Friday, September 14, 2012 - Much More Than a Film

Much More Than a Film

-by Sinclair Noe

DOW + 53 = 13,593
SPX + 5 = 1465
NAS + 28 = 3183
10 YR YLD +.11 = 1.87%
OIL + .69 = 99.00
GOLD + 3.30 = 1771.50
SILV un=34.78
PLAT + 25.00 = 1714.00

One crazy little film that never even made it into theaters is all it takes to start World War 3. Go figure. I don't really think it will be WW3 but you never know. I mean, I can understand how people get passionate and caught up in any film featuring Cindy Lee Garcia of Bakersfield, California. How many Oscars has she won? And any movie produced by Sam Bacile, you know it has a certain production quality. Say it slowly S A Mbacile (Is a Embicile). And you just have to think somebody is behind this otherwise very obscure movie. Authorities now believe the filmmaker is a guy in Cerritos Californa named Nakoula Nakoula, who just recently got out of prison after pleading guilty to bank fraud in 2010. Maybe this guy is a complete idiot or maybe he's a puppet; I'm guessing the latter. Someone who has interests somewhere was pulling the strings.

The results are nowhere near obscure. The bodies of 4 US diplomats killed in Libya were returned to US soil today at Andrews Air Force Base. Flags across the country are at half-staff. There are protests against the US in at least 18 countries in the Middle East, Africa, and Asia. About 50 Marines landed in Yemen after the US embassy there was stormed. In Khartoum, Sudan the German embassy was overrun; although US embassies seem to be the main targets. Libya closed airspace over the Benghazi airport for a while because of heavy anti-aircraft fire by Islamists aiming at US drones flying over the city. Some 25,000 took to the streets of Gaza City. About 10,000 people held a protest in the Bangladeshi capital.  There were also protest in Malaysia, Nigeria, Jordan, Kenya, Bahrain, Qatar, Bangladesh, Pakistan, Iraq, and Iran.

Yesterday the Fed announced QE3 to infinity and beyond; it's an open ended bond buying program. They vow they won't stop till the economy gets enough. And even though the initial $40 billion a month in mortgage backed securities seems smaller than Qe1 and 2, since it is open ended, the numbers could eventually grow much bigger.

Amidst the shuffle and flurry you might have missed their economic forecast. The Fed expects the economy to expand between 1.7 percent and 2 percent this year, down from their June projection of growth between 1.9 percent and 2.4 percent. The officials continued to predict that the unemployment rate would not fall below 8 percent. In other words, they don't expect their new QE plan to have any effect this year, or at least not enough effect to be positive; or maybe they are saying the economy is in such rotten shape that it would much, much worse without their action.

And a big part of the problem with the Fed's QE plan is that it doesn't get the money out into the economy. There are three things that can happen with the money the Fed prints.

First, it can go back to the Fed; the banks park the reserves and earn a quarter of a percent; this helps to make the banks look like they have sufficient capital cushion; this should scare everyone because the banks are probably not capitalized. If the banks were adequately capitalized, the Fed could have cut the payout. If you wonder why the Fed isn't pushing the banks to get more money into circulation, the worry isn't inflation, the problem is the balance sheets of the banks.

Next, the banks can take the money from the Fed and put it into high risk, high reward. This is very profitable for the bankers, and the Fed will backstop most or possibly all of their losses.

Next, the banks can make loans. The banks can make high interest credit card loans; they can make high interest consumer loans; they can and do make outrageously high interest rate payday loans (yes, the big banks are among the very biggest payday lenders); they can make guaranteed student loans; they can make mortgage loans and turn around and sell those mortgages back to the Fed. The Fed now buys almost all mortgages, in one form or another. This might seem to carry some level of risk.

QE to infinity and beyond seems a little desperate. If you accept the basic idea behind the Fed's actions, that propping up asset prices will also lift up consumption and lift the entire economy, you might just want to sit back and let the stock market rally and the housing recovery do their trick. “Let them eat stocks and housing” has not been terribly successful. Even with super low rates, it has also taken massive sequestering of inventories for the housing market to have the appearance of stabilizing. We have low household formation due to young adults facing high unemployment, low paying jobs with generally short job tenures, and heavy student debt burdens. On top of that, we have generational headwinds as boomers hit retirement age and want or need to downsize. Keeping money on sale is not going to induce banks to lend more if they can’t find enough qualified borrowers. And the consumer deleveraging story is not as positive as the statistics would lead you to believe. A lot of it is involuntary, meaning driven by foreclosures. Toss in the Zero Interest Rate Policy war on savers.

