Wednesday, August 20, 2014 - Sunlight is the Best of Disinfectants

Financial Review with Sinclair Noe

DOW + 59 = 16979
SPX + 4 = 1986
NAS – 1 = 4526
10 YR YLD + .02 = 2.42%
OIL + .63 = 93.49
GOLD – 3.80 = 1292.40
SILV + .04 = 19.55

No economic reports today, but the Federal Reserve released the minutes of the July 29-30 FOMC meeting. You will recall that the Fed left interest rates unchanged and continued the taper by reducing large scale asset purchases by $10 billion a month, with the plan to end purchases by October. The Fed had said in its policy statement following the July meeting that there was "significant" labor market slack, but the minutes showed many members of its policy-setting panel thought this characterization "might have to change before long."

Most Fed officials wanted further evidence the labor market and the economy were showing significant improvement before changing their view on raising rates, but they said, "Labor market conditions had moved noticeably closer to those viewed as normal in the longer run," and policymakers "generally agreed" the job market was healing faster than they had expected.

Most Fed policymakers felt any change in their view on when to start raising rates "would depend on further information on the trajectories of economic activity, the labor market and inflation." Well, we got more data yesterday showing that inflation is not a problem yet; so that leaves economic activity and the labor market. The economic trajectory has remained sluggish since the beginning of the recovery; GDP turned negative in the first quarter of this year and then showed a very strong bounce in the second quarter. Is the second quarter bounce sustainable? It seems most Fed officials think it could be. And the Fed minutes almost seem to gloss over this long-term sluggishness, or what the Center for Economic Policy Research callssecular stagnation. What is secular stagnation?

A persistent gap between actual and potential output. Because of an imbalance between saving and investment, the nominal interest rate required to maintain full employment falls to less than zero -- not just briefly, but persistently. Since the rate can't be cut to less than zero, monetary policy (as currently conceived) can't keep the economy running at full potential.

A slowdown in growth of potential output. This may happen because of demographic changes, or because innovation isn't what it used to be, or for other reasons.

An irreversible drop in the level of potential output. Even if the full-employment rate of interest is still positive and the growth in potential output hasn't slowed, the recession may have permanently cut its level -- for instance, by causing workers to leave the labor force and not come back. Even if the economy now grows as fast as it did before, it's on a lower track and won't ever converge with the path it was on pre-crash.

This all means that the Fed’s long awaited economic liftoff might not happen, at least for another 20 years or so. But the Fed doesn’t seem to be concerned with this problem, which means that if the US economy experiences secular stagnation, the condition will be self-inflicted.

That leaves the Fed with the question of the recovery in the labor market. So, it really boils down to jobs. More jobs, and specifically, the quality of the jobs. So far, the average wage is stuck at $24.25 an hour; too many jobs are part-time or temporary. If we start to see some movement on wages, and more full-time positions, that might be a sign for rate increases. One area of remaining slack is the low participation rate, the percentage of working age population that is still in the labor pool; many people got out of the pool. Last month the economy added 209,000 net new jobs. The unemployment rate moved up to 6.2% from 6.1%. The jobless rate can rise for both good reasons (more people looking for work) and bad reasons (fewer people having a job).  Even though the economy added jobs, more people joined the labor force, and that is why the unemployment rate moved higher.

There are many things that could derail the recovery in the labor market, but for now the Fed thinks things are on track, and that means a probable rate increase in the first half of 2015. Any rate increase is likely to be incremental. Right now the fed funds target rate is between zero and 0.25%. It would likely be increased by 25 basis points, with the lower range representing the rate on overnight reverse repurchase operations. In reverse repos, the Fed borrows funds overnight from banks to mop up excess cash in the financial system.

Market reaction to a slightly more hawkish Fed stance: well, the dollar index continued higher, Treasuries dropped but then settled down, precious metals were a little lower, oil was higher, stocks initially threw a little tantrum and then recovered. After all, there were no real surprises.

Elsewhere, we’ve been waiting for the Department of Justice announcement on a settlement with Bank of America. Bank of America has reportedly reached a record $17 billion settlement to resolve an investigation into its role in the sale of mortgage-backed securities before the 2008 financial crisis. The official announcement will come tomorrow. The deal works out to $10 billion in cash, and $7 billion in soft dollar consumer relief - which is really a gift to the bank involving credits for various forms of consumer aid that the bank would or should be doing anyway. So, if you have a BofA mortgage and you’ve been having trouble with a loan mod or a refinance – try again. And by the way, the bank will make money on consumer aid.

