The news story above, which will no doubt be taken as Gospel by all and sundry who ingest it over the next 24 hours, summarizes a quarterly survey from The National Association for Business Economics.

Sara Johnson, one of the geniuses who helped read the report from its original stone tablet, told Reuters that it “provides new evidence that the U.S. recession is abating…

“Industry demand was still declining in the second quarter of 2009,” Johnson continued, “but the breadth of decline had narrowed considerably since late 2008, raising prospects for stabilization in the second half.”

We’ve gone over the “less bad as good” point many times here in these pages, so let’s skip ahead and look at what’s leading this “stabilization.”

“Of the four major sectors, financial services showed the strongest demand, with an index reading of +15. The transportation, utilities, information and communications sector had the lowest reading at -90.”

So, having just been handed the largest, system-wide smack down since the Great Depression, financial services are apparently back in the economic driver’s seat. Your editor remains a little dubious here but, even if we assume that this is the case and that the likes of Goldman and JP Morgan are in fact leading the way, is this really reason to cheer? In other words, is what’s good for Goldman and JP really good for America?

Earnings reports from Wall Street’s two remaining powerhouses last week showed that a huge portion of their second quarter profits came from “trading and investment banking results.” Who, besides these two institutions, wins when their traders are posting profits?

As Bill Bonner explains, “Anyone who takes this as evidence of a recovering economy should work for the government. Only a government economist or a mental defective (excuse us for being redundant) could believe that genuine prosperity can be built on a foundation of speculating by large financial institutions. You can see why by asking a simple question: whom were they trading against?”

“Speculating is a zero-sum game,” Bill continues. “No matter who wins, the economy is not a bit better off; it has not a centime more in resources. Goldman and JPMorgan report earning, together, more than $6 billion. Who was on the other side of that trade?”

Your editor cheers the possibility of a recovery as much as the next guy. We prefer freedom, prosperity and apple pie for all. But we prefer the kind of recovery that is based in solid capital formation, robust productivity, job market growth and increased manufacturing. In increase in trading profits at a couple of government-coddled, risk-heavy banks is not the kind of basis for recovery that imbues great confidence, in other words.

When a Roman carpenter had finished building a new house, he was forced to stand under the doorway as the scaffolding was pulled away. If the roof ended up on his head, it was considered his punishment for erecting a dangerous structure. That way the homeowner avoided injury and the carpenter could never endanger another unsuspecting customer. We may have come a long way since those days, but when the roof comes down on the economy, the only people standing under the doorway are the poor fools who bought the place. The CEOs, economists and policy wonks responsible for the mess are already down the street, building a whole new development.

Source:  The House that Recovery Built

After dividends, the second-largest U.S. bank reported net income of $1.52 billion, or 40 cents a share, on $25 billion in revenue.

Investors have been cautiously cheering the performance of the financial sector, whose enormous losses led the stock market into decline. JPMorgan’s quarterly earnings report – like that of Goldman Sachs Group Inc. (GS) and rosy estimates from Bank of America Corp. (BAC) – serves as another psychological prop to jaded investors.

Perhaps the biggest surprise was JPMorgan CEO Jamie Dimon’s claim that the Wall Street bank has the resources to pay back the $25 billion it borrowed from the U.S. Treasury’s Troubled Asset Relief Program (TARP). Earlier this week, Goldman Sachs sold $5 billion in shares to repay half of what it borrowed from TARP.
“We could pay it back tomorrow,” Dimon said on a conference call, adding that the bank is waiting for guidance from the government.

JPMorgan’s investment banking business was a large driver of profits, bringing in a record $8.3 billion in revenue, including $4.9 billion from fixed-income trading alone. The investment-banking arm brought in $3 billion during the same period last year.

“It is almost certain we will see no improvement in those numbers for the next three quarters, probably through the middle of next year,” Gavin Graham, director of investments at Bank of Montreal Asset Management in Toronto, said in a Bloomberg TV interview.

Source: JPMorgan Beats First Quarter Estimates, Continues Bank Earnings Rally

With the economic calendar being so light, I thought I would take some time to give you my thoughts on what I see happening in the markets over the next 12 months.

