Wednesday, April 23, 2014

Wednesday, April 23, 2014 - A Brilliant Future From Cool Ideas

A Brilliant Future From Cool Ideas
by Sinclair Noe

DOW – 12 = 16,501
SPX – 4 = 1875
NAS – 34 = 4126
10 YR YLD - .05 = 2.68%
OIL - .2- = 101.55
GOLD un 1284.70
SILV + .06 = 19.55

It’s earnings season, and this is a chance to compare and contrast. This morning, Facebook posted earnings of $642 million in net income, or 25 cents a share, in the first quarter, versus $219 million, or 9 cents a share in the year ago period. Overall revenue grew 72% year-on-year to $2.5 billion in the first quarter, topping estimates. Facebook now has 1.28 billion active users, and more than 1 billion do their Facebook stuff on a mobile device. Then Facebook announced their Financial Director was resigning. Shares were up about 3%.

Nobody puts on a better presentation than Apple, that’s how they grew to be the most valuable company in the world. Steve Jobs would walk out and announce Apple had created a new mp3 player, and also a new way to connect to the internet, and also a new camera. Wow, three new products, nope…, he would hold up the iPhone – just one very cool thing from Apple; tech geeks heads would explode.


Today, Apple posted earnings of $10.2 billion or $11.62 a share, on revenue of $45.6 billion. Analysts expected the company to report earnings excluding items of $10.18 a share; Apple reported a 4.6% rise in March-quarter revenue to $45.6 billion; Apple sold 43.7 million iPhones in the quarter. Then they announced they were adding to their stock buyback with an additional $30 billion over the next year. Then they announced a 7 for one stock split, to make their $500-plus shares a little more affordable. Wow, the share price exploded in after-hours trade by about 8%.

You see the difference.

The really cool thing that Apple is now working on is something you’ve probably never heard of and wasn’t part of the earnings report today. Apple is making sapphires. Natural sapphire is a gemstone variety of the mineral corundum, a crystalline form of aluminum oxide. Corundum is colorless, but in natural sapphires, various impurities create a range of colors: chromium makes the gem red, becoming a ruby; iron and titanium create the prized cornflower blue of a true sapphire. Synthetic sapphire is colorless, unless deliberately colored.

Sapphire has been used in a variety of specialized applications for years, where its purity, clarity, high stable dielectric conductive properties, and high optical quality, along with its hardness, have made it worthwhile despite its relatively high price. Think lasers and high end, luxury watch faces.  Apple is making a billion dollar bet on sapphire as a strategic material for mobile devices such as the iPhone, iPad and perhaps an iWatch. Though exactly what the company plans to do with the scratch-resistant crystal, and when, is still the subject of debate.

Apple is creating its own supply chain devoted to producing and finishing synthetic sapphire crystal in unprecedented quantities. The new Mesa, Ariz., plant, in a partnership with sapphire furnace maker GT Advanced Technologies, will make Apple one of the world’s largest sapphire producers when it reaches full capacity, probably in late 2014. By doing so, Apple is assured of a very large amount of sapphire and insulates itself from the ups and downs of sapphire material pricing in the global market.

The Arizona project was revealed in November, with Apple paying $578 million for GTAT to install and run its advanced sapphire growth furnaces in a plant built and owned by Apple. The news triggered a frenzy of speculation that Apple planned to use sapphire crystal sheets to replace the glass currently used in touch displays for its 2014 iPhones, iPads or a new line of “wearables” such as the long-rumored iWatch, or all of the above.

That’s only the tip of Apple’s investment. Once the synthetic sapphires emerge from the furnaces, they’ll be shipped to Apple’s supply chain partners in Asia for slicing, polishing, laser cutting, coating and eventual assembly. No one has used sapphire in large-scale consumer electronics or consumer goods products. Apple created a sapphire cover for the iPhone 5 camera lens, and for the iPhone 5s Touch ID fingerprint sensor. It’s mainly the sheer foundry capacity that Apple is creating in sapphire that fuels the speculation that it has big plans for sapphire in bigger uses, such  as a replacement for the cover glass, presumed to be Corning Gorilla Glass, in at least the high-end iPhone model.

A sapphire cover would presumably be less likely to break or scratch, but the big payoff could be the ability to change the underlying LCD technology of the screen, rendering more colors and using less power than today’s LCDs, while improving the speed and accuracy of the touch interface. 

It will cost more, by some estimates about $20 more per screen, but what it shows is that when Apple believes in a new technology or material, they’re willing to take a hit on the bill of materials costs. Of course, to commit for the long term, there needs to be a convincing cost reduction roadmap somewhere.

Some think technology stocks are poised for a 2000-style crash. And if they aren't ready to fall now, they may be soon. What is it about financial bubbles that make them so hard to detect? One reason is that memories are short. Some 20 years ago Wall Street merrily poured into technology stocks, and was horribly burned. Not many years later, the rest of America piled into residential real estate with similar abandon, and similar results. Meanwhile, big tech companies are using their stock to fund eye-popping mergers and acquisitions, most famously Facebook's $19 billion takeover of WhatsApp in February (of which $12 billion is in Facebook shares). Apple seems to be able to continue to do cool stuff, and maybe a billion dollars is a good price for a better iPhone screen. Maybe it’s a sign of over valuation in tech. David Einhorn of Greenlight Capital thinks tech may be ready to resume its slide, but it is a cautionary tale:

We have repeatedly noted that it is dangerous to short stocks that have disconnected from traditional valuation methods. After all, twice a silly price is not twice as silly; it’s still just silly. This understanding limited our enthusiasm for shorting the handful of momentum stocks that dominated the headlines last year.

Now there is a clear consensus that we are witnessing our second tech bubble in 15 years. What is uncertain is how much further the bubble can expand, and what might pop it.

In our view the current bubble is an echo of the previous tech bubble, but with fewer large capitalization stocks and much less public enthusiasm. Some indications that we are pretty far along include:

The rejection of conventional valuation methods;
Short-sellers forced to cover due to intolerable mark-to-market losses; and
Huge first day IPO pops for companies that have done little more than use the right buzzwords and attract the right venture capital.
And once again, certain “cool kid” companies and the cheerleading analysts are pretending that compensation paid in equity isn’t an expense because it is “non-cash.” Would these companies be able to retain their highly talented workforces if they stopped doling out large amounts of equity? If you are trying to determine the creditworthiness of these ventures, it might make sense to back out non-cash expenses. But if you are an equity holder trying to value the businesses as a multiple of profits, how can you ignore the real cost of future dilution that comes from paying the employees in stock?

Given the enormous stock price volatility, we decided to short a basket of bubble stocks. A basket approach makes sense because it allows each position to be very small, thereby reducing the risk of any particular high-flier becoming too costly. The corollary to “twice a silly price is not twice as silly” is that when the prices reconnect to traditional valuation methods, the derating can be substantial. There is a huge gap between the bubble price and the point where disciplined growth investors (let alone value investors) become interested buyers. When the last internet bubble popped, Cisco (the best of the best bubble stocks) fell 89%, Amazon fell 93%, and the lower quality stocks fell even more.

