Should Citi Pay for its Mistakes

There is one point of view that deems that the creation of the M-LEC to bail-out Citi and other banks from their SIV crisis is a concept that interferes with the free market. The other side of the argument promotes the need for stability in the market place to avoid a string of cascading failures underlines the need for the creation of the SIV Superfund.

From a risk tolerance perspective, why should banks such as Citi be bailed out for their own mistakes? Shouldn’t the shareholders and the company pay the price in a free market economy? Isn’t the SIV bailout effectively a form of capital-based socialism; where firms avoid the consequences of their decisions? Certainly, the financial market would not offer group bailouts for individual who can not meet their financial obligations; why should it be any different for a large bank.

Allan Sloan of Fortune takes Citi to the task in his recent article:

Citigroup: 'Gimme shelter'
http://money.cnn.com/2007/10/26/magazines/fortune/citishelter.fortune/index.htm?postversion=2007102914

Free Falling

New York magazine had some interesting commentary on “what it would take to send the U.S. economy into free fall”. Many of the points made in this article align with an earlier post:
Increasing Risk: Headwinds
http://hingefire.blogspot.com/2007/10/increasing-risk-headwinds.html

The article from New York magazine is definitely worth a read:
The Catastrophist View
http://nymag.com/guides/money/2007/39952/

Spooky: Housing News

The entire market lifted up today on the report of the expected quarter percent rate cut from the Fed, and the unexpectedly high 3.9% economic growth rate announced this morning by the Commerce Department.

However the haunting specter of the housing market is hovering over the party; the figures released this week demonstrate the further grim erosion of this sector. For the eighth consecutive month housing prices have fallen nationwide, with the S&P/Case-Shiller index representing 10 large cities dropping by 5%, the largest drop since 1991.

U.S. home prices fall again
http://money.cnn.com/2007/10/30/real_estate/bc.homepriceindex.ap/index.htm?postversion=2007103009

Driven by the foreclosure epidemic the driven the level of U.S. homeownership to recent lows of 68.1%. A record 17.9 million U.S. homes stood empty in the third quarter as lenders took possession of a growing number of properties in foreclosure.

New housing starts fell 48 percent to a 1.19 million annual pace in September from a three-decade peak of 2.29 million in January 2006; clearly demonstrating the harsh implosion of housing bubble. Further underlining the issues, inventories of unsold homes are piling up to record levels.

U.S. Homeownership Falls in Longest Slide Since 1981
http://www.bloomberg.com/apps/news?pid=20601087&sid=a6RQFLs4H9QI&refer=worldwide

America's Big, Fat Housing Inventory
http://biz.yahoo.com/bizwk/071030/oct2007db20071024022437.html?.v=1&.pf=real-estate

Defaults on Insured Home Mortgages Rise 22 Percent
http://www.bloomberg.com/apps/news?pid=20601087&sid=adj1IxSTPIDI&refer=home

The housing related turmoil has driven consumer confidence to a two year low. The Consumer Confidence Index fell to 95.6 from 99.5 in September, not an auspicious sign right before the critical holiday shopping season.

Consumer confidence falls to two-year low
Numbers for October ignite concern about upcoming holiday season
http://www.msnbc.msn.com/id/21543609/

So this years vote for the scariest Halloween costume goes to the “Housing Market”.

Quick Takes: The Next Subprime

There is growing evidence that the non-recourse consumer debt is under stress. Credit card debt shares similar aspects to subprime; it has been sliced, diced, and re-packaged by Wall Street in the securitization market.

Both the amount of debt on cards and delinquency rates are rising rapidly over the past few months. The rising rates of bad consumer debt places the packaged securities backed by credit card receivables under pressure. In a situation eerily similar to the recent sub-prime crisis, these securities would decline in value and over-leveraged firms would face margin calls. Leading to widespread havoc and a lock-up of the market as illiquid issues could not be priced. It would make the meltdown during August appear to be a light-weight rehearsal for the focal tragedy performance.

Adding fuel to the situation is that many consumers are using plastic to stave off defaulting on their mortgages. The end game is pretty clear for most of these homeowners, and it is just a matter of time until most default both on their homes and credit card debt.

The $915B bomb in consumers' wallets
Americans have record credit-card debt and banks are starting to sweat an uptick in default rates, reports Fortune's Peter Gumbel. Why some fear this could be the next subprime.
http://money.cnn.com/2007/10/29/magazines/fortune/consumer_debt.fortune/index.htm?postversion=2007103007

Stressed US borrowers use plastic to delay default
http://ca.today.reuters.com/news/newsArticle.aspx?type=oddlyEnoughNews&storyID=2007-10-28T175606Z_01_N28327700_RTRIDST_0_LIFESTYLE-USA-CREDITCARDS-DEBT-COL.XML

529: Where age-based plans make sense

529 age-based plans have dominated this saving for college market. This is one of the few segments where time-based plans make sense for most investors, which is why more then 70% of funds in some plans are held in age-based 529 funds. The automatic adjustment as the child approaches college age help parents from regularly having to re-balance and monitor these funds.

The regulatory oversight from the states for their 529 plans have helped avoid the time-based college saving plans from becoming a pyramid of fees; a problem common in retirement fund-of-funds offerings.

