Monday, January 31, 2011

USD - Does Anyone Want It

The USD is really struggling lately.  The USD and the EUR in the race to the end, right now is favoring the EUR.  We have a potential banking crisis in the EU, Ireland revised down their GDP forecast to 1% from 2.4%, the UK just had their GDP contract, there is talk of bond hair cuts for EU bailouts, PIIGS CDS and yields continue to rise and Ireland and Greece are so bad off they are already talking about extending the term of their credit to 30 years.  All of this still is finding investors more willing to buy the EUR versus the USD.

Below are two charts.  One is a three year daily showing the trend line that has served as support each time it's been tested.

This next chart is a three month, daily showing the range the USD traded in for well over a month before finally breaking down.  Even in the face of geopolitical risk, the USD just cannot catch a bid.  Today's price action was a bearish reversal of Friday's risk off trade. People seem to just no longer trust the safety of the USD.  The implications should the USD not maintain reserve currency status are very scary indeed.  Should that happen we can kiss goodbye our low interest rates, our $2.75 gas and more.   From a technical standpoint it appears the USD is hell bent on testing the trend line once again.  It is due for a bounce purely from a technical standpoint.  What if it doesn't bounce though?  What if all it gets is just a bounce and eventually just sells off.  

We have a group of academics, named the Fed conducting a real world test in currency debasement.  There are food riots throughout the world.  China just reported lower manufacturing expansion and higher inflation.  Rice prices closed limit up today.  Should the Fed be successful in their all out debasement of the USD and risk losing reserve currency status, they also risk losing their power.  It boggles the mind that some guy appointed by the President can have so much control over the world economy and not be subject to any real time audit and accountable to no one. 

Clearly something has gone awry, no?


Q4 GDP - A Look Inside

GDP missed with a 3.2% read versus the estimates of 3.5%.  Looking purely at the highlights, two things stood out.  First, the drawdown in inventory for the first time in five quarters.  Inventory was a net drag on GDP by 3.70%.  The second and probably more eye catching stat was the Final Sales figure which showed a solid rise to 6.87% from a prior read of .94%.  So at the headline level although a miss, the report showed some positives.

Like anything though you need to read behind the headline to find the true story.  Without making GDP to confusing, let's break it down to the simple formula

GDP = Consumer (C) + Investment (I) + Government (G) + Trade Balance (T)

The chart below shows how each component of GDP have changed over the past eight quarters.   The two areas that standout are the changes in (I) investment and (T) trade.  We did notice (G) government begin to turn down and become a net drag on GDP and we also saw (C) consumer tick up adding more to GDP growth.  For the most part though (I) & (T) were the largest fluctuations.

The Trade component was a little confusing as it showed an increase in exports which makes sense considering the dollar debasement, but a substantial decrease in import growth by 2.40%.   The drawdown in inventories would be offset partially by the drawdown in imports but the amount was larger than would be expected considering the fact that the consumer showed strength this holiday.  GDP is quoted in real terms (inflation adjusted) from nominal values.  The BEA uses different price deflators in this adjustment and the deflator for imports is much larger than that of GDP as a whole (.3% for GDP and 21.8% for imports).  So part of this trade benefit to GDP was purely using an uneven price deflator that favored GDP versus imports.

The Investment component which is where inventory resides, showed the first drawdown in inventory levels in five quarters.  Odds are this is not a blip but rather a trend where inventory will continue to be a drag on GDP.  Until real demand comes back into the economy the desire to build GDP to higher levels will not be there.   So as inventory levels stagnate or reduce further based on sales, the (I) investment component of GDP should put more downward pressure on GDP.

The table below shows the past eight quarters and a breakdown of GDP by various components. 

Another way of calculating GDP is using final sales and changes in inventory. 

GDP = Final Sales + Changes in Inventory

In other words, Final Sales = GDP - Changes in Inventory.  As a result the big drawdown in inventory resulted in a big rise in final sales.   The graph below shows final sales over the past eight quarters.  Seems rather hard to have full faith in this GDP calculation method with final sales going up in one quarter from .94% to 6.87% (that's quite a trajectory).  Graph of final sales over the past eight quarters is below.

So on the surface GDP was a miss but looked OK.  Behind the headlines though questions do arise.  It's also important to note that this is the first of three more revisions to GDP.  For most of the report there are only two months of data (October and November) with December being more of an estimate.  


Ah - Risk Assets

Frustration level is climbing even though going into today we knew how it could possibly play out.  Volume was LOW today, oil caught a nice bid and the VIX retraced a small portion of its 24% move up.  Still, watching days like today for the past few months has become rather annoying.

Bulls that are long anything are rewarded each day and grow smarter and smarter each day.  Little hint of sarcasm there with the smarter comment.  Anyone who has blown up an account, which is pretty much any successful trader understands the worst thing that can happen is finding success in the market when you really don't know what you are doing.  The smarter you think you are the more you are being ready for an expensive lesson on trading capital markets.

I noticed a comment the past few days from a "retail" site I pop in on at times of how their prior level of leverage was not enough.  They are literally finding any money they can and moving it into equities and leveraging up.  You can't get anymore bullish than that from a retail standpoint.

Silver managed to catch a bid today while gold did not but did recoup some of its losses. Tomorrow is the million person march in Cairo so that could be interesting.  Banks are shut down and food is tight (and people are tired after seven days of protests) so things could get really volatile fast.  There's talk of protests on Saturday in Syria and reports of fighting with youths and police in Sudan.

Anyone who thinks this is going away soon because equities caught a bid (more like half a bid) could surely be mistaken.  Tomorrow is the first of the month and a recent study showed the best trade was to simply go long equities the first day of the month.  Literally just hold the first day of the month.  So, we may see a little more bids come into the market.  But following the April 2010 high, which I am sure many traders are watching the correlations, be careful about Wednesday.  Don't forget the NFP report is on Friday. Heaven help anyone who believes any "strong" report out of ADP this month.


