Thursday, October 31, 2013

Thursday, October 31, 2013 - Halloween Miracles

Halloween Miracles
by Sinclair Noe

DOW – 73 = 15,545
SPX – 6 = 1756
NAS – 10= 3919
10 YR YLD + .02 = 2.54%
OIL - .53 = 96.24
GOLD – 20.20 = 1323.70
SILV - .83 = 22.01

The S&P closed near its intraday low, but it's been a good October. For the month, the Dow gained 2.8 percent, the S&P 500 added 4.5 percent and the Nasdaq rose 3.9 percent. The S&P 500 is up 23.2 percent for the year so far.

The S&P/Case-Shiller index showed that home prices in 20 large metro areas rose 1.3% from July and 12.8% from August 2012. Prices haven't risen this fast year over year since Feb. 2006. Still, there are signs of a cooling. The rate of monthly increases in the 20 large cities peaked in April. Since then home prices continued to rise, but at a slower pace each month. This month 16 cities reported smaller gains in August compared to July. Las Vegas saw the largest annual increases, with prices soaring from a year earlier  29.2%. In San Francisco prices jumped 25.4%; in Los Angeles 21.7%; in San Diego 21.5%.

The Chicago purchasing managers index jumped to a reading of 65.9 in October, up from 55.7 and well ahead of the consensus of 54.5. Readings above 50 indicate expansion.

The number of Americans filing first-time claims for unemployment insurance fell by 10,000 last week, to 340,000 from 350,000 the week before. Though it's the third straight week that claims have dropped, the number of applications is still within a range that signals a sluggish labor market. The unemployment rate at 7.2% is almost certain to climb in October because of the government shutdown. The jobless rate includes workers who are temporarily laid off from their jobs, even if they eventually get paid for time missed. As a result, the unemployment rate in October will include furloughed government workers as well as private-sector employees laid off by companies that rely heavily on federal contracts. The unemployment rate could jump up to 7.5%. The number of net jobs created, however, might not be affected nearly as much. That number is derived from a separate Labor Department survey of businesses about how many people they hired in a month.

The unemployment rate in the 17-nation eurozone remained unchanged in September at a record high of 12.2 percent. The number of unemployed rose by 60,000 to 19.45 million. The jobless rate for those aged under 25 edged up to 24.1 percent from 24 percent in August. The unemployment rate for the wider 28-nation European Union remained unchanged at 11 percent.
 Figures on government spending and debt were released today. The government's fiscal year runs Oct. 1 through Sept. 30. Total public debt subject to limit was $17.043 Trillion. The deficit through August dropped to $755 billion.
Settlement talks between the Justice Department and JPMorgan are in danger of breaking down over the bank’s demands that it avoid future criminal charges and that another government agency pay some of the $13 billion price tag.
Federal prosecutors have been working with JPMorgan for months to resolve allegations that the bank knowingly sold securities made up of low-quality mortgages in the lead-up to the financial crisis. As of last week, the nation’s largest bank had agreed to a tentaive $13 billion settlement that would expunge multiple government probes. Details of the agreement were being hashed out, but now the sides have reached an impasse.
Attorneys for JPMorgan proposed a deal that would give the bank protection from future criminal investigation. Federal prosecutors assumed that aspect of the deal was settled and were bothered when attorneys asked that the bank be released from future criminal prosecution. There also remains a standoff over whether JPMorgan or the Federal Deposit Insurance Corp. is responsible for losses on mortgage securities issued by Washington Mutual, the failed bank that JPMorgan bought out of receivership for $1.9 billion in 2008. Some of those securities are a part of the complaints that JPMorgan is trying to resolve in its settlement with the Justice Department.

Have your ever heard of the push-out provision? It's a little known provision in the Dodd Frank reforms, and the bank lobbyists have killed it, and lawmakers came together in bipartisan unity to bury it. The idea behind the push-out provision is that the banks would have to separate their swaps trading units from the main bank, where funds are FDIC insured. So, now that the lobbyists have killed the push-out provision, they can gamble in derivatives trading using insured deposits.

Now, if you're wondering why or if this is significant, just look at Cyprus, or if you want to get a bit closer, look at Detroit. Both pensioners and bond holders argue they should have priority in claiming a stake in the city's assets in the bankruptcy process. However, a different class of creditor has legally senior status. Holders of financial derivatives enjoy super-priority in bankruptcy, thank to changes in the bankruptcy law of 2005; they are not subject to the ‘automatic stay’ provision intended to prevent a disorderly grab for collateral by competing creditors. They can press their claim immediately, prior to bankruptcy proceedings and therefore before claims by competing creditors are considered. This may potentially leave nothing for other creditors to divide during subsequent proceedings.

The latest court proceeding in Detroit was to determine if retired city workers might get 16 cents on the dollar, even though the Michigan constitution contains a provision which bans any action to cut pension benefits of public employees, or whether the federal bankruptcy code trumps the state constitution. And if you think Detroit is the only city with these kinds of problems, think again. And if you think it only applies to retirement plans, remember what I just told you about the push-out provision. That's right, the super-priority position of financial derivatives also applies to your FDIC insured bank account.
Bill Gross, the billionaire founder and chief investment officer of Pacific Investment Management Co., also known as PIMCO, writes an investment outlook; kind of a regular newsletter that he posts on the website. The latest from Bill Gross is a bit of a surprise. He says wealthy people need to stop whining about the taxes they pay, realize their success is mostly dumb luck and pay even higher taxes to help the less fortunate. Gross writes in his latest monthly missive, entitled "Scrooge McDucks,": "Having gotten rich at the expense of labor, the guilt sets in and I begin to feel sorry for the less well-off." It's a Halloween miracle. 

And he continues: “Admit that you, and I and others in the magnificent '1%' grew up in a gilded age of credit, where those who borrowed money or charged fees on expanding financial assets had a much better chance of making it to the big tent than those who used their hands for a living.”