The well-defined timeframes associated with saving for college are also beneficial to making these age-based plans successful; when a youngster is in 8th grade it is pretty clear how many more years until they go to school.

The lack of multi-level fund fees in many age-based 529 programs does not mean that parents should ignore the other fees found in many state plans such as yearly maintenance fees. Many plans are still charging $15 to $50 maintenance fees. It is very easy for a small 529 savings plan of $500 to lose money each and every year after fees are considered. It is very easy to land up with a balance of well under $400 in some plans after years of savings and “gains”, once the fees are subtracted. Take a close look at the fee structure in any 529 offering that you are considering; whether the plan is age-based or not.

Age-based funds dominate 529 plans
http://www.investmentnews.com/apps/pbcs.dll/article?AID=/20071029/FREE/710290345

Grandma’s Money Market Fund feels the SIV pinch

The SIV panic did not really set in among regulators until “supposedly-safe” money market mutual funds started to take losses. The federal regulators are now calling foul.

‘Securities regulations state that money market funds can only buy short-term, very safe securities. In particular, rule 2a-7, part of the Investment Company Act of 1940, says that money market funds can only hold securities that have "minimal credit risks."’

Impacted money market funds include offerings from industrial giants such as Bank of America, who watched $640M of customer funds get flushed down the tubes when Cheyne Finance went under, to smaller brokerages. The list of firms, whose money market funds are holding SIV paper, includes major players such as JP Morgan, Fidelity and Federated.

It is now obvious that SIVs never merited AAA ratings, which would imply these securitized products had the strength to weather any storm. The defense made by some funds that the debt was “ultra-safe” because it was highly rated, does not really hold up when performing any type of basic risk analysis of these instruments.

Money market funds are supposed to be the safest investment; something that a retired grandmother can feel safe in. The financial manipulations of Wall Street in building derivatives have now destroyed this trust. Money market funds offered by most brokerages are not covered under FDIC protection so retail customers will take the hit. No wonder steam is rising from the brows of regulators. The question remains will they implement the necessary reforms to eliminate future occurrences, or stand frozen like a deer in the headlights.

A recent article in Fortune discusses SIV impact on money market funds in more detail.

Risky money market fund bets may be illegal
Money market funds may have broken a law dictating a conservative investment profile by investing in SIVs, reports Fortune's Peter Eavis.
http://money.cnn.com/2007/10/25/magazines/fortune/funds_sivs.fortune/index.htm?postversion=2007102605

Don’t cry for me Argentina

Recent reports from notable sources have accused Argentina with manipulating their economic data in order to reduce the amount of interest that the government must pay on inflation indexed debt. About 40 percent of the nation's $136 billion debt is inflation-based securities; the tampering caused bond holders to miss out on over $250 million in interest payments in the past twelve months. In reaction, ‘Argentina's benchmark inflation-linked bonds have tumbled 24 percent this year, making the country's debt market the worst performer in the world’.

Governments always have a temptation to manipulate economic data for their own political or fiscal agendas. Most governments do toy with the figures by regularly changing the definition of employment or altering the mix of items factored into inflation. The situation in Argentina demonstrates what occurs when a government takes it one step too far.

Argentine Debt Devastated by Data Suspicion, Election
http://www.bloomberg.com/apps/news?pid=20601109&sid=axTqfaTiLf4I&refer=home

Despite the meteoric rise of the Latin American stock indexes over the past years; the situation in Argentina is a prime example of the risk in this region’s markets.

New Blog Features

Several recent improvements have been made at HingeFire. You can now subscribe to get the new blog material emailed to you once per day! See the “Get the Blog via Email” box.

There is also an icon for subscribing to the RSS feed immediately. Furthermore each post now has an Add This button so you can bookmark the material to your favorite service such as Digg, Del.ico.us, Technorati, and others.

A BlogRoll is also now supported. If you run an interesting financial blog then I will be happy to add it if you reciprocate.

Most of these suggestions came from readers and I would like to thank them!

Please also check out the free stock screener at: http://www.hingefire.com/

Quants meet Reality

The Quants on Wall Street this summer received a harsh introduction to reality and the impact of multi-sigma events in the market. Traditionally, significant dislocations that tear apart the fabric of mathematically driven funds occur about every 18 years based on historical analysis. Most quants ignore history and focus on short term back-testing studies; blindly confident in their belief that these events have been arbitraged out of the market by superior math and will never occur again. Akin to the railroad engineer holding his hands over his eyes while driving the train over the cliff.

In earlier posts, the phenomena of quants was touched on:
Will Someone tell the Financial Whiz Kids that their House is Built of Cards
http://hingefire.blogspot.com/2007/10/will-someone-tell-financial-whiz-kids.html

A number of recent articles put the role of quantitative analysis and algorithmic trading in the limelight as the driver of recent market disruptions. The losses from in-house algorithmic trading desks have been extreme over the past couple of months as volatility spiked and pricing diverged from historic patterns. Morgan Stanley reported a $480 million loss in the third quarter from the bank's in-house equities trading desk that employed computer generated models to drive returns. Many other investment banks demonstrated similar issues while a number of hedge funds closed up shop.

