MLPs

Master Limited Partnerships   Y. Siegel
Credit Suisse Take on MLPs: NGLs - From Supply Glut to Supply Shortage 212 325 8462
NGL Update Call with Industry Expert Peter Fasullo from En*Vantage: Key takeaways: 1) "The NGL business has never been so good". NGL prices are firm, frac spreads are at record levels and the growth in NGL production is being more than matched by robust petrochemical demand. 2) NGLs extraction is expected to grow by 500,000 bpd (23%) between now and 2015-2020. 3) Ethane extraction (excluding Marcellus) should grow even faster over this time frame. 4) Ethane demand is increasing because it is a cheaper feedstock for ethylene steam crackers. 5) Ethane demand is likely to grow by another 100,000 bpd over the next two years as the ethylene industry converts more furnaces and debottlenecks. 6) Canada is likely to import as much as 90,000 bpd of ethane over the next 10 years. 7) At least 85,000 bpd of Marcellus ethane will be required in the Gulf Coast to satisfy demand. 8) Short-term, planned and unplanned ethylene plant downtime can impact NGL fundamentals. Please contact your Credit Suisse salesperson for a copy of the slides and transcript.

Our Take: We also hold a positive outlook for NGLs and the MLPs that will benefit from building the requisite NGL infrastructure. The following MLPs within our universe have significant NGL exposure. EPD, ETE/ETP, DPM and NGLS are rated Outperform, TRGP and OKS are rated Neutral.

Our Take on EPD's Sale of ETE Units: ETE represents a non-core holding for EPD and we would expect EPD to continue to exit its remaining ownership of 34.5 million units. We maintain our Outperform rating on ETE. Although EPD's sale may create a perceived overhang on ETE's units, we view ETE's leverage to distribution growth and increasing units outstanding at ETP will drive strong distribution growth (9.9% 3-year CAGR).

Takeaways from the AGA Conference: Last week we attended the American Gas Association Financial Forum in Orlando. We had one-on-one/small group meetings with eight companies including CNP, NI, AGL, UGI, SE, MDU, TRP and ENB. Common themes included the continued growth opportunity tied to shale and unconventional resource plays, weakness in natural gas storage fundamentals and the importance of MLPs to energy infrastructure investment. See the full report for key takeaways.

Gross Processing Margins Down Slightly: Margins closed the week at $1.00/gal, down from $1.02/gal the previous week, driven by lower crude oil and NGL prices.

MLPs Up Last Week: The Alerian and Cushing 30 MLP Indices closed the week up 1.4% and 1.1% respectively vs. loss of 0.8% and loss of 0.3% for the Russell 2000 and S&P 500 indices.

Ford Meetings

Begin forwarded message:

From: "Michaeli, Itay "
Date: May 25, 2011 6:59:05 EDT
To: undisclosed-recipients:;
Subject: F: Takeaways from Management Meetings; Reiterate Buy

Key Points:
 
What's New? — We recently visited Ford’s headquarters where we met with members of senior management. We walked away with increased comfort around key issues and reiterate our recently upgraded Buy rating ($18 target).
 
Key Takeaways — Management appeared constructive regarding industry pricing discipline, and noted that its own recent price increases were received well. Although management reminded us that 2011 price momentum could slow after a stellar Q1, an affirmation of the overall price-discipline strategy, May pricing checks and Ford's product cadence point to a continued favorable environment. On costs, management indicated that internal structural cost forecasting has proven itself reliable (limited cost creeps) and that the recent commodity pullback has been a welcome development.
 
Progress Towards Investment Grade— A restoration of investment grade ratings was a key thesis behind our recent upgrade of Ford shares. Though management understandably could not provide a timetable for an upgrade, we sensed that our late-2011/early-2012 timetable resonated as a reasonable base case. Management pointed to the benefits from removing collateral packages and widening the funding sources at Ford Motor Credit, which we think would improve long-term growth prospects. An historical analysis of crossover situations points to a favorable re-rating potential (see Figures 1 & 2) for the shares, particularly given Ford’s captive finance position.
 