Afternoon Update

The markets that never die... Seriously, this stuff is getting old.  So far though other than moving above the middle bollinger, the candlestick pattern is similar to that of the April highs.  For it to continue we'd see strength tomorrow and considering it is the first of the month, that is very likely unless some shock event happens.

Interesting to note the SPX retraced exactly 50% of Friday's move before turning back. Volume is pretty light compared to 50MA volume and Friday.  Oil is up another 3% plus though which tells me people in the commodity space are not discounting a Suez canal shutdown or some other impact on oil prices.

The close will be interesting to watch.  Rumors of PIIGS debt haircuts and Ireland revising down its GDP from 2.4% to 1% (ouch) should at some point in some normal world put pressure on the euro.  Like I say, should...


Morning Update

Amazing, in the face of all the news and uncertainty markets catch a bid.  As we compared back to the April 2010 correction, the day following the big red candle we did bounce back to the middle bollinger and so far that is playing out today.  What is really interesting is the DXY.  It gave back all its gains.  Have to wonder what the future of the USD really is.  Seems like no one wants it.

I'm not adding to any positions until I see how the next two days plays out assuming they are similar to what we saw last April.  Markets are still conditioned to buy the dip and this move up will further exhaust any long money left.

I'm glad I mentally prepared myself for this move up in thinking through what the price action may be today.  Still crazy early and data in a few minutes could move the needle either direction.

I still believe shorts will be more emboldened here with a stop set at the prior highs on Friday.


Sunday, January 30, 2011

Comparison To April 2010 High

The current market action is eerily similar to that of the April 2010 highs and subsequent correction.  Granted Fed QE is still in operation unlike April, yet POMO is beginning to show less ability to move markets.  The key comparisons are as follows:

  • In both run ups to the high, the middle bollinger band was not tested until just before the top was in.  

  • Both runs up did not touch the lower bollinger band at all during the move up.

  • Both tops showed massive divergence on the MACD

  • The move that pierced the middle bollinger band in both run ups was a massive red candle down.  The candle on Friday was more powerful than the similar candle in April for it set a new high, failed to hold that high and closed on the low.   Both candles also found support at the prior low where the middle bollinger was first tested.

  • This is the key in understanding where we go from here.  After the big red candle back in April, the next two days did move up, yet failed to make new highs before finally rolling over.  Looking at the Asian markets right now and the ES futures, we may be in a similar attempted move up.

Personally, I think enough damage has been done from a technical standpoint, combined with questionable macro news (UK starting a new recession for example, US missing GDP on Friday, etc). I think many are not fully understanding what is happening in Egypt.  To me it's not an Egypt story.  No, I think it's a global revolution story.  People have been oppressed for years and have finally had enough.  Bears may be emboldened again should the market attempt to move up.  It sets up a great trade with your stops at the prior highs should the market experience a move up the next few days.

The majority are expecting the market to move down on Monday, I would imagine and we know how that never works out.  Even with the Fed and POMO and a market that always seems to catch a bid, the risk reward here favors the short trade to purely cash trade in my opinion.  I remain short and hedged via credit call spreads but until a clear direction is shown, I won't be adding to my current position.


Monday January 31

So the big question is how will the markets react the next few days.  Have we begun a well needed correction or something bigger or will this be just another buy the dip "opportunity."

Anyone who claims they understand these markets right now is lying to you.  No one has any clue what is going on with risk assets.  Sure they are rising but based on nothing other than the concept of the Bernanke put.  Leverage is at Lehman levels, short interest is at a year low and the effects of POMO arguably are not as strong as back in the August pre-annoucment.

It's important to realize that all of us bears, bulls, whatever you want to call people have been conditioned to buy the dip.  All dips have rallied the past 2 years pretty much.  So to simply say this is the dip that does not bounce would be naive.  There is a chance, a very good chance this dip does not bounce but we can't assume that with 100% certainty.

A majority of people "in the market" don't do their homework.  They read the headlines. They don't question the headlines, let alone read the story.  They take at face value what the media tells them or what some analyst tells them.  Right now the group trade is very long in the tooth and highly participated.  So with that said, many will be ready to deploy any cash that is left to go long.  The same goes for bears who are very tired and timid at this point.  Any signs of strength could easily build into even more strength.  I saw a quote on Friday from a "trader" and I use that term loosely.  Their quote "Egypt is a small country, the market is overreacting."

The easy trade has been buy anything, literally anything, ignore entry price because it will rise in value.  Bill Fleckenstein says it best when he says "nonsense becomes knowledge."  Anyone long anything feels pretty dam smart and the longer this rally has gone on the more their self confidence has been reinforced.  Should this be the start of a larger correction, expect many "smart longs" to fight the tape as the bear did for a while. Expect them to buy any dip they can with any money they have left.  It's worked for two years so why should it not work now they will ask themselves.

To think this is simply about one country in the Middle East is very naive.  Many governments are borderline ready to experience their own Egypt and many more are going to do whatever they can to prevent any increase in discontent within their country.  China is dealing with severe inflation right now and a labor force demanding more income, thus the 10% rise in minimum wage lately.

So there is a very real possibility markets show some strength the next day or two.  You have to ask yourself though is that real?  Personally I think any short term strength is simply a bounce.  POMO is long in the tooth and its strength wearing thin.  From a technical standpoint, lots of damage was done in very heavy volume across pretty much all sectors.  Commodities have been selling off the past two weeks. The USD has shown some firming, especially with Friday's news.  The VIX put in a 24% move to the upside (looks like some people on Friday decided they needed more than the Bernanke put).

The fact that Egypt is gaining in momentum versus quieting down should be worrisome across the world from an economic to policy standpoint.

