Coming Full Circle

Is it just me or does anyone else find it somewhat ironic, that one of the most often sighted reasons for the current predicament we now inhabit, namely that interest rates were held too low for too long by the Greenspan Federal Reserve, is apparently one of the cures.

The cheap money policies of the Federal Reserve that led directly to the biggest housing bubble in history and an acceleration of an even bigger debt bubble, is now the one the answers for how to fix it. Inquiring minds may wish to ask why the US government's brightest think this is the right path to take.

Quite simply the answer is that they don't know anything else, the Federal Reserve is the proverbial one trick pony. They encourage speculative bubbles on the way up and then rather than let them deflate of their own accord, try to reflate them on the way down.

This asymetric approach to monetary policy is a key reason why the US stockmarket is now lower than it was 10 years ago. Instead having a proper recession in 2001 and letting asset prices correct to realistic levels the Fed propped it up with cheap money.

That may seem to be a strange statement in light of the fact that the S&P500 declining -49%, but that was after the ridicuous prices of the dotcom bubble. That meant that the ensuing bullmarket that kicked off in 2003 started at the highest market P/E ratio in history.

The corporate profits that drove stock prices were underpinned by an unsustainable low cost of capital causing unsustainably high profit margins. What you are seeing now is a steady reversion to the mean. However, once again the one trick ponies at the Federal Reserve are doing their best to prevent that from happening.

Will it work? David Callaway of marketwatch.com suggests it won't and I think he may be on to something.

Arguably, it was a dramatic easing of interest rates after the tech bubble collapsed that plunked us into the systemic soup in the first place, allowing people to take out mortgages at ridiculous rates and Wall Street to make a killing by packaging the mortgages and playing various rates off each other. But it won't work this time around. Nobody's lending, and nobody is borrowing.

Since the current consensus is that financial armageddon and the great depression markII has been avoided, attention has turned to how bad the current recession will be and how bad are corporate profits are going to feel the pinch. There mainstream is that the 4Q08 will be the trough of the recession and that the US economy will be on the road to recovery in the second half of 2009.

Since the consensus never saw the current crisis coming, never saw a stockmarket decline or a corporate profits recession, I feel comfortable in betting that the consensus will be proved wrong again.

US Home Prices Down 20%+ Cash Shiller

Both the 10 city and 20 city Case Shiller Home Prices Indices are now down more than 20% from peak to trough. I'm actually surprised that the year over year declines continue to increase, albeit at a slower pace. Remember that the Case Shiller numbers are for August and that recent data on new and existing home sales point to further declines in US home prices.

That shouldn't be surprising, on a 20 city basis, US home sales have reverted to price levels last seen in May 2004. So if you bought a home prior to 2004 there is a good chance you are still in front. However whatever gain you are sitting on will continue to erode or disappear altogether over the next 12 - 18 months

Did Someone Say More Capital?

Last week I noted in "Bank Injections just the Beginning" that US banks would need much more than the $50 billion that has been injected by the TARP program to date. The story below is about UK banks, but it is a pre-cursor to what is coming down the pike for US banks. From the TIMESONLINE:

Banks may need further support from taxpayers as recession bites
Britain's banks may need to raise capital above and beyond the £50 billion of taxpayer-underwritten money already earmarked for them.

The Bank of England's report into financial stability today suggests that a recession as severe as that of the early 1990s would lead to credit losses of £130 billion for Britain's six biggest financial institutions and possibly wipe out the entire government-backed funding package.

Not only will US banks be getting more capital but I think one or more of the large players, GS, C, MS for example will be forced to merge with another entity just to survive.

Sign of the Times in Retail

Oh well, Friday in the US turned out to be somewhat of a fizzer, the market falling just -3.5%. A year ago a move of that magnitude would have seen major headlines, today however, such moves seem relatively tame.

Markets in asia today continued to slide, the Nikkei opened up and is now down more than -5% as I write. But enough of the market commentary. This post is about somethign much more trivial. Today I had a read of Specialty Fashion Group's annual CEO's report. This is what it had to say on the outlook for 2009.

We anticipate a tough financial year ahead. As mentioned previously, July trading was good and we saw positive growth compared to last year. However, since then we have experienced a decrease in foot traffic through our stores and like for like sales have been negative for the past three months.

We certainly support the Federal Government’s pre Christmas spending package and anticipate the extra cash for pensioners and families will provide some boost for us through the significant Christmas trading period.

The environment is very volatile at present and with the Christmas trading period still ahead of us, our first half results remain unpredictable.

There is nothing special in this, it is just a continuation of a growing trend within the retail industry. If you didn't see it last week, here is what Harvey Norman had to say on their October sales:

Like for like writen sales for the 28 days ended 19th October 2008 from the franchised "Havey Norman" stores in Australia decreased by 5.8% when compared to the same period last year. Retail margins continue to be under pressure.