And Gross suggests the soaring income inequality of the past few decades is a serious problem for the entire US economy: “Developed economies work best when inequality of incomes are at a minimum. Right now, the U.S. ranks 16th on a Gini coefficient for developed countries, barely ahead of Spain and Greece. By reducing the 20% of national income that “golden scrooges” now earn, by implementing more equitable tax reform that equalizes capital gains, carried interest and nominal income tax rates, we might move up the list to challenge more productive economies such as Germany and Canada.

I would ask the Scrooge McDucks of the world who so vehemently criticize what they consider to be counterproductive, even crippling taxation of the wealthy in the midst of historically high corporate profits and personal income, to consider this: Instead of approaching the tax reform argument from the standpoint of what an enormous percentage of the overall income taxes the top 1% pay, consider how much of the national income you’ve been privileged to make.”

Gross notes that the 1 percent now take up 20 percent of U.S. income, up from 10 percent in the 1970s -- a fact he attributes at least partly to the massive tax cuts for the wealthy enacted by Presidents Ronald Reagan and George W. Bush.
Gross also points out that the wealthy have gotten all of the benefit of the explosive rise of the financial sector over the past several decades, along with a 30-year decline in interest rates. Together, these two factors lined the pockets of the wealthy, but left everybody else behind. And Gross offered a policy prescription: “If you’re in the privileged 1%, you should be paddling right alongside and willing to support higher taxes on carried interest, and certainly capital gains readjusted to existing marginal income tax rates. Stanley Druckenmiller and Warren Buffett have recently advocated similar proposals. The era of taxing ‘capital’ at lower rates than ‘labor’ should now end.”
And then Gross takes a shot at Carl Icahn, and probably quite a few other captains of industry by adding: “If X can’t grow revenues any more, if X company’s stock has only gone up because of expense cutting and stock buybacks, what does that say about the U.S. or many other global economies? Has our prosperity been based on money printing, credit expansion and cost cutting, instead of honest-to-goodness investment in the real economy?”

Wednesday, October 30, 2013

Wednesday, October 30, 2013 - Fed Holds Steady and Floats a Balloon

Fed Holds Steady and Floats a Balloon
by Sinclair Noe

DOW – 61 = 15,618
SPX – 8 = 1763
NAS – 21 = 3930
10 YR YLD + .02 = 2.52%
OIL - .85 = 97.35
GOLD – 1.40 = 1343.90
SILV + .22 = 22.84

Nobody expected the Fed to make any major policy changes at the conclusion of today's 2-day FOMC meeting. And the Fed surprised no one as they kept their cheap money policy in place. So why are the markets down today, with the Fed continuing its easy money giveaway? I'll explain in a moment.

Language in the October statement mirrored the "moderate pace" of economic improvement that the Fed saw at its last meeting in September. The statement, though, did omit a reference from last month that fiscal tightening could slow growth in jobs and the broader economy. Let's dig into the Fed statement:
...economic activity has continued to expand at a moderate pace. Indicators of labor market conditions have shown some further improvement, but the unemployment rate remains elevated. Available data suggest that household spending and business fixed investment advanced, while the recovery in the housing sector slowed somewhat in recent months. Fiscal policy is restraining economic growth. Apart from fluctuations due to changes in energy prices, inflation has been running below the Committee's longer-run objective, but longer-term inflation expectations have remained stable.

...economic growth will pick up from its recent pace and the unemployment rate will gradually decline toward levels the Committee judges consistent with its dual mandate. The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished, on net, since last fall.

...Taking into account the extent of federal fiscal retrenchment over the past year, the Committee sees the improvement in economic activity and labor market conditions since it began its asset purchase program as consistent with growing underlying strength in the broader economy. However, the Committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases.

And so, the Fed will continue buying $45 billion a month in Treasuries and $40 billion a month in mortgage backed securities, and they will maintain their zero interest rate policy, but they seemed to be making the case that when they can get a little more data, the data will be good and they can taper. Maybe even in December. How do we know?

Because John Hilsenrath said so. Hilsenrath is a reporter with the Murdoch Street Journal and he's something of a mouthpiece for the Fed. He gets the Fed data before other reporters and he then reports what the Fed tells him to report. Within 15 minutes of the Fed statement, Hilsenrath had published two articles analyzing the statement. He is either the fastest typist in the world or he gets the information spoon fed ahead of the embargo. The key takeaways according to Hilsenrath:

The Fed dropped its reference to financial conditions having tightened in recent months, as it noted in September. That’s a nod of approval to rising stock prices and the recent drop in long-term interest rates. The Fed also removed a reference to its concern about higher mortgage rates, which have dropped since the last meeting.

The Fed retained language it used in September which suggested officials had an eye on pulling back from their bond buying program if the economy improved. It noted “underlying strength” in the broader economy and said it chose to “await more evidence” on the economy’s performance before adjusting the bond-buying program.

And then the kicker:

Taken together, the Fed isn’t taking a December adjustment to the bond-buying program off the table
. But that comes with the strong caveat that it depends on whether the economy is living up to its expectations.

Citigroup then piled on by raising it's odds for a December/January taper. It's pretty simple really; the further down the path we go, the closer we get to the end. The Fed hopes there will be enough economic data to support a taper, even though we've gone through 5 years of this mess with anemic growth and little to indicate the economy will kick into high gear. And the Fed's nearly $4 billion in bond buying seems to have only produced an artificial and temporary boost for stock and bond prices. It's impossible to predict where prices will go when the Fed stops buying because we're dealing with an artificial construct, but the bet is that prices might move lower.

Of course, we've seen this before. The Fed floated the trial balloon on tapering, and the markets responded with a taper tantrum; and it is a good bet that is what we are seeing today; just enough taper worry to back off record highs and slow the parabolic rise on the charts; the Fed tapping on the brakes without changing gears.

The January FOMC meeting will be the last for Chairman Ben Bernanke, who is stepping down after eight years. President Barack Obama has chosen Vice Chair Janet Yellen to succeed Bernanke. Assuming that Yellen is confirmed by the Senate, her first meeting as chairman will be in March. Many economists think no major policy changes will occur before a new chairman takes over.