Volatility puts algo trading under pressure
http://www.reuters.com/article/reutersEdge/idUSL2648150020071026

Nassim Nicholas Taleb discussed the impact of multi-sigma events on the market in his recent book “The Black Swan: The Impact of the Highly Improbable” “The term black swan comes from the ancient Western conception that all swans were white. In that context, a black swan was a metaphor for something that could not exist.” A Black Swan is a large-impact event that greatly deviates from the ordinary and is difficult to avoid. Taleb’s embedded thesis is that financial engineers are lulled into false complacency, not planning for the worst case and are never prepared for events that rip the fabric of their models.

The MIT Technology Review recently posted a pair of excellent articles about the role of financial engineers in the implosion of the derivatives market this past August; a crisis that is still unfolding. There finally appears to be a glimmering of understanding that the structured derivative market is a house of cards that can be crumbled by multi-sigma events, and it is just a matter of time until the Black Swan visits any leveraged market sector. The brick wall of reality trumps math every time… or in just a matter of time.

The Blow-Up: Part 1
In Wall Street's summer of scary numbers, all eyes were on the mathematically trained financial engineers known as "quants."
http://www.technologyreview.com/Biztech/19530/?a=f

The Blow-Up: Part 2
How the financial engineers known as "quants" contributed to Wall Street's summer of scary numbers.
http://www.technologyreview.com/Biztech/19531/?a=f


References:
Black Swan
http://www.investopedia.com/terms/b/blackswan.asp

Black swan theory
http://en.wikipedia.org/wiki/Black_swan_theory

Nassim Nicholas Taleb’s book can be found at:
http://www.amazon.com/Black-Swan-Impact-Highly-Improbable/dp/1400063515

Dismal Housing – RTP

The housing situation in the RTP area continues to slide downhill. Most of the country caught the real estate flu and now we got the sniffles. It was just a matter of time until the national housing problems spilled over into our market; there is no shot that can make a local area immune to the symptoms. You can only hope to weather the storm better then many metro markets because the Raleigh area did not have an out-of-control ramp up in pricing over the past few years.

Recent headlines in the Raleigh News & Observer show the decline over the past few weeks. Builders are putting on huge discounts, houses are on the market for long periods of time, and sellers are dropping prices. While real estate brokers are complaining that they have not sold a home in weeks.

I have recently spent some time talking with builders and real estate agents while on the sidelines of soccer games. The general perspective is that homes in the $200K to $400K range are still selling well in the Raleigh area. These homes are generally affordable for RTP area professionals, and do not require jumbo or other unconventional loans which are now difficult to get.

Houses in the $500K plus range are a totally different matter. The wheels have ground to a halt in both re-sales and new homes in this price segment. The situation is even worse in the high-price townhouse and condo market.

Today’s local business headlines loudly proclaimed that “Home builders are dealin'” – Many have told me six months ago that “it would never happen here”. One line in the article spells it out – “Comstock is offering $75,000 off its Courtyard townhouses in North Raleigh's Wakefield Plantation, a 16 percent discount from the original $463,900 price. Discounts of $35,000 are available at Comstock's Kelton II townhouses in Cary's Preston neighborhood, a 10.5 percent cut.” So much for the critical “the prices on high-end townhouses won’t drop” feedback from several months ago, when I predicted this situation. After all, who wants to buy a 1400 square foot condo for $500K when a 2700sq foot house can be found for $350K just yards down the road.

The builders of townhouses have stopped handing out upgrades and free cars… and now have moved on to straight old-fashioned price cutting. And when they tell you that the “big” price discount is for this weekend only and you need to sign now – don’t believe them. Come back next weekend for an additional $30K off.

The recent statistics map out the gloomy Triangle housing picture. Overall, sales of existing homes were down 24% in September, the inventory of unsold homes rose 23.7 percent from one year ago, and pending sales were down 14 percent, falling to their lowest level in four years. The number of homes on the market with reduced prices was 50 percent higher than a year ago, and the number of withdrawn listings was up 19 percent. The number of home sellers who simply surrendered and allowed their listings to expire was up 52 percent.

In the words of Moody's Economy.com economist Michael Helmar, who tracks Triangle housing, "That’s big. Your market is on a downward track, and it looks like there may be some more pain to go."

Will someone tell me when the roller-coaster reaches the bottom? I am afraid to open my eyes. However the screaming is the builders, real estate agents, and mortgage brokers; contrarily I would urge them to open their eyes and face reality.

Home builders are dealin'
In-your-face ads, major price cuts, aggressive tactics reveal a dour market
http://www.newsobserver.com/print/saturday/business/story/751331.html

Housing market takes nasty turn
Triangle sales fall; more homes sit unsold; more sellers lower prices
http://www.newsobserver.com/print/wednesday/business/story/747353.html

There is an Elephant in the Room – SIVs

Minyanville had some good topical commentary on SIVs. The recent creation of a Super-SIV fund, backed by banks and coordinated by the Fed, is effectively a bailout of Citi. Peering ahead like a sloth caught in the headlights, Citi was facing a situation with their SIVs that had the potential to sink the entire firm; which would cause a confidence crisis across all investment banks. This drove the creation of the Master Liquidity Enhancement Conduit in an attempt to calm the waters. Another unmentioned concern is that the financial engineering in the banking system is not merely limited to the SIVs associated with commercial paper, any sector of the leveraged derivative market has the potential to be a poorly constructed house of cards which can come crashing down in a matter of weeks.