Reiterate Buy, Potential Catalysts Ahead — Ford is hosting an investor day on June 7 in New York. We believe management may provide additional medium-term parameters around key metrics. While we don't view out-year consensus estimates as conservative, a reassuring margin outlook should be sufficient to revive sentiment in the shares at the currently low 4.0x 2011E EBITDAP multiple (~10% FCF yield) and amidst industry pricing strength.  The upcoming UAW negotiation will also be a focal point, with the focus on whether Ford is able to narrow the remaining modest cost gap with domestic competitors (even at an upfront cost).
 
Please click on the following link for access to the full report: https://www.citigroupgeo.com/pdf/SNA81019.pdf
 
_______________________________
Itay Michaeli
Autos & Auto Parts
Equity/Debt Research
Citi Investment Research
(212) 816-4557
itay.michaeli@citi.com 
 
"We Value Your Feedback! The Institutional Investor Poll matters to our Analysts. If you value our work, we would appreciate your recognition. Please visit www.institutionalinvestor.com/rankingassistance to request a ballot."
 
 
For important disclosures regarding Citi Investment Research & Analysis ("CIRA"), including with respect to any issuers mentioned herein, please refer to the CIRA disclosure website at https://www.citigroupgeo.com/geopublic/Disclosures/disclosure.html. 
 
 
 
 

Gold man's read on the NFP for April

Results from the household survey were disappointing. Total household employment fell by 190k, and the unemployment rate rose to 9.0% (8.96% unrounded) from 8.8% previously. Results were somewhat better after adjusting for methodological consistency with the nonfarm payroll data; on this basis the household survey measure of employment would have increased by 50k. However, the labor force participation rate was unchanged during the month, indicating that the rise in the unemployment rate reflected job losses rather than an influx of persons into the labor force. While the news was discouraging, it follows four months of declining unemployment, and the level of the unemployment rate remains down 1.1 percentage points from its peak. The employment-to-population ratio fell slightly to 58.4% from 58.5% previously.

Services ISM, yuk

The April ISM Non-manufacturing index was at 52.8%, down from 57.3% in March. The employment index indicated slower expansion in April at 51.9%, down from 53.7% in March. Note: Above 50 indicates expansion, below 50 contraction. 

Click on graph for larger image in graph gallery.

This graph shows the ISM non-manufacturing index (started in January 2008) and the ISM non-manufacturing employment diffusion index.

From the Institute for Supply Management: April 2011 Non-Manufacturing ISM Report On 

Is Buffett's Teflon Finally Wearing Out

Is Warren Buffett’s Teflon finally wearing off?

After key lieutenant resigns under cloud, some asking if it’s time for Buffett to go

By Ben Berkowitz

NEW YORK — Aside from maybe the odd cheeseburger stain on his tie, nothing much sticks to Warren Buffett.

Whether his underlings are convicted of helping insurance companies inflate results or a major company he helps oversee is sanctioned for accounting shenanigans, his admirers don't seem to care. Or at least, they haven't historically.

But with a key Buffett lieutenant resigning under a cloud recently, some sophisticated investors are no longer willing to overlook the obvious. For all the shareholders who still consider Buffett the epitome of American capitalism, there are others who wonder whether the time may be near for Buffett to take a graceful bow and exit the stage.

Some will clamor for that this weekend, when 40,000 of his shareholders prepare to descend on Nebraska for the annual meeting of Berkshire Hathaway, the ice-cream-to-insurance conglomerate he runs with absolute authority.

"I want to hear more about Sokol, I want to hear more about how they're going to outperform the markets. I want to hear about what (Buffett's recent) trip to India leads us to believe about how the money is going to be invested in the future," said Michael Yoshikami, chief executive of wealth management firm YCMNET Advisors and a widely quoted Berkshire shareholder.

Investor disappointment reflects not just the revelation that David Sokol, once Buffett's presumed successor as chief executive, bought stock in a company he then pushed Buffett to acquire. It is also because of Berkshire's lackluster performance recently, and questions about the firm's ability to thrive after its octogenarian chairman and chief executive moves on.

Berkshire Hathaway has grown exponentially over decades, but many investors question how it can possibly do as well in the future. With the dozens of companies that Berkshire Hathaway owns having had relatively little oversight for years (by Buffett's own proud admission), some wonder how much earnings power Berkshire actually has and whether future earnings can be as strong as past.

