BA,SAS,Swiss still in the midst of the storm

Markets have continued to drift gently higher since I last wrote - proving my upside market sense and timing to be out of step with prevailing sentiment . After the sharp increases of April and May which gave us the strongest bear market rally in history, there seems to be less conviction that the equity rally has much further to go amid signs that interest rates in the UK and US might have to reverse course and move higher. In the broader economy it's interesting to note that:

• Irish prices fell by 4.7% in the year to May - the steepest fall since 1933
• US household net worth ( including real estate,stocks, and bonds ) was off $14 trillion from its 2007 peak
• US May retail sales were off 10.8% from year ago levels - gas station sales were down 33.8% and car dealership sales off 19.6% from prior year levels.

I keep on looking for signs of 'green shoots' in the airline industry but all I see so far is proliferating weeds. If I could discern that corporate or vacation passengers were returning to their established travel plans then I would feel much more confident that we had hit a low point from which the economy was set to recover. In the airline sector, like the auto and banking sectors we are just beginning to see that consolidation and capacity reduction are needed to remove chronic over supply and restore profitability.

IATA has said that the worlds airlines are seeing few concrete signs of recovery and many of them are at a knife edge. Yields are crumbling and losses are widening at a hectic pace. IATA also revised its forecast for industry losses in 2009 to $9 billion a doubling from its forecast of $4.7 billion made just two months ago. After September 11 airline revenues fell by 7% and it took three years to recover. This time round revenues are down by more than 15% and the demand side is showing little sign of improvement.British Airways CEO says the carriers business faces 'serious threats' while Aer Lingus managements says this is the most difficult environment in its 73 year history.

• May 2009 Air France-KLM y-o-y passenger numbers down 7.8%. Asia Pacific down 10.9% and Trans-Atlantic down 9.3%.
• May 2009 SAS Group y-o-y passenger numbers down 17.1%.
• May 2009 SkyEurope passenger numbers down 37.5%
• Swiss CEO says that premium passenger and cargo demand has stabilized at a very low level and that prospects of a recovery this year are unlikely.

From the perspective of the airlines this economy ain't on the mend and higher fuel and financing costs aren't going to make it any easier to make a profit let alone survive. I'm told that Uniteds order for 150 new planes is dependent on the manufacturers finding the financing! I think we will avoid a depression thanks to government largesse but consumer expenditure hit by higher taxes,higher borrowing costs and higher unemployment is going to take a long time to recover. This now becomes a stock pickers market with sectors where demand is little impacted by a huge downturn in credit looking attractive no matter what happens to the broader indices. Pharmaceuticals fit the bill, as do restructuring plays, consolidation candidates, agriculturals and some precious metals.

Am I missing something?

It must be advancing middle age. I just wish I could get more gung ho on this stock market rally. Even the news that the market is now only down 44% from its peak and that the 50% off everything sale is over doesn't make me bullish. All I can think is that at 44% down I need 75% upside to get the pension plan back to where it was. Having said that the trading desks are arguably right in saying that the economy's contraction is slowing and can probably wring more upside out of the market even though this coming week sees a rash of probably disappointing earnings numbers. The unknown in all of this rosy market outlook is the snowballing scandal over Mr.Hervesi and the New York State Pension Fund - it probably isn't as bad as some of the rumours are suggesting but there again I didn't believe that Madoff had sequestered $50bn!

Yes,the bank numbers over the last week looked better than expected but with the sheer scale of Federal cash sloshing around in the system is that a surprise? Also a quick scanning of the notes to the accounts takes me back to the days of being an analyst - the devil is in the tiresome detail and there is sure a lot of detail in Citi's ( and GS's and JPM's ) earnings release. From what I can see this downturn is being more destructive of loan books than anything in the last 30 years. Returns on corporate bonds post default seem to be running at around $0.30 - at this rate all the bank capital raised over the last two years is gone. If I'm right then there is going to be another round of capital raising and lending books are going to remain extremely tight. Just wait until credit card defaults and Commercial real estate impairments start to kick in . I come full circle to my bugbear that unemployment is a major driver of loan defaults and that bank loan books are sick and getting sicker.

I see Blue Wings ,a Russian oligarch owned airline in Germany, has filed for bankruptcy. If the oligarchs can't keep their day to day operations going what does it auger for all those banks who lent to Moscow and were secured against much stronger commodity prices and a robust rouble? If Barclay's equity is about 3% of its assets, and loan loss provisions are about 0.3% then further trouble might lie ahead. I'll do the numbers on Deutsche ,which is even more exposed to Russia, but would expect the numbers to look much the same.

Sterling has been rising this week. I'd love to believe that quantitative easing is working and getting the UK economy on track but with money supply growth of 19% inflation looks like a very scary possibility- as we're still on the deflation/inflation fence we've added a bit more gold to the pension pot below $890.The Chancellor announces his budget this coming week so it may be a question of selling sterling on the news - after all what can the poor guy do ahead of an election? Tell the voters that there are going to have to be huge cuts in public sector funding? The news
that building societies are on the hook for £50 billion of self certified and highly dubious ' whole-loan sales' couldn't come at a worse time. These fast track applications seem to have received little or no scrutiny by the FSA.

We're beginning to reshape the pension plan for the ten year view by switching into blue chip plays with good cash flow and market share. This downturn is going to wipe out excess capacity through consolidation - interestingly FIAT added 10% yesterday on the view that a deal with Chrysler will be completed within the 12 day deadline. The survivors are going to have both improved market share and increased pricing power - the weaker players are simply going to go. The better managed companies have reduced inventory and have recognized that capacity utilization isn't going anywhere fast. Talking to managements over the last week there doesn't seem to be any great rush to use cash to make acquisitions just yet - the view from those I've talked to is that as the pain in the economy increases prices for viable companies with stretched balance sheets will get even more attractive. The pressure on third and fourth tier suppliers is dreadful.I guess that there is going to be massive differentiation in equity valuations going forward- that's the real opportunity here.