Monday, August 18, 2014 - Theory and Instinct; Nobody Knows

Financial Review with Sinclair Noe

DOW + 175 = 16,838
SPX + 16 = 1971
NAS + 43 = 4508
10 YR YLD + .04 = 2.42%
OIL - .71 = 96.64
GOLD – 7.30 = 1297.20
SILV + .04 = 19.68

Over the weekend, the geopolitical hotspots did not explode. Kurdish forces made progress against ISIS militants in Iraq; Ukrainian forces made progress against pro-Russian separatists in eastern Ukraine. The ceasefire between Israel and Hamas is holding.

In economic news, the NAHB/Wells Fargo Housing Market Index showed that homebuilder sentiment rose for the third straight month in August. That should be a positive for new home construction.

Meanwhile, mortgage-finance giant Fannie Mae cut its outlook for the housing market this year and next, because rising mortgage rates, bad winter weather and consumer “conservatism” are all hitting the housing market. In its August forecast, Fannie said it expects construction starts for single-family homes to hit 642,000 in 2014, down about 8% from its July forecast of 696,000. Likewise, Fannie cuts its outlook for new single-family homes sales in 2014 by 11% to 431,000 from 486,000.

Housing affordability hit its lowest level in nearly six years in June. The National Association of Realtors reports the mortgage payment for a median-priced US home in June requires 16.3% of median household income. Even though housing affordability is still historically quite favorable by the NAR’s index, homes are not only becoming less affordable, but affordability may be even less favorable for first-time buyers. A separate index maintained by Goldman Sachs that looks only at marginal buyers shows that housing affordability is largely in line with its historic average.

The New York Federal Reserve says a new SEC rule designed to reduce runs on the money market mutual fund industry could create runs instead. At issue is part of the new SEC rule giving funds the ability to limit outflows by restricting redemptions when liquidity runs short. New York Fed economists say: “The possibility of a fee or any other measure that is costly enough to counter investors’ strong incentives to run amid a crisis will give investors a strong incentive to run preemptively to avoid such measures.”

It is Monday, and so there was some M&A activity. Dollar General made an $8.9 billion dollar, all cash bid for Family Dollar Stores. You will recall that Dollar Tree recently made a bid for Family Dollar, which works out to $74.50 a share, while today’s bid by Dollar General works out to $78.50 a share, and it’s cash.

So, for the most part, it was a typical Monday. But we are in the Dog Days of summer, and in these seemingly quiet, low volume, illiquid sessions we can see a small move quickly turn into a bigger move; a leisurely stroll turns into a gallop, turns into a stampede. The Fed 's Jackson Hole, Wyoming, symposium at the end of the week is also expected to send a dovish message to stocks, with employment and inflation nearing Fed goals, Fed Chair Janet Yellen has consistently cautioned some labor market measures still show enough slack to warrant keeping interest rates low. Heading into this year’s Jackson Hole assembly, the labor market is giving off mixed signals even as unemployment falls. About 28 percent of all part-time workers in July reported that slack business conditions or a dearth of full-time jobs kept them from finding full-time work. That’s up from a 19 percent share at the start of the downturn.

Most people are saving next to nothing, while just a few are saving a significant amount. Those who do save are saving a lot, more than $1.2 trillion a year. According to the Fed’s financial accounts data and definitions, the personal savings rate has averaged about 10% of disposable income since the recession ended, up from around 7% before the recession. That means upper-middle class and wealthy Americans are saving nearly $400 billion more a year than they used to. The Fed has been keeping interest rates low, and part of the thinking is that it forces investors to chase yield, but Americans have nearly $11 trillion parked in cash, and bank accounts, and money market funds that pay next to zero. So, the Fed might keep rates low, until we’re all willing to gamble, at which point, rates rise, and we all lose our bets.

The high share of workers who are part time for economic reasons is one reason that the Labor Department’s broadest measure of unemployment remains far above its 8.8 percent pre-recession level. U6 unemployment, which includes involuntarily part time and discouraged job seekers in addition to the jobless, is 12.2 percent, or almost double the 6.2 percent level of the main unemployment rate. Both increased by 0.1 percentage point in July from five-year lows in June.

So, what is this market worth? Robert Shiller says the stock market is very expensive right now. Shiller is the Nobel Prize winning Yale professor who helped create the cyclically adjusted price earnings ratio, which takes average inflation adjusted earnings from the past ten years. In a New York Times article yesterday, Shiller noted that the ratio is now at 25, up from 23 a year ago, and well above the historical average of about 15. The ratio has only moved above 25 three time in the last 130 years; it happened in 1929, 1999, and 2007; and of course the markets crashed. Makes sense; to justify high valuations, earnings would need to rise significantly, or prices would need to fall.

A 5 year long rally in US stocks has taken valuations higher, leaving some investors anxious, but the CAPE is just one measure of value. The S&P 500 trailing 12 month PE is right around 17.5, which is just a little above the long-term average, but not out of line. And most estimate for the next 12 months put the forward PE multiple at about 15.

Still, the bull market is getting long in the tooth; it is now the fourth longest bull market; topped only by the bull runs ending in 1961, 2000, and 1929; and of course we know how those markets finished. The lack of a meaningful correction is a severe divergence from the norm. In the summer of 2012, stocks posted greater than a 10% pullback. Since that time, all corrections have been contained to single digits. History shows that other incidents of abnormally small corrections have preceded large corrections exceeding 20%. But it doesn’t mean a crash is imminent; the markets will eventually falter, but it could be a long, long time. Meanwhile, the Nasdaq Composite made it up to a 14 year high today. Which sounds bullish, but really means that the past 14 years were lost.

Maybe stocks will fall from here; maybe stocks will rise from here. I don’t know. Maybe the housing market will go up from here; maybe housing prices will drop. I don’t know. The yield on the 10 year Treasury note was up 4 basis points to 2.42%; nobody knows why. The price of oil dropped below $97 a barrel; apparently because the ISIS idiots did not blow up the Mosul Dam; apparently because we have built up a stockpile of oil while cutting back on demand; that could all change tomorrow.

George Soros is the biggest money making fund manager around. He’s the only hedge fund manager to have earned $40 billion in profits for his investors. George Soros just turned 84. In an article from the Irish Times they quoted his son, Robert Soros, on the success and brilliance of the co-founder of the Quantum Fund. Robert said: “you know [that] the reason he changes his position on the market or whatever is because his back starts killing him. It has nothing to do with reason. He literally goes into a spasm and it’s this early warning sign.”

Soros has admitted to relying greatly on “animal instincts”, saying the onset of acute pain was often “a signal that there was something wrong in my portfolio”. His decisions, then, “are really made using a combination of theory and instinct”.

The economic recovery is underway, or not, depending on any expert opinion of the hour. The main stumbling block to recovery is uncertainty or not, again depending. As we wait for factories to begin operating at full capacity, investors are growing increasingly frustrated at more than half a decade of prudence, pushing chief executives to loosen the purse strings. Capital spending could increase as early indicators show that industrial companies are beginning to run at higher levels of capacity than has been the case over the last five years. When factories and the like are running at less capacity on the back of lower demand there is very low capital expenditure. In the aftermath of the financial crisis companies hunkered down and re-engineered their balance sheets, diverting funds from investment to pay off debt or stockpile cash. However, even since the recession ended and the economy has picked up, many have continued to hoard cash leading to growing calls from investors to deploy cash reserves, which earns low returns sitting on balance sheets.

It is now estimated that global firms are sitting on a stockpile of $7 trillion in cash. The world’s corporate giants are poised to tap into record cash reserves and possibly embark on a long-awaited spending spree, fuelling hopes of a massive boost to the global economic recovery.

The bulk of the cash is held by 5,100 of the world’s biggest companies, which had combined reserves – cash and short-term debt – of $5.7 trillion as of the end of 2013, according to Thomson Reuters Datastream. The cash pile total excludes financial companies such as banks and insurers, who are required by regulators to hire capital.