In the post-bubble period, people stopped talking about valuing companies based on eyeballs (average monthly users), total addressable market (TAM), or price-to-sales. When the re-rating occurred, the profitable former high-fliers again traded based on P/E ratios, and the unprofitable ones traded as a multiple of cash on the balance sheet.

Our criteria for selecting stocks for the bubble basket is that we estimate there to be at least 90% downside for each stock if and when the market reapplies traditional valuations to these stocks. While we aren’t predicting a complete repeat of the collapse, history illustrates that there is enough potential downside in these names to justify the risk of shorting them.

So is there a tech bubble, or isn't there? Maybe tech stocks aren’t overvalued; the market is more balanced now than it was in 2000. Back then, tech stocks accounted for 14% of all earnings in the S&P 500, but a third of the index's capitalization. Nowadays the two figures are about the same at 19%.  Nor is the IPO market overly frothy like it was 15 years ago. In the first quarter of 2000, 115 companies went public, raising $18 billion; in the first quarter of this year, 63 IPOs raised $11 billion. Moreover, the IPO market isn't as crazed as it was 15 years ago: The first day run-up in share prices after their IPO is a third of what is was in 2000, evidence that investors haven't lost all sense of proportion.


The problem is that bubbles, tech and otherwise, can easily be analyzed away. No one expects the tech bubble to explode using exactly the same formula it did 14 years ago. Tech is more bubble-prone than other industries. Investing by nature is betting on the future, but in the case of tech, the future is a growth story based on extracting a brilliant future from a cool idea. 

Tuesday, April 22, 2014

Tuesday, April 22, 2014 - Helicopter Drops Were Successful, and Other Revisions

Helicopter Drops Were Successful, and Other Revisions
by Sinclair Noe

DOW + 65 = 16,514
SPX + 7 = 1879
NAS + 39 = 4161
10 YR YLD + .01 = 2.73%
OIL – 1.77 = 101.88
GOLD – 6.60 = 1284.70
SILV - .05 = 19.49

Sales of previously owned homes fell in March for a third consecutive month as rising prices and a lack of inventory discouraged would-be buyers. The National Association of Realtors reports closings, which usually take place a month or two after a contract is signed, fell 0.2% to a 4.59 million annual rate, the lowest level since July 2012. It was the seventh drop in the last 8 months pushing sales down 8.5% compared with the same month last year before adjusting for seasonal patterns.

The drop in demand might not lead to a flat-line in home prices. That’s because one obstacle to lower sales is the low number of homes on the market. The number of houses for sale at the end of last month rose to 1.99 million compared with 1.93 million a year earlier. At the current pace, it would take 5.2 months to sell houses compared with 5 months at the end of February.

There are some positives in the housing market: distressed sales are down; delinquencies are down; negative equity has declined; and even though inventory is up slightly, that is a positive because inventory had been too tight.

The median price of an existing home climbed 7.9% from March 2013 to $198,500. The appreciation was led by a 12.6% year-to-year advance in the West, while the Northeast posted a more moderate 3.2% increase. As prices increased, sales dropped, with the biggest 12-month drop coming in the West at 13.5%, and the smallest in the Northeast, with a 4.4% decrease.

Million-dollar home sales are on the rise, while deals for cheaper homes are dropping. In March, sales of single-family existing homes priced at $1 million and above were up 7.8% from the year-earlier period. Meanwhile, sales of homes that cost between $100,000 and $250,000 fell 9.9% over the past year. This might say something about the weak labor market and eroding income levels; it also speaks to mortgage lending practices, which remain strict for all but the jumbo market, where standards have eased; and it screams about the growing divide in America.  

Meanwhile, each month Bloomberg conducts a survey of 67 economists and one of the questions is where yields on the 10-year Treasury note are headed for the next six months; and the answers have overwhelmingly been that yields are headed higher. This month’s survey was more than overwhelming, it was unanimous; 100% say yields will be up by the end of the year. The last time the survey had that result was in May 2012, when benchmark yields were well below 2%.

Of course the Federal Reserve has said they intend to keep their target for Fed Funds rate right at zero; that has been the policy since the aftermath of the 2008 meltdown and Janet Yellen has let the markets know that there is no reason to expect a change in the policy “for a considerable time” after it ends its QE bond buying program, which means no change until around the Spring of 2015; and even then, it will be dependent on data showing the economy has improved. So, what has unanimously convinced economists that yields are going higher, faster than the Fed has plotted? What is wrong with the current, low interest rate environment?

Fed Governor Jeremy Stein delivered a speech last month arguing that the Fed should withdraw stimulus or raise interest rates, even if that means allowing a higher-than-normal unemployment rate, all to prevent the growth of a bubble in the bond market. Stein points to three things: first, the rising level of private-sector debt as a percentage of the US economy; second, narrowing spreads between risk-free Treasuries and corporate bonds; and third, the growing proportion of corporate debt going to riskier companies, or junk bonds going to companies that have a greater likelihood of defaulting on their loans.

Private sector, non-financial debt has now grown to 55% of gross domestic product. Meanwhile, low rates may have distorted the proper evaluation of risk; the spread between Baa rated corporate debt and risk-free Treasuries has dropped. Those spreads were high during the financial crisis but have since dropped down below pre-crisis levels. Total corporate bond issuance hit $1.3 trillion last year, not just recovering but surpassing pre-crisis levels and a big chunk of that issuance, $336 billion, is going to junk bonds.

The housing market has seen some recovery, depending on location, but the latest data on new and existing sales shows a market that is slowing for now. The market for debt has been expanding much faster than seems reasonable, and might indicate an area of concern for the Fed. Or maybe the Fed is realizing that their policy just hasn’t worked and they are now sitting on a huge balance sheet that can’t be artificially propped up indefinitely.

Meanwhile, the former Fed Chairman Ben Bernanke was speaking today at the Economic Club of Toronto and he said the Fed could have done a better job communicating during the financial crisis. He said the public incorrectly believed the Fed’s emergency-lending programs benefited Wall Street over Main Street. Bernanke also said, “There will be a time coming soon when inflation will improve and when central banks will move to a more normal monetary-policy road.”

Of course, that might be part of the problem; the markets always expected the Fed to have their helicopter drops directly over Wall Street and then get back to more normal monetary policy. In other words, the Fed never truly committed to all out monetary stimulus, and the result was a prolonged economic slump as the velocity of money slowed to a crawl. Bernanke would like to say everything worked out for the better, but that wasn’t really the case.

Bernanke likes to think Fed policies helped Main Street as much as Wall Street, but we all know better and now we have facts to refute Bernanke. The New York Times reports the American middle class is no longer the most affluent in the world; we have lost that distinction even as the wealthiest Americans outpace their global peers and most American families are paying a steep price for high and rising income inequality.

