04/29/09   Creative Accounting for Banks

Editor’s Corner

Creative Accounting for Banks

Ron Rowland

Today was Fed Day, but no one seemed particularly nervous before the meeting. The mood can be summarized in four words: “Economy Bad, Stocks Good.” The American economy is shrinking at an alarming rate: Gross Domestic Product fell at a -6.1% annualized rate in the first quarter, which was better than the -6.3% rate of the prior quarter but still worse than analysts had projected. The two quarters combined represent the economy’s worst six-month period since 1957-58.There was a silver lining in the numbers: consumer spending rose +2.2% last quarter. This is not completely surprising, given the near-paralysis that prevailed as the bear market unfolded last fall. Consumer confidence had to bounce back, and it did. Inventory levels fell sharply as companies unloaded their goods at fire-sale prices. The sharp drop in imports and fixed investment indicates businesses are still reducing production capacity as fast as they can. The net result for equities is that consumer-driven stocks are prospering, relatively speaking.

The bank “stress tests” are complete, and today Bloomberg reported that six of the 19 largest banks will be told to find more capital. Where will they find it? Private investors seem unlikely to step up to the plate, at least in the amounts that will be needed. The TARP program only has $100 billion left. Congress is in no mood to approve more bailout funds. The solution, we suspect, will be to deploy creative accounting. By converting preferred stock to common stock, banks will be able to show more capital on their balance sheets even if no one gives them any more cash. Will this solve the underlying problems? Not really, but it will buy a little time.

What will the holders of preferred stock think of this? The U.S. Treasury (that means YOU!) is now one of the largest such investors, so what anyone else thinks doesn’t really matter. The stock will be converted, the Treasury will cease receiving dividends, and the government will suddenly have not only shares, but votes – maybe enough to constitute a controlling interest in some banks. How the Obama administration will use its new power remains to be seen. We continue to think the insolvent banks should have been seized by FDIC and unwound in an orderly manner. If this is a step in that direction, then we will be pleased. The current process has taken far too long and cost way too much.

Treasury yields blew right through the 3% mark following the FOMC announcement, with the ten-year bond ending the session at 3.096%, the highest point since November. Traders who expected the Fed to significantly increase its buying of Treasury and agency securities did not get their wish. This is a curious development. We have believed for several months that the Fed would defend the 3% level, but today they did not. Whether this is because they are out of ammunition or have simply adjusted their goals is unclear. It is a potentially significant development that bears watching.

Finally, we must mention the swine flu. With the number of cases escalating quickly and the first U.S. death reported today, there is ample reason to be cautious. On the other hand, the health authorities appear to be on top of the situation. If the worst happens, the consumer rebound that is encouraging investors could be choked off very quickly. In Mexico City the government has, among many other precautions, ordered all restaurants closed. Just imagine what such measures would mean in the U.S. Reduced travel will also be problematic for many regions and industries. Moody’s released a report this week estimating that a pandemic would reduce global GDP by 0.8%, or $334 billion. With the economy already on soft ground, this is the last thing we need. So remember to wash your hands.

Sectors

As noted above, the consumer consumption rebound has boosted Consumer Discretionary to the top of our rankings, with technology not far behind. This could change quickly if the flu scare begins to cut into leisure travel, shopping, and restaurant traffic. Technology actually looks the best from a technical analysis perspective, with a nice double bottom formed by the November and March lows and January/February resistance now overcome. The three defensive sectors of Utilities, Health Care and Consumer Staples are on the bottom. The biotechnology subsector made some impressive gains this week based on flu speculation. Energy and Industrials are both improving.

Styles

All Style categories had a slight increase in absolute strength while relative rankings remained exactly the same as last week. Mid Caps hold three of the top four spots while the four Large Cap/Mega Cap categories are on the bottom. This is indicative of a growing risk appetite by investors, but it may not last long.

International

Our global rankings became more compressed since last week as the top-ranked regions lost momentum and the lower-ranked markets gained momentum. China pulled back the most but still managed to hang on to the top spot. Other emerging markets also declined. Canada, helped by strength in its currency and an improving Materials sector, had the best improvement in relative ranking, climbing to the #3 spot. 

Note:

The charts above depict both the relative strength and absolute strength of various market sectors, styles, and geographic locations on an intermediate-term basis. Each grouping is sorted (top to bottom) by relative strength. The magnitude of the displayed RSM value is a measure of absolute strength, which is our proprietary method of measuring and reporting the intermediate-term strength as an annualized value.


“Sometimes a headache is all in your head.  Relax.”


Hartman Jule


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