"Obviously Berkshire has intrinsic value but now I have to question that intrinsic value," said Janet Tavakoli, an expert on derivatives and author of "Dear Mr. Buffett," a 2009 book laden with fulsome praise for the legendary investor. Tavakoli, like many others, has revised her thinking sharply in the intervening years.

Yet she, like so many others, added an important caveat about Buffett: "(His) brand is so powerful you are reluctant to question."

Sokol affair
By now the details of Sokol affair have been told many times. Citigroup bankers pitched a long list of companies to Buffett's presumed successor, and he told them he thought Lubrizol Corp, which makes lubricants and other chemicals, might make a good acquisition target. He started buying up shares for his own account, and after building up a $10 million position he pushed Buffett to buy the company.

As Buffett put it, Sokol made only a "passing" mention that he owned some Lubrizol shares.

Sokol made about $3 million on the trade, perhaps at Buffett's expense. Buffett has been called to task for how he handled the matter. In a letter to investors, he announced Sokol's resignation, explained the stock issue and offered a grant of absolution: "Neither Dave nor I feel his Lubrizol purchases were in any way unlawful," he wrote.

Less than three weeks later, the first shareholder suit was filed, accusing Berkshire's board of breaching its fiduciary responsibility. More are expected, particularly from bigger firms with a track record of winning large settlements for shareholders.

Governance experts say Buffett blamed the sin but not the sinner.

"The response wasn't as strident as ... I would have hoped for in suggesting that personal stock transactions that are related to corporate stock transactions are problematic and not the sort of thing that the company thinks is a good idea," said Charles Elson, director of the Weinberg Center for Corporate Governance at the University of Delaware.

"And I would hope in these situations that you would be pretty tough on that in your response."

Some of Buffett's biggest investors also say he should have chastised Sokol or told him to sell his stock. What is murkier, however, is the question of whether Buffett actually did anything wrong from a legal standpoint.

"There's a lot of very problematic behavior here that doesn't easily find an explanation, so the question remains, what in fact was going on here?" said Harvey Pitt, chief executive of Kalorama Partners and the former chairman of the U.S. Securities and Exchange Commission.

"Why would somebody be allowed and be deemed to have acted properly in profiting to the tune of $3 million based on his privileged position at the company?," Pitt added.

It wasn't the first time that Buffett has been close to people behaving questionably. But few of his investors have cared, and the damage to his reputation seemed slight if at all.

In 2008, for example, the government won convictions of four executives from his reinsurance business for helping other insurers inflate their results. The nearly uniform reaction from legions of Buffett fans around the world: yawn.

And in 2005, the SEC sanctioned the Coca-Cola Co, whose audit committee Buffett sat on, for inflating earnings. His admirers barely batted an eyelash.

'That's my guy'
Buffett, of course, benefits mightily from his folksy image. After all, it's tough to imagine how someone who drives himself to work and stops at McDonald’s for a bite on the way home can also be guilty of high crimes of finance.

"Warren Buffett works very hard reflecting an image that 300 million Americans, six billion people around the world say, 'That's my guy. That's the way I'd like to be like.' And he works very hard at that -- not every week or every month, but every day. And I think by working hard at it every day, he drives that image hard into people's minds," said Robert Dilenschneider, a public relations executive who heads the Dilenschneider Group in New York.

The audience at the annual meeting is one of the tools he uses to burnish his reputation. There is no better financial television than footage of Buffett having an ice cream at (Berkshire-owned) Dairy Queen, with hordes of investors thronging him and hoping he might drop a stock tip on the floor with the crumbs of his vanilla cone.

It is hard to interrupt that storyline.

"With the cash that he was able to squeeze out of that dying textile business (Berkshire Hathaway) and astutely reallocating it year after year after year, the business grew from $18 a share to $120,000 a share," said Roger Lowenstein, author of a well-regarded 1995 Buffett biography and a number of other finance books.

"I have no doubt that he'll be regarded as the investor and probably the financier of the era. This incident sort of tells people that he's human."

Performance under fire
While many would agree with Lowenstein on Buffett's place in financial history, his returns of late have not necessarily matched his reputation.

Berkshire shares have only barely matched the S&P 500 since September 2008, the depths of the crisis and the time Buffett made some of his most lucrative bets, like buying Goldman preferred shares that threw off more than $15 a second in dividends.

