Mile High Insights

The Scary Part of the Journey

08/31/08

The S&P 500 meandered throughout the month of August within a 3 % band. 1285 down to 1250, up to 1310, down to 1260 and back up to 1300. Volume was light as is usual during the prime vacation month in the northern hemisphere and not even momentous events like the democratic national convention or a Russian invasion could rattle the markets out of their lethargic lurch. Spinning in Washington and spinning wheels on Wall Street created friction and rising temperatures but did not result in any sustained upward movement. The markets seem stuck. Durable goods orders for July were much stronger than expected, due to rebate checks and special one time items. Real (inflation adjusted) GDP for the second quarter was revised upward to 3.3%. Nominal GDP (before inflation adjustment) rose to 4.5%. There were good and bad news in this report and it is important for us to understand the positives and negatives of the report. The basic formula for calculating the GDP is:

GDP = C + I + E + G

Essentially, the report consisted of one clear positive, one more positive than negative and one negative surprise. The negative surprise was that the GDP deflator, which adjusts GDP for the impact of inflation, was estimating an annualized inflation rate of 1.33%, which of course is ridiculous, given that the core CPI hovered around 2.5% throughout the quarter and headline inflation rose from 3.9% to 5.5% during the three month span. Even so, GDP seems to have increased even after adjusting for inflation. The good news is that inventory investment (part of the "I") declined (though less than anticipated), which shaved off 1.4% of GDP and otherwise would have shown GDP at 4.7%. The not so good news is that inventory rebuilding in the current quarter seems not nearly as urgent as before. The best news was that nearly 90% of GDP growth was due to the "E" in the equation. Net Exports contributed 3.1% of the 3.3%. Tony Crescenzi commented: " Investors will be pleased that the underlying strength of the economy was better than previously thought, but attentions are focused on the dark period ahead for the economy, which is likely to grow substantially less in the quarter ahead. This is a widely known notion, however, which means that it is already largely priced in."

The first chart above was first introduced in our Newsletter in April. I therefore refer interested readers to the more extensive explanations in that particular month. Suffice it to say that experts can not agree on the impact that inflation may have on GDP data, which is why we give you the choice to look at nominal GDP, CPI adjusted GDP or PCE adjusted GDP. It seems clear that only nominal GDP is positive and that the other two measurements of the economy seem to have entered negative territory. Mind, however, that this is not the official version. Real GDP officially came in at positive 3.3%. We can quarrel over the methodology, the fact remains that the economy is not very strong and continues to shed jobs. The second chart above shows us the Commercial Paper market. Securities and Exchange Commission rules state that commercial paper can be issued for "transactions purposes" only, which means money borrowed through the commercial paper market will find their way into the economy, via inventory investment and other places where working capital are necessary for current production. The CP market therefore gives us a good impression about merchants' future intentions. Tax-rebate checks spurred spending during the quarter, increasing the need for inventory restocking, which is depending upon working capital. Companies generate working capital through internally generated cash flows, as well as through the issuance of commercial paper and through commercial & industrial loans. The total amount outstanding is now at its highest since April. It is important that this market continues to expand, albeit slowly.

The first chart above shows you the other indicator for merchants' intentions and banks willingness to finance those intentions. The amount of all outstanding Commercial and Industrial Loans (C&I Loans) continues to rise. The ascent however has slowed to a crawl and is almost stalling out. This needs to be watched also. We can not afford a contraction in C&I Loans. Credit is the lubricant of every economy and outright credit contraction (despite a nominally expanding economy) works like a brake. The slowdown seems to come from both sides. Borrowers seem reluctant to expand in the current economic climate and lenders seem reluctant to lend in the current economic climate. I have the impression, however, that the condition of the lenders seems to improve slowly but surely. Look at the second chart. The total amount of Non-Performing Loans is still rising and will probably continue to rise for the next three or four quarters. However the 6 months rate-of-change seems to indicate that the point of maximum acceleration has been passed and that things are getting worse at a diminishing pace. We all know that Wall Street loves the second derivative and this is a classic case. Despite all the negative headlines and scary fundamentals, the banking sector has continued to advance. It is true that many banks need to raise a lot of capital under onerous conditions to avoid bankruptcy but for some reason the markets seems to have discounted this already. It looks to me like the bottom is in for most regional banks and for the major homebuilders. Here is what Tony Crescenzi has to say while commenting on the GDP report:
"Again, since this idea is probably already largely priced in, the time to invest in riskier assets, such as stocks, corporate bonds and distressed assets is upon us. No greater than 50% (25% is probably the max for now) of an intended position is advisable, however, until the theory about the dark period being priced in has been tested on one, two, or three employment Fridays."
I agree completely. The scary part of our journey through the 2008 recession is upon us. The bottom seems to be in for many stocks; however, it is always darkest just before dawn and the headlines are probably the scariest while we climb out of the valley. The employment picture continues to deteriorate and the potential for one or two extremely bleak employment reports (starting with the one coming up this week) is very real. Everybody's faith in a recovery will be severely tested in the coming months, but by the time we enter the year 2009 I am convinced that "the bottom" in many indices will appear in the rearview mirror.

Hermann Vohs

Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.

This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.