Thanks, Maestro…

Good Evening: A day of mixed news led to a day of mixed results in Wall Street. Stocks initially rose on word of a large pharma deal and better than expected economic data, but large layoff announcements during the trading session took the starch out of the equity rally. Given the large competing forces at work, forecasting the rest of 2009 should be akin to throwing dice. But, as we will see, GMO’s Jeremy Grantham and BAC/MER’s David Rosenberg toss out their latest views in spite of all the uncertainty. They both point out that only thing we can know for sure is that it is dangerous to allow bubbles to ever inflate.

U.S. stock index futures were pointing to a lower open early this morning when word came that Pfizer had entered a definitive agreement to buy Wyeth (see below). That any M&A can take place in this environment, especially one that involves some borrowing, was construed as an immediate positive. Stocks rallied 1% to 2% soon after the opening bell rang, and they levitated further upon the release of the day’s only economic data. Existing home sales were actually 6.5% higher in December (month over month; sales were down 3.5% year over year). Also, leading indicators also posted a positive surprise, gaining 0.3% instead of an expected decline of the same magnitude. The major averages popped to new highs (up 2% to 3%), but those levels turned out to be the high water mark.

The “good” news items described above had, unfortunately, a darker side to them. Existing home sales were boosted in no small part by foreclosure sales, while leading indicators would have fallen sharply without a huge swelling of the U.S. money supply. Even the Pfizer deal had warts, since the two companies announced they would be laying off almost 20,000 people as part of their cost-cutting strategy. PFE was hardly alone, either, since Caterpillar also announced a 20K layoff, and they were joined by Sprint, Home Depot, and ING (see below). The job cuts announced just today totaled 77,000 — an amount normally seen during an entire month, according to Challenger, Grey, and Christmas.

As analysts and investors took into account this less rosy view of today’s news flow, equities promptly sprang a leak. A trickle at mid day, the leak expanded after lunch until almost every major average was down on the day. A late rally and dip left the averages with modest gains ranging from a fractional advance in the Dow Transports to a 1.25% rise in the Russell 2000. Treasury securities were on the defensive for most of the day, and their yields rose between 2 and 6 bps. The dollar also went down, leaving the dollar index 1.4% the worse for wear at day’s end. The sagging greenback didn’t help crude oil (-1.6%), but it did help the metals complex. Overall, the CRB index managed to post a gain of 0.6%.

The final two links below represent the views of both Merrill’s David Rosenberg and GMO’s Jeremy Grantham (free registration is required to view the Grantham piece). Making absolutely no apologies to Al Gore, Mr. Rosenberg’s “Some Inconvenient Truths” is a somewhat lengthy attempt to describe our current economic environment. He pulls no punches in detailing why he thinks the U.S. economy is “likely enduring a depression today”. Not content with a startling headline, Mr. Rosenberg then goes on to lay out his reasons why the U.S. will be stuck with very sub par growth in the years ahead. I won’t list all of his reasons here, but layoffs of the type announced just today are a big source of concern to Mr. Rosenberg. As for a restart of lending and borrowing, it is his view that the over-indebted U.S. probably needs to extinguish some $6 Trillion of debt before financial balance sheets can support a new lending cycle.

Continued delevering of this size and scope will take quite a bit of time, thinks Mr. Rosenberg, and he is joined in this concern by Mr. Grantham. The longtime head of GMO goes even further, though, and thinks “somewhere between $10 to $15 Trillion in debt will have to disappear”. He also rails at the forces that allowed the massive build up of debt that will have to be “stranded” and he fingers our central bankers as the prime culprits. He has few kind words for almost anyone in charge during the past 10 years, saying anyone who proclaims either to not be able to recognize an inflating bubble or who thinks bubbles can be popped and then mopped up is simply delusional. It’s a marvelous rant.

Taken together with Mr. Rosenberg’s views, it is easy to see why I’ve been saying 2009 has more work to do to the downside in the equity markets. We may see periods of advancing stock prices when the crowd believes government stimulus can save the day, but such moves will likely only help cushion the fall. It was to warn investors about the potential consequences of a credit bubble that caused the likes of Jeremy Grantham, David Rosenberg, Nouriel Roubini, Barry Ritholtz, Bill Fleckenstein, Jim Grant and others to write about it while it was expanding from 2003 to 2007. They properly maintained that bubbles, especially ones blown against the collateral of residential real estate, are simply too dangerous to let inflate.

Mr. Grantham reminds us that there are really only three ways to deal with a broken credit bubble: 1) liquidate (the deflationary route the U.S. took after 1929, 2) stimulate enough to allow for a long sideways period of repair (a la Japan after 1989), and 3) inflate enough to reduce the real value of the debt burden. He mentions a fourth way out — blow an even larger bubble in another asset class (e.g. housing). Unfortunately for all of us, this was the path chosen by Alan Greenspan when faced with the broken equity bubble of 2000-2002. Instead of allowing our economy to face the music back then, he set in motion (and even cheered) the events that have led us into our current predicament before retiring to the lucrative lecture circuit. Perhaps we should all take the time to pen a note to the Maestro and offer him what golfer Nick Faldo once said to the irritating British press: “Thanks from the heart of my bottom”.

— Jack McHugh

Caterpillar, Sprint, Pfizer Slash Jobs as Sales Fall

Pfizer Bids About $68 Billion for Wyeth; Boards Meet

Obama and the Teflon Men, and Other Short Stories. Part 1. Jeremy Grantham (Free Registration Required for Access)

Some inconvenient truths.pdf

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