I'm positioned short via hedged option trades.  I won't be adding to the trade though until confirmation that my assumption of any bounces are indeed just that.  I'm trying to prepare myself mentally though for various options come Monday and into the week. Pretty much everyone who manages money, whether it be their own or a fund is confused right now in terms of market direction.


Saturday, January 29, 2011

COT Report Week Ending 1/25

Some interesting divergences with the SPX and the commercial positions on oil and copper in the most recent Commitment Of Traders report.  Leaving my bias out, looking purely at the charts, the SPX appears ready to finally correct.  So without any further commentary, here's what we have.  For those new to the COT report there are three categories of traders (1) Commercial - don't fade these people, (2) Non Commercial (3) Non Reporting - fade these people.

SPX versus Copper Commercial Net

SPX versus Crude Commercial Net - the only "color" I will add here is notice how about six weeks ago the SPX popped above the position line when the prior sixty weeks it was below, all while the rate of change of the CL position has slowed.  

SPX versus Nymex Light Sweet Crude - This chart is as of 1/25 (Tuesday) before oil prices spiked with the protests in Egypt.  So if I were to draw the chart as of Friday 1/28 the divergence would be far less but "this time it's different."  This time the spike in oil is purely on fear and we know how fear is supposed to affect risk assets.

I have a proprietary trade signal which has correlated nicely with the SPX and also showing divergence.  


Q4 GDP Advance

Wow, what a day yesterday.  Talk about moons aligning lately with riots in Egypt and  more social unrest unraveling faster than Bernanke can print the US peso.  Alright, maybe not that fast because after all the Fed does years of practice printing money.

Everyone was all giddy about the GDP number yesterday even though it was forecasted to be 3.5% and came in "light" at 3.2%.  It's a safe bet to assume the future revisions to Q4 GDP will be revised down considering the government is in the game right now of instilling confidence and almost all data is revised down in subsequent reports.

The big takeaways was the final demand piece of the report.  GDP can be analyzed in many ways, the 50,000 foot view is GDP = Final Demand + Change to Inventory.

Final demand came in at 7.1% which was a very strong number up from 0.9% in Q3.

Let's take a look at GDP under another definitions though.

GDP = Consumer + Investment + Government + Exports - Imports

Imports "grew" in Q4 at 2.4% thus adding to GDP versus being a drag in prior quarters (2.53, 4.58, 1.61).  So net trade imbalance was a positive 3.4% to GDP versus drags on prior GDP (1.71, 4.5, .3).  So how does our personal consumption increase while our imports decrease?

Government was a net drag of .1% versus adding to GDP of .8% in the prior two quarters.  As government "austerity" or shall we say reality of lower tax revenue and higher deficits should cause continued drag to GDP in 2011.

Consumer grew at the expense of a lower savings rate and double the growth of real disposable income.  Either the consumer is ready to spend far beyond their means again or expect this component to come down significantly in future reports.  The other component helping the consumer is the slowdown in foreclosure.  Those homeowners have not been paying mortgages for over fourteen months and as foreclosures are delayed, there is more "stimulus" to the economy.  At some point though, foreclosures will start back up again and that stimulus will stop.

The economy still remains very fragile.  Expect this report to be revised down in future revisions.  With the government limited in their ability to stimulate the economy and in reality becoming more of a drag, any future shocks will have a far more significant impact on growth and this fragile economy's ability to absorb such shocks.


Friday, January 28, 2011

Davos - The Money Quotes

BAC's Brian Moynihan is out with some thought provoking money quotes today (emphasis on sarcasm).  Check these ones out.

On housing prices

"Overall, (housing) prices kind of bump around and it will take a few more years to get through this,"

Bump around?  Thought bumping would be movement in both directions?  Appears he's still waiting for the bump up.  

On employment (or should I say unemployment)

On the issue of unemployment in the US, he said the current elevated figures are caused by those who have been out of a job for a long time and not by newcomers, which is a good sign for the quality of credit portfolios.

So apparently unemployment is a FIFO process.  So those laid off recently will be the first to be employed versus those searching for jobs in excess of six months?  Next time someone submits their resume (what is it five applicants for every one job available) they should just put a date stamp at the top so the employer won't have to bother reviewing the resume, just hire those most recently laid off?

On credit quality

The credit quality of the portfolio has improved and, overall, "the credit quality issue is behind the company and behind the US," Moynihan said.

The credit quality "issue" is behind us?  So you are reducing provisions for loan losses and loan loss reserves in the face of falling asset prices, the highest duration of unemployment above 9% since ever and a shadow inventory that is not only growing but in a legal process that shows no sign of letting up in the near future.  

Do these comments sound like someone that should be running one of the largest banks in the US?   Look at the confidence this man exudes.  


Thursday, January 27, 2011

Bank Revenue VS Efficiency Ratio

Below are two charts comparing the efficiency ratio (non interest expense / revenue net of interest expense) and revenue net of interest expense for JPM, WFC and BAC.

I won't add a lot of color as the charts speak for themselves.  For the past two fiscal years, JPM and WFC have experienced flat revenue growth while BAC has experienced revenue contraction.  Banks can be complicated animals to understand but if you break it down to very basic, big picture analysis they are actually easier to view.  There are some FASB accounting of the top line but no where near the balance sheet gimmicks of mark to myth.

Now look at the efficiency ratio, they have continually risen the past two fiscal years for JPM, WFC while BAC has experienced rapid growth.  Not a whole lot of FASB gimmicks here either.  The difference of these two is a deteriorating pre tax pre provision (PTPP) income.  

If the economy was growing one could argue that revenues will improve and non income expenses will "grow" into these new revenues and thus efficiency ratios will fall to more sustainable levels.  The problem though is home prices are deteriorating and the economy is stagnating.