Congress' budget fight has clouded the Fed's timetable. Though the government reopened Oct. 17 and a threatened default on its debt was averted, Congress adopted only temporary fixes. More deadlines and possible economic disruptions lie ahead in December and January and February. So, there is a strong probability that any data the Fed considers will be distorted by fiscal policy or the lack of fiscal policy.
At some point, the Fed will taper, but they are also caught in a liquidity trap. You could make the case that the early rounds of QE contributed to a bounce in economic activity, but you could also argue that there is almost always a surge in economic growth following post recession weakness due to pent-up demand. Plus, in the early rounds of QE there were actually several more direct bailouts, including cash for clunkers, cash for casas, and even cash for refrigerators and toasters and other appliances. Maybe the Feds massive injections of cash have helped to keep the economy from slipping backward, but current indicators are showing signs of weakness.

Consumer and business confidence has been hammered by the political fight that triggered the government shutdown and pushed the nation to the brink of a nasty debt default, and a slew of recent data has pointed to economic weakness.

Economic reports today showed private sector employers hired the fewest number of workers in six months in October, although we'll wait until November 8th for the monthly jobs report. ADP revised September’s job gain down from 166,000 to 145,000. The government shutdown and debt limit brinksmanship hurt the already softening job market in October. Average monthly growth has fallen below 150,000. Any further weakening would signal rising unemployment. Meanwhile, inflation stayed under wraps last month. Other data on hiring, factory output and home sales in September had already suggested the economy lost a step even before the government shut down. Readings on consumer confidence this month have shown the fiscal standoff rattled households right as we head into the holiday shopping season.

In trading following the market's close, Facebook gained almost 10% after reporting revenue that was stronger than expected. Expedia gained almost 20% after reporting its results. On the downside, Starbucks shares fell 2.8 percent to $78.60 after the bell because the world's biggest coffee chain gave a 2014 profit outlook that was below expectations.

In the latest batch of earnings, General Motors reported stronger-than-expected quarterly profit because of strength in its core North American market and a smaller-than-anticipated loss in Europe. GM shares moved higher.
On the downside, Yelp dropped after it reported a wider third-quarter loss, while Western Union shares slid 12.4 percent to $16.85 after the company posted a steep drop in third-quarter earnings.
Earnings haven't been amazing, but they've been steady and sustainable, which the market likes enough to help us reach all-time highs. When the season ends and we focus on the macro again, that probably won't be good for the market.
Of the 313 companies in the S&P 500 that had reported earnings through Wednesday morning, 68 percent have topped Wall Street's expectations, above both the 63 percent beat rate since 1994 and the 66 percent rate for the past four quarters. Revenue performance has been mixed, however, with 53 percent of S&P 500 companies beating expectations, well below the 61 percent average since 2002, but slightly above the 49 percent rate for the last four quarters.
Tomorrow morning the Labor Department will release jobless claims for the past week. Due to recent computer upgrades in California, claims data has been distorted higher and should continue to trend back to an average of 335,000. Also due out are the regional Chicago and Milwaukee manufacturing surveys.

There will be a lot of economic data released tomorrow around the world. The Bank of Japan will make its monthly monetary policy statement, which is expected to turn a bit more dovish due to a slower rate of growth in inflation and employment. Fifty-three major US companies will report earnings tomorrow.
The rest of the world is still upset with the US for listening in on their phone calls. Responding to the firestorm of controversy over its spying on European allies, the head of the National Security Agency said today it would do everything in its power to avoid being caught doing it in the future. And I hope you've had a great day; if however it was a little less than you had hoped for, take consolation in the fact that you are not Kathleen Sebelius.
Live streaming and archived audio at

Tuesday, October 29, 2013

Tuesday, October 29, 2013 - Happy Birthday

Happy Birthday
by Sinclair Noe

DOW + 111 = 15680
SPX + 9 = 1771
NAS + 12 = 3952
10 YR YLD - .01 = 2.50%
OIL - .95 = 97.73
GOLD – 8.90 = 1345.30
SILV + .01 = 22.62

The internet is 44 years old today. Happy Birthday. Oct. 29, 1969, that was when the very first message moved between the first two computers connected on the new network designed to link the numerous computer science projects funded by the government. 
On that day 44 years ago, an operator at Professor Leonard Kleinrock's lab in UCLA's Boelter Hall began tapping out the word "LOGIN" and sending it to a sister computer at SRI, a government contractor, in Menlo Park. He got as far as "LO" before the SRI unit crashed. Later that day the bug was fixed and the message completed. Within a year, ARPAnet linked 10 computers across the country.
The first email message using the "@" symbol in its address went out in 1971;  the TPC/IP protocol was developed in 1974; Tim Berners-Lee implemented the world wide web in 1989 and that is the version that we access through our browsers. So, you could make the claim the internet, as we know it and use it, is just 25 years old.

