Socialism or Capitalism

The core of American business has been driven through a capitalistic society. Entrepreneurs raise money privately to create new companies. As these entities grow, the capital markets allow these businesses to raise additional funds from banks, the bond market, and the stock market. As companies prosper, so do the creditors and investors. When businesses falter, the creditors have protections written in the form of covenants on their debt and the priority given to them through security or other subordination language. This process has worked well for many years as small companies have grown into large global enterprises and poorly managed and over leveraged companies sometimes get reorganized through the bankruptcy process. Of course, these are the extremes but the United States is the leader of capitalism because this process is fair and not corrupted by government.

The world's financial system is in unprecedented times. Banks and other financial institutions have been weakened globally and their zeal to lend has been dramatically curtailed. The capital markets, although improving, is still not accommodating to many of the companies that easily accessed capital in the past few years. Unfortunately, many of these companies have increased their leverage during the peak years and are suffering during these weak economic times. We expect the bankruptcy rates to skyrocket this year and next and the reorganization of these entities will move the ownership from shareholders to creditors.

This brings us to the auto industry. We have been arguing for a restructuring of GM and Chrysler though prepackaged bankruptcies since November. These over bloated and over leveraged entities have needed to reorganize their cost structure and capitalization for a long time. Unfortunately, management was never willing to make hard decisions in euphoric economic times and are now being forced to right their ships during the worst economic time since the Great Depression. Banks and the capital markets did not provide new capital to GM and Chrysler so the government became the lender of last resort.

It is never a good idea to meld government finances with private enterprise. Just ask companies in Russia and Venezuela. Many banks took TARP money from the government to shore up their liquidity and it certainly seems like a curse as the Obama Administration lays out compensation conditions for employees of these companies. We can only anticipate what other requirements might be put forth to constrain corporate managers from running their businesses for the benefit of the shareholders. Many of these TARP banks are creditors of GM and Chrysler. Is the government pushing these financial institutions to make decisions in the restructuring process that is counter to the rights they process as secured lenders? It certainly appears that way when it comes to Chrysler.

The Obama administration is clearly orchestrating Chrysler's bankruptcy and has set the terms for a GM restructuring. Non TARP creditors in Chrysler are fighting back. They have a secured loan and expect to get better terms than unsecured lenders. The UAW and their health and pension plans are not secured. The rules of bankruptcy have not changed and the Obama government can not unilaterally change them. It certainly feels like a new Socialist Government is trying to abrogate the contractual rights of the lenders. If these methods of coercion persist, Capitalism in the United States could be harmed forever.

We warned that the government should have only made a loan to the auto companies in bankruptcy. They chose to do it their way and will likely lose some of the taxpayer money because they didn't do their homework. These restructurings are very complex and the creditors have rights. Just because Mr. Obama favors unions doesn't mean he can give them greater ownership of these companies than they deserve in bankruptcy. Furthermore, as long as the government loans to GM aren't breached, the Administration cannot unilaterally cram down the creditors.

Many of these actions are disconcerting. Investors have complicated analysis to make as shareholders or creditors. Thankfully, in the U.S. we don't have political risk to worry about. Or do we? The Obama Administration is clearly adding more risk to investing as its Socialistic principles are impeding our Capitalistic Society.

April Was A Winner but May Is Here

If you owned stocks in April, you are wealthier today as the S&P was up 9.4% and the DOW up 7.4% for the month. The economic news wasn't great but earnings season has produced better than expected results for 70% of the companies who have reported. Investors have climbed aboard the stock train as they don't want to miss the road to a stronger economy. We still do not believe the economy will get better until sometime in 2010 as the gloabal financial crisis has a long way to go before the deleveraging process is complete.

The good news is that the Government and the Federal Reserve continue to try and address the big problems. By summer time the auto industry may be streamlined and set on its way to recovery. There may be some pain and fighting to get there but a financial and operational restructuring is definitely needed to allow U.S. auto companies to compete with powerful foreign car companies.

Today is D-Day to find out the details of the Government's stress test for banks. It sounds like there is a bunch of bickering going on about the results and we will have to wait till next week to find out how much capital needs to be raised by some of the banks being scrutinized.

We have been concerned about rising defaults in various consumer loans and the financing of their asset backed deals. The same can be true for the commercial real estate markets. It looks like the Fed is trying to address those issues as it may set up TALF lending facilities for both these markets. The Federal Reserve traditionally only made short term loans but is now considering a program with maturities of three to five years. A successful launch of such a program could be very positive for the economy and the markets. Perhaps investors have seen these tea leaves coming and discounted the results in stock prices.

The Bulls Are Winning

The economic news isn't much better but investors seem to remain optimistic. GDP was down 6% but consumer confidence perked up. The swine flu seems to be spreading and raising global concerns but the stock market is discounting its economic effect. If that news isn't negative enough, will the imminent bankruptcy of Chrysler create any waves?

