Bad Dream?

Good Evening: In the wake of yesterday’s horrid close in U.S. markets, global equity investors refused to be drawn into Wall Street’s nightmare during the overnight hours. And, after sleeping on yesterday’s action themselves, U.S. investors also awoke this morning with a bit of an appetite for risk. Yesterday’s risk aversion was quickly forgotten in the hopes it might just have been a bad dream.

There were no large economic releases this morning for investors to fret about, so the early focus was on GE and Sears Holdings. Both companies disappointed on the earnings front (GE lowered its guidance a bit, while Sears posted a large Q3 miss), but both also managed to rally nicely after each offered shareholders a stocking-stuffer. GE promised to maintain what is now a large dividend, and Sears promised to close some stores and increase its stock repurchase program. The stock market opened modestly higher in response, and, mirroring yesterday’s action in the opposite direction, equities never did touch the unchanged mark from above. The lack of follow through to yesterday’s mini-meltdown encouraged the bulls enough to then push the major averages up some 3% by lunchtime.

The only other news worth noting this morning came from the automakers, whose managements once again returned to Capitol Hill seeking capital. This time, however, instead of issuing dire warnings with their mouths while extending their hands in search of a bailout, managements humbly appeared before lawmakers with concrete plans and a request for loan guarantees rather than cash with no strings attached (see below). To outside observers, it looked as if maybe, just maybe, our government might start getting smarter about bailouts.

The better feelings towards GM and Ford were tested early this afternoon, though, when both companies issued dismal November sales figures. The annualized rate of U.S. car sales came in just above 10 million units, a level not seen in more than a quarter of a century (see story and Merrill’s take below). As these figures came trickling out, they seemed to spook the stock market. The indexes gave back most of the day’s gains before finding their footing with 90 minutes to go in the session. Equities then rebounded to set new highs as the closing bell rang. With a 3.3% gain, the Dow lagged its peers, while the Russell 2000’s 6% gain was best in show and enabled this small cap index to claw back half of yesterday’s losses.

The advance in equity prices only somewhat slowed the momentum for buying Treasury paper. Prices were up and yields fell across the board by 2 to 8 basis points. To give the power of the recent Treasury rally some context, the 30 year bond closed at a record low yield of 3.17% (see below). With so many investors clamoring for “safe duration”, Blackrock’s Peter Fisher came up with the best idea of the day: Our Treasury should consider selling 100 year debt to lock in low yields while it still can (see below). Like common shares, the dollar also reversed today. Its 0.2% drop couldn’t do much to help commodities, however, as energy prices continued to fall. Decent gains in the precious metals limited the damage, but the CRB index still gave back another 2%.

Though I remain somewhat friendly toward the stock market in the near term, I still cling to my long term view that equities will struggle as 2009 progresses. I’ve cited a litany of reasons for this ursine posture in past commentaries, but a decent summation of them can be found in the latest “Investment Outlook” from PIMCO’s Bill Gross (see below). Mr. Gross points out that while stocks “look cheap” using P/Es or measures of replacement cost values, they are actually far less cheap than they appear when one considers the continuing paradigm shift away from the use of cheap leverage. Echoing the sentiments of GMO’s Jeremy Grantham, Mr. Gross predicts corporate profit margins will have to fall from record levels until they reach, or even fall below, their long term mean. The most obvious culprits for this impending decline in U.S. corporate profitability, according to Mr. Gross, are the higher cost of capital, lower leverage ratios (especially among financial entities), higher corporate taxes, and increased government regulation. Mr. Gross nicely ties his arguments together in the conclusion of “Dow 5000 Redux”:

“My transgenerational stock market outlook is this: stocks are cheap when valued within the context of a financed-based economy once dominated by leverage, cheap financing, and even lower corporate tax rates. That world, however, is in our past not our future. More regulation, lower leverage, higher taxes, and a lack of entrepreneurial testosterone are what we must get used to — that and a government checkbook that allows for healing, but crowds the private sector into an awkward and less productive corner”.

I agree, though the above factors won’t impact all companies in the same way. Perhaps before plunging back into common stocks, investors might be well served by considering whether the companies they are buying have business models that can adapt to these new realities. It will be companies that rely on real engineering as opposed to financial engineering that will adapt best in the years ahead.

— Jack McHugh

U.S. Stocks Advance, Rebounding From Worst Drop Since October
http://www.bloomberg.com/apps/news?pid=20601087&sid=awEWgQgJblpM&refer=home

GM, Ford, Toyota Say U.S. Sales Tumbled on Recession
http://www.bloomberg.com/apps/news?pid=20601087&sid=aYhbnZcipFb4&refer=home

General Motors, Ford Ask Congress for Up to $27 Billion in Aid
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aNIpTQmEPNVA

Treasuries Advance as Inflation Concern Fades, Fed May Buy Debt
http://www.bloomberg.com/apps/news?pid=20601087&sid=aujABg8jkhqg&refer=home

Treasury Should Consider 100-Year Debt, BlackRock’s Fisher Says
http://www.bloomberg.com/apps/news?pid=20601087&sid=azGBEQQJhY24&refer=home

PIMCO Investment Outlook: Dow 5000 Redux, by Bill Gross — December 2008
http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2008/IO+Dow+5000+Gross+Dec+08.htm

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Auto sales lower still in Nove.pdf

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