The Problem with SIVs
Due to years and years of increased leverage we effectively have a banking system that is not functioning.
http://www.minyanville.com/articles/C/index/a/14597/from/yahoo

Quiz – What won’t hold $30

Unfortunately one of my favorite stocks is looking technically weak and is likely to drop below the $30 level. On many good market days, it trails the market or drops. On down market days, the stock exceeds the index downside regularly. The recent up moves have small volume, and the overall short-term price trend is down. While the stock is still generally correlated with the overall market, it is showing a comparative weakness over the last few weeks. If it falls below $30 then it is likely to dive towards $28.

Fundamentally the stock is worth much more, and many analysts have projected prices above $38. The company has solid revenue, growth prospects, and free cash flow. Let’s hope the upcoming conference call in a couple weeks sparks some life back into the price and reverses the recent trend because this business has a lot to offer.

I believe that most of the audience can pass this quiz by naming the symbol….

Rising Tide: Chinese IPOs

Investors still have a strong appetite Chinese IPOs. Another slew of Chinese IPOs are arriving on U.S. exchanges this week. Longtop Financial Technologies Ltd. and jewelry maker Fuqi International Inc. will begin trading this week. In other recent news, Chinese games developer Giant Interactive selected the New York Stock Exchange for its $801m offering, the largest initial public offering in the U.S. by a Chinese company since 1999.

At the same time the government of China is preparing large state enterprises for listing. While earlier there has been speculation over the offering of large state firms on exchanges, recent news last week makes the plans more concrete. Beijing is preparing thirty “national champions” controlled by the central government for initial public offerings, most likely before 2010. A list of 30 candidates was revealed last Tuesday in Chinese newspapers. It includes leading companies in several strategically important industries such as metals processing (China Minmetals), nuclear energy (China National Nuclear Corp), aviation (China National Aviation Holding Company), and power equipment (Dongfang Electric).

It is not clear what the division of ownership will be among the mainland exchanges, Hong Kong, and foreign markets; nor what ownership privileges will be assigned to classes of shares.

This is coupled with the news that PetroChina, China's biggest oil and gas producer, is settling on pricing for an initial public offering in Shanghai that is expected to raise nearly $10B. There is an increasing trend among Chinese companies that are already listed in foreign markets and Hong Kong to return to domestic exchanges for further sizable offerings. This demonstrates the strength and maturity of the mainland Chinese markets.

With an economy that is still growing at over 10% per year, it is not clear how long the IPO trend will continue, or if fears about a Chinese investment bubble are properly founded.

China Readies Large State Enterprises For Listing
http://www.forbes.com/markets/2007/10/16/china-soe-listings-markets-equity-cx_jc_1016markets01.html?feed=rss_markets

PetroChina Begins Consultations on IPO
http://biz.yahoo.com/ap/071022/china_petrochina.html?.v=3

IPO Spotlight: Chinese Companies Heat Up
http://biz.yahoo.com/ap/071022/ipo_spotlight_longtop_financial.html?.v=1

NYSE wins $800m Chinese IPO
http://www.financialnews-us.com/index.cfm?page=ushome&contentid=2449001138&uid=8907-2510-832401-522848

Increasing Risk: Headwinds

The headwinds facing the stock market have increased from a mellow breeze to a near gale over the past three months. It will be difficult for the market to continue an upward trend when facing these gusts; in fact is increasingly likely that the market will rollover and dive.

These factors are likely to put the brakes on the U.S. economy increasing the probability of a recession. While any individual factor is not enough to swamp the boat, the combination of all the factors puts a severe dampening on forward progress. The market is tacking against the prevailing wind and will have difficulty in maintaining headway.

It is apt that this commentary is being provided in late October, a period in which the market historically faces calamity, keep in mind 1929 and 1987. It is not clear if the headwinds will spark a loss of confidence that will lead to an immediate tumble, or if the events will play out over a period of months with the indexes washed over by the general economic conditions. Many times the market acts as a leading indicator of a broader economic slowdown. It is more apparent each week that the storm is brewing, and the factors outlined below will have an impact on your portfolio.

Lower earnings and increased warnings

Every earnings season sees a mix of hits and misses. The trend in the current season shows an increasing number of companies guiding down and a larger number missing their original estimates, while barely exceeding their revised numbers. This trend is likely to continue during the course of this fall earnings season; underneath the covers it provides a tale of a U.S economy that is effectively slowing despite the financial engineering used by a number of firms to make their numbers appear better.

The warnings are not confined to any single sector; it varies from candy suppliers such as Hershey to Investment Banks such as Citi whose net tumbled 57% in their report this week. The forecasted earnings growth for the S&P500 have fell from 6.2% to -0.2% between July 12th and October 16th.

Earnings Expectations Shrink Among Wall Street Analysts
http://www.schaeffersresearch.com/commentary/observations.aspx?ID=20581&c=obsfeed

Retail Sales Dropping

While a broader September retail sales report this week came in higher then expected. It is difficult to spotlight any good news contained in the report except that automobiles are still selling.