I'm aware that retailers like JB Hifi seem to be continuing to do well, but for how long can that be sustained? Unemployment in Australia has yet to rise significantly and with households carrying the biggest debt burden in history the stimulus lobbed at Australian consumers by the government will be barely noticed.

Whilst the stock prices of retailers have taken a battering along with the rest of the market, given the headwinds faced by consumers, I believe the extent of the economic slowdown in Australia is yet to be priced in for most of the major retailers. My favourite pick in this sector is TRS, but even they need to get cheaper for me to dip my toe in.

Are You Exhausted Yet?

As I sit down to type this on Friday night, the German and French stockmarket's are down more than -8%, the UK is down more than -7%, S&P500 futures are down -6.5% which is limit down. Limit down is the circuit breaker that prevents further selling until the market has had time to cool off.

The speed at which events are unfolding is mindnumbing. There are so many things to write about but it is just impossible to include them all. Things like the Baltic dry index, down more than 90%, the UK economy has just contracted -0.5% in 3Q08. The unintended consequences of backing Australian bank depostis leading to a halt on redemptions by the likes of Perpetual, AXA and Babcock & Brown. OPEC cutting 1.5 million barrels of production. Falls in International air passenger traffic not seen since the SARS scare of 2003. and on it goes.

It's against this backdrop that panic is starting to take hold. Just 2 weeks ago stockmarkets experienced their worst week since the great depression. However the panic seems more extreme at this moment, I heard on bloomberg tonight one trader say "God help us!" That is the kind of talk I've been wating to hear. The capitulation low that everyone has talked about might be here.

That said, I wouldn't be surprised to see the market finish up in the US today, although it looks highly unlikely at the current time, that's the kind of volatility we are dealing with. The VIX has exceeded all previous records - which leads to another point worth noting.

We keep hearing comparisons to previous times, the bear market of 1974, the recession of the early 1980's, the depression of the 1930's. However, this market continues to defy all expectations. We are in unchartered territory and all the old metrics can't be relied upon.

We have unprecedented leverage in the form of hedge funds and exotic financial instruments such as credit default swaps. Sure there have been times of excessive leverage in the past but nothing even comparable to the present day.

All that said, if you are a long term investor that tries to purchase shares in good businesses at fair prices then there is reason to be optimistic. The current prices of many businesses have not seen such attractive levels for a couple of decades. It takes of bit of courage to wade into the markets with such uncertainty, but if you can stick to a disciplined approach you will be well rewarded in a few years time.

ANZ Profit Down -23%, Waffle on Outlook

ANZ today unveiled a -23% drop in cash earnings which had largely been flagged to the market well in advance. Basically ANZ suffered from a few large exposures to weapons of finacial mass destruction as NAB did. As can be seen below those exposures led to a huge spike in credit loss provisions.

On the all important outlook for 2009, ANZ bascially admitted that they don't have a clue.:

Commenting on the 2009 outlook for ANZ, Mr Smith said: “Market conditions globally remain difficult and unpredictable. The restructure of our business announced in September is designed to accelerate progress with our Super Regional Bank strategy, lift customer focus and drive performance improvement.

“Managing a large commercial bank means managing through a range of conditions. While we expect choppy conditions to continue in 2009, ANZ is well positioned to manage this cycle, to continue to invest and maximise the opportunities which arise.

“We have the foundation, a clear direction and the capacity to deliver performance and value to our shareholders over the longer term,” Mr Smith said.

That is corporate speak for we don't have a clue. Again, as with NAB if you think these these banks are relatively stable and can maintain earnings and therefore dividend levels then they may not be such a bad place to be as interest rates continue to be cut. However, given the outlook for credit can how much certainty can you put in that scenario playing out?

Bank Injections just the Beginning

I've noted over the past week the improvement in certain credit metrics such as the TED spread and LIBOR rates, however it is one thing to provide liquidity and guarantees to the system but quite another to get banks freely lending to corporates and houselholds.

The conventional wisdom of the treasury directly injecting capital into the "chosen ones" is that it will help shore up their capital bases and that would give them confidence to start lending to each other again and kickstart lending in the broader economy.

However, as Chris Whalen of Instituional Risk Analytics points out in the following interview, the losses coming down the pike will mean that the capital injections will be used just to absorb those losses and thus more funds will be needed to prop up these institutions in the coming months.

Who the hell is Chris Whalen and why should we believe him? Whalen is one of the few that went against the chorus of bullish cheerleaders and predicted the current crisis and the implosion of Freddie and Fannie. Much more credible than the pundits that never saw the current crisis coming and are now saying that the worst is over.

