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Tuesday, 6 July 2010

Minyanville's 2010 Mid-Year Review

Todd Harrison

The midpoint of 2010 has arrived and it's time to take stock of what we've seen and where we're going.

The first six months of the new decade have been anything but boring as we've witnessed events that may forever change the face of free-market capitalism. We traversed the depths of despair and the height of hope and the world is on edge as we ready for the back nine.

The following topics were offered as our Ten Themes in early January. Let's recap them and update where we stand.

Theme 1: The Man Behind the Curtain

"The stock market is the world's largest thermometer and the single biggest proxy of our collective financial health. In a finance-based economy laden with debt and mired in derivatives, the only "solution" to the financial crisis was to push risk out on the time continuum with hopes that a legitimate recovery will take root.

Following massive bailouts in the financial, housing, and automotive industries -- not to mention the curious absence of traditional sources of demand -- this redistribution of risk may emerge as a modern day Ponzi scheme."

Update: The musical chairs continue and the global stakes have never been higher; all the while, risk hasn't been destroyed, it simply transferred from one perception to another. (See: The War on Capitalism)

During the first phase of the financial crisis, sovereign lifeguards saved corporate America. The natural question is therefore begged, who is left to save the lifeguards? While the first six months have been a battle, I believe we're in the eye of the storm, a relative calm between the first phase of the financial crisis and the cumulative comeuppance that'll flush -- and perhaps reset -- the system. (See: The Eye of the Financial Storm)

Theme 2: Adapt, Don't Conform

While credit markets suggest further equity strength is not only possible -- it's probable -- the disconnect between stock prices and the underlying economy, or the chasm between perception and reality, continues to widen.

Conventional wisdom dictates that equities will enjoy further upside before facing headwinds later this year, akin almost to the mirror image of 2009. Respect -- but don't defer to -- these choppy waves of optimism. When caught in a riptide, the surest path to survival is to swim parallel to the shore until the dangerous current passes.

Update: Last year, the S&P rallied more than 50 S&P points out of the gate, reversed lower to lose more than 270 points and bottomed in March before embarking on one of the sharpest bear market rallies in history.

This year, the S&P lost 70 points into the beginning of February, reversed 175 points higher and topped in April, establishing the first in a series of lower highs. S&P 1040 remains the level of lore. If that zone breaks, a pure technical lens suggests a measured move to S&P 860, or 18% below current levels. (See: The Market is Speaking. Are you Listening?)

Theme 3: The Tricky Tri-Fecta

In 2007, we previewed the deterioration of the middle class and the friction between the "have's" and "have not's." In 2008, we forecast percolating societal acrimony. Last year, we spoke of the migration towards social unrest and geopolitical conflict.

As this dynamic evolves, real risk remains across the spectrum of social strife. While this assumes many shapes and forms -- populist uprising, the rejection of wealth and an emerging class war -- we should remember that global conflicts have been historically triggered by financial hardship.

Update: While some of those dynamics proved true -- societal acrimony, including a bulls-eye on the back of Goldman Sachs (GS), BP (BP), policymakers, and politicians, plus social unrest stateside and abroad -- others thankfully haven't, at least not yet.

From the Flotilla friction to Iran tensions to saber rattling on the Korean Peninsula to recent reports that factions within Turkey have declared Jihad on Israel, with European social strife on the rise, and a global play for crude mixed in for good measure, sovereign posturing is ever-present and on the rise. Can you feel it?

Theme 4: The State of the States

States across the union -- particularly those that benefited from the housing bubble and the taxable income associated with it -- are now experiencing a massive reversal of those golden years. The decline is so swift that it will take several years for the real estate reset to flush its way through municipal budgets.

Additionally, The US public pension system -- one of our 2009 themes -- faces a higher-than-expected shortfall of $2 trillion that will increase pressure on strained finances and further crimp economic growth, according to the chairman of New Jersey's pension fund, as quoted in the Financial Times.

Update: Illinois has pulled ahead of California in the "State Most Likely to Default" race, although they're neck and neck (27.8% vs. 27.3%). To put things in perspective, both still trail Greece (57%) in the Big Picture Blues but they maintain a healthy lead on the dark horse Spain (21%)

Meanwhile, states continue to slash budgets in a desperate attempt to address yawning deficits. Efforts include rolling back pensions of public employee unions, cutting public services such as police forces and reducing the allocation of educational monies throughout the learning ladder. Many municipal bonds, in my view, may be offering investors a false sense of security.

Theme 5: It's a Walk-Off!

Expect housing foreclosures to increase in scope and size. As courts continue to rule on lending practices -- many are demanding proof that lenders have a legal right to the underlying property and in some cases, they've wiped away mortgage debt and invalidated foreclosure proceedings -- the judicial process will influence how rapidly this dynamic unfolds.

Look for underwater consumers to migrate away from big-ticket obligations, such as homes, and migrate down the debt food chain to credit card obligations, which will eventually lead to higher delinquency rates."

Update: According to a recent study from the University of Chicago, the percentage of foreclosures that were perceived to be strategic was 31 percent in March 2010, compared to 22 percent in March 2009, according to UPI. RealtyTrac reported foreclosure filings on 932,234 properties in the first quarter, a seven percent increase from the previous quarter and a sixteen percent increase from the first quarter of 2009.