The internet was a government project, built with your tax money, because private companies, such as AT&T and IBM, didn't see enough profit in the idea. That's what government is supposed to do, take on important jobs shunned by the private sector.
The network was the brainchild of Robert Taylor, then chief of the information technology office at the Defense Department's Advanced Research Projects Agency (ARPA), who demanded that the computer research projects he was funding around the country learn to talk to one another. In 1966 he secured a $1-million appropriation for the design and construction of a network that would be known at first as the ARPAnet, but its role as the Internet's parent is undisputed. Taylor later moved to the Xerox Palo Alto Research Center and oversaw the invention of the personal computer.
Today also marks the 84th anniversary of Black Tuesday, when the Dow Industrial Average lost 11.7% just one day after Black Monday. These two Black trading days, which destroyed nearly a quarter of the Dow's value in less than 48 hours, mark a sharp break between the Roaring '20s and the onset of the Great Depression. Some $30 billion in market value was destroyed in these two days -- an amount equal to more than 30% of U.S. GDP -- and at this point in the Great Crash, the Dow had already lost 40% of its value since peaking at 381 points in early September.
The most surprising thing about Black Tuesday, to those of us with the benefit of hindsight, is that the national mood was overwhelmingly positive. Toward the end of the day, wrote the Los Angeles Times, "There was a wave of optimistic feeling among the brokers. Old traders 'felt it in their bones' that the worst was over." Journalists, financiers, and politicians from across the country stridently championed an imminent return to prosperity. The Associated Press and The New York Times  gathered many notable statements in Black Tuesday's aftermath, and to these seasoned professionals, Wall Street's future was so bright that everyone would soon need to wear shades:
The Kansas City Star wrote: "Now that the inevitable deflation has come, business conditions remain essentially sound ... the way is prepared for a further advance in industry."
"The sagging of the stocks has not destroyed a single factory, wiped out a single farm or city lot or real estate development... all those things are still there," claimed New York News.
"The stock market crash is the result of many forces, most of them transitory, and all of them combined incapable of upsetting the firm base of prosperity," wrote the Baltimore Sun.
"The country is in reality no poorer than it was before the boom set in," claimed the Des Moines Register. "We may look forward confidently to a much saner and much safer financial winter than promised a few weeks ago."
The Davenport Times wrote, "The nation is economically sound. Now, not a month ago, is the time to be bullish on America."
Black Tuesday was also remembered for it's frenzied trading volume of more than 16 million shares. Nowadays, we have personal computers and the internet and high frequency traders that can move 16 million shares faster than I can say 16 million shares.

Today, the Federal Reserve FOMC is meeting. Tomorrow the FOMC will wrap up their 2-day session and publish a statement on their thoughts for monetary policy. They will basically maintain the status quo. We better hope so anyway; they haven't communicated any significant policy shift; the markets abhor surprises from the Federal Reserve. Still, we wait for the fat lady to sing because you never know what can happen in the bottom of the 9th inning with 2 outs.

Over the past few days, here on the Review, we've talked about the Fed andthe day when they will eventually begin to taper Quantitative Easing, and we've also talked about new rules from the Fed designed to have big banks hold more capital reserves to serve as a cushion in an emergency so we never have to bailout the banks again. Today, I'll explain how those ideas go together and the longer-term implications.
In the next 12 to 24 months, capital markets are going to struggle due to a shortage of government debt. That's right, not enough government debt. The problem of not having enough government bonds, notes, and bills might seem like a good problem because it assumes the government is balancing budgets and reducing deficits, but any significant reduction in the issuance of Treasury securities would directly impact lending and credit markets in the US and globally. Interest rates would rise, and capital markets would become distorted.

Before you scream out that I've lost my mind and there is no way our huge budget deficits will be tamed any time soon, especially with a dysfunctional government and politicians tripping over campaign donors to make a mess of everything, just consider: we thought massive deficits were incontrovertible and the budget impossible to balance. Then it happened under Clinton. Treasury issuance was greatly reduced as a result.
Long before budgets are balanced and deficits reduced, the soon-to-be vastly ratcheted-up demand for Treasury securities will be felt. The demand will come from banks, trading houses, and financial institutions of all stripes. What’s happening now is that regulatory changes are going to force banks and financial institutions to hold more Treasuries, a lot more Treasuries, and demand will accelerate over the next few quarters and couple of years.
New Basel rules will be implemented. New Dodd-Frank rules, those already written and the hundreds more that may get written, will eventually be implemented. And other regulators are imposing their own rules and requirements. The net result is that financial institutions are going to have to hold more and better capital and make themselves more liquid. They’ll do that by owning more “risk-free” Treasuries.
Ben Bernanke, chairman of the Federal Reserve, came out last Thursday with new liquidity requirements for banks and systemically important financial institutions. The “liquidity reserve ratio”will require institutions to hold high-quality liquid assets to cover anticipated total net cash outflows over a 30-day period.

What constitutes high quality assets? Treasuries. If you have to have liquid assets that aren’t going to fall off a cliff in a financial crisis that you can liquidate, meaning there have to be buyers, US Treasuries are it.

On top of filling liquidity requirements, Treasuries will be in huge demand as marginable collateral for credit default swaps, once the final language in Dodd-Frank is written and swaps are exchange-traded and trades are settled through clearinghouses that guarantee counterparty obligations. To do trades through a clearinghouse that’s taking on counterparty risk, margin has to be posted by traders. Collateral used for margin is only good if it can be quickly sold, especially in a multi-trillion dollar market where collapsing prices could implode global markets.

What constitutes high quality assets that are universally accepted as collateral? Treasuries.

The next best thing to Treasuries are agencies. Agency paper refers to debt instruments not issued by the US, but guaranteed either explicitly or implicitly by the US;such as debt issued by Fannie Mae and Freddie Mac. Those two giant Government Sponsored Enterprises (GSE) are the best example of issuers of agency paper.
And what are the politicians in Washington trying to do to Fannie and Freddie? Well, they're trying to kill them off. They are in Congress’ crosshairs right now. There are at least four proposed bills floating between the Senate and the House that all envision the disintegration of Fannie and Freddie. When that happens, assuming it will, there will be a lot less agency paper to be used as liquid collateral. The two GSEs, along with the Federal Home Loan Banks, have almost $7 trillion in debt outstanding that are considered safe assets. A dramatic reduction in agency paper will further increase the demand for Treasuries.

Eventually rising demand runs head on into reduced supply. It happened in the 1990's, and as a result of those two opposing dynamics happening, capital markets filled the void by manufacturing increasing amounts of guess what? AAA-rated mortgage-backed securities (MBS) and other then highly rated asset-backed securities (ABS). And yes, that's the kind of garbage that lead to lawsuits because there was garbage thrown into the pool. MBS and ABS aren't the same thing as Treasuries.

Are we headed down that path again? Probably.

Because the demand for Treasuries will result in institutions hoarding them, lending against less liquid collateral will cause interest rates to rise and credit conditions to tighten.