The spotlight on individual stores is less promising. Many retailers have issued warnings about dropping sales or are coming in at the lower end of their forecasts. Wal-Mart, the world's largest retailer, posted a 1.4 percent gain in September same-store sales, at the lower end of its forecast. Macy's Inc. and J.C. Penney Co. said sales declined. Nordstrom, among the few chains to post a gain, fell short of analysts' estimates. Specialty retailers at malls also posted declines. This drop is driven by the fact that consumers are in many ways tapped out, and are facing higher monthly expenditures for needed items such as gas and food. Driven by fuel costs, consumer prices have risen sharply at a 0.3% rate in September, for an overall increase of 3.6% in 2007 which is above the 2.5% rate recorded for all of 2006.

Home Prices Dropping

The news from the housing front continues to become gloomier. It is difficult to find a word of encouragement anywhere when the word “housing” is included in the conversation. The reports this week show that home building has hit a 14 year low, while unsold inventory is near record highs. Recent surveys have indicated housing price drops in the majority of metro area markets in the U.S.

Home building at 14-year low
http://news.yahoo.com/s/nm/20071017/bs_nm/usa_economy_dc_7

The Foreclosure Crisis

The foreclosure situation in the U.S. has reached a level where Washington is paying attention, over 1 million plus stand to lose their homes over the next two years. This increasing number of foreclosures weakens consumer confidence, reduces consumer spending, and wreaks havoc on the financial sector. Most of these foreclosures are associated with subprime debt and ARMs resetting.

Washington has put a number of bipartisan measures in place, but most of this legislation will do little to minimize the crisis. It is more likely that the federal government’s prompting of banks to take steps to alleviate the pressure on homeowners by not adjusting the rates upward will have greater impact in reducing the number of homes on the foreclosure register.

Congress takes action on home loan crisis
http://www.wthr.com/global/story.asp?s=7170592

The Credit Crimp

As foreclosures are soaring, most homeowners are finding it difficult to get Alt-A, subprime, or jumbo loans. The mindset that these homeowners had in which they planned to simply refinance to a lower rate as their ARMs reset has caught them in a trap. The problem being that no bank will extend them a new mortgage.

Mortgages are not the only consumer debt impacted by the credit crunch. Many homeowners are finding that their HELOCs are being cancelled with little explanation. Credit card holders being hit with higher rates and having their cards cancelled if they late on paying any of their debt.

An earlier post from August 3rd discussed the Credit Crunch and the associated scenarios for the economy. It appears that we are solidly in midst of the “middle case”.
Credit Crunch – Increasing Risk
http://hingefire.blogspot.com/2007/08/credit-crunch-increasing-risk.html

Consumers Tapped Out

So what happens when the majority of homeowners have used their houses as ATM machines to purchase other stuff, and suddenly they have gone back to the bank and the ATM spigot is cut-off. Well, first of all they stop buying stuff. No more big SUVs, fancy boats, exotic vacations, and vanity items.

This is readily apparent in reports on big ticket items and non-essential retail. Coupled with falling home prices, rising prices of necessary items, job losses, and dropping consumer confidence; there is an expectation of continued erosion in consumer spending. Simply because from a big-picture perspective consumers no longer have the cash to spend.

The consumer buying binge is over
http://money.cnn.com/2007/10/15/news/economy/colvin_buyingbinge.fortune/index.htm?postversion=2007101609

Lower consumer confidence

With debt piled on their backs, their home values dropping, banks not giving loans, and their neighbors losing jobs; consumer confidence is hugging all time recent lows. There is no expectation that the situation will improve after the upcoming fourth quarter with the associated holiday spending. While consumer spending always spikes during this time of year; it is still likely to be below most retailer’s expectations.

One recent article provided this description - “Consumer confidence continues to hover in negative double digits, above its recent lows but below its recent average.”

Confidence Is Low and Steady
http://abcnews.go.com/Business/story?id=3737552&page=1&Business=true

Corporate credit market jitters

The recent creation of a Super-SIV fund by major banks to stem credit losses associated with commercial paper is symbolic of the fear regarding corporate market rather then a cure for the ills. The concept that a complete segment of the corporate credit market has ground to a halt and most firms can not even define the pricing of the instruments should cause a gut-wrenching moment for all investors. The situation may work itself out over time, or implode into a large-scale bailout situation that makes the subprime crisis appear to be a minor side-show.

An earlier post discussed the formation of the Super-SIV fund.
Credit Market with the Jitters
http://hingefire.blogspot.com/2007/10/credit-market-with-jitters.html

Increasing oil prices

The recent spike in oil prices acts as a drag on the entire economy. Transporting goods costs more, small businesses are crimped with fuel costs, families spend more fuel, and homes cost more to heat. Fuel costs show up in the prices of everyday necessary items that all households need; the cost of everything from milk to shampoo goes up.

The increasing oil price rises, which is likely to drive gas at the pump to over $4 per gallon, is one of the most detrimental items to the overall economy. Shortly the fuel costs will be hitting a point where everyone feels the pinch and it will not be ignored by most families in their planning.

