FINANCIAL REVIEW

Buckle Your Seat Belts

Sinclair Noe — January 5, 2015

Podcast: Play in new window | Download (Duration: 13:19 — 6.1MB)

DOW – 331 = 17,501
SPX – 37 = 2020
NAS – 74 = 4652
10 YR YLD – .08 = 2.04%
OIL – 2.82 = 49.87
GOLD + 15.40 = 1206.20
SILV + .40 = 16.29

If Santa Claus should fail to call, bears may come to Broad and Wall. That is the old saying and most people think the Santa Claus rally covers the month of December, or maybe the week leading to Christmas; actually, the rally time frame covers the last 5 trading days of the year and the first 2 trading days of the New Year, which would include today. And today the markets were down; the worst day in 3 months. The Santa Claus rally is really an indicator.

In 1999-2000 rally time-frame suffered a horrendous 4% loss. According to the Stock Trader’s Almanac, on January 14, 2000, the Dow started its 33-month 37.8% slide to the October 2002 midterm election year bottom. NASDAQ cracked eight weeks later falling 37.3% in 10 weeks, eventually dropping 78% by October 2002. Saddam Hussein cancelled Christmas by invading Kuwait in 1990. Energy prices and Middle East terror woes may have grounded Santa in 2004. In 2007 the third worst reading since 1950 was recorded as sub-prime mortgages and their derivatives lead to a full-blown financial crisis and the second worst bear market in history.

For the past 4 trading sessions, the S&P 500 is down. The S&P 500 hasn’t had a 4-day losing streak in 264 trading days. This is the longest such streak without a 4-day decline since 1928. Which means that over the past 87 years, we’ve seen a whole bunch of 4-day losing streaks; that is the norm, but since 2013 we’ve gone through a period where stocks just haven’t gone down. Maybe you’ve been lulled into a sense of complacency.

The S&P 500 finished 2014 up about 11%to post the sixth consecutive year of positive returns. Since 1927, there have only been two periods that the S&P has had longer winning streaks. From 1982 to 1989 the S&P rose for 8 straight years, and that includes the crash of 1987, where the S&P still managed a small gain for the year. Between 1991 and 1999 the S&P rose for 9 straight years, but only if you reinvested dividends in 1994. And if you want to use the entire month of December as an indicator, well, December 2014 was the third weakest December since the turn of the century; only 2007 and 2002 were weaker. Now, consider that both 2002 and 2008 were very weak market environments and 2014 was relatively strong.

So, the question is “can the S&P 500 post gains for a seventh straight year?” And the answer is that I don’t know and you don’t know, and the talking heads on TV and the internet bloggers don’t know. What history tells us is that a bull market doesn’t last forever. Eventually and inevitably, stocks will drop; it could happen this year, or not; maybe next year, or not. Maybe the bears are coming to Broad and Wall, or not.

What we do know with some certainty is that the bears have come to the oil patch. US crude dropped more than 5% today, dipping below $50 a barrel for the first time since May 2009. And even as prices have dropped, production remains high. Russia’s oil output hit a post-Soviet high last year, and Iraq’s oil exports in December were highest since 1980. ConocoPhillips announced it struck first oil at a Norwegian North Sea project. Saudi Arabia cut prices for European buyers.

Open interest for $40-$50 strike puts in US crude have risen several fold since the start of December, while $20-$30 puts for June 2015 have traded. Meaning there are some people willing to gamble that oil could hit $20; that is a big gamble, but some people are taking the bet, or at least they are buying some insurance against falling prices. And that brings us to the shale producers in the US. Saudi Arabia is trying to gain market share and edge out US shale producers with lower prices, calculating that the 50% drop in oil prices will force US oil companies to drill fewer new wells, causing US production growth to stall and putting a floor under oil prices. But the shale players have, by and large, hedged their positions and insured against lower prices. If prices continue to fall, the US oil producers will eventually be exposed to low prices, but for now they are like the little Dutch boy with a finger in the dike.

New hedging strategies are only likely to get disclosed in quarterly earnings reports in late January, so for now we don’t know how much hedging is really going on. A rough gauge of hedging activity is to look at net short positions of oil producers and other non-financial companies in the US crude oil futures and options markets, and those net short positions have grown from 15 million barrels in August to more than 77 million barrels last week. For many companies that set up “in the money” hedges prior to the slump, the downturn offers a chance to cash in or extend their protection.