And don't forget, the Fed has given no indication they have even considered an exit strategy. A mere 1% increase in interest rates, from 3.5% to 4.5%, increases mortgage payments on a 30 year fixed rate mortgage payments by 13%. That will translate into a meaningful dent in housing prices. And where does the Fed go if a financial crisis or other shock occurs?

If you're looking for ways to play the Fed move, just look at past performance. Here's a partial list of ETFs that were the big winners during QE2: silver (SLV), oil equipment (IEZ), oil services (OIH), oil/gas equipment and services (XES), oil & gas exploration and production (XOP), energy (XLE), coal (KOL), metals and mining (XME), natural gas (FCG), global energy (IXC), agriculture (RJA), small cap growth (IWO), Russia (RSX), semiconductors (SMH), and private equity (PSP). This is not intended as specific recommendations, just some ideas. No guarantees that these will repeat their QE2 performance. For example, the agriculture ETF may be more influenced by drought than QE. The common theme is that the ETF's represent commodities.

Another possible play is the US dollar. The Dollar Index hit a high in late July and it has been dropping in anticipation of QE3 and now in the announcement of QE3. So, we had a failed breakout from a long base, and a breakdown to challenge the lows of the year around 78.10. While I don't expect a straight down breakdown, this is a fairly powerful move that might challenge the lows of May 2011. If you look at the charts of the Dollar Index, you would find the mirror image in charts of the CRB, which peaked in May of 2011 and bottomed earlier this summer. Whenever the printing press is cranked up, you can expect a move in tangibles.

In prior QE scenarios we've seen stocks and commodities jump higher, then a minor sell-off followed by consolidation for a couple of weeks. I would expect the same, but this time it might be more pronounced, in part because of the bailouts in Europe, and also the unrest around the world. So, we are seeing global stocks moving to a 13 month high, the dollar moving to a four month low, oil at a four month high, gold at a 6 month high, and the S&P 500 right around 5 year highs.

Now, one of the big movers in past QE's was oil, and we've seen oil moving up to around $100 a barrel. And the violence in Libya will not bode well for Libya's oil production ambitions. Libya was never a huge producer, but this might affect up to one million barrels a day. While that obscure movie is being upheld as the root cause of the intensifying protests and the death of the US envoy to Libya, it has only served to give added momentum to another more important development. The most likely key to all of this is al-Qaeda’s second in command, Abu Yahya al-Libi, who was killed by a US drone attack in Waziristan on 4 June. The catalyst for the attack in Libya and the unrest that has spread to Yemen, was a lengthy video released by al-Qaeda leader Ayman al-Zawahiri, marking the anniversary of 9/11 and admitting to the death of al-Libi, who is Libyan. This was a very powerful call to avenge al-Libi’s death and it came only 24 hours before the attack on the US consulate in Benghazi. Osama bin laden is dead but Al-Qaeda is still alive.

As big as QE3 is here in the US, the situation in Europe may be bigger. Former European Central Bank President Jean-Claude Trichet said today “The Europeans have a special responsibility because we are the epicenter of the worst crisis since World War II. And that, of course, calls for highly responsible decisions." He said all the advanced economies are undergoing their first major adjustment since the Second World War.

Trichet said that policymakers had naive beliefs that the developed world's financial and economic systems were resilient and stable. Last week, the ECB rolled out its bond-buying program, known as Outright Monetary Transactions, or OMT, which will buy the bonds of struggling countries if yields rise to levels that might make borrowing costs unsustainable. Trichet said governments now have to use the time provided by these measures to work hard to restore their economies to health. He says it's not just the struggling peripheral economies which need to deliver, but also the stronger economies which have to prop them up. Germany , the euro zone's biggest economy, was the only member of the ECB to vote against the plan for OMTs last week.

Actually, there were several concessions to the Germans in last week's deal. Perhaps the most important was the dropping of the ECB's previous aim to cap the bond yields of euro-zone members. Instead, the previously openended buyer of last resort commitment was replaced by greater selectivity and far stricter conditions. Those conditions include a formal application from any euro-zone member nation seeking support. Also, any applicant country will have to agree to German style reduction and economic restructuring programs; in other words, submit to German directed austerity. And it only applies to shorter term bonds, and it only applies if the ESM and the ESFS commit funds in parallel.

What this really means is that the Germans are demanding more of the austerity programs that have been a resounding failure so far.

Also, the Netherlands held an election yesterday, the far right, anti-Euro-union, pro-austerity parties lost.

Meanwhile, Spain isn't ready to submit to German austerity. Catalonia, a once prosperous region of Spain is now ready to get out from under the constraints of the Spanish government. An estimated 1.5 million Catalonians took to the streets in protest for independence.

We hear about all these other protests, what about 1.5 MILLION people on the streets?