Quantitative easing has masked the problem so far. But, as QE is tapered out and if deficits are reduced while at the same time new regulations to make banks safer increases demand for Treasuries, we will face unforeseen capital markets dislocations and economic uncertainties.

Monday, October 28, 2013

Monday, October 28, 2013 - Markets Are All About the Fed

10282013 Script
Markets Are All About the Fed
by Sinclair Noe

DOW – 1 = 15,568
SPX + 2 = 1762
NAS – 3 = 3940
10 YR YLD + .01 = 2.51%
OIL + .69 = 98.54
GOLD + .30 = 1354.20
SILV - .09 = 22.61

The Federal Open Market Committee, the FOMC, is the Fed's policy making arm; they will meet on Tuesday and Wednesday to determine possible changes or adjustments to monetary policy. The broad consensus right now is that nothing will change. The government shutdown and a mixed batch of economic data convinced many the Fed would delay any move to begin trimming its stimulus into next year.

The longer the Fed keeps its policy loose, the longer US yields will stay low, making the dollar less attractive. The dollar index was just a smidge higher today, but still trading very close to a 9 month low just under 79, reached on Friday, while the euro has been trading near 2 year highs. As long as the Fed's easy money policy remains in effect it provides abundant liquidity for Wall Street. Last week the S&P 500 hit records and many global stock markets were also near record highs. The MSCI world equity index has been moving higher for 4 consecutive sessions and is near records of January 2008. The Fed's easy money policy has served to support gold and other metals markets. After all the recent bullish movement, you might think the Fed's dovish policy stance has been well priced into the markets. Maybe.

If you want to see the graphic definition of an uptrend, just look at the S&P 500 chart over the past year. With the exception of a few minor whipsaws, the chart is a good progression of higher highs and higher lows depicting a gain of more than 400 points. It hit record highs, at least on a nominal basis, but if you look at the index in inflation adjusted terms, the high was in August 2000, and the purchasing power of a dollar invested in the S&P 500 is still more than 12% below the August 2000 level; and to get to a new high, we would need to top 2000 on the index. The price to earnings back in 2000 were much higher than today, meaning relative valuations today are more justifiable, but that doesn't tell us whether or not we'll advance to a new high in this cycle. There are some positive, almost bullish considerations: Corporate balance sheets are in excellent shape, which could prompt elevated returns for shareholders; shareholder-friendly M&A driven by still low borrowing costs could add another boost to the market rally.

And there is still cash on the sidelines. Plenty of people burned back in 2008 have been parked in cash reserves, but every now and then the market temptation becomes too great. The rotation from cash to stocks typically takes longer than most people imagine, and just about the time that cash comes back into the markets, we might expect yet another rotation; after all, earnings have a lot of work to catch up to valuations, and there are still strong fiscal headwinds. Plus, it's been about 6 years since the start of the last recession and about 4 years since the recovery (if we can call it a recovery), and these things tend to repeat with regularity; it's called a business cycle.

Today, we had economic reports showing manufacturing output inching slightly higher in September, while contracts to buy previously owned homes posted the biggest drop in more than 3 years. Manufacturing production edged up 0.1% last month after advancing 0.5% in August. The National Association of Realtors said its Pending Homes Sales index, based on contracts signed last month, dropped 5.6% to the lowest level since December. The decline was the largest since May 2010.

The index, which leads home resales by a month or two, has now dropped for four straight months. Realtors believe home resales, which dropped in September, peaked in July and August. The reports come on the heels of data last week showing a gauge of business spending tumbled in September. That data, combined with a disappointing reading on hiring released earlier this month, has offered a dull picture of economic activity.
Rates on 30-year fixed rate mortgages rose to an average of 4.49 percent in September from an average of 3.54 percent in May, according to Freddie Mac. But a surprise decision by the central bank in mid-September not to cut its purchases and soft economic data have pulled rates lower since then. With politicians in Washington still to agree on a budget, uncertainty over fiscal policy may also continue to hinder growth

Over the next couple of days we'll see reports on producer prices and consumer prices, retail sales and home prices, the ISM manufacturing report and more. It probably won't matter. The Fed's keeping the digital printing press running and the economic data is not compelling enough to change the QE, not yet, likely not this year.

Quantitative Easing, the Fed's $85 billion a month debt purchase program has has caused significant inflation (even if the inflation isn't reported in the official economic reports) and made national debt soar (even if much of that debt now rests on the Fed's balance sheets); it has made the bond markets fragile and volatile. The value of bonds look nice on balance sheets but unless one plans to cash them in like growth play stocks, their worth as income producers has been lousy. Income investors look for “risk-free returns” but QE creates a "return-free risk" scenario. If you are heavily weighted in fixed income, it is with a grip white-knuckled by the real, perhaps inevitable fact that at some point QE will end or simply fail to keep yields low and asset values high. And the whole idea of income investing is a stable buy and hold approach that makes it difficult to pare gains, just as it is painful to accept losses. Classical measures of value have been destroyed. It is very difficult to find true price discovery or a reasonable degree of certainty about these markets except that they are artificial and fragile, and increasingly vulnerable to exogenous influences. Just as the Fed force-feeds liquidity to the equity markets, it also provides the essential sustenance for the bond markets, and this seems the major lift, maybe the only justification for rising markets.
In this context, if you "buy the market" you're betting on continuing QE and an absence of crises that have lingering effects. While QE is likely to continue so long as policy-makers prefer to keep the markets climbing for whatever reasons happen to suit them, and remember policy-makers change from time to time, we still have geopolitical, and economic, and fiscal, and political crises ready to explode. So if you simply develop an allocation, buy and mainly forget about it, the chances for painful surprises are high.

And the longer the markets rally without a pullback, the more delicious that uptrend chart looks, the more the warning signs point toward the latter stages of a bull market. There is for instance the narrowing of the rally to a handful of 'story stocks' that trade at ever more absurd valuations and seem to be able to inexorably rise into the stratosphere, discounting a glorious future that may or may not arrive. Similarly, the pace of IPOs has vastly increased. Whereas IPOs were in 'slumber mode' for much of 2009-2012, issuance has really taken off this year and is at the highest level since 2007. Not only that, but many stocks are once again soaring by up to 100% on their first trading day, which is strongly reminiscent of the insanity that reigned in 1999 to early 2000.