For example, a company that had sold swap contracts to hedge a part of its 2015 production at $90 a barrel, essentially shorting forward oil prices to guard against a drop, could buy them back now at around $57 for a profit of about $33 a barrel. They could then roll that over to shield themselves against a further market slide by buying swaps and options pegged closer to current prices. With the December 2015 put option for $60 a barrel now trading at around $9 a barrel, swaps cashed in now could buy a producer nearly four times more protection at that price. There are, of course limits to this strategy. If prices continue to slide, it will eventually result in cutting off production. We just don’t know the “if or when or level” of the cut-off point.

Meanwhile, the lower prices are rippling out beyond the oil patch. Today, JPMorgan downgraded its rating on Caterpillar citing concerns about the company’s exposure to oil and gas, and indirect exposure to mining, construction and emerging markets. Caterpillar supplies turbines to offshore rigs, as well as reciprocating engines and transmissions for on-site drilling. It also provides construction equipment that is used in infrastructure development, along with aftermarket and other services. Caterpillar also has exposure to Canadian Oil Sands, which are susceptible to a significant slowdown in demand. Further, the analysis determined that construction equipment demand has been strongly correlated with the expansion of fracking. High oil prices helped spur the boom in fracking, which in turn triggered a boom in construction in places such as North Dakota and other shale oil rich states.

As the price of oil slumps, some companies in the energy industry will go out of business. Not only will that cost jobs in the sector, but it will also cut spending on things like plants and equipment. Today energy stocks led the drop on Wall Street, down about 4%.

Which all sounds rather ominous, but I’m not finding many people crying for the big oil companies. Yesterday I filled the tank on my car and paid $1.89 at the pump, saving about $20 or so compared to what it cost me to fill the tank in January of 2014. Repeat that transaction with millions of American drivers and pretty soon you’re talking about real money. Thank you very much.

The big economic news this week will come on Wednesday and Friday. Wednesday features the release of minutes from the Federal Open Market Committee meeting in mid-December. That will likely be secondary to the Friday jobs report. You will recall that last month’s jobs report showed a big spike in jobs in November. The first guesstimate for November came in at 321,000 new jobs. Friday’s report is expected to show somewhere around 220,000 new jobs for December; which would mean the economy might have generated nearly 3 million new jobs in 2014, the best performance since the US created some 3.2 million jobs in 1999. The economy added an average of 241,000 jobs a month through the first 11 months of the year, up 24% from a 194,000 pace in 2013. Over the past 3 years, the unemployment rate has dropped from 8.6% to 5.8%, and at some point you might imagine this would lead to some increase in wages, which have been flat lining. One reason for stagnant wages is that there are still a lot of people who want a full-time job but can’t find one, some 18 million people are in that category or long-term unemployed or underutilized; that’s down from a high of 27 million but still about 5 million from where it should be and where it would take the slack out of the labor market.

And I couldn’t finish out this first Financial Review of 2015 without another edition of “Banks Behaving Badly”. JPMorgan Chase has become the first bank to settle a US antitrust lawsuit in which investors accused 12 major banks of rigging prices in the $5 trillion-a-day foreign exchange market. Last November JPMorgan paid $4.3 billion to settle a separate lawsuit with US and European regulators (actually agreed to pay $4.3 billion but only paid about $600 million to date). The US Department of Justice is among the government agencies that are still investigating the issue. New York’s Department of Financial Services is also conducting its own probe.

Terms of today’s settlement were not revealed. Settlement papers are to be filed with the US District Court in Manhattan later this month. In their complaint, investors including the city of Philadelphia, hedge funds and public pension funds accused the 12 banks of having conspired since January 2003 in chat rooms, instant messages and emails to manipulate the Forex markets. The 12 banks held an 84% global market share in currency trading, and were counter-parties in 98% of US spot volume.

Meanwhile, the euro dropped to its weakest levels since 2006. ECB president Mario Draghi is looking at the prospect of deflation in the Eurozone which might lead to large scale sovereign bond purchases. Italy is experiencing a triple dip recession, France is struggling, Germany is being dragged down, in part due to their own intransigence, and Greece; well, nobody is even sure Greece will stay in the Eurozone. And this all affects the larger multi-national US corporations that do a substantial amount of business in Europe.