The deal requires Bank of America to acknowledge making serious misrepresentations about the quality of its residential mortgage-backed securities issued by itself and by Countrywide Financial and Merrill Lynch. In exchange, BofA will probably not have to actually admit wrongdoing, and they get a free “get out of jail” card.  

Usually these settlements include a statement of facts which is most notable for its absence of facts and details. That silence means the Department of Justice is essentially protecting the banks from private lawsuits by deliberately withholding evidence which could result in even further disclosure of really bad behavior and even bigger damages and other unexpected outcomes. The biggest unexpected outcome would be that the public finally says to hell with the bankster criminals and we all see through the flimsy apologists in the media and the cronies in politics.

Most people know the banksters got away with murder; and I use the word literally, not figuratively. Most people want to see bankster executives prosecuted. Most people understand that the fines in these settlements are just a slap on the wrist, cost of business paid by shareholders, and taxpayers. Yep, the fines are typically considered tax deductible.

Tomorrow, the DOJ will announce the biggest settlement ever against a bank: $17 billion. But we know, it’s really a little under $10 billion in cash, with all kinds of little gifts to the banksters to soften the blow. And we know this will do nothing to deter future wrongdoing. You can place a huge derivative bet that they’re still committing those same crimes and new ones (such as subprime auto), so the prosecution clock resets daily.

And the crazy part is that the Department of Justice and BofA think we’re all too stupid to understand the cronyism. They will portray the settlement as a get tough stance on the bankers. Hogwash, I know it, you know it.

About 100 years ago, Supreme Court Justice Louis Brandeis wrote his famous statement that "sunlight is said to be the best of disinfectants" in a 1913 Harper's Weekly article. He went on to say that transparency is “justly commended as a remedy for social and industrial diseases.” Brandeis actually wrote privately about the idea of transparency 20 years earlier, writing, “about the wickedness of people shielding wrongdoers and passing them off (or at least allowing them to pass themselves off) as honest men."

About 100 years ago, the country was struggling with what was known as the Money Trust, the rough equivalent of today’s systemically important financial institutions, or too big to fail banks. Brandeis asked how the great wealth of his day had been accumulated, and he concluded: “power breeds wealth as wealth breeds power. But a main cause of these large fortunes is the huge tolls taken by those who control the avenues to capital and to investors. There has been exacted as toll literally ‘all that the traffic will bear.’”

Just a reminder, some of the mortgage problems of Bank of America date back to their acquisition of Countrywide; BofA had their own illegal mortgage problems. The guy who started Countrywide and nearly ran it into the ground is Angelo Mozillo. Until now, the harshest penalty imposed on Mozilo has been a $67 million settlement with the SEC from 2010 to resolve allegations that he misled Countrywide investors. Actually, Mozilo was forced to disgorge about $45 million from the sale of stocks, some of which may have been based on insider information; and then Bank of America paid for most of the other penalties; which is to say shareholders and consumers paid for Mozilo’s penalties.

The US attorney’s office in Los Angeles is now preparing a civil lawsuit against Mozilo and as many as 10 other former Countrywide employees. Government attorneys plan to sue Mozilo, Countrywide’s former chairman and chief executive officer, and other individuals using the Financial Institutions Reform, Recovery and Enforcement Act. The law, approved by Congress in 1989 in response to savings-and-loan scandals, gives prosecutors 10 years to bring cases and has less stringent liability requirements than criminal charges.

Prosecutors dropped a criminal probe of Mozilo in early 2011. The Citizens for Responsibility and Ethics in Washington, a watchdog group, sued the Justice Department in June to try to obtain its records detailing investigations of Mozilo and Countrywide. The group faulted the government for failing to prosecute either Mozilo or the company “despite substantial evidence of wrongdoing.”

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.

Friday, May 30, 2014 - Record Highs, Bonds, Coal Mines

Financial Review with Sinclair Noe

DOW + 18 = 16,717
SPX + 3 = 1923 (another record)
NAS – 5 = 4242 (not a record)
10 YR YLD + .01 = 2.45%
OIL - .71 =  102.87
GOLD – 4.60 = 1252.30
SILV - .23 = 18.91

For the week, the Dow rose 0.7%, the S&P 500 gained 1.2% and the Nasdaq added 1.4%. For the month of May, the Dow gained 0.8%, the S&P 500 rose 2.1% and the Nasdaq climbed 3.1%. Meanwhile, if you are looking for action, the bond market is the place; the yield on the 10 year note has dropped from 2.65% to 2.45% this month.