• As I mentioned in my piece on Dec. 17, I think the market will do well in 2009. There are just way too many coincidences lining up to lead me to believe otherwise. I still think there will be periods of decline, but overall, the market should close 2009 significantly higher.
• The banking industry will undergo historic consolidation. Like it or not, some of the $700 billion from the bailout will be used to buy up smaller banks. As larger banks scramble to right the ship, the deposit base of hundreds of smaller banks will be too hard to ignore
• The hedge-fund industry as we know it will cease to exist. Much like the investment-banking industry, the business model will come to an end. Regulators will be forced to rein in the industry as investors complain about mounting losses.
• The housing industry bottoms out during the first quarter or so, and then new regulations enacted by President Obama buoy the market. Foreclosures trail off as banks are finally willing to adjust loan balances to reflect market prices.
• Green investing finally gets the push it needs. Even as gas prices drop, people finally realize that long-term solutions are needed. “Green” stocks are one of the hottest sectors this year.
• GM and Chrysler are forced by the government to merge.

Source: Light Economic Calendar Allows For My Thoughts On 2009

But let’s start with the financial news first. Macquarie Group (ASX:MQG) told investors yesterday that its profit fell by 43%, thanks to write downs in assets. It was the first time since going public twelve years ago the “Millionaire Factory” has reported an earnings decline. Still, the $604 million profit number was higher than what analysts were expecting ($594 million) and the stock finished up over 16.5% on the day.

In the revenue results and write downs you can see how the decline and fall of the investment banking model has hit Australian shores. MQG reported a 13% decline in fee and commission income (to a paltry $2.2 billion). Trading income fell by 14% to $722 million. The big one was the 43% decline in income from asset and equity investments.

There were some strange assets in the back rooms of the Factory. The company took over a billion dollars in write downs on its Italian mortgages and fund management assets. It did not, however, take any write downs on Macquarie Airports or Macquarie Infrastructure Group. Hmmn.

Picture the good ship Macquarie Group as something like a Noah’s Ark/Pirate Ship full of a menagerie of debt-financed assets. Under Captain Allan Moss as CEO, Australia’s version of Goldman Sachs sailed the high-seas of global finance, buying assets with borrowed money, bundling them into funds, and then charging retail investors fees to invest in the funds. It’s the sort of business those Somali pirates who hijack oil tankers should look into. Far more lucrative.

Twelve years of collective booty and swag gave the Factory quite a collection of eccentric and fee-generating assets. Some of those assets are not ageing so well. But you’ll note the company chose not to mark down the value of its infrastructure or airport funds, the two big ones.

It claims the current market value of those assets isn’t what they are really worth. The book value is more accurate. In the meantime, it is throwing other less attractive assets overboard. Deck chairs…Italian mortgages…extra chickens…everything must go!

There’s no doubt that asset values are likely to fall more next year and that revenues will continue to fall too. Still, the company says it will sell $15 billion in assets and then set sail, on the lookout for more acquisitions again. Garn!

It’s looking to sell its margin lending book. And new CEO Nick Moore said it will securitise its motor vehicle loan book, move it off the balance sheet, and sell it off. Thus the liquidation continues in the financial world. Loss-making assets are written down or thrown overboard at…er…fire sale prices.

What’s really happening, mixed metaphors aside, is that the Millionaire Factory model is giving way to deleveraging reality. In a world with falling asset values and tighter bank credit, it’s harder (and much less profitable) to build a cleverly constructed portfolio of assets and generate fee income from operating them.

In the post-credit crunch world (or post-Deluvian, if you accept the nautical metaphor), you have to focus on cash, not debt. One example would be Cash Converters, a sort of Main Street Macquarie, without the debt, and substituting Italian loafers for Italian mortgages. Cash Converters buys low and sells high. It’s the perfect business for the first world depression.

Cash Converters helps people turn lazy assets (guitars, mobiles, stereos, old harmonicas) into cash. And what is that but the liquidation of the consumer spending boom? Of course, most stuff isn’t worth as much people think it is. When you own something, you tend to think it’s worth more than everyone else.

Then you try and auction it on eBay or take it to a pawn shop or Cash Converters. There, you find that it’s worth a lot less than you believed in your heart. Such is life, as Ben Cousins and Ned Kelly might say. Kris Sayce at the Australian Small Cap Investigator (whom we often call the Ned Kelly of the Old Hat Factory) has been looking at Cash Converters as an example of what he calls “Main Street Stocks.”