Lastly, here is a very scary chart from a bank balance sheet risk standpoint.  The foreclosure process is going to get only longer in duration.  Many thought robo-signing would be resolved through some simple legislation or after thirty days of bank imposed moratorium.  That was four months ago.  Instead, we now see BAC announcing a halt to NODs in non judicial states in addition to the already halted judicial foreclosures.  Sure they can foreclose but first they need the proper paperwork.  Therein lies the problem for them.

So while foreclosures slow in the short term bank earnings may actually improve through the combination of accounting tricks that allow banks to accrue interest income on delinquent credits and further reductions in loan loss provisions and loan loss reserves.  Watch for further deterioration though in cash and cash equivalents as cash flow cannot hide behind FASB favorable rules.  At some point in the future, provisions for loan losses will surely grow as they did at the beginning of the crisis.


US Debt - Is It Too Late Already?

I'm not an economist (would I admit it if I were anyway?).  So this post is more back of the envelope thinking.  The budget deficit is forecasted in 2011 to be 1.5 trillion dollars or roughly 10% of US GDP.  Let's just assume politicians could do the right thing and somehow balance the budget in 2011.  This means government would be a 10% drag on GDP (possibly more depending on the multiplier).  Imagine a 10% reduction in GDP?  That would reduce tax receipts and thus cause a deficit again.  Let's assume the deficit is reduced from 1.5 trillion in 2011 to 1 trillion.  That is still a massive drag, not stimulus on an economy that two years after recession still cannot grow absent government spending.   As odd as this sounds perhaps the only chance the US has at any meaningful debt reduction in FY 2011 is if the Fed continues to expand its balance sheet through additional QE.  Problem with that though is at some point the bond market will demand higher yield causing higher debt service for the existing debt that is currently rolled about every four years.

So with the looming debt ceiling being reached there will be lots of talk about not raising it but that seems simply impossible.  One really has to wonder have we already reached a point of no return from a fiscal standpoint.   This economy is very fragile right now and susceptible to any shock event.  The government is in little to no position financially to stimulate beyond QE.  In our current financial environment any debt reduction most likely will reduce GDP, reduce tax revenue while increasing the need for emergency unemployment while further limiting an already constrained consumer.  Debt reduction is truly needed unless our true plan is to do what Iceland did and simply default.  

Unfortunately our economy has nothing currently to truly grow.  Imagine if during the crisis of 2008, the trillions used for bailouts instead were used to truly invest (sorry Obama but your investment is still spending) in alternative energy.  Products that the US could play a lead role in developing and exporting.  It would have been a tough few years but we would have worked through many of the inefficiencies in our economy today.  Our debt level may even have been higher but we would have an economy poised for true demand not spending driven growth.  Unfortunately, a great opportunity was wasted due to failed and misguided leadership on both sides of the aisle.  


The USD - Which Way Does It Go

Well the DXY broke out of its wedge.  Only problem, it broke out both directions and now is back in the middle again.  Geopolitical risk could come into play here pretty soon.  Riots for both food and political reasons are growing worldwide.  As we have witnessed with the equity markets, when group think takes over, it's almost impossible to start a movement.

It will be very curious to see how things in Egypt play out as they appear to have a pro democracy leader heading back to Egypt today to help lead the movement.  It is certainly a very tense time in the world and like the USD or not, it does represent short term safety and could very easily catch a bid as the risk trade is unwound.  Something to keep an eye on at least.

Markets appear to be more volatile the past few days in terms of intraday swings versus the December non stop march of the bulls.


Wednesday, January 26, 2011

AAII Sentiment Survey - Week Ending 1/25

Well, quite a change in sentiment this past week.  Bullish sentiment dropped from 50.7% last week to currently 42.0%.  Meanwhile bearish sentiment rose from 29.1% to currently at 34.3%.  I present two charts below comparing the SPX to bullish sentiment and SPX to Bull / Bear spread.  As you can see below, both have correlated very well.  Two thoughts I have is that (a) this market is truly set for a decent correction and (b) the correction will be fast and if you blink you may miss it.  The reason I say it may be fast is the fact that bearish sentiment has moved up so fast and the market still makes new highs.  Regardless of my view / interpretations, the data speaks for itself.

Screen shot 2011-01-26 at 11.18.07 PM

Screen shot 2011-01-26 at 11.18.22 PM


BAC - The Consumer Side Of The Business

I examined BAC earnings by the seven business groups as defined in their earnings supplement  to get a sense what is driving and what is impeding growth.  What struck me as rather odd was the mix with the consumer side of the business.

I define consumer by adding the (1) Deposit Business, (2) Home Loans and Insurance and (3) Global Card Services.  Below is a chart of each business unit as a percentage of total revenue net of interest expense.

Deposits - The fee side of the business, saving / checking accounts, money market funds, CDs, student loans.  This business has started contributing more to the business but for the most part has remained flat.

Global Card Services - after taking a dip it has turned back up and contributed almost a third of total net revenue.  I know this part of the business has been showing improved credit quality but I don't necessarily think that trend continues.  For many, credit cards and HELOCs remain a key source of funding.  In a recent post I discussed how only 35% of Americans have 3 months of emergency funds available.  For now this business group has experienced continual drops in provisions for loan losses (14% drop Q4 2010 over Q4 2009).  I suspect that reverses trend though in the coming year.

Home Loans - I was really surprised at this one.  It has literally fallen off a cliff.  Q4 2010 had a 600 million non interest loss making this quarter look even worse but clearly the trend is flat to slightly down.  This clearly shows how weak the US housing market is with BAC being the leader in home mortgage.  I came across a report from iEmergent (chart below) which forecasts flat to declining home loan origination in 2011 versus 2010 with refinance activity falling significantly.

iEmergent expects mortgage loan purchase volume plus refinancings of between $903.8 billion and $990.7 billion this year.  "Expect total volume to move toward the lower end of the range if mortgage rates rise and the refinance spigot shuts off during the first half of the year," said Dennis Hedlund, president of the Iowa-based firm.