After-tax middle-class incomes in Canada are now higher than in the United States. The poor in much of Europe earn more than poor Americans. The data on Europe is a bit tricky as some countries such as Portugal and Greece have seen income fall sharply in recent years, while other countries, such as Sweden and the Netherlands have narrowed the gap. One large European country where income has stagnated over the past 15 years is Germany, but even poor Germans have fared better than poor Americans.

The struggles of the poor in the United States are even starker than those of the middle class. A family at the 20th percentile of the income distribution in this country makes significantly less money than a similar family in Canada, Sweden, Norway, Finland or the Netherlands. Thirty-five years ago, the reverse was true. The top 5% of American income earners still top their global counterparts, and for those well-off families, the US still represents the world’s most prosperous economy. The US still holds the title of the world’s richest large country based upon per capita gross domestic income, but those numbers are averages which don’t capture the distribution of income.

The results of the 35 year study compiled by LIS recognize 3 major factors behind the weak income performance in the US. First, educational attainment in the US has risen far more slowly than in much of the industrialized world, and especially among younger workers. Literacy, numeracy, and technology skills of younger Americans have fallen well behind counterparts in Canada, Australia, Japan, and Scandinavia, and close to those in Italy and Spain.

Another factor is the distribution of income in the US; it has been growing faster for the top earners, but shrinking for the middle class and poor. Yet the American rich pay lower taxes than the rich in many other places, and the United States does not redistribute as much income to the poor as other countries do. As a result, inequality in disposable income is sharply higher in the United States than elsewhere.

So despite Bernanke’s assertions that the Fed helicopter drops benefitted all American, we know better. And we also know that there are some policy tools that haven’t been used that could change the situation. The best place to start would seem to be the financial industry, since this is the sector that benefitted most from Fed policy and has continued to act as a drain on the productive economy.

A new IMF analysis found the value of the implicit government insurance to backstop too big to fail banks, just the idea that the government would not allow the mega-banks that have been labeled systemically important would not be allowed to fail, that subsidy is pegged at $50 billion a year in the US, and about $300 billion a year in the Eurozone.

Maybe the Fed could even act like a regulator and break up the biggest banks, cut them into small pieces; and in that way, if there was a failure, it wouldn’t represent a threat to the broader economy; as long as that threat hangs over our heads, it is hard to accept Bernanke’s assurances that Fed policy benefits all equally.



Monday, April 21, 2014

Monday, April 21, 2014 - Why Stocks Continue Going Higher


Why Stocks Continue Going Higher
by Sinclair Noe

DOW + 40 = 16,449
SPX + 7 = 1871
NAS + 26 = 4121
10 YR YLD un 2.72%
OIL - .01 = 103.64
GOLD – 4.30 = 1291.30
SILV - .21 = 19.54

The S&P 500 has gained for five straight sessions, marking the longest winning streak since October. This has not been a pretty rally. Volume was light today; that has been part of the trend; light volume on up days and heavy volume on down days.

We are smack dab in earnings reporting season, and 87 companies have posted results through this morning with 62% beating earnings expectations; that’s down from 66% beating earnings over the past 4 quarters, and those earnings expectations have been ratcheted lower and lower, so it should be an easy bar to cross. And still the markets have been moving higher.

Dozens of S&P 500 components will report earnings this week, including Apple, Biogen, Facebook, McDonald’s, AT&T and Caterpillar. More than 30 companies in the Nasdaq 100 (NDX) are slated to report earnings. After the close of trade Netflix posted a first-quarter profit of $53 million, or 86 cents a share, up from $3 million, or five cents a share, a year ago. The company in January had projected a profit of 78 cents a share. The stock shot up about 7% to $372 in extended-hours trading. After a jump of 300% in 2013, Netflix had slumped recently.

As part of the earnings announcement, Netflix announced a price hike, but it will only be for new customers, and the hike won’t happen for about 2 or 3 months, and existing customers will be grandfathered in with a non-specific grace period.

Also, Netflix sent a letter to shareholders in opposition to the proposed Comcast-Time Warner Cable merger. The letter says that if the merger is approved, “the combined company’s footprint will pass over 60 percent of U.S. broadband households...with most of those homes having Comcast as the only option for truly high-speed broadband. The combined company would possess even more anti-competitive leverage to charge arbitrary interconnection tolls for access to their customers. For this reason, Netflix opposes this merger."

Two months ago, Netflix agreed to pay Comcast for access to its high-speed network to improve the video quality and loading speed for Netflix streaming customers.

On a related note, major television broadcasters and Aereo will argue before the US Supreme Court tomorrow in a case that is about much more than the future of a controversial startup. The outcome could have far-reaching effects on the future of television and cloud computing, the quality of wireless service, and entrepreneurs trying to create the next big thing in technology.

You’ve never heard of Aereo? Don’t feel bad, I’m not even sure I’m pronouncing it correctly. It is a 2 year old startup that captures broadcast airwaves and then streams those signals to users, for about $8 a month. The broadcast channels such as NBC, CBS, ABC, and Fox are transmitted free of charge to anyone who has a television and an antenna. But cable companies like Comcast and Time Warner pay the broadcasters billions of dollars in fees for the right to re-broadcast the network TV channels as part of paid cable packages. Aereo argues it doesn't need to pay those fees because the broadcast signals which it's capturing and then retransmitting to its subscribers over the Internet, are free.

Broadcasters sued, claiming Aereo is violating copyright law by retransmitting the shows and threatening their industry's business model. If Aereo is legal, they fear there’s nothing stopping cable companies from copying Aereo to avoid paying the broadcasters billions of dollars in fees. If Aereo wins, broadcasters have threatened to yank their broadcast signals off the free airwaves and instead offer them only to paid subscribers.

Aereo streams network TV to subscribers via servers in “the cloud.” A Supreme Court decision against Aereo threatens to outlaw the entire cloud-computing industry. If Aereo is violating copyright law, that means other cloud providers could also be held responsible for helping users access illegal content. For example, Google or Dropbox could be responsible for policing the content stored in a Google Drive or Dropbox account to avoid copyright violations.

If Aereo wins and broadcasters follow through on their threat to stop beaming over-the-air programming, it could have an unintended benefit for smartphone users. As people consume more data on their mobile devices, it has created a shortage of wireless spectrum that could lead to dropped calls and slower wireless speeds if more airwaves aren't freed up.

The government is preparing to auction off some of those unused broadcast airwaves to wireless companies so they can improve service and avoid network congestion. An Aereo victory could prompt broadcasters to sell more of those airwaves to wireless companies, which could ultimately lead to improved smartphone service.

Now, think back a few years, no a few more years, maybe you are old enough to remember when the entertainment industry sued Sony, claiming that allowing customers to use its Betamax VCRs to record TV programming for later viewing amounted to copyright theft. The Supreme Court dismissed their arguments.

Sometimes it is difficult to make sense of the cyber world. For example, do you like Cheerios? The little circular breakfast cereal? Well, if you like Cheerios on Facebook, General Mills thinks that is reason enough to prevent you from suing them, or at least that’s what they thought. Last week, General Mills revealed a new rule to prevent people from joining class action lawsuits if they had joined the General Mills online communities, or entered a contest, or subscribed to newsletters or liked Cheerios on Facebook.