Just this year, Berkshire has underperformed the S&P 500 by about 4 percent. Buffett has said returns will slow, so it does not necessarily come as a surprise.

There is expected to be less reluctance to question him this year in Omaha. Author Tavakoli said shareholder dissatisfaction was already palpable at the last meeting she attended in 2009, as Buffett went on about his bet on Wells Fargo and investors grumbled that he was not talking about the "crony capitalism" they saw behind the crisis-era bailouts.

"It seems as if Warren Buffett has sort of lost touch with the tone of the people who invest in Berkshire Hathaway and their sentiment," she said.

The Q&A session will again be moderated by financial journalists this year, so even if investors don't ask tough questions, reporters may. Words like "contentious" and even "raucous" are being thrown around. And yet, some investors still do not expect much.

"I don't expect any great revelations but what I want is not necessarily what I'm going to get," said YCMNET's Yoshikami.

Yet he still expects the annual meeting to be a "lovefest," given the overwhelming number of shareholders who flock to Omaha annually for nothing more than pearls of Buffett's wisdom (and perhaps some discount pearls from his jewelry business, one of a number of Buffett companies to offer steep shareholder discounts over the course of the weekend).

Yoshikami said that if Buffett gets away from the Sokol episode unscathed, it will be because he has banked sufficient goodwill with investors in the past.

"When you have an inventory of transparency that you can fall back on I think you get the benefit of the doubt," he said. "I think when you self-disclose enough and you have a reputation for self disclosing it buys you some reputation credits."

But no matter what Buffett says or does in Omaha, there is a growing realization that the old days have slipped by. Buffett and his partner, Charlie Munger, are aging, the questions about the future of the conglomerate are getting louder and people are recognizing, as they do, that all good things have to come to an end.

"The passage of time is hitting home. This year is the end of Berkshire as it used to be," said Alice Schroeder, a former stock analyst who wrote what many view as the definitive biography of Buffett.

"It will never be the same. Even if people think Buffett's not going to address all these issues and the questions won't be as tough as they should be, Berkshire as it used to be is over," Schroeder said.

WSJ: Pricing Power (CdeR)

By JOHN SHIPMAN And PAUL VIGNA

More companies that had resisted raising prices are conceding they have few alternatives with commodity costs continuing to climb on everything from steel to cocoa beans.

In the quarters following the recession, the ability to raise prices and make them stick re-appeared primarily at industrial companies selling to other businesses. Now, consumer-oriented companies that haven't been able to raise prices are running out of ways to hold the line on margins.

View Full Image

The result is more retailers, construction-related and consumer-oriented companies are finding they must raise prices, even at the risk of undermining sales. Some vow to find new cost cuts but with little specificity. Airlines, which have had some post-recession success in raising prices by constraining capacity, appear to be reaching a limit on additional increases.

Auto-parts manufacturer Johnson Controls Inc. last week said it will boost its auto and marine battery prices by between 5% and 9%. Johnson Controls doesn't report its fiscal second quarter until April 25, but the company has already raised its profit forecast for the year and posted a 31% fiscal first quarter profit gain.

In contrast, parts retailer Genuine Parts Co., which owns Napa stores, said first-quarter gross profit slipped to 28.5% from 29.2%, due in part to "competitive" pricing pressures. Struggling to raise prices, the company is working to shave more costs, executives said Friday. Chief Financial Officer Jerry Nix said customers are "pushing back" on price increases.

Major airlines, which release calendar first quarter profits beginning next week, have had six significant price increases this year. However, their most recent efforts, including a bid this month to boost domestic fares by between $5 and $10 each way, unraveled.

Food sellers are among the few retailers hoping for inflation to bail them out of declining pricing power. Grocery store operator Supervalu Inc., which last year struggled with food deflation, reported lower fiscal fourth-quarter profit last week. Chief Executive Craig Herkert said that the company did see a "modest amount" of inflation in the quarter and was "successful in passing it through to retail prices."

The Federal Reserve said last week "manufacturers generally [are] finding less resistance to price increases than either retail or construction (where weak demand was a limiting factor)." Fed branches in Richmond, Va., and San Francisco, for instance, noted strong competition and lukewarm demand are limiting local retailers' ability to raise prices.