Oil jumps above $90 a barrel
http://news.yahoo.com/s/ft/20071019/bs_ft/fto101920070736179330

Mixed Manufacturing reports

Te recent manufacturing reports demonstrate a mix trend. Some areas such as New York increased while neighboring areas such as Philadelphia sunk. The lack of correlation in the reports and the slide in national surveys over the past three months, does not spell out a promising trend in regards to U.S. manufacturing.

Philadelphia Fed's Factory Index Dropped to 6.8
http://www.bloomberg.com/apps/news?pid=20601087&sid=ahCdurYvWGHA&refer=worldwide

U.S. Economy: New York Fed Factory Index Unexpectedly Rises
http://www.bloomberg.com/apps/news?pid=20601068&sid=aOCTmTf6mcsU&refer=economy

Increasing Job Losses

The job losses are not simply associated with the mortgage and home building sectors. Recent reports have shown the shedding of jobs across all industries in the U.S.

A good number of larger employers have recently announced significant reductions their workforces. This week, both AOL and Boston Scientific were at the top of the headlines for their sizeable job cuts.

The general trend in each week’s unemployment report is an increasing number of claims.

U.S. Jobless Claims Rose 28,000 to 337,000 Last Week
http://www.bloomberg.com/apps/news?pid=20601068&sid=agxmWCYcodl0&refer=economy

The increasing job losses erode consumer confidence and spending; thereby impacting the earnings of corporations associated with this activity. Consumer spending represents nearly two thirds of the U.S economy, therefore all factors that impact it must be considered from a broader perspective.

Falling Dollar

The falling dollar is a mixed situation. A lower dollar makes imports more expensive, and slows U.S. consumer spending. However a falling dollar also increases exports and makes American products more competitive overseas.

Dollar Falls to Record Low Against Euro on Growth, Fed Outlook
http://www.bloomberg.com/apps/news?pid=20601087&sid=atTi8soeh.KM&refer=worldwide

Another primary concern of a falling dollar is that it will drive investors outside the U.S. to take their money out of the American markets. This outgoing money flow will normally lead to a reduction of the indexes.

The Rush to Downgrade

Credit agencies are nearly stumbling over themselves to downgrade mortgage-backed securities and other derivative instruments. S&P appears to add another batch representing billions every week. This is one of the factors defining the existence of increasing risk of recession as outlined in the 'middle case' in the earlier 'Credit Crunch' post from August 3rd.

“S&P two days ago lowered ratings on $23.4 billion of subprime and Alternative-A securities that were created as recently as June, its swiftest downgrade of mortgage bonds. Investors and U.S. lawmakers have criticized S&P and other credit-rating companies, saying the firms downplayed the risk of bonds backed by loans to homeowners with poor credit.”

S&P Cuts $22 Billion of Subprime Mortgage Securities
http://quote.bloomberg.com/apps/news?pid=20601087&sid=a47IJsAZLTZQ

The Good News

Is there any good news about the American economy and stock markets? There are some positive points that investors should keep in mind.

Historically low interest rates – The interest rates in the U.S. are still near historical lows. This acts as a very positive driver in terms of borrowing costs for businesses, homes, and consumer items despite the credit market issues.

Low unemployment rate – The U.S unemployment rate is still near traditional lows showing that Americans are nearly fully employed. This however ignores the trend from high paying professional and manufacturing jobs to lower paying service sector jobs that has beset the economy.

Increased exports due to lower dollar – The exporting of products from the U.S has climbed and is helping to close the still-significant trade gap over the past couple of months. This is driven by the lower dollar.

Return to traditional lending standards – There is a positive side to the stop of irrational loans in the U.S., it removes energy from the bubble. The return to sane and traditional lending standards is long overdue; however there will be economic pain as the country struggles through the aftermath.

Summary

The headwinds are increasing for the economy and market. While any individual factor is not enough to sink the ship; the combination of all the factors will impede the situation. Earnings growth and other fundamental drivers of the stock prices are under pressure.

It would be wise at this point for investors to adopt a defensive stance for their portfolio. They should underweight sectors in turmoil such as housing, mortgages, and banks while seeking to reduce overall risk. This does not mean that an investor should dump all of their stocks and go to cash; it simply implies that it is time to pay attention to what sectors within the stock market your money is allocated to and take steps to reduce the risk.

Traditionally areas such as consumer staples, tobacco, alcohol, and movies tend to do well during a recession. Investors should take a close look at stocks in these sectors and consider overweighting. Other areas that are ripe for gains in the current economic environment are commodities. The demand for raw materials, crops, and energy are increasing world wide; this will likely fuel the continued price gain in these items.

From a broader portfolio perspective, the percentage allocations that you have to stocks, bonds, commodities, and cash should remain the same based on your age and objectives; there is no need for drastic action in your 401K plan. Think long term!

Tide of Dollars Floods Over Silicon Valley Startups

It seems like Web 2.0 is forming Bubble 2.0. Companies with minuscule sales are being given valuations that rival industry giants.

Is Google really worth more then IBM, a company with eight times their revenue? Is Facebook worth $15B? This trend continues with smaller companies in Silicon Valley that are flush with venture capital cash.