Corporate America dominates the pack with about $2 trillion at its disposal, led by a clutch of tech titans. Apple’s cash mountain of $140bn means it has more unspent capital than any other American company, followed by Microsoft with $83bn, and Google, which has built up $59bn of reserves.

So, investors are hollering for companies to spend their cash and deliver higher returns, because cash doesn’t pay much. There are three things the companies can do: buy other companies, return the money to shareholders, or spend the money on the business and try to grow the business organically. What will they do? Nobody knows.

Wednesday, August 13, 2014 - Oil, At Least in Theory

Financial Review with Sinclair Noe

DOW + 91 = 16,651
SPX + 12 = 1946
NAS + 44 = 4434
10 YR YLD - .03 = 2.41%
OIL - .04 = 97.33
GOLD + 3.70 = 1313.20
SILV - .11 = 19.91

The economic news today did not point to a positive session for Wall Street. Retail sales for July were flat compared to June. Excluding autos and gas, retail sales were up just 0.1%. Clothing sales increased 0.4% but that was primarily due to extreme discounting. That report was confirmed by an earnings report from Macy’s, which missed expectations on earnings and revenue, and then lowered guidance. In after-hours trade, Cisco reported better than expected earnings and revenue.

The US has deployed 130 Marines and Special Operations forces to northern Iraq to help assess ways to rescue thousands of members of the Yazidi religious group taking refuge on Mount Sinjar. Those military advisers will not have a combat role, but the Defense Department left open the possibility that US troops could help create a safe passage for the Yazidi off Mount Sinjar. That might put US troops in direct combat with the ISIS militants trying to kill the Yazidi, a proposition President Obama has not signed off on, but one the military advisers are exploring.

The US and Iran don't agree on much, but it appears the two countries are backing Iraqi Prime Minister Nouri al-Maliki's replacement, Haider al-Abadi. Iran's endorsement on Tuesday means that Maliki, who has indicated he won't go quietly, will have an even harder time holding onto his position. The United States and its allies hope that replacing Maliki, who alienated the Sunnis of Iraq, will undermine support for the militant group the Islamic State in Iraq and Syria (ISIS). For now, Maliki is trying to cling to power, but his days appear numbered.

There are daily multiple sorties by US fighter bombers flying off a US Navy aircraft carrier in the Gulf, some resulting in airstrikes on advancing ISIS forces that have threatened civilian refugees and the Kurdish capital of Erbil. Unmanned US drones are in the air gathering a constant stream of intelligence which is being fed back to a US-manned operations center in Baghdad and then shared with America's allies.

There are close to 1,000 US military advisors in Iraq, including Special Operations forces, divided between Baghdad and Kurdistan and the CIA is believed to be running an operation to supply Kurdish forces, the Peshmerga, with arms and ammunition. Iraqi Kurds have overtaken 2 northern oilfields.  The two oilfields are said to have a combined daily output capacity of some 400,000 barrels per day. The operations are most certainly not entirely humanitarian. France and Germany both say they will send military equipment to help the Kurds defend themselves. Hercules transport planes have been dropping aid to civilians fleeing from the onslaught of ISIS.

While the case for intervention on humanitarian grounds to save the lives of thousands of fleeing refugees is overwhelming, there is now the risk of what is known as "mission creep"; of a small, narrowly defined operation ballooning out of control, sucking in Western countries into a lengthy conflict with no clear exit. Politicians are fond of saying "there will be no boots on the ground" but in practice there are already growing numbers of US military personnel deployed to Iraq behind the scenes. The ISIS fighters are now embedding in residential areas like Mosul, essentially using civilians as shields. Already Iraqi government airstrikes around Mosul have led to reports of civilian casualties. What if advice and air power alone are not enough to prevent the ISIS from taking more towns in Iraq and Kurdistan? What if Baghdad itself or the cities of Kirkuk or Irbil look threatened?

The militants from ISIS have been causing problems in Iraq and Syria for several months, but then they took control of the area around Kirkuk, a gigantic oilfield; then they captured the Mosul Dam, which controls electricity and might serve as a weapon; and then they encroached on the Kurdish capital of Erbil, an oil boomtown which happens to have a US consulate but also has hundreds of employees of companies like Chevron and ExxonMobil; that’s when the airstrikes against ISIS started. To be fair, it was also when ISIS became especially barbaric, and tens of thousands of Yazidi refugees became stranded. The current US intervention certainly has humanitarian purpose, but it would also be wrong to pretend that oil is totally irrelevant to the larger crisis in Iraq.

Meanwhile, the markets are discounting any disruption in distribution in Iraq; Iraq is currently the world's seventh-largest oil producer, churning out some 3.3 million barrels per day; Kurdistan in the north is only responsible for about 10% of the national production; most Iraqi oil exports come from the southern part of the country, and those oil fields are far away from the current fighting, so it’s highly unlikely that there will be a disruption, at least in theory.

In theory, all oil sales in Iraq are supposed to be handled by the central government in Baghdad, which then splits revenues among the various regions according to an existing agreement. Iraqi Kurdistan has been pushing to sell more of its own oil directly to other countries, bypassing the central government entirely, because Kurdish officials claim that the central government hasn't been sending Kurdistan its promised share of oil revenue.

The United States is officially opposed to Kurdistan's direct sales of oil abroad because it might undermine the unity of the Iraqi government. There's currently an oil tanker filled with about 1 million barrels of Kurdish oil parked about 50 miles offshore from Houston that can't unload its crude. State Department officials have been quietly warning any potential buyers of the Kurdish oil that they could face "serious legal risks." But now, the Kurds are stepping up the fight against ISIS.

Iraq has scheduled to export about 2.4 million barrels per day of Basra Light crude in September, up from 2.2 million in the previous month. Libya has resumed shipments of crude. According to the IEA: "The Atlantic market is currently so well supplied that incremental Libyan barrels are reportedly having a hard time finding buyers." If Iraqi oil goes offline, even for a short time, the rest of the world does not have enough spare capacity to replace that production; that would likely push oil prices over $125 a barrel, and that might then increase the leverage for Putin.

And it had been thought that sanctions imposed on Russia over its support for Ukrainian rebels might cause disruptions in oil distribution. Russia is the largest oil producer in the world, at over 10 billion barrels equivalent per day or 13% of world supply. However, the markets are looking at Russia and saying that Putin needs to sell oil even more than the EU needs to buy it. Russia turning the taps off would cause an oil shock in the West as it would cause a steep rise in prices and significant disruption, however it would also bankrupt Russia. At least in theory.

Ukraine vows to stop Russian-supply convoy unless conditions are met. Wary that the Russians may be trying to move military supplies into their country to aid pro-Moscow separatists, Ukrainian officials said they would not allow a convoy of 280 Russian trucks to cross the border unless the Red Cross took over the delivery. Ukraine says the cargo, which Russia insists is humanitarian aid, must be loaded onto other vehicles by the Red Cross. It will take the trucks about two days to make the 620 mile trip from Moscow to eastern Ukraine.

Ukrainian state-run energy firm Naftogaz said yesterday that the ongoing dispute over natural gas prices between Kiev and Moscow may lead to disruption in Russian gas transit to the European Union (EU) countries. Kiev and Moscow have been locked in a dispute for three years over a 2009 contract under which they agreed to tie the price of gas to the international spot price of oil. In June, Russia's energy giant Gazprom has cut all gas supplies to Ukraine after the two sides have failed to reach an agreement on payments. The dispute between the two former Soviet countries triggered fears that Russian gas transit to Europe may be halted. Currently, around 15 percent of EU gas supplies flow through Ukraine.

Yesterday, the International Energy Agency (IEA) said: "Oil prices seem almost eerily calm in the face of mounting geopolitical risks spanning an unusually large swathe of the oil-producing world." Global oil prices have fallen to their lowest levels in 13 months. Brent crude is trading around $103 a barrel, and WTI is around $97, then 10^th straight session with prices under $100. Retail gas prices have dropped about 23 cents a gallon since April.

