Applied Investment Technology, Inc.

January 2012  Market News

 From  December: ….the nonfarm payroll employment rose by 120,000, slightly below consensus; the RATE dropped by a whopping .4 % to 8.6%; an  addition of 120,000 jobs is not going to impact the rate by that much; it was a decline in the labor force; over 300,000 people just dropped out of the active work pool; not great news unless you are in the WH & spinning the rate drop as “proof that the policies are working!” other items in the data worth noting are:  1) gains in temporary services were described as “modest”  2) the average work week was unchanged at 34.3 hours  3) average hourly earnings went down by 2 cents or .1%, to $23.18;Over the last year hourly earnings have increased by 1.8% while inflation has been 3.6%;  the civilian labor force participation rate has declined by .2% to 64%; long-term unemployed (those unemployed for 27 weeks or more) number 5.7 million & are 43% of the unemployed; the sectors to gain the most jobs are retail, leisure & hospitality, professional/business services, & health care; manufacturing & construction remain flat; Other news boosted global markets.. central banks will unite to lower the overnight index swap rate from 100 basis points to 50 basis points….. It’s HUGE!! dollars have been clobbered as they become more available & cheaper rates; with all that has been done year to date to boost the economy and the markets…. We are unchanged for the year; Europe and the US are far from in the clear; Fed has said they will provide more assistance if needed, translation —QE3; retail sales appear to be strong, but at what cost??  Manufacturers are “eating the costs” which is to say they are not making the money they need to actually have a “black Friday”; retail chains lack pricing power as wage increases are low & REAL spending power is vanishing; global economic slowdown is resonating throughout with China being the latest victim as exports slow; They have a property glut with empty cities that were built in expectation of unlimited growth; we all know what happens when expectations are unrealistic!   Boom to bust!   South Korea factory output has fallen & Japan unemployment is on the rise; consumers face increasing oil prices; the WH continues to shut down more sites for leasing & exploration; the job crushing stupidity of putting off the decision on the XL Pipeline until after the elections; Everything is political and has a price! Volume has continued to be very low except when the shorts got caught and had to cover!!  market activities were dictated by the events in the Euro Zone, again!  The leaders came up with a pact that would subject member nations’ budget to greater oversight & stiff penalties imposed by the EU; lone holdout was the UK, who has never joined the euro & refused to put their fiscal affairs in the hands of Brussels; pact has $267 billion in loans to the IMF from the ECB & lowered interest rates by 1/4% to 1%; ECB will offer unlimited loans to their banks for up to 3 years & broadened the collateral they could use for the loans; trouble in the making but the pact managed to ease the concerns of the markets for the moment; QE was avoided; many believe that ultimately the ECB will resort to QE versus austerity, which is being blamed for the spreading recession in Europe; Housing… Despite a 20% drop in homes prices, & in some areas as much as 40%, along with mortgage rates lower than anyone ever dreamed of, in the 3-4% range, housing activity remains in a depression; affordability is said to be attainable for families on a median income; affordability assumes the pre-housing bubble of a 20% down payment & many are not able to come up with it; their income is no longer adequate; surveys fail to take into account - the growing factor in the home-purchase equation: property taxes; residential property taxes have risen to the extent that “in many parts of the country, homeowners pay more in taxes than in mortgage interest”; “the residential property market is a boiled frog: rising property taxes are killing it”... states and municipalities need the revenue & don’t cut spending fast enough to shrink deficits; Property taxes make up 35% of state/local government revenue; prior to the housing crisis was 29%; due to the drop in individual tax revenues, the property tax income is vital to the governments; property values decline, reappraisals are lowering the property taxes, putting further strain on budgets; property taxes are adding to the real cost of housing & isn’t considered in the normal measure of housing affordability; further problems for housing is the growing student loan debt; now totals a staggering $865 billion which is more than all outstanding credit card debt, & other household debt (other than mortgages); problem for the housing market because an increasing number of 25-34 year olds (prized demographic for the housing sector) now live with their parents; number is up 26% from the start of the recession in 2007, & the home ownership rate for this group is the lowest since 1999; wizards of smart in DC are proposing a MASSIVE refinancing program to allow those current on their payments but deeply underwater, to get another low cost loan to free up capital.  they are talking about a bout of QE that would entail purchases of as much as $2 trillion of mortgage backed securities; sum of money is staggering & if the inefficiencies would be absurd, fraught with waste & money slipping through the cracks, & more government workers to handle the onslaught of activity! id December, a volatile year, nothing resolved, the cans all kicked down the road, election battles taking over everything in DC & the markets are virtually unchanged for the year!    Expect more of the same….. At least until the outcome of the elections becomes clear!! talk about what went wrong, why it happened & what to expect in the coming 12 months; one reflective article dealt with why the “recovery” has been so slow; without housing & technology, an economy can’t grow with any vigor; a stat in the article stated that in the 41 years since 1970, the average quarterly rate of growth (calculated on an annual basis) has been 2.8% —and keep in mind that this includes all the negative periods during the recessions; our recent 9 quarters of “recovery” have managed to eke out an annual growth rate of 2.4%....no one is expecting better for 2012; housing & growth in government (both of which have been a drag over the last 9 quarters) are excluded, growth in real private sector GDP has only averaged 2.6% versus 3.8% & 4% for the 9 quarters in the 2 previous recessions of 74-75 & 80-81; growth of government has caused the largest decline in economic freedom on record; growth is measured using 5 equally weighted categories including: “size of government”; “access to sound money”; & “regulation of credit, labor, and business”.  Economic Freedom as defined by Milton Friedman’s index, is likely to decline even more as the bickering heats up with elections around the corner; the predictions for the coming year? Loaded with caveats & the usual “if then” statements; not worth going into what is on the docket of expectations.   One area that most agree on is Europe….  If all goes well there, and investors figure out the game, then markets might meet the failed expectations of 2011; If Europe has a banking crisis, which will spread to the US, all bets are off & it will be another losing year for the markets; the glass half full argument, say that given all the turmoil in Europe, it’s amazing that the S&P is only down 3% YTD; many events are out of our control & Europe has managed to kick the can down the road; Europe has resisted the “Bernanke PUT” so far which is to say they have decided against QE but it’s still a possibility when all else fails; Investors have been sitting on the sidelines for some time & as the year draws to an end this is not going to change.  Holiday events and chaotic markets are not going to tempt investors to jump in now so the WALL and BROAD rally that is a seasonal event (most of the time) is going to elude the markets this season; we have is a disaster in DC & the hope is that the voters do a better job in 2012. 