Nearly everyone is looking for an explanation as to why longer-term interest rates continue to fall in the face of reduced Fed support and what is being hyped as better economic data. This wasn’t supposed to happen. The Federal Reserve has been propping up Treasury bond prices, and suppressing yields, for the past several years by buying large quantities of bonds each month in an effort to increase investment and consumption, and force investors into riskier assets. To some extent, the Fed’s QE purchases have worked; ultra-low interest rates have supported housing price increases and have led to skyrocketing stock prices.  Household net worth has increased by $25 trillion from the financial-crisis lows in the first quarter of 2009.  However, these gains in net worth have overwhelmingly accrued to the well-to-do while low- to moderate-income folks continue to suffer from poor employment opportunities, stagnant incomes, inadequate retirement savings, and rising costs for everything from food and energy to health care and education.  In other words, the economy hasn’t really improved but the Fed may have created financial asset bubbles.

Last December the Fed began winding down its large scale asset purchases by tapering, or incrementally reducing the amount of purchases over a scheduled period of a year or so. Back in December the Fed was buying $85 billion a month in mortgage backed securities and treasuries; they have now cut that to just $45 billion a month, and by the end of the year they anticipate they will end the large scale asset purchases. This means that demand for treasuries and MBS has, or should have dropped significantly. If there is less demand and the supply stays the same, then prices should fall and bond yields should be moving higher. The exact opposite has been happening; long term bond prices have increased and bond yields have been falling; and the timing of this increase in prices and drop in yields coincides with the start of the Fed taper.

Is there something wrong with the supply/demand equation? Is there invisible demand out there? Well, treasuries are considered a safe haven investment, and if we saw volatility in the stock market, we might expect a move to the safe haven of treasuries. Right now the CBOE Volatility Index known as the VIX, is down. As the 10-year yield touches the 2.4% level, its lowest in nearly a year, the VIX is hovering around 11.5, near its lowest levels since before the financial crisis.

The VIX measures volatility in the US market, so maybe we need to broaden out horizons. Europe is experiencing low-flation, and in some Euro countries the low-flation has turned to deflation; as a consequence, the rates in Europe are very low: German 10 year bonds yield 1.36%, France yields 1.75%, Spain 10 year notes yield 2.86%. In a global market there is something wrong with pricing. Why is the US bond yield higher than the French bond yield? That does not compute.

Of course, one explanation is that foreign investors are looking for a place to park money and if you can get a better yield on US treasuries compared to French bonds, it just makes sense that you wouldn’t buy the French bonds; add in the idea that buying US treasuries serves as an effective hedge against home currency depreciation and treasuries should be attracting money that might be held in emerging market economies.

In general, if economic growth is expected to accelerate, interest rates should rise as well.  The reason for this is fairly straightforward.  Increased demand for goods and services should lead to price increases.  Inflation is one component of "nominal" interest rates.  The other component is called the "real" rate of interest, and it is determined by the demand for money.  As economic growth accelerates, the demand for money should increase as people become more confident in making spending and investment decisions.  Therefore, higher inflation expectations and higher demand for money should lead to higher interest rates in a strengthening economy; but they haven't. Perhaps the weak economy of the Eurozone is holding back rates in the US, or maybe the US economy isn’t as strong as we imagine.

Another consideration has us going back to the supply-demand equation; if supply dries up faster than demand dries up, then that would push prices higher. Remember that the federal deficit has been trimmed to the lowest levels in about 13 years and that means the government isn’t issuing as much new debt. And the housing market has slowed and that means there should be less in the way of mortgage backed securities.

That was certainly the case for the first quarter; the US economy shrank. And there are no real signs of inflation in the US, or at least we didn’t see inflation for quite some time. That may be changing; the April CPI and PPI showed a minor pop in prices; the low interest rate environment has boosted financial asset prices, so stocks and housing prices have moved higher; food prices are also higher but they tend to be overlooked as a weather related aberration, although I doubt that is temporary; the labor market is still weak and despite the unemployment rate dropping to 6.3% there is tremendous slack and little participation and there doesn’t seem to be any wage inflation. The Fed might claim the economy is getting stronger and the Fed might not consider deflation to be a problem, but the bond market seems to be saying the recovery is sick. At least for the Main Street economy.