NAB FY08 Profits Down 11%

Considering the massive losses other financial institutions have taken around the world over the past 12 months, NAB's -10.7% drop in cash earnings for FY08 looks very respectable. However, of more interest is the outlook going forward and on that score NAB expects continued deterioration.

Measured half on half NAB profit fell -25% in 2H08 from the 1H08. You can put a lot of that down to the pre-announced losses on CDO's that added up to close to a billion dollars reflected in the sharp increase in provisions shown above. Also not mentioned in any reports I saw was that NAB's tax rate fell to 21% in second half from 27% in the first half. If NAB had the same tax rate in the second half , that would have sliced a further $150m from the bottom line.

On the outlook going forward NAB painted a sobering picture:

Economic conditions appear likely to continue softening well into 2009. The combination of the much higher prices for oil and other commodities seen in recent years with the higher cost and reduced supply of credit represents a sizeable adverse shock to the global economy. The reduction of household sector wealth flowing from sharply lower equity prices and widespread falls in house prices weighs further on economic prospects.

Once again there is no denying that NAB is doing comparatively better than it's global peers, but in an environment of rising bad debts and a slowing in credit growth to businees and households, the outlook for bank profits remains muted at best.

However, if forecasts of 9% earnings growth can be met for next year, the current dividend yield of over 8% looks very attractive, especially as interest rates continue to come down. That is of course if you believe those earnings forecasts, right now that is not a bet I am willing to make.

Economy vs Credit Markets

Back in late September I recommended that investors pay close attention to the credit markets. At that time I said that if stresses in the credit markets persist, the equity market would be in for tough times and as you know, October has been no picnic for equities.

However since the measures announced by European and US governments to guarantee overnight lending markets there have been some noticeable improvements in credit markets as demonstrated below by the reduction in the TED Spread.


Also of note, the 2 year swap spread has fallen from over 150 bps earlier in the month, back down to 124 bps as of Friday.



The flight to safety trade in 3 month treasuries has also eased from a low 0.20% earlier in the week to 0.78% as of Friday. Whilst these metrics are far from happy days are here again type readings they show significant improvement from a week ago levels.

However the flip side to this story is the latest economic data spilling out from the US. I noted some of this earlier in the week, Retail sales and the Empire State Manufacturing survey falling off a cliff. Housing starts and permits are hitting new cycle lows and builders sentiment is at its lowest ever. Also out during the week, the Philly Fed manufacturing index recorded it's sharpest ever 1 month decline to an 18 year low whilst consumer confidence also plunged the most ever in a single month in October.

On the earnings front there has been some decent reports from some tech and materials companies whilst some surprising negatives from the likes of Pepsi. However, I believe that earnings in the current quarter will be somewhat of a headfake given that things didn't really start to fall apart until September and the stimulus package was also still at play early on in the quarter.

4Q08 earnings are currently expected to be higher than 3Q08. That will just simply not be the case. The latest data from Zacks shows that for every earnings upgrade there are five downgrades.

So what will dominate? The repair of the credit markets or the gloomy economy? As usual, I have no strong convictions about short-term market direction. No doubt the progress being made in the credit markets is a positive, however I believe the economic fundamentals will prevail in the medium term.

Much of the economic growth and prosperity of the last decade has been built on cheap credit and rising asset prices. Inflated asset prices are no longer available to borrow against to fuel excess consumption. The change in social mood towards a recognition of frugality instead of excess should also not be underestimated.

These will be good long term developments however they will bring about short to medium-term economic pain. Consider a chart from John Maudlin's weekly column showing the sharp decline in US Mortgage Equity Withdrawl (MEW). MEW's hit an irrationally exuberant high in 1Q06 when $223.6 billion was extracted, just two years later and that figure has plummeted to $9.5 billion in 2Q08 as shown below.


How is the consumer, faced with higher unemployment, no prospects for wage growth for those with jobs, nothing to borrow against and tighter lending standards across the board supposed to keep spending at the pace of just 12 months ago? On the subject of tighter lending standards, also from Maudlin's weekly note, GMAC has said it won't lend to anyone with a credit score under 700, that rules out more than 40% of Americans. Welcome to the new reality.

Another Leg Down for US Housing

BUILDING PERMITS

Privately-owned housing units authorized by building permits in September were at a seasonally adjusted annual rate of 786,000. This is 8.3 percent (±1.6%) below the revised August rate of 857,000 and is 38.4 percent (±1.6%)below the revised September 2007 estimate of 1,277,000.

Single-family
authorizations in September were at a rate of 532,000; this is 3.8 percent (±1.6%) below the August figure of 553,000. Authorizations of units in buildings with five units or more were at a rate of 225,000 in September.

Permits have equaled the low reached in January 1991. If permits fall lower (which I'm sure they will) you would have to go back to 1982 to see lower numbers.

