FINANCIAL REVIEW

The Ghosts of October

Sinclair Noe — October 28, 2014

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Financial Review
DOW+ 187 = 17,005
SPX + 23 = 1985
NAS + 78 = 4564
10 YR YLD + .03 = 2.29%
OIL + .38 = 81.38
GOLD + 2.90 = 1229.00
SILV + .09 = 17.31

Today, we’ll start with a few earnings reports then move to economic news.

After the close Facebook reported a profit of $806 million, or 30 cents a share, up from $425 million, or 17 cents a share, a year earlier. Excluding share-based compensation and other items, earnings rose to 43 cents a share from 27 cents. Revenue increased 59% to $3.2 billion. Earnings were up about 90%; revenue up about 60%. Shares were just a little lower in after-hours trade.

Dupont reported operating earnings per share of $0.54 were up 20 percent from $0.45 per share last year, in-line with estimates.

Pfizer reports a third-quarter profit of $2.67 billion, or 42 cents a share, up from $2.59 billion, or 39 cents a share. Revenue slipped 2% to $12.36 billion.

Freeport-McMoRan reported earnings of 53 cents per share for third-quarter 2014, reflecting a decline of 32.9% from the year-ago earnings of 79 cents. Profit declined 32.8% year over year to $552 million, hurt by lower pricing of copper and gold.

The S&P/Case-Shiller index of property values increased 5.6 percent from August 2013. Prices are still going up, but at a slower pace. Home prices in the 20-city index adjusted for seasonal variations decreased 0.1 percent in August from the prior month. Unadjusted prices rose 0.2 percent.

In August, durable goods orders dropped 18.3%. Durable goods orders have been volatile in recent months because of big swings in aircraft orders. The thinking was that there would be a modest rebound as businesses increased spending, and aircraft orders would rebound. Not exactly. Durable goods orders for September dropped 1.3%; excluding transportation equipment bookings declined 0.2%. Cars and trucks sold at a 16.3 million annualized rate last month, capping the best quarter since 2006. There was a 2.8% drop in demand for machinery, the biggest decline since February 2013, as bookings for computers and electronic equipment fell 2.5%. Businesses just aren’t investing in their business.

And while businesses are pessimistic, consumers are optimistic. The Conference Board’s consumer sentiment index climbed to 94.5, the strongest reading since October, 2007; up from 89 in September. Steady hiring and fewer layoffs over the past 12 months have pushed unemployment lower; even if they aren’t good paying jobs, they are still jobs; and most people think they will get a raise eventually. Americans are also feeling better because it doesn’t hurt as much to visit the gas pump. Average gas prices have dropped 31 cents in the past month to a nationwide average of $3.03. Incredibly, we feel good about gas at $3 a gallon.

A follow-up to yesterday’s comments about the European Central Bank’s stress test of Euro banks; 25 of the 130 banks failed the test; several others narrowly averted failure. For several banks, the fix is minor. For a few, there may be no corrective action that can save them. But the idea, or at least what the ECB hopes will be the takeaway, is that the Euro banks are in pretty decent shape, everything is under control, and they can start lending again. Of course, we heard the same argument in the 1990’s, but back then it was about cleaning up the troubled Japanese banks; however, healthier Japanese banks could not stop a long, slow deflationary slide. The problem is that bad banks can crash an economy but healthy banks are not an economic engine to drive prosperity.

We are almost through the month of October, and the market has seen pullbacks, but not a crash. It is worth noting that today marks the 85th anniversary of Black Monday, 1929. Stock prices began to decline in September and early October 1929, and on October 18 the fall began. Panic set in, and on October 24—Black Thursday—a record 12 million shares were traded. Investment companies and leading bankers attempted to stabilize the market by buying up great blocks of stock, producing a moderate rally on Friday. On Monday, however, the storm broke anew, and the market went into free fall. Black Monday was followed by Black Tuesday, during which the Dow Jones Industrial Average fell 13% and 12% back-to-back. Investors after Black Monday’s slide were assured that “banking interests” were supporting the market, “with a hand on the throttle.” But of course, that was not the case. Banks can crash markets, but they really can’t revive the economy.

