Investors’ Thirst for U.S. Government Debt Yet To Be Quenched

We have been hearing warnings for years. Just wait until China stops buying our debt… the borrow and spend cycle in the U.S. will come to a grinding halt. Since the Obama Administration has already spent about $1.4 trillion (~$800 billion on stimulus and ~$600 billion on a down payment for healthcare reform), these calls are growing ever more prevalent.

Of course, China will continue to have excess cash reserves that need to be invested, and they only own a fraction — less than 10 percent — of the total U.S. debt outstanding (contrary to the widespread belief that they effectively own the United States), but it is not unreasonable to think demand would drop a bit as we continue to borrow money. The interesting thing, however, is that demand for U.S. debt is showing no signs of slowing down.

Part of the reason the stock market is doing so well today (Dow up 150 with less than one hour of trading left to go) is because we got the results of yet another U.S. debt auction and it went very well. The U.S. successfully sold $27 billion of seven-year notes with strong demand.

Demand can easily be gauged by what is called the “bid to cover ratio” which simply tells you how many dollars of bids were submitted for each dollar of debt that was auctioned off. Today’s note offering registered a bid to cover of 2.82 so we received $76 billion of bids for only $27 billion of notes.

Are we paying through the nose for this money? Not exactly. The yield on the 10-year bond right now is around 3.5% or so. I wish I could borrow money for 10 years at 3.5%. Not only is the government trying to do so, but it is finding great success even in this fiscal environment. To me, that bodes well for the future of the United States.

CNBC’s David Faber Publishes Book Follow-Up To “House of Cards” Documentary

Several months ago I pointed out that CNBC’s David Faber put together a two hour documentary about the housing bust and credit crisis entitled “The House of Cards.” I got lots of positive feedback from readers who watched the special so I thought I would let everyone know that Faber has written a book (just released) on the topic, which branches out from his television special.

The book is called “And Then the Roof Caved In: How Wall Street Greed and Stupidity Brought Capitalism to Its Knees” and it appears the early reviews are superb. On Amazon.com, for instance, the first 21 ratings from customers have all given the book 5 out of 5 stars. If the last few years of U.S. economics and finance interest you, I strongly recommend it if you are looking for some quality reading material.

U.S. Energy Department Paves Way for Nuclear Power Plants, Public Companies To Benefit

You may have heard that the U.S. Department of Energy is planning to offer $18.5 billion in loan guarantees for the construction of more nuclear power plants. Not only would additional nuclear capacity reduce greenhouse gas emissions, it would also help private energy companies boost their market positions. Federal loan guarantees will reduce the cost of capital and make expanded nuclear power an easier goal to attain.

This is good news for investors too, as four publicly traded companies will share the $18.5 billion raised. The companies include NRG Energy (NRG), Scana (SCG), The Southern Company (SO), and UniStar, a joint venture between France’s EDF and Constellation Energy (CEG). These utility stocks are already fairly inexpensive on a valuation basis, with high dividend yields, so new future growth opportunities will only make them even more attractive.

The growth will help some more than others (Southern, for example, is a huge power player already, so nuclear might not make a large dent in their business), but I believe ventures like these serve to identify the leaders in the energy transformation movement. As a result, investors may want to take a closer look.

Full Disclosure: Peridot Capital was long shares of Constellation Energy preferred stock at the time of writing, but positions may change at any time

Contrary To Media Reports, Rising Housing Starts Are Not A Good Sign

From the Associated Press this morning:

“Construction of new homes jumped in May by the largest amount in three months, an encouraging sign that the nation’s deep housing recession was beginning to bottom out. The Commerce Department said Tuesday that construction of new homes and apartments jumped 17.2 percent last month to a seasonally adjusted annual rate of 532,000 units. That was better than the 500,000-unit pace that economists had expected and came after construction fell in April to a record low of 454,000 units. In another encouraging sign, applications for building permits, seen as a good indicator of future activity, rose 4 percent in May to an annual rate of 518,000 units. The better-than-expected rebound in construction was the latest sign that the prolonged slump in housing is coming to an end, which would be good news for the broader economy.”

Pretty lousy analysis if you ask me. It is true that more construction will show up in GDP calculations as so-called “economic growth” but the idea that growth in housing starts is good for the housing market and means the housing recession is coming to an end is completely wrong.

In case the AP hasn’t noticed, housing prices are cratering due to a supply-demand imbalance. When supply exceeds demand, prices drop (economics 101). It is widely believed (and I agree) that a bottom in housing prices (and therefore an end to the housing recession) is needed before the U.S. economy can really begin a sustainable recovery (such an event would boost consumer confidence and spending, and help the banks feel better about extending credit). In order for home prices to stabilize, we need the supply-demand picture to balance out.

How will supply and demand meet if we build more supply when the problem has been (and continues to be) an excess supply of unsold homes? They won’t, which is why a pick up in housing starts will only serve to prolong the housing recession, not help to curb it. Hopefully the pick up in May is a one month phenomenon.