CBO Forecasts

Just hearing that the CBO just revised the 2011 deficit from 1 trillion to 1.5 trillion.  That's 500 billion higher than originally "forecasted."  Notice how the Big O had no mention of stimulus last night.  Called it investment but no formal plans for any as he knows the Feds are done from a fiscal stimulus capacity.  Done until the next crisis and then we'll see another trillion stimulus.


30 Year Treasury - Big Move Is Coming

Only question is which direction?  Check out this narrowing wedge which has some more time to play out.  The bond market appears as confused as the equity markets.

The USD (per the DXY) is too looking set for a more immediate break out and based on the chart pattern, odds favor down but based on the COT report commercial traders may in fact be ready for an upward breakout.  The red line below is a trend line that goes back to 2008 with four successful tests.  


Tuesday, January 25, 2011

1/25 Markets

What was that last hour?  Was it nervous short covering?  Was it desperate buying?  Was it an algo gone mad?  One thing we know about markets tops is volatility is present and we have certainly seen volatility the past few days.

Oil and Copper both have served as excellent guide to the future of equity prices and since the highs of copper on 1/3 the following divergence has occurred.

Copper - down 5.7%
Oil - down 6.8%
SPX - up 1.6%
IWM - down 3.5% from its 1/19 high

Seeing that move down in the USD towards the end of the day was a little ominous and may have triggered some equity buying perhaps?  These markets are very confusing right now.  What's happening across the globe in terms of uprisings against the government are equally scary.  All it takes is one shock event and treasuries and the USD will catch a very solid "flight to safety" bid at the expense of equities.

We are at very high levels of optimism with risk assets and very high levels of leverage.  A very toxic combination when the day arrives.


Mortgage Lending

Mortgage lending can be quite a profitable business.  Based on recent earnings, the amount of interest income is three to four times that of their actual interest expense.  So for every .30$ spent in interest expense for example it produces $1 in interest income.  Not a bad model at all.

We need banks, don't get me wrong.  Without some ability to form credit most of us would be living in an apartment and not a home.  So in the good times, banks are very profitable but just like with trading risk management is key.

I was doing a back of the envelope calculation to see at what points do defaults wipe out earnings from the vast majority of conforming loans.

I assumed a $200,000 mortgage, 5% 30 year fixed rate, a recovery of 40% on defaulted credits (would include the expense of foreclosing as well).

It only takes about a 9% default rate to wipe out the net interest revenue of the other 91% that conform.  


Monday, January 24, 2011

Loan Loss Reserves - A Comparison

Rather interesting when you compare the Loan Loss Reserves as a % of Total Loans and Leases for C, BAC, JPM, WFC.

For the most part C, BAC, JPM are reserving roughly the same amount (4-5% for BAC and JPM and 6% for C).  Wells on the other hand leads us to believe they have far higher quality credits on their balance sheet with reserves in the 3% range.  Not sure why that is.  For WFC to reserve relative to BAC and JPM they would need to add about 15 billion or in other words, they are more prone to balance sheet risk assuming their credit quality is similar to their competitors.

Based on some recent litigation regarding put back requests, it is arguable that BAC and JPM are under reserved as well and should be reserved more in the range of C.  Taking it one step further, does anyone honestly believe any of these reserves are based on the reality of a double dip in housing prices that has been ongoing for about four months now?  What about second tier credit quality?  What about the risk of mortgage cram downs?  What about the risk of increased strategic defaults in the face of the longest duration of unemployment ever?

Balance sheet risk could very well be the theme of 2011 bank earnings.


Not Everyone Dislikes Bernanke's Monetary Policy

Dr. Ben may have accidentally helped Japan out of their endless deflationary spiral as demonstrated from the following Reuters snippet.  

"The Bank of Japan on Tuesday revised up its consumer price forecast for the fiscal year beginning in April, a move that reflects the impact of recent rises in commodity prices."

Oh wait, what's this next line?  

"On the underlying economy it kept its assessment that while the economy was showing signs of a moderate recovery, the improvement seems to be pausing."

So inflation due to money supply growth and NOT velocity growth can actually cause an economy to go back into the tank?  Scratch Japan from the list.  


Cramer - Does He Do These Shows While Drunk?

I don't watch the show.  Admittedly I did back in the day before I knew better but seriously.  I came across his seven reasons why you should like this market.  Read number five which is highlighted in yellow below.  The fact that stocks are selling off after good earnings report is a positive?  What?  I'm missing something.  Perhaps it's best I don't understand his "rational."


Definition Of A Bad Bank

Wrapping up the BAC Q4 2010 analysis and check out this doozy of a chart, Total Revenue (net of interest expense) VS Efficiency Ratio.  In other words, a measure of how much you have to work with and how efficient you are in that work.

So we see falling revenues and a rising efficiency ratio (which really should be called an inefficiency ratio based on the way it is calculated).  Either this economy better respond fast or they better get expenses under control.  Both of which seem rather lofty goals in the current environment.


Waiting For Trades To Set Up

One thing I am working on improving as a trader is letting a trade come to you.  GE is one such trade.  Normally I would have jumped on this trade from the short side on Friday in disbelief of the gap up and the move higher.  The momentum continued into today.  On a daily  chart this pattern played out before right at the April high.  Back then it closed well above the upper bollinger and the following day pushed higher until reversing and then moving down.

I pulled up a 5 day 30 minute chart and waited until GE closed below support which it did.  I sold some Feb 19/20 call spreads.  Ideally I'll buy back the call spreads when the gap is filled.