We’ll let you know what he’s up to…but we think it has something to do with companies that actually do more business in a recession and increase both revenues and earnings-without relying on debt. If you have your own suggestions for “Main Street Stocks,” let us know at dr@dailyreckoning.com.au

Dan Denning

Source: Macquarie Group (ASX:MQG) Profits Fall By 43%

This from InvestmentU:

Structured products are securities that are sold as an opportunity to enjoy substantial gains with full principal protection.

For example, an underwriter might offer investors the upside potential of the S&P 500 – or a substantial percentage of that upside – over a certain period of time (say, five years) while guaranteeing no less than full value of the initial investment at maturity, even if the index goes down.

(Or, instead of the S&P 500, the investment might be linked to Asian currencies, or commodities, or something else.)

How can you offer all or most of the upside of a risky investment with a principal guarantee? Well, in the early days, Wall Street would take U.S. government zero coupon bonds – which sell at a discount and pay zero interest, but gradually compound in value until they mature at $1,000 – and combine them with index options.

So, for instance, if you invested $100,000 – and investors tended to bet large since their principal was guaranteed by Uncle Sam – $80,000 might go into zero coupon bonds and most of the rest into S&P 500 call options.

Most of the rest? Well, there were Wall Street fees that had to be covered, of course.

Nothing was wrong with these early investments, really. But they were nothing more than a gimmick. You could buy the zero coupon bonds and options yourself and achieve the same thing, saving yourself the fees that Wall Street imposed when it created these products.

Unfortunately, something happened along the way that changed the game completely. Yields on government bonds came down. And the cost of buying index options went up, especially in bull markets.

Yields on U.S. Treasuries just weren’t high enough to make this game work anymore. So instead of investing most of the money in U.S. government bonds, Wall Street firms substituted their own unsecured debt instead. This was disclosed in the prospectus, of course. And it seemed like no big deal as long as these Wall Street giants remained healthy.

But they didn’t.

Structured Products Are An Investor’s Nightmare

Investors who bought structured products from Lehman Brothers, for example, are today standing in line alongside the firm’s other creditors.

These “principal-guaranteed” securities are now selling for 10 cents on the dollar, according to SecondMarket, Inc., a specialist in illiquid assets.

SecondMarket says it has already heard from investors holding more than $2 billion worth of Lehman structured products.

The firm estimates that small investors bought $34 billion of these products through October of this year alone. This surpasses the more than $33.5 billion that were bought last year.

(In truth, of course, these products are sold, not bought. No one wakes up and says “I think I’ll invest in a structured investment product today.”)

Last week The Wall Street Journal told the story of Charles Brooks, a physician in Allentown, PA:

• He put a significant sum in two Lehman structured products because he liked the idea of having some exposure to market gains along with protection from losses.
• Today he says these “protected” assets are worth approximately seven cents on the dollar. Sixty-five years old, he is now delaying his retirement planning.
• And he is angry at Wall Street. “There’s no end to things they can invent that seem to me little more than a gamble for the enjoyment of the inventors,” he says.

I don’t fault Dr. Brooks for believing that a note guaranteed by Lehman Brothers was pretty safe. Ninety-nine percent of investors would have made the same assumption 12 months ago.

Structured Products Are A Wall Street Gimmick

The shame, really, is that by buying these structured products, he was sold a Wall Street gimmick. There is nothing magical about these products that offer huge upside potential with a principal guarantee.

After all, I could take $100,000 from you, put the vast majority of it in U.S. government zero coupon bonds and use the balance to play roulette at the Bellagio for five years. If I win, you would get back a lot more than $100,000.

And if I lost everything, which of course I would, I could still guarantee the full return of your hundred grand when bonds mature.

Like I said, gimmick.

There are two lessons here for every investor:

The first is as old as investing itself: If it sounds too good to be true, it probably is.

Number two, however, is just as important. Whenever you hear that an investment, an insurance policy, an interest payment, a stock dividend, or a particular return is guaranteed, be sure to ask the next question: By whom?

Source: Structured Products: Another “Safe Investment” Bites the Dust

This from Money Morning:

It used to be that buying a stock was like buying a house. You’d find a house that looked super from the street – and inspect it carefully, before committing to a deal.

