Axios Capital’s Review/Preview

Friday October 22, 2010

The Period in Review

The big news this period is that the housing/foreclosure mess is once again front and center and making every effort to
derail what little stability we have. PIMCO, Blackrock, and the NY Fed (among others) are suing Bank of America over
allegations that Countrywide did not properly service mortgage loans. They are seeking to force Bank of America to
repurchase soured mortgages packaged into $47 billion in bonds by Countrywide. The NY Fed in 2008 acquired
mortgage debt through the rescues of Bear Stearns and American International Group Inc.

As more news comes out about this mortgage debacle, it remains clear to me that the four major banks – BofA,
JPMorgan, Wells Fargo, and Citigroup all have massive amounts of liabilities regarding this potential fraud that could
measure into the trillions. Here’s an example from Wells Fargo. WFC currently has a $1.8T mortgage servicing portfolio.
Of that, 8% ($144B) is non-current – meaning they aren’t collecting any money on this loan. Another $24.5B is
subprime. $79.2B is 2005 or earlier vintage. From their conference call this week, they stated that Pick a Pay mortgage
foreclosures were accelerating (These are the pay option ARM loans I’ve mentioned so much in the past. Basically, they
are under reserved big time. How big time? They only have $1.3B in loss reserves compared to exposure (which could
hit in the next 12 – 24 months) of close to $300B. Don’t believe me – look at the chart below from their earning release
and do the math yourself.
Remember, that is just a fraction of their outstanding servicing portfolio and there are more out there with an economy
that’s going through a standing eight count right now. Here’s a bit from David Rosenberg that gives more details:

“There is a wave of new supply that is going to be hitting the market in the future because only 20% of
the 1.2 million homes in the foreclosure process are on the market (as per a great column on this in
yesterday’s Investor’s Business Daily — RealtyTrac data cited here). Of the 900,000 homes that banks
have repossessed, just 30% are for sale at the current time. So tack 600,000 units onto the ‘shadow
inventory’ and we are talking about a total backlog of up to 3.5 million (tack that on to the 4 million
homes that are officially listed for sale right now).

And, the foreclosure process has picked up pace of late — 282,000 homes entered it in August compared
with 225,800 in June, and a growing share are now in “prime” mortgages. While there is glee whenever
the home sales numbers come in above expectations, keep in mind how dysfunctional the market is —
24% of all homes sold in Q2 were foreclosed units (according to RealtyTrac) and in turn, these units are
selling at a 26% discount to the rest of the sales universe and hence the renewed downward pressure on
house prices of late. It will very likely take between 3 to 5 years to clean up the excess supply in the
housing market and until it reaches some balance, expect more deflation — perhaps exceeding 10%
before the bottom is reached.”

Let’s do a little cocktail napkin math. 3.5M new foreclosures multiplied by an average home price of $165,000 equals
$557.5B. That’s just new foreclosures and that number alone is $40B more than all of their market caps combined,
which is quite more than enough to sink all four major US banks.

I can feel your eyes glossing over at those numbers, so here’s Art Cashin to add a little reality to that $557.5B number:

“Numbers like billions and trillions tend to numb the mind. They are too large to grasp in any “real”
sense. Thirty years ago an older member of the NYSE (there were some then) gave me a graphic and
memorable (at least for me) example. “Young man,” he said, “would you like a million dollars?” “I sure
would, sir!”, I replied anxiously. “Then just put aside $500 every week for the next 40 years.” I have never
forgotten that a million dollars is enough to pay you $500 per week for 40 years (and that’s without
benefit of interest). To get a billion dollars you would have to set aside $500,000 dollars per week for 40
years. And a…trillion that would require $500 million every week for 40 years. Even with these examples,
the enormity is difficult to grasp.”

To be fair, he was talking about QE, but it certainly applies in this case as well.

This isn’t lost on investors either.

1. Granted this newest piece of information just hit, but we see that NYSE short interest remained virtually
unchanged for the month of September, starting the month at 14.36 billion shares and ending the month at
14.35 billion.

2. Pension funds are also cutting their exposure to equities

3. UBS research reports that "long only funds increased their net selling to levels last seen in October 2008." The
week outflows by long-only funds were $783 million in the week ended October 1.

