The subprime/CDO mess has hit the US banking system and markets hard.  We deserve it.  We caused it.  In my opinion, on a relative scale - this problem has been more devastating elsewhere.  Consider the German banks - not the big ones most Americans have heard of like DB - but the regional second-tier banks like IKB, BayernLB and WestLB (and don’t forget Sachsen).  Click here.  Except for bailouts rescues by the German government - all these entities would likely have totally failed.  They still might.  My biggest concern is the health of the German fiscal situation, continued monetary policy impacts and their economy.   On a longer term basis, it is impossible to avoid the structural problems that this amount of intervention will have.  I cannot help but wonder how much capacity is left to cover for these losses.  What is really sickening to me, as an American, is that the German taxpayer is bearing the brunt of this mess.  A mess that was caused by US politicians, financiers and lying “homeborrowers.”  In the US, we just freeze rates for the offenders and suspend foreclosures.  In the US, we send taxpayers a check so they can spend their way through the subprime-induced hardships.  Meanwhile, in Germany taxpayers are taking the hit.

I am not looking forward to the Valentines (Bernanke, Paulson, Cox) tomorrow. Not because I dislike or disrespect any of these three. Actually, I get disheartened watching Congress interrogating anyone. Hopefully, the Senate Banking Committee will be less ridiculous than some of the clowns that ran the steroid circus today, but I cannot put anything past them. Previous Congressional Q&A for Bernanke has not been inspiring. In fact, I seriously wonder what understanding of capitalism, economics and markets some of these people have. If it doesn’t go well, I think Bernanke, Paulson, and Cox will turn into Heartbreak Kids for stocks.

While researching for my preceding post, I came across this great example of how ridiculous the process of measuring and identifying recessions has been over the years. Please read this one entitled “Did Recession Begin in 2000?” Hopefully it troubles you that this article was written in 2004, about 3 years after the recession supposedly began. Way too much credibility is given to economists and anyone else who claims to be able to identify the beginning of a recession or predict when it will end. The best of the best at NBER found it tough enough to do even with a few years of hindsight. The current recession is no different. And if you don’t believe that we are in a recession right now, don’t worry…I am sure you won’t mind if I tell you for sure 3 years from now.

In the second quarter of 2000, many investors were still convinced that the retreat from record highs was temporary. In fact, I remember the usual claim that “after such a big run, it’s only normal to have a pullback.” To many permabulls, April, May and June of 2000 were providing “great buying opportunities.” Sound familiar?

As the economy slowed from about 5% GDP growth in Q2-2000 to less than 2% in the 4th Quarter 2000, suddenly everyone seemed to agree it was time for the Fed to cut rates. There were denials about the probability of a recession and more importantly, when the rate cuts came in I remember hearing about an economic and market recovery that was 6-9 months away. At first, it was expected that the summer of 2001 would be the time for a rebound. It didn’t happen, so suddenly the date got pushed back again and again. Investors kept believing the good old days were always just 6-9 months away. Sound familiar?

If not, here is a great reflection from an excerpt of a 2002 speech by William Poole, President of the St. Louis Fed (click here for full text)

The Fed has room to act, but does it have the knowledge to act? It has been well documented that forecasters, including Fed forecasters, have great difficulty predicting the turning points of business cycles, or even recognizing them soon after they occur. Hence the best that can be reasonably expected is that the FOMC would be able to initiate policy actions several months in advance of cycle turning points, or to adjust policy on the basis of accumulating evidence to help reduce the magnitude of a recession once one is observed as having started.

The most recent cycle is a useful example of exactly this process. The business cycle peak is dated in March 2001. The FOMC started lowering the intended funds rate at the beginning of January 2001, a two-month lead on the cycle turning point. At the previous meeting in December, the FOMC had indicated its concern that the economy might be weakening with this language in its policy statement:

“Against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the Committee consequently believes that the risks are weighted mainly toward conditions that may generate economic weakness in the foreseeable future.”

As will be clear if you read the FOMC’s published minutes over the course of last year, the Committee did not foresee the extent of the downturn. But over the course of the year the Committee did sense the continuing weakness and did respond readily to incoming information suggesting that the expected revival of activity was not occurring.

My interpretation of these events is that in 2000, especially toward the end of the year, the bond market sensed that the economy was weakening. The decline in the nominal yield was almost entirely due to a decline in the real yield. We know that to be the case from observing the behavior of indexed Treasury yields, which provide a direct market reading on the real rate of interest. This observation fits in with my earlier comment that the real rate of interest is related to the rate of economic growth.

Still, the market would not have bid down long rates in the absence of an anticipation that short rates, controlled by the Fed, would be falling. In fact, the market expected that the Fed would respond to the weakening economy; long rates came down during 2000 in anticipation of the action that the FOMC subsequently took. The timing of the Fed’s January 2001 rate cut took the market by surprise, but not the fact of the cut. Moreover, once the rate cuts began, the odds on a revival of economic activity rose, which I believe is why bond rates did not fall as the FOMC cut the intended funds rate repeatedly over the course of the year.

