Technology Spike offsets Lending Collapse

One of today’s Ned Davis research articles observes that “Bank Loan Demand is Nonexistent in Q1.” Really? In a high default world with borrowers locked into their existing house because they can’t qualify to buy a move-up home unless they’ve already sold the old one, loan demand is low? With some banks pushing performing loans into the foreclosure category while shopping for ever-lower appraisals in order to create a deficiency and thus creating a mountain of problems for local developers where no molehill existed prior to the bank’s actions, it’s hard for me to believe that the problem is with loan “demand.”

Wells Fargo’s CEO, John Stumpf, was quoted this week saying his bankers are having trouble finding qualified borrowers. “We have a ton of liquidity,” Stumpf observed, but “finding qualified borrowers is impeding lending.” Is it any wonder, after bailing out these banks with government money, that people are appalled that the banking system is now part of the problem?

Bank loan growth declined at a 10% annual rate in Q1, the fifth consecutive quarterly drop. Over the past year, commercial and industrial lending has declined 16%. So after the “shadow banking system” collapsed, leaving only the newly-rescued traditional banks to vie for the remaining customers, banks are now having a tough time finding new customers who need to borrow money. Hard to believe, isn’t it!

In fact, the economy is desperate for the liquidity to which John Stumpf has been clinging. While he pays borrowers nothing, ratchets up lending rates to several points above prime, shrinks his lending base but notches higher profits for doing less work, the U.S. economy gasps for breath.

To be fair to my readers in banking, the point of this rant is that it is not the individual banker’s fault, but it is clearly a systematic banking problem; the fault lies squarely with the banking system. It is not the price of money which has shut down the system. The banks’ cost of money is essentially zero. But regulators have turned off the spigot, fearful that a dehydrated economy may result in bad loans somewhere down the road.

It is not a lack of borrowers, or even qualified borrowers, that is the problem. The problem is that our lenders are tightening standards and transforming performing loans into bankruptcy filings, forcing customers out of the bank portfolio when loan agreements mature knowing full well that borrowers are unable to refinance the debt in this environment.

From an investors point of view, the bottom line is that money is still very “tight.” The Federal Reserve left the punch bowl at the party until everyone on the block was drunk. Finally, the capital markets locked up. The Feds have practically declared that money is FREE, however the strings that are attached to this handout are so stringent that no one (except the U.S. Congress) has been deemed “qualified” to borrow money.

Somebody needs to march over to the Treasury Department and knock some heads together. We’re still letting the inmates run the financial asylum. Freddie Mac and Fannie Mae are tightening lending standards.
Why? No one cares what they think! They’ve proven that they don’t know anything about making credit decisions. Someone needs to tell them that investor-owned condominiums are far preferable to boarded up, empty shells. Having saved his buddies at Goldman Sachs, Treasury Secretary Geitner needs to tell his bankers to roll over existing loans, as long as they are performing.

This economy is slowing down, and the core of the problem is in our financial system. Banks are shrinking the customer base rather than stepping up to fill in the void left by the financial sector collapse.

• Money supply growth is barely positive, signaling difficult times ahead.
• Small business borrowers are hurt the most.
• The National Federation for Independent Businesses “Optimism Index” has been declining, from already appalling low levels.

Given that we need these businesses to start hiring, instead of continuing to lay off nearly 500,000 workers per week, this economical disaster far surpasses the crisis in the Gulf.

But who would grill the Congressmen?

Thankfully, there are some signs of life that have kept us moving forward. Retail sales have rebounded from the 2008/2009 lows. Americans are an optimistic bunch. Surveys about customer spending attitudes are among the statistics that signal a recovery is possible, if not immediately imminent.

The Baltic Dry Index shows that the economic recovery overseas is progressing in spite of us. For similar reasons, I suspect, energy demand continues and the U.S. rig count continues to recover. If the recent ill-advised moratorium on deep water drilling continues, it probably means additional drilling in less bountiful regions, but more drilling activity overall.