 

And you probably remember back in 2008, when tensions with Iran helped push oil prices up to a record $148 a barrel. So, with all the problems around the world now, why are oil prices dropping? The US is pumping the most oil in 27 years, adding more than 3 million barrels of daily supply since 2008. 

 

Supplies from the Organization of Petroleum Exporting Countries, which pumps about 40% of the world’s oil, rose to a five-month high of 30 million barrels a day in July as Libyan output recovered and Saudi Arabia increased production. At the same time, global demand is weak, although it is expected to pick up towards the end of the year. Meanwhile Mexico has privatized its oilfields, at least partially. The state-owned energy group Pemex will lose the monopoly it has held since nationalization in 1938. Mexico’s oilfields had been under-performing and production dropped by more than a million barrels per day in the past few years. So, if we can just hold it together for a couple more years, North America could become energy independent. Until then, it could go either way, at any moment, and send the economy into a tailspin in a heartbeat, at least in theory.

Monday, August 11, 2014 - Dog Days

Financial Review with Sinclair Noe

DOW + 16 = 16,569
SPX + 5 = 1936
NAS + 30 = 4401
10 YR YLD + .01 = 2.42%
OIL + .20 = 97.85
GOLD – 1.20 = 1308.90
SILV + .10 = 20.11

It was actually a quiet day on Wall Street; not much economic data today; we’re winding down earnings reporting season. It is a Monday, so there was some M&A action, but for the most part a slow day; we used to call them the dog days of summer. On a day like this, you can claim whatever you want for whatever market movement there is.

NATO sees a "high probability" of a Russian invasion of eastern Ukraine as some 20,000 Russian troops massed on the nearby border. Kiev had the number at 45,000 Russian troops. The Kremlin announced it had sent a convoy of humanitarian aid to Ukraine under the auspices of the International Red Cross. Western governments are generally opposing, in advance, any Russian aid missions, which they fear could serve as a pretext for a military incursion to support pro-Russian separatists fighting the Ukrainian Army in the country’s southeast. The European Commission issued a statement warning “against any unilateral military actions in Ukraine, under any pretext, including humanitarian.”

Ukraine, the United States and European nations have repeatedly warned Russia against mounting a stealth invasion under the disguise of humanitarian aid, and have looked on with growing alarm as Russian officials have spoken in ever-stronger terms about the humanitarian plight of eastern Ukrainians.

Meanwhile, the US continues its bombing-slash-humanitarian mission in Iraq. The United States launched a fourth round of airstrikes Sunday against militant vehicles and mortars firing on Irbil as part of efforts to blunt the militants' advance and protect American personnel near the Kurdish capital. Reinvigorated by American airstrikes, Kurdish forces retook two towns from Sunni militants. U.S. warplanes and drones have also attacked militants firing on minority Yazidis around Sinjar, which is in the far west of the country near the Syrian border. The US has begun providing weapons to Kurdish forces; the move to directly aid the Kurds underscores the level of  concern about the ISIS militants' gains in the north.

Iraq's president named a new prime minister to end Nuri al-Maliki's eight year rule, but Maliki refused to go after deploying militias and special forces on the streets of Baghdad. But Maliki's Dawa Party declared his replacement illegal, and Maliki's son-in-law said he would overturn it in court. Washington delivered a stern warning to Maliki not to "stir the waters" by using force to cling to power. Maliki himself said nothing about the decision to replace him.

Maliki's opponents accuse him of  keeping key security posts in his own hands instead of sharing them with other groups, alienating Sunnis in particular by ordering the arrest of their political leaders. Islamic State fighters were able to exploit that resentment to win support from other Sunni armed groups. Maliki's Shi'ite State of Law bloc emerged as the biggest group in parliament in the April election, but does not have enough seats to rule without support from Sunnis, Kurds and other Shi'ite blocs, nearly all of which demand he go. Maliki also appears to have alienated his supporters in Iran. Obama says a more inclusive government in Baghdad is a pre-condition for more aggressive US military support against ISIS.

Israeli and Palestinian negotiators resumed indirect talks mediated by Egypt today, as a 72 hour ceasefire appears to be holding, at least for the first few hours.

So, we still have geopolitical hotspots, but for today, they are smoldering rather than exploding; although that could change in a heartbeat.

Stanley Fischer, who took over as vice chairman of the Fed in June, deliver a speech in Stockholm today.  Fisher says economists and policy makers had been repeatedly disappointed as the expected level of growth failed to materialize: “Year after year, we have had to explain from midyear on why the global growth rate has been lower than predicted as little as two quarters back.”

Fischer said it was difficult to determine how much of the slackness was because of cyclical factors and how much represented a more fundamental, structural change in advanced economies. He warned of 3 headwinds to growth: a weak housing market, cuts in federal government spending and weaker global growth that reduced demand for American exports. Fischer also questioned whether the recent weak growth is a temporary problem or a more long-term structural problem. 

A new report from the US Conference of Mayors looks at the weakness of earnings in the recovery. Jobs growth in the US since the 2008 recession has been undermined by lower wages, with workers earning an average 23% less than earnings from jobs which were lost. The average annual salary in sectors where jobs were lost - particularly manufacturing and construction - during the 2008-9 financial crisis was $61,637; Job gains through the second quarter of 2014 in comparative sectors showed average wages of $47,171, implying $93 billion in lower wage income. The report also showed that 73% of metro areas had households earning average salaries of less than $35,000 a year. American workers, on average, earned $24.45 an hour in July, up only a penny from June. Over the last year, wages have grown just 2%, in keeping with where they have been stuck since late 2009. The study also found a continuing accumulation of wealth among the top 20% of the nation's earners. From 2005 to 2012, the highest income bracket was responsible more than 60% of all income gains in the country.

The pipeline group Kinder Morgan, the biggest of the master limited partnerships, announced yesterday that it would acquire its three associated companies and reorganize as one corporation based in Houston. The new Kinder Morgan will have an estimated enterprise value of about $140 billion, $100 billion of market value and $40 billion of debt, making it the third-biggest energy company in the United States, after Exxon Mobil and Chevron. Kinder Morgan, which encompasses a huge network of oil and gas pipelines across North America, will acquire its two related M.L.P.s ‒ Kinder Morgan Energy Partners and El Paso Pipeline Partners ‒ and a third related company, Kinder Morgan Management, for $71 billion. Kinder Morgan will pay a premium for each company and use mostly stock to finance the purchases, allowing shareholders of the three targets to essentially continue their ownership.

Under the existing structure, Kinder Morgan’s related companies were obliged to pay out a majority of their profits to investors, including significant payments to Kinder Morgan itself. The distributions had grown so large in recent years that Kinder Morgan was lending money back to the related companies so they could fund growth. It was a profitable arrangement, but became overly complex and ultimately constricted the combined companies’ growth. The move is expected to free up cash for the company to invest in new capital expenditures needed to accommodate new reserves of natural gas being tapped across North America. It’s also expected the move will allow Kinder Morgan to become more acquisitive.

Last week, Bank of America reportedly agreed to a settlement deal with the Department of Justice for $16 billion, with $9 billion in cash fines, and $7 billion in soft dollar relief to borrowers. We still haven’t heard confirmation; but that would break the record for the largest bank settlement in history, set less than a year ago by a $13 billion agreement between Justice and JPMorgan Chase.

The numbers that accompany these deal announcements always seem impressive. But how large are they, really? That depends on your point of view. Bankers fraudulently inflated a housing bubble. They became extremely wealthy as a result, but the housing market lost $6.3 trillion in value when the bubble burst. It had only recovered 44% of that lost value by of the end of 2013. That's more than $3 trillion still missing from American households. As of the first quarter of this year,  9.1 million residences - 17% of mortgaged homes - were still "seriously underwater," which means that homeowners owed at least 25% more on the home than it was worth.

And homeowners weren't the only ones hurt by banker misdeeds. When the bubble burst, it took the economy with it. Unemployment and underemployment remain at record levels, even as the stock market surges and corporations enjoy record profits. Payments on those 9.1 million underwater mortgages are a form of wealth transfer from Main Street to Wall Street, as homeowners continue to overpay the bankers who inflated those mortgages in the first place - or risk losing their homes to them. If this added burden harms their credit score, they'll pay banks more for other forms of borrowing as well.