Under the new terms, those who violated the rule would be limited to arbitration or informal negotiations as a means of conflict resolution. And when you think about it for a moment it seems a bit heavy handed that a cereal company could take away your right to sue, even if you found a rat in your Progresso soup, or something yucky in your Yoplait, or actual leprechaun parts in your Lucky Charms. General Mills has now reversed the policy, and they even claim there was no policy in the first place, it was just a misunderstanding of how far they could throw around their corporate weight.

Financial markets have been fairly calm lately — no big banking crises, no imminent threats of euro breakup. But it would be wrong and dangerous to assume that recovery is assured; our still-sluggish economic progress could still be undermined by bad policies, or the argument of the past few months is that the economy could be derailed by inclement weather.

The Conference Board’s leading index is designed to forecast economic activity, not the weather. So, the split between the leading and coincident indexes so far this year offers further evidence of how the weather slowed growth in the first quarter. It also supports expectations that economic activity is picking up this quarter.

The board compiles 10 forward-looking data series, including jobless claims and new orders, to calculate its leading index, and the coincident index contains four series, including nonfarm payrolls and business sales. While growth in the coincident index usually follows the rate of the leading index with a lag, the gap between the two has widened in recent months.

Today, the board said its leading index increased a larger-than-expected 0.8% in March, and the coincident index increased 0.2%. In the past four months, which included the harsh winter period, the leading index has increased 1.5% while the coincident is up just 0.4%. The gains in the leading index mean economic fundamentals should allow the recovery to pick up steam in coming months. If so, the coincident index should post better gains. Today’s Leading Economic Index says, “The economy is rebounding from widespread inclement weather and the strengthening in the labor market is beginning to have a positive impact on growth.”

The Fed is trying to exit QE, but it won’t be easy, and they say one of the determinants is the employment picture and inflationary pressures. A new research paper by Fed economists says those two categories should not be considered separately.

Fed Chairwoman Janet Yellen has argued that a significant portion of the long-term unemployment problem is due to a depressed economy rather than structural issues such as aging or the gap between workers’ skills and employers’ needs. According to her line of thinking, Fed policies could help spur hiring by boosting demand. If the problem is primarily structural, as some other economists have argued, Fed policies are less likely to make any difference in employment. In a speech earlier this month, Yellen said, “I believe that long-term unemployment might fall appreciably if economic conditions were stronger.”

The new research paper corroborates Yellen’s findings. The new research says that by using regional data sets rather than simply national figures, and economists were able to “discriminate the independent influences of short- and long-term unemployment” on inflation.

“The results suggest that long-term unemployment has exerted similar downward pressure on inflation to that exerted by short-term unemployment in recent decades.”

Or economic recovery could be undermined by green men.
For the past two weeks, pro-Russian gunmen in green uniforms with no insignias, have been taking over government buildings in eastern Ukraine. Russia did not claim them; they were unidentified “green men”. To no one’s surprise, US intelligence is now saying the “green men” are indeed Russian military, and this is a pretty clear breach of the non-escalation agreement reached last week in Geneva. So, now the US State Department is saying that Russia and their “green men” need to vacate occupied buildings and checkpoints, accept an amnesty and address their grievances politically, or the financial sanctions against Russia will be escalated.


Friday, April 18, 2014

Friday, April 18, 2014 - Yes, We Have No Avocados

Yes, We Have No Avocados
by Sinclair Noe


The markets are closed today in observance of Good Friday.

No economic reports today.

Let’s take a look at next week’s economic calendar. On Wednesday, we’ll get reports on new and existing home sales. New home sales are expected to be up slightly, while existing home sales are expected to post a decline for the third consecutive month. Higher mortgage rates and rising prices have pushed some potential buyers out of the market. The average rate on a 30-year fixed mortgage is up almost a full percentage point from its recent low one year ago.

The softness in home prices in the first quarter has also hurt homeowners struggling with negative equity. The pool of underwater borrowers peaked at 12.8 million, or 29% of all properties with a mortgage, in the second quarter of 2012. Rising prices have lifted millions back above water. As of the first quarter of this year, some 9.1 million homes (or 17% of homes with mortgages) were "seriously" underwater, owing at least 25% more than property's estimated market value.

Next Friday, we’ll see the Consumer sentiment index, which has been showing a lack of enthusiasm reflecting the weak pace of hiring and meager pay raises for most households, which in turn results in sluggish consumer spending.

Thursday, we’ll get a report on durable goods orders. If economic growth is finding traction, you would expect to see businesses spending more on equipment, which should show up in the nondefense goods excluding aircraft, subcategory of the durable goods report. If businesses are seeing an increase in demand for their products, they would be expected to ramp up production. You can’t boost profits forever by just cutting costs.

Earnings season kicks into high gear next week. Apple, Microsoft, AT&T, McDonald’s, Netflix, and Facebook all report next week. S&P 500 companies' first-quarter earnings are projected to have increased 1.7% from a year ago. The forecast is down sharply from the start of the year, when profit growth was estimated at 6.5%, but has climbed from a low of 0.6% reached on Wednesday.

Yesterday, an international deal was announced in Geneva to defuse the East-West crisis in Ukraine; the pro-Russian separatists occupying buildings in Eastern Ukraine apparently didn’t get the memo. Leaders of gunmen who have taken over city halls and other sites in and around Donetsk this month in pursuit of demands for a Crimea-style referendum on union with Russia, rejected the agreement struck in Geneva.

Moscow renewed its insistence that it has no control over the "little green men" who, as before Russia annexed Crimea last month, appeared in combat gear and with automatic weapons to seize public buildings - a denial that Western allies of those who overthrew the pro-Russian president in Kiev do not accept. The White House renewed President Barack Obama's demands that the Kremlin use what Washington believes is its influence over the separatists to get them to vacate the premises. It warned of heavier economic sanctions than those already imposed over Crimea if Moscow failed to uphold the Geneva deal.

There’s no question the US can inflict great financial damage on the Russian economy, and there are indications that the Russian economy is already experiencing the early stages of a recession, but all is fair in love and war. And Russia can fight back with more than just restricting nat gas exports.  Russia's cyber-warfare experts are among the best, and they have already attacked – trial runs if you will – even though that information wasn’t really mainstream news. And the US is vulnerable, mainly because we are so dependent on technology.

So, let’s take a look at what’s on the menu for the holiday weekend. Higher prices, at least for food.

Almost everything you eat is costing more, or will. The US Department of Agriculture had been projecting about a 3% rise in the price of fresh fruits and vegetables this year; they will have to revise higher. The CRB Food Index takes a look at commodity prices for a range of foods; that index is up 20% since the start of the year. And it will likely get worse.