One reason the bankers could not stop the freefall back in 1929 was overextended investors were forced to dump their stocks to meet margin calls. The falling prices triggered a panic. The bankers and financiers tried to inspire confidence by buying shares but they were quickly buried under the avalanche of margin debt.

One of the side effects of the Federal Reserve holding interest rates at near zero levels for the past few years is that it has made margined investing in stocks more attractive. And there is now more margin debt that in 2007, and even more that 85 years ago, in October 1929.

And it’s not just margin debt but stock buybacks that are now financed by debt. It’s a nifty trick when it works. A corporation borrows money at very low rates, buys their own shares, and magically the earnings per share goes up, but only because there are fewer shares outstanding. Buybacks add nothing to a company’s productivity or real value, they only juice up stock prices so executives and shareholders can enjoy bigger profits. The corporations do not invest in their business, they do not make orders for durable goods, and computers, and equipment to improve efficiency. They do not hire new workers. Demand slips. GDP grows more slowly. Prices stagnate and a disinflationary trend can lead to deflation.

For the 12 months ended June, companies raised their stock repurchases to $533 billion, an increase of nearly 27% from a year earlier. Meanwhile, combined buyback and dividend expenditures for the period reached a record of $865.9 billion, with buybacks representing 61.6% of the total. That brings total buybacks since the beginning of 2005 to $4.2 trillion, or nearly one-fifth of the total value of all U.S. stocks today. Each dollar of buybacks appears to be having a greater effect on raising the prices of certain stocks. That’s because fewer shares are changing hands each day. On Wall Street, it’s referred to as a “drying up” of liquidity.

Corporations have been reducing stock buybacks in the past few weeks, and maybe that was just a temporary adjustment because of blackout periods associated with earnings season, or maybe it was a bigger trend associated with the end of QE3. Corporations have been happy to buy back shares using borrowed money with rates near zero, combined with the Federal Reserve shrinking the supply of financial assets by buying US Treasuries and mortgage backed securities. But tomorrow the Fed is expected to announce the end of QE3; no surprise; they’ve been tapering off QE purchases for the past year, but it will change the dynamics of supply and demand.

And we’ve started to see that changing dynamic in the corporate bond market, specifically in high yield or junk bonds. The major bond dealers are reducing their holdings of junk bonds, selling more than $7 billion net since mid-September. Part of the reason is that banks will be required to hold quality paper for the next stress test, and junk bonds don’t qualify; so there just isn’t much of a market there; which means liquidity is drying up.

Now put it all together; the economy is improving, but corporations that were involved in buybacks (IBM comes to mind), they don’t see their profits rise because they have not been investing in productive growth; the Fed hints at raising interest rates; buybacks dry up because there are no buyers for high yield debt; the corporations can’t juice their earnings reports anymore and they can’t grow earnings organically. If stocks start to fall, the bond bubble would also start leaking air. And then the margin calls kick in.

Tomorrow the Fed will issue their statement on monetary policy; maybe they will keep QE going for a while; more likely, they will end QE3 as promised; maybe they will hint at QE4; maybe they will hint at keeping interest rates near zero for a very long time. The Fed will surely be mindful not to spook the markets, like Greenspan did in 1987. Now the Fed has at least learned the importance of an overabundance of guidance. But it has been a very long time since Wall Street has stood on its own, without the very substantial benefit of the Fed propping it up. The problem is that if Wall Street stumbles, it could get buried under an avalanche of illiquidity and debt.

Of course panic selling could kick in at almost any time, but it doesn’t mean that it is the most likely outcome. Six years ago, the Fed stepped in with the first bailouts, followed by $4 trillion or so in stimulus. The pundits back then thought the Fed’s stimulus would cause inflation to soar and the dollar would collapse. They were wrong, even if they still won’t admit it. For now, the economy is reasonably solid, even if it is slow and plodding. The banks are in better shape now than in 2007, assuming that anybody has any kind of realistic notion of the multitude of ways the books are cooked. The crash of 2008 is history, much like Black Monday 1929. The recent pullback is now fading in the rear view mirror and the further we go down the road, the more it looks like bargain hunters stepped in to buy the dip, again. And as we head to the holiday season we’re likely to forget the ghosts of October, and the lessons painfully learned 85 years ago today.