integrated several skill sets into the financial industry and into a book that is a reasonably easy read for anyone with a financial background. Many people will look at this book as biased toward a select few high net worth individuals in the world; however, while reading this book I found it a great look into the inside track of what has been called the sexiest industry in the financial world. Derailing all traditional rules for success in the financial industry, Marks makes his mark.

Five Day Rally, For Real?

Just looking at the charts for the S&P 500 today, I am a little surprised at the move we are seeing so far today. We are coming off of a down week last week, but nothing too surprising given the circumstance that the market was trading off. Since a new low was made last Wednesday at 1364 (and a subsequent reversal rally that day), the market has rallied nearly 50 points (3.5%) from those lows. That is a pretty substantial move in a market that reading the media, you would have thought the world’s economies were crumbling. Quite to the contrary, world markets look to have stabilized, although it could very well be a head fake in another move lower. The Shanghai Index, which fell 9% on February 27th, has regained 5.2%. Hong Kong’s Hang Seng index has regained 3.1% in the past five trading days and even the German Dax index has increased 3.7% in the last week. These are all great rallies, but what is the core reasoning behind the move?

Let’s focus on the U.S. since that is really what we know most about. First, last week was an expiration week; therefore, historically it has a bullish bias. Could that be the main reason for the market’s gains? The follow through the first two trading days this week has me thinking that something else is behind the move.

The data that has been presented in the past week has been mixed at best, so this might not be the greatest catalyst. On Tuesday, retail sales came in at +0.1% vs. +0.3% expected, while sales ex-auto were -0.1% vs. a +0.3% estimate. These are weak and the downtrend in consumer spending has continued (see chart below, click to enlarge).

Wednesday is what I believe could have been a key reversal day, yet it was the same day that Asian markets were down 2-3% and European markets were down 1-2% respectively. It looked like the morning weakness was based on overseas trading and the subprime mortgage mess, but midday, the markets reversed. Why? It is possible that all the sellers were washed out and the bulls took control, but there was no real catalyst to the move. With inflation numbers out the next two mornings, it could have been ugly. When the PPI and CPI report came out slightly hotter than expected the markets continued to try and push higher, but the end of week volatility and expiration closed the markets near 1400, or about the same point the key reversal day closed its interesting day. No change for the last two days of trading for the week.

That brings us to yesterday and today. Yesterday, the morning gap of 10 points was never filled in throughout the day as the market traded higher just as overseas markets had done the same morning. The slow grind upward lacked both volatility and the presence of sellers. Why wouldn’t the sellers have come in at any point and started pressuring the market? It could be because they are waiting to hear what the Fed has to say on Wednesday during the FOMC announcement. They are expected to keep rates at 5.25% (a 98% chance, according to the markets), yet their statement may have some indication of the latest subprime meltdown. If the statement is upbeat, it will be good news for the bulls, but if it has any tone of worry, we may see the sellers come back to play and drive the S&P back to its lows near 1364 or even lower.

Take a look at the chart below. You can see the market is sitting right at the thick red line, which is one I have drawn as a resistance area. Technically, it is very strong as the red line indicates both a prior resistance area and a 38.2% retracement using the February highs and the first low made in March (see below, click to enlarge). This number is critical as it also happens to come into play during the FOMC meeting. It could very well be a re-test before breaking lower. We will see what happens tomorrow afternoon, but keep in mind the intermediate trend is still downward, even with a 3% gain in the past five trading sessions.

Source: Briefing.com, eSignal

Uncomfortable Market Thoughts

I have just a few thoughts on the market today. The market has been acting quite suspiciously and I am not too comfortable with this. Some of the activity may well be due to today’s expiration and the typical bullish bias during expiration week, but I believe investors (the market) have ignored some pretty stern “warnings” over the past few days.

The sub-prime lending issue is an isolated event, but it has further implications in the housing market, which ultimately has an effect on the health of the economy. The decrease in unemployment over the past few years can be mainly attributed to the housing market. If the housing market continues to weaken (as it easily could), then the economy will feel the ill effects in the form of lost jobs and lost growth. The economy is already slowing as seen in both manufacturing numbers and earnings guidance. Throw in slightly higher oil prices, inflation pressures, global tensions/risks, the “yen carry trade”, hawkish comments from Alan Greenspan and investors that have seen their egos battered for better or worse and we have a market that might just pay attention to the economy’s health.

A side note on Greenspan: Now that he is out of the public office as
chairman of the Federal Reserve, he feels as if he can more freely talk about
the economy and his views on certain risks. In fact, groups of banks and
institutional firms pay a hefty price tag for his opinions at conferences and
meetings. Let it be known that he does see risks in the economy, specifically
the housing market as he noted in a March 15th speech mentioning that “if home
prices go down from here, I think we’ll have problems”. Maybe this is his
irrational exuberance speech from the 1990s. Is it going to be a time that we
look back 6 months later and said, the warnings were there, why didn’t we see
this coming? I guess we’ll see.

Although Wednesday was a technical key reversal day (hitting new lows at 1363, then bouncing and finishing substantially higher at 1387). A 10% correction may not have been made quite yet, but may be in for a little rough and tumble ride over the next few months while the housing market, inflation and global tensions play out even further. False rallies, false bottoms and higher volatility is what I see in the coming months.

Source: eSignal