pre market Friday Sept 30--worrying signs in Europe

German Retail Sales slid 2.9% in the month of August compared to July, and compared to the estimate of .5%.  Signs of slowdown are all over Germany which has been the engine of Europe.

Luxury Good retailers have escaped the worst of the market downturn, but appear to be weakening.  Stocks of European luxury goods makers, like Burberry, have declined in early European trading today on worries about a slowdown in China.  Few have noticed the rapidly rising exposure of these companies to China.  Burberry, 33% of Revenues, and Tiffany, 38% of Revenues, are examples.  

The ECB, which aims to keep annual gains in consumer prices just below 2 percent, said earlier this month that inflation may average 2.6 percent this year and 1.7 percent in 2012. Economic growth may weaken to 1.3 percent next year from 1.6 percent in 2011, it said.  (Bloomberg)

European stocks are down across the Board this morning, signaling a US decline at the opening.

Obama's re-election challenge

Most people are aware that President Obama's approval rating has fallen dramatically in the last 12 mos and is now below 50%.  While he still wins most of the hypothetical races against his Republican challengers, this is largely due to the differences in name recognition between an incumbent President and challengers that are not household names at this point in the election cycle.  Obama's election chances would be slim if the election were held today.  Of course, the election is over a year in the future and "a week is a long time in politics" much less a year.

President Obama has lost ground since 2008 in critical voter demographic groups such as Independent , Jewish voters, Young and, even black Americans.    With unemployment over 9% and hitting blue-collar and youth employment particularly hard, the President is vulnerable in many states.  Many of his core constituents, especially young, Jewish and Black Americans, are less enthusiastic about Obama today than in 2008.  Even a 5% decline in turnout among these key Democratic demographic groups, and others, such as union members, would be a serious problem for the President. 

In analyzing his 2012 election prospects we need to start with an analysis of 2008.  Obama's election victory is widely misunderstood.  Since the end of WWII, only once has a party held the Presidency for 3 consecutive elections: Reagan/Bush in 1980-88.  In fact since 1900, it has happened only 3 additional times.  It is the nature of American politics that once a President serves 2 terms, the public is likely to want a change (remember, "Hope & Change"). The Outsider can always run on a platform of "its time for a change".  President Obama was particularly adept at using this theme, but don't forget that Bill Clinton was also. 

Despite the advantage of running in an environment in which the Republican incumbent was extraordinarily unpopular, the 2008 election was much closer than understood due to the vagaries of the electoral college.  Obama won the election with 365 electoral votes, or 95 more than the 270 necessary to win.  But consider that the election in the following states in 2008 was very close. These states might easily swing to the Republican nominee in 2012 especially if the economy continues to be weak and unemployment high. (The electoral votes shown below represent the votes allocated in the 2012 election not the 2008 election due to the changes resulting from the 2010 census.)

NC 15 Electoral votes, O margin of victory 14,000 votes,
CO 9 Electoral votes, O margin of victory 200,000 (4%)
FL  29 Electoral votes, O margin of victory 200,000 votes (1.25%)
NM 5 Electoral votes, O margin of victory 120,000 votes (7%)
Ohio 18 Electoral votes, O margin of victory 200,000  (2%)
VA 13 Electoral votes, O margin of victory 220,000 (3%)
IN 11 Electoral votes, O margin of victory 24,000 votes (less than 1%)
=total 100 Electoral votes, O margin of victory !,000,000 (less than 1.0% of national votes)

Close McCain Wins were MO 10 Electoral Votes, and MT 3 Electoral votes. 

These are likely to be the battleground states in the 2012 election, along with PA (20 Electoral votes).  If you eliminate NM, VA, IN, MT and CO as traditionally Red States, the battleground states have a familiar ring:  OH, FL, PA, MO for a total of 77 Electoral votes in these key "Super" swing states.  In the latest polls from Real Clear Politics, Obama leads Romney by 1 or 2 percentage points (within the margin of error) in OH, FL and PA. 

If we look at 2010 mid term elections, several Blue states won by Obama in 2008 are vulnerable to a moderate Republican nominee, such as Wis (Rep Gov), IL (Rep Senator), MN (Rep Gov), NH (not happy with President Obama), IA, Nev and even Mich. Very few McCain states, other than MO, are vulnerable.  If any of these Blue states turn Red, it would cushion a Dem victory in PA.   