Interesting Morning

Weird morning today.  Market just feels like it wants to rollover but perhaps that is my months and months of wishful thinking.  Something more bizarre though is the number of police officers being shot across this country.  Maybe there is more news coverage but it just seems like it happens not only daily but to multiple officers.  Just read last night 4 officers were shot in Detroit and now a similar report out of Florida.

DXY is really due for a bounce here.


Sunday, January 23, 2011

BAC Earnings Versus Balance Sheet Risk

I spent the weekend going back to Q1 2007 through the most current quarter and pulled financial data from BAC financial statements (yeah, I know, I need a life).  What I want to understand is very simple.  Does BAC have the earning potential to absorb a further drop in home prices.

I'm sharing this data as part of a group think exercise and asking for any feedback that can help all of us.  Before I show the two simple charts, let me shed some light on the terminology for those who actually did something more social this weekend versus study bank financials.

Total Net Revenue is broken into two groups:

1 - Net Interest Income (interest income minus interest expense)
2 - Non Interest Income

Combing the two gives you total revenue.   That revenue then needs to cover three main expenses:

1 - Non Interest Expense (staff, legal, pretty much all operating expenses)
2 - Provisions for credit losses
3 - Income to shareholders.

The first chart I show is Total Net Revenue minus Non Interest Expense (in other words income left to cover provisions for credit losses and income to shareholders) VS Provisions for Credit Losses.  This one is simple and not good looking.  Since Q1 2009 income available to service provisions has dropped dramatically and shown no recovery.  At the same time provisions have also dropped.  Sure there is some tweaking of provisions to prevent / minimize losses but the question that needs to be answered is will the red line (provisions for credit losses) be forced to trend up again.   To answer this question, I then looked at total loans and leases on the balance sheet and allowance for credit losses (the amount reserved for future credit losses).

This chart shows Loans & Leases  VS Allowance For Credit Losses VS Provisions for Credit Losses.  Some observations, loans and leases for the most part have stayed flat and through Q4 2009 allowance for credit losses did move up rather significantly.  Since that time they have begun moving back down.  As of right now BAC has reserved for a 4.45% losses to total loans and leases.  Assuming all loans and leases are held at par then in other words the balance sheet is priced at 95.55% of par.  

The question I am struggling to understand is does this data alone and the realization that shadow inventory has grown the past year show that provisions (the orange line) will be forced to move up again regardless of the future of home prices.  Provisions are made up of two components:

1 - Changes to allowance for credit losses (balance sheet adjustment)
2 - Actual loss incurred during a given quarter

Provisions have been moving down since Q4 2008, a year ahead of the move down in allowance for credit losses.  In other words BAC through 2008 was realizing lower losses yet reserving at a higher rate.   Why would you reserve for future losses unless you were all but certain of those losses.  If anything you would reserve as little as possible in the face of diminishing earnings (chart 1 above).

Banks have reported a time line in excess of 14 months from default to REO so there is a lag time between the actual loss incurred and the balance sheet adjustment.  


Saturday, January 22, 2011


What else can you call the two following developments this week.  True insanity.

First and I can't even begin to understand this one nor is it worth the brain power to get into the minds of the newest in ponzi schemes.  Somehow, again don't ask me how the EFSF (European Financial Stability Facility) is looking to buy back debt which now trades below par.  Who are they buying it back from?  Don't they own it?  Didn't they buy debt from Ireland and Greece, etc?  

This one is amusing as well.  So there has been no shortage of talk about the Fed and the capital losses they have realized in just a few months as treasuries yields have risen.  To remain "solvent" the Fed will adjust their liabilities to offset the drop in asset prices.  So the more they lose the less they owe.  What?  I'm not making this stuff up.

Do these events sound like desperation to you or did I just fall on my  head and lost any sense of rational thinking I had?  


The Health Of The Consumer

There is a lot of talk in the financial media about the strength of the consumer.  Pundits will tell us to never count the consumer out.  The holiday season was strong, iPad sales are strong, the high end consumer is spending.  In a word, nonsense.

The number of people in some form of default on their mortgage continues to rise.  The average time from the first missed payment to REO is in excess of fourteen months and higher depending on who is reporting.  Imagine not making a mortgage payment for fourteen months.  What do you do with that money?  You don't save it all.  You spend it on things you are "entitled" to because the sad truth right now is our society for the most part feels entitled.

Consumers guard their credit card and HELOCs because it is their only form of credit and yet the banks spin this as a positive about their assets, their credit quality.  Again, I say nonsense.  I came across two charts that really support this view.

For the first time in over sixty years, Americans had a net withdrawal of financial assets, whether it be savings, 401K plans, etc.  Americans are suffering hard right now.  One in five are employed part time.  Part time work is necessary and there is nothing wrong with that form of employment but the reality is you cannot grow an economy with limited wages and reduced benefits.

Now this one was the scary report from FINRA.  The simple question, how many Americans have available funds to cover three months of normal expenses.  35.3% do while 60.4% do not.  GOD forbid someone loses a job, for every three that lose work today, two need immediate government aid.  One in seven Americans are on food stamps.  There are many people hurting right now and for the media and financial system to spin it as all is well is very sad.  


Friday, January 21, 2011

BAC Q4 2010 Earnings

I'm not a forensic accountant, just a trader taking time to meticulously go through BAC earnings in depth and do some simple math.  From a going concern standpoint, this bank looks to be in some trouble.  They need asset prices to rise, legislation that prevents repurchase risk, no more lawsuits, no wiki-leaks, a strong economy, lots of capital.  Basically a miracle.

Net interest income was the only positive for Fiscal 2010 for BAC as it was up 9.4%.  The bad news?  A 7.9% decrease in total net revenue and a 24.5% rise in non interest expense for Fiscal 2010 versus 2009.  To be fair, there was a 12,400 goodwill impairment taken during Q3 and Q4 2010 but to be even fairer one must realize in Fiscal 2010 BAC halved its provision for loan losses over 2009 from 48,570 to 28,435.

