Axios Capital’s Review/Preview

Friday July 30, 2010

Review

The market displayed its now typical schizophrenic behavior again this period showing us huge down days immediately
followed by huge up days. I remain convinced that the incredible volatility we are seeing will lead to a substantial
dislocation in the markets. I fail to see how it can lead to anything else. The $64,000 question is, of course, when?
Retail investors are leaving the equity markets in droves (as I will discuss) and HFT’s account for some 80% of market
volume. The macro environment is quite poor: debt levels are rocketing to all time highs, there is persistent joblessness
and underemployment, the housing market continues to deteriorate with record delinquencies and foreclosures, and
personal bankruptcies are moving at break-neck speed. The best news I can point to is that FedEx and Expediters
International both raised guidance pointing to increased export traffic, rail traffic has been strong (more or less), and
earnings so far are a little better than mixed (but that’s coming off weak comps!).

Earnings for Q2 have definitely been on the positive side of the fence. What appears clear thus far is that B2B is working
well. Corporations are flush with cash; they have to be as even they no longer have any dependable access to credit.
What is also clear is that B2C is a disaster as unemployment remains very strained and transfer payments still make up a
huge portion of personal current income. You know things are bad when Coinstar (CSTR) with their Redbox division and
Netflix (NLFX) both showed stains for the first time and issued mixed guidance for the upcoming quarter. Banks are
managing to report profits by lowering their provisions for bad debt (with DTI ratios still at 120%).

The ECRI Weekly Leading Index once again printed a negative number dropping to -10.7 in its last release. As a
reminder, the last five prints have been: -6.5, -7.7, -8.3, -9.8, -10.5, and now -10.7. I think a negative GDP print for Q3
has gone from possible to probable. This is a staggering occurrence when considering how relatively good Q2 earnings
have been.

Looking to housing, RealtyTrac states that despite all the taxpayer money that has been thrown at the situation, 154 of
206 cities with populations above 200,000 have posted increases in foreclosure filings on a YoY basis. For new homes, it
now takes 12.4 months to find a buyer and unsold inventory supply now stands at 7.6mths, not counting the tidal wave
of upcoming and in-process foreclosures (a.k.a. shadow inventory). ASPs are down 9.8% - the 3rd steepest discount ever
generated the 2nd worst number new homes sales number ever. With foreclosures accelerating and bankruptcies
showing no sign of slowing, we are now hearing about Fannie and Freddie issuing “automatic refi’s” for their mortgages
– system wide. Meaning, anyone with a loan will see their mortgage automatically refinanced to whatever the “at the
moment” historically low rate is saving consumers an estimated $30-45B. I’m glad for them, but we continue to set a
bad precedent by continually rewarding those who have made bad decisions. This is just now making the rounds in the
last day or so, and it bears watching as I will put nothing past the uber-Keynesians at the Fed and Treasury department.

Continuing along the macro theme, we are also seeing credit contracting further, consumer confidence slipping,
mortgage apps falling, energy production falling (raw steel production slipped 1.7% and is down three weeks in a row to
a three-month low, coal production fell 4.8% - down three of the last four weeks to its lowest level since January ’09,
and rest assured that offshore oil production will fall off a cliff with the drilling ban), and the latest unemployment data
tells us that over the four week period between June 5th and July 10th, 1.5 million people lost their emergency
unemployment claims (benefits). If labor participation were at levels just from April, unemployment would be well over
10% (probably close to 10.5%) not the currently stated 9.5%. All of that with Congress extending unemployment
benefits seven times in the last two years. Ouch.

As David Rosenberg says, “This all follows a very bad May and June … so what we have is a downtrend in the making, not
a blip. Double-dip odds are clearly not zero.”

Rosenberg received more support today as Q2 Advance GDP printed a disappointed 2.4% from an upwardly revised 3.7%
for Q1. Real estate, prompted by the tax credits, was a large part of that 2.4%. That does not bode well for Q3 at all.

Investors continue to take notice as the latest report from ICI (really, the last two...or twelve) shows continued sizable
outflows of $1.5B from domestic equity funds. Last week was twice as big at $3.2B in outflows. That brings total
outflows for the year to an epic $39B. From ZeroHedge:
“Even as the market has surged 10% in the last three weeks, just under $10 billion have been redeemed
from mutual funds, completely invalidating the move and further justifying the skeptics who see
absolutely no reflection to reality in the volumeless ramp orchestrated by a few momentum HFTs and a
couple of Primary Dealers with some excess leftover Discount Window change. Not to mention that 12
weeks in a row of outflows pretty much marks game over as far as retail participation is concerned in
stocks. Regardless of what the market does, where it closes, how high it ramps, etc, retail just pulls
money indiscriminately from the market, without any regards for what the fraudulent and fabricated
current level of the DJIA may be: all mom and pop just want is to get the hell out of stocks stat and get
into fixed income.”

(Chart courtesy ZeroHedge)

Looking across the pond to Europe, the Euro stress tests came out last Friday and were resoundingly ridiculed by most
everyone with an independent bone in their body. How does one stress test without testing for sovereign debts losses –
possibly the most serious potential threat to the region? Liquidity risk is and remains the critical risk to the Eurozone
and its financial system.