Further proof today showing American shoppers dialed it back in April. Household purchases fell 0.1%, the first decrease in a year, and following a 1% gain in March; that was the bounce back from the pent up demand of the frozen winter. After adjusting the figure to account for inflation, the news was worse; spending dropped by the most since September 2009 as income growth cooled. Incomes advanced just 0.3% in April, and without pay gains, consumers lack confidence. Consumer sentiment dropped from 84.1 in April to 81.9 in May. What we’re seeing is the failure of trickledown. The stock market may be strong, the well-off may be better off, but it doesn’t trickle down. The economy is never going to recovery without broad based demand, and that will only happen when the labor market gets strong, until then, the Fed is pushing on a string with QE and the Zero Interest Rate Policy.

There are many possible reasons behind the move in bonds, but a big part still has to do with the economy, even with all the subplots of the international markets and the inflation-deflation debate, we get back to the idea that the economy is weak, and the recovery is uneven. The first quarter GDP contraction was certainly weather related but that doesn’t mean the economy will bounce like a quarter on a trampoline. Second quarter GDP should be positive but probably not sizzling hot. I don’t buy that story, and apparently the bond market isn’t buying it either.

Next week’s economic calendar includes the ISM surveys of business activity in the manufacturing and services sector. What will be important to the outlook is what the surveys say about employment, export prospects and inventories. On Wednesday the Fed will release its Beige Book of regional economic reports. The next Fed FOMC meeting is June 17-18. Next Friday is the monthly jobs report; the unemployment rate, the headline number is at 6.3%, but that’s based on a participation rate at 62.8%. If the participation rate moves higher, look for the unemployment rate to jump.

Another big event next week, President Obama on Monday will unveil a plan to cut carbon pollution from power plants and promote cap-and-trade, undertaking the most significant action on climate change in American history. The proposed regulations could cut carbon pollution by as much as 25% from about 1,600 power plants in operation today. Power plants are the country's single biggest source of carbon pollution; responsible for up to 40% of the country's emissions.

The rules, which were drafted by the Environmental Protection Agency and are under review by the White House, are expected to put America on course to meet its international climate goal, and put US diplomats in a better position to leverage climate commitments from big polluters such as China and India. The plan is certain to result in political backlash with critics making doomsday claims about the costs of cutting carbon. Coal mining companies, power plant operators and others are already lining up for legal challenges to the executive action, claiming the approach oversteps the EPA’s authority.

Wednesday, May 07, 2014 - On the Mend, Not Too Big, No Reason to Jail; Not Exactly

Financial Review with Sinclair Noe

DOW + 117 = 16,518
SPX + 10 = 1878
NAS – 13 = 4067
10 YR YLD un = 2.59%
OIL  + 1.35 = 100.85
GOLD – 18.00 = 1290.90
SILV - .25 = 19.40

Federal Reserve Chairwoman Janet Yellen testified before the congressional Joint Economic Committee today. Here’s the quick summary: taper from QE is on track, after the Fed exits QE asset purchases they will look at the possibility of raising interest rates – maybe 2015 or 2016, they will hold almost all of the mortgage backed securities they purchased on their books to maturity, the labor market is getting better but there are still some areas of concern such as long-term unemployment and underutilized workers and the participation rate, the housing market has flattened but she expects it will pick up again, it would be better if Congress was part of the solution rather than part of the problem, the economy paused in the first quarter but we’re on the mend.

That’s a couple of hours of testimony and Q&A in a nutshell. I just saved you a lot of time. You’re welcome.

There is a lot of talk about a stock market bubble, almost everywhere you hear someone with an opinion, but of course no one knows for sure. You could look at many indicators that seem bubbly: high margin debt, Shiller PE Index at the highest levels since 1929 and 2000, frothy M&A activity, IPO activity has been or was hot for a while, just like back in the dot.com days.

Just look at the recent bloodbath for Twitter, following the six-month lockup combined with a bad earnings report; high flying tech stocks plummet back to earth in 140 characters or less. If you want frothy, look at Tesla, which reported a $50 million dollar loss after the close of trade today; and even though revenue increased, share prices took a hit. It’s that kind of action that makes it feel like a bubble, but that doesn’t mean it is a bubble; not today anyway.