Saturday     January 7th, 2012

Happy New Year to all!!   Markets got off to a great start on the first trading day of 2012, only to have Europe get in the way once again.  As stated last year, much of what takes place domestically will depend on the events in Europe.  So far there is evidence of a deepening financial crisis which has pushed borrowing costs higher for some bond issuers.   As a result the EURO got hammered and financial shares were trounced.  

Highlights of what is taking place include the following:  Greece and Hungary are still leaning toward default; Italy had to discount newly issued shares of their bank UniCredit at 65% plus a huge discount to the market price.  The discount shocked investors such that they sent the banks share prices down by 39% just last week.   Obviously this was a drag on the entire banking sector.

Next is the issue of where the banks are going to get the money they need to raise when Italy had to discount so heavily…..  They need to raise 107 billion euros and the action in Italy suggests that Europe’s financial sector is overpriced.   Worse yet, capital is fleeing Italy, which is a larger concern than the declining values of the debt. 

Spain is under pressure as their bond yields rose when the government of Valencia confirmed they were a week late in paying a debt of $123 million euros. With all the turmoil, the Euro fell to a 16 month low due to the EZ debt and fears of a recession.   Across Europe shares of many companies have retreated to their absolute trough levels of 2009.  OUCH!!

Moving briefly to the situation in China…..  They have joined the US, the EZ, Japan, and the UK in balance sheet deleveraging.  China has engaged in an accelerated program of domestic investment using credit creation in its domestic banking system.  This provided a much needed boost to demand when the industrialized economies were all deleveraging.   This source of aggregate demand is slowing significantly and that will translate into much slower Chinese growth.  

What effect will this have on the United States?   The US continues to make progress in private sector deleveraging but almost NO progress when public sector balance sheets are included.  Households and banks have generally reduced debt either via defaults or orderly recapitalizations.  Despite the progress to date, the deleveraging process is not nearly complete.  This is especially the case given that the government continues to run large structural deficits to support private sector demand.  In addition, the unfunded liabilities as a result of demographics are starting to affect public balance sheets at a faster rate. 