Lukas Sustala of the Austrian paper Der Standart wrote an article questioning the validity of the stress tests as well. He
questioned the basis for the test by asking about the result when using the Basel III standard of 8% Tier 1 capital instead
of the 6% Tier 1 capital used in the tests. According to Sustala, the failure rate goes up exponentially with 39 of the 91
banks tested failing and the impaired assets amounting to an eye-popping 2.6T €. Can you say capital infusion? From
the article:
"The stress tests were a farce (taking no account of counterparty risk or a sovereign default), but at least
they provide some good data points (I currently look into all the sovereign holdings of the individual
banks, so there is more to come). 39 banks fail the 8% criteria."

If we see 5x as many banks failing with a move from 6% to 8%, it’s quite obvious that they are teetering on the edge.

Obviously, reporters and analysts weren’t the only ones skeptical as Euribor, the Eurobank inter-offer rate, rose every
day from the release until today when it fell tiny amount. The interbank lending market reached its highest level in
nearly a year with 3-month Euribor at 0.896% down from .899% yesterday. (1-day and 1-week rates trended lower) As
you may remember from our debacle in 2008 and 2009, these borrowing costs rise when banks are nervous about
lending to each other.

From the WSJ:

Analysts at Société Générale estimated this week that European banks face potential losses totaling up
to €225 billion under the stress tests and that banks' capital shortfalls will total about €30 billion.

The only country in Europe that seems to be progressing nicely is Germany. Per the Ifo Business Institute on July 23rd,
their Business Climate Survey rose to 106.2 from 101.8, which is the biggest single gain since reunification.

France is starting to see some decent recovery as well as recent reports from Total SA, and Air France as well as some
others were quite positive.

Greece, Spain, Portugal, Hungary, Belgium, and more remain in dire straits.

Preview
Since David Rosenberg has this already prepared all nice and neat, I’ll just let him get this section started:
Momentum into Q3 has softened dramatically. A few examples:
 ISM was 60.4 in April and was down to 56.2 in June and likely down to 54 to start Q3.
 Philly Fed was 31.9 in April; was down to 19.6 in June and down to 5.1 to start Q3.
 NY Empire index was 20.2 in April and was down to 8.0 in June; and down to 5.1 in July to start
the third quarter.
 NAHB was 19 in April, fell to 16 by June and was down to 14 as Q3 began.
 Consumer confidence was 57.7 to start Q2 and closed the quarter at 52.9.
 The NFIB index also started Q2 as 90.6 and finished at 89.

I think claims above 500k and ISM below 50 will be surprises for consumer cyclicals and industrials in the
next few months.

David also mentions that the Dallas Fed’s business activity index has an 86% correlation with ISM. Well, that just printed
-21 for July from -4 in June. ISM was at 49 the last time this number was this low and is now estimated at 54.9 for
Monday’s release.

Now that the Fed is likely to stop paying interest on cash held by banks, the banks went on a treasury buying binge
picking up nearly $50B in UST’s. The carry trade is working for banks and it’s obvious that the Fed will continue to be
“accommodative”, so why not? If we have problems with the UST in the next 2-3 years, the real problems could be
exponential as banks are very much levered to these securities. (Remember, this is all money injected into the banks to
make them appear more stable) A move to 4.50% - 5.00% from its current ~3.00% on the 10 year could devastate the
banks.

QEII is on the horizon and it is my belief that it will be met with a very negative response (not counting any knee-jerk
reaction/s). Taxpayers are not interested in more debt, in more money printing (computerized or not), or in more
excuses. I also believe it’s possible that the bond vigilantes could respond with fervor and thrash Treasuries. Now, go
back and read the prior paragraph again.

Don’t believe me that QEII is coming? According to a Pepperdine University study, if you invested $1,000 in the DJIA on
January 1 of the first year of every Presidential term and sold on October 15th of the second year for every year since
1950, your $1,000 would today be worth approximately $650, without adjusting for inflation.

On the other hand, had you invested $1,000 on October 15th of the second year of every term and sold on December
31st of the last year of every Presidential term since 1950, your $1,000 would now be worth more than $70,000.
The timing behind that is not a coincidence.

On the subject of Keynesianism and soft money policies, I just finished reading “End the Fed” by Ron Paul and he does a
tremendous job of explaining exactly how the Fed is at the root of the majority of our financial problems, from creating
nonstop inflation and destroying our purchasing power to redistributing wealth from the poor and middle class to the
political/power elites (The oil bubble of 2008 is a good example - In 2008, the price of oil went ballistic, but the U.S. was
already in a recession [it began in Dec. 2007]. There was no rational reason oil should have gone ballistic. The Fed's easy
money just fueled a bubble. It was like a $500 billion tax on consumers courtesy of the Fed. That's the added amount
that it cost you, and it helped push consumers over a cliff in late 2008.). History recognizes that all great inflationary
periods begin with the monetization of debt. Inflation transfers wealth from creditors to borrowers and is devastating
to the poor and beneficial to the wealthy. It destroys purchasing power from those with little.

