Friday, July 25, 2014 - Hot and Dry

Financial Review with Sinclair Noe

DOW – 123 = 16,960
SPX – 9 = 1978
NAS – 22 = 4449
10 YR YLD - .04 = 2.47
OIL - .13 = 101.94
GOLD + 13.30 = 1308.20
SILV + .35 = 20.82

For the week, the Dow is down 0.8%, the S&P is flat and the Nasdaq is up 0.4% in its second straight weekly rise.

In economic news, durable goods orders were up 1.4% in June, but May’s numbers were revised lower to show a 1.2% decline. Shipments of core capital goods fell 1%. Core capital goods shipments are used to calculate equipment spending in the government's gross domestic product measurement. The government will release its first snapshot of second-quarter GDP next Wednesday. The economy contracted at a 2.9% rate in the first three months of the year, with business spending on equipment falling at a 2.8% rate.

Investors have been selling junk bonds. In the past week, investors pulled $2.3 billion from junk bond funds. That marked the biggest outflow since June 2013, when the Fed was hinting about tapering. The high-yield market has pulled back in recent weeks, sending prices lower and yields higher. The bond market is not as liquid as it once was; trading volume is down across the board, and trading desks have been cut back, meaning a big sell-off could look more like a run on bonds.

Yesterday we told you about Amazon.com’s earnings report, or more specifically, a lack of earnings. Amazon has a unique business model where they manage to consistently increase sales without actually turning a profit. If it seems like this kind of model has limitations, you are correct, and today Amazon hit the wall. Yesterday’s non-earnings report went from bad to worse as Amazon announced the current quarter will result in bigger losses than the last quarter. The $126 million dollar loss will swell to a $400 million dollar loss, maybe as much as $800 million.

Breaking down the forward guidance, about $410 million of the current quarter loss will be in the form of stock compensation. What makes this even more interesting is that the company lost about $14 billion in market cap today. Jeff Bezos lost $3.5 billion from his personal fortune; Bezos may be an internet visionary, but lacks some basic math skills.

Also yesterday, Visa reported net income for the quarter ended June 30 rose 11 percent to $1.36 billion, or $2.17 a share, from $1.23 billion, or $1.88, a year earlier. Analysts had expected $2.10 a share. Visa’s losses accounted for about one-third of the decline in the Dow today. So, the earnings side was good but the company reduced its revenue forecast for the rest of the fiscal year. One reason for the reduction – Russia. After the US imposed sanctions on Russia, Putin recommended Russia create its own payment system. Visa said that tensions with Russia may affect earnings by “several pennies,” and those headwinds, in the form of lower cross-border volumes, are likely to continue in the short term in international corridors such as Ukraine, Venezuela and Argentina.

The European Union has been holding meetings in Brussels to find agreement over imposing sanctions on Russia over its behavior in Ukraine. They have decided to put together an outline on sanctions and get together again next week; the outline would exclude the crucial gas sector.

Following the downing of Malaysia Airlines Flight 17, many Europeans are eager for their governments to do something to punish Putin for fomenting instability in the Ukraine. However, the debate over economic sanctions is shining an awkward spotlight on the large and important trade relations between Russia and Europe. Russia is Europe’s gas station, and if Europe decides to stop doing business with Russia, they will have to figure out a new and likely more expensive way to put gas in the car and to heat their homes.

According to the Energy Information Administration, oil and natural gas accounted for 70% of Russia’s export revenues in 2012; and most of those exports go to Europe; and most of Europe has not figured out how to provide their own energy. Oil reserves in the North Sea are expensive to tap; fracking technology hasn’t happened for a number of reasons; and so Europe depends on Russia for about 30% of its natural gas. Many of Europe’s biggest corporations are directly involved in importing fuel from Russia, and many of Europe’s biggest industries, such as utilities, power-hungry manufacturers, car manufacturers, transportation systems, and anyone else who uses electricity – all rely on fuels imported from Russia.

