What You Can Take to the Bank Jan 20, 2012

Here’s the news of the week – and how we see it here at McAlvany Wealth Management:

1. What You Can Take to the Bank: Banks and financials significantly impact S&P500 earnings.  They contribute more than any other segment – 18.23%.  Right now, we are getting mixed signals from the banks as they report year-end numbers.  Some beat expectations (set low enough for any results to show well), while others didn’t.  All were busy crafting earnings.

Selling assets was a way to improve capital ratios and generate more income.  Some continued the practice of shifting loan loss reserves out of the rainy day category into the current income category. Even this didn’t goose the numbers enough for JP Morgan (adding 11 cents to earnings from the re-categorization), which still missed market expectations.

January stock performance in the financials has been exceptionally positive off the lows.  It was an ugly year in 2011 for this segment, as it was for emerging markets, and these appear to be rallying on a perceived value basis. Our conclusion thus far is that accounting creativity is getting stretched thin, and if business does not pick up considerably in 2012, stock prices could get ugly by year end.  The deterioration in earnings has continued throughout 2011, along with the need for accounting gimmicks to “meet” or “beat” the expected EPS number.  However, the practice is now long in the tooth.

Citigroup perfectly captures what we are saying.  Citi included $8.2 billion in their earnings for 2011 that came from a release from loan loss reserves.  In addition, Citi booked a $1.8 billion “paper” gain on its own debt.  Combined, these two moves accounted for 88% of its full year profit, keeping the company in the black.  Is that legitimate to do?  Well, it’s legal.  Our point is simply that those games come to an end at a certain point, and reality will set in.

European banks are moving toward the Basel III agreements requirement of safer balance sheets (reduced leverage and improved asset quality).  Rather than raise liquidity by issuing new shares, many are selling assets to positively impact their capital ratios. Write-downs of European sovereign paper continue at a steady pace and have been a drag on 2011 results.  2012 might be a better year, barring a sovereign default (the probability of which is high, but nothing is certain with political interests in play).  If we have a surprise event in Europe, you can bet that the Federal Reserve will be dropping dollars from the chopper.

We note year-end results for the financials because, judging by the jump in stock prices here in the first few weeks, you might think broader recovery is nigh – led by this sector.  We wish such were the case.  Instead, we would remind you of the extreme counterparty exposure in the international banking community, tied to the overlapping bets in the derivative market.   Frailty exists in the banking market like the thin smile of a schizophrenic.  What you see is not likely to be what you get.  We would advise you take very little to the bank – for either deposits or equity investment.  As and when accounting gimmicks go away and banks are earning an honest dollar (theoretically possible) versus a crafted buck, we might then see financials leading the way, as they often have – but a fresh credit cycle seems a long way off.

2. Bad News is Good News: A common characteristic of the manias back in the ’90s was that bad news was good news since it warranted more stimuli from the Fed.  Good news was treated as good news, of course, rendering everything that hit the tape as bullish.  Today, it seems we have a whiff of this phenomenon at work.  Corporate earnings on the whole seem to be disappointing, with revenue “misses” galore while US economic data is mixed, at best, but with what we see as a downward bias.

News from Europe has it that bond markets have stabilized, removing the shine from the dollar for the moment.  But “the bear” has remained in hibernation as stocks continued to rally into the close of this week.  So far, the Dow has added in excess of 2000 points from the lows set last October – enticed by visions of “QE” dancing in the foreground – and why not, when no expense has been spared for Europe? (See the box scores.)

US economic data was mixed.  The CPI and PPI showed inflation to be nonexistent, while jobs (a lagging indicator, in our opinion) picked up through a smart decline in jobless claims.  On the flip side, and perhaps more important, housing data in December began to founder.  Starts and existing homes sales disappointed, while permits were flat.  Record low mortgage rates combined with healthy mortgage applications (refi) are apparently not helping at this point.

TIC data improved somewhat in the month of November.  These figures measure foreign creditor purchases of our dollar and related securities.  The data can be volatile from month to month, but when viewed over a longer period of time – over the last six months, in this case – inflows to support our currency are steadily declining at a time when they have historically increased (in times of uncertainty).  China became a net seller of US dollar securities (perhaps in favor of gold, judging by the record inflows of the metal to Hong Kong).  The countries comprising the eurozone have also been predominantly net dollar sellers since the beginning of 2007.  As the outflows grow, one nation at a time, so goes the dollar….

Another positive for gold – physical demand is growing nicely to start the year.  The US mint has sold 106,000 ounces in gold coin so far in January.  This compares to 65,500 ounces in December.  This demand has remained steady, in contrast to the more volatile paper contract markets. The latter were primarily responsible for the sharp declines in the metals at year-end.

Kinross Gold reported delays and increased costs in planned production related to the Tasiast mine.  The stock declined nearly 18% on the week.  Although this is a setback, the company still holds value in the industry in the long run and has drawn the attention of possible suitors.

Best regards,

David McAlvany
President and CEO

David Burgess
VP Investment Management