FINANCIAL REVIEW

The Only Winner is Gravity

Sinclair Noe — October 9, 2014

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Financial Review

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DOW – 334 = 16,659
SPX– 40 = 1928
NAS – 90 =4378
10 YR YLD un 2.33%
OIL – 2.96 = 84.35
GOLD + 2.10 = 1224.60
SILV – .03 = 17.45

Triple-digit swings in the stock market have become common in recent days. Just this week, the Dow jumped 274 points Wednesday, reversing a 272-point decline on Tuesday. We’ll talk about volatility in just a moment.

In economic news:
Germany’s exports sank 5.8 percent in August, the biggest monthly drop in five years. The figure raised concerns that Europe’s largest economy may fall into recession. European Central Bank President Mario Draghi says Europe’s problems are structural, not cyclical and there can be no recovery without reforms. Draghi was speaking in New York; he said the Euro banking sector is still going through deleveraging; they are not lending; and there are limits to what the ECB can do to produce growth. And deflation is highly contagious.

The number of people who applied for U.S. unemployment benefits in the first week of October edged down by 1,000 to a seasonally adjusted 287,000, holding below 300,000 for the fourth straight week. Jobless claims are now 21% lower compared to one year ago. What we are starting to see is that so many businesses fired workers during the downturn and they have been very slow to rehire or hire new workers, which means not many people are losing jobs right now.

Wholesale inventories rose by 0.7% in August. Inventories of durable goods, such as autos and machinery, rose 0.8%, while inventories of nondurable goods rose 0.5%. Wholesale sales fell 0.7%, following a 0.4% gain in July.

The Bloomberg Consumer Comfort Index climbed to 36.8 in the period ended October 5 from a four-month low of 34.8. A gauge of attitudes about the world’s largest economy registered the biggest increase since 2007. According to Bloomberg, a pickup in hiring, more job openings and lower gasoline prices are combining to brighten Americans’ spirits even as the stock market languishes. While today’s figures showed confidence improved among the college educated, homeowners and almost all income groups, the weekly gain left sentiment close to its third-quarter average. Gas prices make US consumers happy, or at least semi-happy. And prices are falling.

Now, let’s take a look at volatility because this week the markets have been on a really wild roller coaster ride, and it looks like the only winner is gravity. All 30 stocks in the Dow Jones Industrial Average were down. The VIX, the volatility index jumped 24% to just over 18, which is its highest reading in 18 months but still below the 20-year average of about 20. Maybe the markets were just too complacent.

For now, volatility is back and it tells us the markets are uncertain. Traders and market makers and specialists are not sure about the next move, and when there is uncertainty there is a lack of bids. Typically, there are investors lined up to buy stocks, however when there is uncertainty, there are fewer traders in line. The spread between the bid and offer widens, and when prices drop fast, the bidders have two choices: widen the spread even further, or step away completely. The result can be a downward spiral. It works in both directions; spreads widen quickly both on down days when investors are anxious to get out at any price and on big up days when investors will pay up to get into a stock. For now, investors are getting out.

Maybe people forgot the Federal Reserve is in the process of exiting QE, the massive asset purchase plan that has poured trillions of dollars into the market over the past few years. Remember the taper tantrum? When the markets tanked at the mere thought of the Fed exiting QE; now it really is almost finished. The purchases are widely credited for fueling price increases of all kinds of investments.

Investors have had a lot of advance notice that the end is coming, and the hope is that the announcement won’t cause big markets swings given all the time they’ve had to prepare. Many mutual fund managers say their bigger concern is when the Fed will start raising short-term interest rates, which the central bank has said won’t be for a “considerable time.” Every time that the Fed has ended QE, rates have gone down, and stock prices have gone down; it happened in 2010 and 2011, and it looks like it’s happening again.

The Fed’s bond-buying program helped the stock market not only to surge but to do so in nearly uninterrupted fashion, even when the economy was improving only modestly. The last time investors saw a 10 percent drop for the Standard & Poor’s 500 index was three years ago. This week’s volatility may be a preview of things to come after QE ends.