HOUSING STARTS

Privately-owned housing starts in September were at a seasonally adjusted annual rate of 817,000. This is 6.3 percent (±12.0%)* below the revised August estimate of 872,000 and is 31.1 percent (±8.3%) below the revised September 2007 rate of 1,185,000.

Single-family housing starts in September were at a rate of 544,000; this is 12.0 percent (±8.3%) below the August figure of 618,000. The September rate for units in buildings with five units or more was 254,000.

Starts are now at their lowest since January 1991 whilst single family starts are at their lowest since February 1982.

HOUSING COMPLETIONS

Privately-owned housing completions in September were at a seasonally adjusted annual rate of 1,097,000. This is 11.7 percent (±14.0%)* above the revised August estimate of 982,000, but is 20.4 percent (±9.6%) below the revised September 2007 rate of 1,378,000.

Single-family housing completions in September were at a rate of 806,000; this is 17.0 percent (±11.5%) above the August figure of 689,000. The September rate for units in buildings with five units or more was 260,000.

Completions were higher but given that they follow starts they will fall sharply in coming months.

Also yesterday, the builder's sentiment index fell to record low of 14 in September. Given what has happened to the economy in late September and into October hsousing clearly has further to fall both in temrs of activity and prices. Soon we will crash through all records set in the last housing implosion in the early 1990's and there is a high probabiltiy that the lows of the early 1980's will be taken out as well.

Back to the Economy

Since governments around the world came together and saved the world from the brink of financial armageddon, (yes I'm being sarcastic) we can afford to briefly shift focus back to the economy. Since credit markets froze over in September there has been a perception that the US and global economy fell off a cliff.

Today we got some data to confirm that. US retail sales fell -1.5% in Spetember and is down -1.0% from a year ago - the first year over year decline since October 2002. US consumers have been on the ropes for a while but with rising unemployment and a lack of credit they are finally tanking big time.

Also out yesterday the Empire State manufactuing index fell to an all time low of -24.6. If that wasn't enough The Fed's Beige book was released yesterday and the outlook was equally grim. This from the report:

Reports indicated that economic activity weakened in September across all twelve Federal Reserve Districts. Several Districts also noted that their contacts had become more pessimistic about the economic outlook.

Expect more of this kind of nasty economic data going forward in the coming months and expect Australia to follow not too far behind.

Why the Market Isn't Cheap

There is a cacophony of opinion currently doing the rounds that stocks are cheap, dirt cheap in fact and that there are bargains everywhere. Now I certainly don't think after a -40% decline that stocks are expensive, they aren't and if pushed to make a call one way or the other I'd have to say they are on the cheap side but there is no reason that they couldn't get cheaper from here.

I wish I had a chart for the ASX All Ords PE ratio but unfortunately I can't get the data. The above chart of the S&P500 12 month trailing PE shows that stocks as at the end of September were not particularly cheap trading at 16.8 times and keep in mind that is based on earnings expectations for 3Q08 of -2.6%, a forecast that will turn out to be too optimistic in my opinion.

Of course, since the end of September, stock markets have declined significantly in the first two weeks of October. Based on yesterday's close of the S&P500 and earnings for 4Q08, the 12 month trailing PE drops to 13.0 times. Then looking out to the end of 2009 the 12 month trailing PE drops to just 10.0 times and that is certainly very cheap.

However as mentioned many times before the E in the PE cannot be trusted looking ahead. Especially given what has happened in the last few weeks as the credit markets have seized up and earnings of all types of companies are coming under pressure. Of note recently was Pepsi coming in light on earnings and Intel's guidance for the 4th quarter is looking a little wobbly.

For example, 6 months ago 4Q08 earnings were forecast to rise more than 74%. At the time I said that was ridiculous. As the chart below shows estimates have come down to a forecast growth rate of 49.6%. That will also prove to be ridculous although I do expect them to be up given the very easy comparsions from 4Q07.

The point is that a PE of 10 on the S&P500 based on current earnings is a pipe dream. Earnings for FY08 for the S&P500 are currently forecast at around $76.70 whilst FY09 earnings are forecast at more than $103 or 35% higher. Given the hole the economy fell into in October those earnings need to come down substantially.

Personally I doubt FY09 earnings will exceed $80 and indeed they could be substantially lower, however using $80 as a base case, that would put the PE for the S&P500 based on yesterday's close at around 12.5x. That is still reasonably attractive but remember that multiple sank to around 7 times in the early 1980's. Of course we are not in the 1980's but it is an indication of how depressed multiples can get.

One final note. Regardless of whether we have hit bottom or there is further to go, it is important to remember that not all stocks bottom at the same time. Some have seen their bottom already and some have yet to see it. There definitely are some cheap stocks out there at the moment which will prove to be good long term buys and whilst I still expect the overall market to make new lows in the coming months, I also hope put some money to work.

