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Good Evening: After taking the weekend to reconsider last week’s celebrations over seeing less awful than expected economic data and the relief in feeling less angst than expected in the wake of the stress test results, investors decided to take profits on Monday. Financial companies led the downdraft in part due to the recent levitation in bank shares, since the banks themselves have decided to respond to the rising demand for their equity with a fresh dose of supply. Negative comments about the banks by Meredith Whitney only reinforced this directional wind shift, as did some proposed tax hikes by the Obama administration. Because it is too soon to tell if today’s reversal will last more than a session or two, perhaps it will be instructive to look at some economic data that lies outside the spin zones found in New York and Washington, D.C.
Friday’s upside surprise in terms of the April jobs figures (-539K vs. expectations for -630K) looked less flattering the more analysts pulled apart the data. Not only were there downward revisions to prior months, but also the weakness in manufacturing, construction and other, higher-paying pursuits was met with strength in either temporary jobs (by the U.S. government for the upcoming census) or fictional jobs (the infamous “birth-death model” somehow estimated new job creation by small businesses of more than 200K). Maybe I should be more open-minded, but I don’t think a new business has been created when former investment bankers hang out the “consultant” shingle while in outplacement, nor would I count all the out of work traders goosing their P.A.s from home. And even if one is moved to take Friday’s unemployment report at face value, losing more than half a million jobs in a month falls a wee bit shy of the 100-150K job additions normally associated with a minimally growing economy.
As the market participants who are actually employed filed back to work this morning, they had little in the way of either economic data or earnings results to guide them. It made the headlines you see below all the harder to miss. A group of stalwart banks, especially those receiving a “good housekeeping” seal of approval from Treasury stress regulators late last week, decided today was the day to cash in the recent rally in their shares by offering a good deal more of them. The new share issuance by Key, USB, Capital One, BB&T, and PNC was marketed as the sort that would enable these fine institutions to repay their TARP loans. To me it looked more like an attempt by this group to avoid having to some day take TARP II funds rather than funding a way to pay back those received in TARP I. Time will tell, but Meredith Whitney’s comments late in the day on CNBC imply my interpretation might not be far off the mark (see below). Saying she wouldn’t touch bank stocks here, Ms. Whitney also pointed out that the business models for financial firms have changed because the government is now involved. “For investors, you invest on what you know to be the rules of the game,” said Whitney. “But with the government involved, no rules apply.” (source: CNBC.com)
If investors needed a further reminder that Uncle Sam is making profits more difficult to come by for corporate America, the Obama administration announced some targeted tax hikes in its proposed budget today (see below). Broker dealers, traders, certain types of insurance, large estates, and “carried interest” all had bull’s-eyes placed on them for prospective tax increases. Rather than comment on the politics of this move, I will stay in the policy realm instead by simply noting that Uncle Sam has some rather large bills to pay. That wealthy individuals, partnerships, and corporations will all be targeted to pony up is exactly the type of change our new President promised while on the campaign trail, and it should come as no surprise to investors. What may start to bother them as they re-price forward earnings at higher effective tax rates is that less of what companies earn will be falling to the bottom line. This announcement is just one of many recently that suggest that even when GDP some day returns to 2007 levels, corporate profits are likely to make a much slower journey back to their highs.
Since all of the above news items hit at various times during the day, the overall reaction in the capital markets came in waves rather than all at once. With bank shares cowering in the face of new issuance prior to this morning’s open, U.S. index futures pointed to a lower open. 1% losses at the bell soon became 2% losses across the board before prices dug in a bit. NASDAQ was definitely the firmest of the major averages, and while most of them could only repair approximately half the early damage, the NASDAQ actually managed to turn green for a spell. The averages settled into a somewhat quiet and narrow range for most of the rest of the day. Ms. Whitney’s late day appearance on CNBC only added to the woes facing the banks, and the KBW bank index closed almost 7% lower. The rest of the averages followed the financials and went out near their lows, with the aforementioned NASDAQ (-0.45%) holding in best and the Dow Transports (-3.85%) bringing up the rear. Treasury prices were firm in part due to the weakness in equities, but also because the Fed took advantage of a hole in the Treasury’s issuance calendar to create demand out of thin air. Our central bank’s monetized purchase of more than $3 billion of government debt helped cause yields to fall between 8 and 12 bps. The dollar stabilized after last week’s drubbing, but commodity prices snoozed for most of today’s session. The CRB index fell a modest 0.25%.
If you took the time to read Jeremy Grantham’s latest Quarterly letter, you might get the sense that what lies around the corner in the stock market is pretty tough to handicap with any conviction. A large hole in private credit formation opened after Lehman failed last fall, only to be met with a vast governmental attempt to fill it. The U.S. economy responded to the initial loss of many traditional borrowing arrangements as would any machinery suddenly deprived of fuel; it seized up. Washington has responded by pouring freight car loads of its own brand of financial fuel into the tank, enough so that investors and economists have been straining their eyes looking for the proverbial green shoots that indicate forward motion will soon resume. Not so fast, say the railroad analysts at Credit Suisse, however (see above). Rather than review the entire 24 pages about rail car loadings, these opening paragraphs amount to a real time glimpse of U.S. economic activity:
“Bottom Line: Last week proved no different than the last 4: railroad carloads were down more than 20%. Week 17 saw a year-over-year volume shortfall of 21.6% – which is slightly worse than the 20.4% drop in Week 16.
• The weakness is broad based – whether it be industrial, bulk or consumer related – every segment has shown precipitous declines in each passing week. Worse, we are one-third of the way through the second quarter and volumes are well below even the substantial declines seen in the first quarter (recall that 1Q09 industry carloads were down more than 16% year-over-year).
• The railroad carload data are telling a very different story about the economy than one might surmise by looking at the S&P 500. Our concern is that the carload data are ahead of the curve; the light at the end of the tunnel that seems to be boosting stock prices may just be an oncoming freight train.
• Volumes: All commodity types posted steep declines during Week 17. Specifically, we saw sharp drops in metallic ores and minerals (-52.6%), motor vehicles and equipment (-37.6%), non-metallic minerals (-26.4%) chemicals (-21.6%), coal (-18.0%) and intermodal (-17.0%).” (source: Credit Suisse)
As you can see, the type of rail activity that should be accompanying any improvement in economic activity is nowhere to be found. In fact, Credit Suisse indicates economic growth is stuck in reverse. Back before the Great Crash and Great Depression, legend has it that Jesse Livermore and his forward–looking peers used rail car loadings to detect shifts in agricultural and industrial activity. Long before the Commerce and Labor Departments put out seasonally adjusted economic statistics, it was rail car loadings and even the Dow Transportation Average itself that were thought to be leading economic indicators. It’s easy to see why, since lower shipments to intermediate and end users would eventually lead to lower orders for the manufacturers. The Credit Suisse team says the data they track shows shipment trends are weakening, not strengthening.
I doubt Mr. Market had rail shipments on his mind when he experienced a small case of vertigo today, but these numbers bear watching. And if the banks continue to pull back, whether due to dilution or more analysts like Ms. Whitney telling folks to stay away, then last week’s abundant confidence will itself start to pull back. Besides, the banks have tried more than once during this bear market to tell everyone that everything was hunky dory. Then, as now, they hit the resulting bids to raise fresh capital from trusting souls. If we pay no attention to what the banks are saying and instead focus on what they are doing, the decision on bank stocks becomes a simple one. They know their businesses and they are selling shares. Shouldn’t a prudent investor do the same?
— Jack McHugh
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Keeping Score
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