And yet, these settlements do not require banks to provide principal relief for these underwater homeowners. They don't ask banks to return homes that they wrongfully took from their owners. They don't ask banks to forfeit every penny of earnings received through forgery or perjury. They don't even ask them to restore the credit ratings of defrauded customers. What's more, there's very little reason to believe that these large sums will be paid in full. Much of the "consumer relief" in past deals has turned out to be nothing more than gamesmanship with numbers. Banks modify loans in ways that are advantageous to them, offer deals they almost certainly would've offered anyway, and then count them against their "settlement" obligations. What's more, it hasn't been announced whether this deal will be tax-deductible. If so, Americans will get shortchanged at the federal level, too.

Bank of America is a repeat offender with six violations since November 2011, but there have been no criminal prosecutions of big-bank executives, an omission that Federal Judge Jed S. Rakoff lamented in a recent speech. Rakoff called the lack of prosecutions from the Justice Department and the Securities and Exchange Commission "technically and morally suspect" and characterized the excuses they've given for failing to prosecute as "hollow" and "lame."

Surveillance Will Continue Until the Paranoia Stops

Financial Review with Sinclair Noe

DOW – 75 = 16,368
SPX – 10 = 1909
NAS – 20 = 4334
10 YR YLD - .05 = 2.42%
OIL + .71 = 97.63
GOLD + 7.10 = 1314.00
SILV - .06 = 20.05

Normally, at least for the past 5 years, any dip has been seen as a buying opportunity. Lately, investors see a dip as reason to sell and ask questions later.

The Bank of England holds UK interest rates at a record low of 0.5% for another month. And the European Central Bank holds interest rates at 0.15% and announced they would keep rates low for an extended period of time. ECB President Mario Draghi warned there would be a "continued moderate and uneven recovery" in the eurozone. The annual inflation rate in the 18 countries of the eurozone was 0.4 percent in July, down from 0.5 percent in June; not quite deflation, but not headed in the right direction. Italy just announced its second consecutive quarter of negative GDP; which is the basic definition of a recession. Meanwhile, the website of the ECB has been hacked, and the hacker reportedly contacted the ECB and demanded a ransom for the stolen data.

The New York Times reported yesterday that a Russian crime ring had hacked more than a billion internet passwords, maybe more than 4 billion. It’s being called the biggest hack in history; which may or may not be accurate. Russian hackers are just a small part of the hacking world, about 2%. The major global hackers are Indonesia, China, the US, Taiwan, Turkey, and India. And while Russia may not constitute the same volume as other hackers, they make up for it in audacity; for example, the breach of the Target retail stores. And the recent tensions and sanctions between Russia and the US probably mean there will be no coordinated effort to crack down on international hacking. Of course, it might be argued that for true audacity, nobody can touch the NSA.

How dangerous is this hack? Hard to say. We still don’t know which websites were breached. We still don’t know how the hacked data will be misused. And we are being advised that the best thing to do is to change your password on various sites you use; which isn’t that difficult. There are, of course, companies that you can pay to provide cyber protection; coincidentally, these same companies are the ones that alert us to cyber problems; and I have a nagging suspicion some of them might actually create the problems in the first place. What this really does is to raise awareness that data hackers can collect almost anything, and digital security has been a weak spot in technological progress.

Perhaps braced by Moore’s Law, technology marches on; the journal Science reports that IBM researchers have developed a new computer chip they call TrueNorth.  The new chip was “designed to approximate the structure and function of the brain in silicon”, plus it is power efficient. The chip contains 5.4 billion transistors, yet draws just 70 milliwatts of power. By contrast, modern Intel processors in today’s personal computers and data centers may have 1.4 billion transistors and consume far more power, about 35 to 140 watts. The new chip weaves together all those transistors into an on-chip network of 4,096 neurosynaptic cores, producing the equivalent of 256 synapses. IBM has also tethered 16 of  these chips together in four four-by-four arrays, which collectively offer the equivalent of 16 million neurons and 4 billion synapses, showing that the design can be easily scaled up for larger implementations.

Think of the synapses as memory, and the neurons are the processor; working together they provide fairly complex pattern recognition, and what might be described as sensing capabilities. Right now, the chip is not real fast, but it can be strung together, and on a per watt basis, it really starts to fly. The low power consumption opens up a world of possible uses. This might be the chip that powers the internet of things, embedded in all sorts of devices and possibly revolutionizing mobile devices.

The big question is whether the chips can learn? Not yet, however IBM has already tested the chip’s ability to drive common artificial intelligence tasks, including recognizing images; TrueNorth was able to recognize things like people, cyclists, cars, buses, and trucks with about 80% accuracy. Keep in mind that this is a new chip, still in its early stages of development.  IBM is still investigating how to commercialize this processor and has made no commitments to either manufacture the chip itself or license the design out to others.

The problem with the idea of having even more devices than your smartphone and tablet gathering information for your convenience, of course, is the many ways all that data can be used against you. Traditionally, we think of the government as the invader of privacy, but as capabilities change, we see private corporations getting into the act. Last year the Wall Street Journal reported on new facial recognition technology; police could use an iPhone to take a photo, and then cross check the face in a criminal database; sounds good in the battle against terrorism, but the company that makes the technology wasn’t just considering sales to law enforcement, but also to the health care and financial industries. Yea, I don’t know exactly what those applications might be but I don’t think I like it.

Are health care companies going to start sensing every drop of sweat, every minute we work out, every time we puff a cigarette or sip a cocktail? Maybe we won’t even have to bother going to the doctor anymore. And what about the health insurance companies? Financial engineers believe they can pretty much put a price on anything. So what is your freedom worth? You need air, water, food, and relationships to survive. You want to go shopping, to the movies, to see friends. You have kids, romantic attachments, familial obligations. You like being able to travel, to explore, to watch TV. You need medical care. What are each of these worth? It’s a question that analysts are thinking about.

Or how about the school districts in Houston that require students to wear electronic tagging badges to improve security and increase attendance rates; the same electronic tagging badges formerly used to keep track of cattle.

The “Internet of Things” is probably the next Big Thing. How big? ABI Research estimates that over 30 billion devices will be connected to the Internet of Things by 2020; Gartner puts the number at 26 billion – not including 7.3 billion PCs, tablets, and smartphones. That’s a lot of internet-connected things, considering that there are “only” a little over 7 billion people on this planet, and many of those people are not connected to the internet, much less to electricity. And as technology increases and prices drop, in accordance with Moore’s Law, it opens up the possibility of connecting almost everything from the simple to the complex, and not only connecting, but sensing, monitoring, and controlling almost every facet of your work, home, and private life.

And then that brings us back to the hackers. How secure would all those embedded devices be in a world full of such things. You don’t need to break a code, it would be easier than ever to hack into everything you do, or think about doing. Don’t worry, I’m sure it will all work out fine, but the surveillance will continue until you stop being paranoid.

Some things never change. Bank of America is the latest big bank to work a deal with the Department of Justice. We’re still waiting for an official announcement but it looks like BofA has agreed to a $16 billion settlement for its role in the sale of toxic mortgage securities. The deal is reportedly for about $9 billion in cash and more than $7 billion in soft-dollar relief to consumers; things like loan mods or refi’s which they are supposed to be doing anyway; and this could still be a sticking point in the deal. The two sides continue to hammer out details and are still negotiating a statement of facts. For example, will BofA be forced to admit wrongdoing, and if so, will they actually describe what they did and who did it when they broke the law. Will they be able to deduct the fine from their taxes, thus sloughing off the burden onto taxpayers?

If or when the record deal goes through, Bank of America will have paid more than $50 billion in penalties and consumer relief in deals with government agencies, not including private investors, after acquiring subprime giant Countrywide and investment firm Merrill Lynch at the height of the crisis. And that raises the biggest question of all: how is it possible to cheat so many people out of so many billions without anybody actually breaking a law?

