Thursday, November 21, 2012 - Size and Composition

Size and Composition

by Sinclair Noe

DOW + 109 = 16,009
SPX + 14 = 1795
NAS + 47 = 3969
10 YR YLD - .01 = 2.78%
OIL + 1.59 = 95.44
GOLD - .40 = 1243.40
SILV + .14 = 20.09

Intraday, the Dow industrials were higher last Friday and last Monday, but this was a record high close, and that is what we look at – the close. The reason we look at the close is largely arbitrary, and the reason we celebrate the Dow record high close as opposed to the S&P 500 record high close, is again arbitrary. The significance of a close above 16,000 is not a big deal; it's just a number. Earlier in the week the market looked at the round number and could not close above; there was a pause; then today, a move above. Test, retracement, breakout; that's bullish.

We have discussed that there is a disconnect between the markets and the broader economy. We have discussed that the trickle down effect or the wealth effect has been less than satisfying for. Still, some of that money will filter into the broader economy; and the bottom line is that it's better than a poke in the eye with a sharp stick.

At some point the Fed will taper; the easy money party will end; until then, well, enjoy the milk and cookies.

Initial claims for state unemployment benefits fell 21,000 to a seasonally adjusted 323,000. Meanwhile, prices at the wholesale level dropped 0.2%. The PPI core rate, excluding gas and food rose 0.2%; so the lesson is that we can all get lower prices if we just stop driving and eating; and, we are seeing disinflation at the wholesale and retail levels. Also this morning, the Philadelphia Federal Reserve Bank reported its business activity index fell to its lowest level since May. Wall Street's pretzel logic saw this bad economic news as a positive, indicating the Fed will continue to be accommodative. Just how long the Fed can keep pumping easy money into the stock market is the big question. Japan may serve as a playbook. Today the Bank of Japan left its massive stimulus policy, known as Abenomics, in place. So, with Japan as a guide, the Fed could do much, much more. The dollar rose to its highest against the yen in more than four months.

Today, European Central Bank President Mario Draghi said the ECB would not cut the deposit rate into negative territory. Draghi tried to dispel talk the ECB was considering charging banks to deposit cash overnight in a bid to boost economic activity. The Federal Reserve pays banks to deposit funds, and there has also been talk that they might consider not paying to get that money out of the vaults and into circulation. Draghi said the central bank did not see deflation materializing, but clearly deflation is a greater concern than inflation, and deflation may force the ECB to reach deeper into their tool belt.

It's generally accepted that central banks monetary policies implemented in response to the global financial crisis prevented a deeper recession and higher unemployment than there otherwise would have been. These measures, along with a lack of demand for credit as a result of the recession, contributed to a decline in real and nominal interest rates to ultra-low levels that have been sustained over the past five years.

A new report from the McKinsey Global Institute examines the distributional effects of these ultra-low rates. Over the past 5 years, governments in the eurozone, the United Kingdom, and the United States collectively benefited by $1.6 trillion both through reduced debt-service costs and increased profits remitted from central banks.

Nonfinancial corporations benefited by $710 billion as the interest rates on debt fell, however this did not result in higher levels of investment. The impact that ultra-low interest rates have had on banks has been mixed. They have eroded the profitability of eurozone banks, resulting in a cumulative loss of net interest income of $230 billion between 2007 and 2012. But banks in the United States experienced an increase in effective net interest margins and a cumulative increase in net interest income of $150 billion. The experience of UK banks falls between these two extremes.

Meanwhile, households in these countries have lost a combined $630 billion in net interest income; that's not total losses from the economic downturn, that's just net interest income.

There are limits to central bank monetary stimulus schemes. The Federal Reserve has been buying mortgage backed securities at a rate of $40 billion per month and they now hold an estimated 26% of the total of mortgage backed securities outstanding. Each month the Fed continues buying, they increase their stake by 0.8%. Even if the Fed were to taper in March and stop all MBS purchases by the end of 2014, Fed holdings of MBS would rise to about 34% of the total MBS market.

The Fed has already distorted the housing market, and if QE continues much longer, they could corner the market. What would that look like? I'm not sure, I'm just asking. Another question is whether the asset purchases have really done the job. The Fed might want to look at buying something else. Quantitative easing can be targeted at all kinds of assets and with the Fed swallowing up the entire MBS market, maybe it's time to look elsewhere. There is probably nothing to prevent the Fed from jumping into the corporate bond market, or maybe they could start buying up municipal bonds; they could start with Detroit, Riverside, and Stockton.

Regardless of whether you agree with the idea or not, or whether you appreciate the irony or not, the point is that the Fed can not only make adjustments to the size but also the composition of its asset purchases.

Today marked a big change in the Senate. I'm still trying to figure how it will affect business and the economy but a friend asked me to speak on it today, so I'll say a few words.

Senate Majority Leader Harry Reid pulled the trigger today, deploying a parliamentary procedure dubbed the "nuclear option" to change Senate rules to pass most executive and judicial nominees by a simple majority vote. The Senate voted 52 to 48 for the move, with just three Democrats declining to go along with the rarely used maneuver.

From now until the Senate passes a new rule, executive branch nominees and judges nominated for all courts except the Supreme Court will be able to pass off the floor and take their seats on the bench with the approval of a simple majority of senators. They will no longer have to jump the hurdle of 60 votes, which has increasingly proven a barrier to confirmation during the Obama administration.

Reid opened debate in the morning by saying that it has become "so, so very obvious" that the Senate is broken and in need of rules reform. He rolled through a series of statistics intended to demonstrate that the level of obstruction under President Barack Obama outpaced any historical precedent.

Half the nominees filibustered in the history of the United States were blocked by Republicans during the Obama administration; of 23 district court nominees filibustered in U.S. history, 20 were Obama's nominees; and even judges that have broad bipartisan support have had to wait nearly 100 days longer, on average, than President George W. Bush's nominees. There has been gridlock; that's true. Changing the rules can come back to bite you at a later date; that's true, too.

I have no problem with the filibuster, at least the old fashioned filibuster. I hate the modern filibuster, where a senator just says: “I filibuster” and everything grinds to a halt. If you want a filibuster, then stand up on the Senate floor, (like when Mr. Smith Goes to Washington) talk until your voice or your bladder gives out. Read from Dr. Seuss of actually try to display intelligence. We know this is possible because every time a Senate committee calls an expert witness to testify at a hearing, we never hear the witness, just the various Senators, bloviating on without end.

And if they ever did bring back the old fashioned filibuster, the could set up a wind farm on the steps of the Capitol to capture the never-ending torrent of hot air.