Tuesday, November 18, 2008

R.I.P. Good Times?

Wall Street rebounded today in another turbulent session, as investors rushed back into the market after the Standard & Poor's 500 index tested a 2003 low:

The market, which had been down four of the past five sessions, has been volatile amid worries about how long a recession might be. That's driven many retail investors to the sidelines, while big institutional traders like hedge funds keep major stock indexes vacillating.

That was the case on Tuesday as stocks rallied in the final hour of trading. At least some of the buying was because fund managers whose portfolios are tied to the S&P 500 had to find a replacement for Anheuser-Busch Cos. The brewer was officially removed from trading at the market's close after its takeover by Belgium's InBev SA was completed.

Investors also used the market's big drop earlier in the session as chance to scoop up undervalued stocks. There was some encouragement about corporate earnings after Hewlett-Packard Co. said fourth quarter and 2009 results will sail past Wall Street expectations.

But still underpinning the market were concerns that the economy has fallen into a recession that could be the worst downturn in more than two decades. A disappointing reading on wholesale prices and the housing market only confirmed this.

The Labor Department reported that wholesale prices plunged a record amount in October, a drop that could indicate a rising threat of deflation.

Meanwhile, homebuilders' confidence in a near-term housing recovery sank to a new all-time low this month, according to the National Association of Home Builders/Wells Fargo housing market index. NAHB Chairman Sandy Dunn said the report "shows that we are in a crisis situation."

Analysts said the market continues to search for a much-elusive bottom, and could yet again retest lows. The major indexes continued to attempt some sort of recovery from October's devastating losses.

"We're going to need more strength from here for a period of time to develop a convincing story that the market has bottomed," said Alan Gayle, senior investment strategist at RidgeWorth Investments.

There are other things going on in the background. VIX options expire tomorrow and there is lots of premium left, that traders see a significant probability that markets could open down sharply tomorrow on additional bad news (for a video explanation, see Adam Warner's, So Long Nov. VIX).

The settlement of VIX options might explain all this crazy volatility we have been seeing lately. However, the Wall Street Greek made this interesting observation:

Historically, significant market corrections have occurred during periods of great volatility. This leaves your Wall Street insider worried, because I see a dangerous catalyst on the horizon. I realize the market is already off sharply, in fact exactly 40% from its October 9, 2007 peak on the Dow. Also, between now and Christmas, the government will likely authorize aid to the auto sector (estimated $25 to $50 billion); the Fed will likely reduce rates by another 50 basis points; and tax loss selling will be exchanged for replacement purchases of other beaten down shares. These are all positive catalysts for stocks.

On the down side, economic data should continue to supply bad news. A Russian fiscal crisis looms as well, because the price of oil is below the point where Russia and also Iran need it to be to make money. Between now and Christmas, we would not expect to see the catalyst that concerns us, for the simple reason that the global importance of uninterrupted holiday shopping cannot be overstated.

However, sometime soon, and most likely after January 1st but before Barack Obama is sworn in as President of the United States, I have concern that Israel, with or without the assistance of the U.S., might bomb Iran. The nightmare that follows could be chaos unlike the world has seen since World War II, or at least that possibility looms. So while the market may rally Santa Claus style, it could be short-lived and offer false profit.

I tend to agree that we are due for a solid rally. Toro's Running of the Bulls Market Blog had some great graphs from Bill Cara juxtaposing the 1974 and 1987 market collapses with the current one. As shown in the charts above, this augurs well for the stocks going into the New Year.

Moreover, as I have repeatedly argued, pension funds, mutual funds and hedge funds need some sort of rally to materialize to make up for those severe losses they suffered in September and October. So don't be surprised if we do rally going into year-end, led mostly by energy stocks.

That is the good news. Now, the bad news. Unlike the Wall Street Greek, I am less concerned about Israel bombing Iran than the internal bombs exploding in the financial system (ie. endogenous risks, not exogenous risks!).

Today, we learned that the CMBS market is beginning to show fissures as two of the largest loans in recent commercial mortgage bonds, including one for two Westin hotels, appear near default, underscoring the stress that has upended the $700 billion market and sending yields soaring:

Commercial real estate securities have been shattered this year amid expectations weak underwriting standards of recent years and slowing economic growth will increase defaults from historically low rates. Many loans were made on expectations that cash flows from office rents, retail stores and hotels would continue to rise.