For companies that have balked at raising prices so far, falling profits are leaving them little room to maneuver. "Firms that are seeing input costs jump are likely worrying that if they pass through those increases they will lose sales as consumers cut back to pay for gasoline," wrote economist Joel Naroff of Naroff Economic Advisors. "But the constant drum beat of rising costs has to be affecting earnings."

For instance, toy makers Hasbro Inc. and Mattel Inc. each have said they are raising prices in the face of rising costs. Hasbro last week reported profit fell 71% on flat revenue while Mattel's net dropped 33% amid higher expenses.

Hasbro Chief Operating Officer David Hargreaves said Thursday that the company hasn't had any pushback from retailers after raising prices earlier this year. Retailers understand commodity costs are increasing, he said, and "I think they accept that the prices need to go up a bit to cover these costs."

But resistance to price increases can hurt sales. Revenues at United Forest Products Inc., which makes a variety of housing-related wood products, fell 1.5% and the company reported a $3.7 million loss.

Chief Executive Michael Glenn said in an effort to increase sales "some of our operations simply took ... business priced at levels that were unacceptable." United Forest added fuel surcharges late in the quarter to counter rising diesel costs, but it has been "a little bit of a battle" to get customers to accept them, he said.

BRCM upgraded at Oppenheimer on valuation.

Sent from my Verizon Wireless Phone

Distressing Home Sales Gap

Another update ... this graph shows existing home sales (left axis) and new home sales (right axis) through February. This graph starts in 1994, but the relationship has been fairly steady back to the '60s. Then along came the housing bubble and bust, and the "distressing gap" appeared (due mostly to distressed sales).

Click on graph for larger image in graph gallery.

The gap is due mostly to the flood of distressed sales. This has kept existing home sales elevated, and depressed new home sales since builders can't compete with the low prices of all the foreclosed properties. 

Mauldin, QE2 - Posted so it will be archived

This is in addition to the email just sent out, same thing, but I thought to post it here in case you wish to refer to it in the future.

