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.

Monday, July 07, 2014 - Small Steps

Financial Review with Sinclair Noe

DOW – 44 = 17,024
SPX – 7 = 1977
NAS – 34 = 4451
10 YR YLD - .03 = 2.62%
OIL - .67 = 103.39
GOLD - .50 = 1321.00
SILV - .10 = 21.15

 

It was a long holiday weekend that was over way too fast. And the problems of the world haven’t gone away. Let’s get caught up on some of the big stories.

In Iraq, the situation is deteriorating. There had been muted hope for some sort of an inclusive government to hold the country together. Don’t count on it. Iraq’s new parliament has called a recess and they won’t meet again for 5 weeks. So Iraq is now politically paralyzed. Meanwhile, a Sunni Islamist insurgency killed an army general near Baghdad.  It looks like Prime Minister Maliki is digging in his heels, raising the risk that Iraq will fragment along ethnic and sectarian lines.

ISIS, the Sunni insurgents are holding territory in western Iraq and just north of the capitol. The Iraqi military, backed by Shi'ite militias and volunteers, has yet to take back any major cities but is trying to advance on Tikrit. Kurds in northern Iraq have taken advantage of the chaos to expand their autonomous territory in northern Iraq. Most Sunnis and Kurds walked out of the last parliament, saying they believed the prime minister and president should be chosen along with the speaker as a package, not one at a time. They could not resolve the impasse, so the acting speaker postponed the meeting.

In eastern Ukraine, pro-Russian rebels built barricades in the streets of Donetsk and it looks like they will try to make a stand. Although most shops and businesses in Donetsk were still open, some were shut, and residents are concerned that government forces could soon attack. Rebels have been barricaded into government buildings in Donetsk, which they declared capital of an independent "people's republic", but until now the city mostly functioned normally.

You may recall there was an election in Afghanistan last month. They announced preliminary results today. The losing presidential candidate is now saying the results of the election were improperly counted and he is describing it as a “coup” against the people. His rejection of the election results sets the stage for a possible bloody standoff between ethnic groups or even secession of parts of the fragile country, which is already deeply divided along tribal lines. The vote to pick a successor to Hamid Karzai was intended to mark the first democratic transfer of power in Afghan history, a crucial step towards stability as the US prepares to withdraw the bulk of its troops by the end of the year. Not so great.

Hamas stepped up rocket fire at southern Israeli towns and Israel called up reserve troops today in anticipation of a possible escalation of hostilities. Hamas has vowed revenge for what it saw as Israel's deadliest attacks in which six Palestinian militants died, though Israel denied any involvement. The surge in violence has raged since the kidnapping and killing of three Israeli youths last month and a Palestinian teen last week. Israel said more than 40 rockets were launched as militants' funerals were held in Gaza. Thirty struck inside Israel and the rest were shot down by rocket interceptors. Air raid sirens wailed as far north as the outskirts of Tel Aviv and Jerusalem.

And then there’s Chicago, where the Fourth of July holiday resulted in widespread violence that left 80 people wounded and 14 dead.

On the economic calendar, Alcoa will kick off the earnings reporting season after the close of trade tomorrow. Alcoa has long held the ceremonial role for starting earnings season because it was in the Dow Industrials and it had the ticker symbol AA. Alcoa is no longer one of the Dow 30 stocks, but the tradition holds. Actually, we’ve already seen about 25 companies from the S&P 500 report earnings.

Second-quarter profit growth is expected to come in at 6.6% for the Standard & Poor’s 500-stock index, which would be an improvement over the 5.6% growth in the first three months of 2014. Revenues are expected to grow 3%. While negative second-quarter profit warnings have outpaced positive ones by a 4.2 to 1 margin — well above the 2.6 to 1 negative-to-positive ratio since 1995 — the future outlooks from CEOs are far more bullish than the first quarter, when there were nearly 7 negative profit pre-announcements for every positive one.

With stocks at all-time highs and no longer cheap after a five-year bull run, Wall Street wants to see companies deliver profit and revenue growth in the coming second-quarter earnings season sizable enough to warrant the market’s big move. Indeed, the bull market’s continued health will hinge on vibrant corporate profitability. Whether or not stocks continue trending higher will likely depend on second-quarter earnings reports, as well as management’s guidance of full-year earnings.

