Bulls Make Money, Bears Make Money, and Hogs Get Slaughtered 5-13-2009

May 13, 2009 Edition, Volume III

Inside Signature Update

• Beware of Extremes
• Stress Tests May Have Revealed, But Offer A Lesson In Finance
• It’s not that easy – this is still a risky market

Beware of Extremes

In the midst of any meaningful crisis, certain ideas come to the forefront to be aired once again for a public looking for some measure of reason. Tuesday morning’s Deseret News, one of Salt Lake City’s major daily news outlets, featured an article detailing how various white supremacist groups have used the election of President Obama to stir up angry citizens and enact violence on minority populations throughout the region. It wasn’t two months ago that several otherwise knowledgeable colleagues forwarded articles to me regarding the ‘Amero’ - a novelty coin purported to be a newly minted currency for the Americas. And just this morning I was offered the newest and most certain income opportunity of a lifetime, ‘not really a multi-level company’, but replete with structure, compensation model, and marketing hype of popular network marketing and network marketers. I could go on.

For some reason, in our society many of us choose to gravitate to extremes when what once worked doesn’t appear to be working now. We love to have someone else to blame or to associate ourselves with some ideology or business concept that will change our world, if not everyone elses. Too many of us want what we want or choose to see things through deeply colored glasses without regard for reality, common sense, or reason.

In economics we look for outcomes that create efficiency or provide optimization. Blame is irrelevant, an outcome that only advantages one party is considered a market failure, and the idiom ‘there ain’t no such thing as a free lunch’ has its own acronym – TANSTAAFL; okay… economists can’t make anything simple. My paternal grandfather, after whom I’m named, offered one piece of advice that I’ll carry for the rest of my life; I can still hear him say, ‘Don’t believe anything you read, and only half of what you see’, often to be followed by ‘Think son, think’. He was right. The volume and import of decisions made based on assumption, void of objective observation, or without taking into account potentially difficult outcomes would astound us if we stopped to really consider.

Once every twenty years or so, respected social or political leaders will herald the end of capitalism or decry the evils of a free-market economy. But in the end, there is no end; and our economy responds to thrive once again. From my perspective, the only real value in extremes is to help test operating principals. What appears to make sense often falls apart when taken to extremes; oh … and the thrill that comes just below redline of an aggressively tuned small block – that’s an extreme worth pursuing!

Stress Tests May Have Revealed, But Offer a Lesson in Finance

The recent buzz over stress testing of the nation’s nineteen largest banks has done more to stress the public and the markets than anything else. It brought no revelations regarding the strength of the banking system, but may have created a good opportunity to teach the public a lesson concerning capitalization in the corporate world.

The stress tests sought to determine how well these banks might fare in the event of further economic declines - something along the magnitude of the declines we’ve already experienced. Even though Ben Bernanke, while testifying before the US House and Senate, recently explained that further declines were highly unlikely and that the US banking establishment is stronger today than it was six and nine months ago, with most firms posting meaningful profits. Many consumers have expected that any bank found needing additional equity capital as a result of the stress test must be a bank at the brink of insolvency. This is not the case; there is a substantial difference between the potential need for further equity capital in the event of market declines and the need for liquidity to meet business demands today or tomorrow.

Most suppose that capital equates to resources available for spending and investment; and in many cases it means just that. But with regards to the type of capital being measured in the bank stress testing by the US Treasury, capital equates to equity. Specifically, shareholder equity, Tier 1 Capital, and that’s a different thing altogether. Capital, as represented by shareholder equity, refers to the net value of a company that may be attributed to shareholders and against which there is no corresponding liability. It is reported in a very particular manner on a corporation’s balance sheet and is often referred to as Tier 1 Capital or Tier 1 Equity.

Common stock is equity – it represents the value of the company in respect to shareholders. Though both common and preferred shares are offered for the purpose of raising capital for a company and signal ownership in that company, preferred shares are more likely to be stated as liabilities in that preferred stock holders are not only entitled to a specified dividend, which must be paid, but they stand in line before common shareholders in the event of a bankruptcy. Preferred shareholders are owed something by the company; common stock holders own the company and are owed nothing. Though bonds issued by a corporation will create capital with which a corporation may choose to purchase assets or fund operations, they also represent a debt that must be repaid to the bondholder; they are the opposite of equity.

