March 20, 2010

Market Insights - 20 March 2010

Here is the latest issue of Market Insights. As always, please email any questions to: . 

In This Week's Issue
• Weekly Snapshot
• Chart Of The Week
• Weekly Barometers 
• Lehman Brothers - The Fall Of A Sith Lord? 
• Naïve Expectations Versus Actual Performance
• Fed Maintains Ultra-low Rate Policy
• Are We Still In A Bear Market?
• In Dodd We Trust

Weekly Snapshot
• Renewed concerns about Greece strengthen US$, pressure on Euro and commodities (Reuters)
• SEC, Fed were warned of Lehman's liquidity problems prior to collapse (FT)
• German producer prices fell 2.9% an annual basis in February (Economist)
• Leading Economic Index (LEI) for the US increased 0.1% in February (Conference Board)
• US consumer prices unchanged in February on a seasonally adjusted basis (BLS)
• US current account deficit increased to $115.6 billion (3.2% of GDP Q4 of 2009 (ESA)
• Euro area annual inflation was 0.9% in February, down from 1.0% in January (Eurostat)
• US producer prices declined 0.6% in February, seasonally adjusted (BLS)
• Fed maintains the target range for the federal funds rate at 0 to 1/4% (AP)
• US Housing construction drops 5.9% and building permits fell 1.6% in February (ESA)
• China's holdings dipped by $5.8 billion to $889 billion in January compared with December (AP)
• US industrial production edged up 0.1% in February following a gain of 0.9% in January (FRB)

Chart Of The Week
Oil prices had an interesting week reaching a high of $83.36 but then retreating to a test of the $80 level.  $80 per barrel seemed unreachable just a year ago when crude prices were just moving above $40 again.  In historic perspective including inflation adjusted prices, oil is not all that expensive.

Historic Oil

Weekly Barometers  (click on chart for larger image)

Stock-2010-0319   FX-2010-0319

Lehman Brothers - The Fall Of A Sith Lord?
It took about a year and a half and a 2200 page report by the court-appointed examiner, Anton R. Valukas, to explain what most of us instinctively knew: Lehman Brothers used some rather creative accounting enabling them to "keep on dancing while the music was still playing".  One of the most popular catch phrases this week has been "Repo 105", an inside term for an accounting practice enabling Lehman to have as much as $50bn vanish from its balance sheet and temporarily reduce its debt levels.

The Financial Times has a nice explanation of how this Repo 105 worked:

With these new revelations, finger-pointing has already begun.  Apparently, US regulators (SEC and New York Fed) were warned about potential liquidity problems at Lehman prior to their collapse.  The New York Fed was not able to confirm this and the senior staff at the SEC overseeing Lehman Brothers are no longer working with the SEC - how convenient.

While these revelations are yet another indication of how horribly wrong everything went within the financial services industry, what is much more concerning is the unsettling feeling - correction - the implicit knowledge that this was only the tip of an iceberg and that there is more to come.  As they say, it always takes two to Tango...

Moreover, if Lehman engaged in this practice, others must have done the same.  This seems like a perfect time to quote Jedi Masters from the Movie Star Wars...

Mace Windu: There's no doubt that the mysterious warrior was a Sith.
Master Yoda: Always two there are. No more, no less. A master... and an apprentice.
Mace Windu: But which was destroyed? The master or the apprentice?

Naïve Expectations Versus Actual Performance 
Oil futures were up again this week reaching an intra-day high of $83.36 before closing just above $8o on Friday.  This year’s high at $84 was within arm’s length and could be tested again within the next trading week if bullish momentum re-ignites.  These price levels also bring back memories of the summer of 2007 when oil started its ascent all the way to the all-time high of $147 in July 2008.   Looking at the trend development so far, it is rather tempting to jump on the band wagon in the hope of catching a possible repeat of the triple digit prices.


Without making any prediction as to the near-term price targets at this time, I am taking this opportunity to highlight a peculiarity of certain instruments that the average investor may not be aware of.  With the growing popularity of ETFs, there are now various ways to express an opinion and create exposure to various asset classes which not too long ago had been outside the realm of an average investor.  These days, it has  become seemingly as “easy” as buying a stock.  One must caution however, that some of the recent ETFs tracking specific asset classes are not meant to be long-term instruments.  Examining the United States Oil Fund (USO) as an illustration, the fund sponsors note that:

The United States Oil Fund, LP ("USO") is a domestic exchange traded security designed to track the movements of light, sweet crude oil ("West Texas Intermediate").