4. For a staggering 24th week in a row they pulled money from domestic equity funds, although it was the smallest
withdrawal to date.
Short Interest Levels:

Domestic Equity Flows:

With all of these factors going against the equities markets, and the inverse indicator of average investors showing their
smallest withdrawal in this series, one wonders if we are marking a top here. All week the market seemed to want to go
down and they often traded down for the majority of several days only to find its way out of the hole to close positive.
Many see that as a positive, but I’m not so sure. That doesn’t mean we are headed south, but my radar is up and so are
my hedges.

On the other side of the pond, Europe’s issues continue. The rising Euro has Germany chomping on a bite block. But, as
you can see from the numbers below, the Eurozone economy is slowing down without seeing coincident drops in
inflation measures.

In the UK (September vs. August Data):

 Retail Sales +0.5% vs. 1.0%
 House Price Balance -36% vs. -32%
  Final CPI 3.1% vs. 3.1%
 Consumer Confidence 53 vs. 62
 Jobless Claims 5.3 vs. 3.8
 Retail Sales -0.2% vs. -0.7% (worse than expected)

In Germany:
 CPI 1.3% vs. 1.3% YoY
 Wholesale Price Index 0.1% vs. 1.6%
 GDP forecast revision 2010 to 3.5% from1.5%
 ZEW Survey Economic Sentiment -7.2 vs. -4.3
 PPI 0.3% vs. 0.0%
 Oct PMI Services 56.6 vs. 54.9 in Sept

Eurozone:
 August Industrial Production 1.0% vs. 0.0% in July
 September CPI 1.8% (in line) vs. 1.8% August
 October Services PMI 53.2 vs. 53.6 in September

This week saw a couple of negative actions in the bond market. First, the Spanish had what some pessimists would
describe as a failed debt auction (at best it was unimpressive) with a bid to cover ratio of just 1.44 vs. 2.57 in the last
auction. Second, bond spreads from Irish, Portuguese, and Greek10 year bonds widened compared to benchmark Bunds
to + 6.49%, +6.80%, and +5.90% respectively.

Let’s not forget that the French and Greeks are still rioting (it’s not protesting when they are beating up cops).

Looking to Asia, China raised interest rates this week in their first direct attempt to try to stem what is becoming
rampant speculation in various parts of their economy. Their economy seems to be slowing with Q3 GDP down to 9.6%
from 10.3% YoY. Industrial production was also down slightly to 13.3% vs. 13.9% YoY. (More stats here) Also, per the
WSJ, car sales from the leading global manufacturers continue to slow, “...leaving it unclear whether a slowdown in the
country's auto sales from earlier this year is stabilizing."

Some other Asian economic data points:

China Sept Trade Balance Exports 25.1% vs. 34.4% in Aug; Imports 24.1% vs. 35.2%
China Sept Property Prices 9.1% vs. 9.3% Sept 2009 - Expectations were 8.8%

Aussie Sept Business Confidence 10 vs. 11 in Aug

Aussie Oct Consumer Conf 117 vs. 113.2 in Sept
Aussie Oct Consumer Inflation Expectation 3.8% vs. 3.1% Sept

Japan Sept Consumer Confidence 41.4 vs. 42.5 Aug

Japan Sept Machine Orders 10.1% vs. 8.7% in Aug
Japan Aug Industrial Production -0.5% vs. -0.3% in July
Japan Aug Capacity Utilization 15% vs. 15.4% in July

It’s easy to see the optimism many have for the future of the equity markets. So far this earnings season, the numbers
have been quite good, but it seems that this optimism is based only on items that support their viewpoint instead of
forming a more well-rounded opinion. This includes earnings reports that were able to beat low-balled or outright
lowered expectations from analysts (like Alcoa), a weak dollar that greatly assisted many US multi-nationals, and from
current Fed policy (QE) that is presumed to help all equities due to the elixir of lower interest rates.
Looking Forward
I believe the panacea of QE is going to be a head fake. We all know that it’s priced in and that (asset price inflation) is
what really interests the Fed. Since jawboning has done the dirty work already, I can’t help but wonder if the Fed may
actually decide to take it easy with the QE. Of course, they will follow through with some purchases (and the latest news
is that they will buy Muni’s as a way to assist state and local governments without straight up giving them cash) as
evidence that they are serious. However, if they can dictate the pace of the Treasury/Muni buybacks without spending
close to a Trillion dollars, then they get the best of both worlds.

