5/19/09 (TARP pay back?, Buffet All In!, What's Next?)

Traders,

As I mentioned yesterday it seemed like last week’s sell off was controlled and low key – there was no GAP DOWN or panic. Even the VIX indicated that the selling was controlled. In that kind of an environment – there is more confidence at buying on the dips and optimism that it was just a slight correction.

Couple that with yesterday’s bullish news – Lowe’s getting on track, LIBOR spread decreasing, and Buffet’s investing in Wells Fargo – the futures were already to a good head start in the pre-market. The market rallied throughout the day across the board (3% rally) and we are now quickly back up to those resistance levels of 8500 in the INDU, 1400 NDX, 900 SPX, and 500 RUT. The question on everyone’s mind – are those just being tested again – or do we have room to again stretch our legs further.

The repeated concern is the disconnect between the market place and the economic conditions. Certainly the man on the street is not feeling the same bullish optimism that the market is seeing. Several companies announced more lay-offs, including a big cut at AMEX, meanwhile GM is knocking at the bankruptcy door, and lastly consumer spending and income is still contracting.
Why the disconnect? I would say that there was a general Doom & Gloom feeling coming into 2009 and when economic data should that the decline was slowing down (rightly or wrongly) the perception was that the market, primarily in the banking sector, was oversold and undervalued, hence the big rally. However, what is still the big concern – is the recovery – which economist and analyst continue to push out – from the end of 2009, to 2010, and now some are saying 2011. We certainly will hit bottom sooner, rather than latter, but the recovery and growth seem further off.

It is the reason that for long-term holders the focus should be on companies with solid balance sheets, revenue, and a management style that has come to reality that growth and revenue will continue to contract and how to expand margins. Lowe’s indicated as much yesterday – they have come to reality – the revenue is slowing down, they are not expecting a boom in housing, they are not expecting a boom in major renovation – so how to capitalize on that? Focus on what does move- people are fixing instead of replacing, painting instead of new cabinets, and homes are consistently in repair. Managing a business to those expectations and understanding margins are going to separate the solid companies from those that are still clinging on to failed business models (like GM or Chrysler).

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Pay back the TARP?

Goldman, JP Morgan, and Morgan Stanley had indicated in the past they wanted to pay back the TARP – especially after Congress slapped on all sorts of rules and penalties – from pay to board members. However, when Goldman and the other had indicated or attempted to ask to pay back the money (in full or in part) – there was Administrative and Congressional push back. Why, well some conclude that it may make the banks that cannot pay back look worst and others argue it is a ideological reason that the administration and Congress want to revamp and put in check the banking industry – beyond regulations. Regardless of the reason, they have not been able to pay it back – yet.

While now they have officially applied to pay back as much as $45 billion collectively and tax payers should rejoice – getting back that money that may not have been needed in the first place. It would also allow these banks to break away from some of the more troubled banks like Bank of America or Citigroup which have tremendous stress from acquisitions and other vertical market debt.

They question now is will they be allowed to. The administration, Congress, Bernanke, and Geithner are playing some spin games for sure and their motives are rather uncertain. Geithner said the other day he would welcome the payback of the TARP funds, provided the regulators sign off. Barney Frank made similar comments and added lots of buts and ifs. Certainly they know that the TARP’s strings are powerful and they don’t necessarily want to cut those strings. Some are afraid they may have to come back and get the money back if the economy nose dives again.

For now – the news had given Goldman, Morgan Stanley, and JPM a serious boost yesterday – but this morning they seem to be giving up a little ground.

One interesting observation I heard on Bloomberg – was that IF these few are able to pay back the TARP and others do not – will there be a disconnect in the financial and banking indices in which we could see a spread in price between the Non-Tarp vs. Tarp. Hedge fund traders are already looking into correlation risk and rewards and it could certainly bring some interesting volatility into that sector.

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Buffet - all in?

Buffet has been the face on the financial news over the last year. He made a bold investment (with some excellent strings attached) into Goldman ($5 billion), he had supported Obama, he had seemed to be on top of his game in the face of this massive economic slowdown. However – things are looking rocky over at Berkshire. Likes take a look….

