Five Things You Need to Know: Prepare Now for the Inevitable Downgrades
When times get tough, the tough do more with less.
Kevin Depew's daily Five Things You Need to Know to stay ahead of the pack on Wall Street:
1. Prepare Now for the Inevitable Downgrades
It's remarkable that equities continue to have days - like today - where they seemingly trade in a vacuum untouched by credit markets. Meanwhile, entire segments of the credit market remain impaired, if not shut down.
This morning Goldman Sachs (GS) Chief Financial Officer said credit markets are trading as if the economy is in the middle of the worst recession we've seen in a long time and that "fear has overwhelmed greed." Viniar even likened conditions in the leveraged-lending market to August and September when issues were only just beginning. The implications are that we have more work to do to make our way out of the woods.
But wait, there's more. Yesterday Standard & Poor's again warned that bond insurers Ambac (ABK) and MBIA (MBI) face the loss of their Triple-A credit ratings, a move the ratings agency was quick to point out could damage banks with direct exposure to the insurers.
S&P said most of the potential losses for banks would be through hedging arrangements that the bond insurers had provided on the least risky tranches of collateralized debt obligations (CDOs), the Financial Times reported. Bond insurers had hedged $125bn of subprime-related CDOs, S&P said.
Citibank (C), Merrill Lynch (MER) and CIBC have all reported hedges on the so-called super- senior tranches of high-grade CDOs and have recently taken reserves for counterparty risk, the FT article noted. Fitch Ratings is also warning that it may cut MBIA's AAA rating of its insurance unit.
Why do we care about any of this? Because, increasingly, it looks as if the bond insurers will face what should be inevitable downgrades. Otherwise, the message from the ratings agencies will be that Ambac and MBIA have the green light to host cash burning parties in the middle of the parking lots of their respective corporate headquarters without fear of losing the Triple-A stamp of approval. That's some message.
But we think it probably plays out something like this. The downgrades will happen; the pressure on the ratings agencies to justify the Triple-A ratings is becoming too intense. Naturally, equities will respond poorly to this eventuality. But so will some form of bank-sponsored bailout. The catch is that the downgrades will happen sooner rather than later, before any world banking-sponsored bailout can happen. Why? Because only after the downgrades will any kind of bank-coordinated capital injection and rescue plan make sense.
The bottom line? Credit markets are still deteriorating. They say that before you can seek help, you have to hit rock bottom. For the bond insurers, rock bottom is still one more weird, groggy morning waking up hungover in an alley away.
2. After the Downgrades
The selling pressure for equities could be intense if (when?) the downgrades of the bond insurers occur. Meanwhile, the equities indicators we follow are pointing to risk decreasing in the market, not increasing... what gives?
Below is where we stand with the point and figure bullish percent indicators for equities, based on Investors Intelligence data.
Demand is now fully in control of equities.
Note that although the indices sold off sharply yesterday, both the High-Low indices moved up, a bullish divergence.
- NYSE Bullish Percent: Xs (Positive), 31.3%
- S&P 500 Bullish Percent: Xs (Positive), 34%
- Nasdaq Composite Bullish Percent: Xs (Positive) 23.8%
- Nasdaq-100 Bullish Percent: Xs (Positive) 26%
- Russell 2000 Bullish Percent: Xs (Positive), 30.9%
- NYSE High-Low Index: Xs (Positive), 44.1%
- Nasdaq High-Low: Xs (Positive), 17.5%
While downgrades of the bond insurers will likely be met with harshly negative sentiment, this will likely set up opportunities for strong relative strength sectors. But we will continue to avoid financials and consumer discretionary sectors.
3. Companies Doing More With Less
When times get tough, the tough do more with less. That's the message from this morning's Productivity report from the Department of Labor. The headlines will say that productivity increased more than forecast, up 1.8% annualized, versus 0.5% expected. but inside the numbers the figures point to the key drivers of productivity being an attempt to get ahead of a tough recessionary environment.
Unit labor costs rose 2.1% annualized, compared to expectations for a rise to 3.8%. But hours worked fell more than expected, down 1.5%, the second quarter in a row hours have fallen. Finally, note that real compensation, adjusted for inflation, dropped 0.3%.
4. The Real Storm Comes After the Storm
In the wake of record-setting foreclosures nationally, cities are busy filing lawsuits and developing land banks, among other things, to reduce the number of vacant properties left over from the collapsing housing boom.
An Associated Press story notes that Buffalo, N.Y., brings property owners and lenders together in court on monthly "Bank Days" to find solutions for cleaning up vacant homes. the Wall Street Journal reports that a San Diego city-county task force is considering ways to buy empty homes before speculators and investors swoop in in order to reserve them for lower-wage workers. In Providence, R.I., the mayor's office is working to have some properties transferred to local community-development corporations, which will then convert them into affordable housing and commercial space with the city's financial help, the same article notes.
The housing collapse is a long-term story with many years of issues still ahead. Land banks, lawsuits, rescue plans, the bulk of the fallout has yet to hit.
5. Nobody Does It Like Sara Lee
And now for some good news. We listened to the Sara Lee (SLE) conference call this morning because the company is among those directly impacted by rising foods commodities costs, and among the first to raise prices for customers to pass through those increased costs.
Although the bad news for consumers is that prices are going up, the bright spot in the data is that, so far at least, Sara Lee is not seeing any changes in demand curves nor trade-downs from consumers in response to rising prices. Even in coffee, which tends to fluctuate more often than other items, Sara Lee is not seeing changes in demand.
"In the U.S. on meat and bakery we're gaining share in every single [segment]; we're not seeing a shift to private label on the bakery segment that one could perhaps see if there was a trade down from the consumer standpoint," Sara Lee CEO Brenda Barnes said.
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