The End of QE2? The Fed committed to buying $600 billion of Treasuries between the beginning of QE2 in November and the end of June. June is 3 months away. What will happen when that buying goes away? The hope when QE2 kicked off was that it would be enough to get the economy rolling, so that further stimulus would not be deemed necessary. We’ll survey how that is working out, with a quick look at some recent data, and then we go back and see what happened the last time the Fed stopped quantitative easing. First, the guy on the street is getting squeezed. Real US consumer spending slowed in January and looks like it did only marginally better in February. The Fed argues that inflation is mild, as they prefer to look at “core” inflation (inflation without considering food and energy). If you look at it that way, they are right. And in normal times, I can kind of see why we strip out energy and food, as they are very volatile price points and can move a lot from month to month. But that argument gets a lot weaker when your main policy, that of significant quantitative easing, is perhaps CAUSING the rise in food and energy (as well as weakening the dollar)! If the Fed policy is at least contributing to the cause of total inflation, arguing that food and energy don’t count doesn’t hold water. Let’s look at the following chart from economy.com. In particular, notice the rise in the last three months since the beginning of QE2. Inflation is running at over 5% on an annualized basis. Companies like Kimberly (diapers, etc.), Colgate, P&G, and others all announced 5-7% price increases this week. These are companies that provide staples we all buy. Those prices matter. Even Wal-Mart will have to pass those increases on. To say that food and energy don’t matter misses the point. These items have real economic impact. As my friend David Rosenberg wrote this morning: “In February, there was no inflation at all in average weekly wage-based earnings but there was 0.5% inflation in consumer prices, meaning that real work-related income was crushed 0.5% and has now deflated in each of the past four months and in five of the past six months, during which it has contracted at a 2.3% annual rate. Once the effects of fiscal stimuli wear off, this negative income trend will show through in a much more visible slowing in real consumer spending that we doubt the markets have fully discounted. So far, what has happened in equities has been treated as a financial event – just wait until the economic event follows suit. And it’s not only fiscal stimulus that is soon to subside. We still have that 86% correlation over the past two years between movements in the Fed balance sheet and the direction of the S&P 500 – this too will come home to roost before long, whether or not we end up seeing a resolution to the crises in Japan, Libya or Bahrain.” He goes on to give us this chart: How’s that QE2 thingy working for you, Mr./Ms. Average Worker? Prices up, income down? And remember, most workers got the equivalent of a 2% pay hike with the temporary boost in Social Security, which goes away at the end of the year (and without which the economy and consumer spending would be even worse!). Maybe that’s why New York Fed Chief William Dudley got heckled this week. (Courtesy of the Agora 5 Minute Forecast:) “Dudley – a 21-year vet of Goldman Sachs – stepped out of his bubble to explain Fed policy to real people in Queens. “It might not have been the first time Dudley attempted to gain the trust of the hoi polloi, but we’re pretty sure it’ll be the last. The details here were reported widely. We divined the scene from a Reuters report. “First Dudley swore up and down that inflation was no problem. ‘When was the last time, sir,’ came a reply from the audience, ‘that you went grocery shopping?’” “Dudley boldly proceeded to explain the concept of ‘core CPI’ – the cost-of-living measure designed for people who don’t eat or consume energy. Heh, we know firsthand how well that goes over… “Then in a brilliant stroke, he pointed to Apple’s shiny new iPad 2 to illustrate his point. ‘Today you can buy an iPad 2 that costs the same as an iPad 1 that is twice as powerful,’ he gamely explained. ‘You have to look at the prices of all things.’ “‘I can’t eat an iPad,’ someone yelled from the crowd.” Ouch. (For the record, I do go to the grocery store and Wal-Mart and Home Depot, as well as other less frugal venues.) And core inflation may soon be under pressure. There were two articles yesterday, one from Yahoo and the other on Bloomberg. Both related to rising pressure on rental costs. (My recent lease renewal increase was significantly above core CPI!) (From http://realestate.yahoo.com/promo/rents-could-rise-10-in-some-cities.html) “Already, rental vacancy rates have dipped below the 10% mark, where they had been lodged for most of the past three years. ‘The demand for rental housing has already started to increase,’ said Peggy Alford, president of Rent.com… By 2012, she predicts the vacancy rate will hover at a mere 5%. And with fewer units on the market, prices will explode.” Look at this graph showing their projections: Here’s what to pay attention to. Notice that since 2002 (or thereabouts) rental costs have been flat, and down of late (inflation-adjusted). If Rent.com projections are anywhere close, we could see a rise in rents of 15% by the end of 2012. Let’s remember that 23% of the CPI and 40% of core CPI is Owner Equivalent Rent. If they are right, that adds about 3% to total CPI and 6% to core CPI! Will the Fed be telling us to focus on core inflation in 12-18 months? And those prices will start to show up steadily. “This is a sharp change from the recession, when many Americans couldn't afford to live on their own. More than 1.2 million young adults moved back in with their parents from 2005 to 2010, said Lesley Deutch of John Burns Real Estate Consulting. Many others doubled up together. “As a result, landlords had to reduce prices and offer big incentives to snag renters. Now that the recession is easing, many of these young people are ready to find new digs, mostly as renters, not owners. Plus, the foreclosure crisis continues unabated, and the millions losing their homes are looking for new places to live.” Producer Prices