1. He called derivatives, “financial WMDs” – but the primary business is insurance and he also placed the single largest derivative trade on the S&P 500. He sold $4 billion worth of out-of-the-money puts in 2007 – which recently went against him costing Berkshire $6 billion and causing criticism.

2. His Goldman, Wells Fargo, and GE holdings have been extremely volatile, even though they have gained recently.

3. Criticism from shareholders as they want to know his successor, but he will not give any definitive answer.

4. Berkshire lost its coveted AAA credit rating.

All these concerns have been reflective in Berkshires shares dropping significantly in price.

Buffet has stumbled in the past – in the airlines and financials, but has always recovered. He is certainly one of the brightest and most successful investors in history, but that doesn’t make him infallible. Recent, and fair, criticism has been his recent spending binge and risk taking in the economic times. The positions maybe too big or “all in” type beats. Not that his decisions are bad – but maybe just too big.

No the problem is that Berkshire’s cash holdings are dwindling fast and Buffet who is used to making decisions and investments without being handcuff is now being forced to reduce investments because of the drop in cash holdings. As one report in Bloomberg reflects – “He’s tapped out!” he spent over $600 million in stock purchases in the first quarter, but had to reluctantly sell other holdings to finance his new purchases. He is fully deployed, unless he sells something.

He does drive some of the best deals on Wall Street – from massive warrant attachments and high interest payments coupled with equity in his GE and Goldman deals. However, those were whopper positions – that certainly help dry the well.

Even Buffet admitted he had to sell three stock holding to fund other deals, that he preferred to keep.

http://www.bloomberg.com/apps/news?pid=20601087&sid=ak_yonqvS.yg&refer=home

Why all the Buffet concern or “Buffet Watch” – just like the President – Buffet is very influential regardless if you’re an investor or not. He is closely watched and regarded – because if his perception or circumstances change – what does that mean for the rest of the market?

Keep an eye on his positions and media exposure – a friend of mine calls him “the billionaire economic gauge”.
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Futures Pre-market

The futures were up in the pre-market, following yesterday’s rally – but have come off sharply as U.S. Housing Starts (just released) unexpectedly fall to record low. Futures pointing to a lower opening.

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Support / Resistance

Resistance test?

INDU 8500 (We just got there – it looks to be a resistance level and housing starts down is showing a lower opening now. Do we close above or head back down?)

NDX 1400 (We are just below the number and futures looked to initially test it this morning – until the housing starts sent futures down. Watch the close!)

SPX 900 (Closing just above it and looking higher – but now futures are pointing lower. Watch the close.)

RUT 500 (Closing just below it after the big rally yesterday – does it get above it?)

It looks like the reality with the housing start data is sending optimism to the sidelines again and the resistance points will not see the hopefully breakout futures had been pointing too.

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Conclusion

The battle still seems to be between economic reality and the optimism that we are finding a bottom. Not that one is wrong or the other is right – the concern should be the spread or the disconnect between the market and economic conditions. There are 3 outcomes:

1. Economic conditions rally and we don’t just slow down but start a recovery with new jobs which closes the spread and reflects the market optimism – which seems unlikely.

2. Markets remain neutral to negative with volatility contracting as the economic conditions slowly improve and eventually over time (6 months, 9 months, 18 months) the spread narrows – seems more likely.

3. Market correct and head down quickly to meet economic reality as a recovery seems further off and then the market finds a bottom as the market and economic realities begin to track each other again – seems likely as well.

I think the only answers are 2 or 3 – because it will take a long time to see the economic conditions on the ground for the U.S. consumer to change. It doesn’t happen overnight and takes months, if not years.

If we see the flow of money (in and out) dwindle in the market we could have scenario two – where the market’s volatility and range decreases – up or down 5-10% annually – a neutral, range bound, or slightly negative market condition until the economic conditions can catch up.

Scenario 3 will only happen is the optimism and hope begins to fade – the economic data (like the recent housing starts) reflect negative conditions and with a GM bankruptcy that could be the straw that fades that hope and optimism we have seen the last 10 weeks and that could mean a correction in the cards – where the market quickly snaps down to reflect the current economic conditions and concern for growth.

I think if optimism and hope can continue – that scenario two is the most likely, but there are pretty high odds that 3 could happen. The problem is that when 3 happens – it happens when you least expect it. That means – be prepared.