From this standpoint, it is not surprising that President Obama is focusing on shoring up his standing about his base.  If he has further slippage, he will suffer the same fate as Mondale, or Carter.

German Parliament backs expansion of rescue fund

The lower house of parliament passed the measure with 523 votes in favor and 85 against, granting the fund powers to buy bonds in secondary markets, enable bank recapitalizations and offer precautionary credit lines. It raises Germany’s guarantees to 211 billion euros ($287 billion) from 123 billion euros.
source--Bloomberg

Both main German parties supported the move, strengthening Ch. Merkel's political position.

NBA strike: is anyone listening

Last week, the NBA announced that a portion of the pre-season games would be cancelled due to the strike/lockout.  It barely made the fine print of the local Sports sections.  Compare this to the daily hysteria over the lack of offseason training camps of NFL teams and then the delay in the start of offical training.  The NBA has a real problem.  Michael Jordan, Magic, and Bird lifted the NBA to first class entertainment status.  Since then, even with LeBron and Kobe, the league is suffering in terms of its popularity and image.  The fall sports calendar is crowded with the Baseball playoffs and World Series, college football and the NFL.  Is anyone paying attention to the NBA before January?  Basically this is a joint screwup between the players and the owners, just like the NFL.  For the sake of the internecine battle to divide Billions of $$$ (during a recession), they are losing the hearts and minds of their core fans.  There are too many alternatives.  You guys should get real--and fast!!

Another Day of Greek tragedy (continued)

Secretary Geithner, in his interview last week with Jim Cramer, said that it was impossible that a European bank (outside of Greece) would be allowed to fail.  This is manifestly true.  The French Government is not going to let any French bank fail, nor is the German Gov't, etc.  This is easy since there is a precedent--TARP.  Although the media keeps talking about the $400 B of outstanding Greek bonds, the rescue package for European banks only needs to replenish lost capital, a small fraction of the total loss, say 10-20%.  This would allow the banks to refinance over a longer period outside of the current panic-y climate.  I very much doubt there is much exposure to Greek debt within the US banking system. 

I think there is greater recognition this week that the EU is going to have to craft a definitive plan and not just keep kicking the can down the road.  However, with 17 countries, there is always someone who is out of the loop or who wants to grandstand.  In the end, the Germans will push through what they want, even if it is a little squeaky. 

today's stock market action (+150 pts)

The US stock market has rallied for three consecutive sessions, with today's gain over 150 pts on the Dow Jones average.  Is the fear over? No, not yet, as shown by the sharp sell off in the closing hour in which the DJ gain fell by over 150 pts.  While this is not a repeat of 2008, the market is still weak from a fundamental perspective.

Since July 21, the DJ has fallen from over 12,724 into a trading range of 11,613 on the high side on August 31 and 10,713 (August 11, but 10,733 on Sept 22--5 days ago).  But volatility has been phenomenal with six declines of over 500 points in a two month period.  This compares to 3 declines of the same magnitude in the prior 10 months of the year. 

Two issues have dominated investor thinking over the last two months, i.e., since July 21.  One is the concern about a meltdown of the EU as a result of fiscal crises in Greece, Portugal, Ireland, Italy and Spain.  But clearly investor concern has been focused on Greece, and the feat that a contagion could spread more broadly through Europe.  As I have advocated in prior posts, this is a solvable problem.  In the meantime, the drip, drip, drip of the crisis has exacerbated market sentiment.  A solution to the European fiscal crisis would reduce volatility dramatically.  However, even a definitive solution would not fuel the US equity markets above the current trading range. 

The second issue is the slowdown in economic growth, both in the US but more broadly in Europe and Asia.  This is a medium term issue; hopefully only a year or two years in duration.  All economic data continues to point to a slowdown at best in economic growth.  Many analysts think that things will deteriorate further into a "double dip".  While anything is possible, there is no data supporting that view.  For instance, weekly US initial unemployment claims continue to hover over 400,000.  While this is clearly not good, and indicative of the economic slowdown since it is not improving, it is not climbing.

The biggest drag on the US economy relates to housing.  This is the most worrisome data point since it is slowly worsening in some respects, such a declining housing starts, with continuing high foreclosure rates and lack of financing creating a drag on that market.  This is one of the two most important markets for the US, both psychologically, and economically.  The other major market is the equity market, again both psychologically and financially.  Many Americans have their 401k invested in equities, and declines in the equity markets have an immediate impact on the American psyche, even of ordinary people. 