Profit On TARP Repayments Only To Cancel Out Other Losses

Before we start jumping for joy that the government stands to make a nice profit on the $68 billion of TARP money that is now eligible to be repaid, let’s consider that the gains are only from relatively healthy institutions. By forcing each of the nation’s biggest banks to accept TARP funds, former Treasury Secretary Paulson essentially assured profits would be generated on some of the loans, but we really need to look at the big picture. In order for the taxpayer to come out ahead, the gains on the good investments need to cancel out the losses on the bad ones.

Do the profits on $68 billion of TARP capital do the trick? Hardly. AIG received $70 billion from TARP, GM and Chrysler got $17.4 billion, and another $30 billion in slated to fund bankruptcy proceedings for the auto makers. That’s more than $117 billion that the government has tied up in 3 firms. It will take years to get that money back, and in the case of AIG, it appears unlikely a full recovery is a reasonable expectation. So, while $68 billion coming back to us is a good thing, let’s not get carried away and start calling TARP a solid “investment” just yet.

Full Disclosure: No position in AIG or GM at the time of writing, but positions may change at any time (unlikely in this case, however)

Interest Rates Only High If Compared With Six Months Ago

Call me a skeptic when it comes to getting really nervous about rising interest rates. “All of this debt we are selling is really having a severe impact on interest rates,” they say. It is true that interest rates on 10-year government bonds have doubled from 2% to 4% in recent months. However, not looking more than six or twelve months back does not give a very clear picture. Below is a decade-long chart of the yield on the benchmark 10-year treasury bond:

See why I am not buying the whole “higher interest rates will kill the economic recovery” argument? Yields between 4% and 6% were pretty common before the recession began and they existed with solid economic growth and less government debt. Even if yields rise further, to the 5%-6% range, it won’t be the end of the world. In fact, it might actually be nice for consumers. We finally have a positive savings rate in the U.S. and it would be good to get bank certificates of deposit to yield 5% again so those dollars being saved could earn solid interest.

Of course, many will argue that if mortgage rates reach 6%-7% the housing market will never recover because people will no longer be able to afford to buy a house. Consider these numbers, though. The monthly payment on a $200,000 mortgage at 5.5% (today’s rate) is $1,136, compared with $1,331 at a 7% mortgage rate. If you are earning ~$5,000 per month (about what you should make to buy a $200,000 house) another $200 per month (before the interest tax deduction, mind you) really should not be the difference between renting and buying for most people. Mortgage rates would have to go up a lot more to cripple the housing market, in my view.

Powerful Market Rally May Be Running Out of Steam

After a very surprising employment report this morning (payrolls declined ~350k versus expectations of ~525k), the market reacted well at first but sellers have emerged. The fact that the market is flat today tells me the rally is losing steam (normally that type of jobs report would mean 200 or 300 points on the Dow). We may be at a point now where slow economic improvement has been priced into stocks, and as a result, incoming data that supports that thesis may not give a huge jolt to equity prices going forward.

This is a perfect example of how the stock market discounts the future ahead of time. We have had an enormous move since early March (S&P 500 up 42% from 666 to 944) on expectations that the economy would begin to slowly improve. Now that it appears to be happening, the market is looking ahead at what might be next. The answer to that question is a lot less clear.

My personal fair value target for the S&P 500 remains 1,050 but I have been raising cash into this rally below that level because there are still risks to the economic recovery and I want to save some cash for the next market drop. Recovery has to be a foregone conclusion, in my view, for the 1,050 level to solely dictate my actions.

Not only that, but more and more strategists are looking for 1,000 on the S&P 500, whereas they weren’t even mentioning it as a possibility a month or two ago. As a contrarian, that makes me think it is getting less likely we will reach that level in the short term.

Market Loves GM Bankruptcy

I kid, of course. The market is up 200 points today, not because GM is filing bankruptcy, but rather because investors seem to understand that the event itself is not at all catastrophic. After all, Chrysler is emerging from bankruptcy shortly and actually saw sales go up after they filed. It seems that most people, investors and car buyers alike, understand that Chapter 11 is a legal corporate process first and foremost and should be an afterthought to car buyers. Still, who would have thought the market would react quite so well initially?

Two short points on GM. First, the stock is up 20% today to about 90 cents. It’s worthless, folks. Those who still grip their “efficient markets hypothesis” tightly can use this as a perfect case study against the theory.

Second, how will we be able to judge whether “New GM” is viable long term after they emerge from bankruptcy (which many say will be before summer ends)? It’s all about cost structure. Many attribute their latest woes chiefly to the weak economy and lack of credit, but they seem to have forgotten that GM was a money loser in 2006 and 2007, when credit was flowing more freely than any other time in our history.

Consider the chart below, which shows how far from profits GM has been over the last three years:

As you can see, GM needed a near-10% mark-up over cost to breakeven on their vehicles. They never hit that goal in 2006-2007, even before they started selling cars for less than they built them for in 2008. If “New GM” can get their costs down, and have them be predictable and stay low, the company might be able to make a comeback down the road. It won’t be easy, but Chapter 11 was the only way to make it even a reasonable possibility.

Full Disclosure: No position in GM, past or present.