Monday Morning

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Last week, the markets continued its volatile decline.  The DJIA and the S&P 500 indices tested their October 10 lows, Thursday, but rebounded, to close up 552.59 and 58.99, respectively, for the day.  For the week, however,  they were both down following an about face by Treasury Secretary Hank Paulsen on buying toxic mortgages from troubled banks; deteriorating economic and housing data; and the impending showdown between congress and the auto industry.  At stake, another taxpayer bailout for the challenged carmakers versus bankruptcy for General Motors and the loss, of perhaps, millions of auto and auto-related jobs.

For income investors, fear is currently keeping treasury yields low prices high.  The public is piling into municipal bonds as the last safe haven for cash, too.  In 2009, headwinds will appear that will disturb all fixed income markets.  The US, next year, will issue two trillion dollars in new treasury obligations.  Markets will not be able to absorb this much debt without raising yields.  The Chinese domestic stimulus package of 500 billion dollars will inhibit one of our largest buyers of treasuries.  The collapse in oil prices will take petrodollars away from Middle Eastern oil producing countries that deposit those dollars into US banks and purchased treasuries.  At some point, our issuance of debt will also weaken the dollar.

I wish that there were more positive news items to report.

This morning in Barron’s, Jacqueline Doherty wrote a story on which defensive stocks to own in a severe recession.  Colgate Palmolive (CL), Clorox (CLX), Procter & Gamble (PG), and Kimberly-Clark (KMB), sell products people use in good times and bad.  I know stock investors are salivating current prices and yields, but I believe the stocks will go much lower over the next six months.  Still, we can improve on her strategy by using long-term options (LEAPS).  Look at the chart below:

Stocks versus LEAPS

Stocks	Friday Closing Price	500 Shares	LEAP Call Jan. 2010 Strike Price	Friday Closing Ask Price	5 Contacts	Difference
Colgate Palmolive	62.06	$31,030	WTPAM - 65	8.80	$4,400
Clorox	59.30	$29,650	WUTAL - 60	10.00	$5,000
Procter & Gamble	63.11	$31,555	WPGAM - 65	8.70	$4,350
Kimberly-Clark	57.37	$28,685	WKLAL- 60	7.10	$3,550
Total Cost		$120,920			$17,300	$103,620

 

By using LEAPS, you are risking $17,300 to control two thousand shares of high quality stocks until January 2010.  In addition, the difference of $103,620 is available to invest in deeply discounted closed-end equity income funds such as Nuveen’s non-leveraged JPZ, JSN, JLA, or JPG, yielding 13.84%, 15.56%, 16.07%, and 14.01%, respectively, as of Friday’s price.

The Dow futures are lower this morning, and its Monday.  Buckle up; this morning could be a bumpy ride in the markets.

Macro Trends Spell Doom for Banks and Their Profits

The rise and fall of debt is continuing without abatement. In the U.K., bankers refuse to write new mortgages. U.S. consumers are tapped out. Businesses are finding their cost of borrowing prohibitively expensive to continue certain lines of business, i.e. consumer auto leasing at Chrysler Financial, all the while asset-backed portfolio valuation is tenuous and overvalued, at best.

After 30 years, two generations of consumers and businesses relying on hyper-credit to generate an enviable lifestyle for the middle and working class, trumpeting painless capitalism – all winners, no losers, and endless increasing corporate profits, that bubble has burst.

This perspective should be viewed from two positions, first, historical and secondly, relative to global living standards. The U.S. is the largest economic engine in the world. Household debt has tripled in the last 25 years.

In 2008, the inability to service debt is akin to the credit depression of the 1830's. Europe in the 1820's became mesmerized with transcontinental travel by train and flooded America with credit. The term transcontinental attracted money then the way dot.com attracted funds in the 1990's. A land rush, sponsored by the government, coincided with this period. Between servicing the railroad bonds debt and the leveraged real estate debt, remaining disposable income left little domestic spending for growth. Expansion became contraction. The great depression of the 1930's was more a function of technological advances increasing output, relative to consumption, thereby collapsing demand.

Our savings rate is the lowest in the developed world. It has dropped below 1 percent. Yet, we also buy more things than anyone else using maximum credit. Credit cards, home equity loans, secured and unsecured personal loans, loans against retirement accounts; any loan that continues the buy now, pay later, merry-go-round, until recently, without question and interruption, was marketed and consumed. Ironically, brokerage firms' margin accounts, the villain of the stock market crash of 1929, is our most conservative usage of debt, today.

Currently, home equity, which rose on cheap capital and hid stagnate wages this decade, has reversed while its cost has risen. Homes that were once ATM machines only three years ago are being repossessed in the tens of thousands each month by banks. Equity in an individual's home once was his or her greatest investment. Servicing debt on growing negative equity is becoming harder to do, both financially and philosophically, for underwater consumers. Prosperity from the mirage of supply-side economics has vanished for the masses.

Looking back, in the 1980's, deregulation through supply-side economics redefined risk and value. In the 1990's, heretofore, imprudent levels of credit, a peace dividend from the end of the cold war in the 1990's, and the integration of cheap global labor, provided the west a temporary and significant head start re-imagining comfort and convenience for the working and middle class.

Looking forward, new banking regulations, regardless of the outcome of the November elections, will restrict the future of credit and leverage for commercial and investment banks. The defense industry peace dividend was consumed years ago by the endless war on terror. Wages in developing countries are rising, and so is the cost of limited natural resources. And, the true bill on previous runaway debt created and consumed in a lax atmosphere is past due.

We are heading into a global recession. The IMF projects at least $1 trillion in total write downs. Total U.S. residential single family home real estate value is expected to fall another 5 per cent to 20 per cent; easily another $1 trillion in value. Bankers are considering reducing outstanding credit lines in the next two years by at least $2 trillion dollars.

Yes, banks and their profits are in dire straits.

Tuesday Market Action

Bears returned to the market today, our domestic credit crisis grizzly and the recent unexpected guest Russian bear, pushing pricing lower by the closing bell. The Dow finished down 139.88 or 1.19 per cent, the S & P was off 15.73 or 1.21 per cent, and NASDAQ lost 9.34 or .38 per cent.

Fresh downgrades by analysts on major banks stopped the stock market recent rally. The fighting between Russia and Georgia added anxiety to a market that was beginning to find its sea legs after a volatile June and July.

Moscow stated that it would withdraw its troops after days of intense warring, now that Georgian troops have pulled back from their Abkhazia and South Ossetia provinces. Movement by Russian troops leaving the area has not been detected, to date.

Oil and Gold both closed lower extending their unwinding from recent highs. The September contract for West Texas Intermediate ended its trading session $113.01 a barrel, off its low of $112.31. Gold dropped intraday to $802.90, then rallied to finish at $814.50.

The June trade deficit, reported by the Bureau of Economic Analysis, shrank to $56.6B from an expected $61.5B. This is one more clue suggesting that our economy is slowing down this quarter.

With state tax receipts down this year and in all likelihood going lower, states are considering a digital download tax. Retail e-commerce sales are expected to hit $130 billion this year.

The dollar traded mixed against major currencies.