Recently eBay concurred that they greatly overpaid for Skype. At some point, valuation of companies needs to be tied to how much revenue they generate instead of the size of their web audience. It is likely that the Web 2.0 bubble focused on tying valuation to advertising potential before generating a single dime of revenue is a bubble that is ripe to deflate.

However at this point the exuberance, and Web 2.0 buzz, is continuing. Venture Capitalists are pouring money into the start-ups and larger companies are continuing to purchase them at lofty valuations.

Silicon Valley Start-Ups Awash in Dollars, Again
http://www.nytimes.com/2007/10/17/business/media/17bubble.htm

A $100B Super-SIV Fund will not plug the Dyke

Barron’s takes the creation of the recent Master-Liquidity Enhancement Conduit, or MLEC fund to task… stating that it will not stop the flood while called the size of the fund “a spit in the bucket” compared to the mountain of existing bad debt.

I discussed the formation of the Super SIV in an earlier post, observing that the credit market still has a bad case of the shakes:
Credit Market with the Jitters
http://hingefire.blogspot.com/2007/10/credit-market-with-jitters.html

The Barron’s article expands upon this with some interesting commentary.
$100 Billion Won't Plug the Leaky SIVs
http://online.barrons.com/article/SB119244948063659074.html

Regional Banks – Continuing Credit Turmoil

The recent earnings from many of the regional banks reflect the impact of the credit crunch and subprime turmoil. Washington Mutual announced a 72% profit drop today. Wells Fargo, U.S. Bancorp, KeyCorp, and others were impacted in a similar manner in their reports this week.

Nearly all the banks made statements in which they said that they do not see the situation improving over the next six months; this is a solid sign that investors should expect further decline in the financials. The credit turmoil is not simply contained to mortgage lenders and investment banks, but has infected regional and local banks that tend to adhere to traditional lending standards…. This is not good news for the banking stocks in your portfolio.

Credit Crunch hits Regional Banks
http://www.marketwatch.com/news/story/credit-crunch-hits-regional-banks/story.aspx?guid=%7B736175B9%2D4000%2D4639%2D8EC5%2D312494C117A2%7D&

Will Someone tell the Financial Whiz Kids that their House is Built of Cards

Business Week came out with an in-depth article that pulls back the covers on the failure of the Hedge Funds at Bear Stearns. The most troubling part of this article is the broader implications that are not discussed. Most hedge funds in the market are simply emulating each others styles trying to squeeze some excess alpha out of the market while ignoring the risk of multi-sigma events in their plans. There are been numerous articles over the past couple of years discussing that hedge funds were all chasing the same strategies. The management of the Bear Stearns funds was not much different than any other fund on the street… except that they got caught during the crunch in August.

In many ways the Bear Stearns funds were built to collapse, in a situation that is eerily similar to the misguided genius that managed LTCM in 1998. Basically these guys were wandering around the room blind-folded while trying to hit the golden piñata, while the market acted as a pitbull that attacked anyone holding a bat. The management of the funds at Bear Stearn lacked rhyme or reason, and any plan to survive a downturn.

The article is a must read….
Bear Stearns' Bad Bet
http://www.businessweek.com/bwdaily/dnflash/content/oct2007/db20071011_175964.htm

China - Sticking to the Game Plan

China still appears to be sticking with their game plan regarding the pegging of the Yuan to the Dollar in a tight fixed range, despite inflationary and other pressures on their economy. From a distant perspective, the Chinese government is being very wise in their policy which is built around:

• Diversifying over time from the Dollar to other currencies to reflect the overall allocation of trade with their nation. More reserves will be held in Euros, Pounds, etc. This reduces currency fluctuation risk.
• Purchasing other assets beside U.S. government bonds. The recent purchases have included private equity funds, stocks, bonds of other nations, and real estate. These moves increase the return on the reserves while diversifying the risk from a single type of instrument (U.S. treasuries and bonds).
• Maintaining the peg of the Yuan to the Dollar in a tight range. This eliminates the risk of major moves in the currency market from impacting the Chinese economy. This implies that the government will not have external Forex traders and hedge funds dictate their future. Strict control is maintained over the peg preventing foreign currency market arbitrage plays that would cause a run on the Yuan with associated economic devastation.
• Cleaning up the banks in China. Many banks have bad debt with poor controls and the government has taken steps to clean up the mess including foreign ownership of some banking assets to reduce risk. One primary reason for the currency peg was to protect the banks that were on shaky structural ground. This provided the government with time to clean up the mess and align the banks with western financial standards.

The downside of the government policy in regards to the peg is the friction with trade partners and inflationary pressure associated with runaway growth. During the past year interest rates were raised several times in an attempt the cool the economy, and other measures were implemented to reduce lending. However at this point the overall game plan has worked out well for China over the past few years. The question will be can they stick to the plan in the upcoming months.

Yuan, Rupee Rise at Record Pace in Fight on Inflation
http://www.bloomberg.com/apps/news?pid=20601068&sid=avCQ7I4bVhmo&refer=economy

It's time to play Bay Area Mortgage Meltdown

I have regularly been informed that the Bay Area is immune to a mortgage meltdown and the housing prices are still humming along. The statistics and information appear to demonstrate a different story.