The bottom line is that, as a result of the problems in Europe, the slowdown in China and other emerging economies….. The outlook for the US growth (which was only 1.5-1.75 in 2011), is a mere 1% growth in 2012 or perhaps worse.   Global growth is expected to be a mere 1-1.5% in 2012 which is much lower than what the “experts” expect or “hope for”!!  The risks to the “expert” opinion is to the downside.  Much of that is due to inflation expectations! 

One quick paragraph on the jobs report issued on Friday……  the 200,000 jobs reported consisted of 42,000 slots filled by couriers & messengers as a result of seasonal factors.  Those jobs are likely to disappear and prove a “holiday pop” (as stated in Barron’s) more so than a trend change that is likely to continue.  According to the Liscio Report, over the last year, “tax collections don’t seem to be keeping up with what the Bureau of Labor Statistics is telling us.”

The percentage of workers suffering long term hardship, which includes folks who have abandoned the labor force, is approaching a shocking 7%.   While there have been some flickering signs of life in the US economy, the housing and financial sectors are still in serious trouble; markets are going nowhere for obvious reasons and with the elections dominating WH policy decisions, I still believe that 2012 will be a difficult year for markets.   As stated last year, until Europe is on more stable footing, the uncertainty and fear will dominate!   

AIT will maintain the conservative and defensive as warranted by current conditions.   Please don’t hesitate to email or call with any questions or concerns! 

January 15th  SUNDAY

“And now for something completely different” (straight from Monty Python) — oddly appropriate since Europe once again managed to dominate the news and markets last week.  While the averages managed to squeak out a small gain, the downgrades in Europe, while expected, will not help the situation.  S&P lowered ratings on Cyprus, Italy, Portugal, Spain, Austria Malta, Slovakia, Slovenia and France.   Without getting into a lot of minutia, the critical item as to the downgrades is they will have to pay more to issue debt and there’s a good chance that further downgrades will take place in the next 24 months.  Neither factor will assist these countries in getting a handle on their debt crisis.

Back here in the US, the confidence indicators are rising and this renewed optimism has many questioning whether there will be a QE3.  However, it’s still a high probability since Bernanke is in an accommodative mood and the credit multiplier is NOT working.   The best chance for an economic recovery is a renewal of releveraging and that depends on a recovery in housing.   That would require working through all the excess inventory of homes and the only way to do that would be a policy of comprehensive mortgage debt relief.   Consider the fact that coming into 2012, Congress could get almost nothing passed, which makes 2012 a sure pre-election period of absolutely nothing being done except by executive order. 

The Fed has advised Congress to allow Fan and Fred to throw more money away in an effort to support housing with another mortgage relief program.  Keep in mind that since 2006 more than $7 TRILLION has vanished in home equity.   In addition to this news, Barron’s ran an article this week on the nations mortgage insurers that is more bad news for all involved in the housing market.  The bottom line is that the increasing foreclosure claims from the housing bust has decimated their financial results and capital bases are being wiped out!   The insurers were UNDER reserved for the insured mortgages that went delinquent. They took an enormous risk by doing so and then attempting to delay the time from when a loan went delinquent to when the claim was paid.   Sound like any banks of late??

The mortgage insurers are facing enormous looses and this is putting another obstacle to recovery.  The reason is because many who can’t come up with the 20% down payment will rely on private mortgages to finance the purchase.  The insurers cover the first 25% of a mortgage’s value against default.  This then affects Fan & Fred who own the bulk of the mortgages enhanced by private insurers.  Like one giant snowball!!

Lastly this week, a few words about the earnings season that has just begun.  Corporate guidance, in terms of  preannouncements, now has a ratio of negative to positive by 3.5 times.  It’s the highest it’s been since Q4 of 2008.  Investor pay for profits, NOT GDP.  And the hurdles for earnings in the corporate sector for 2012 are many and building:

1. Recession in Europe which affects 20% of revenues of US corporations

2. Slowing in Asia—China’s import growth was sliced to half YoY in December

3. Margin squeeze from high oil prices

4. The stronger US dollar impact on foreign sourced profits

5. Reduced tax benefits

6. Higher employment expenses & lower productivity growth

7. Crimped pricing power per the latest NFIB survey

8. Profit margins are coming off 6 decades highs — no more room for expansion

9. No yield curve for the banking sector; limited ability to squeeze more earnings from loan loss reserves

While some are excited by the early market action, the treasuries are telling a completely different story.   The message given is that there is no cyclical momentum as the yield on the 10 year treasury has been dragged back below 1.9%.  This is not a healthy signal from the broad market!