California has suffered a double hit: very little rain in the lowlands and a lack of snow in the mountains in the north and east. Snowmelt provides water for many of the state's farmers during the growing season and for the huge population centers in the south. Snow this year was only about 30% of the historical average. Now, the snow is melting, and in some streams and rivers there is so little water that wildlife crews have had to truck stranded salmon downstream so they could make it out to sea. This likely means some waterways will dry out this summer.

And while the West has been dry, the Midwest and Northeast had one of the harshest winters in more than 3 decades. So far this year, corn and soybean futures prices have increased 15%, and wheat prices are up 20%. Last year, high prices for corn saw farmers respond by planting the most acreage in 70 years, which in turn pushed prices down by about 40%. The USDA says farmers will plant just a little less corn this year and just a little more soybeans. Market conditions favor less corn, so other crops picked up acres from corn.

As always, the growing season is subject to weather, and the past 4 years have not been normal; either too dry or too wet to be ideal. Some farmers are expecting a return to normal, or at least hoping. And even if crop harvests are abundant, prices will be underpinned by exports. Of course, the weather might not be normal.

We seem to be undergoing a change in climate that resulted in Vermont posting its coldest month of March ever; while nearly two-thirds of the Great Lakes remained frozen by early April, impacting commercial shipping; the Northwest and Northern Rockies were wet – too wet, resulting in a fatal landslide in Washington state; and California and Arizona had a record warm start to the year, with temperatures in the first 3 months of the year more than 5 degrees above average. If you are looking for normal weather, that doesn’t seem to be the direction.

After a drought in 2012, farmers slaughtered huge numbers of cattle and hogs as feed costs soared. All that extra meat on the market helped keep a lid on prices in 2013, and now, the US cattle herd is at a 63-year low. If you are considering ham for your Easter dinner, hog prices are at a 7 year low, but it won’t last long. The smaller supply of animals ready for slaughter plus the expectation of higher feed costs have sent prices soaring.

Meanwhile, the California drought will likely result in higher prices for many fruits and vegetables. Professor Timothy Richards at Arizona State University recently published research on which crops will likely be most affected and what the price boosts might be. He estimates the following possible price increases due to the drought:

• Avocados likely to go up 17 to 35 cents to as much as $1.60 each.
• Berries likely to rise 21 to 43 cents to as much as $3.46 per clamshell container.
• Broccoli likely to go up 20 to 40 cents to a possible $2.18 per pound.
• Grapes likely to rise 26 to 50 cents to a possible $2.93 per pound.
• Lettuce likely to rise 31 to 62 cents to as much as $2.44 per head.
• Packaged salad likely to go up 17 to 34 cents to a possible $3.03 per bag.
• Peppers likely to go up 18 to 35 cents to a possible $2.48 per pound.
• Tomatoes likely to rise 22 to 45 cents to a possible $2.84 per pound.

Industry estimates range from a half-million to 1 million acres of agricultural land likely to be affected by the current California drought, and between 10 and 20% of the supply of certain crops could be lost.

Just as farmers in the Midwest can shift acreage from corn to soybeans, we will shift our sources for food. When prices increase, farmers outside of California, including foreign suppliers, will be incentivized to ship more crops to the US. That will in turn put downward pressure on costs. But with water-supply problems expected to persist for years, California farmers will have some difficult choices to make. They’ll need to determine which crops should receive the limited amount of available water, and which should be allowed to fall away. The long term consequences for California agriculture could be profound.

The cost of growing food accounts for only about 15 cents of every $1 we spend on it. The rest goes to processing, packaging, marketing and transportation. Most US consumers are in a position to cope by spending less on other goods or switching to other types of food. In other words, going to fewer movies or purchasing less beef and more chicken, the price of which has risen much less than beef this year. However, nearly 47 million Americans rely on food stamps, or SNAP – the Supplemental Nutrition Assistance Program, and as food prices go higher the number of enrollees is likely to climb. And even with food stamps, many families will find it difficult to provide sufficient nutrition.

Keep in mind the US enjoys the world’s cheapest food prices. There are even more significant implications for poorer countries, where consumers devote a far larger share of personal income to food. Remember the Arab Spring uprisings started a few years ago with food shortages and rising prices. Food shortages also figure in the unrest in Venezuela. The US is the world's biggest food exporter by a wide margin; whatever happens to domestic prices won't be confined to our shores.


Thursday, April 17, 2014

Thursday, April 17, 2014 - The Growth Industry for the Next 20 Years

The Growth Industry for the Next 20 Years
by Sinclair Noe

DOW – 16 = 16,408
SPX + 2 = 1864
NAS + 9 = 4095
10 YR YLD + .08 = 2.72%
OIL + .83 = 104.59
GOLD – 7.60 = 1295.60
SILV + .02 = 19.75

Stocks ended a holiday-shortened week with mixed results. Stock markets will be closed tomorrow in observance of Good Friday. The S&P 500 had its best week since last July. For the week, the Dow rose 2.4%, the S&P 500 added 2.7% and the Nasdaq advanced 2.4%.

With less than one-fifth of S&P 500 companies having reported results so far, about 63% have topped earnings expectations and 52% have topped revenue expectations. Of course that’s part of the dance between corporations and analysts, but it does move stock prices. For example, Goldman Sachs reported an 11% drop in quarterly profit and revenue fell 8%, but the results were better than estimates and share price was higher on the day.  Among the other earnings related movers today, Google, IBM, Mattel, and United Health were down on poor earnings news, while Morgan Stanley, GE and Pepsi moved higher.

The number of Americans filing new claims for unemployment benefits rose less than expected in the latest week and came near pre-recession levels. The Labor Department also reports weekly earnings of the typical full-time worker rose 3% in the first quarter compared to a year earlier, the fastest pace since 2008. Median earnings came in at $796, that’s the point where half of all workers made more and half made less. This means that earnings growth is now outpacing inflation in consumer prices, which increased at 1.4%. Earnings that rise faster than costs mean workers will have more money to spend on discretionary purchases, or maybe to shore up their personal finances.

This might indicate that the labor market is getting tighter, or at least working through some of the slack, as companies have to pay a bit more to retain or attract workers. Consumers that spend more, boost business profits, which means companies respond by producing more, which means more hiring and an even tighter labor market, which leads to higher worker earnings. Of course, this is just one report, and one report does not make a trend.

One of the reasons it might not be a trend is that the income is not evenly distributed. Recent Labor Department research shows that the top 20% of earners accounted for more than 80% of the rise in household income from 2008-2012. Income fell for the bottom 20%. That had a direct impact on spending. The top households increased spending by about $2,300 from 2008-2012, notably on health care, transportation and education. The 20% of households with the lowest incomes cut spending by about $150.

Top diplomats from Ukraine, Russia, the European Union and the United States have agreed on a set of measures to ease mounting tensions in eastern Ukraine. In Geneva today, Secretary of State John Kerry said the measures include disarming pro-Russian militants occupying buildings in eastern Ukraine and the return of the buildings to their legitimate owners. A joint statement from the four powers says amnesty will be granted to protesters who surrender weapons and leave the buildings, except for those found guilty of capital crimes.