The ability for banks to tweak earnings by adjusting provisions for loan losses is a disservice to investors.  From Q4 2009 to Q4 2010 allowance for credit losses increased by 4,685 which means in all of Fiscal 2010 total balance sheet write down due to loan losses was 33,120.  The total in 2009 was 48,570.  2010 saw record foreclosures.  If someone can explain to me why 2010 provisions were so low other than to simply offset goodwill impairment charges and tweak earnings, please let me know.  I honestly would like to understand.  Seems to me BAC is setting themselves up for some nasty earnings in 2011 which will make 2010 look good.  Right now they look horrid.  My take at least.


BAC Efficiency Ratio Q4 2010 VS Q4 2009 (Updated)

I updated this post as I realized I had used the wrong data (blame it on a really boring options expiration day).

Ouch!  This past quarter the efficiency ratio was 93.2% (non interest expense / revenue net of interest expense) versus 65.3% in Q4 2009.  That is a pretty massive increase in expenses while total revenue net of interest expense dropped from $119,643 in Q4 2009 to $110,220 in Q4 2010 (an 8% drop in revenues).

So you have falling revenues and higher expenses.  In Fiscal 2010 BAC spent 83,108 in non interest expense (70,708 backing out 12,400 in goodwill impairment, anyone say they paid too much for Countrywide) versus 66,713 in Fiscal 2009.  The result was an efficiency ratio of 75.4% (64.2% net of goodwill) for Fiscal 2010 versus 64.2% for Fiscal 2009.

This is not a good trend and whatever CNBC analysts say, this bank is trouble.  


BAC Cash Flow Statement - The Easy Version

Banks are very eager to return the dividend and signal all is well.  To do that you need to generate cash, no?  It's always easy to talk trash when the actual deadline is months away.  I used to love racing on the track and there was never a shortage of trash talking months before an event.  Things got quiet on the starting line though.  Seems BAC needs a little more time to come up with the coin to pay shareholders.  Thought all was well though?  My opinion, the large banks are doing what the Fed is doing.  Trying to make us believe all is well. I'm not buying it (literally).

December 7, 2010

BofA head Brian Moynihan said his bank would raise its dividend "as soon as we can."

January 21, 2010

CEO Brian Moynihan told CNBC the bank would be raising its dividend in the second half of the year, rather than the first half.


COT Report Week Ending 1/18

Just started looking through the data and one chart did pop out.  The chart below is of 30 year treasury yield vs commercial net position.  Looks to me like the 30 year is ready to begin catching a bid (lower yield) which based on SPX correlations should put pressure on equities.


Investor Intelligence Sentiment Survey

Similar to the AAII results the Investor Intelligence survey shows historically high bullishness.   What a massive move up from the bearish levels back in September.


It's All About The FX Markets

Horrid earnings from BAC, yet this market is catching a bid.  EUR catching a bid in the face of Irish Parliament falling apart.  Looks like a technical trade with euro trying to fill the gap while the DXY looks to find support and move up from here.  Ask me China will defend the USD as best they can.


Thursday, January 20, 2011

Dwindling Loan Loss Reserves

The major banks have reported this week and have exceeded on the bottom line (top line for the most part was down Q4 2010 versus Q4 2009).  The reason for the bottom line beat is they reduced their provision for credit losses.  In fact each quarter since at least Q4 2009 they have continually dropped the total allowance for loan losses as a percent of total loans outstanding.

Chris Whalen said it best referring to JPM's earnings "Jamie Dimon is making a bullish bet on housing."  What happens if asset prices do not rebound but rather fall?  What happens if the foreclosure process extends further with all that is going on in the industry?  What happens if mortgage cram downs occur?  What happens to second tier liens?  

At some point should asset prices fall the banks are not prepared from an earnings standpoint to take the hit to their balance sheet.  Rather than lower the provision for credit losses they will need to ramp them back up and take a major hit to bank earnings.  Banks are also talking about raising their dividend (good luck finding the cash for that) in the coming year.  

The data below supports the theory that their "bullish bet on housing" is the wrong side of the trade.  Perhaps there is a strategic reason for them to kick the can down the road right now from a reporting standpoint to build confidence in their equity.  In some sense why do the right thing now when there is a chance (albeit slim) that asset prices will rise and total allowances are at adequate levels.  

As traders we know prices ALWAYS over correct.  Whether it be to the downside or upside, the market never gets it right initially.  Looking at this chart below which looks at historic home values the argument can be made that home prices will depreciate possibly as much as 30% more.

The Case-Shiller Price Index below is also showing a double dip in home prices.  Many argue that since this index does not measure the entire market that it in fact lags and still it is showing a drop in home prices.

The chart below shows sales activity in 25 major metropolitan areas.  There are no "bids" in this market.  How can prices rise when supply outweighs demand?

Lastly Lender Processing Services recently reported the following

"Foreclosure inventories also continued to rise for the fifth straight month as delinquent accounts are referred for foreclosure, but the sale of foreclosure properties declined. When compared to January 2008 levels, the foreclosure inventory of jumbo prime loans is nearly seven times higher; the inventory of agency prime loans is nearly six times higher; and the foreclosure inventory of option adjustable-rate mortgage loans is approaching five times the inventory in January 2008."

The banks may argue that falling asset prices does not mean increased balance sheet risk as they hold to maturity or higher delinquency rates.  Perhaps that is their bullish bet.  There is plenty of data that counters that argument and clearly shows the less financial interest a homeowner has in their asset the far greater chance they will strategically default.  


SPX Kiss of Death or Buy The Dip

Today's high touched the trend line which failed yesterday.


