Friday, January 31, 2014

Friday, January 31, 2014 - January Out

January Out
by Sinclair Noe

DOW – 149 = 15,698
SPX – 11 = 1782
NAS- 19 = 4103
10 YR YLD  - .03 = 2.67%
OIL - .76 = 97.47
GOLD + 2.80 = 1246.90
SILV + .03 = 19.27

The Dow started the year and the month at 16,572 (-926). The S&P 500 started the month at 1845 (-63). The Nasdaq Comp, for the month, went from 4160 (– 57).

For the week, the Dow fell 1.1 percent, the S&P 500 slipped 0.4 percent and the Nasdaq dropped 0.6 percent. In January, the Dow slumped 5.3 percent, the S&P 500 lost 3.6 percent and the Nasdaq fell 1.7 percent. January marked the worst month for the Dow and the S&P 500 since May 2012, and the worst for the Nasdaq since October of that year.

Yield on the 10 year Treasury note dropped from 2.99% to (- 32bp). And this is a little telling, the Vix, the volatility index went from 14.32 to 18.22    (-3.9)
The Vix might be indicating that the market is not sufficiently scared of the emerging market contagion; certainly the Vix is higher than the start of the month, but remember that December saw record highs for the major indices, and a really scary Vix reading would be around $49, for those of you who remember the beginning of 2009. In other words, there are a whole bunch of people who haven’t figured out that we’re in a downturn in the markets. So far the US markets are just experiencing a small move, but the rest of the world is taking a bigger hit. About $17 billion has poured out of emerging market funds this month.

Right now, there is growing angst regarding the emerging markets. The Dow was down more than 200 points to start the session today. And really, none of this should be a surprise. We know that emerging markets have been struggling with the Fed’s taper and other stimulus plans of developed economies. Things tend to unravel slowly and then all at once. It’s hard to figure out where we are in the unravelling. When will this little downturn end? I don’t know but I’m guessing the Vix will be higher than today.

A new State Department report on the proposed Keystone XL oil pipeline finds that the project would have a minimal impact on the environment, an assessment likely to increase pressure on the White House to approve it. But the report sets no deadline for doing so. The proposed pipeline would carry crude derived from oil sands in Canada to refineries in the United States. The evaluation fell to the State Department because the proposed $7 billion project by TransCanada Corp would cross the US-Canada border.

A New York State judge has approved an $8.5 billion agreement by Bank of America to settle most of the claims by nearly two dozen mortgage securities investors.  In a 53-page decision, Justice Barbara R. Kapnick of State Supreme Court in Manhattan ruled that the 2011 settlement was reached in good faith.

The settlement had been challenged by the American International Group, an investor in the mortgage securities, which contended that the trustee overseeing the bonds did not push aggressively enough for more money from Bank of America. AIG argued that the settlement shortchanged investors and accused the trustee, Bank of New York Mellon, of conflict of interest and of shirking its duties. The judge determined that the trustee did not abuse its discretion in entering into a settlement.

There’s something rotten in Denmark, and it’s Goldman Sachs. Denmark gave the global financial giant Goldman Sachs the go-ahead on Thursday to buy a stake in its state utility. Some members of the Socialist People’s Party were so upset, they withdrew their ministers from the country’s governing coalition. Some party members said the deal ceded too much power to Goldman. Thousands of people have taken to the streets in recent weeks to protest the deal; a prominent banner featured the vampire squid that has become a symbol for Goldman Sachs. Nearly 200,000 Danes signed an online petition against the deal, a record.

Under the terms of the deal, Goldman would invest about $1.45 billion for an 18% stake in Dong Energy, the state utility. Dong Energy has a number of businesses, including offshore wind farms, drilling for oil and gas in the North Sea. The utility has about one million gas and electric customers and operates coal and biomass power plants. The deal does not buy Goldman a controlling share, but the minority stake would come with special privileges. Goldman would get a seat on the utility’s board. And the bank, along with two Danish pension funds, would have veto power over changes in the utility’s strategy or its executive suite; specifically the utility’s chief executive or chief financial officer. The Danish pension funds are investing about $550 million.