And as we look at earnings, don't forget the buyback effect, which helps earnings per share to increase even as revenues slip. In fact, since corporate leverage is often increased in order to finance buybacks, shareholders in many cases will ultimately end up worse off. In the short term everybody loves the effects of buybacks of course, but be warned: buybacks tend to peak when stock prices are near a peak.

And one more consideration is margin debt, which provides leverage to increase profits in a bull market but is worse than salt on a wound in a bear downturn. NYSE margin debt has soared to a new record high, exceeding $400 billion for the first time ever. The risk-reward situation in the market is dangerously skewed toward risk. Investors are skating on ever thinner ice. Once the risk becomes manifest, forced selling will exacerbate the decline in prices. The stock market keeps levitating on the promise of more money printing. It remains possible that the advance will enter a blow-off stage or a panic buying type advance during which prices rise almost vertically, increasing considerably in a very short time. That would be a clear indicator to take profits and run, but there is no guarantee of a parabolic chart pattern; a 'blow-off' doesn't have to happen. Whether or not it happens misses the point, which is that risk has increased enormously.

Friday, October 25, 2013

Friday, October 25, 2013 - New Records on Bad News

New Records on Bad News
by Sinclair Noe

DOW + 61 = 15,570
SPX + 7 = 1759
NAS + 14 = 3943
10 YR YLD - .02 = 2.51%
OIL + .79 = 97.90
GOLD + 5.60 = 1353.90
SILV - .13 = 22.70

The S&P 500 closed at a record high. The Nasdaq Composite closed at a 13 year high. The Russell 2000 hit a record high intraday, but closed slightly down on the day. The Dow Industrial Average did not hit a high; maybe next week, but not today, and so no milk and cookies.

For the week, the Dow was up 1.1%, the S&P up 0.9%, the Nasdaq up 0.7%. Based on results so far and estimates for companies still to report, S&P 500 earnings are expected to have risen just 3.4 percent in the third quarter, with 69 percent of companies reporting earnings above analysts' expectations. Revenue growth is seen at 2.2 percent for the quarter, with just 54.2 percent beating sales estimates, below the long-term average of 61 percent.

Consumer sentiment dropped in October to its lowest level since the end of last year. The Thomson Reuters/University of Michigan's final reading on the overall index on consumer sentiment fell to 73.2 in October from 77.5 in September and was the lowest final reading since December 2012. This report covered the time when the government shutdown. Consumer confidence is often linked to consumer spending expectations, and so there is some concern this report might foretell a weak holiday spending season.

Meanwhile capital goods orders were weak in September. Excluding orders for aircraft, orders dropped 1.1%. This report covers data prior to the shutdown. It's estimated the shutdown will shave as much as 0.6 percentage point off annualized fourth-quarter gross domestic product through reduced government output and damage to both consumer and business confidence. And even before the impasse, the pace of hiring by US employers had slowed sharply in September, as we learned earlier this week in the delayed jobs report.

This shutdown and threat of another coming in January are clearly going to change how people act and feel. Government employees and contractors (and other creditors) have been presented with a realistic scenario of not being paid either for a period of time, or even never being paid. Behavior will change in response to this newly found recognition of a vulnerability. The partial bounce back may even be muted by social security recipients realizing that they may one day find their checks delayed (and need to have a cash reserve to deal with that).

The single biggest impediment to a stronger economic recovery has been the years of dysfunction in Washington and the policies that have emerged. S&P estimates the shutdown will cost the economy $24 billion, but that's just the shutdown. Most substantively, the sharp decline in the budget deficit, from $1.4 trillion in 2009 to $642 billion in the 2013 fiscal year that ended Sept. 30, has braked the economy at a time when it was already improving only slowly.

Federal spending has been declining for 2 straight years and the Congressional Budget Office calculates that the pullback in spending, together with higher taxes will cause the economy to grow by 1.5 percentage points less this year than it would have if the deficit had remained constant, that’s the equivalent of 1.5 million fewer jobs.

So, we have bad economic news and expectations for a weak 4th quarter and the stock market at record highs, because on Wall Street, bad news is good news. The weak economy means the Federal Reserve is not going to taper, or cut back on it's quantitative easing program of buying $85 billion a month in securities.

Right now the potential costs of withdrawing even a little bit of monetary support from the economy appear much greater than they were. For proponents of asset purchases, the cost-versus-efficacy calculation that figures into their votes each meeting is now chiefly about assessing the impact of slowing purchases, rather than of continuing them. The Fed holds its next FOMC meeting next week, and it looks like there will be about zero chance of a change in QE. The window to make changes in the bond buying program is now closed, and likely closed for quite some time.

Yesterday I addressed at length (click here) the Federal Reserve's proposals to have banks increase capital reserves, which is a positive though incomplete effort to avoid future bailouts. That process of increasing reserves would be phased in beginning in January 2015, and that taper could produce a shortage of high-quality assets. So, the pigs on Wall Street gorge at the Fed's Free Money trough, and push equities to new highs; and if it all sounds irrational and a tad exuberant, well it is; but the market can be irrational at times and brutal at others.

White House officials say the have submitted the paperwork necessary to confirm Janet Yellen as the next head of the Federal Reserve. Yellen will meet Senators next week as part of the process to install her as the next head of the central bank.

Yellen is expected to secure the 51 Senate votes needed to confirm her position. However, the hearings are expected to be contentious. Several Republican Senators have already indicated that they will oppose Yellen's nomination. Kentucky Senator Rand Paul is threatening to block the nomination to get a vote on his Fed transparency bill, which would require the Fed to undergo a complete audit by a specific deadline. 