If the EU were to suddenly grow a spine and just say no to Russian oil and natural gas, it would certainly inflict some short- term pain on Russia, but oil and gas are fungible and the market is global. One of Putin’s first moves was to sign a deal with China to make Russia a major supplier of natural gas. Europe does not have a quick replacement for Russia’s natural gas and winters in Europe can get very cold.

The US does not depend on Russian fuels; however, there are a couple of strange side stories coming out of the sanctions. First, is the as-yet-unaddressed need to restart NASA, so we don’t have to depend on Russia for ride sharing to the space station. The other, is that Americans don’t really care much about Russia anyway; last week the US imposed a fresh round of sanctions on Russian companies, including weapons manufacturers. How did patriotic Americans respond? Well, you can no longer buy Kalashnikov AK-47s. Technically you can, you just cannot find any. The move sent American gun buyers into frenzy, seeking to buy any AK-47s on any store shelf.

It should come as no surprise that Russia has stepped up its direct involvement in fighting between the Ukrainian military and separatist insurgents, unleashing artillery attacks from Russian territory and massing heavy weapons along the border. So, while the EU considers drafting a new outline of possible sanctions for further possible consideration; Russia may send in the troops.

About 34% of the contiguous United States was in at least a moderate drought as of this week.

Things have been particularly bad in California, where more than 80% of the state is in “extreme” drought, state officials have approved drastic measures to reduce water consumption. California farmers, without water from reservoirs in the Central Valley, are left to choose which of their crops to water. Parts of Texas, Oklahoma and surrounding states are also suffering from drought conditions. East of the Mississippi, rainfall has been rising. But global warming also appears to be causing moisture to evaporate faster in places that were already dry. Researchers believe drought conditions in these places are likely to intensify in coming years.

A new study released yesterday by NASA and the University of California Irvine shows we are losing water at a shocking rate in the West. Using a satellite designed to track changes in groundwater, the research team found that the Colorado River basin—, which supplies water to 40 million people in, seven states—lost 15.6 cubic miles of freshwater in the last 10 years. From December 2004 to November 2013, the Colorado basin lost nearly 53 million acre feet, or almost double the volume of the nation’s largest manmade reservoir, Lake Mead. (Actually, Lake Mead is no longer the biggest reservoir in the country; a lake in North Dakota takes that honor, as Lake Mead has shrunk.) More than 75% of that loss was due to excessive groundwater pumping. It is the first study to quantify just how big a role the overuse of groundwater plays in dwindling water resources out West.

How did this happen without anyone noticing it? The answer, basically, is that up until this study, nobody had a good way of measuring how much water is stored underground. And the researchers aren’t certain how much groundwater is left. The U.S. Bureau of Reclamation manages water above ground in the basin’s rivers and lakes, and its losses are documented. Pumping from underground aquifers is regulated by individual states and is often not well documented.

In the last seven years, Lake Mead’s dwindling has accelerated. The lake is now just barely more than 1,080 feet above sea level, slightly below its previous record low set in November 2010. Lake Mead is expected to drop another 20 feet into record territory by summer 2016. The low water level is already affecting hydroelectric power production. If the water level drops below 1050, the Hoover Dam might not be able to produce electricity.

Well before then, perhaps as soon as next April, downstream water rationing will kick in—this has never happened before. A 2007 shortage-sharing agreement sets three elevations for which water restrictions will be imposed on the Lower Basin states of Arizona, California, Nevada, and New Mexico. The first shortage level, 1,075 feet, will likely come into effect in the next several months. It would require a total water use cut of 4.4%, with Arizona taking an 11% cut, Nevada a 4% cut, New Mexico 3.3% and California remaining the same.

Right now, Phoenix has officially recorded just over one inch of precipitation since the start of the year; the normal amount is just less than 4 inches. The problem is that when above-ground water supplies run low - which is happening now, and it is common in California, even when there isn’t a drought - water managers use groundwater to meet public and farming needs. The study finds that so much groundwater has been used that it will be impossible to recover it naturally; overall supply of available freshwater will continue to decrease as a result.