All during the course of 2001, up to the time of the terrorist attacks in September, current data came in generally weaker than expected but forecasters kept expecting that the economic recovery was just around the corner. The Fed responded to the weaker data by cutting the funds rate aggressively, and the bond market responded to those cuts and the expectation of economic revival by holding long rates in a relatively narrow range.

Moreover, there were a number of instances in which data releases suggested that the economy might see a revival fairly quickly, and these tended to keep long rates from following the declines in the federal funds rate. Let me cite just one example of many. On Friday, April 27, 2001, the 10-year Treasury bond yield jumped by 14 basis points, a large change for a single day. The market was responding to the release of the GDP estimate for the first quarter, which showed growth at a 2 percent annual rate. That was an increase from the 1 percent rate in the fourth quarter, and double the increase that the market had been expecting. In reporting on market activity, the Wall Street Journal said that, “many already had been wagering that the Fed’s aggressive monetary easing this year would spur growth and spark a rebound in stocks before long. … Now, analysts say, the Treasurys market could face a painful period in which yields continue to ratchet higher, the Fed eases less and people pull money out of bonds in anticipation of a continued resurgence in stock prices.” (April 30, 2001, p. C15)

The view that economic revival was just around the corner remained into early September. However, when the terrorist attacks occurred, the outlook suddenly looked much worse. The Fed cut the intended funds rate sharply further, and bond rates fell to what turned out to be their lows for the year as forecasters revised down their employment and output forecasts.

Fun trip down memory lane - isn’t it?

One of the things that bugs me the most about the similarities of economist and investor behavior between now and then is the proclamations by many “clairvoyants” of when we will see a recovery. Once again, I keep hearing things like “economic weakness will last for another 6 months and then we will come out of it.” Evidence? Do they have any evidence? What is this based upon? These morons weren’t predicting a recession 6 months ago, how the hell am I supposed to believe they can now predict when it will end or how severe it will be!?! These are all rhetorical questions. NO ONE knows.

During the decline, there’s been a lot of portfolio management advice about “going defensive” through purchases of stocks that have held up well in the past during economic weakness or recessions. This is a common piece of “wisdom” that you can hear coming from really successful fund managers and investors. Good for them. You will not hear that from me because I don’t do it. If in my normal course of analysis whether we are in a boom or bust period of the cycle a stock looks like it is likely to head higher - I would be inclined to consider buying it. REGARDLESS OF ITS INDUSTRY. REGARDLESS OF HOW THE INDUSTRY HAS DONE DURING PAST PERIODS OF ECONOMIC WEAKNESS.

I really don’t like the idea that you should let the assessment of the economy by economists (or anyone else for that matter) tell you what sectors you should buy. Please remember how pathetic economists are at predicting the onset, severity or duration of a recession. It scares the hell out of me to think that investors buy stocks for themselves this way. It makes me feel even worse that professionals would do this for others.

I look at each stock on its own merits. Obviously, if demand is picking up for a company considered to be defensive and this “going defensive” strategy is the source of that demand, I am affected by it. As for looking at specific stocks because they are considered “defensive”, I just think that is dangerous.

Big Pharma used to be considered great “defensive stocks.” I look at MRK and most of the other names in this space and I wonder how someone would have felt buying them as recently as December when the economy already appeared to be slowing. What about other traditional defensive sectors / industries like utilities, food, beverages, tobacco, oil, etc. I know the market’s been tough lately(at least since December) on fears of the economy slowing (among other things), but pull up a bunch of stocks considered to be defensive and analyze how well they did as a group relative to the index. With a few exceptions, I see very few that did better than companies that are not defensive.

Defenders of the defensive strategy will probably tell me that it’s too early to judge. That’s an interesting point - the whole timing thing. So when do you get in? Typically for an investment like this to work out, you need to buy before everyone else does it. When was/is that? I remember hearing this advice back then or if it wasn’t at the end of December, then when is it? Is it now? Is it next month? Since few (none) of us can say for certain when a slowdown begins or ends until it’s obvious that it happened a few quarters ago, when exactly do you go defensive?

To me, this whole concept is problematic. Yet, I realize that experts in the industry and the media are fascinated by it. They are treated as if it’s so easy… so brilliant… so foolproof. Unfortunately, it’s none of those things. If you find a great stock that you think is undervalued and your technical analysis is encouraging and it happens to be considered defensive - good for you. If you find all those things and it isn’t “defensive” - good for you.

I am struggling to decide what is more bogus, the retail sales data or the US Congress hearing on steroids in baseball.

I am not going to parse the retail data like Barry does so well. From time to time (if not frequently), the government spits out an economic report that is so inconsistent with previous months or other sources for the same issue that I just don’t waste my time trying to analyze how they mess up so dramatically. Given that I have a bullish bias right now, my critics can just skip the usual comment about how I am always so negative and refuse to accept positive data. First off, this data is not positive. At best it is not negative. With certainty, it is useless. It’s always fun to disagree with the financial entertainment networks who have been hyping this report as some sign that the consumer is not struggling. And of course, suggesting that it’s a good reason to buy stocks. I don’t disagree that there are reasons to be optimistic about individual stocks - this retail sales data is not one of them.