In an effort to quell this emerging trend, Fannie Mae (FNM) implemented a new rule that will block homeowners from getting another mortgage for seven years if they strategically default. "Walking away from a mortgage is bad for borrowers and bad for communities," said Terence Edwards, Fannie Mae's executive vice president for credit portfolio management, "our approach is meant to deter the disturbing trend toward strategic defaulting,"

Theme 6: The World According to TARP

While the rush to repay TARP dominated recent headlines, the causal elements of the modern day financial crisis remain very much in place, corporate debt obligations notwithstanding.

Richard Suttmeier of ValueEngine.com estimates the FDIC will have to tap its $500 billion line of credit by the end of this year and 800 banks could close by 2013 as Alt-A mortgages reset and unemployment pulls prime mortgages into default.

Update: There have been 83 bank failures thus far this year, more than double the pace set in 2009.

To add insult to injury, the Government Accountability Office recently reported that the FDIC failed to catch errors totaling $386 million in its estimates of loss-share transactions, according to The Wall Street Journal. Ouch.

Theme 7: Bracket Buster

According to Sports Illustrated, if you invested $25 in a US treasury EE bond on January 1, 2000, it would now be worth $36.10. If you plunked that money in the S&P, it would be worth $22.45. Had you invested in an index fund that tracked the value of professional sports franchises, it would have doubled or tripled.

As the Age of Austerity permeates, look for attendance at sporting events to decline as consumers curtail discretionary spending. This should manifest through regional blackouts and the contraction of major league franchises. While there will be relative winners -- soccer should benefit with the arrival of the 2010 FIFA World Cup -- we'll likely see "status backlash" against high profile professional athletes.

Update: Status backlash indeed; while Tiger Woods and Michael Vick set this trend in motion, Ben Roethlisberger, Lawrence Taylor and Jamarcus Russell, for this self-loathing Raider fan, proved yet again that money can buy many things but public opinion isn't for sale. (See: The Short Sale of American Icons)

Structurally, we've yet to see contraction on the professional level but the realignment of college conferences -- and the raid on the Big 12 -- is likely the first step towards major restructuring. Overall annual revenue for college athletics programs is estimated at about $10.6 billion, according to the NCAA. Look for institutions of higher learning -- and perhaps the student-athletes -- to jockey for a bigger slice of that pie.

Theme 8: European Disunion

The European Union is committed to the regional and economic integration of 27 member states, with sixteen countries sharing a common currency. That was a fine idea when it was first founded but the economic fallout of the financial crisis will put loyalties to the test.

Look for the Union to adopt more stringent guidelines in the coming year, including but not limited to distancing itself from the weaker links such as Greece and Ireland. Sovereign defaults, as a whole, should jockey for mind-share. This could conceivably spark a rally in the US Dollar, which could have ominous implications for the crowded carry trade.

Update: In February, Minyanville offered the point of recognition would arrive, that our debt issues are cumulative, and when that happened, the contagion would no longer be contained. We warned of the unintended consequences of European austerity initiatives, including but not limited to social unrest and the abatement of risk appetites. (See: A Five-Step Guide to Contagion)

That played through in spades, with Greece flirting with default before the EU unleashed a trillion dollar emergency loan package. While that's a massive amount of money, the conditional elements of contagion remain very much in place. The dollar, for its part, is up more than 10% year-to-date. (See: Will the EU Emergency Fund Work?)

Theme 9: Hot Pockets

Over the last ten years, the cumulative imbalances in the marketplace compressed volatility in an array of asset classes until it unwound with great vengeance and furious anger. That caused a multitude of bubbles and busts throughout the financial spectrum, including technology, housing, China, and crude oil.

While "fat tail" (outlier) events are by definition rare -- and we've experienced more than our fair share the last few years -- the confluence of technology and artificial market influences will manifest with sharp spates of market volatility surrounded by stretches of quietude.

Update: Two words: Flash Crash. (See: The 1000-Point Plunge)

Theme 10: The Rising

Minyanville professor Peter Atwater, CEO of Financial Insyghts and the former Treasurer of Bank One, offers that the battle between the faced vs. the faceless -- populist reforms at the expense of big business -- will emerge as a prevalent theme this year. As he aptly reminds us, "Those to whom much has been given, much is expected." Indeed, the lifestyles of the rich vs. a struggle to exist will continue in 2010.

Update: Who would have thought that six short months later, financial services, health care, and energy would all be considered evil? From "fat cat" bankers to tough talk on the beltway -- the White House vowed to keep a "boot on the neck of British Petroleum" -- it's hard not to notice the forward path of the wrath

The leaders coming out of a crisis are rarely the same as those who enter it. Through that lens, there is both cause for concern and fertile ground for new beginnings. I will again offer that we live in one of the most dynamic junctures in world history, a "changing of the guard" so to speak, and in order to get through it, we needed to go through it. (See: Opportunity Lies on the Other Side of the Crisis)

This too shall pass, and when it does, there will be profound opportunities for those who proactively prepare and steadfastly persevere.

Position in S&P

Nothing contained in this article is intended as a solicitation for business of any kind or for investment in the firm.

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