"Of the Bay Area's 236 ZIP codes, 25 are foreclosure hot spots - places where more than eight of every 1,000 homes were repossessed by lenders this year."

MORTGAGE MELTDOWN
NEIGHBORHOODS CRUMBLE IN WAVE OF FORECLOSURES
LOCAL TROUBLE ZONES: Epidemic repossessions hit several ZIP codes
http://www.sfgate.com/cgi-bin/article.cgi?file=/c/a/2007/10/14/MNVPSEMVQ.DTL

The Downside of taking 401K Loans

In the past, I have urged people not to take loans from their 401K plan. Raiding your 401K should be your avenue of last resort. Unfortunately an increasing number of people in the U.S. are taking loans from their corporate 401K plans. The following article outlines some of the significant negatives associated with this activity.

Cash-strapped Americans raiding their 401(k)s
http://www.chicagotribune.com/business/yourmoney/chi-ym-borrowing-1014oct14,0,5181066.story

Nortel - The News Continues

Nortel continues to take it on the chin with negative news flow, even though some will view the current news of the $35M settlement with the SEC as trying to put the past behind them. The Bloomberg article is interesting in that it provides some solid information of the history of the financial dishonesty at Nortel.

Nortel Pays $35 Million to End SEC Accounting Probe
http://www.bloomberg.com/apps/news?pid=20601087&sid=aq4vfUmPByrU&refer=worldwide

In today's counter-intuitive news

Stock Options for CEOs Harm Company Results
http://biz.yahoo.com/rb/071012/column_lifting_ceo.html?.v=1&.pf=career-work

This may get the vote for today's very odd business article. It claims that "option heavy" CEOs under-perform CEOs with less options. 'Companies with "options-heavy" CEOs had an average annual shareholder return of 26 percent versus 36.5 percent for companies run by "options light" CEOs during the study period.'

One interesting point is that the study period was from 1993 to 2000, a time when the market was booming, and included 950 companies. The study did not focus on the tech sector, nor did it take a look at the impact of broad-based stock employee stock option plans implemented by many tech firms. It does however bring the immediate question to mind if broad-based employee stock option plans help or hinder the bottom line for shareholders.

Credit Market with the Jitters

The corporate credit market still appears to have a bad case of the shakes, to the point that investment banks coordinated by the Fed are preparing for a bail-out.

The sales of commercial corporate paper have suffered over the past few weeks due to the fear wrought by the subprime sector. Despite the contagion, commercial paper sales have increased during the past few weeks giving some the perspective that the possible crisis is in the rear view mirror.

However the rather large Structured Investment Vehicle (SIV) market, that is generally associated with lower quality corporate debt, appears to have come to a complete halt. These derivatives are backed by commercial paper, and are similar to the CDOs that have provided excessive angst in the subprime market. Generally the SIVs used short-term commercial paper with low interest rates to purchase longer-term mortgage-backed securities and other instruments with higher rates of return. A market arbitrage that bears resemblance to international interest-rate carry trades, but tends to blow up spectacularly when one of the underlying tenets alters

The banks would create a Super-SIV fund (Master Liquidity Enhancement Conduit or M-LEC) that would provide emergency financing to bail out SIV entities in order to prevent sell-offs. The Fed and Treasury hope that this will reassure investors in these vehicles and kick some life back into the commercial paper market.

The key question remains regarding how much impact this event should bear over the broader stock market. Deteriorating credit conditions are normally very bad news for investors. Should the implementation of this SIV fund from the banks be taken as fair weather news to calm the seas or with a dose of fear?

Banks May Pool Billions to Avert Securities Sell-Off
http://www.nytimes.com/2007/10/14/business/14bank.html?_r=1&oref=slogin

Banks set plan to revive credit market
http://news.yahoo.com/s/ap/20071015/ap_on_bi_ge/banks_credit

HingeFire Stock Screener has Arrived.

The first release of the HingeFire Stock Screener is available at http://www.hingefire.com/ Please register and download the tool.... and try it out! Note that this initial release is primarily focused on demonstrating the concept and getting feedback from users of what they want to see added to the tool. So in some sense current release is a "Proof of Concept" but still a very powerful tool for your investing.

What are the key advantages of the HingeFire screener? One is the ability to merge fundamental and technical screening in a single tool. Some investors tend to focus on fundamentals and others on technical indicators. We believe that all investors should focus on both in order to put the market edge in your corner. Fundamentals provide a good sense of the long term outlook for a stock while technical indicators help greatly with short-term timing for entries and exits.

Our team plans to add a lot of educational material to our site over time showing how you can win by utilizing a merged fundamental and technical approach to your stock selection. Over the upcoming months both the website and tool will be evolved significantly so please keep checking in.

Please see the User Guide for the tool at:
http://www.hingefire.com/download/HF-userguide.pdf

After you have used the HingeFire Stock Screener for a while, please take our user survey and provide our team with guidance regarding what you would like to see added to the tool.
http://www.hingefire.com/user-survey.html
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One of the benefits of being a HingeFire user is that you get to drive future development directions for the product. We look forward to your feedback! Either use the survey or contact us directly at support@hingefire.com with your suggestions.

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