We have said many times that the auto companies need to restructure their operations, deleverage significantly, and lower their employment costs. Everybody seems to have moved in that direction but the only stumbling block is how the stakeholders divide up the company ownership. Fierce negotiations and high stakes poker are typically involved in massive restructurings and it is no different for Chrysler and GM. Shareholders will get virtually nothing and the debtholders, unions, and government are just fighting for their fair share. The result will be more competitive companies that will have a fighting chance to prosper when economic conditions improve.

We are seeing some positive earnings reports from Starwood, Proctor & Gamble, Owens Illinois, and DOW Chemical. This will surely lead to some higher stock prices. We continue to own core stock positions but remain cautious on the economy for the rest of the year. Stocks don't go up forever just like they didn't go down forever. The key is to understand what is happening between the relationship of stock prices and future earnings. Bear rallies can last awhile and produce sharp spikes in stocks. We believe that is what is going on now but we are happy to ride the wave with fear every day. Don't forget that the banks still own many toxic assets, the commercial real estate problems are around the corner, and consumer loan defaults are rising.

The Swine Flu Sneezes On The Markets

Perhaps the swine flu rage is the black swan which will be the catalyst to lead stocks down. Investors are raising cash as the concern for a greater slowdown in economic conditions will develop from the spreading disease. Should the sickness continue to spread, travel will decline and many industries will be affected.

The new shocking news is that Citigroup and BankAmerica need to raise more capital says the Wall Street Journal. If this is a surprise to anyone, then they must be living on another planet. The banking crisis is not over yet even then the financial markets are more stable. Many banks need to rid themselves of toxic assets and raise additional capital to bolster their balance sheets. The results of the stress tests should only confirm what we all know.

It is still earnings season and earnings are weak. U.S. Steel had lower volume and lower prices; Masco lowered its forecast; and Pfizer lowered its forecast. If companies continue to reduce forecasts, the markets will readjust their expectations and investors will sell stocks. We remain cautious and await more company earnings reports.

A New Week Approaches

Last week we were expecting weak earnings reports from many companies along with dismal outlooks. That is exactly what we got and the markets ended the week on a positive note. Perhaps investors were expecting much worse but the picture certainly appears gloomy for the balance of the year. We continue to have core positions in stocks but remain highly cautious. As the markets move higher we add to our S&P put position because we are not convinced that the raging bull since March 9th is not just another bear rally. The financial system does not look like it will implode but significant risk is everywhere in the credit markets.

The restructuring of the auto industry is still a question mark as is the weakening consumer credit markets and the impending collapse of the commercial real estate industry. We hate to be a broken record but risk management is the most important aspect of investing and unless one remain focused on the major issues staring at us, it is easy to get lulled into complacency. Simply being a long term investor is much more difficult with the current volatile markets. Each day brings a new challenge and portfolio adjustments are needed to address the news and events as they unfold.

More earnings reports are on the way as are the details of the banks' stress test. Perhaps this week the negative news will bring a swoon to the markets.

The Volatility Continue

The banks led the stocks lower on Monday and they drove them higher yesterday. The world didn't change in a day but Secretary Geithner spoke sweet words of encouragement about the banks and investors leaped at every positive word. Many companies reported yesterday with very few having good numbers. The important aspect of the earnings reports were not what happened last quarter but how does the future look? It appears that some companies feel that the bottom has arrived while others don't see any hint of sunshine. We have seen minor signs of positive economic activity in the past that ultimately faded away. Such a period was last spring. Will that happen again? Time will tell but for now we remain cautious as the replenishment of inventory phase could be giving companies some false hope.

Investors Get Punched

We have been cautioning for weeks that the bull is not quite back yet? Bank America finally woke everyone up. Their numbers were good for the last quarter but credit is deteriorating in all sectors. The next few quarters will remain quite bumpy. The negative comments by its CEO and the notion that the government will convert TARP loans into common equity helped to trash the whole banking sector yesterday. The result was plummeting financial stocks and the overall market declining more than 4%.

Remember, it is earnings season and the 1st quarter may have shown some bright spots but we are in for some tough economic times ahead. Investors have become more bullish over the past six weeks as stocks have soared but we have cautioned that companies will not meet future expectations. Dupont, Caterpillar, Merck, IBM, and Bank of NY Mellon all have reduced expectations for the year.

Our readers are not surprised by the dismal corporate news but investors seem shocked and dismayed. This week we have a ton of earnings reports and the news is likely to stay negative. It will be interesting to see if the market remains resilient. We believe the bear rally is now officially over and investors will try to properly discount where stocks should be. Perhaps we will retest the lows of March 6th but if not, stocks should remain weak until more positive tea leaves indicate there is economic light at the end of the tunnel. 2009 can be written off for any growth so we need to see if there is any visibility into the first quarter of 2010.