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With key index barriers breached, what comes next?

Monday, February 7, 2011

SIMON AVERY

savery@globeandmail.com

Amid all the fear and uncertainty in the markets during the last year, stocks have slowly but steadily climbed to levels not seen since before the great financial crisis of 2008.

Major indexes are hovering near, or indeed have already broken through, key psychological barriers. Last week, the Dow Jones industrial average closed above 12,000 and the broader Standard & Poor's 500 index topped 1,300, levels not seen since June, 2008. In Toronto, the S&P/TSX composite index ended last week about 220 points short of the 14,000 mark.

It's not just North American markets that are closing in on these impressive markers. In Europe, London's FTSE 100 index has eclipsed the 6,000 level several times this year, France's CAC 40 is trending close to 4,000 and Germany's DAX recently crossed the 7,000-point threshold.

Technical analysts love events like these. They look at key resistance levels as a line in the sand between bulls and bears, and if the bulls can get across it and stay on the upside for a few trading sessions, the analysts consider the event a positive indicator of further gains.

The latest thresholds the markets have encountered are indeed big on the psychological level, with some acting as resistance points going back several years before the financial meltdown.

"What's quite intriguing is that with all the news out there it just seems as though things are in balance right now," says Colin Cieszynski, analyst with CMC Markets Canada Inc. He thinks that markets are probably fairly valued relative to current economic conditions and what people have anticipated for the near-term.

"Things are just starting to go sideways around these big psychological levels. It's like we've been drawn to them and now that we've gotten there people don't know quite what to do," he says. "It's possible markets could linger around these levels for some time until we get some kind of catalyst to kick them into gear again."

What that catalyst might be is anyone's guess. This week is light on economic reports. The most salient will likely be U.S. international trade figures for December coming on Friday. Economists forecast that the U.S. trade deficit expanded to $40-billion (U.S.), up from $38.3-billion in November, on higher oil prices and more consumer imports.

It might be one of the major central banks that triggers the break. On Wednesday, U.S. Federal Reserve chairman Ben Bernanke testifies before the congressional House Budget Committee on the economy, jobs and the budget. But there is no reason to expect that he will shift his stance on the need for Fed stimulus as long as the country struggles to create jobs.

On Thursday, the Bank of England announces its latest monetary policy. Although an immediate rate hike is not expected, with inflation now running above the BOE's target in Britain, some say the market is beginning to price in coming increases.

Runaway commodity prices may also prove a significant force in shaping investor sentiment. Market-watchers generally believe that these rising prices won't initiate inflation in North America because unemployment remains so high, which means workers have little leverage to negotiate higher salaries.

But Ed Yardeni, president and chief investment strategist at Yardeni Research Inc., notes that the effect of high commodity prices is starting to hit corporate performance. Consumer staples, energy and materials are the only three sectors where the number of companies delivering positive earnings surprises for last quarter has increased. "The latest earnings season is showing a divergence between companies that benefit from higher commodity prices and those that get squeezed by the higher costs of their input materials," he wrote in a note last week.

Regardless of the actual news breaking in the coming days, seasoned investors will be watching the key resistance levels on the major indexes for more signals about the market's true strength.

With the stock markets doing as well as they are, there is the sense in the investor community that they are doing much better than they should be. With the trade deficits expanding and the economic indicators not improving substantially, what is behind this level of optimism?

By MICHAEL RAPOPORT

During the financial crisis, investors fretted over "toxic," hard-to-value assets that banks were carrying. Those fears have faded as bank profits have rebounded, loan delinquencies have declined, and bank stocks have soared 25% in the past five months.

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Associated Press

Some banks have yet to reckon with all their "toxic" assets, among them mortgage-backed securities, whose values took a hit when the housing market cratered. Above, construction on a home in Phoenix.

But banks still hold plenty of the bad assets that once spooked investors: mortgage-backed securities, collateralized debt obligations and other risky instruments. Their potential impact concerns some accounting and banking observers.

In part due to those bad assets, the top 10 U.S.-owned banks had $13.8 billion in "unrealized losses" that have lasted at least a year in their investment portfolios as of Sept. 30, according to a Wall Street Journal analysis. Such losses are baked into banks' book value, but don't get counted against earnings as long as the banks believe the investments will later rebound. If those losses were assessed against earnings, it would have reduced the banks' pretax income for the first nine months of 2010 by 21%, according to the Journal analysis.

Unrealized losses are just one way in which the troubled assets obscure banks' true financial condition, accounting experts say. With the banking recovery well under way, they think the banks should no longer delay a reckoning and should count those losses against earnings.

Another problem: Even when banks do take real charges because of their securities losses, accounting rules allow them to keep some of those charges from hurting their bottom line.

Making the picture even murkier, the value of many risky assets are based solely on the banks' own estimates—leaving valuations uncertain and, some critics say, overstated.

"They're still inflated because I don't think the bullet ever really got bitten," said Jack Ciesielski, publisher of the Analyst's Accounting Observer.

The banks say they mostly don't need to take charges for losses on their risky assets. They say they will ultimately realize the assets' full value by holding onto the securities and collecting the principal and interest payments associated with them.

One problem centers largely on "Level 3" securities, illiquid investments that can't be easily valued using market prices. According to the Journal analysis, as of Sept. 30, the top 10 banks had $360.7 billion in "Level 3" securities. That amounts to 42.6% of the banks' shareholder equity, a pile of assets whose value is hard to verify.