There is an interesting side case that is important to understand the BofA settlement. The bank had been low-balling the DOJ, offering to settle for maybe $3 billion, until last week, when Judge Jed Rakoff a federal judge in Manhattan ordered the bank to pay nearly $1.3 billion for selling 17,600 loans, many of which were defective. Bank of America had previously lost that case, which involved its Countrywide Financial unit, at a jury trial. Turns out, that going to trial was a very, very bad idea for BofA, and when Rakoff issued his ruling, the bank had no negotiating leverage in this case. The Department of Justice started preparing a suit to take to trial, and Bank of America returned to the negotiating table. The case before Judge Rakoff dealt with a Countrywide loan program known as the Hustle, which represented only a small fraction of the firm’s mortgage portfolio, meaning that penalties in cases dealing with larger programs could skyrocket.

Monday, August 04, 2014 - Giving Up the Ghost

Financial Review with Sinclair Noe

DOW + 75 = 16,569
SPX + 13 = 1938
NAS + 31 = 4383
10 YR YLD - .01 = 2.49%
OIL + .09 = 98.38
GOLD – 6.00 = 1289.20
SILV - .17 = 20.23

Let’s start with economic data; on Friday we had the monthly jobs report: 209,000 jobs and the unemployment rate ticked up to 6.2%. It was a decent jobs report but came in a little under expectations. Still the economy has been adding jobs at a strong clip this year. Early in 2014, the Conference Board’s employment trends index pointed to stronger job creation even though the economy temporarily contracted, and that’s exactly what happened. Hiring accelerated, the economy snapped back in the second quarter, and over the past six months the economy has added jobs at the fastest clip since 2006.

The Employment Trends Index increased in July to a reading of 120.31, up from 119.91; this represents a 6.6% increase from a year ago. The 6 month growth rate in the index is the strongest in over 2 years, and suggests solid job growth is likely to continue in the coming months. Job openings keep hitting post-recession highs. There were 4.64 million job openings in May, near an all-time high; and layoffs are extremely low, even compared to the prerecession period.

While there are some signs of strength in the jobs market, wages have been stagnant. Worker pay was a smaller piece of the US income pie than earlier estimated as some Americans collected significantly more in interest and dividend payments over the past two years.  According to revised data from the Commerce Department, employee compensation, including wages and benefits, was lower for each year from 2011 to 2013 than previously calculated. With the revisions, employee compensation was reduced by $9.5 billion in 2011, $5.1 billion in 2012 and $14.6 billion last year. It accounted for 52% of gross domestic income in the last quarter of 2013, down from a prior estimate of 52.2%.

More rank-and-file workers are participating in the recovery as companies report record profits and boost hiring. Compensation has accelerated this year, rising $134 billion after a $153 billion surge in the first quarter. It marked the biggest back-to-back gains since the six months ended in the first quarter of 2007. That’s because companies are hiring again and more people are returning to the workforce, not necessarily because paychecks are getting fatter. We’ve added millions of people to the payroll since the low point of the economy, but we haven’t added at all to the payouts that workers are receiving. Little has flowed to workers except as an increase in their employment rate.

The latest data on consumer credit is due out Thursday. It’s likely to show non-revolving debt like auto and student debt is continuing to grow rapidly. But credit-card debt has barely budged. Auto loans made up a big part of the growth in second quarter GDP. In the second quarter, motor vehicle and parts spending grew an annual 17.5% rate. Put another way, cars made up 3.7% of all consumer spending, the highest rate since the first quarter of 2008. Growth in subprime auto loans has climbed more than 130% in the past five years.

The New York Times recently reported that many subprime auto lenders are loosening credit standards and focusing on the riskiest borrowers, and then many of the subprime auto loans are bundled into complex bonds and sold as securities by banks to insurance companies, mutual funds and public pension funds, a process that creates ever-greater demand for loans. Subprime loans make up about a third of new car-sales and two-thirds of used cars; with many subprime loans carrying interest rates of 23% or more; the loans were typically at least twice the size of the value of the used cars purchased.

Now maybe you are thinking that there were financial reforms put in place following the downturn; reforms that would prevent subprime lending practices. The Dodd-Frank Act did create the CFPB, the Consumer Financial Protection Board, and you might imagine this would protect consumers from less- than scrupulous lenders. Auto loans were stripped out of the CFPB's jurisdiction by an amendment proposed by Representative John Campbell (R-CA), a former used car dealer. Ripping off poor people has become an art form, and one of the requirements is that the companies engaging in this performance art keep themselves outside regulation as much as possible.

General Motors Financial said today it was served with a subpoena from the Department of Justice directing it to turn over documents related to underwriting criteria on subprime auto loans. The Financial Institutions Reform, Recovery and Enforcement Act, allows the Justice Department to sue over fraud affecting a federally insured financial institution.

A Federal Reserve survey of 75 domestic and 23 foreign banks shows that banks are seeing solid demand for loans, but the banks aren’t making it easy for borrowers. Banks reported stronger demand for prime residential mortgages for the first time since last summer and for home equity lines for the first time since October 2013. Credit standards on prime mortgage loans have eased somewhat, but mortgage standards still remain tighter than in 2005. The July survey also shows that new qualified mortgage rules has reduced approval rates on applications for prime jumbo home-purchase loans and nontraditional mortgages but have not impacted prime mortgages. Banks were somewhat more willing to make consumer-installment loans than they were in the April survey.

New research from the Federal Reserve and Northwestern University finds that expanding unemployment insurance benefits reduces the likelihood of mortgage delinquency. About 5 million foreclosures were completed between 2008 and 2012, but it could have been much worse. The survey says unemployment benefits prevented about 1.4 million foreclosures between 2008 and 2012.  

The researchers discovered there were other side benefits from jobless benefits. Banks who saw a lower default risk expanded credit access. Mortgage investors lost less than they otherwise would have. Local governments took a smaller hit. Also, more owners hanging onto their properties meant that homes stood a better chance of not falling into disrepair, which in turn would have sunk property values in their neighborhoods. And here’s one key finding for housing-policy wonks: Fewer troubled properties cut the government’s costs for expanding jobless benefits by narrowing the number of bad loans that would have been covered by federally controlled mortgage-finance giants Fannie Mae and Freddie Mac. Savings related to Fannie and Freddie decreased net costs for the federal government’s jobless-benefits expansion by about one-fifth.

Today’s bank failure comes from Portugal, and it was a big one. Banco Espirito Santo gave up the ghost; the bank will be shut down, and its healthy businesses transferred to a new bank. Portuguese officials were unable to find private investors to prop up the bank, and so the government will use 4.9 billion euro, or about $6.6 billion of its own funds to bail out the bank, or at least part of it. The bank will be spit in two, with the healthy part going to Novo Bank; the healthy part will include deposits and viable assets; so for now, the depositors and senior bondholders are safe.

Regulators are investigating possible accounting fraud and abuse of privileged information by the Espírito Santo family. Toxic loans, mainly to the Espirito Santo corporate parent and various subsidiaries, will be quarantined in a separate bad bank, which will be owned by shareholders and junior bondholders. Eventually, the new bank, or Novo Bank, will be sold in an attempt to recover the taxpayer loan. It is not clear whether even a sanitized version of Banco Espírito Santo will be worth enough to repay the loan.

Banco Espírito Santo provides something of a preview of what may happen in October when the European Central Bank discloses the results of an exhaustive review of bank holdings in the eurozone. The review is intended to uncover precisely the kind of hidden problems that have undone Banco Espírito Santo.

The central bank review is expected to expose an unknown number of other banks with problem loans or other woes that they have failed to disclose to regulators or shareholders. There has been concern that the central bank’s findings could destabilize the eurozone financial system. The European Union still lacks a comprehensive system for dealing with troubled banks, meaning countries must finance their own bailouts.