More on that in the coming days.

Happy New Year. Buckle your seat belts.

FINANCIAL REVIEW

Some Perspective on the Markets

Sinclair Noe — December 16, 2014

Podcast: Play in new window | Download (Duration: 13:16 — 6.1MB)

DOW – 111 = 17,068
SPX – 16 = 1972
NAS – 57 = 4547
10 YR YLD – .04 = 2.07%
OIL – .58 = 55.33
GOLD + 1.50 = 1196.00
SILV – .47 = 15.82

Allow me to provide some perspective. On December 5th the S&P 500 index hit an intraday high of 2079 and a closing high of 2075. That was 7 trading session in the past, which may be a long time if you are trading on the minute bars, but in the grander scheme of things it was just a few days ago. The downturn has been fast and sharp, as downturns are want to be. This downturn has lopped about 90 points off the S&P, or about a 4.3%; which does not qualify as a correction and certainly not a crash, but it does catch your attention.

Both the S&P 500 and the Dow Industrials have dropped below their 50 day moving averages. The Nasdaq Composite has pulled back close to the 50 day moving average. You will recall that stocks hit highs in September and then pulled off sharply in October; from October until 7 sessions ago, the Dow and the S&P just shot higher. With the recent downturn, the major averages have taken out the highs from September, which is to say we have broken near term support.

Then consider that December is usually one of the better months on Wall Street; and you’ve probably heard about the Santa Claus rally, which is the idea that there is happiness and good will on Wall Street… No wait. It is the idea that there are people investing Christmas bonuses, also some tax considerations (or buying after selling off the tax losses), and the idea that retail sales pick up for the holiday shopping season. And the Santa Claus rally does not apply to the entire month of December. It refers specifically to the last five trading days of the year plus the first two of the New Year. Over the past 60 years or so the rally has resulted in an average of 1.5% gains for that 7 day trading window. Of course not every year produces a Santa Claus rally, and 1.5% is good, it beats a 1.5% decline, but hardly reason for joy, or for specific trading. It sometimes serves as a more general indicator of market direction, and the easy way to remember it is the old jingle from Yale Hirsch: “If Santa clause should fail to call, bears may come to Broad and Wall.”

Today it was a Russian bear. Late yesterday we told you that the Russian Central Bank had raised interest rates from 10.5% to 17%. Imagine if the Federal Reserve hiked interest rates like that; you might, rightfully, suspect that there was an urgent problem. Russia has urgent problems. The currency, the ruble, is collapsing; capital is fleeing the country; oil, the number one export has crashed in price and now Russia faces a major budget deficit because the government is financed largely by oil revenue. The Central Bank of Russia is hoping that with interest rates so high, keeping money on deposit in Russia will start to look attractive; kind of like putting lipstick on a pig.

The Russians have tried this before, with five previous interest rate increases, usually 50 or 100 basis points at a time, which had zero effect; the central bank has spent at least $75 billion this year to prop up the ruble and that was just throwing money away because Russians pulled more than $100 billion out of the country; and so yesterday the Central Bank of Russia went whole hog. The hope is that by stabilizing the value of the currency, the interest rate increase will reduce the sense of financial panic and rapid outflows of money. Maybe. But consider the other effect of higher interest rates; it essentially puts the brakes on economic growth, or in this case economic growth just ran into a brick wall. Russia was already headed into recession, and now high rates will slow things down even more. And this is with a backdrop of 10% inflation.

The rate increase might be a last-ditch move by the Russian government to try to contain the drop in the currency without adopting controls on the flow of capital or other more extensive measures to keep money in the country. And if yesterday’s rate hike fails to stem the collapse in the ruble, then things might play out in very unusual ways. Secretary of State John Kerry suggested that Western sanctions could be removed quickly if Russia withdraws from Ukraine. At the same time, the White House announced that President Obama will sign a bill that would allow him to slap tough new sanctions on Russia.

So, it looks like Putin is getting his comeuppance, but this story hasn’t played out yet. There are no guarantees that Putin will rollover, and even if he does, there are no guarantees the Russian economy will bounce back. Instead of heading into recession, the Russian economy could run right into depression, and that might complicate a whole host of things.