Speaking at the White House, President Obama said he hopes Russia will honor the agreement but he also said that given past practices, there are no assurances of cooperation from Moscow. He said the administration is holding talks with European allies about possible new sanctions if Russia reneges on the deal.  The agreement does not specifically require Moscow to withdraw 40,000 troops massed on its border with Ukraine, and does not reference Russia's annexation of Ukraine's Crimean peninsula last month. It also does not obligate Moscow to hold direct talks with the interim government in Kiev. Peace monitors will be put in place and dialogue will continue, but this is a very real diplomatic move toward de-escalation. That’s good.

This has been a most unusual geopolitical act of aggression in Ukraine; it has revealed the use of sanctions as an economic weapon going up against the threat of cutting off natural gas supplies as an energy weapon.

In Russia, the economic costs have been masked by recent patriotic fervor but could soon haunt the Kremlin, as prices rise, wages stall and consumer confidence erodes; the major Russian stock market index dropped 10% in March; by some accounts, more than $70 billion in capital has fled the country so far this year; key interest rates jumped to 7% from 5.5% to combat inflation and support the ruble, a step that could slow growth; and unemployment has spiked. Beyond the whipped up patriotic fervor there isn’t much reason for Russians to feel good about their situation. The only thing positive for the Russian economy is its energy supplies.

And when Russia intervened in Crimea, they threatened to turn off the energy supply to Ukraine and Europe. The clock is ticking. Europe has about 6 months before the cold weather returns, to wean themselves from dependence on Russian nat gas.

One way to replace Russian gas is through home-grown renewable energy production. Today, the Ukrainian embassy in Washington DC hosted officials from the renewable energy industry to try and lure investment in green energy such as solar, wind, and biofuels. It will be interesting to see where this goes.

The oil industry would like to take the crisis in Ukraine and use it as an opportunity to flood the European market with fracked-in-the-USA natural gas. For this ploy to work, it's important not to look too closely at details. Like the fact that much of the gas probably won't make it to Europe because any gas fracked in the US would actually be sold on the world market to any country belonging to the World Trade Organization.

Plus, it would require massive infrastructure bailout in Ukraine and Europe; a single LNG terminal can cost $7 billion and it still requires massive infrastructure beyond the terminal. There could be a couple of very cold winters in Europe before those massive industrial projects are up and running.

Plus, there is the environmental problem of even more fracking in the US; Americans might put up with fracking in their own back yard if it results in energy independence and more jobs, but when you switch the argument to energy security for Ukraine and Europe, it becomes a tougher sell.

Plus, there is the concern about expanding fracking in light of the recent studies coming out in very plain and blunt language stating the climate is changing and fracking and burning carbon based fuels is a huge culprit. The gas industry itself, in 1981, came up with the clever pitch that natural gas was a "bridge" to a clean energy future. That was 33 years ago. That’s a long bridge.., to nowhere.

The answer is in renewable energy sources. If Russia wasn’t threatening to take away the nat gas, nobody would pay any attention to Putin. Real energy independence is also energy security, and it will be impossible to achieve as long as we rely on the oil and gas industry. So, how long would it take to become energy independent? Less than you might imagine.

It would take a big change in thinking and in political will, but we’ve done it before. During World War II, the US retooled automobile factories to produce 300,000 aircraft, and other countries produced 485,000 more. In 1956 the US began building the Interstate Highway System which eventually extended more than 47,000 miles and changed commerce and society. Clean technology is the answer, and not just because fossil fuels are cooking the planet but because the clean tech is more efficient.

Today the maximum power consumed worldwide at any given moment is about 12.5 trillion watts, according to the US Energy Information Administration. The agency projects that in 2030 the world will need almost 17 trillion watts of power as the global population and living standards rise, with almost 3 trillion watts being consumed by the US. That forecast is based on the idea that we continue with the current mix of energy sources we use today, which is heavily dependent on fossil fuels.

If, however, the planet were powered by clean technology, with no fossil fuel or biomass combustion, an intriguing savings would occur. Global power demand would only be about 11.5 trillion watts and the US demand would drop to only about 1.8 trillion watts. That means that in 2030, we would need less wattage than we need today; and that decline occurs because, in most cases, electrification is a more efficient use of energy. For example, less than 20% of the energy in gasoline is used to move a vehicle and the rest is wasted as heat, whereas 85% of electricity delivered to an electric vehicle is used to provide motion.

Of course clean technology would require massive infrastructure investment as well. The good news is that it is not money handed out by government or consumers but rather an investment that is paid back through the sale of electricity and energy, and because of the efficiencies and the advances in the technologies, it is cheaper than fossil fuel based energy. Energy will be the growth industry of the next 20 years; it is essential for a growing population and a standard of living; and as Putin’s intervention in Crimea has reminded us, it is essential for geopolitical stability.


Wednesday, April 16, 2014

Wednesday, April 16, 2014 - What is Really Plausible

What is Really Plausible
by Sinclair Noe

DOW + 162 = 16,424
SPX + 19 = 1862
NAS + 52 = 4086
10 YR YLD + .01 = 2.63%
OIL + .05 = 103.81
GOLD - .20 = 1303.20
SILV + .07 = 19.73

Let’s start with some earnings news and then we’ll move over to economic data.

Google posted $3.4 billion in net income, or $5.04 per share, in the three months ended March 31, compared to $3.3 billion, or $4.97 per share, in the year-ago period. Revenue rose 19% to $15.4 billion, but analysts had estimated $15.5 billion, and the shares were getting clobbered in late trades.

IBM reported its lowest quarterly revenue in five years; IBM reported revenue of $21.7 billion for the quarter, but that marks the eighth consecutive decline in quarterly revenue. The company has been restructuring its business by cutting jobs and selling its low-end server business. This is not what you would call a growth model.

Also, from the faulty business model file: Bank of America posted a $276 million loss for the most recent quarter. The financial results included a pre-tax expense of $6 billion, or approximately 40 cents a share after tax, to cover litigation costs as the bank moved to resolve mortgage-related litigation fallout from the financial crisis that began in 2007 and other issues; far worse than the $3.7 billion investors had braced for. The bank today agreed to a $584 million settlement of litigation over nine residential mortgage-backed securitizations insured by the Financial Guaranty Insurance Company. The FGIC said the securitizations were sponsored by Countrywide, which Bank of America bought in 2008.

Since the 2008-2009 financial crisis, Bank of America has logged some $50 billion of expenses for settlements of lawsuits and related legal costs, before taxes. Without those charges, its income before taxes would have been about three times higher. When does it end? How do you factor this when you try to value shares of a company? The simple answers: it ain’t over yet, and don’t even try.

In economic news: China reported that its economy grew at its slowest pace in 18 months at the start of 2014, but the increase was better than expected and showed some improvement in March.

From the Census Bureau: privately owned housing starts in March increased 2.8% from February to a seasonally adjusted annual rate of 946,000; single family housing starts increased 6% from the month before at an annual rate of 635,000. Building permits authorized were down 2.4% from February at a seasonally adjusted annual rate of 990,000, but it’s still 11.2% higher than March of last year.

