While watching the Goldman Sachs hearings during lunch earlier this week, I couldn't help but feel like it was a political setup. People are upset about the financial crisis (rightfully so) and many senators are feeling the heat from constituents. While there were many companies involved in trading the mortgage securities market, it seems like Goldman has become the target - likely because Hank Paulson the former Treasury Secretary was the CEO for Goldman and many believe the bailout was a direct attempt to help Goldman survive. Given all the discussion this week, I thought it would be helpful to look at some of the issues surrounding the case. We will don't believe Goldman acted in the best interest of clients at all times, based on the current information available, Goldman Sachs likely didn't do anything illegal - however, Goldman acted in a way that was socially unacceptable and improper.
First, we have to go back to the late 1990's and the passage of the Commodity Futures Modernization Act, which exempted swaps and derivatives from regulation. All the big problems in the country seem to stem from something the government does or in this case didn't do. Below is a link to the BAM Weekly Bulletin article from last year.
http://brightassetmgmt.blogspot.com/2009/04/blame-commodity-futures-modernization.html
Second, Goldman didn't cause the financial crisis. They participated in trading and creating swaps and derivatives in the mortgage backed securities market, but they single handily didn't cause the collapse. It was a combination of several events happening at the same time. Remember, nothing Goldman or any other firm did with respect to creating or trading derivative products was illegal - the products were unregulated so technically there were no rules.
The word "synthetic" is the word that is important in this discussion. It's not a real asset, like the peanut butter and jelly you might find on a peanut butter and jelly sandwich. When an asset is "synthetic", every buyer for the product creates a seller who is effectively short the asset. Since the asset doesn't actually exist, there needs to be a buyer and a seller; it can't be one-sided. So, if a customer wants to buy a "synthetic" asset from Goldman Sachs that would make either Goldman or a third party the seller.
One of the reasons Goldman Sachs created the synthetic products was because there was strong demand from its customer base and this is an important point. Customers wanted to purchase assets that were tied to sub-prime mortgage back securities (and other mortgage related securities) either directly or synthetically, in order to increase risk or reduce exposure to risk, because they believed the underlying position would be very profitable or wanted to hedge an existing position. Because there was such positive sentiment about the mortgage market at the time, there weren't many investors interested in taking a negative view. Goldman and some other seemingly smart investors had an idea that the mortgage market may unravel at some point and were comfortable with betting against the mortgage market, or taking the other side of the trade in this example. We also have to remember that the average investor doesn't have access to a "synthetic CDO". Most sophisticated investors (hedge funds, pension funds, endowments) who were buying the synthetic products from Goldman and other firms for that matter were smart enough to understand what they were involved in. Goldman Sachs basically created products that were demanded by its customers and took, with other third parties, the other side of the trade.
We will have to wait and see what happens next...
Friday, April 30, 2010
Friday, April 23, 2010
S&P 500 Earnings Update
Our assessment is that the US market averages (based on S&P 500) are still at the higher end of fair valuation, if not slightly overvalued, based on final earnings estimates for 2009 ($56.86) and current estimates for 2010. However, valuations don’t seem to matter as the markets continue to power higher on expectations of a stronger economic recovery and increased corporate profitability.
As of January 1, 2010 earnings estimates for the S&P 500 stood at $75.27 for 2010, representing a 32% increase over finalized 2009 results. As of April 1st, earnings estimates have increased to $78.15, a 37% increase over 2009. A 15 price-earnings multiple (long-term average valuation) on the $78.15 estimate translates to a 1,172 value for the S&P 500 Index. Given the abundant liquidity in the markets, low interest rates, and expected low inflation, market participants could put a premium on future corporate earnings and be willing to pay more for those earnings; pushing markets significantly higher. For example, placing price-earnings multiple of 18 on earnings of $78.15 translates to a 1,406 value for the S&P 500; while a multiple of 20 would put us back to the old market highs reached in 2007. We can’t rule out the possibility, if economic conditions remain favorable, of the markets moving back to new highs over the next couple of years.
However, as we have stated previously, while we do believe earnings will increase in 2010, a 37% increase is probably a bit optimistic. We will likely need to see double digit GDP expansion in order to see such an increase in earnings. While this type of increase in earnings may not happen; it’s the perception of what may happen that matters. Right now the perception is that earnings will increase significantly and the economy will continue to accelerate with or without job creation. As long as this perception holds weight with market participants, the markets will likely continue to climb as this outcome is priced into stock valuations.