Add in earnings season and you’ve got a lunch date with Pepto-Bismol. Now, here’s how CFO’s and CEO’s get ready for earnings season; they pull out the pots and pans and assorted crockpots and they turn the heat to medium high and they start cooking the books. A couple of years ago, Duke and Emory Universities conducted a survey of chief financial officers and they found that about one in 5 companies admitted to cooking the books, or “managing” earnings reports to mischaracterize economic performance. And about 60% try to pump up income.

The report found, “Earnings misrepresentation occurs most often in an attempt to influence stock price, because of outside and inside pressure to hit earnings benchmarks, and to avoid adverse compensation and career consequences for senior executives.” And the CFO’s admit that it is difficult to unravel the book cooking from the outside looking in.

Here are the expectations as we enter 3Q earnings season. Earnings growth is estimated from 4.5% to 5%, generally speaking. The telecom sector should come in with the highest earnings growth and consumer discretionary is expected to post year over year declines. (Think Sears and JC Penney). The healthcare sector is the only S&P 500 sector that saw earnings expectations increase during the quarter, rising to 10.6% from 9.4%.

Back in June growth expectations called for 8% to 9% growth, but that’s just part of the game; aim high and then ratchet down expectations. So far 82 S&P 500 companies have issued negative earnings per share guidance, while 27 have reported positive guidance. The current 12 month forward price to earnings ratio of the S&P 500 is 15.

The security breach and hack of JPMorgan Chase has raised more questions than it has provided answers. We still don’t know who was behind the hack. It looks like it came from Russia, but that’s not very specific. We still don’t know what the motive was. Was it plain old theft, or was it official government retaliation? Authorities believe that the hackers may have tried to infiltrate about a dozen financial institutions, but we don’t know how far they got, or the motives for the other hacks.

The FBI and the Secret Service have begun a criminal inquiry into the attacks, but the only thing we know for now is that the biggest, most fortified financial institutions in the world, entrusted to safeguard trillions of dollars of the nation’s wealth are in fact, clueless and extremely vulnerable.

A most entertaining trial has been taking place this week; this is the story of former AIG CEO Hank Greenberg, who mismanaged AIG, cooked the books, got involved in selling credit default swap insurance on almost every mortgage related security, which led to a near systemic catastrophe, and when AIG was about to go belly up, the government stepped in with a bailout. And now Greenberg says the terms of the bailout were a little too harsh for his liking.

The trial features all-star lawyers, two former Treasury Secretaries, and today, former Fed Chairman Ben Bernanke took the stand. Bernanke said allowing American International Group Inc. to go into bankruptcy would have been catastrophic; echoing comments earlier this week from Hank Paulson and Tim Geithner. Bernanke said he couldn’t recall whether federal officials discussed the interest rates and fees it charged the insurance giant in exchange for an $85 billion loan during the 2008 financial crisis.

Emails from Bernanke were introduced into court evidence, highlighting the government’s belief at the time that the restrictions on AIG should serve as a warning to other insurance firms that were allegedly acting irresponsibly. The emails also show that the Fed tried to keep the terms of the bailout secret from the public, because accountability and transparency were not the preferred currency of the crisis.

And we learned something very strange about Bernanke; he used to send emails under the alias of Edward Quince. An imaginary figure Bernanke created to send emails. Maybe he thought a pen name would give him a level of privacy. Maybe he thought this was some kind of cloak and dagger spy game. Maybe he was just a smidge schizophrenic. Maybe he thought a pseudonym would shield him from whatever he was doing. Maybe that’s how he plans to refinance his house. Nobody knows for sure.

Bernanke was scheduled to introduce ECB president Mario Draghi for the speech in New York, but the AIG trial made for a scheduling conflict. In the process, we learn that Bernanke now charges $200,000 for a speech, so his testimony today was expensive. It also raises the question of why he’s trying to refinance his house, when he could just make a couple of speeches and be done with it.

The Nobel Prize for literature has been awarded to Patrick Modiano; he is a French novelist who has written books, screenplays, and children’s’ books. And even though his work has been translated into several languages, I have never heard of him. If we lived in France, I’m sure I could tell you more.

http://www.ecb.europa.eu/press/key/date/2014/html/sp141009.en.html

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2103384