Thursday, May 22, 2014 - A Heckuva Business Model

Financial Review with Sinclair Noe

DOW + 10 = 16,543
SPX + 4 = 1892
NAS + 22 = 4154
10 YR YLD + .02 = 2.55%
OIL - .31 = 103.76
GOLD + 1.80 = 1294.70
SILV + .10 = 19.59

Yesterday we told you Russia and China had signed a 30 year, $400 billion dollar deal for Russia to deliver natural gas to China. Today, both countries vetoed a United Nations Security Council Resolution seeking to refer Syria to the International Criminal Court for possible war crimes. In the short-term, the Russia-China gas deal won’t have a big impact. The deal will not be in place until 2018 and even then will only see Russia selling a fraction of its gas exports to China every year, exports to the EU could still well be two to four times the size.

The economic links between Russia and Europe will continue to be significant and they will continue to be reliant on each other when it comes to energy; the former to sell the latter to buy, but this link gives an advantage to Russia, especially when the weather turns cold. At least symbolically the deal highlights Russia’s desire to move away from links with Europe. Combine this with Europe’s desire to increase energy security and the relations between the two sides could become increasingly cold and distant. Although, some countries due to geographical proximity, such as Bulgaria or Hungary; or due to long standing economic links, such as Germany - will surely continue to have good relationships with Russia. The entire Ukraine crisis has brought the return of a Cold War, and the gas deal sets up an East and West Economic Bloc.

It also raises questions over future tie ups between Russia and China. Areas such as payments systems, broader financial markets, transportation and machinery have all been touted as sectors for potential cooperation between the two countries. Again while a long term issue, such ties up may concern the West since Russia and China are currently reliant on their exports in many of these areas. Both the EU and US will need to figure a clearer policy for how to deal with such changes.

Unrest continues in Ukraine. BBC reports at least 11 Ukrainian soldiers were killed during an attack on a government checkpoint in eastern Ukraine. The attackers were described as heavily armed terrorists. Russia has claimed that it was pulling back troops from the Ukrainian border, but that has not been confirmed by satellite photos.

Thailand’s army chief went on television today to announce a military coup, after two attempts to negotiate an end to political impasse failed. The country’s Constitution was “temporarily suspended,” and the military said it terminated the caretaker government but said it expected the nation’s Senate, courts and independent organizations to function normally. The military imposed a nationwide curfew, and ordered all street protesters to leave their rallying sites.

In economic news, the National Association of Realtors reports existing home sales increased 1.3% to an annual rate of 4.65 million units, marking only the second gain in sales in nine months. Sales remain down 15% from a peak of 5.38 million units hit in July. Compared to April last year, sales fell 6.8%.The inventory of unsold homes on the market increased 6.5% from a year-ago to 2.29 million in April. That was the highest level since August 2012. The median home price rose 5.2%, the slowest pace since March 2012.

In this cycle we’ve had enormous price increases before we had the demand, which was a function of institutional buying of homes, which pushed prices higher. One thing we should have learned about housing is that when prices start rising, there is a herd mentality that kicks in. It wasn’t just institutional buying, it was a combination of events that swirled around institutional buying. The institutional buyer bought up distressed properties, resulting in fewer distressed inventory, add in people who were locked into their homes by negative equity or low equity;  and for many would-be buyers, it’s just tough to get a decent mortgage, or any mortgage at all.

This doesn’t mean banks aren’t lending – they are; it turns out that banks are ready, willing, and able to lend to small businesses, but you might not like the deal. Typical interest rates are about 125%.  Subprime business lending, the industry prefers to be called “alternative”, has swelled to more than $3 billion a year; that’s twice the volume of small loans guaranteed by the Small Business Administration. Wall Street banks are helping the industry expand by lending originators money. They’re starting to package the loans into securities that can be sold to investors, just as they did for subprime-mortgage lenders. It’s a heckuva business model.

Manufacturing activity picked up in May; Markit's "flash" US manufacturing purchasing managers index rose to 56.2 from 55.4 in April.

New applications for unemployment benefits rose sharply in mid-May, reversing a big drop earlier in the month that put initial claims at a seven-year low. The number of people who applied for new benefits climbed by 28,000 to 326,000 in the week ended May 17. That number might grow in the coming weeks thanks to HP.