There is a new study taking a look at the state of banks in the US, the limits of Dodd-Frank reform, and what should be done with banks that are too big to manage. The study was requested by Democratic Senator Sherrod Brown and Republican Senator David Vitter, and the study finds that some institutions remain too complex and interconnected to be unwound quickly and efficiently if they get into trouble. That means that banks still would be able to force a taxpayer bailout in some form, and the banks are essentially receiving value in that implied guarantee. And the new study had the Government Accounting Office look at the value of that implied bailout. Turns out it was a tough calculation as the value of the implied guarantee varies, skyrocketing with economic stress (such as in 2008) and settling back down in periods of calm. If we were to return to panic mode, the value of the implied taxpayer backing would rocket. In other words, the threat of high-cost taxpayer bailouts remains very much with us.

Friday, August 01, 2014 - Jobs, Mainly

Financial Review with Sinclair Noe

DOW – 69 = 16,493
SPX – 5 = 1925
NAS – 17 = 4352
10 YR YLD - .05 = 2.50%
OIL - .32 = 97.88
GOLD + 13.70 = 1295.20
SILV - .09 = 20.40

The first Friday of each month brings us what I consider one of the most important economic reports we can cover, the jobs report; and so we provide comprehensive (wonkish) coverage.

The economy added 209,000 net new jobs in July. The unemployment rate moved up to 6.2% from 6.1%. Even though the economy added jobs, more people joined the labor force, and that is why the unemployment rate moved higher. The 209,000 new jobs was below estimates of about 230,000. The report from June was revised from 288,000 to 298,000; the May report was revised from 224,000 to 229,000 for a net 15,000 in upward revisions.

Employment is up 2.57 million year over year. We have regained the jobs lost in the downturn, and total employment is 639,000 above the pre-recession peak. Total employment is up 9.35 million from the lows of the recession, and private employment is up almost 9.9 million from the lows; the difference reflects the job losses in government related jobs.

So far this year an average of 229,000 new jobs a month have been created. That’s a significantly higher pace than in 2010 when a mere 88,000 jobs a month on average were added. Since the start of the year the economy has added 1.6 million jobs.  At the current pace, the economy could add 2.75 million jobs this year, which would be the best year for total and private job growth since 1999.

This was the sixth month in a row with more than 200,000 jobs added, and that hasn’t happened since 1997. It was probably a bigger achievement 17 years ago, because the economy and the labor force was smaller back then, but the employment recovery has been chugging along through a first quarter that was frozen by the polar vortex and rebound in the second quarter. And the private sector has been adding jobs consistently since the first quarter of 2010.

The unemployment rate was up to 6.2%. The jobless rate can rise for both good reasons (more people looking for work) and bad reasons (fewer people having a job). This month, more people were looking for work. The Labor Force Participation Rate increased to 62.9% in July; this is a measure of how many people who are of working age are actually in the labor force and working or looking for work. The idea that the pool of labor is increasing is a positive; the idea is that some people who have been unemployed for a long time are now finding jobs. The trend in employment growth remains more than strong enough for the unemployment rate to keep trending down, even though the rate rose a tenth this month

Part of the decline in the participation rate was due to demographics; many older workers retired, whether they wanted to or not, while many younger workers stayed in school or returned to school. So, it’s helpful to look at people aged 25-54, in their prime working age; among this group, the participation rate declined slightly; this confirms that younger and older workers were jumping back into the labor pool.  Still, the employment to population rate, which measures the country’s population that reported having a job in July was unchanged at 59%, a number that was up only barely from its 58.7% level of a year ago.

There are still more than 3.1 million workers who have been unemployed more than half a year. And there are just over 7.5 million people working part-time for economic reasons. These workers are included in an alternate measure of unemployment known as the U-6, which includes unemployed and underutilized workers; U-6 increased from 12.1% to 12.2%.

Many people think the U-6 is a more accurate measure of the jobs market, but let’s dig a little deeper. There are 9.6 million people unemployed and actively looking for a job. There are more than 2 million people who have stopped looking for a job within the past year. When you start adding all the unemployed workers who want a job, plus involuntary part-time, plus discouraged workers, you come up with about 23 million people that could possibly move into the labor pool. There is still massive slack in the labor market, and it will take a long time to take up the slack. For now, it is a slow, steady slog.

Where is the job growth coming from? Professional and business services added 47,000 jobs. Retail employment gained 27,000 jobs. Manufacturing added 28,000 jobs last month but the sector has recovered only 30% of the jobs lost during the recession. Construction added 22,000 jobs. Leisure and hospitality gained 21,000. Education and health services added 17,000. Government added 11,000. State and local government employment is now up 151,000 from the bottom, but still nearly 600,000 below the peak. Federal government jobs have dropped by 22,000 since the start of the year. The loss of government jobs is one of the major factors in the slow jobs recovery. In previous downturns, government did not have layoffs, and sometimes increased hiring. In this downturn government jobs were cut in a wave of austerity measures.

Even though the economy has been adding jobs, it has not been enough to push a recovery in wages. In July, average hourly wages rose a penny to $24.45, a disappointing result after strong gains in June and May. In 23 of the past 24 months, the yearly increase in hourly pay has ranged from 1.9% to 2.2%, or about one-third less than usual during an economic recovery. The 12-month increase in wages as of July was just 2%; and inflation wiped out about three-fourths of that gain. There’s been no change since the start of 2014. While it might seem counterintuitive that wages are flat while jobs are being added, the likely reason is that there are a lot of poor paying jobs plus a few very good paying jobs. The average length of the workweek for private sector workers was unchanged at 34.5 hours.

Stronger than expected US growth figures on Wednesday showed second quarter GDP up 4% on an annualized basis, along with hawkish comments from US Federal Reserve board member Charles Plosser, it prompted fears that the central bank may increase the cost of borrowing sooner than expected. Today’s non-farm payroll numbers were just weak enough to ease concerns about possible tightening from the Fed, yet not so awful as to indicate a downturn. It still points to a job market and an economy that is improving, but there is no real wage pressure and nothing to indicate inflation is a concern.

We had a couple more economic reports today. The Institute for Supply Management said its index of national factory activity rose to 57.1 in July, the highest since April 2011, from 55.3 in June. A reading above 50 indicates expansion in the manufacturing sector.

The Thomson Reuters/University of Michigan's final July reading on the overall index on consumer sentiment came in at 81.8, down from the final June reading of 82.5. The surveyors report that consumers’ attention has been dominated by jobs and income growth.

For the week, the S&P 500 fell 2.7%, its biggest weekly percentage loss since the week ending June 1, 2012, while the Nasdaq fell 2.2%. The Dow ended down 2.8% for the week. The Dow's losses dragged it further into negative territory for the year. For the year-to-date, it is down 0.5%.

Markets have suffered a turbulent few days, hit by a combination of interest rate concerns and growing geopolitical worries. The violence in Gaza also added to the sense of events escalating out of control; a proposed 72 hour cease fire didn’t last one day. An Israeli soldier was captured, and it looks like violence will escalate over the weekend. The week saw Argentina defaulting for the second time in 12 years, while continuing tensions with Russia over the Ukraine led to the imposition of further sanctions which could hit businesses and put the brakes on global growth.

It was a big week for US economic activity, with jobs and GDP statistics and a Fed meeting, but it was European equity markets that took a real tumble. Portugal was a big loser, as Banco Espírito Santo reported the largest-ever loss for a Portuguese company, sending its shares spiraling and prompting probes into possible accounting fraud at the bank.

Portugal’s major stock index dropped 10% for the week. German stocks were hit following stepped up sanctions against Russia, a major supplier of natural gas to Germany; the DAX index slipped 4.5%. Greece, Austria, Spain, UK, and France all saw declines of 3% or more. The major Russian index dropped about 1%.

Europe posted its own jobs report. Eurozone unemployment dropped to 11.5%, which is absolutely horrible, but getting better. Meanwhile, the region continues to flirt with the prospect of deflation, with euro zone wide prices rising a scant 0.4% in July from the prior year. So, there is still plenty the ECB can do to stimulate the economy over there.