Currently, the S&P 500 is trading at nearly 16 times its estimated earnings over the next four quarters, which is a tad above the long-term average. Heading into the season, analysts are upbeat, with more analysts’ raising profit forecasts than lowering them for the first time since the first quarter of 2012, but more upbeat analysts could result in a more downbeat market reaction.

On Wednesday, the Federal Reserve will release the minutes of its last meeting, held June 17-18. Wall Street will again be looking for any clues related to the timing of the first interest rate hike by the Fed. After the strong jobs report Thursday, some Wall Street firms revised their rate-hike timetables, warning that rates could start rising earlier-than-expected next year. However, the Fed might not be so positive about jobs. There’s been concern about the degree to which a falling unemployment rate is overstating labor-market strength.  You’ll likely see general agreement that the labor market has been improving, but there will be difference in opinion about the drop in the unemployment rate. Officials have also been eyeing tepid wage growth.

That’s one of the strange things about the jobs report; it does a poor job of measuring the strength of the jobs created. When we try to measure performance in the stock market, we don’t look at the number of new stocks available to investors, instead we measure the price of the stocks, the value of the stocks. But when we look at jobs, we don’t look at the value those jobs bring. One of the things we’ve seen is that many of the jobs being created are part-time.

So, it's interesting that the recent news of job market "improvement" doesn't mention that of the 10 occupation categories projecting the greatest growth in the next eight years, only one pays a middle-class wage. Four pay barely above poverty level, and five pay beneath it, including fast food workers, retail sales staff, health aids, and janitors. The job expected to have the highest number of openings is "Personal Care Aide" – taking care of aging baby boomers in their houses or in nursing homes. The median salary of an aid is under $20,000.

We’re starting to see some improvement as the job market gains traction; more than half the jobs the economy has added so far this year are in positions that pay higher than the hourly wage. Some 58% of the new jobs created in 2014 pay above the average hourly wage of $24.45. By contrast, about 48% of the new jobs created in 2013 paid above the national average. Businesses in 2014 are hiring more white-collar employees, construction is on the mend (at least compared to the first quarter), health care is going strong and even the long-downtrodden financial industry is finally getting into the act. About 42% of the new jobs, meanwhile, fall into categories that pay less than the average wage.

Still there is a general lack of upward wage pressure; workers demanding more money as the labor market improves and the pool of potential employees shrinks. Wages have risen just 2% over the past year and weekly wages have actually fallen in the past two months. Part of the problem is part-time work; part of the problem is that the good paying jobs are limited to certain sectors. The bigger problem is that the increase in the number of jobs is not translating to higher wages and that, in turn does not translate to faster economic growth.

This week’s economic calendar also includes reports on small businesses, job turnover, and consumer credit. There was a 10.2% surge in consumer credit in April. The growing dependence on debt could prolong consumer spending a few more months, but in the absence higher real wages, this type of consumption cannot last much longer, certainly not if we see both gas prices and inflation-driven interest rates edge higher later this year.

It’s unlikely we’ll get any big pronouncements from the Fed. They probably talked about how the economy has rebounded from the terrible slump of the 1^st quarter, but if you read the minutes for any major move on interest rates, don’t hold your breath. Neither short-term nor long-term rates will go significantly higher in the next few years. More likely, modest increases that might even be quickly reversed. The implications of another extended period of depressed rates would be bad news for savers and pension funds, but it should help the stock market.

After the Fed’s June meeting, they made clear that they expected to finally begin lifting their benchmark rate in 2015, if the economy continues to expand and unemployment continues to decline. Even so, 12 of the 16 members of the policy committee expected the Fed's rate to be no higher than 1.5% by the end of 2015 — a full 18 months from now. Asked for their rate prediction for the end of 2016, the majority of the Fed panel expected 2.5% or less. And because the Fed's rate influences all other interest costs, that would suggest still-low rates across the board.

What we are learning about this version of the Fed is they move slow and in small steps.