Venture capital certainly was one of the culprits driving up stock market prices in 1999 and 2000. Then, as now, low interest rates also played a part. In fact, the bursting of the bubble was related to the Federal Reserve raising interest rates six times between 1999 and 2000.

Maybe the Fed learned a lesson. While an overvalued stock market seems related to the Federal Reserve’s monetary policy and a chart of the S&P 500 is almost a mirror image of the Fed’s balance sheet, one of the goals of "Quantitative Easing," the Fed's program of buying treasuries to increase monetary supply and reduce the value of bonds, was to bolster other assets relative to bonds. With interest rates still so low, bonds are a lousy alternative to generate return, leaving more money in the stock market than if we were to have higher interest rates.

Fed Chair Yellen seems to be cautious with statements about interest rates and well aware that raising rates could reawaken the sleeping bear. Plus, we still have about $15 trillion in debt constantly rolling over, and if interest rates tick higher, that debt turns ugly fast. The stock markets know this and keep prices high. Of course, even with this knowledge, the business cycle hasn’t been repealed and the exit from QE and a Zero Interest Rate Policy remains fraught with peril.

Fed chairwoman Janet Yellen said, “many recent indicators suggest that a rebound in spending and production is already under way, putting the overall economy on track for solid growth in the current quarter.” The question is whether that pickup in output is being accomplished through better productivity or more hiring and longer workweeks. We got data on that issue this morning from a Labor Department report showing productivity fell at a 1.7% pace in the first quarter.

Some of the first-quarter drop reflects the drag on output caused by the harsh winter. But looking longer-term, productivity growth has slowed. Compared to a year ago, productivity is up a weak 1.4%. Of course, the demand for labor has not revved up much in recent quarters, so the growth in unit labor costs is also muted, up just 0.9% in the year ended in the first quarter. Part of the problem is that companies have been involved in relentless cost cutting, and after a while you can’t get any more water out of that well.

Of course, we haven’t recovered fully from the financial crisis. Ordinary Americans took huge balance sheet hits in the crisis: the loss of home equity, which only in some markets has come all the way back; job losses and pay and hours reductions, which led many to run down savings as they readjusted; declines in stock market portfolios; the flip side of ZIRP, the Zero Interest Rate Policy, is lower income thanks for retirees and other income-oriented investors.

Before the crisis, if someone was hit with a financial emergency, like an accident or sudden job loss, those who had houses could often draw on home equity. Yesterday we reported that negative equity is falling; bit by bit over the years, homeowners have been climbing out of that hole, and new data from Black Knight Financial Services show that borrowers are approaching a threshold that will see only one in 10 US borrowers underwater on home loans.

Of course, the main reasons why negative equity has dipped is a combination of slightly higher prices, but also because foreclosures wiped away the mortgages of many of the most indebted. In January 2010, 10% of borrowers owed at least 50% more than their homes were worth. By January 2014, that number fell to 2% of borrowers.

With that home equity piggybank depleted or non-existent, the last-ditch financial fallback is accessing retirement savings; not complete liquidation, but just dipping in with an early withdrawal or a loan. Borrowing is limited to a maximum of half of plan assets or $50,000, whichever is lower. While the borrowing is interest free, the funds need to be repaid in five years. Early withdrawals typically carry a 10% penalty.

A Bloomberg story details how prevalent 401(k) withdrawals have become. For the latest year in which data is available, 2011, 4% of all households paid early withdrawal penalties. A Federal Reserve study found that 9.3% of taxpayers with retirement accounts paid early withdrawal penalties, an increase from 7.9% in 2004. Adjusted for inflation, the government collects 37% more money from early-withdrawal penalties than it did in 2003. Meanwhile, the amount of home equity loans outstanding was $704 billion in 2013, down 38% from the 2007 peak.

In addition to the lack of recovery from the financial crisis, we still haven’t fixed the underlying problems. Bank of America is holding its annual shareholder meeting. Not surprisingly, the hot topic dealt with some missing money; $4 billion, more or less; an accounting error that resulted in not enough capital to pass the Federal Reserve stress test, consequently dashing the buyback program and halting any dividend increases and sending share prices down 5% so far this year.  

