I remain pessimistic over economic and equity market prospects. And with ample reason. But, through Friday, the markets thought otherwise. That will soon change.
Though the Dow and S&P 500 were down slightly for the week, the equity markets nevertheless closed the week on a strong note. This is typically a sign of optimism because of the potential for adverse surprises over the weekend. This is an upbeat indication, as was the decline in the VIX volitilty index. Taken together these measures suggest more market confidence (even if misplaced), that the balance of forces will lift equity prices higher. In reality, the bear-market rally has relatively little room left on the upside. It will soon be time to reset short positions in ETFs, and not just because of the potential adverse consequences of the swine flu. Next week first quarter real GDP is likely to be reported down 6%, with more bad news to follow. The month of May begins a period of market vulnerability. One straw in the wind is a step-up in insider selling, typically an advance indicator of impending equity market declines. Similarly, a reported decline in equity market short positions undermines the market's potential to move higher or just maintain current market price levels.
Also significant was last week's rise in gold prices back above 900, with a current spot price of 913, and a jump in Treasury yields, with the ten-year yield back at 3.0%, the highest level since the Fed indicated its plan to buy Treasury bonds. These developments reflect a number of reports, events and beliefs. There was a report that China has substantially more official gold holdings (76% more)than previously thought. That bullish report on gold helped mitigate the market fear of impending gold sales by other central banks and official institutions to fund their assistance programs and stimulus efforts. Treasury yields are being boosted by the the coming sizable Treasury quarterly auctions usually slated for the second week in May. The so called "Duke of York effect" in which Treasury portfolio holders raise cash for the auction by selling nearby maturities. This raises yields on the new auction issues which effectively makes them more enticing to potential buyers. The reference is to the old English nursery rhyme that I believe goes "The Duke of York had 10,000 men. He marched them up to the top of a hill. Then he marched them down again." That process could push Treasury bond yields higher before they more than reverse the yield rise after the coming auctions. But, there are also likely other important and misleading forces at work in these latest developments.
Among these are erroneous market expectations of an early economic recovery and renewed inflation. These various misguided beliefs were influenced by outright official boosterism and a smattering of seemingly less dire economic reports. Some of these recent economic reports were the result of questionable seasonal adjustments that had the effect of artificially inflating the reports so they appeared less dire or even actually improved. However, if the seasonal adjustments for recent data merely borrowed strength from the presumed recovery later in the year, reports for that later period will only look worse than they deserve. Fed Chairman Bernanke's reference to spotting "green shoots" of recovery and Treasury Secretay Geithner's comparable remarks raised excessively optimistic expectations that had to be subsequently watered down. Secretary Geithner followed with a comment that it is "too early" to say risks have receded and that indeed more action needs to be taken to counter the worst financial crisis in generations. But, not everyone grasped the deliberately mixed message.
The banking system faces major financial distress that will be the source of new profound and deep declines for the US and global economy. Nevertheless, the markets' worries over the still to be released report of the bank stress tests were deceptively lightened by Treasury Secretary Geithner's seemingly offhand remark that all the 19 tested banks have adequate capital. They do not. Also the details of the stress test themselves suggested a low hurdle that all the major banks can pass.
The Administration is trying to have it both ways. They want to be credible. But, that objective can be at odds with their attempt to encourage spending, lending and investing. That explains their efforts to bolster more than warranted confidence in the stability of financial institutions and foster the mistaken belief that the worst of the recession is over and that we are in an economic bottoming process. To those ends the concept of the bank stress test was created. It was hoped that the clean bill of health given to those banks that passed (and all would) could be as effective as the restoration of confidence at the Depression era reopening of banks after the Bank Holiday.
Before you buy into that potential fiction let's look at some of the bank developments that do not get adequate press and their decidedly adverse financial and economic implications. Major banks are rapidly cutting their customers credit card and other lines of credit in their own deleveraging process. By some measures such lines have been cut in half. That critically reduces the availability of credit on which strapped consumers and businesses depend. Indeed, many consumers depend on their unused credit lines as their only emergency funds and reserves. Without access to such funds they will either turn far more cautious in their spending or default on their obligations. It is credit, not money, that is the driving force of the economy. If credit declines and it is, the expansion of the money supply will not make up for it or prevent deflation and economic contraction.
Banks are at the beginning of a new wave of delinquencies and defaults of credit card debt and non-residential commercial real estate debt. Commercial real estate prices are already down some 35%, wiping out owner equity and creating losses for even prudent lenders and certainly for those that lent 80% to 90% or more on overly generous appraised value. The home mortgage forclosure rate at many banks is rising at an accelerating pace after their self imposed moritorium on foreclosures ended. That only adds to downward pressure on home prices, already burdened by a 10-month overhang of unsold homes. Existing home sales fell an additional 3% in March, suggesting the residential market is not stabilizing. It is not likely to do so until next Spring.
Recent bank loss reports only appear less burdensome for many banks because of the favorable change in mark-to-market accounting rules. The improvement in banks' earnings from securites trading was partly due to a preannounced Federal decision to buy Federal Agency securities which allowed banks to stock up on them before reselling at a profit. There were other special factors that helped to artificially boost bank earnings, including a shift in fiscal year that in some instances reportedly omitted a month of unfavorable earnings. The increased yield spead between banks' cost of funds and lending rates is a source of profit. But it will take an extended period before such earnings are sufficient to allow adequate writedowns of losses against even enhanced capital.
Far too many banks missed the opportunity afforded by their exceptionally inflated earnings reports to raise new capital. They will regret it. The IMF estimates US banks will require $275 billion in additional common equity capital to meet or maintain its 4% of assets floor. At the same time the IMF estimates European banks require $600 billion more equity. In aggregate, Eurpean and US banks, it is estimated, will not turn a profit after projected writedowns until 2011. That presumably is consistent with the IMF expectation of a 1.3% GDP contraction in the global economy this year, a significant turnaround from a 0.5% increase previously predicted. Moreover, it does not expect a global recovery until next year. For the US, the IMF forecasts a 2.8% GDP decline this year and no growth next year. In my opinion the IMF could well be optimistic. In either case there is more pain to come.
Philip Braverman, President
Braverman Economic and Financial Consulting
One Hewitt Square #249
East Northport, N.Y. 11731
Email address: philipbraverman@Gmail.com
This and earlier weekly reports can be accessed by going to internet explorer and typing the following: philipbraverman.blogspot.com
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