While the equity markets have stayed within a narrow range, two important developments have occurred in the last several days.  First, Gold, the biggest indicator of fear, has declined sharply in value-- against all predictions.  Second, the US$ has strengthened against the Euro and other currencies such as the GB£ and CDN$.  These are positive signs for the future.

For the present, I would advise caution.  The economic facts have not changed, and until they do, there is no fuel for a long term rally, just bargain hunting.  This lack of underlying positives from an economic standpoint leaves the equity market vulnerable to any new negative whisper or rumor about Greece or the EU.  Also, we are approaching earnings season in less than a month.  It is likely that some companies will be reporting reductions in guidance due to slower GDP growth.  While this should be already discounted in prices, I would be cautious and believe it when I see it.  

Normally, I would say this is a time to sell into rallies and buy on dips.  But in many cases, the "highs" are lower, and the dips are just as severe.  For instance, companies like CAT, ETN,  JCI, MAN, are all over sold but still suffering lower highs and lower lows.  In the long term, these are all good companies at bargain basement price levels, but they could go lower.  Again, this is a time for caution.  Not fear, just caution.  With a long enough time horizon, I would recommend buying some of the leading brand names which have seen their dividend yields rise to a level that is above 10 year treasuries.  The dividends are relatively safe, and there is a good potential for price appreciation for the medium term.  But I would still not fully commit to equities at the moment.  It is still time for caution until the economic horizon looks a little brighter.

The European Crisis

The world's financial markets are currently swaying to and fro on a daily basis in reaction to every twitch and whisper of key Euro leaders with respect to the European fiscal crisis, in the PIGS, but also Italy and even Belgium. What is the issue and solution?

The issue is that Greece is heavily indebted beyond its ability to repay its government bonds. But a default would create ripples throughout Europe, especially among European banks that hold Greek debt. The write off of Greek debt that would be required would jeopardize their capital ratios. But more broadly, it would create a market perception of likely default by other heavily indebted nations, first Portugal, and then Ireland. These are all small countries on the periphery of Europe, both economically and geographically. But if this perception were to spread (called "contagion") to larger heavily indebted countries, especially Spain and Italy, then the economic disruption, and the threat to the Global banking system, not just European banks, would be far greater.

What should be done? Many commentators casually suggest that this is the end of the EU. I think this is a superficial and foolish analysis. The heart of the EU is the Franco-German alliance, and neither of these countries is going to abandon the EU very easily. Why? Because it is in their respective economic and financial interest for the EU to survive. There is a deep psychological thread in the German psyche dating back to its creation in 1870 of being isolated in Europe between enemies (Russia and France). The EU has created the longest period of peace in Europe for centuries. As a result, the Germans will work to preserve the EU unless it becomes prohibitively expensive for them. Of course, the French want to be in the EU because it strengthens their trade relations with the member states, and protects them from more competitive markets in Asia, and even the US. Add in the historic trading partners of each, The Netherlands, Belgium and Luxembourg, and this core of Europe accounts for over 50% of EU GDP.

Similarly, this core group is going to fight to retain the Euro which has brought great economic and financial advantages to them as exporting countries with heavy manufacturing bases. The Euro has become one of the leading currencies in the world and a counterweight to the US$. This was impossible when each country had a separate currency. Again, France and Germany, see the Euro as very much in their respective interests, for slightly different reasons, but will fight for its survival.

What is the solution to the Crisis? There are three problems that have to be addressed, and they are interlinked.
1. Ring fence Greece so that a default is either impossible, or the Euro banks are protected via a Euro-TARP with respect to capital ratios. This has to be definite and certain. If Greece defaults, then simultaneously, the EU will have to announce step 2 to halt any further deterioration in credit in the Eurozone. Currently there is too much uncertainty about the likelihood of a default and the likelihood of a ECB rescue plan. These risks have to be taken off the table.
2. Some method of funding the other crises in Europe, including Portugal, and Ireland. The chance of default of these countries MUST BE RULED OUT ONCE AND FOR ALL. The message to the financial markets must be: IT STOPS HERE. For example, all financing after a Greek default could be made through Eurobonds and not national bonds.
3. Some method of controlling future deficits within the EU. For instance, a council of finance ministers that monitors sovereign budgets and uses its persuasive power to insure that future deficits are within a range of reason.