Tight credit conditions have also eliminated refinancing opportunities.

"In this market, if loans are transferred for imminent default, I would expect more of those will default," said Mary MacNeill, an analyst at Fitch Ratings in New York. "Lack of liquidity and overall declining values" of the properties make that more likely, she said.

A $125.2 million commercial mortgage for the Promenade Shops at Dos Lagos -- a retail center located in California's home foreclosure-ridden Riverside-San Bernardino-Ontario metropolitan area -- this month was also transferred to a special servicer, which focuses on troubled loans, according to Credit Suisse.

The Promenade loan is 10.8 percent of one of the JPMorgan CMBS containing part of the Westin loan.

Traders ramped up bearish bets on Tuesday, pushing yield spread premiums to record levels on CMBX-5 indexes, a series of derivatives containing the most recent CMBS issues. The spread on the top, "AAA" rated CMBX-5 rose about 120 basis points on Tuesday to a record 540 basis points, more than five times the level in May, according to a dealer.

Delinquencies on loans in CMBS could rise about a quarter percentage point to 0.75 percent in the fourth quarter from the third quarter as the credit crunch saps liquidity, or the money available for lending, Fitch said on Monday. That compares with rates above 20 percent for the riskiest residential mortgages.

The percentage of commercial real estate loans sent to special servicers has jumped to nearly 1 percent of deals by mid-2008 from less than 0.5 percent a year earlier, according to JPMorgan data. The data suggest more defaults, and possibly interest shortfalls for investors as fees to special servicers mount, JPMorgan said in a slide presentation this week.

Servicers can keep loans out of default by extending loans or through other borrower negotiations, but that depends on whether they see value in the property, Fitch's MacNeill said.
Environmental Data Resources (EDR) trend data published today confirms that the outlook for commercial real estate is bleak:

EDR's ScoreKeeper State of the Market Report reported a 17% decline in the number of environmental site assessments conducted across the U.S. in the third quarter of 2008 compared to the same period last year.

Because Phase I environmental site assessments (ESAs) are a standard pre-closing activity for many commercial real estate transactions, this data is a leading indicator of the overall health of the commercial real estate market in areas across the country.

The impact of the downturn in commercial real estate transactions on Phase I ESA volume is tempered in part by the fact that site assessments are also conducted for foreclosures, which are increasing as loan defaults rise.
And before you get ready to party like it's 1999, I got some more bad news for you for 2009.

About a month ago, Sequoia Capital, one of the best VC funds in the world, had a 56 slide presentation of doom called "R.I.P. Good Times" (click here to view the presentation).

When I was working at a large pension fund helping the VP Private Equity set up his business unit, I managed to arrange a meeting between that VP, the president of the fund and Doug Leone, a senior partner at Sequoia.

So what? Who is Sequoia Capital? You might not have heard of them but this is the fund of all funds, printing money as they funded companies like Cisco, Apple, Oracle and a ton more.

You would think that Mr. Leone would salivate at the opportunity of meeting the VP, Private Equity and president of a large Canadian pension fund. But he wasn't interested in the least.

"Listen kid, you're persistent, but we are not interested in meeting government pension funds. Our last $500 million fund was oversubscribed by $4.5 billion and we are fighting over whether to cut allocations to Harvard or Yale."

At this point, I just quietly replied: "Mr. Leone, we are just looking to get some views on venture cap."

"Ok, I will tell you our views in a nutshell. Most pension funds do not have a clue about venture cap so they end up losing their shirt. In venture capital, if you are not invested with the top funds, don't bother investing at all."

He reiterated that same message to my president and vice-president when he met them.

As I scrolled through that presentation above, I stopped at an email on slide 52 where someone asked Michael Moritz and Doug Leone about current market conditions.

In their reply, they dusted off an old email from April 2000 and resent it, stressing that companies need to 1) raise funding as soon as possible; 2) aggressively examine and pursue M&A opportunities; 3) be realisitic on valuations and 4) in the down draft, the VC community will start exercising their leverage.

Very sound advice. They then end the presentation with a simple message: Get Real or Go Home.

I hope public pension funds and corporate plans absorb this advice because if they do not get real soon, millions of people will be going home or worse still, homeless.

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