Today, JPMorgan Chase announced it has reached a $5.1 billion settlement with the US Federal Housing Finance Agency (FHFA) over charges it misled mortgage giants Fannie Mae and Freddie Mac during the housing boom. A separate settlement with the US Justice Department is expected to be announced soon, that's the proposed $13 billion deal. It is the biggest settlement ever by a US bank. In a statement JP Morgan said the settlement resolves the biggest case against the firm relating to mortgage-backed securities.

The bank added that the agreement relates to "approximately $33.8 billion of securities purchased by Fannie Mae and Freddie Mac from JP Morgan, Bear Stearns and Washington Mutual" from 2005 – 2007. As part of the agreement with the FHFA, the bank will pay $4 billion to Fannie Mae and Freddie Mac to settle claims that it violated US securities law.
It will pay the agencies an additional $1.1 billion for misrepresenting the quality of single-family mortgages.JP Morgan has set aside a total of $23 billion to help the bank work through its many investigations by regulators in the US and abroad.
Last month, the bank agreed to pay more than $1bn to help it end various investigations into its 2012 "London whale" trading debacle, which cost the bank more than $6 billion in trading losses.
It's estimated that JPMorgan has now paid out more than $31 billion in fines and legal costs since 2009. The settlement announced today is the biggest settlement ever by a US bank. Now, what seems really crazy is that you have these massive fines and legal costs, and you still have apologists for Jamie Dimon to stay on as the chief at JPM. Either JPMorgan is incapable of turning a profit without violating the law, or they have squandered an enormous amount of profits by violating the law.
Meanwhile, kudos to Bill Black for recognizing a bit of media legerdemain, specifically, this one sentence which describes this week's jury verdict against Bank of America for the Hustle scam: “Bank of America, one of the nation’s largest banks, was found liable on Wednesday of having sold defective mortgages, a jury decision that will be seen as a victory for the government in its aggressive effort to hold banks accountable for their role in the housing crisis.”
I'm still waiting for aggressive efforts to hold banks accountable.
An earthquake of magnitude 7.3 struck early Saturday morning off Japan's east coast, the U.S. Geological Survey said. Japan's emergency agencies declared a tsunami warning for the region that includes the crippled Fukushima nuclear site. Japan's Meteorological Agency issued a 3-foot tsunami warning for a long stretch of Japan's northeastern coast, which isn't really much more than a swell.
There were no immediate reports of damage on land. Tokyo Electric order workers near the Fukushima nuclear plant to move to higher ground but there were no reports of trouble at the plant. All but two of Japan's 50 reactors have been offline since the March 2011 magnitude-9.0 earthquake and ensuing tsunami triggered multiple meltdowns and massive radiation leaks at the Fukushima Dai-ichi nuclear power plant, about 160 miles northeast of Tokyo. About 19,000 people were killed.
The Fukushima plant has been leaking radioactive water into the ground and into the ocean, and there are concerns about the stability of the damaged buildings holding radioactive fuel rods. So, something like an earthquake could easily damage the buildings, resulting in a meltdown 85 times larger than Chernobyl. But the good news is that did not happen; not today.

Thursday, October 24, 2013

Thursday, October 24, 2013 - Liquidity and Leverage and a bit of Levity

Liquidity and Leverage and a bit of Levity
by Sinclair Noe

DOW + 95 = 15,509
SPX + 5 = 1752
NAS + 21 = 3928
10 YR YLD + .04 = 2.52%
OIL + .37 = 97.23
GOLD + 13.60 = 1348.30
SILV + .16 = 22.82

Liquidity is essential to a bank's viability and central to the smooth functioning of the financial system," so says Fed Chairman Ben Bernanke; and so today the Fed proposed that big banks keep enough cash, government bonds and other high-quality assets on hand to survive during a severe downturn like we saw in 2008, and the idea is that we avoid a global financial meltdown like we almost saw in 2008. Liquidity is the ability to access cash quickly; that's important when nobody is sure about what the bank truly has in the vault. Liquidity is what prevents a bank run; liquidity averts a financial meltdown or credit crunch.

The Fed proposal today subjects US banks for the first time to liquidity requirements. The big banks, with more than $250 billion in assets, would be required to hold enough cash and securities to fund their operations for 30 days during a time of market stress. Smaller banks, those with more than $50 billion and less than $250 billion, would have to keep enough to cover 21 days. Fed officials said the rules are stronger than new international standards for banks. The public has 90 days to comment on them. After that, they would be phased in starting in January 2015. The requirements were mandated by Congress after the financial crisis.

The proposal would require setting aside about $2 trillion, and the Fed estimates US banks are currently $200 billion short. The Basel Committee on Banking Supervision in January agreed on a liquidity coverage ratio meant to ensure banks can survive a 30-day credit squeeze without bailouts like 2008. That standard would let lenders go beyond cash and low-risk sovereign debt to include some equities and corporate debt.The US version would permit a limited amount of government-sponsored enterprise debt while excluding private-label mortgage-backed securities; so some Fannie Mae and Freddie Mac. The US version is considered a bit tougher than the international version as far as what can be considered reserves.

Where this starts to get interesting is in the requirements dealing with what the banks have to hold to be considered liquid. It's not just cash; it's cash and securities and other high quality assets.