Up 35-40% in the Last Six Months Then let’s look at business. The Producer Price Index was out this week, and it was way up – 1.6% for the month, or an annualized 20%+. Even if you look at the last year, it was up a real 5.8%. That is inflation in the pipeline. Look at this chart from economy.com. Notice the trend since QE2 was announced in August and implemented in November. I won’t bore you with the details, but for those interested, go to www.bloomberg.com and search for “Japan supply issues” and further on “semiconductors.” It is clear that, at least for a while, prices of electronics and tools are going to rise as one company after another is shutting its production lines down in Japan. Auto manufacturing plants in the US will have to close soon, as critical parts from Japan are not going to be forthcoming. Flat screen TVs? The iPad 2 I keep trying to find? All sorts of companies are going to get their costs squeezed even further. Remember, the above PPI numbers are from before the Japanese earthquake and tsunami and nuclear disaster. (I was in Tokyo less than two weeks ago. I can’t imagine the stress and anguish going on there. The scope of the disaster is just shattering. I encourage my readers to go to http://american.redcross.org and donate directly to their Japanese fund or the charity of your choice. A few details from Japan, though, gleaned from here and there. Sony alone makes 10% of the world’s laptop batteries. Japan is responsible for 30% of global flash memory, 20% of semi-conductors, and 40% of electronic components. The point is that the Fed has created real pressure in the price pipeline, primarily on basic commodities and energy. “Crude” goods, which is basically materials before there is any value added, are up 28% from a year ago and pushing an annualized 35-40% for the last six months. Those costs are filtering in to final finished products. And when you add in the supply-related problems from the recent disaster? It is not a pretty picture for profits. Let’s go back and look at a graph from friend Vitaliy Katsenelson, from a few weeks ago. It points out that corporate profits are back close to all-time highs as a percentage of GDP. As the brilliant Jeremy Grantham says, and I am paraphrasing, corporate profits are among the most mean-reverting of all statistics. And this makes sense unless capitalism is broke. High profits entice competitors to come in and take market share by selling for less. If corporate profits went back (mean-reverted) to their longer-term average, P/E ratios would be close to 24 at today’s prices. Corporations have some room to absorb some price increases, but at the expense of the bottom line. What Happens When We Come to the End of QE2? We have only one instance where the Fed cut back on quantitative easing, and that was last year. It is a data set of one, but it is all we have. So, let’s look at what happened. As noted by several sources (but I am looking at Rosie’s list right now), the Fed let its balance sheet contract by some 12% from late April to late August. Quoting: “Now over that interval ... “The S&P 500 sagged from 1,217 to 1,064…. The S&P 600 small caps fell from 394 to 330…. The best performing equity sectors were telecom services, utilities, consumer staples, and health care. In other words — the defensives. The worst performers were financials, tech, energy, and consumer discretionary…. Baa spreads widened +56bps from 237bps to 296bps… CRB futures dropped from 279 to 267…. Oil went from $84.30 a barrel to $75.20…. The VIX index jumped from 16.6 to 24.5…. The trade-weighted dollar index (major currencies) firmed to 76.5 from 75.5…. Gold was the commodity that bucked the trend as it acted as a refuge at a time of intensifying economic and financial uncertainty — to $1,235 an ounce from $1,140 and even with a more stable-to-strong U.S. dollar too…. The yield on the 10-year U.S. Treasury note plunged to 2.66% from 3.84%…” What will happen this time around? Is the economy strong enough to grow on its own without stimulus, or strong enough that the Fed will be reluctant to continue with QE3? My friends at Macroeconomic Advisors have reduced their first-quarter GDP projection to 2.5%. Morgan Stanley has dropped theirs from 4.5% less than six weeks ago to 2.9% today. That is a huge drop in a short time for a forecasting model. Forecasts at other economic shops are being slashed as well. States and local governments, as I have continuously noted, are cutting more than 1% of GDP from their budgets as I write. That translates into real-world pressure on the GDP (even if it’stemporary, which I believe it to be, we live in the present). I am not ready to use the “R” word, but Muddle Through could show up with a true vengeance this summer, with higher inflation and slower growth. I lived through the ’70s, and frankly, I would just as soon not go see that movie again. The danger here is that the Fed (Bernanke) watches the economy slow and decides we need another round of quantitative easing. I have resisted that idea but, as I have noted, sometimes we need to think about the unthinkable. And thus, I come to the end of the letter with a brief note on a very worrisome conversation I had yesterday with Martin Barnes, editor of the esteemed Bank Credit Analyst. Martin is one of the people I call when I want to know what the Fed might do. I guess I was looking for assurance that the Fed would not do QE3. I did not get it. “Look, John” (insert Scottish brogue as I paraphrase), “if the Fed sees the economy rolling over into recession they will put their mandate for employment ahead of their mandate for stable prices.” “But that would mean higher inflation in the face of a slow economy.” “And?” he shot back. “That would just be the price of trying to increase employment, in their minds.” “But at some point you have to bring out your inner Volker!” I intoned. “What about the future?” The conversation continued, but I never got my warm and fuzzy assurances. For the record, another round of QE, unless there is a true liquidity crisis (and the last QE did not qualify!), would be a disaster, at least from the cheap seats where I sit. There are all sorts of inflationary and stagflationary consequences, none of which I like.

Something Does Not Compute!