Meanwhile, Congress is calling a 5 week recess, an extended summer vacation, which even Europeans think is excessive. They managed to get a few things done before running away. They passed a $16 billion VA bill to help deal with extensive treatment delays and a recent record-keeping scandal. They cobbled together a patch for highway funding, just a temporary patch. This Congress has only managed to pass 142 bills into law, which puts the legislative branch on pace for its least productive session in modern history. And now they’re heading out for a 5 week vacation. Maybe we’ll get lucky and they won’t come back.

Thursday, July 31, 2014 - Ugly Day, Ugly Logic

Financial Review with Sinclair Noe

DOW – 317 = 16,563
SPX – 39 = 1930
NAS – 93 = 4369
10 YR YLD un = 2.55%
OIL – 2.12 = 98.15
GOLD – 14.00 = 1281.50
SILV - .23 = 20.48

Well, this was just ugly. The worst day for the Dow Industrial Average in about 4 months. Back on April 10^th, the Dow dropped 267 points; that same day, the S&P 500 was down 30 points. Today wiped out the gains from July, with July marking the first negative month for the Dow and the S&P since January.

The S&P is still up about 5% for the year to date, but the Dow started the year at 16,576. All those record highs for 2014 have just been washed away. That’s how it goes; the markets scratch and claw, higher and higher, inch by inch it’s a cinch, until the cinch breaks. A couple of weeks ago, we talked about shorting, and the advantage of shorting is that the moves can be quick and severe. Sure enough. And while this might just be one bad day, long overdue, the Dow dropped below its 50 day moving average, which is one of the major measurements of a trend.

So, the question is why did the stock market nosedive today? One recurring theme I’ve been hearing is that traders are afraid the Fed will pull away the punchbowl. Yesterday’s GDP report showing better than expected 4% growth in the second quarter combined with today’s employment cost index, which rose 0.7% in the second quarter, made people nervous about the prospect of an improving economy and the possibility of wages pushing inflation higher.

Now wait just a minute; that doesn’t sound so bad; the economy is expanding at a 4% pace which is certainly better than a contracting economy which we saw in the first quarter; and workers are being paid a little more – not much just a little - and that’s certainly better than watching the middle class shrink into oblivion. If you look at this explanation for the market decline, it is an example of perverse logic, where the stock market traders are in opposition to economic prosperity and are only happy in the face of hardship; other people’s hardship, not their own.

There might be something to that interpretation. Beginning in 2008, the Fed cranked up a series of programs to stimulate the economy. Of course, the Fed didn’t really stimulate the economy but they did stimulate certain financial sectors, such as housing, and very clearly the stock and bond markets. During that time, the Fed added over $3.5 trillion to their balance sheet, which now holds nearly $4.5 trillion. The basic mechanics were that the US government borrowed money by selling Treasuries, and the Fed bought a large portion of those Treasuries with freshly printed money. Since 2013 the Fed’s balance sheet has grown even faster than government debt, which has leveled off, almost. Overlay a chart of the S&P 500 with a chart of the Fed’s balance sheet; the similarities are more than coincidental. A big chunk of the money the Fed was printing sloshed over into the stock market. When the Fed stops printing all that money, who is left to buy stocks?

The accumulated “surplus” of printed money will only last a couple of months. Sooner or later (probably sooner), the stock market will start to feel the pain of this monetary tightening. Of course the Fed isn’t really exiting the money printing business. They won’t sell off the assets held on their balance sheet; they will let those treasuries and mortgage backed securities mature and expire, maybe even roll over a few. And government debt hasn’t disappeared, so the Fed will continue printing money. We don’t know how the Fed taper and eventual increases in interest rates will turn out; neither does the Fed know. It’s a big experiment; the Fed might throw a curveball or two along the way; the stock market traders might throw a tantrum, knocking down your IRA in the process. The recurring theme today was that the Fed might pull away the punchbowl; the Fed hasn’t actually done that; they said this week they would not do that anytime soon. There has been considerable consideration given to a Fed exiting. Imagine when they actually do it.

The big institutional traders may already be headed for the doors. Last week, investors added $379 million into equity mutual funds, the kind that’s popular with retail investors. At the same time, exchange-traded funds focusing on equities; the kind of securities traded by institutional investors because of their liquidity and lower cost, saw a whopping $7.97 billion in outflows. That’s the biggest outflow seen since February.

Anyway, the Wall Street traders’ logic is flawed; the 4% growth in second quarter GDP really isn’t as good as it seems. The 4% growth implies the economy is on a very slow growth path when averaged in with the -2.1 contraction in the first quarter. Taken together, the economy grew at less than a 1.0% annual rate in the first half of 2014. That is hardly cause for celebration on Main Street or trepidation on Wall Street. Also, the strong growth in the second quarter was in direct response to the weak growth in the first quarter. Inventory growth was very weak in the first quarter, subtracting 1.16% points from the quarter's growth, and so a reversion to the mean, or a return to a more normal pace of inventory accumulation in the second quarter was a strong boost to growth, adding 1.66 percentage points. Final sales grew at just a 2.3% annual rate in the second quarter. Even that rate was likely inflated to some extent by the weakness from the first quarter.

But that wasn’t the only demon plaguing the stock market today. If it’s not one thing, it’s another. And there have been a lot of other things.

The bond market has its own demons. Fitch warns a jump in US high-yield default rates looms. There have been 10 LBO related bond defaults thus far in 2014, compared with nine for all of 2013. While most sectors remain relatively calm, the utilities and chemicals sectors are seeing huge spikes in defaults. Since the Fed pushed rates down near zero people have been chasing yield and that means the high yield market has become crowded, and that means the yield on risky debt has dipped to a little less than 6% on average, compared to a more typical yield of a little less than 9% for junk  debt. If or when the Fed starts targeting higher rates, who will be looking for the junk with the not so high yield? A reversion to the mean would result in big capital losses, and it could turn ugly if people start running for the exits and can’t find a bid.

And then we can’t forget the geopolitical problems of the world. A negative July in stocks was matched by a negative July in Ukraine, and Israel, and Gaza, and Iraq, and Syria, and Libya. Toss in sanctions on Russia, which will also hurt the European Union.  And then late yesterday, Argentina put a cherry on top.

Argentina has defaulted, or as S&P described it, a “selective default”. A quick recap: In 2001 Argentina defaulted on its debt and it forced most of its creditors to take a haircut, that is a lot less money than the face value of the bonds. After the default, Paul Singer, a hedge fund manager of NML Capital, bought a lot of the bonds at a big discount, pennies on the dollar, and then demanded the bonds be paid in full. Argentina refused to pay the vulture hedge funds. So Singer took his case to the courts – not in Argentina, but in the US. The case was heard by a judge who didn’t really understand all the fancy talk about bonds, and so he ruled against Argentina. About a month ago, the US Supreme Court said they would not interfere. So now, Argentina can’t pay off the bondholders who accepted the discount, unless they also pay off the hedge fund vultures who demand full payment; which basically negates the whole idea of the default in the first place. So, the US courts have essentially told the sovereign country of Argentina that it is more important to pay off the hedge funds, than it is to default and reboot the Argentine economy on a fresh start.

While Singer’s firm has yet to collect any money from Argentina, some debt market experts say that the battle may already have shifted the balance of power toward creditors in the enormous debt markets that countries regularly tap to fund their deficits. Countries in crisis may now find it harder to gain relief from creditors after defaulting on their debt.

The big question, however, is whether Argentina will ever pay Singer and his vulture fund fellows what it wants. If the firm fails to collect, that would underscore the limits of its legal strategy. There is no international bankruptcy court for sovereign debt that can help resolve the matter. Argentina may use the next few months to try to devise ways to evade the US courts. In dire economic crises countries need to be able to slash their debt loads. The idea is similar to bankruptcy for individuals, a chance to restructure debts and start fresh because we long ago learned that throwing people in prison for the debts didn’t help anybody. The legal victories of the holdouts may embolden creditors to drive harder bargains after future defaults, which in turn could prolong or postpone debt restructurings and extend the economic misery of over-indebted countries. So, the problem in Argentina is not unique to Argentina, it affects the global economic system, we just don’t know to what extent.