But what if you couldn’t get inside? Or even worse, what if the property changed after you carefully inspected it, so that you ended up buying a house with a trashed interior, or a crumbling foundation that made the house risky to live in, and virtually worthless to sell? Or what if a new regulation made the house you spent so much for – and had saved so long for – obsolete overnight, so that you were left with nothing to show for the years of saving and investing, possibly even forcing you and your spouse to forgo your long-dreamed-of retirement? Instead, you both have to keep working.

That’s a lot like what we’re seeing in the U.S. stock market right now.

If the “house” I referred to is an analogy for the stock market, we’re all having to watch as government regulations, elected lawmakers, credit providers, rating agencies and others all work to change the way business is conducted – in many cases, changing the game after consumers (investors) spend all their hard-earned savings for that house (major stock or mutual fund purchase).

If that’s truly the case, it’s understandable if most U.S. investors are left feeling burned – or even worse, helpless – to the point that they’ve decided it’s better to just sit on the sidelines. After all, why participate in a game in which there’s no way to win?

But what if you knew, ahead of time, what marketplace changes to expect? Then you’d be in the driver’s seat – right? You’d know what to anticipate, could craft a profit strategy to follow, and then could just sit back, watching and waiting for the events you’ve already positioned yourself to profit from.

Investment expertR. Shah Gilani – a retired hedge fund manager who’s been chronicling the credit crisis as a Money Morning contributing editor – thinks it’s possible to peer into the future and see the changes that are looming. Gilani, the editor of a new trading service called the Trigger Event Strategist, is predicting a series of so-called “aftershocks” from the financial crisis that investors need to watch for.

These “trigger events” are seismic occurrences that will cause major aftershocks. And the fallout from those aftershocks will bring about marketplace changes that, properly played, will not only help investors dodge unnecessary additional losses – this fallout can actually be exploited for profit, Gilani says.

“It’s like having a meteor hit the earth,” Gilani says. “Because of the seismic-level events that will result from the aftershocks of this meteor strike, there will be all sorts of other trigger events” that will translate into profit opportunities, if properly played.

Some of these will involve going long – that is, actually buying the stock, option or security that’s likely to benefit the most from the trigger event. But this strategy can also involve short selling – identifying the company, stock, fund or security that’s going to be punished the most, and profiting on that decline.

In this story, we’re going to take a look at five key aftershocks investors can look for. These are by no means the only ones Gilani is predicting: But they are five of the most dramatic, and are among the most important ones investors need to be able to understand and interpret. They are:

• The collapse of the investment banks.
• New government regulations.
• The implosion of the commercial real estate sector.
• The transformation – and consolidation – of the insurance industry.
• And the overseas fallout that will force the International Monetary Fund (IMF) to intercede.

Let’s consider each “aftershock” in a little more detail.

• The collapse of the investment-banking sector: Lehman Brothers Holdings Inc. (LEHMQ) has filed for bankruptcy, Merrill Lynch & Co. Inc. (NYSE:MER) will become part of Bank of American Corp. (NYSE:BAC) – guaranteeing itself a dependable source of capital, via bank deposits, but also putting itself under much closer regulatory scrutiny. As a Money Morning investigative report showed, banks are using bailout money to buy other banks, or investment banks, creating some real behemoths.

Investment banks used short-term borrowings, and a lot of leverage, to operate what was an “extraordinarily profitable business,” whose services were needed, Gilani said. Indeed, the need remains and the model wasn’t completely bad – it was the extraordinary use of leverage, combined with some questionable “financial engineering,” that caused the sector to go off the tracks.

“Even now, if you could go back in time and buy Goldman Sachs (GS) at its IPO, would you do it? Of course you would. It’s an extraordinarily profitable business model,” he said. “Not long after this cycle returns, and the [investment banking] players come back onto the field, [you’ll be able to] invest in Citi (C), or you can invest in Wells Fargo (WFC) … but why don’t you come back and redo the old Goldman Sachs model? After all, you remember how profitable it was for such a long time.”