As for the inquisition of Roger Clemens, what a freaking joke! I don’t enjoy baseball. I don’t worship sports celebrities. More importantly, I don’t enjoy watching members of Congress wasting time and resources on subjects like this. I’d prefer that they investigate how the government can spit out so many bogus economic reports.

Two weeks ago when the stock market went up almost 4.9%, I heard a lot of cocky bulls.  It seems that every time we get a rally, the same morons are smiling and cheering and breathing a sigh of relief that they were right about the rally all along.  Nevermind that they were wrong for weeks and months or that they became wrong one week later.  I see a lot of cocky behavior again today.  1% up days are commonplace.  So are 1% down days.   This morning’s rally is nothing to be cocky about.  Volume on the upside has been pathetic for weeks.  Subtract out volume from short covering and it’s even worse.

Does today’s rally impress you?

Do the supposed reasons for today’s rally impress you?

I look at the headlines today and am more than disappointed. A bailout rescue from Buffett for municipal bond insurance. A bailout rescue from Treasury to freeze foreclosures on defaulting home mortages. GM’s record loss of $38.7 billion. GM offering to buy out more union workers. The Fed “successfully” did another TAF for $30 billion yesterday to pump liquidity to struggling banks.

If this is the kind of thing investors get excited about we are in real trouble. As for me, I am unimpressed. I’d much rather see marginal up days on minimal news. I don’t get to pick the reasons stocks go up or down, but I do get to evaluate whether they are sustainable or just temporary spin and hype. I was hoping for a continuation of yesterday’s positive action and instead, I got more bailouts. There’s an old theory about markets heading higher despite bad news. The way all today’s headlines have been presented - this is good news. So if we are now heading higher on good news I guess I missed the days and days of bad news that pushed us higher.

Warren Buffett is a genius. We all know that. Today’s disclosure about his willingness to take over the municipal bond commitments from monolines like MBIA, Ambac et al is a great deal. FOR HIM! FOR MUNICIPAL BOND ISSUERS! FOR MUNICIPAL BOND INVESTORS. But NOT FOR MBIA OR AMBAC! If this happens, I believe those companies are burnt toast. They were toast before… this would be burnt toast.

Here’s how I look at it: in finance, we discount cash flows and much of a firm’s value comes from a terminal value calculation based on the assumptions of a going concern that provides cash flows for indefinite periods into the future. If Buffett takes the cash flows from MBIA and Ambac that we have reason to believe are profitable, reliable and ongoing (the muni bond insurance premiums) and leaves them with only premiums from derivative products that will hopefully expire and not be replaced with new CDO insurance, it’s over. In that case, the firm value is simply the net present value of a declining stream of premiums less the net value of capital over estimated payouts. Most likely, the result of that calculation is less than zero. I just don’t see a future for these companies under the Buffett scenario. Note that I don’t see much of a future for these companies under any scenario.

GREAT FOR WARREN! He looks more and more like JP when he does stuff like this. He’s the only one that can and I much prefer this solution to the alternatives, especially if it avoids government interfering with capital markets. I do have to wonder about the monopoly power that Berkshire would have in the muni bond insurance industry until others show up to compete. But other than that, this looks like a great solution for everything but the CDO aspect which is still very ominous and unquantified. We’ll have to see how it plays out and whether anyone from MBIA or Ambac just voluntarily hands over their obligations and their future cash flows.

Too many people talk about making a buy list. It’s rare that you hear anyone saying to prepare a list of stocks you’d like to sell. My opinion has always been that you should keep two lists with you at all times. The volatility of these markets should have taught all of us that lesson but I am not getting the feeling that is the case. It’s way too easy to complain about how bad things are and then sound optimistic by advising people to put a buy list together. I am telling you that it’s time to figure out what you want to buy. AND I am telling you that it’s precisely the time to figure out what to sell out of your portfolio.

In my opinion, one of the key components of effective portfolio management comes from learning how to maintain both lists. Doing that successfully is a reflection of flexibility, keeping an open mind, managing trading biases, being able to admit when you are wrong and a bunch of other psychological traits that will contribute to gains and help avoiding losses. It is critical that you do not get hung up spending all your time thinking about what to buy. It should not be the case that you only look to sell something to raise cash for a new position you want to add. And when you sell something proactively, you should already have a few names that have already been fully analyzed to fit with your investment criteria.

I am frequently told that I am too bearish and other times I am told that I am too neutral on the market. Rarely do I ever get criticism when I am bullish like I have been 53% of the weeks since HEDGEfolios showed up on the Internet in January 2005. Funny how perception of my negativity is not proven by the facts. The point is that I always have both lists working on a giant scale. Right now - about 50% of all the approximately 3500 stocks I cover have UP signals - the other half is DOWN. One of the biggest reasons that HEDGEfolios has consistently outperformed comes from always balancing my willingness and readiness to sell with my willingness and readiness to buy. How about you?  How much time do you spend analyzing stocks you might want to buy?  How much time do you spend analyzing what to sell and why you want to sell?  Please make 2 lists.