The error, unearthed by a bank employee earlier this month, stemmed from how Bank of America calculated certain losses on bonds that it acquired when it bought Merrill Lynch in the depth of the financial crisis. The bank had been making the same mistake for several years. As a result of the error, Bank of America has $4 billion less capital than it had represented to the Federal Reserve on this year’s stress test.  The bank still faces billions of dollars of legal costs to settle cases with federal prosecutors over its mortgage lending practices. Executives have declined to detail how much they are reserving for those cases because it could hurt their negotiating position. Not surprisingly, many shareholders are opposed to increasing executive compensation packages this year.

Charles Holiday, the Chairman of BofA said: “I believe very strongly that this bank is not too big to manage.’’

James Gorman is CEO of Morgan Stanley; speaking at a conference in New York, Gorman said he didn’t believe more bankers should have gone to jail for the financial crisis. At first blush, Gorman makes a good argument, but there are some holes. Gorman said, “Bad judgment, incompetence, negligence, greed: these might be socially unacceptable… but they’re not criminal offenses.” And that’s true, and I don’t believe any Wall Street bankers  have been criminally charged with bad judgment or for being greedy; in fact, no major Wall Street banking executive has been criminally charged… with anything. However, fraud, conspiracy to commit fraud, aiding and abetting fraud, forgery (as in robo-signing), perjury (as in false documentation), intentional misrepresentation or lying publicly about securities (as in securities fraud), violation of Sarbanes-Oxley, and a few other things that took place – those are indeed criminal offenses.

Gorman also said Glass-Steagall should not have been repealed, even though he doesn’t think it played a role in the financial crisis. Again, not exactly correct. Glass-Steagall  was the depression-era law that kept securities underwriting and trading separate from commercial banking; in other words, investment banks could be involved in speculative trading, they just couldn’t use depositors money for their gambling. Glass-Steagall was repealed in 1999 in a sneaky bit of legislative legerdemain that was written by and allowed the merger of Travelers and Citicorp to create Citigroup. Since then, the US government has been forced to rescue Citigroup 3 times. The repeal of Glass-Steagall might not have caused the financial crisis but it certainly played a role.

Gorman now joins some interesting company calling for the reinstatement of Glass-Steagall. Former CEO’s of Citigroup John Reed and Sandy Weill now regret the repeal and recognize the dangers. Politicians from both sides of the aisle have introduced legislation over the past few years to reinstate Glass-Steagll and effectively break up the big banks to protect taxpayers and restore confidence in the financial system.

Wednesday, April 30, 2014 - Record Highs in First Gear

Financial Review with Sinclair Noe

DOW + 45 = 16580.84 (record close)
SPX + 5 = 1883
NAS + 11 = 4114
10 YR YLD - .04 = 2.65%
OIL – 1.59 = 99.69
GOLD – 4.60 = 1292.30
SILV - .29 = 19.25

Back on December 31^st, we finished the old year with a record high close on the Dow Industrial Average at 16,576; since then the index has bobbed up  and down, briefly hitting an intraday high of  16,631 on April 4^th, but on that day we finished in negative territory. Today, a record high close. The S&P 500 is closing in on the record high close of 1890, but not today.

Now, when you hear the Dow is breaking records, you might think the economy is roaring, cruising along the highway in fifth gear. You would be wrong; the economy is stuck in first gear and the clutch is slipping. The Commerce Department reports the economy expanded at a mere 0.1% annual pace in the first three months of the year, one of the weakest rates of growth in the nearly 5-year-old recovery.

A slowdown had been expected due to the harsh winter weather that froze business activity across a large swath of the country, but this report was worse than expected. The gross domestic product had been expanding at a 3.4% pace in the second half of last year. No worries, the weather has warmed and everything is returning to normal. Yeah, not exactly.

There has been a rebound in the monthly data for March but there have been some disappointments as well. On the positive side, households have pared down some of their debt, credit is a little more available, and consumer spending should bounce back. Even the 2% growth in consumption spending is not all that encouraging; 1.1% of that consumption growth, more than half, was attributed to higher household expenditures on health care.

Home construction is likely to pick up speed as the weather improves, but the housing market seems to be slowing down, with reports this week on new home sales turning soft and existing home sales turning negative in many areas. Residential investment has been negative for 2 quarters. The housing market probably won’t deliver much horsepower as the engine of economic growth but it should be a little better than the winter months, when many parts of the nation were frozen.

An area of concern is business investment, as company spending on equipment fell in the first quarter, and the 3 quarter average is barely positive. The change in inventories subtracted 0.57 percentage points from growth in Q1, exports subtracted 0.83 percentage points. The outlook for trade is soft; the US is not immune to weakness overseas; China’s economy has slowed; there are problems in the Eurozone; and emerging markets are still struggling. Meanwhile, incomes have flat lined and unemployment remains unpleasantly high.