Australian Government Blows $10 billion

The Australian government today reminded its citizens that they belong to a welfare state announcing that they will waste approximately $10 billion worth of taxpayers money.

Firstly they will lob $4.8 billion at starving pensioners who can't feed themselves. Then another $3.9 billion down the drain for low and middle income families, so they can continue to go out and buy worthless crap they don't need.

But the icing on the cake is the increase in the first home buyers scheme. The payment under the first home buyers scheme will be doubled from $7,000 to $14,000 and first home buyers who buy newly-constructed homes will receive an extra $14,000 taking their total grant to $21,000.

So once again, the idiots in power have decided to keep houses unaffordably high for most people and entice the gullible to come in and take on huge amounts of debt. The best way to make housing affordable would be to take the first homebuyers grant away altogether. House prices would fall and the average Australian might have a chance of buying one and paying it off before they die.

But no, we are a nation of consumers who save nothing and depend on the government for a deposit on a house so we can go out and treat ourselves to a new plasma TV and other worthless crap we don't need. Through its actions the government encourages people to be fiscally irresponsible and punish those who save and spend prudently. All in an attempt to keep the debt driven consumerist society afloat.

Thankyou Mr Rudd, you've proven your lack of economic credentials.

Australian Lending Finance Continues to Contract

Credit contraction continued apace in August as data from the abs showed lending finance across all major catergories fell in August. Housing finance fell -2.1% in August, Commercial finance -7.9% and personal finance -5.2%. From their peaks Housing finance is down -26%, personal finance -18% and Commercial finance a whopping -41%.

The decline in Commercial finance is even more staggering considering that it only peaked in January 08 whereas personal and housing finance peaked in Jun 07. Whilst it has been a precipitous drop, commercial finance has only reverted to levels last seen in October 2005.

However given what has happened in credit markets in September and the first half of October, it is safe to say that lending finance will continue to contract. This is reinforced by the latest performance of contruction index released last week by Aig which showed a marked contraction in the construction sector.



This is the 7th monthly contraction in constructiuon and the weakest reading in the 3 year history of the series. Drilling down by component, activity, employment and new orders all hit new lows.

Also a harbinger of future employment, the ANZ job ad series released today showed year over year declines for total ads for the first time in 6 years.



Taken altogether, recent data points to a sharply slower Australian economy, slowing more rapidly than the RBA would like to see I suspect. Have stock prices fully discounted a recession in Australia? I don't think so, particularly with respect to Australain retailers which are yet to feel the knock on effect to sales of higher unemployment and a contraction in credit.

Paulson Gets Religion

So after the big bronx cheer in response to the TARP program. Paulson and Bernanke are now getting some religion about injecting equity into troubled banks (that would be almost all of the major ones). Although they can claim that the TARP program gave them special priovisions to do just that, it seems to me to be a change of direction or at least a change of emphasis from
the auction process.

Paulson Says Will Buy Bank Equity `Soon as We Can'

Oct. 10 (Bloomberg) -- U.S. Treasury Secretary Henry Paulson said the U.S. will buy equity ``as soon as we can'' in banks and other financial institutions to restore market stability and revive economic growth.

The Treasury is ``working to develop a standardized program that is open to a broad array of financial institutions,'' Paulson said at a press conference after a meeting in Washington of finance ministers and central bankers from Group of Seven countries.

The injection of equity would be aimed at sustaining banks and other financial institutions through the worst credit crisis in seven decades. Paulson declined to give a timetable or details about the purchases, and signaled that markets may be in for turmoil ahead.

Two weeks ago I talked about what I thought was one of the weaknesses of the bailout auction program, namely that it does not instill confidence in the banking system because you don't know who s going to remain standing.

If financial institutions are unsure of who is going to make it, they will continue to be reluctant to lend and thus the credit markets will remain under stress.

So with the rest of the world now scurrying about trying to present a united front at the G20 meeting in Washington, it seems that the partial nationalization of the global banking system is now well and truly on the way.

German Bailout Likely to Be Over $400 Billion

WASHINGTON -- German Chancellor Angela Merkel heads to Paris to present Sunday to her colleagues from the euro zone a financial sector bailout plan for Germany that's expected to be more than half the size of what has been enacted in the U.S.

A person familiar with the situation told Dow Jones Newswires that the government is considering a total bailout plan of €300 billion to €400 billion ($402 billion to $536 billion), which includes state guarantees and the option to get a direct stake in banks. As part of this, the government is mulling recapitalizing financial institutions by injecting €50 billion to €100 billion in capital, the person who declined to be named said.

U.K. Banks to Announce Bailout Details

Some of the U.K.'s largest banks are expected to detail early Monday their participation in a bailout plan that could force the departure of some of their top executives, according to people familiar with the situation.

