Breakfast on Wall Street – 25 September 2013

Market Commentary

The S&P 500 and the Dow Jones Industrial Average both declined on Tuesday, 25th September. The S&P was down 0.26% and ended the day at 1,697.42, while the Dow was down 0.43% to close at 15,334.59. It is quite evident that market performance is echoing guarded investor sentiments. Before basing their trading decisions on the declines, investors should remember that both indexes are trading within 1% of their all-time highs.

The obsessive concern with the potential tapering of the Fed’s bond buying program gave way to euphoria in the markets last week when the Fed decided not to reduce the growth rates of its balance sheet – yet. Subsequent to the relief rally, the market this week has decided to concentrate on other news that might affect long and short-term fundamentals. The primary issue is again centered in Washington where the likelihood of a government shutdown is ever increasing. The House Republicans are yet to support a budget deal that does not include killing all financing for the President’s signature healthcare bill – Obamacare. The President has sent clear signals that he will veto any bill that comes to him that does not include financial support for Obamacare.

While there were no significant data releases on Friday or Monday, the Case-Shiller Home Price Index data was released yesterday. The data was extremely positive with US home prices rising at its fastest pace in the last seven years. The 20-city Composite rose 12.4% year-over-year in July. This supports our earlier forecast that had predicted an improving housing market. We had published a note in August citing improving fundamentals, low prices and increasing rents as primary grounds for a surge in the housing market. However, rising mortgage rates from May ought to slow down the rise in the index in the coming months. Home prices will still rise, albeit at a slower pace. The markets that had been severely depressed during the recession (like Los Angeles and Las Vegas) will continue to outperform tighter markets like New York and Northern New Jersey. This is a sign of the risk-on trade in real estate, where large players like The Blackstone Group (NYSE: BX) are buying properties in these depressed markets to rent them out. We are also bullish on markets that are contingent on the government, primarily in DC, Baltimore and their suburbs. Investors should note that the size of every new government has been larger than the previous one; it has never mattered which party commands the White House, the Senate or the Congress.

While the housing market provided some good news, Consumer Confidence again came in worse than expected. While we have been cautioning about Consumer Confidence in the last few months, it is curious that brokerage analysts are not revising their expectation downwards. With unemployment at 7.5% nearly 4 years after the end of the recession and both manufacturing and small business surveys still showing no signs of a positive sentiment, Consumer Confidence cannot possibly keep moving upwards. The effects of the poor confidence data has also been seen in retail sales numbers and will continue to do so.

Blackberry Buyout

We recently published a note on Blackberry (NASDAQ: BBRY) suggesting that—despite its recent troubles—investors should be bullish on the firm. Our reasoning was based on the fact that the stock was trading at $8.75, while we had calculated a liquidation value of around $6 billion, that is, a $10 – $12 price per share. Our earlier analysis is available here.

However, the offer from Fairfax Holdings and its CEO, Prem Watsa, which is already the largest shareholder in Blackberry, is significantly below our lowest estimates. We believe the company is being undervalued by Fairfax and a counterbid is unlikely due to plummeting market share and rising inventories. According to IDC, Blackberry’s global market share in smartphones is 2.8% in 2013. It was 5% in 2012 and 11% in 2013.

The Fairfax-led consortium has offered to buyout Blackberry for $4.7 billion or about $9 per share. Despite the fall in market share, we believe that Blackberry’s recent announcement that states that the firm will be focusing only on corporate clients is one that will help them bounce back. Blackberry is not the new Palm and we do see a future of the firm as a running concern. Even if there are no growth expectations for the firm, the liquidation value of its assets, cash holdings and patents is definitely above $10 per share. With a $130 million break-up fee, shareholders might be ready to go ahead with Watsa for the moment. We hope that Fairfax can arrange the financing for the buyout (Fairfax has no penalty for walking away), but we will glad to see a counterbid closer to what the company is actually worth.

Data Release

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Earlier This Week

Merkel Set for Her Third Consecutive Term as Chancellor

Angela Merkel is heading for a third consecutive term as the German Chancellor. Her party, the Christian Democratic Union (CDU), along with its sister party, the Christian Social Union (CSU), is set to record their best election score since the German Unification. As per exit polls, her party is likely to win 42% of the vote which, just three seats short of an absolute majority. This is a national validation of her skillful handling of the Eurozone crisis and of the domestic economy. Meanwhile, Merkel congratulated her party, while terming the victory as a “super result.”

China Manufacturing Growth Expands, Reaches Highest Levels in 6 Months

The Chinese economy is gathering momentum after a recent slowdown and is showing signs of sustained recovery. China’s manufacturing index expanded in September to hit a six-month high, indicating a financial recovery in the world’s second largest economy. China’s Purchasing Managers’ Index stood at 51.2, compared to 50.1 in August, while its industrial output, exports and retails sales have all increased at a faster pace in recent months. The recent manufacturing growth data has raised optimism that the Chinese economy will achieve its targeted growth rate of 7.5% this year.

Obama Backs Potential Talks on Nuclear Deal with Iran

President Barack Obama and the new Iranian President, Hassan Rouhani, raised hopes of a new era of US-Iran diplomacy. Commenting on Iran’s nuclear program, Mr. Rouhani said that Iran had the right to pursue a peaceful program on nuclear energy but also asserted that nuclear weapons were against their religious and ethical principles. President Obama has embraced Tehran’s approach to nuclear diplomacy and said that he would coordinate with Iran for any possible dialogues. This is the first time in years that it seems that Iran might be agreeable to negotiate a treaty that would permit it to acquire nuclear energy and yet prevent its use as a weapon. However, Mr. Rouhani criticized Washington’s approach in handling terrorism across nations and use of drones to kill alleged terrorists.

GM to Sell $4.5 Billion Bonds to Reduce Cost of Capital

General Motors Co. will sell $4.5 billion of unsecured debt in order to reduce its overall cost of capital. GM will use $3.2 billion of the proceeds to buy back 120 million preferred shares valued at $3.2 billion that are held by a United Auto Workers union retiree health-care trust. The residual $1.2 billion of the proceeds will be used to settle payment of 7% notes, which are held by the Canadian Auto Workers’ Union Health Care Trust, scheduled to expire in 2018.

Debt Ceiling Deadline Raises Concerns In Washington

The prospect of a debt default is making political parties and the markets anxious as the deadline for the Washington budget deal is approaching. The lawmakers are pressing hard to authorize more borrowings to ensure that the US meets its debt obligations, as both the parties have not yet come up with a concrete strategy. The Republicans are proposing spending cuts in exchange for raising the $16.7 trillion borrowing limit, which would mean that Congress would have to slash spending on programs like pensions and healthcare for the elderly.

Bank of America Faces Trial for Defective U.S. Mortgages

Bank of America Corp. will set to go to trial for selling defective mortgages leading to the financial crisis in 2008. The lawsuit filed in October by Fannie Mae and Freddie Mac, the U.S. government enterprises, held the bank responsible for the thousands of subprime mortgages, which later defaulted, resulting in losses estimated to be $848.2 million. The claim marks the first instance where a major bank will undergo a trial by the government for the flawed mortgages that triggered off the sub prime crisis. However, Bank of America termed the claims as “simply false” and maintained that no fraud had occurred.

Data Releases Later this Week

To follow up on our bearish call on crude oil, we will be keeping a watch out for Crude Inventories data coming out tomorrow. Of course, we will also be analyzing the the most important numbers of the economic release cycle, which are the Jobless Claims data coming out on Thursday and the Personal Income and Spending data releasing on Friday.

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