To be sure, banks aren't quite as exposed to bad assets as they used to be. At the top 10 banks, Level 3 securities have declined 24% in the past two years, while Level 1 and Level 2 securities, which are much easier to value, rose. The amount fell as banks sold some Level 3 assets, switched them to Levels 1 or 2, or wrote some down. Unrealized losses also have declined.

Bank of New York Mellon Corp., for example, took a $4.8 billion charge against earnings in 2009, much of it related to mortgage-backed securities, to reduce its balance-sheet risk. The bank subsequently sold some of its lowest-quality securities. Chief Executive Bob Kelly said on a conference call at the time that "we're putting our investment securities issues behind us" and "we want to sell the securities where we think there is just no value there."

Many banks haven't been that conservative.

"In a lot of cases banks are probably deluding themselves" about the future value of those securities, and whether they will ultimately recover as much from those securities as they contend they will, said Bert Ely, an independent banking consultant.

Often, the impact of these assets isn't easily visible. Much of the information about risky assets is only in the banks' regulatory filings, not in their earnings releases. Though major banks have announced their fourth-quarter earnings, investors won't be able to see how much in risky assets the banks are currently holding until they file their annual reports with the Securities and Exchange Commission in about a month.

Citigroup Inc., for instance, didn't mention its high level of Level 3 securities when it announced fourth-quarter earnings. As of Sept. 30, the bank held $79.1 billion of Level 3 assets—equal to 48% of its book value. That includes billions in credit derivatives, asset-backed securities and some subprime-mortgage-backed securities.

Jon Diat, a Citi spokesman, said the bank is "comfortable with its treatment of Level 3 assets," provides extensive disclosure and "adheres to all applicable accounting policies and standards."

Zions Bancorp had $905.1 million in one-year-or-more unrealized losses as of Sept. 30, which would have made its nine-month 2010 loss of $306.7 million worse if counted against earnings.

"We have detailed disclosures regarding how we value and determine credit impairment on these securities, and we believe that our valuations are reasonable," said Doyle Arnold, Zions's chief financial officer.

PNC Financial Services Group Inc. had $1.6 billion in year-plus unrealized losses as of Sept. 30, or 55% of pretax income for the first nine months of 2010. Spokesman Fred Solomon said PNC is "very comfortable with our ability to recover these amounts."

Another avoidance method: As long as banks say they don't expect to sell a security, they are allowed to put some of the security's losses into a balance-sheet line known as "other comprehensive income," where they don't affect net income or regulatory capital. Banks were given this leeway in 2009, when the Financial Accounting Standards Board, which sets accounting rules, gave in to pressure from Congress and softened the rules on writing down assets. A FASB spokesman declined to comment.

State Street Corp., for instance, had $420 million in non-credit impairment losses in 2010, which would have cut its pretax income by 20% if they were counted against earnings.

Carolyn Cichon, a State Street spokeswoman, said the bank's asset-impairment charges have declined, and the bank's accounting "continues to reflect our position that we have the ability and intent to hold the securities to maturity."

Write to Michael Rapoport at Michael.Rapoport@dowjones.com

For anyone hoping that the worst of this recession is behind us and the recovery is well underway, this paints a fairly scary picture. If the banks have still not learnt their lesson, how long would it take for us the economy to dip again?

According to Booz & Company the recession had at least one major upside: it forced companies to improve their innovation. Many invested more in R&D, while others streamlined costs. What is clear, however, is that most of them see innovation as the way to rebound from a tough market.

How much did the top companies spend on R&D in 2008? Toyota and Nokia share the top of the list at just under $9 billion.

Direct mail offers sent to consumers dropped from 2.1 billion in Q3-2006 to just under 0.4 billion in Q3-2009, in what can be attributed to how the U.S. economy has affected credit card companies--or at least their desire to expand at all cost.

I am not sure I will buy this one, but it sounds like an interesting read. The early reviews have been decent and if you have a small business that is struggling right now, this might not be a bad investment.

Engineering News reports that the financial crisis is hindering African biofuels exports, said Hart Energy Consulting Global Biofuels Center (GBC) biofuels director Maelle Soares Pinto. GBC sees a overcapacity in the European Union (EU), the most likely market for biofuels exports from Africa. Pinto also said several African countries benefit from special tariffs in the case of ethanol exports to the EU. Hart’s GBC executive director Tammy Klein adds that, as yet, there is still not a demand driver in the African marketplace.

Europe doesn't have enough land to grow its own biofuels, and the continent needs to increase its biofuel consumption at least five to six times to meet EU targets. Most European countries are increasingly looking towards African lands for production of biofuels. This is partially due to familiarity--most of these lands were governed by European nations until a few decades ago--and partially because of how much unused land is available in Africa.

This poses a number of challenges to the African governments. They need to balance their food and fuel production; find a way to increase their share of the value chain; and ensure that their own energy consumptions costs go down. Most importantly, they need to make sure that someone will buy the biofuels produced by their farmers--and the recession is turning many of them away.

More companies are looking to make deals with tax authorities on transfer-pricing terms to avoid unexpected penalties, tax advisers report.

While most professional service providers are struggling, transfer pricing has been an area that is seeing tremendous demand in the market. The tax authorities are looking to offset revenue decreases due to a bad economy from more aggressive international tax audits, often resulting in significant adjustments and penalties.

While a lot of this aggressive behaviour can be labelled "getting our fair share" much of it is unnecessarily aggressive and unreasonable. How do you safeguard against the taxman?