The announcement, aimed for about 7 a.m., is expected to include details on how much will be raised from the government and private investors.
...
One plan under consideration is to shutter London stock trading to allow investors to digest the news. That plan hasn't been finalized ...

If it were such good news you would think that the stockmarkets might stay open for it, so it must be quite drastic. As mentioned previously, we are in uncharterred territory now, governments around the world are pulling out all the stops.

However, the deleveraging of balance sheets the and deflation of asset prices will continue. No doubt the stockmarket looks set to bounce sharply soon, but a dead cat bounce is all it will be.

With the stockmarkets of the developed world now down more than -40% from their highs, most are expecting that we are near a bottom. I'm hearing daily how this is the second or third worst bear market since WWII. What's to stop it becoming the worst?

Market commentators are still prattling on about how cheap the market is. It's not cheap, it's not expensive now either but it certainly isn't cheap. Forward P/E's are completely useless because you can't have any faith in what the E is. More on stockmarket valuation in the coming days.

Jim Chanos Tells it Like it is

I've mentioned before that sometimes CNBC has some great interviews. Yesterday, legendary investor Jim Chanos co-hosted squawk box on CNBC and gave his views on a number of issues such as short selling and mark to market.

Jim Chanos on short selling.

Expiration of Short Selling Ban


On government intervention. Interesting perspective, the problems may be too big for government to fix.


Government's Involvement in Banks


...on mark to market, such a common sense argument, these phony free market capitalists that praise the virtues of the free market but then want to suspend prices that they don't like are the biggest of big hypocrites.


Market to Market Controversy


On his short position on Macquarie Bank and its flawed business model.


Legendary Short Seller Jim Chanos

Well worth a watch.

Aussie Employment Growth Slows in September

The abs reported today that Australian job market added just 2,200 jobs in September. In addition August was revised downward to a gain of 10,200 (14,500 previously). Remember that the Australian economy needs to create between 15 - 20k jobs per month just to keep up with new entrants into the labour force. Thus the unemployment rate rose to 4.3%.

Probably the most notewothy data point in today's numbers was that -15,400 full time jobs were lost, the most in 2 years, whilst 17,700 part-time jobs were added. It's still too early to see a trend and it should also be noted that these numbers are subject to large revisons. That said, given the sharply deteriorating economic picture we can expect the unemployment rate to rise substantially next year.



Employment is a lagging indicator so I would't expect large consecutive monthly drops in payrolls until next year. However I expect the unemployment rate to reach 6% or higher by the end of 2009 as we enter our first recession in 18 years.

Walgreen - Substantial Deterioration in US Economy

It is becoming increasingly obvious that the US economy basically fell off a cliff in September. Personally I think the US economy was already in recession but it looks beyond any doubt now. However, since the third quarter ended in September, 3Q08 GDP and earnings will only be a prelude to how bad things get in the fourth quarter. Today Walgreen gave a hint of what is to come:

Walgreen drops bid for rival Longs Drug

Walgreen said it was withdrawing its offer since Longs had refused to hold constructive talks. It also noted the "substantial deterioration" in the outlook for the U.S. economy over the past few weeks. The global credit crunch has forced government-led bank bailouts and cast doubts on the strength of consumer spending.

"We do not believe it would be in the best interests of the shareholders, customers, or employees of either Walgreens or Longs to allow this situation to remain unresolved for an extended period of time," Walgreen Chief Executive Jeffrey Rein said in a letter to Longs.

Both the number and value of housing finance commitments excluding refinancings fell -2.0% in August. The number of housing finance commitments excluding refinancings is now back to levels not seen since October 2000.

As mentioned a month ago, this will be known as the Spring selling season that will not be.

We've Seen this Movie Before

Well the RBA certainly didn't waffle on about inflation today, dropping the cash rate 100 bps. The last time the RBA cut the cash rate by 100 bps was April 1992. Naturally the market rallied on the news of a bigger rate cut than expected. However what does it really mean that the RBA has departed from its policy of incremental moves in the cash rate?

Quite simply there are serious problems. You only need to take a look at the statement accompanying today's rate decision.

Conditions in international financial markets took a significant turn for the worse in September. Large-scale financial failures in several major countries were accompanied by serious dislocation in interbank markets and heightened instability in other markets, including sharp falls in share prices. Official actions in a number of countries have been aimed at restoring stability, by adding to short-term liquidity and laying a foundation for longer-term recovery in the health of balance sheets. Nonetheless, financing is likely to be difficult around the world for some time ahead. This is also affecting Australia, albeit by less than in many other countries, given the
relative strength of the local banking system.

translation - the shit has well and truly hit the fan.