Let’s set the way back machine for 1994. John Meriwether, the acclaimed head of bond trading for Salomon Brothers open a little hedge fund called Long Term Capital Management (LTCM). Meriwether brought on Myron Scholes and Robert Merton, a couple of geniuses who had earned a Nobel Prize for something known as the Black Scholes model, which was a way of pricing options over time – still used today – and really opened up the use of derivatives. LTCM was a big success, generating returns in excess of 40% in its second year.

Now let’s set the way back machine to the summer of 1997. The baht, the currency of Thailand ran into trouble and was devalued. You might not think it was a big deal; Thailand is not exactly a major player in the global financial markets, but it started a capital flight, with cash flowing out of developing Asian economies. Next thing you know the currency crises spread to Malaysia and the Philippines and South Korea. Several Asian companies defaulted. And then the crisis spread to Russia, driving the value of the Russian ruble sharply lower and the Russian stock market went into free fall.

In 1998, Russia’s central bank raised its key rate to 150 percent and it wasn’t enough to stop the flight of capital from Russia. The ruble collapsed. LTCM is heavily invested and heavily leveraged in global markets, including Russia.

Risk is generally considered to be a function of potential market movement based on historical market data. For example, the odds of drawing the ace of spades from a deck of cards is 1 in 52 because there are only 52 cards in a deck and only one is the ace of spades. But financial markets are subject to uncertainty, which is another way of saying there are an unknown number of possible outcomes in the deck, not just 52. Before 1929, a computer would have calculated very slim odds of a Great Depression; after it, considerably greater odds. Just so, before August 1998, Russia had never defaulted on its debt, at least not since 1917, at any rate. When it did, credit markets behaved in ways that Long-Term didn’t predict and wasn’t prepared for.

In August 1998, the LTCM calculated that its daily “value at risk”, meaning the total it could lose on any given day, was only $35 million. Later that month, it dropped $550 million in a day. Eventually the losses grew to $4.5 billion. And LTCM was leveraged about 33 to 1, meaning that the hedge fund only held about 3% in equity; meaning that if the hedge fund went belly up, the losses would grow as they rippled out through investors and financial institutions. Wall Street feared that its unraveling could set off a systemic meltdown. The Federal Reserve stepped in and arranged a bailout among 14 major banks to rescue LTCM. The only major bank that did not go along with the Fed bailout was, ironically, Bear Stearns. Within a few weeks, calm returned and the crisis passed.

The current situation has a way to go before it gets as desperate as the summer of 1998, but you never know exactly how and where contagion can spread. In 1998, the global financial system came close to a meltdown as a hedge fund run by geniuses failed to accurately measure risk. Fast forward to today, and substitute LTCM for a bunch of highly leveraged European banks. And just a reminder, the Eurozone is going through a bit of a rough patch itself right now.

The saga of Long-Term Capital Management looms large in the psyche of global markets, even if the lesson went unlearned. We saw another near meltdown of the global financial system in 2008 and the story line was eerily similar to the summer of 1998. Highly leveraged financial institutions used derivatives to place big bets on the subprime mortgage market rather than bets on the Russian ruble. Bear Stearns, ironically, was one of the first to falter. The risk was ill-considered. When people figured out there was a problem, liquidity evaporated. The belief that one can safely get out of a liquid market is one of the great lessons that went unlearned.

This is not to say that the collapse of the Russian ruble is going to repeat like 1998. History doesn’t repeat, but sometimes it rhymes. The ruble plummeted into a freefall, losing as much as 19% before recovering slightly (down just 5%) as panic swept across Russian financial markets after the surprise interest-rate increase failed to stem the run on the currency. But the panic in Russia spread to other developing markets from Dubai to Indonesia.

And nobody really knows how this will play out. Putin may feel pushed into a corner, he might lash out; he might think NATO is afraid of him. Imagine Cyprus with nukes. The last time oil prices experienced this kind of run-up and decline, the Soviet Union fell. If that’s not terrifying enough, consider that Russia is not the only country headed for problems. The Middle East is full of countries that need a high oil price to protect their economies.

We’re heading into the holidays, usually a good time for the markets, usually a time when you can get together with family and friends and leave all your cares behind. Stay awake kids.