Forced Hands

Despite a steady flow of weak economic data, equity markets turned out a strong performance, with last week being the best for the S&P 500 since 1974. But November was still a down month overall, with all three indexes posting losses. 

The S&P 500 finished last week up 12 percent, though it was down 7.4 percent on the month. The Dow Jones Industrial Average gained 9.7 percent over the holiday-shortened week but lost 5.3 percent in November. And the Nasdaq Composite rose 11 percent for the week but shed 10.8 percent for the month. 

Last Tuesday, the Federal Reserve announced plans to buy more than half a trillion dollars of mortgage debt. The Fed will purchase up to $500 billion in mortgage-backed securities and $100 billion in direct debt of Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE), as well as in Federal Home Loan Banks.  

The goal is to encourage lending and to keep rates low, and the plan seems to be having the desired effect. First thing Tuesday morning the average rate on a 30-year fixed-rate mortgage was almost 6.4 percent, but within hours it had fallen to an average of 5.5 percent. That was the biggest one-day drop in rates in seven years. 

That will do little good for distressed homeowners hoping to refinance their way out of trouble, though plunging home values over the past year have left many with loan-to-value ratios too high to qualify for refinancing. Still, it will encourage qualified borrowers to refinance, freeing up more cash for other spending, and should help bring more buyers into the market. 

The other bit of news which helped spur last weeks performance was the bailout of Citigroup (NYSE: C) The irony of the situation is that US Treasury Secretary Henry Paulson sparked the very action he’d hoped to avoid. 

Paulson, having decided to hold off until the new presidential administration takes office, had announced that there would be limited further action to prop up financial institutions. The plan to buy troubled mortgage related assets had also been abandoned. 

Those statements sparked an almost immediate decline in the prices of mortgage-backed securities, to which Citigroup is still highly leveraged, further undermining confidence in the ailing megabank. Given the bank’s other troubles, those words set it squarely on the path to collapse. 

That forced Treasury’s hand, with regulators agreeing to make a further $20 billion equity injection and assume possible losses from a $306 billion pool of troubled assets. 

Paulson should have realized that it doesn’t take much to spook already jittery markets, and saying that the government was taking a step back from announced bailout plans was more than enough to trigger a panic. 

On Tuesday, the Commerce Dept issued revised GDP data for the third quarter, showing a larger decline than previously reported. Initial estimates showed a 0.3 percent decline, but as more data became available it became apparent that consumer spending was slower than initially estimated, falling 3.7 percent rather than 3.1 percent, and exports rose by 3.4 percent rather than 5.9 percent. All told, trade only added 1.07 percent to GDP, rather than an initially estimated 1.13 percent. 

Fourth quarter GDP numbers probably won’t reflect growth either, with durable goods orders plunging 6.2 percent in October and consumers unlikely to make as large of a contribution to GDP as they have in the past. A marginal 2.2 percent uptick in spending over the holidays is unlikely to pick up the slack of a broadly slowing economy. 

There has been some good news, though. The National Retail Federation announced that shoppers spent about $41 billion over the holiday weekend, up about 7.2 percent from last year’s total. Overall holiday retail sales are now forecast to rise 2.2 percent this year, coming in at over $470 billion. 

While that will be the smallest gain in six-years and the pace of sales growth has been slowing since 2006, it does show that Americans are still willing to spend money. And they’re particularly apt to spend at discounters, with almost 55 percent of shoppers going to stores such as Wal-Mart (NYSE: WMT). 

Jobless claims also fell more than expected last week from a 16-year high, with initial claims down to 529,000 from last week’s 543,000, down more than 2.5 percent. Continuing claims also declined, down more than 1.3 percent, to 3.962 million. Current estimates suggest that the economy shed some 300,000 jobs in November, though we’ll know for sure when the nonfarm payrolls report is released Friday. 

Consumer confidence also improved in November, rising to 44.9 from a revised record low of 38.8 in October. Most of those surveyed basically reported that they just couldn’t imagine things getting much worse than they already are, so hopefully those won’t turn out to be famous last words. 

All told, “defense” continues to be the watchword for investors. 

Elliott Gue examined opportunities in the energy patch in the most recent issue of The Energy Letter; despite low expectations for the sector in the midst of a broad economic slowdown, there are some defensive plays there:

At one point last week the S&P 500 was down almost 49 percent year-to-date. That would have put it on pace to be the worst year in the history of the index; the biggest drop for the index to date is a 47.1 percent decline in 1931, right in the teeth of the Great Depression. 

As I’ve noted on a few occasions in this forum, there’s no doubt the US economy is in recession; based on the Index of Leading Economic Indicators, it’s likely the country has been mired in this downturn since late 2007. Moreover, I suspect that we’re currently experiencing the worst downturn for the US economy since the 1970s.  

But no post-war recession in US history has lasted longer than 16 months; in all likelihood, we’ll begin to see signs of economic stabilization and recovery by the end of 2009. Of course, the market typically leads the economy by several months. While timing the turn precisely is next to impossible, it’s likely we’ll see a major low for the market sometime next year.  

For a shorter-term perspective, it also appears that the year-end rally I’ve been looking for over the past few weeks has finally arrived. This rally will disproportionably benefit energy-related shares.  

Energy stocks haven’t been immune to this downturn; as of this writing, the S&P 500 Energy Index is off about 34 percent for the year against a roughly 40 percent decline in the S&P itself. Clearly, most of that decline occurred in the second half of the year.

The decline has been both broad and deep; in fact, there’s only one stock in the S&P Energy Index that’s positive for the year. There have also been some notable losers, such as refiner Tesoro Corp (NYSE: TSO), off more than 81 percent so far this year amid the decline in US demand for gasoline and other refined fuels.  

This vicious bear cycle has left many fundamentally well placed energy stocks trading at valuations unseen since the late 1990s when oil was trading in the teens and natural gas under $2 per million British thermal units.  

It’s clear the market has totally overreacted and has overshot the fundamentals to the downside. There will definitely be a slowdown in spending and activity in the energy patch, but, as I explained in the last issue of The Energy Letter, this isn’t 1998. Oil and gas prices are unlikely to challenge their 2008 highs for at least another year, but severe supply restraints will ultimately mean higher prices.  

In this light, the obvious question is what subsectors and stocks within energy stand to benefit most in the current environment and which are vulnerable to more selling. 

Click here to read more about Elliott’s three investment themes for 2009.