Is hyperinflation near? (If it is, it will end the Fed in my opinion) It’s a question that has been asked repeatedly over the
last couple of years with deflation currently dominating. What we do know is that deflation can persist for some time
before inflation makes itself known (See Jens Parssons book “the Dying of Money” about inflation and the Weimar
republic). In those cases, when inflation arises it comes with stunning force. It’s this that has some many central
bankers scrambling to read Parsson’s book.

But, that’s not the only problem facing the Fed. Here is Rep. Scott Garrett in an exchange with Ben Bernanke during
Bernanke’s recent Humphrey Hawkins Testimony:

Garrett: Well, there you go. So the normal practice is not what was followed here. It just seems to me that we may have
gone down a different road than we've ever gone down in U.S. history, where the Federal Reserve has engaged in buying
a security, it's not Treasury, it's not guaranteed by the full faith and credit of the United States for its lifetime, nor is there
any repurchase agreement from any other entity that you purchased - that you have a trade with an agreement with -
and that the Fed in essence could have created money if the government does not guarantee them. At least, that could
be the situation we could find ourselves in 2012.

So, now we actually have the potential to see the Fed violate its charter, and that could put it on very shaky ground with
a rising Tea Party desirous of hard money policies.

Dr. John Hussman had much to say about this conversation in his last update and here is his breakdown of the
conversation (any emphasis is mine):
It's important to understand that historically, the Fed has never actually "created money" out of thin air.
What it has always done is purchase Treasury debt, paying for that debt by creating "Federal Reserve
Notes" (see the top of your dollar bill). When it has purchased other types of securities, it has
historically done so using "repurchase agreements." These enable the Fed to sell those securities back
at a known price, even if the security itself was to default. By restricting the vast majority of its purchases
 to U.S. Treasury securities, the Fed has always operated under a budget constraint: Congress has always
had the sole, Constitutionally enumerated power to authorize the spending that creates government
liabilities, and the Fed has merely affected whether those liabilities were held by the public in the form of
Treasury debt or in the form of Federal Reserve Notes (money).

For example, if Congress votes on a billion dollars of spending, and the Treasury issues debt to finance
this spending, the Fed might buy that billion dollars of Treasury debt and create a billion dollars of
currency to pay for it. But notice that from the standpoint of the public, the end result is still a billion
dollars of government liabilities that was explicitly authorized by Congress. The Fed was never involved in
spending decisions, which is fiscal policy.

Contrast this with what the Fed has done in this instance. It has taken its balance sheet up from about
$800 billion two years ago (almost exclusively in Treasury securities) to over $2 trillion today, mostly in
Fannie Mae and Freddie Mac liabilities. The government's backing of Fannie and Freddie debt was
always implicit - they do not have the full faith and credit of the U.S. for their full maturity. If Congress
chooses to restructure that debt after 2012, the Federal Reserve will have created money without an
offsetting asset of equal value on its balance sheet. It will have spent money out of thin air to pay off
the holders of Fannie and Freddie securities. This would constitute a fiscal policy decision that was not
actually voted on by elected representatives in Congress.

This is the crux of the matter. If Republicans take back Congress in November (and stick with their platform), then I
believe the likelihood of this event occurring goes up dramatically. This would then put the Fed in violation of its charter
and could give rise to the movement to eliminate the Fed altogether. Salvation might not be far behind should the Fed
eventually be eliminated as a return to hard money will go a long way to solving many of our fiscal issues – not the least
of which is the ability to constantly run gigantic budget deficits. We will finally have to live within our means. The
monetarists argue that we cannot grow effectively without monetary expansion, but I’m not sure that’s accurate. It
seems to me that creating wealth is creating wealth and the by doing so the value will be expressed within our currency
creating additional purchasing power.

Things to watch out for in the coming week: I’m expecting a very weak ISM number, and any change in unemployment
will be a negative one. We have reports on both coming this week with ISM on Monday and Unemployment on
Thursday.

On Tuesday US Personal Income data is released, along with German retail sales data. Thursday is big internationally as
well with BoE and ECB rate announcements.

Friday is the biggie domestically with July employment and payroll data, as well as June consumer credit.

Looking at where the market is trading in relation to the earnings coming out, how can anyone argue that we haven’t
gotten ahead of ourselves? The easy comps will be behind us now and based on almost any measure the economy is
not picking up, it is slowing down. Now, there is also a raging battle between QEII and austerity (it seems like austerity
has been successful in Ireland and UK). That is likely to cause further disruptions both in the US and globally. Should the
S&P be trading closer to 10x, where it trades in true recessionary/near-recessionary periods? If so, then that means we
are 30-40% overvalued currently. Just marking the S&P down by 25% from current levels gives us a level of 825/840 on
the S&P. Under the current situation, with earnings and the global economic outlook as they are, 825/840 seems to be a
much more reasonable level than 1100/1120.

Have a great weekend!

Leo
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