Hewlett Packard announced earnings after the close, sales fell, revenue fell, but profits were higher, and they will cut an additional 11,000 jobs, bringing the total for outstanding job cuts to 16,000.  It’s a heckuva business model.

Yesterday, William Dudley, the president of the New York Fed gave a speech to the Regional Economic Press Briefing in New York, and he said: “There have been significant and long-lasting changes to the nature of work. As a result, many middle-skilled workers displaced during the recession are likely to find that their old jobs will never come back. Furthermore, workers are increasingly facing higher skill requirements in order to land a good job. These dynamics in the labor market present a host of challenges for the region to address. However one thing is clear: workers will need more education, training and skills to take full advantage of the types of job opportunities being created in our region, as well as across the nation.”

No doubt education is important. More education and skills will not stop your fall but it might slow it down. And a point that Mr. Dudley failed to grasp, or at least communicate is that a significant percentage of corporate profits have relied upon the widespread loss of worker economic share over the past few decades.

If you have bought or sold on eBay in the past few months, change your password and monitor your financial information. The company says hackers attacked between late February and early March with login credentials obtained from "a small number" of employees. They then accessed a database containing all user records and copied "a large part" of those credentials.

The hackers stole email addresses, encrypted passwords, birth dates, mailing addresses and other information, though no financial data, nor PayPal databases were compromised. The eBay breach would be larger than the one Target Corp disclosed in December, which included some 40 million payment card numbers and another 70 million customer records. Why are we just hearing about the eBay hack now? That is a very good question and so far eBay hasn’t provided a good answer.

We’ve noted many times that bankers have a get out of jail card. This week, Credit Suisse entered a criminal guilty plea in New York for its role in an ongoing tax evasion scheme, but that was a corporate entity, and no actual human bankers went to jail; in fact, the CEO and Chairman get to keep their jobs; but today we note that the handcuffs have been slapped on a banker, the former head of investment banking for JPMorgan Chase, in China.

You may recall the recent allegations against JPMorgan in China. Jamie Dimon had a clever little business development strategy to hire the children of Chinese politicians, to win support for JPMorgan banking activities in China; it’s a heckuva business model, except apparently the SEC’s antibribery unit thinks this might be bribery and thus a violation of the Foreign Corrupt Practices Act; except the SEC was not behind today’s arrest, and we all know that US law enforcement and regulators would never actually arrest a banker. However, finding jobs for the children of China’s elite in exchange for bank underwriting is apparently illegal in China, too.  And in China they have this strange custom of arresting people who break the law, even if work for JPMorgan.

In case you missed it, this week’s criminal settlement with Credit Suisse marked a turning point for law enforcement in dealing with the big banks. The Department of Justice says it proves they will go after the big banks and slap them with felonies convictions, even though they get misdemeanor punishment. Well, the proof is in the putting.

And now we have a new case that will show whether there is really any crackdown on wrongdoing, specifically money laundering; regulators are investigating Charles Schwab Corp and Bank of America Corp's Merrill Lynch brokerage over whether the brokerages missed red flags that could indicate attempts to move money illicitly or to feed proceeds from illegal activities into the financial system. The SEC is probing Schwab and Merrill Lynch for violations of anti-money laundering rules that require the brokerages to know their customers.

Treasury Undersecretary for Terrorism and Financial Intelligence David Cohen began urging regulators two years ago to make sure financial institutions are identifying the true beneficial owners of their accounts. Cohen's exhortations came amid concerns that bad actors, such as drug cartel members and terrorists, are growing more creative in their attempts to secretly transfer tainted funds.

The SEC's investigation so far has found Charles Schwab and Merrill did not pay close enough attention to their clients' true identities, and accepted shell companies and individuals with fake addresses as clients. In both cases, some of the accounts, whose ownership the brokerages did not adequately investigate, were eventually linked to drug cartels. The investigation is not yet complete, and the only thing we know with certainty is that it’s a heckuva business model.