Tuesday, August 17, 2010


In the back of my mind there is an ever present exogenous factor -- namely, Middle East unrest -- that could upset the market's delicate balance.

And, we certainly have gotten terribly complacent about this unknown variable.

In these uncertain times, with such a wide range of economic/stock market outcomes (many of which are not benign), it is not a great strategy to chase strength.

U.S. Industrial Production rose by 1.0% in July, well above the consensus expectation.

The S&P 500 could move toward (and perhaps even past) 1,150 over the next few months.

With the stock market oversold and the bond market overbought, and with sentiment deteriorating further as hedge funds de-risk and retail investors remain inert, and with growing evidence of economic stabilization and the potential for better forward-looking metrics (including good Spain and Ireland government debt auctions last night), and with some early signs of increased M&A activity, the market outlook has improved.

Over the course of the next few months, I can now see the U.S. stock market moving toward the upper end of my expected range (1,020-1,150).

An overshoot could occur if economic statistics improve moderately and fixed income reverses its recent climb, creating the possibility of an important and market-moving reallocation trade.

One of the most important Fed surveys is the one that records senior loan officers' intentions to lend. The survey indicated that we experienced the largest easing of credit terms at the country's banks in over three years. In a more normal and active market, this survey would have been market-moving.

The results, buried in the minutia and noise of the trading day yesterday, were undeniably upbeat, as the survey indicated that we experienced the largest easing of credit terms at the country's banks in over three years (albeit from very low levels) during the second quarter. Importantly, demand appears to be stabilizing from previous weakness.

The results foreshadow better third-quarter 2010 economic growth than the Cassandras and double-dippers are suggesting:

* 3.5% of the banks tightened credit terms vs. 3.6% in first quarter 2010 and 35% in second quarter 2009;

* 84% of the banks indicated that credit terms were not changed vs. 86% in first quarter 2010 and 61% in second quarter 2009;

* 12.3% of the banks lowered credit terms vs. 10.7% in first quarter 2010 and 4% in second quarter 2009;

* while lending for lower credits did not ease, credit terms eased for standard mortgages, consumer and commercial loans; and

* loan demand has generally stabilized as contrasted with the prior weakness.

Last night, the BTIG strategist Mike O'Rourke captured the essence of why we have seen improvement in credit terms and why it should continue:

As this economy has undertaken the process of deleveraging, the overwhelming majority of the willingness to borrow has come from the U.S. government. Simultaneously, investors have been tripping over one another to lend to the U.S. government, even for meager returns. Large corporations are flush with cash, small businesses have not experienced a pick‐up in business that merits borrowing or expansion, and consumers are still in the mind-set of paying down obligations. The net result of these factors is that despite having $1 trillion in reserves, bank lending has been contracting. The banks have noted repeatedly they are willing to lend it, but they have been having trouble finding creditworthy borrowers. The fact is those who they would like to lend to the most (i.e., the large corporations) have record levels of cash, and they are uncertain how to deploy it in the current "unusually uncertain" world.

C&I loans outstanding are bumping along the bottom of nearly three-and-a-half-year lows and are down 25% from the peak levels registered in 2008. The Fed survey released today noted that banks are starting to ease lending standards on these loans. Even more important is the reason that banks began easing standards. According to the Fed, "Banks pointed to increased competition in the market for C&I loans as an important factor behind the recent easing of terms and standards." It is interesting that the banks are becoming motivated to lend. As it stands now, C&I loan demand by borrowers is finally just stabilizing after years of shrinking.

What we believe is happening here is that banks are begrudgingly being forced back into banking by the market and investors. Think about when second-quarter earnings season commenced last month, the banks set the tone with revenue misses on the top line as earnings beat on the bottom line. We would speculate that the banks will likely be punished again if they don't exhibit improvement in coming quarters. The key problem during the second quarter was the weakness of the capital markets business. It is safe to say that business has not picked up here in the third quarter. Investors don't want to see these institutions operate as if they are in runoff mode, not replenishing maturing loans with new ones, leading to that shrinking C&I.

Likewise the banks can only use conservatism and prudence as a mantra for so long while they are releasing credit reserves and keeping $1 trillion parked at the Fed for emergencies. In addition, it is highly likely credit written here in 2010 is likely to be among the best vintages in a very long time. Instead of writing new loans, the banks have been providing financing to the U.S. government and the GSEs by purchasing Treasuries and agency MBS. Hiding behind securities backed by the U.S. government, explicitly and implicitly, has been the "safe" way for banks to earn during the early stages of the recovery. As is clearly obvious, as these yields continue to compress, the risk/reward ratio will actually shift in favor of lending to a business for an actual spread rather than parking in two-year Treasuries for less than 50 basis points. Finally, one last data point from the Fed survey is that 22.6% of banks have increased their willingness to make consumer installment loans. Similar to the case for business lending, the demand is not there yet. It is lagging business demand, but it is moving in the direction where it can stabilize in the coming months.