Again, I stress that AIT will remain conservative with capital preservation as the priority!

January 21st   Saturday

Another holiday shortened week with low volume but more gains were added to the indices, due to a lack of major catastrophes in Europe and earnings that were mainly in line with expectations in spite of the Google bomb!   While sentiment has improved on the domestic front, all is not well in Europe which is to say that complacency here in the US will be very dangerous. 

We must continue to focus on Europe because their banks are heavily intertwined with ours and should a crisis take place, it will have severe repercussions on our economy.   Many believed that the ECB solved the regions problems last month with the LTRO (Long Term Refinancing Operations) program.  Yes, the pressures eased slightly but the central banks are not equipped to deal with solvency issues even if they provide liquidity to the marketplace.   The $624 billion that the ECB provided is not being loaned out as intended but the banks are instead sitting on the money.  In the meantime, because the S&P downgrades have eroded the balance sheets of the individual governments, they can’t provide further assistance either.  The nine downgrades are going to have ramifications and these were not priced in as the euro went to fresh lows on the news!! 

In addition, the situation in Greece on the restructuring talks has hit another impasse and the risk increased of an outright default has been raised again.  Greece can’t meet it’s growth or fiscal targets and they have 14.4 billions euros of bonds maturing in March (almost 7% of their GDP).   It’s likely they will default since the chances of raising the kind of money needed is slim, and their banking system has seen a huge run on its deposit base — 65 billion euros (1/2 of total deposits) in the last two years. 

Turning to France….  The downgrade by S&P was a statement that kicking the can down the road is no longer a viable strategy; Spain and Portugal are basket cases and to make things worse, they have an emigration wave (to Brazils’ benefit) that is draining them of workers.  I could go on with respect to Austria and Hungary, etc. but you get the idea.   One final blow came out of the ECB when it said it did not support the watered down fiscal compact between France and Germany that took place at the last summit.   Bottom line is that the European clouds are NOT parting, more troubles are ahead and it would a mistake to not expect more market volatility!!

A quick note on the China situation….  Their problems are not simply the shrinkage in foreign exchange reserves.  The WSJ cites estimates that the country experienced up to $100 billion of capital flight last quarter as concerns over the equity and property markets grew.  Recall in previous comments I pointed out the RE glut in China where cities have been built but no one is in them!  

Moving to the US…. Last week I stated that the decline in the 10 year treasury to roughly 1.9% was telling us what the bond market thinks of the macro economic picture.  Clue — it’s not good!!

As an example… the headlines on the job front are all about how much better the jobs picture is…  BUT… the recession supposedly ended 30 months ago and the labor force has CONTRACTED by nearly 1 million!!  In the past two months this it has been 170,000 fewer workers.  Contrary to what you might think or read, it’s not about retiring boomers since they are trying to remain in the work force longer out of NEED!   This contraction in the work force is due to discouraged workers who are just giving up!   In the past 9 recessions there were an average 3.5 million NEW workers in the labor force…..  This time around the data is suggesting a pickup in firings and a renewed DECLINE in job openings. 

When the recession “ended” the labor force participation rate was 65.7% and today it’s at 64%.  This tells us that the unemployment rate is now a totally meaningless statistic and further explains the angst in the public.  People know when things are just not right and the restlessness is quite apparent.  In the span of a year economic growth has been cut in half, Europe is in recession and Asia is softening.  The weak dollar is no longer providing a tail wind for manufacturing or the banks and we have likely reached the limit in cost cutting.  Policy stimulus is OVER!!

In closing, I will iterate a quote from Feliz Zulauf from the Barron’s Roundtable  When asked the question “what happens at the next level of turmoil?” His response:

             “The banking system goes broke. Assume Greece won’t repay anything, or at most 10% of it total debt. It is not just the government but the private sector that is bust.  That means banks in other countries will be in trouble, which means they will be nationalized.  Governments won’t have the money to pay for this, so they will assume even more debt.  That is the chain of events I expect in 2012, and if you believe it won’t affect the US you are dreaming.”

I am certain that the right course of action is to remain very conservative, in spite of what the talking heads are saying on CNBC and elsewhere.  Or perhaps because of??