The Federal Reserve reports industrial production increased 0.7% in March, following a 1.2% advance in February; for the first quarter industrial production moved up at a 4.4% pace. The increase in industrial production, which beat economists' expectations for a 0.5% gain, reflected in part a 0.5% rise in manufacturing output. There were also hefty increases in production at mines and utilities.

The Federal Reserve has just released its April Beige Book, a collection of anecdotes on economic conditions from business contacts across each of the 12 Fed districts. Economic growth increased and consumer spending rose, at least for people who weren’t completely snowed in. The Fed seemed quite fascinated with the weather, mentioning it more than 100 times; it’s like they had never seen snow before, and they seemed amazed that it makes actual work difficult for some people.  

Transportation, manufacturing, financial services, and auto sales all improved, though the reports on residential housing markets were “varied.” The Beige Book also talks of delays to crop plantings and shipments of commodities, as well as a pig virus that hurt hog farming. Labor market conditions continued to slowly improve with minimal wage pressure, and prices were generally stable or slightly higher.

Fed Chair Janet Yellen delivered a speech to the Economic Club in New York. She said the economy is improving, it will continue to improve, and by 2016 it will be normal, and then it will all be good. Yellen said: “I find this baseline outlook quite plausible.”

Yellen laid out 3 questions that will guide the Fed policymakers: Is there still significant “slack” in the labor market? Is inflation moving back toward 2 percent? What factors may push the recovery off track?

Is there still significant “slack” in the labor market? Why yes, yes there is. The unemployment rate is at 6.7% and Yellen would prefer to see it closer to 5.2% or 5.6% and she thinks it will take about 2 more years to get there. Further slack exists in the share of the workforce working part time and the long term unemployed and the low level of participation in the workforce. Toss in almost no wage pressure.

Is inflation moving back toward 2 percent? Yellen said inflation significantly persisting below 2% was more likely than inflation moving substantially above 2%. At the moment, the Fed’s favorite measure of inflation is less than 1%, well below the Fed’s annual inflation target of 2%.Inflation is likely to gradually move back toward the central bank’s target. Yellen said that to some extent, the low rate of inflation seems to be due to factors that are likely to be temporary, including lower consumer energy prices and a drop in import prices.

What factors may push the recovery off track?  Yellen says there can be a lot of ‘twists and turns’ in the economy” and the central bank has no “fixed idea” about what will come to pass. The Fed will try to set the course and Yellen said the central bank’s new forward guidance can serve as an “automatic stabilizer” that helps investors from overreacting to “twists and turns” the economy may take.

She cited the ongoing fiscal drag on the economy. This is a recurring theme; we heard Bernanke talking about this for a long time. Allow me to translate from Fedspeak to plain language. The Federal Reserve is responsible for monetary policy; Congress handles fiscal policy. So fiscal drag means that the policies laid out by Congress have hurt the economy. The Fed has tried to stimulate the economy, much like stepping on the accelerator while the Congress has been applying the brakes. That’s a bit simplistic because there are other factors at work. The Fed is stepping on the gas, the Congress is stepping on the brakes, and we’ve got rotten, ill-behaved bratty children in the back seat, reaching over and grabbing the steering wheel and threatening to drive into a brick wall; in this example, the bratty kids in the back seat are the banksters.

Just a little reminder of a story from the Summer of 2013; when we learned that Goldman Sachs was in the aluminum business. Goldman had 27 industrial warehouses in the Detroit area, where they stored aluminum. Goldman also had an interest in the financial markets for aluminum; they bet on price movement in the commodity; and they exploited pricing regulations set up by an overseas commodities exchange, which essentially allowed them to keep aluminum in storage longer than allowed, which keeps it off the market and out of production, which jacks up prices, based upon simple supply-demand, and then they bet on those higher prices. They literally had trucks moving aluminum from one warehouse to another, all around Detroit, but they wouldn’t ship it out for production. The move cost consumers more than $5 billion over the last 3 years.

The inflated aluminum pricing is just one way that Wall Street is flexing its financial muscle and capitalizing on loosened federal regulations to sway a variety of commodities markets. The maneuvering in markets for oil, wheat, cotton, coffee and more have brought billions in profits to investment banks like Goldman, JPMorgan Chase and Morgan Stanley, while forcing consumers to pay more every time they fill up a gas tank, flick on a light switch, open a beer or buy a cellphone. Federal regulators were also looking at JPMorgan and 3 other banks for rigging electricity prices.

Using special exemptions granted by the Federal Reserve and relaxed regulations approved by Congress, the banks have bought huge swaths of infrastructure used to store commodities and deliver them to consumers. After hearing of all the abuses by the banks, some people thought it might be good to rethink these policies. And about 9 months have passed, and finally 2 senators, Sherrod Brown and Elizabeth Warren, have sent a letter to the Fed, suggesting that "As a general matter, [big banks] should be prohibited from owning physical assets like warehouses, pipelines, and tankers."

Aluminum prices have continued to rise not necessarily because the commodity has become more valuable or scarce, but simply because the wait times for physical delivery have steadily grown longer. In some cases, the wait has lasted more than a year. Meanwhile, commodity traders have come up with a unique solution to banks hold physical commodities in warehouses to manipulate prices. The London Metals Exchange will give traders the ability to hedge aluminum prices, as the commodity continues to rise due to lengthy delivery times that have thrown a wrench in a number of supply chains.

Here are a few facts for your consideration: roughly one-third of everything we buy goes to interest; the interest goes to private banks; at the height of the financial crisis over 40% of US corporate profits went to the financial industry, up from 7% in 1980. The simple reality is that I we could just get those crazy banksters under control, we would have at minimum a couple of trillion extra dollars floating through the economy, and we wouldn’t have to worry (as much)  about the Fed and Congress and monetary policy versus fiscal drag, and we would all be talking about the phenomenal economic recovery. And that is not only plausible, but that’s a fact.


Tuesday, April 15, 2014

Tuesday, April 15, 2014 - Yellen in the Lions' Den

Yellen in the Lions' Den
by Sinclair Noe

DOW + 89 = 16,262
SPX + 12 = 1842
NAS + 11 = 4034
10 YR YLD - .01 = 2.62%
OIL - .22 = 103.83
GOLD – 24.20 = 1303.40
SILV - .41 = 19.66

Stocks were all over the place today. We started with triple digit gains for the Dow Industrials, dipped to triple digit losses, then back into positive territory for the close with the major indices closing just below their morning highs. This kind of volatility does not engender confidence; it does warrant caution.

The utilities sector gained 1.3% and finished ahead of the other groups, extending its YTD gain to 11.8%; the biotech ETF added 1%, while the broader healthcare sector advanced 1.1%.Tech stocks have been beaten up quite a bit over the past couple of weeks. The Nasdaq 100 Tech Index (NDXT) is down 7% since April 1st. The Nasdaq Composite has exhibited weakness, but not to the point of meeting the definition of a correction; it would take a slide to 3,922 to mark a 10% fall from the March 5 closing high at 4,357; a 10% pullback from the March 6 intraday high of 4,371 would be achieved at 3,934.