Economic activity in the major countries is also weakening, and evidence is accumulating of a significant moderation in growth in Australia’s trading partners in Asia. The expansionary effects of the recent surge in Australia’s terms of trade are still coming through, but some decline in the terms of trade now looks likely over the coming year, with many commodity prices having declined from their peaks.

translation - the decoupling theory was bogus, China will not save us.

The recent deterioration in prospects for global growth, together with much more difficult market conditions even for creditworthy borrowers, now present the risk that demand and output could be significantly weaker than earlier expected. Should that occur, inflation would most likely fall faster than earlier forecast.

translation - forget inflation, we're now just trying to prevent a recession. That's the real message here, with credit markets frozen and the deleveraging process underway across all asset classes, the global economy is essentially grinding to a halt. I've been saying for a while that I think the RBA will go much lower in this cycle on the cash rate than most think and that we will end up under 5%. After today the futures market is now expecting the cash rate to be at 4.5% by March 2009.

During the last cycle the cash rate got as low as 4.25% in the first half of 2002. This cycle is looking much worse and I wouldn't be surprised to see rates end up around 3%. The inflationistas have had it wrong, as predicted months ago, deflation would become the over-riding issue and that is finally becoming clear.

We've Seen this Movie Before

But won't rate cuts save the day? Well lets take a look at what happened in the US. Starting in September last year the Fed cut the federal funds rate 7 times taking it down 325 bps from 5.25% to 2.00%. What was the result? As you can see below, the Fed's medicine simply has not worked.



So be wary of the dead cat bounces that inevitably follow rate cuts in this type of environment - one in which the economy is deteriorating and earnings expectations are being cut.

How Low Will the RBA Go?

As of Friday the SFE cash rate futures contract was pricing in a 96% chance of a 50 bps cut by the RBA at tomorrow's meeting. Back in August I posed the question: Just how far will the RBA go? At the time I said they will go they will go much further than most expect. At that time the futures were pricing in a rate of 6.5% by March 2009.

Just two months later and the futures market as shown above is expecting the RBA to lower the cash rate a full 100 bps lower than that to 5.5%. That's pretty aggressive but I think it's close to the mark. From March the futures are looking flat at 5.5% out until early 2010. I actually think we could get under 5% before the RBA is done in this easing cycle.

Whilst the RBA will still talk about inflation the game has clearly changed. Credit markets are freezing up and the RBA needs to act to prevent a strong slowdown. At least that is what they will be thinking. My view is that at times like these, monetary policy is of little use as we have seen in the US.

As highlighted before, Fed easings did not bring down market rates for mortgages in the US. I think we will see the same result in Australia. Banks will pass on what they can but they won't be able to follow fully every RBA cut with such onerous funding costs.

Households and small businesses will continue to suffer as the Australian economy slows into 2009 and RBA cuts will provide little relief. I haven't called a recession in Australia previously but looking at the data I am fairly confident in calling Australia's first recession since 1991 in 2009. Expect unemployment to rise to 6% or higher by the end of next year.

Data out in the last week showed that the Australian manufacturing industry contracted for the 4th straight month while the services sector contracted for the six straight month. That can't be good news, also I caught a smh article last week that showed small business bankrupticies are on the rise. Combined with higher funding costs that is one reason why I cannot see bank stocks as attractive at current prices.

The market will be hoping for a 50 bps cut tomorrow, anything less will probably be a disappointment. However any rally will be shortlived, the market has a way to go before lower earnings outlooks and recession are priced in.

Jobs Crumble, The Bailout Rally That Never Was

The ADP report proved its uselessness as a proxy for non-farm payrolls as the BLS reported a drop of -159,000 in September. Here are the details in brief:

Construction -35,000
Manufacturing -51,000
Retail -40,000
Service providing -82,000
Professional and Business services -27,000
Education and Health services -25,000
Leisure and Hospitality -17,000
Government +9,000

As you can see the losses were broadly based. The good old Birth/Death adjustment estimated that 42,000 new jobs were created in September. The BLS also made the noted the following:

Hurricane Ike
Hurricane Ike struck the east coast of Texas and portions of coastal Louisiana on September 13th in the midst of the establishment survey reference period. For the weather conditions to have affected payroll employment, people would have had to be off work for the entire pay period and not paid for the time missed. Therefore, it is unlikely the storm had substantial effects on the national employment estimates.

In the household survey, people who miss work for weather-related events are counted as employed whether or not they are paid for the time off.

So the permabulls are left with no excuses this month. Whichever way you slice it, this is a very weak report. It took longer than I expected to see losses in excess of 100k but it has finally arrived and they will continue for some time.

If you can take anything positive away from this report is was that the unemployment rate remained at 6.1%. Also, the BLS today gave its preliminary revision to payroll numbers between March 2007 - March 2008. The final revision will be announced with January's NFP report in February next year.