Bank regulation has moved to a system where bank assets are measured on a risk-weighted basis. This is the mechanism that encouraged Eurobanks to buy toxic AAA rated CDOs and sovereign debt; both had zero risk weights under Basel II; and because there was no risk, the banks could and did leverage those no risk positions. The US did not implement Basel II prior to the crisis, but similarly focused on risk-weighted assets rather than simpler total leverage measures.
The credit risk weightings mean that instead of reserving the standard 8 percent of capital in respect of a debt, the bank can cut that by the weighting applied to the asset class. Effectively, the reduction in credit risk weighting operates as a powerful subsidy to the borrowers and equally powerful incentive to over-leveraging the lenders. So the 2008 crisis started with bad mortgage debt, spread to bad bank debt, carried over into bad agency debt, and now encompasses bad sovereign debt. Each of these categories was given preferential capital weighting under the Basel Accords, and now all are open sores on the financial system and the stability of excessively indebted governments. Not only did the Basel weightings encourage poor risk assessment, they directly contributed to the inadequate capitalization of banks for the risks they assumed.
So, the idea of increasing capital reserves sounds good in theory, and to a certain extent in practice, but it only goes so far. It's a good thing to have the banks have a lot more equity capital, so they're not just gambling with other people's money. The problem is that high-quality assets are only high quality until they aren't. A system in which banks or bank-like institutions are tightly coupled with one another, and in which those institutions have too much debt relative to equity, is prone to meltdowns that can spill into the real economy and cause massive damage. Whether these liabilities are in the form of derivatives and off-balance-sheet assets or overvalued tulips pledged as collateral, too much debt without loss-absorbing equity to match it is simply too dangerous to exist.
It is difficult to measure the exact cost to society of our undercapitalized large banks blowing up during the most recent financial crisis, but it was certainly enormous. The nonprofit advocacy and research group Better Markets pegged the cost at roughly $12 trillion, whereas the U.S. Government Accountability Office put it at $22 trillion. Regardless of which figure one uses, it is obvious that the United States is a much poorer society because there was too much leverage backed by over-valued collateral in our financial system. The proposed rule strikes at this problem.

In a crisis the market cares about the leverage ratio, not risk-adjusted capital. Risk weights are prone to manipulation by internal bank models. In 2008 there was a steady downward trend in risk weights and upward trend in leverage leading into the crisis, and less-capitalized banks manipulated risk weights after their internal models were approved by regulators. The use of a leverage ratio in the United States by regulators meant that American banks were, relatively speaking, better capitalized than their European counterparts.

Risk-weighted capital ratios also have the added downside of increasing, rather than reducing, systemic risk. Regulators deemed certain asset classes as less risky than others. Mortgage backed securities, some sovereign debt, agency debt, and interbank debt all effectively received subsidies because regulators determined that banks had to hold limited capital against them. Risk-adjusted capital allowed banks to treat Greek sovereign debt as bearing the same risk as German sovereign debt. Regulators cannot predict the future, but risk-adjusted capital models require them to. Leverage ratios do not. So, a crisis beginning in mortgage debt spread through agency debt, interbank debt and into sovereign debt. Everything fell apart because the chain was only as strong as the weakest link.

This also takes us back to the differences between insured depository institutions that are subsidiaries of bank holding companies and the holding companies themselves; another way of looking at it is the difference between FDIC insured bank accounts and the trading desk of a bank such as the London Whale trading desk. We need firewalls between these institutions. The less interconnected the system is, the less risk it poses to the real economy. The greater the interconnection and the reliance, and the ability to dip into insured accounts in times of trouble – the greater the risk. We used to have a great firewall; it was called the Glass-Steagall Act. We should consider it again.

Fed vice-chair Janet Yellen, who has been nominated to replace Fed chairman Ben Bernanke, expressed concern that there could be a shortage of high quality liquid assets if the Fed tapers and reduces its reserves. Fed officials said that was a concern but that is why the products covered under high-quality liquid assets are varied to include invest-grade corporate debt securities, among other instruments. What that means is that not much has really changed with the vulnerability of banks over the past 5 years, and also that the Fed is not yet ready to taper. So, for today at least, it was risk on.

Now, one more bit on the banking front today, we've talked a bit about the $13 billion settlement over JPMorgan's mortgage practices. It looks like Jamie Dimon wants to clear the decks of all the legal problems. You may recall the Bernie Madoff case. Madoff's bank of choice for about 20 years was none other than JPMorgan Chase; perhaps he liked them because they didn't scrutinize his Ponzi Scheme. 

Federal authorities are preparing to take action in a criminal investigation of JPMorgan, suspecting they turned a blind eye to Madoff's shenanigans.
Prosecutors are reportedly weighing criminal charges against JPMorgan employees who did business with Madoff. It is unclear which employees are under investigation. Prosecutors and JPMorgan have held preliminary discussions about a so-called deferred prosecution agreement. Such an arrangement would suspend criminal charges against JPMorgan in exchange for a fine, certain other concessions and an acknowledgment that the bank will face charges if it fails to behave. Prosecutors may also require JPMorgan, which has repeatedly said that “all personnel acted in good faith” in the Madoff matter, to hire an independent monitor.

Prosecutors could demand that the unit plead guilty to a criminal violation of the Bank Secrecy Act, a federal law requiring financial institutions to report suspicious activity to the government. Prosecutors have reportedly discussed the ramifications of criminal charges with one of JPMorgan’s regulators.

The actual repercussions would depend on the underlying criminal charge. The most serious potential violation could complicate JPMorgan’s business with certain clients, possibly forcing investors like pension funds to withdraw some money from the bank. But a lesser violation would be likely to have more of a reputational consequence.

For the government, it would represent an extraordinarily rare show of force. Ever since a criminal indictment led to the demise of the accounting firm Arthur Andersen, Enron's auditor, the government has been wary of imposing criminal charges on big corporations for fear that it would imperil the institution and have ripple effects on the broader economy. Under federal guidelines, prosecutors must weigh “collateral consequences,” like job losses and economic implications, in such an action.

Ok, I've been talking quite a bit about JPMorgan and their $13 billion settlement. I tend to be a bit serious when I talk about the banksters. Sometimes I wonder if the rest of the world realizes what's going on. Well, last night Jon Stewart of the Daily Show talked about the media coverage, specifically the coverage by CNBC. Stewart showed a clip of Alex Pareene, a reporter for Salon, questioning whether Jamie Dimon should lose his job as chief executive of the bank. And Maria Bartiromo, acting as the great defender of JPMorgan. And then, they went to the videotape from 2008, where CNBC's Jim Cramer waxed eloquent about how Jamie Dimon got such a great deal when he purchased Bear Stearns in a deal with the Federal Reserve. I have to say that a takedown of Maria Bartiromo is probably easier than shooting fish in a barrel. Still, it was entertaining, so click here to link to the videotape.