As always, it pays to understand the true nature of the investments you are engaging in and the prospectus along with all disclosures should be read prior to considering any investment in ETFs.  In reality though, very few people take the time to read a complicated 128 page document such as the Prospectus for the USO.  In this case, it is critical to understand that the fund only seeks to match “daily returns”, a slight nuance in the terminology which can have a significant impact when comparing the returns with the underlying asset over a longer period of time.  Instead of examining some boring formulas, please consider the charts below comparing the returns of USO with the underlying oil price, that of West Texas Intermediate Futures.  In the near term, the USO seems to match the returns of oil futures close enough, albeit certainly not perfect.  Yet, with a longer time period, the performance turns significantly lower.  In the 12 months up to March 17, the oil price is up 65% whereas USO is up only 35%. 

Oil vs. USO -YTD   Oil vs. USO - Past 12 months
USO-Oil-YTD-2010-0317   USO-Oil-2010-0317

This illustrates how vast the difference can be between perception, what some industry professionals call the “naïve expectation”, and actual performance.  USO and similar ETFs may be perfectly suitable investments for some investors.  However, one should be fully aware of the true nature of an ETF’s holdings and should carefully consider the cost of holding the investment for an extended period of time.

Fed Maintains Ultra-low Rate Policy 
As expected by the majority of market participants, the Federal Open Market Committee issued a statement earlier this week maintaining the target range for the federal funds rate at 0 to 1/4%  for an extended period of time.

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve has been purchasing $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt; those purchases are nearing completion, and the remaining transactions will be executed by the end of this month. The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability.

The complete FOMC statement is available here:

While this has been widely anticipated, the more important issue will be how the economy will fair when the remaining special liquidity facilities, most of which will end this month, are no longer in place.  Without the massive federal support, can mortgage rates and other commercial loans remain at current levels? 

Are We Still In A Bear Market?
US Equities have shrugged off many of the gloom and doom forecasts so far this year.  The S&P 500 reached a new 18 month high at 1169.84 this week. published a nice chart this week referencing the current price level to previous iterations in his words, the 1150 congestion area. 


More compelling than the chart is his rationale for using technical analysis when one of his blog readers challenged the very existence of using TA to predict price trends:

I like to include some technical analysis on for a couple of reasons:

1) Strict mathematical indicators, for example, moving averages, can show that the market is susceptible to trends of various durations — up, down, sideways. Technical analysis offers some strategies for making conjectures about continuations and reversals.

2) There's a significant behavioral factor in markets and the economy — irrational exuberance, dismal despair, and everything in between. Technical analysis, with its trend lines of support and resistance, may provide some clues about the underlying market psychology.

As for the predictive power of TA? Not exactly a crystal ball. Same for fundamental analysis. However, a long-term trend, horizontal consolidation, or even an inverted head-and-shoulders formation is probably a better indicator of next week's S&P 500 than an inch of rain in Massachusetts tomorrow.

Ultimately technical analysis, like its fundamental counterpart, is a search for evidence to make educated guesses.

Actually, there's a third reason I like to post some technical charts: Sheer entertainment value. I look at a market bumping and grinding against a couple of trend lines, and I love the suspense. Take that 1150 resistance in the chart linked above. Will it break out? Break down? Or consolidate sideways?

For some of us, these charts are almost as much fun as NCAA basketball!

So there you have it.  And since enough market players are using technical analysis these days, there is a fair amount self-fulfilling prophecy at play too.  Enough people seeing the same pattern will cause traders to tilt to either the Buy or  the Sell button.  Are we still in a bear market?  The medium term technicians will point towards a break-out of the bearish trend line as it developed this week.  The educated guess for a technician would suggest a favoritism towards the upside – that is to say based on just one basic technical trending tool.


But as you might have guessed, it’s not nearly as clear-cut in the real world.  Stock prices have traditionally been a forward looking indicator of the economy in that stocks typically move about 6 months ahead of the real economy.  And the real economy is exactly what may cause some concern and put a reign on further price advances unless there will be some major improvements in jobs and consumer spending going forward.  The economic picture at present does not look nearly as rosy as market advances might suggest. Looking beyond just pure economic growth indicators there are some additional caveats to note:

• Bank lending and credit is still contracting
• About 15% of all residential housing units are vacant
• A significant amount of manufacturing capacity is sitting idle
• 43% of Americans have less than $10,000 saved for retirement
• More than five million homeowners are behind on their mortgages
• Commercial real estate values are down about 30% in the past 12 months
• More than six million Americans have been unemployed for at least six months

These are massive challenges for the all-important American consumer making it less likely that the economic recovery will be as fast and as strong as the stock market recovered in the past 12 months.

In Dodd We Trust 
This was just too funny to pass up.  Enjoy and have a lovely week-end.

The Daily Show With Jon Stewart Mon - Thurs 11p / 10c
In Dodd We Trust
Daily Show
Full Episodes
Political Humor Health Care Reform

Good luck and good investing!

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