I've been saying for some time that the revisions would show that the BLS has been overestimating job growth. Whilst the BLS did announce an overstatement of job growth it amounted to a paltry 21,000. That may be changed again before January but at this stage it looks like the revisions will be minimal.


The Bailout Rally that never was

Interesting to watch the market action after the Bailout Bill passed, the market immmediately came off its highs and then traded in a range before falling into the red at the close.

As stated previously, I never thought this bailout would stop the stockmarket from going lower, but I thought there may be at least a rally. However looked at in terms of the market action earlier in the week you could make the case that Friday's sell-off makes sense.

On Monday the US market was already down around -300 points even on the expectation of the bill being passed. Then when it failed it fell a further -500 points. In that light, the market reaction might make sense. That is, that the market doesn't like the bill but that having a bill is better than having no bill at all.

However, again it should be emphasized that investors should pay attention to the credit markets going forward to establish whether the passage of the bailout bill has restored some confidence.

On whether the bailout bill will actually help is unknowable at this point in time. I've outlined recently why I don't think it will do much good but we are in unchartered territory here. Expecting the unexpected. Governments around the world will pull out all the stops, if credit markets don't start to improve. Don't be surprised if we see some kind of co-ordnated rate cut from the Fed in concert with Europe in the next couple of weeks.

However rate cuts, as I said they would when the Fed started cutting rates last year and have shown since, will not help. As mentioned yesterday I think the market now has to come to grips with a fairly nasty recession and a corporate earnings outlook that continues to deteriorate which has not yet been fully factored into stock prices.

Jobless Claims Hit 7 Year High

Whilst a lot of attention is focussed on the passage of bailout mark II, US economic data continues to deteriorate. Initial Jobless Claims hit their highest levels since September 2001 at 497k. The 4 week moving average hit a 6 and half year high at 474k.



Continuing Claims hit a 5 year high 3.59 million. Some 45k of the intial claims are attributed to Hurricane Gustav. Even deducting that number, jobless claims are clearly in recession territory.

Of course everyone will be wating for the House vote on the bailout bill tomorrow, however pay attention to the payroll numbers and ISM services index because once the euphoria of the bailout bill wanes, the focus will return to the economic data and earnings.

My feeling has been for a while that the US stockmarket is in a state of denial with respect to the economy and earnings, that is that it has not fully discounted a recession and its effects on company earnings. When that reality sinks in it will pave the way for new lows.

UK Home Price Plunge Continues

Nationwide today reported that UK home prices fell -12.4% from the previous year and are now down -13.0% from their peak in October 2007.

The average home price has fallen from around 186k - 162k. The problem here is that the declines are showing no signs of slowing. Last month I said declines could top -15% before the year is out. That now looks to be a safe bet.

The ADP employment report for September was released yesterday showing a drop in non-farm private employment of -8,000 following a revised drop of -37,000 in August. However as noted previously, the ADp report has tended to understimate the extent of job losses when compared to the BLS non-farm payroll report.

Also it should be noted the ADP make a couple of qualifications to this months number:

the ADP Report does not reflect two special factors that might have further depressed employment in September. These are the strike of some 27,000 machinists against Boeing, and job losses related to hurricanes that struck the Gulf Coast.

Whilst most people may think the US is driven by huge corporations, the fact is that most people are employed in small companies. Payrolls of small businesses have continued to grow admidst the current economic malaise, however if stresses in credit markets are not alleviated it may crimo small business job growth going forward.

So once again the NFP on Friday is a bit of a lottery. Consensus seems to be looking for a fall of around -90k but don't be surprised if it is up to 100k in either direction of that number and as usual pay attention to the revisions. Also this month the BLS gives its preliminary estimate of it's annual revision that gets released in February. That give an idea of the extent that job losses have been under reported this year.

US Home Prices Continue to Fall

The Case-Shiller Home Price Index released yesterday showed new records in year over year declines. for the month of August. The 10 city composite index showed a -17.5% year over year decline while the 20 city composite showed a -16.3% fall. From their peaks the 10 city composite is off -21.1% whilst the 20 city composite is off -19.5% from the peak. Of the 20 cities surveyed, 14 recorded declines in July. David Blitzer of S&P had this to say:

“There are signs of a slow down in the rate of decline across the metro areas, but no evidence of a bottom” says David M. Blitzer, Chairman of the Index Committee at Standard & Poor’s. “Little positive news can be found when cities like Las Vegas and Phoenix report annual declines as large as -29.9% and -29.3%, respectively, and all 20 cities are still in negative territory on a year-over-year basis. The Sunbelt continues to be the story, with the seven cities that basically represent that area reporting annual declines roughly between 20 and 30%. While some cities did show some marginal improvement over last month’s data, there is still very little evidence of any particular region experiencing an absolute turnaround.”

So the bottom callers will have to wait for another month, however I think they actually see a bottom until well into next year.