Market Review 20 April 2010

Equity markets rose last week until Friday, when they fell sharply with the announcement of the SEC’s suit against Goldman Sachs.  The picture that emerges from the suit is nasty, plausible but, probably, difficult to prove.  Goldman Sachs was not alone in manufacturing these types of synthetic transactions.

Nonetheless, it appears that the SEC intends to follow the profile of the particular Goldman Sachs transaction known as Abacus 2007 – AC1.  If the case is eventually proven, the path for compensation for those who lost money would be much easier.  The timing of the SEC’s case is important politically, because regulation of the investment banking community is under active discussion in the US Congress.

It is important, however, to realise that much of what is in contention is already history and the impact on world equity markets, therefore, is likely to be short-lived. Of more importance has been the progress of first quarter earnings reports from the United States, which has been good.

As of April 16th, 38 companies in the S&P 500 have reported, representing 12% of total market capitalisation.  The upside surprise ratio stands at 78.9%.  The earnings growth of companies reporting thus far is up 31.8% year-on-year.  The reported earnings growth rate excluding financial sector is 41%.

Elsewhere the Greek situation rumbles on.  The latest IMF/EU delegation expected in Athens today has been delayed by a week because of volcanic ash that prevents flights.  However, it now appears likely that the Greeks will seek to draw down official pledges of assistance from other European Union countries.  This had the effect, at the end of last week, of pushing German government bond yields higher and Greek government bond yields higher still.

In the United Kingdom, the Liberal Democrat leader, Nicholas Clegg, appeared to do well in the three way debate on UK television between himself and the two other party leaders last Thursday.  The most recent opinion poll even suggests that the Liberal Democratic party has more electoral support than any other party in the UK general election, which is to be held on 6 May.  Even that level of support, though, would be insufficient to give the Liberal Democratic party a majority of seats in the UK House of Commons, although it could double the number of seats they currently hold, making a ‘hung’ parliament more likely.  Sterling weakened.

Part of the difficulty on Friday was that Goldman Sachs did not issue its rebuttal until this morning.  In that rebuttal, Goldman was anxious to ensure that attention should be focussed on this one transaction, which involved two professional institutional investors, IKB and ACA Capital Management.  They pointed out that this particular transaction has been the subject of SEC examination and review for over 18 months and that, based on all that Goldman itself had learned from this examination, the firm’s actions were entirely appropriate.

Goldman further pointed out that the institutions were very experienced in the CDO market, extensive disclosure was made in respect of each of the securities in the reference portfolio, similar in detail and scale to those disclosures required by the SEC in public transactions and that the offering documents provided all the information needed to understand and evaluate the portfolio.

In essence, the transactions at issue involved a static portfolio of securities, which was marketed solely to sophisticated financial institutions.  IKB, a large German bank and leading CDO market participant and ACA, the two investors knew about the associated risks.  Goldman pointed out that they were among the most sophisticated mortgage investors in the world, they understood that a synthetic CDO transaction requires a short interest for every corresponding long position.

Goldman Sachs insisted that it never represented to ACA that Paulson was going to be a long investor.  As normal business practice, they asserted, market makers do not disclose the identities of a buyer to a seller and vice versa.  Clearly, Goldman is going to fight it all the way and suits against major broker dealers have been difficult to win.

More generally, the US economy has clearly ended the first quarter on a stronger note than originally anticipated and the second quarter has started even more strongly.  The April manufacturing PMI probably increased to 61.5% and ISI’s company surveys last week were at 46.7 versus 45.4 in March.  Strength in the Empire manufacturing employment index, published on Friday, fits with an improving picture for household employment, which has risen by almost 1.4 million over the past three months.

Credit markets are improving.  ABX prices (housing related securities) have surged in the past few weeks from 35.5 to 44.0 and CMBX prices (commercial real estate related securities) have risen from 86.0 to 91.5. Junk bond yields declined last week to 8.05%.

The range of investors’ views is, though, extraordinarily wide. ISI last week tested the views of their clients in a survey and the range of views was wider than at any stage that they can recall.  The expectations for real US GDP growth in 2011 range from 0% to +6%, the range for house prices from -10% to +15% and the level of the S&P index at the year end from 950 to 1450.

One way or another these views will eventually converge.  To our mind, sharply rising corporate profits, strong growth in emerging markets and rapidly recovering world trade argue for higher business spending, still further rises in commodity prices and equity market strength.  It may be that some of this strength has made some investors even more nervous.

Over the last 301 days, the GSCI measure of commodity prices has risen 80.4% – the most ever in an economic recovery.  Even the most deadbeat areas of economic activity in the United States seem to be catching the mood.  California’s manufacturing PMI for the second quarter increased to 61.7, which is an outstanding figure, and Californian employment data reported last Friday showed that Californian employment over the last three months was actually up 35,000.  New York was up 43,000.

Technically, markets may have been rather over bought in the middle of last week with rises in each of the last seven weeks.  Friday’s action helps to correct that situation but, in our view at least, does not affect the primary uptrend.