As of January 1, 2010 earnings estimates for the S&P 500 stood at $75.27 for 2010, representing a 32% increase over finalized 2009 results. As of April 1st, earnings estimates have increased to $78.15, a 37% increase over 2009. A 15 price-earnings multiple (long-term average valuation) on the $78.15 estimate translates to a 1,172 value for the S&P 500 Index. Given the abundant liquidity in the markets, low interest rates, and expected low inflation, market participants could put a premium on future corporate earnings and be willing to pay more for those earnings; pushing markets significantly higher. For example, placing price-earnings multiple of 18 on earnings of $78.15 translates to a 1,406 value for the S&P 500; while a multiple of 20 would put us back to the old market highs reached in 2007. We can’t rule out the possibility, if economic conditions remain favorable, of the markets moving back to new highs over the next couple of years.
However, as we have stated previously, while we do believe earnings will increase in 2010, a 37% increase is probably a bit optimistic. We will likely need to see double digit GDP expansion in order to see such an increase in earnings. While this type of increase in earnings may not happen; it’s the perception of what may happen that matters. Right now the perception is that earnings will increase significantly and the economy will continue to accelerate with or without job creation. As long as this perception holds weight with market participants, the markets will likely continue to climb as this outcome is priced into stock valuations.
Friday, April 16, 2010
Sentiment Going Parabolic
We usually never cover a specific topic two weeks in a row but the sentiment numbers have gone off the charts. See the chart below from Jason Goepfert at Sentimentrader.com.
Dumb Money Sentiment has reached 75% confidence level, while Smart Money confidence is currently at 29% confidence. The spread has widened to 46%. The last time the spread reached this kind of extreme was in May of 2008. The markets didn't fair to well after those extreme readings.
Back in January of 2010, the Dumb Money Sentiment reached 75%, while the Smart Money Confidence was at 38%; right before the markets declined roughly 9% in about 3 weeks due to concern over economic growth; so caution is warranted.
However, economic numbers have greatly improved since the reports at the beginning of the year and we are in a recovery as opposed to heading into a recession as was the case in May 2008. Any correction or decline in the markets as a result of extreme sentiment readings we are currently seeing will likely translate into an opportunity in undervalued areas of the markets.
Dumb Money Sentiment has reached 75% confidence level, while Smart Money confidence is currently at 29% confidence. The spread has widened to 46%. The last time the spread reached this kind of extreme was in May of 2008. The markets didn't fair to well after those extreme readings.
Back in January of 2010, the Dumb Money Sentiment reached 75%, while the Smart Money Confidence was at 38%; right before the markets declined roughly 9% in about 3 weeks due to concern over economic growth; so caution is warranted.
However, economic numbers have greatly improved since the reports at the beginning of the year and we are in a recovery as opposed to heading into a recession as was the case in May 2008. Any correction or decline in the markets as a result of extreme sentiment readings we are currently seeing will likely translate into an opportunity in undervalued areas of the markets.
Friday, April 9, 2010
Sentiment Reaching Extreme - Again
The Smart/Dumb Money Confidence indicator is reaching an extreme reading again and at one of the widest spreads on record.
As a refresher, the Confidence indices are presented on a scale of 0% to 100%. When the Smart Money Confidence is at 100%, it means that those most correct on market direction are 100% confident of a rising market, and we want to follow their direction. When it is at 0%, it means that the Smart Money are 0% confident in a rally, and we want to be more defensive and hold more cash.
We can use the Dumb Money Confidence in a similar, but opposite, manner. For example, if the Dumb Money Confidence is at 100%, then that means that the Dumb Money investors are supremely confident in a market rally. And history suggests that when these investors are most confident, we should exercise extreme caution. When the Dumb Money Confidence is at 0%, then from a contrary perspective we should be concentrating on the long side, expecting these traders to be wrong again and the market to rally.
In practice, the Confidence Index numbers rarely get below 30% or above 70%. Usually, they stay between 40% and 60%. When they move outside of these levels, it’s usually time to take notice.
As of this morning, the Smart Money confidence has recently dropped to 29%; the lowest level this year. The Dumb Money confidence has just risen to 71%; making the spread between the two 42 points! These readings are each above and below the respective extreme bands of 70% and 30%.