Gilani’s projection: Scrutiny and oversight will increase in the near term, and for some time to come. Look for private equity firms – and hedge funds – to step in as the new providers of the capital dealmakers need to provide needed investment banking services. And don’t be surprised – eventually – to see banks spin out their investment banking arms into standalone units that are better able to maneuver and capitalize on the available marketplace opportunities.

2. New government regulations: The United States must remake itself to once again become the kind of financial market where there’s the right mix of free-market capitalism and nurturing/limiting government regulation – for that’s what created a strong global confidence in the U.S. financial system. Right now, that confidence has been lost, meaning the all-important process of “capital formation” could go elsewhere – to Shanghai, Dubai or London. That would be devastating to any possible U.S. economic rebound, given that financial services is a crucial piece of the country’s $14 trillion economy, and the fact that the sector employs an estimated 6.6 million people.

Gilani’s projection: As this unfolds, there will be opportunities for profit via something he calls “regulatory arbitrage.” But it’s still very early in the game here. Look for a separate Money Morning report on this “aftershock” within the next week.

3. The implosion of the commercial real estate market: Citigroup is cutting 50,000 jobs, Lehman Brothers is in bankruptcy, and consolidations in the financial-services sector are escalating. The bottom line is that these are all possible trigger events leading into the collapse of the commercial real estate sector. This will be “much more problematic than the implosion of the housing sector, as commercial real estate is much harder to move,” Gilani says. “And some of the most expensive real estate anywhere is in the financial-services sector.” Job losses will translate into still more trouble in the commercial slice of the residential real estate market – as expensive apartment buildings and condominiums remain vacant, and unrented. Consumer confidence is shaky, so consumers aren’t spending. That means that retailing is also suffering badly, some chains are closing locations, and some – such as Circuit City Stores Inc. (CCTYQ) –- are even turning to bankruptcy. That’ll leave open spaces in untold numbers of malls and shopping centers

Gilani’s projection:  “We’ll hear a very loud ‘thump’ when this other [credit crisis] shoe falls,” and it won’t be good for the overall economy’s health, he said. But even a seemingly negative aftershock such as this one provides potential profit opportunities.

4. The consolidation of the insurance sector: The collapse of American International Group Inc. (AIG) was just the start of this story, not the end, as many investors believe. Some companies will be swallowed up by others, and some of those successful suitors may actually thrive, making them enticing profit plays. Indeed, with this aftershock, there will be profits to be made on the way down, and more when the rebound comes.

Gilani’s projection: The government can seize banks, allowing the weak ones to fail so long as it guarantees depositors’ money. But it’s a whole different story with an insurance carrier. “If your bank goes out of business, and your money is safe, all it means is that you might have to go elsewhere for a loan. And with fewer competitors, that loan might cost more,” Gilani says. “But if an insurance company goes under, and you don’t have the health insurance, disability insurance, or annuity that you’ve been paying on and counting on, well, that’s devastating.” So devastating, in fact, that the government can’t allow that to happen.

5. The mobilization of the International Monetary Fund (IMF): If there’s one decision that U.S. Treasury Secretary Henry M. Paulson Jr. wishes he could have back, it is the decision to allow Lehman to fail. It was a “line-in-the-sand, get-tough decision, and it was a huge mistake,” Gilani believes. With the inherent instability in today’s world – and the potential for terrorist regimes to gain power – the IMF won’t risk drawing a line in the sand with an at-risk country, he said. Instead, the IMF will employ a “good neighbor” strategy, and help all those it can. And that help will come in the form of major capital infusions – $100 million or more. This will stop any possible “contagion,” like the one that emanated from Asia in the late 1990s. And it will prevent some alluring profit plays, Gilani says.

Gilani’s projection: Some recipients will resent the get-tough policies that the IMF requires countries to put in place. But those policies are good, and actually make the country strong in the long run. Some of the countries he expects will be receiving this capital will make for excellent investments. Again, stay tuned.

Final thoughts: By watching for these “aftershocks,” Gilani says “the bottom line is that, as these events unfold, you’ll understand the ramifications – and you’ll have the chance to trade them ahead of the curve, often for significant gains.”

Source: The Five Financial Crisis “Aftershocks” Investors Can Play for Profit

Editors Note: The first installment in an ongoing occasional news series that looks at the anticipated “aftershocks” of the global financial crisis, in some cases even exploring possible profit opportunities.