Business orders are up as well, and corporate profits have been surprisingly strong, but for the wrong reasons. By laying off workers, companies have enabled a bit of a profit recovery. This is not the sort of recovery that can be maintained, however businesses have clearly exercised tremendous financial discipline in the face of these economic tribulations. As a long-term business strategy, however, it stinks.

The biggest surprise when I updated the May-Investments Leading Economic Indicators this month was the strength in the technology sector. Semiconductor billings for the month of April not only returned to 2007 peak levels, but in April the level spiked up to about 2 ½ times the normal level of billings.

The number was so strong that you have to wonder if it’s a bad data point. Can it continue? If it does, what does it mean for the tech sector? Is the global recovery really driving technology sales that strongly? More ominously, will this level of production result in an inventory build-up if final sales can’t match the additional output?  Electronic retailer, Best Buy, reported disappointing sales this week. It might be an unfortunate time to be rebuilding inventories.

Overall, the economic activity, especially global sales, has been surprisingly strong. While we believe that the markets are incredibly risky right now (which explains why so much of our portfolio sits on the sidelines), we are pleased to see as many signs of economic strength as we do. They are weakening, generally, but this is a great country and a strong business structure. The economy is bending, but not yet broken.

This month’s review of our economic indicator neither gives me the ammunition I need to put a “bear market” fund in the strategy, nor does it give me the confidence to add risk back into the portfolio.

We are in wait and see mode, with a stash of cash on the side.

My recommendation? Go out and buy a new TV so you can watch it all unfold in brilliant color. This economy needs some help.
 
 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Moving More to the Sidelines

With more red flags waiving, we took another step toward the sidelines by selling another position to build up our reserve. We have gradually reduced our equity stake. Of our ten positions, “cash” has now built up to around 30 percent of the portfolio. In addition, we own gold stocks (gold was again up, today, despite a falling stock market). We continue to own two positions in high yield (junk) bonds. Our traditional stock market investments are down to only about 40 percent of the portfolio. As we’ve suggested in previous posts, investors should think of junk bonds as being “equities,” and in that light they are outperforming most other sectors and asset classes in our universe.

In addition to the red flags in our previous post, we have been very concerned about the deteriorating prices in the junk bond arena. If junk bonds are going to have difficulty, then equities are toast. If debtholders are increasingly at risk, then shareholder earnings are going to get slammed.

The “technicals” (equity market charts and squiggles) are also waiving a red flag. Though we don’t heavily rely on technical analysis in building the portfolio, it is hard to ignore that last week’s “rally” looks like the market jumping from “oversold” to “overbought” over the course of a few days, and the subsequent decline moves the major trend to unambiguously lower. It will likely take some good economic news to re-route the trend upward, but good news has been in notoriously short supply in recent weeks.  If good news doesn't bring a trend reversal, then lower valuations ultimately will.

Our “Flexible Beta” approach calls for taking risk when risk-taking is well rewarded. Owning volatile stocks when the market is in rally mode, benefiting from the good side of volatility, helps portfolios grow. Now, however, we believe that upside is limited, the market environment is quite risky, and investors would prefer we proactively reduce our exposure to risk in this market.

In addition to our cash, junk bonds, and investments in gold companies, approximately 40 percent of our appreciation-oriented portfolios own healthcare and pharmaceutical companies, and technology (mostly software and hardware) companies.

We could still add a “bear market” fund to get slightly more defensive, but probably wouldn’t want to do that unless the economic fundamentals clearly and unambiguously get negative. We will update the May-Investments Leading Economic Indicator in a few weeks and may get a clearer sell signal from it, but the last reading was reasonably positive. Whether we’re in a correction (traditionally defined as a market drop of 10% to 20%) or a bear market (a decline of more than 20%) will likely depend on whether the economy does, in fact, double-dip. I think it will. I hope I’m wrong. In either event, this just doesn’t seem like the sort of market where investors ought to be neck deep in volatility.
 
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

Go to Investments main page.