The Labor Department’s Consumer Price Index, or CPI, increased 0.2% in March after posting a 0.1% increase in February. Excluding volatile food and energy prices, core prices ticked up 0.2%.Prices rose 1.5% for the 12 months ending in March. That is up from February’s year-over-year reading of 1.1%. Core prices moved up 1.7% over the 12 months, up from 1.6% in February.

A major factor in both headline and core CPI in March was a 0.3% increase in shelter costs. On an annual basis, housing costs were up 2.7%, the fastest pace in six years. The indexes for medical care, used cars and airline fares also increased in March. Apparel prices rose for the first time this year. Household furnishings and recreation prices dipped in the month. Real or inflation-adjusted hourly wages, meanwhile, fell 0.3% in March to $10.31. Real wages have risen 0.5% over the past 12 months. So, we’re not seeing wage-push inflation.

The big difference has been housing; shelter costs account for a full third of the basket of goods and services tracked in the consumer price index. In the past year, consumer prices excluding shelter have risen just 1%, an indication that inflation pressures are subdued outside of housing.

The old rule of thumb was that rents and utilities combined should not take up more than 30% of household income. A new study by Zillow finds 90 cities where the median rent, not including utilities, was more than 30 percent of the median gross income. A study by Harvard finds that nationally, half of all renters are now spending more than 30% of their income on housing, up from 38% of renters in 2000. Part of the reason for the squeeze on renters is simple demand; between 2007 and 2013 the United States added, on net, about 6.2 million tenants, compared with 208,000 homeowners.

For many middle and lower income people, high rents choke spending on other goods and services, impeding the economic recovery. Low-income families that spend more than half their income on housing spend about a third less on food, 50% less on clothing, and 80% less on medical care compared with low-income families with affordable rents.

Federal Reserve Chairwoman Janet Yellen is scheduled to go to the lion’s den tomorrow, making a speech before the Economic Club in New York. Today, Yellen took the show on the road, speaking to a banking conference in Atlanta, she said current rules on how much capital banks must hold to protect against losses don't address all threats. She said the Fed's staff is considering what further measures might be needed, and such measures would likely apply to only the largest and most complex banks. Yellen said the Fed would review the likely effects of imposing stricter rules on banks. That probably plays better in Atlanta than Manhattan.

At some point Yellen must press the case of the Fed as regulator and in control of the banks rather than vice versa. Now, any threat or hint of threat at tighter control is only likely to result in the big banks moving risky behavior into less regulated areas of the financial system. These areas are often called the shadow banking system.

One area of concern for Yellen and her Fed colleagues is the short-term debt markets. So, Yellen would like to see the banks hold more capital; the idea being that it would make them less susceptible to a run. Now, when you hear that the Fed Chair is concerned about a bank run, this is not the old fashioned bank run, with customers lined up at the door of Bedford Savings and Loan and Jimmy Stewart trying to persuade his neighbors that their long-term loans will provide sufficient liquidity to short-term needs.

The problem goes to an area of regulation overlooked, or perhaps neglected by Congress and the various regulators; specifically derivatives; and after the collapse in 2008 what the regulators did was to concentrate the risk of the derivatives among four major Wall Street banks; the big banks just got bigger.

If you’ve ever stood in a teller’s line at the bank, you may have noticed the FDIC sticker, which reads, “Backed by the full faith and credit of the United States Government.” Effectively, that means, if the assessments the FDIC charges the banks to meet the needs of the Deposit Insurance Fund run short, the taxpayer must prop up the fund to make insured depositors whole. On top of that promise, the National Depositor Preference statute came into being in the US in 1993, making all deposit liabilities at insured depository banks preferred over the claims of other creditors.


The serious wrinkle in the plan is that if one of the four largest banks in terms of derivative exposure was put into receivership by the FDIC, its derivative counterparties have the legal right to assert a super-priority claim on the liquid assets of the bank, jumping in front of depositors. Typically, the counterparties start grabbing their collateral before the public is even aware of the problem.

The Deposit Insurance Fund probably has about $40 billion in assets. With the Dodd-Frank prohibition against further taxpayer bailouts of banks, where would the FDIC turn to stem a run on one of the largest banks?

Under the Federal Deposit Insurance Act, the FDIC, acting as a conservator or receiver for an insured depository institution, has the right to “disaffirm or repudiate any contract or lease.” But here again, Wall Street has the FDIC between a rock and a hard place. Let’s say there was a reenactment of 2008 and Citigroup was sliding toward insolvency. If the FDIC repudiated Citigroup’s derivative contracts, it would set off a panic and contagion at the other three largest banks holding trillions in derivatives, creating an even larger financial tab for the Deposit Insurance Fund to meet. Banks taking deposits of public funds are required to pledge collateral against any funds exceeding the deposit insurance limit of $250,000. But derivative claims are also secured with collateral, and they have super-priority over all other claimants, including other secured creditors. The money is gone before you get to the teller’s window.

But before you lose any sleep over the prospects of another, potentially far worse global financial meltdown, take solace that the economy is recovering. There are a few more jobs, and consumers are spending, and the housing market is improving, and the Fed has been pumping money into the economy to foster this growth of credit. Right?

Well, one of the lessons we’ve learned in the recovery is that there is a difference between credit growth and economic growth. And absent real and sustainable economic growth a gap eventually forms as credit growth expands. The more one spends on a place of shelter the less one has to spend on other things, and overall demand is reduced. Bank lending finances the purchase of existing assets, particularly with reference to real estate. Such existing asset finance does not directly stimulate investment or consumption, but it drives up asset prices, and that leads lenders and borrowers to believe that even more credit is both safe and desirable. The expansion is like a rubber band that can only stretch so far.

So, it seems the greatest danger to the current economy are the very mechanisms that are still used to “fix” the last financial crisis: money-printing and asset-purchases by major central banks around the world that unleashed a global flood of liquidity for over five years. Most of this massively huge pile of cash has landed in the laps of banks, institutional investors, hedge funds, private equity firms, and other speculators has not been used to boost lending to the private, and thus has not contributed to the recovery of the real economy. Instead, it has been poured into financial assets and has artificially goosed their valuations.

This money sloshing through the system and the persistence of zero-interest-rate policies have driven desperate investors ever further out into “all risky asset classes,” including emerging assets, junk-rated corporate credit, Eurozone peripheral debt, and equities. That buying pressure has inflated their valuations even further. And in the emerging markets, it led to an appreciation of exchange rates.

And when the rubber band breaks, there will be a derivatives bet on it. When the derivatives default, the counterparties, operating in an unregulated shadow banking world of their own design, do not have sufficient capital to pay off the derivatives bet, and so the first thing they’ll do is raid the bank vaults, and when that dries up, the short-term credit markets freeze, because none of the counterparties have faith that the other party has any more in capital reserves than they have.