Credit Suisse is on the same line of thought saying they believe a rise in the dollar is coming - that QE is totally baked in.
This is shown buy the large number of net speculative positions in the USD. Due to the size of those positions they
believe there is a 100% chance (based on past occurrences) that the dollar will rally from here. According to a report
today from Credit Suisse the US dollar has rallied 100% of the time from these levels on a 3 month basis. On a 1, 2 and 6
month basis it has rallied 80% of the time:

Another reason why I believe that QE will be a head fake is that lower rates are the wrong answer. In fact, as I’ve argued
previously, they are causing more problems than they are solving. Here’s Merrill’s Jeff Rosenberg:

Our arguments stand in line with the few skeptics at the Fed that liquidity is no longer the problem hence
cannot be the solution. Moreover, too much liquidity now is itself becoming a problem. As credit
strategists and not economists the painful memories of a credit fueled housing price bubble - fueled in
large part by the coincident global monetary policy accommodation of that era - appear too eerily
similar. That experience in our view should argue that the costs of further QE2 in the form of raising the
risks of asset bubbles - now in emerging markets as opposed to housing - should provide greater ballast
against the gusts blowing in the direction of further liquidity provision.
Art Cashin had a great analogy that goes with Rosenberg’s comments:

Let's say oak trees dropped 1.3 trillion acorns last winter and that an industrious squirrel hunted and
gathered far more nuts than he needed. He sought to loan some to others, but the neighboring
chipmunks and deer already had plenty. The Nuts, Acorns, and Seeds Administration, surveying the
landscape, found the level of acorns unchanged at 1.3 trillion. Worried about another tough winter, it
recommends that trees drop another 2 trillion acorns.

That really makes it clear to me that more QE won’t accomplish anything and when investors figure that out (they may
have already), then things could turn ugly and fast.

Now let’s add the QE info to the fact that U.S. Investors Intelligence Sentiment Poll for this past week has the Bulls at
45.1% (from 47.2%) and the Bears at just 22% (from 24.7%). As you can see, the spread widened from the previous
week, and has not been this wide since the week of May 4th. The Dow was down 9% over the next 4-5 weeks.

This, along with the previous list of equity sellers, is incredibly bearish to me over the near term and all of that could be
set off with a huge “sell the news” event...the November elections. I have no idea of the size of drawdown we could be
facing, but considering the move we’ve seen certainly 1100 on the S&P (~7.5%) seems more than possible.

Notable Earnings:

Monday: Boyd Gaming, RadioShack, Amgen, Masco, Plum Creek Timber, Rent-A-Center, Texas Instruments
Tuesday: AK Steel, Arcelor Mittal, Biogen Idec, Coach, Cummins, DuPont, KC Southern, Kimberly-Clark, Regions
Financial, US Steel, Valero Energy, Broadcom, F5 Networks, Massey Energy
Wednesday: Automatic Data Processing, Avery Dennison, Borg Warner, Brinker, Comcast, ConocoPhillips, Dr.
Pepper/Snapple Group, General Dynamics, Hess, Navios Maritime, ThermoFisher, Whirlpool, Agnico-Eagle Mines,
DryShips, GoldCorp, NorfolkSouthern, Open Text, O’Reilly Auto, Sketchers, Visa
Thursday: 3M, Barrick Gold, Blackstone, Burger King, Celgene, Dow Chemical, Exxon, Fortune Brands, Oshkosh Truck,
Potash, Acme Packet, Akamai, Annaly Capital, Coinstar, Human Genome Sciences, Las Vegas Sands, MetLife, Microsoft,
Power-One, Powerwa ve Tech,
Friday: Arch Coal, Chevron, Estee Lauder, Merck, Sony

Notable Events:

Monday: Sept Existing Home Sales,

Tuesday: UK Q3 GDP, Brazil LEI
Wednesday: US Durable Goods, German Oct CPI,
Thursday: Eurozone Economic and industrial confidence for Oct, Bank of Japan Oct Meeting, Japan CPI & Industrial
Production,
Friday: US Q3 GDP, Canada August GDP, German Sept Retail Sales

Have a great weekend!

Leo