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.

FINANCIAL REVIEW

More Jobs

Sinclair Noe — December 3, 2014

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

DOW + 33 = 17912
SPX + 7 =2074
NAS + 18 = 4774
10 YR YLD + .01 = 2.29%
OIL + .49 = 67.37
GOLD + 11.60 = 1211.10
SILV – .04 = 16.52

Record high for the Dow Industrials and the S&P 500.

About 2 weeks before the Federal Reserve FOMC meets to determine monetary policy they gather together reports from across the nation on how the economy is doing; the Fed then binds those reports in a Beige folder, or what we call the Beige Book. As the name would imply, the Beige Book is not always a page turner, but it can provide some useful information as well as an indicator of what the Fed policymakers are thinking, and then there is the occasional surprise nugget of information.

The Beige Book was released today and it shows the US economy holding up well despite global slowing; economic activity continued to expand in October and November, with lower gasoline prices boosting consumer spending. Despite a sharp drop in crude oil prices, drilling activity in shale production districts remained steady; oil and gas exploration activity decreased in North Dakota and increased in Montana relative to a month earlier; production remained at record levels. Lower oil prices have some oil companies concerned and closely monitoring prices, which are close to many firms’ breakeven price.

Employment gains were widespread. Better conditions in the labor market meant more employers were struggling to retain key workers as well as fill job openings in sectors such as information technology, engineering, legal and health services, manufacturing and transportation. Inflation remains tame, thanks to lower gas prices, and also because a stronger job market has not yet pushed inflation higher.

Oil was a dominant theme is this edition of the Beige Book; it got more mentions than any other word. Contrary to the Fed’s outlook for domestic oil producers, Reuters reports a drop of almost 40% in new well permits issued across the US in November. Just a reminder that about 20% of the high yield or junk bond market involves the energy sector, and fully a third of the capital expenditure among S&P 500 companies can be traced to the energy sector. The Beige Book takeaway is that the economy isn’t seeing much response to the falling price of oil right now, but everyone is on the lookout for a big impact.

The Institute for Supply Management said its services index rose to 59.3 last month from 57.1 in October, and just below the post-recession high of 59.6 hit in August. A reading above 50 indicates expansion in economic activity. Two out of the ten components of the survey, employment and imports, fell from October, but all were above the 50 level.

The payroll processing firm ADP provides their own survey of the labor market each month just before the government’s monthly jobs report. Today, ADP estimates the economy added 208,000 private sector jobs in November. The number was just a little below expectations. Services dominated the picture, with 176,000 new jobs, compared to 32,000 in goods-producing. And small business continue to be the biggest job creators, adding 101,000 jobs last month, compared to medium sized businesses which added 65,000 jobs. Both the ADP and the government report on payrolls have risen more than 200,000 in at least 7 of the past 8 months. These are not blockbuster numbers but they are solid growth numbers.

Friday’s job report is expected to come in around 230,000 net new jobs; the ADP report today does not change that estimate. However, it is important to realize that the estimates for November are all over the board, and one reason is because of seasonal adjustments to the number; and the guesstimate is that the seasonal adjustment in October was a bit harsh; also, there is a tendency over the past few years for the Labor Department to make pretty big upward revisions in November. Also, we’ve seen some strong economic data recently. The Institute for Supply Management’s surveys of manufacturing and services firms in November were consistent with GDP growth north of 5%. TrimTabs Investment Research, after analyzing income tax deposits from workers subject to withholding, estimates 306,000 jobs were created. Jobless claims, a proxy for layoffs, were low in the week companies were surveyed. I’m just saying, you want to tune in Friday for the results.

Meanwhile, the Labor Department reported today revisions to third quarter productivity. Productivity grew at a revised 2.3% annual pace instead of 2% from the beginning of July through the end of September. The increase in output of goods and services was raised to 4.9% from 4.4%. Hours worked were revised up by a smaller amount, to 2.5% from 2.3%.Unit-labor costs, meanwhile, fell 1% instead of rising 0.3%. And labor costs for the second quarter were revised to show a 3.7% plunge — a much larger decline than the previously reported 0.5% drop. The amount of compensation employees receive per hour of work rose in the third quarter after declining in the spring, but the increase was small: 1.3% before inflation is taken in to account. That’s down from an initial estimate of 2.3%, though. Adjusted for inflation, compensation rose just 0.2%. Let’s break that down. The report means workers are more productive, but they aren’t being rewarded for producing more. This slow growth in wages is holding back the recovery. If you want to know why most people don’t feel like the economy is strong, it’s because their own paychecks are anemic, despite their hard work.

It seems to me the best way to push wages higher is to have more jobs; that would help push wages for everyone a bit higher. The best welfare program is a job at a living wage. There is no better anti-poverty program than jobs for those who want to work. Offering a job is a hand-up not a hand-out. Working promotes community. It allows for shared prosperity. We all benefit when everyone works. It is consistent with American values. We have a half-century of experience with hand-outs instead of hand-ups. Hand-outs do little to reduce poverty. Inequality is worse.

In other news today:
Honda has announced a nationwide airbag recall in the US. Honda has already recalled 3.5 million cars with Takata airbags and now they’re expanding the recall to all 50 states, despite a parts shortage. In other words, call first.

News out of Ukraine that does not involve Russia. The country’s energy minister said there was a short circuit at a 1,000 megawatt nuclear power plant, the largest in Europe; they reported rolling blackouts throughout the country. The problem is not with the nuclear reactors, still….

The Russian ruble continues its meltdown. About a month ago, the Russian central bank said it would stop intervening to prop up the ruble except in emergency situations. Yesterday and today they intervened.

The dollar hit a 5 year high. The euro dropped to a 27 month low against the dollar. This would be consistent with the European Central Bank taking stimulative measures to boost growth and fend off deflation when they meet tomorrow.

Hackers who knocked Sony Pictures Entertainment’s computer systems offline last week used tools very similar to those used last year to attack South Korean television stations and ATMs. South Korea publicly blamed the 2013 attacks on North Korea. The FBI issued a private warning to companies to be on the lookout for a certain type of destructive malware that can basically wipe out hard drives.

A United Nations global warming conference has convened in Peru, trying to pave the way for an international treaty they hope to forge next year. In the more than 2 decades since leaders first got together on climate change, life on Earth has changed. And this conference provides some of the actual numbers. Carbon dioxide emissions: up 60%. Global temperature: up six-tenths of a degree. Population: up 1.7 billion people. Sea level: up 3 inches. US extreme weather: up 30%. Ice sheets in Greenland and Antarctica: down 4.9 trillion tons of ice. In other words, it is hotter, more polluted, more crowded, and more extreme.

Tomorrow morning at 7:05AM Eastern Time, the Orion spacecraft is scheduled to be launched by NASA from Cape Canaveral. This Orion test vehicle won’t be carrying a crew. The flight is meant only to check out the spacecraft’s systems for the first time in space. But a full-featured version of the spaceship is scheduled to send astronauts beyond Earth orbit in 2021, for the first time since the Apollo 17 moonshot in 1972. NASA plans to use Orion spaceships to send astronauts to an asteroid by the mid-2020s, and to Mars and its moons starting in the 2030s.