Bank Earnings Summary

Ahead of BAC earnings in the morning I wanted to summarize those of C, WFC, JPM this week. The chart below shows the highlights from Q4 2009 through Q4 2010.  The data speaks for itself.  Declining to flat total revenues, declining net interest revenue, declining provisions for loan losses and rising non interest expense.

Bottom line, banks are earning less while expenses are going up.  I read today that MS is deferring part of their employee compensation.  If business is so great and there is no fuzzy FASB math from an accounting standpoint then were is the cash to pay compensation now?

C by far is the scariest looking bank right now.  Should asset prices continue to decline which will result in even further percent home defaults, these banks are not properly reserved.  I see one of those "kitchen sink" quarters in 2011 where banks take a nasty charge to provision for credit losses all at the same time.  Their bet is housing improves but if you think of it, right now they need to show confidence in the economy and their earnings to defend their stock.  From a strategic standpoint it makes sense for them to cross their fingers that asset prices have bottomed and reverse.  I don't see it at all but why take a hit now when you can kick the can further down the road.  Either way you are getting whacked.  My take at least.


AAII Investor Sentiment - Week Ending 1/19

Sentiment remains historically high bullish, low bearish although both have continued to move off their high levels.  The bullish sentiment dropped to 50.7% from last week's 52.3% while the bearish sentiment rose to 29.1% from 23.4%.  The AAII survey results are below.

Also there are two charts of this data VS the SPX.  It looks more and more like a correction in the SPX is imminent (dare I say those words).  Purely looking at this data SPX looks headed to the 1,200 range.  To say the AAII data determines SPX fair value would be a huge stretch and I am not saying that.  The way you can look at these charts though is traders have lightened up on their bullish position and shifted more neutral.


Wednesday, January 19, 2011

WFC Q4 2010 Earnings

Banks have so much room to adjust their allowance for loan losses that saying any bank "beat" on the bottom line is not a fair statement.  I'll do another post on this subject.  For now I wanted to highlight a few items on the WFC report.

Revenue - it was said they beat but beat what?  Q4 2009 total revenue net of interest expense was $22,696 and for Q4 2010 was $21,494.  Last time I checked that would be a 5% decline in revenue.

Efficiency Ratio - just like JPM and C the trend with WFC is not favorable.  Q4 2010 had an efficiency ratio of 62.1% and in Q4 2009 was 56.5%.

Credit Quality - there's a disconnect somewhere (maybe it's me).  Asset prices are declining at an accelerated rate once the tax credit and other "free market" programs wore off.  Apparently WFC doesn't see any risk and have continually lowered their loan loss reserves as follows:

Q4 2009 - 3.13%
Q1 2010 - 3.2%
Q2 2010 - 3.2%
Q3 2010 - 3.1%
Q4 2010 - 3.0%

Granted these are not major reductions in loan loss reserves unlike JPM has but how can you be reducing loan loss reserves amidst falling asset prices?  Chris Whalen, arguably the best bank analyst out there said it best recently in a tweet "Jamie Dimon is making a bullish bet on housing."

Tuesday, January 18, 2011


I don't claim to be an expert on inflation nor will I give an opinion if we will experience inflation, deflation or both.  Prices on essential items are rising.  Prices on non-essential items are falling (home prices, flat screens, etc).  The chart below of the CRB Index shows the rise in input costs contrary to the CPI (ex food and energy) which the Fed constantly talks about as showing no inflation in our economy.  Name one person who doesn't eat or drive.  Just one please.

If you manufacture anything your input costs are rising.  Whether it be oil to run a machine or flour to make bread, your input costs have risen significantly.  You have three choices.  You can raise your prices, lower your margins or reduce expenses.

Raising Prices:

The US economy is on fumes right now (government sponsored or shall I say debt sponsored). There is no velocity, no demand.  Sure you can raise prices on some items such as gas at the pump.  It's a commodity and we all need it, like it or not.  We will pay higher prices.  Other items it is hard to raise prices.  Bread prices at the grocery store seem to be rising but not at the rate of grains.  Flat screen prices are falling and there is no chance of passing along higher costs.  

Lower Margins:

If you can't raise prices then your margins are instantly lower.  If you are a public company you need to manage the bottom line.  I used to own a small business.  If I was in a position where my margins were being squeezed, I would live with it for a while but once it started hurting my own pay check I would have to begin making tough choices.

Reduce Expenses:

Public companies have to hit the bottom line and will lay off staff, cut back overtime, lower wages, etc.  Sure they can cut back other fixed expenses but after two years of slow growth, those expenses must already be scaled back somewhat.

Considering those three options, I see two outcomes playing out in our future.

Outcome 1:

The economy improves, allowing input costs to be passed along to the consumer.  The result will force employers to raise wages.  The scary side of this scenario is there is so much money in the economy right now that any velocity will truly make us a Weimmar republic.  Prices will skyrocket  and the Fed is in no position to stop it.  They cannot reduce their balance sheet for the simple fact the capital losses would be massive.  They would need a bailout from the Treasury.  Imagine that concept.  

Outcome 2:

The economy continues to stagnate as it has the past two years.  Considering that 20% of those lucky enough to be employed are working part time this scenario seems pretty reasonable.  Under this scenario rising prices cannot be passed along.  Sure some will such as gas as we are seeing now and basic needs such as groceries.  Under this possible outcome, companies will be forced to reduce staff and or wages, further reducing overall demand.  Those prices that do get passed along will literally choke off any remaining demand and push the economy back into recession.

Food riots are breaking out across the globe.  China is faced with a very real and serious inflation problem within their country.  I suspect this issue is going to come to a head far faster than June when QE2 ends and QE3 possibly begins.  When the cost of milk doubles in price and wages stagnate, Bernanke will have far more to answer to than a 60 Minutes interview.  

I still can't believe he said he can raise rates in 15 minutes.  How naive does he think we are?  Apparently very.