On Friday we’ll get the monthly jobs report. Today, we got a preview from ADP, the human resources firm, and their data shows the economy added 210,000 jobs in April. The ADP report showed hiring picking up in nearly all industries and company sizes; it just isn’t picking up at a real fast pace.

The Federal Reserve FOMC wrapping up their policy meeting and they issued a statement that they will keep policy on the same track; interest rate targets are unchanged and the taper continues with another $10 billion in large scale asset purchases cut this month, to a mere $45 billion a month. The central bankers said that economic activity “slowed sharply” earlier in the year but noted it has “picked up recently.” And “The committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions.”

The disappointing reading on economic growth earlier in the day underscored how bumpy the road back to normal can be. The FOMC statement repeated language from its last meeting in March stating that it will consider the country’s realized and expected progress toward full employment and 2% inflation in determining when to increase rates. The Fed also reiterated that it will take into account “a wide range of information,” including the health of the labor market, inflation pressures and financial developments. In some ways, you could look at the continuation of the taper as a vote of confidence from the Fed. Fed policymakers have said that the phaseout of bond purchases is not on autopilot; the Fed can speed it up or slow it down, depending on how the economy progresses, but apparently the weak GDP number today was not convincing enough to alter expectations; or maybe GDP falls outside the Fed mandate of price stability and maximum employment, and maybe it isn’t something they should specifically pinpoint. Of course, if the economy turns south, they will have to deal with it.

Many Americans are still wondering when the recovery is going to start, but by economic measures, the economy stopped shrinking and started growing in June 2009, the official start of the recovery. That was 58 months ago. Since 1945, the average length of a business-cycle expansion has been 58 months. So if the current recovery continues, it will end up being longer than average, not to mention much weaker. And today’s GDP number was right on the edge of recessionary. The cold weather excuse only goes so far. Already in the second quarter we’ve had deadly and damaging tornadoes, and as the weather continues to warm, we’ll deal with the effects of drought. You have to wonder if the economy was plagued by more than just weather last quarter.

That doesn’t mean we are now entering a recession; we may be close but we aren’t there yet, and we may still rebound, but this affords a good opportunity to think about how you might handle the next downturn in the business cycle. The stock market was up today, and in light of the GDP report, you have to wonder about stock valuations; the earnings reports haven’t afforded much to cheer. Are you still buying or are you looking to sell into strength.

Since Q4 2011, the average peak-to-trough pull-back on the Dow has been roughly -6%, with no correction exceeding -10%. One may ascertain that a "buy-on-the-dip" mentality remains pervasive among equity investors. So why not add to long, risk-on positions once again? Could this pull-back be different? Aren't stocks "the only game in town" with the excessively accommodative Fed monetary policy?

And while you consider market risk, don’t forget the old idea of the best and worst six months in the stock market; we’re entering the worst six months by the way. The old adage "Sell in May and Go Away", warning investors of a seasonal decline in equities, is often attributed to summer vacations and decreased investment flows relative to winter months. According to the Stock Trader's Almanac, since 1950, the Dow Jones Industrial Average has had an average return of only 0.3% during the May-October period, compared with an average gain of 7.5% during the November-April period. 

When we look at the 13 cases since 2001, the strategy of selling out just before May would have given rise to successful trades in 9 cases, or about 70 % of the time. Moreover, we observe that the "Sell in May" strategy has not failed in two consecutive years since 1992-1993. Given that "Sell in May" failed in 2013, we estimate the odds for a seasonal decline are even higher for 2014. This is not a perfect indicator, but there are not perfect indicators. You have to think that anybody who doesn’t recognize the odds is just trying to sell you something.

And on the question of valuations, at 18 times forward earnings for the S&P 500 and 36 times forward earnings for the Nasdaq, US stocks are generally closer to the high end of their range; that seems a bit pricey compared to emerging markets with 12 times forward earnings. Still, somebody was buying today, at least enough to push the Dow to a record high close. Investor optimism for US stocks has been trending up since the end of 2011, reaching an extreme level in January. Of course that would be a contrary indicator. There are plenty of voices telling you to stay the course, or even buy, and then buy some more. I’m just saying it is important to consider the possibility of selling into strength.