Again, this doesn't mean that markets will decline immediately and the markets could actually continue to move higher in the short-term. However, the risk/reward equation is not favorable and the probability of an increase in volatility rises with each passing day.
As a refresher, the Confidence indices are presented on a scale of 0% to 100%. When the Smart Money Confidence is at 100%, it means that those most correct on market direction are 100% confident of a rising market, and we want to follow their direction. When it is at 0%, it means that the Smart Money are 0% confident in a rally, and we want to be more defensive and hold more cash.
We can use the Dumb Money Confidence in a similar, but opposite, manner. For example, if the Dumb Money Confidence is at 100%, then that means that the Dumb Money investors are supremely confident in a market rally. And history suggests that when these investors are most confident, we should exercise extreme caution. When the Dumb Money Confidence is at 0%, then from a contrary perspective we should be concentrating on the long side, expecting these traders to be wrong again and the market to rally.
In practice, the Confidence Index numbers rarely get below 30% or above 70%. Usually, they stay between 40% and 60%. When they move outside of these levels, it’s usually time to take notice.
As of this morning, the Smart Money confidence has recently dropped to 29%; the lowest level this year. The Dumb Money confidence has just risen to 71%; making the spread between the two 42 points! These readings are each above and below the respective extreme bands of 70% and 30%.
Again, this doesn't mean that markets will decline immediately and the markets could actually continue to move higher in the short-term. However, the risk/reward equation is not favorable and the probability of an increase in volatility rises with each passing day.
Friday, April 2, 2010
Manufacturing Index improves
March's ISM Manufacturing survey delivered better than expected results and this key data point continues to suggest that the economic recovery is gaining more momentum and a solid rebound in manufacturing is taking place than has been broadly recognized. The overall index improved to 59.6 (from 56.5 last month) which is the best reading since July 2004 (interestingly this was one month after the first Federal Reserve Board interest rate hike in the 2004-06 hike cycle). The most important data is supplied by New Orders which improved to 61.5 (59.5 previously), indicating that orders continue to grow rapidly. This new order figure will require greater production which in turn requires re-employment of labor. We are finally seeing the sort of rush to re-build inventories that we typically see when an economic recovery really takes hold. All in all this is a very positive data set and one that suggests that the manufacturing employment cycle is likely about to turn strongly positive.
Economy adds jobs in March
The American economy added 162,000 jobs in March, the biggest burst of hiring in three years, the Labor Department said Friday. The unemployment rate held steady at 9.7%, the level it has been at for the last three months.
The March job gains, which were boosted by temporary hiring for census work, marked the biggest one-month increase since 239,000 jobs were generated in March 2007, roughly 3 years ago. The latest gain was slightly lower than what many economists had been forecasting, but the government also revised upward the payroll count for the first two months of the year. It revised the January payroll date to a creation of 14,000 jobs, instead of losing 26,000 as previously reported. And the losses in February were shaved by more than half, to 14,000.
The news of the hiring last month will be welcomed news to the 15 million jobless American workers. But the latest report somewhat overstated the strength of a slowly recovering labor market. About 30% of the payroll increases last month, or 48,000 jobs, were positions created by the Census Bureau, which is expecting to hire hundreds of thousands more workers in the next couple of months to knock on doors and collect data for the decennial count of the nation's population. Many of these jobs are part-time and will last only several weeks.
However, this jobs report shows that the economic recovery seems to be gaining some momentum as we head into the second quarter of the year.
The March job gains, which were boosted by temporary hiring for census work, marked the biggest one-month increase since 239,000 jobs were generated in March 2007, roughly 3 years ago. The latest gain was slightly lower than what many economists had been forecasting, but the government also revised upward the payroll count for the first two months of the year. It revised the January payroll date to a creation of 14,000 jobs, instead of losing 26,000 as previously reported. And the losses in February were shaved by more than half, to 14,000.
The news of the hiring last month will be welcomed news to the 15 million jobless American workers. But the latest report somewhat overstated the strength of a slowly recovering labor market. About 30% of the payroll increases last month, or 48,000 jobs, were positions created by the Census Bureau, which is expecting to hire hundreds of thousands more workers in the next couple of months to knock on doors and collect data for the decennial count of the nation's population. Many of these jobs are part-time and will last only several weeks.
However, this jobs report shows that the economic recovery seems to be gaining some momentum as we head into the second quarter of the year.
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