So how does a corporation create capital that can be expressed as equity? By issuing common stock and creating profits; sometimes by selling assets and realizing gains.

Let’s take a look at Bank of America and how they are responding to the need to come up with $33.9 billion in equity capital in order to meet the Treasury and Federal Reserve’s newly imposed guidelines.

Bank of America will issue $14 - $16 billion in new shares of common stock, which stock offering has already received a warm reception by the markets. They will also convert $10 - $12 billion of TARP funds into common stock; while this doesn’t raise new capital, per se, it does transfer $10 - $12 billion in debt to equity as the federal government becomes a meaningful equity shareholder in the bank. Finally, the bank is selling China Construction Bank for another $8 billion. These actions will raise between $32 - $36 billion and the Treasury’s equity capital requirement will have been met. Bank of America CEO, Ken Lewis, further notes that the company generated $2.8 billion in profit during the 1^st Quarter 2009 and expects to generate billions more in the coming calendar quarters, and he has made it clear that he intends to use those excess profits to repay TARP loans, thereby reducing the company’s debt load and improving the capitalization ratio.

Lewis isn’t alone in using the stress test as an opportunity to transition debt into equity and to then reduce his company’s dependence on the government. As a number of banks have faced the need to raise equity capital to meet stress test requirements and have stated their plans to get rid of TARP debt in the process, others have chosen to take advantage of the same opportunity.

It was only a few months ago that loud voices could be heard clamoring for the nationalization of the banking industry, and many in the current federal executive and legislative branches wanted President Obama to use the financial crisis to bring banks under federal control. Thankfully, reason prevailed and the domestic banking industry is beginning to thrive once again.

It’s not that easy – this is still a risky market

Federal Reserve Chairman Ben Bernanke was cited Tuesday morning as saying that the risk of deflation is decreasing and commented on the building strength of the US economy. Few would argue that the economy is booming, but we have clearly turned some important corners. Consumer spending, though posting decreases for both March and April, has shown marked improvement from the dangerously low levels of 2008 – absent consumer’s drawing on home equity. Real Estate sales in most markets have increased by more than the seasonally adjusted rates often seen in the late spring or early summer. Granted, home prices have yet to improve in most markets, but buyers are in the market and stretching their muscles. Unemployment has edged towards the 9% level, but the rate of increase in job losses has slowed and we appear to be very near the point at which unemployment will begin to decrease soon - in some markets this has already begun. Inventory levels are now so low that increased consumer spending has an almost immediate effect on the labor markets, and some analysts expect an employment boom on the horizon for the US and China; hard to believe, but a welcome thought nonetheless.

Much of this appears to signal a quick and certain economic recovery, but it’s not that easy. There are still areas of significant risk in these markets. Residential real estate foreclosures are once again on the rise, commercial real estate is showing signs of weakness, the auto manufacturers are far from out of danger, and the enormous budget deficits we’ve created will offer significant inflation pressure if not moderated. The Federal Reserve and Treasury have assured us all that they are prepared to deal with these pressures, just as they assured us that the sub-prime credit debacle of 2006-2007 would have little impact on the overall markets.

The US dollar has weakened sufficiently that oil is now nearing the $60 per barrel range. Traders expect economic improvements in the US and China will stimulate demand, and prices at the pump have begun their climb to well over $2 per gallon. Natural gas is also on the rise and will likely climb well past $5. We learned very recently that these increases in necessary fuel sources ripple through the economy and pressure households and businesses alike.

Gold has rallied to over $900 an ounce, but this appears to strictly be the byproduct of the weakened dollar. Copper, one of the more dependable commodity indicators of economic activity has increased in recent trading from a 52-week low of $1.30 to $2.09 per ounce.

The domestic equities market has enjoyed eight weeks of solid gains and speculation abounds as to whether or not this is a Bull Market, a Bear Market Rally, a secular Bull in a cyclical Bear, etc. CNBC’s Larry Kudlow and Mark Haines, in daily interviews with various market insiders, hear virtually every argument to be made on the issue; but when offering their own opinion, admit that it just doesn’t matter at this point and remind us that Bulls make money, Bears make money, and Hogs get slaughtered – there’s a lesson in there for all of us.

Signature Update is offered by Richard Haskell, Managing Director of Signature Wealth Management and CEO of Signature Management, LLC