Wednesday, July 30, 2014 - GDP, Fed, Vultures, and Banksters

Financial Review with Sinclair Noe

DOW – 31 = 16,880
SPX + 0.12 = 1970
NAS + 20 = 4462
10 YR YLD + .09 = 2.55%
OIL - .72 = 100.25
GOLD – 4.30 = 1295.50
SILV + .06 = 20.72

Last week we told you that this week would be very busy. Well, here we are; today we had a big report on second quarter GDP and the Fed wrapped up a policy session, and that’s just the beginning. 

This morning, the Commerce Department reported the gross domestic product grew at a 4% pace in the second quarter. Boom. First quarter GDP was revised from negative 2.9% to negative 2.1%; but any way you look at it, this was a massive turnaround.

The government also published revisions to prior GDP data going back to 1999, which showed the economy performing much stronger in the second half of 2013, growing at a 4% pace, the strongest 6 months since late 2003. This was the first estimate of second quarter GDP, and the first revision will be released August 28.

Inventories added 1.66 percentage points to this GDP report. Stockpiles were rebuilt at a $93.4 billion annualized pace after a $35.2 billion gain in the first three months of the year. That could mean companies will keep tighter control on the number of goods on hand this quarter, which could cut into economic growth. Or it might mean companies are optimistic about sales.

Consumer spending rose at a 2.5% pace last quarter, which also topped expectations, and more than double the 1.2% advance in the first quarter of 2014, in part due to less spending on healthcare. Purchases of durable goods, including autos, furniture and appliances and recreational vehicles, jumped at a 14% annualized rate, the fastest since the third quarter of 2009. Despite the pick-up in consumer spending, Americans saved more in the second quarter. The saving rate increased to 5.3% from 4.9% in the first quarter as incomes rose, which bodes well for future spending.

Corporate spending on structures, equipment and intellectual property such as software increased at a 5.5% annualized rate after rising at a 1.6% pace in the prior three months. In addition to consumer spending and business investment, growth got a boost from the biggest gain in state and local government expenditures in five years. Congress is still debating spending for infrastructure improvements such as roads and bridges, and if they can’t work out differences that could prove a stumbling block later in the year. A widening trade gap subtracted 0.6% from growth. Excluding inventories and trade, so-called final sales to domestic purchasers climbed at a 2.8% rate, the biggest increase since the third quarter of 2011.

Still, the big swing from negative 2.1% contraction to positive 4% growth seems like a very big swing, almost freakish. We know that the first quarter was hit by bad weather and the polar vortex …, still. So, we can smooth out the numbers by looking at the full year growth rate; over the past 12 months the economy expanded at a 2.4% rate, pretty much in line with the past 3 years; in fact, 2.4% growth would be decent in normal times, but the economy is still in recovery mode, and 2.4% is not enough to achieve “liftoff”. The economy is headed in the right direction, it is gathering momentum, but it is still operating below potential. By the Congressional Budget Office’s estimates, the level of output reported for the second quarter is still $770 billion below the nation’s current economic potential, or 4.2% below. That implies that the nation still has plenty of room to grow if a faster expansion ever kicks in.

The economy is far from perfect, we have a long way to go, but today’s report indicates progress, real, honest to goodness progress.

A price index in the GDP report rose at a 2.3% rate in the second quarter, the quickest in three years, after advancing at a 1.4% pace in the prior period. A core price measure that strips out food and energy costs increased at a 2.0% pace, the fastest since the first quarter of 2012. The inflation picture should lend support to the Fed hawks who want to hike interest rates sooner rather than later, but for now the Fed is standing pat.

The Federal Reserve Federal Open Market Committee reaffirmed it was in  no rush to raise interest rates, even as it upgraded its assessment of the economy and expressed a level of comfort that inflation was moving up closer to its target, and the taper is  still on track. The Fed has kept overnight rates near zero since December 2008 and has more than quadrupled its balance sheet to $4.4 trillion through a series of bond purchase programs. The Fed announced, as expected, that it would reduce its monthly bond purchases to $25 billion per month, but it gave no indication that recent signs of stronger economic growth had changed its previously announced plan to hold short-term interest rates near zero well into 2015.

The Fed acknowledged both faster economic growth and a decline in the unemployment rate, but expressed concern about remaining slack in the labor market. The Fed’s statement said: "Labor market conditions improved, with the unemployment rate declining further… However, a range of labor market indicators suggests that there remains significant underutilization of labor resources."

Some Fed officials see evidence that the economy is settling into a pattern of slower growth, and that monetary policy has substantially exhausted its power to improve the situation. They want the Fed to retreat more quickly from its stimulus campaign, fearing higher inflation, or that it will encourage bubbles in financial assets. Fed chairperson, Janet Yellen, and her allies have taken a more cautious view, arguing that the decline in the unemployment rate appears to overstate the improvement in the labor market, because it counts only people who are looking for work. Yellen expects some people who had been discouraged about their job prospects will return to the labor force as the economy continues to improve, and she has pointed to weak wage growth as evidence that it remains easy to find workers.

More optimism for the economy came in a report from ADP, the payroll processing company; private employers added 218,000 jobs last month, which was down from 281,000 in June. It was the fourth straight month of job gains above 200,000. While ADP’s numbers offered reason to be hopeful, the company’s figures cover only private businesses and often do not track with the government’s jobs report, which will be released Friday.

The ratings agency Standard & Poor’s says Argentina has defaulted after it failed to make a $539 million interest payment due on its discount bonds. The downgrade came late this afternoon as representatives for Argentina and New York hedge funds sought to reach a last-minute agreement on Argentina’s debt. Yet after more than five hours of mediated talks, neither side appeared closer to a deal. Standard & Poor’s lowered its rating on the country’s debt to “selective default”, noting that Argentina had a 30-day grace period following the June 30 scheduled interest payment date to make payment.

This story goes back to 2001, when Argentina defaulted on tens of billions of dollars of sovereign bonds. It later exchanged those bonds for discounted ones with most of its bondholders, but a small group of traders, mainly hedge funds, led by Paul Singer’s Elliott Management refused to take the new bonds, even though they had purchased the discounted bonds after the default, at pennies on the dollar, they demanded full payment, and they have not backed down, and they took it to court in the US.

In 2012 a US federal judge ruled that Argentina could not make payments to bondholders who had agreed to discounted bonds, without paying the holdouts. Argentina appealed and took its case to the United States Supreme Court, which rejected the appeal last month. Argentina had until the end of the day to pay the holdouts or risk defaulting for a second time in 13 years.

A federal judge has ordered Bank of America’s Countrywide unit to pay $1.27 billion in penalties for defective mortgage loans sold to Fannie Mae and Freddie Mac in 2008. US District Judge Jed Rakoff in Manhattan issued the civil penalty against BofA in the first mortgage-fraud case brought by the federal government to go to trial. A jury in Manhattan found Countrywide liable. The judge determined that Fannie and Freddie had paid Countrywide nearly $3 billion for HSSL loans, but determined that 57% of the loans were of acceptable quality. HSSL refers to a Countrywide loan program called the High Speed Swim Lane, which fast-tracked almost any loan; it was also known as a “Hustle” loan.

In today’s decision, Judge Rakoff wrote: “While the HSSL process lasted only nine months, it was from start to finish the vehicle for a brazen fraud by the defendants, driven by hunger for profits and oblivious to the harms thereby visited, not just on the immediate victims but also on the financial system as a whole.”

Separately, Bank of America is reportedly nearing a settlement with the Justice Department to resolve an investigation into its sale of mortgage backed bonds centered on faulty loans the company inherited from Countrywide and Merrill Lynch, which it purchased in 2008. The discussions include how much money will be paid in cash and how much in consumer relief. Potential terms have ranged from $13 billion to $17 billion. The DOJ has been trying to work out a settlement for some time, and was reportedly dissatisfied with a $13 billion deal that included $5 billion in consumer relief. The consumer relief portion of these settlements has typically been an easy out for the banks. The amount of any settlement would come on top of the $9.5 billion the bank agreed to pay in March to resolve Federal Housing Finance Agency claims.