Among the questions about the deal is whether it is being structured to avoid taxes. Goldman’s investment will be made through a company based in Luxembourg. And that Luxembourg company is then owned in part by companies in Delaware and the Cayman Islands. So, the deal boils down to either a big tax evasion scheme by Goldman or a significant investment in renewable, green energy. Time will tell but I’m guessing it’s a bit of both.

Officials in California said that for the first time in the state’s history, they won’t be able to provide any water to contractors that supply two-thirds of the population and a million acres of farmland. The California Department of Water Resources, which had predicted it would be able to supply about 5 percent of the amount requested, said it now projects that it won’t be able to provide any of the 4 million acre-feet of water sought by local agencies.

The reduction means that agencies will have to rely on existing water supplies such as ground water or what is in storage behind dams. The Los Angeles-based Metropolitan Water District, serving 19 million people in Southern California, and the San Francisco Public Utilities Commission, which supplies much of the Bay Area, have built up water reserves and won’t be as hard hit as places such as Sacramento and the Central Valley farming region. About two-thirds of Californians get at least part of their water from northern mountain rains and snow through a network of reservoirs and aqueducts known as the State Water Project. State Department of Water Resources Director Mark Cowin said: "Simply put, there's not enough water in the system right now for customers to expect any water this season from the project."

Farmers and ranchers throughout the state already have felt the drought's impact, tearing out orchards, fallowing fields and trucking in alfalfa to feed cattle on withered range land.  Agricultural production accounts for most of the state's water use and is expected to be hit the hardest by the reduction. At the same time, many cities have ordered severe cutbacks in water use.

If you watched the State of the Union address this week, you might rightly assume that Congress can’t do anything, which would only be partially correct. The House this week passed a Farm Bill. Big whoop. The Farm Bill is normally the most uncontroversial bit of legislation Congress deals with. Not anymore. The bill is 959 pages long and would cost $956 billion.

That cut is twice what the Senate originally proposed, but a fraction of the nearly $40 billion the GOP House voted to cut last year. Those cuts didn't go into effect, but a cut of $5 billion in the current fiscal year was implemented via Congressional inaction last November. The bill budgets $16 billion less than what would have been spent under current law, with the Food Stamp program absorbing almost half those cuts, or right at $8 billion. In a great big federal budget, that might not sound like much but it worls out to 21 fewer meals per month for a family of 4.

The bill also makes some policy changes for famers. It’s a neat little bait and switch. What the bill takes from the ag lobby with one hand, it largely gives back with the other. Of $41 billion in projected savings (over 10 years) from eliminating direct payments to farmers, the bill restores $27 billion via enhanced crop insurance subsidies and a new program that “insures” against adverse price movements. Supposedly necessary to secure the nation’s food supply at a time of record farm, this federal largess flows almost regardless of how much money its recipients already have. People making up to $900,000 per year in adjusted gross income can qualify for payments. The total commodity-program take for any individual “actively engaged” in farming is capped at $125,000, or 2½ times the national median household income. But your definition of actively engaged is probably different than the definition in the farm bill.

Farm prices and farm revenues and net profits had been at record highs, so old-style farm prices that put the floor under prices were no longer effective. So they racheted up the guarantees, converted into a kind of revenue insurance, allowing the money to continue to flow. The insurance scheme also preserves the current incentive structure of large-scale US agriculture, which is to grow as much corn and soybeans as possible. That's great for the corporations that supply inputs to industrial-scale farmers—seed and pesticide companies like Monsanto, DuPont, and Dow. And in the event of floods or drought, the results could get shaky. Depending on the payouts, any savings from cuts in the Farm Bill could be wiped out.

Thursday, January 30, 2014

Thursday, January 30, 2014 - Where Water Flows

Where Water Flows
by Sinclair Noe

DOW + 109 = 15,848
SPX + 19 = 1794
NAS + 71 = 4123
10 YR YLD + .02 = 2.69%
OIL + .59 = 97.95
GOLD – 24.60 = 1244.10
SILV - .57 = 19.24

Gross domestic product grew at a 3.2% pace in the fourth quarter of 2013, which was down from the 4.1% growth in the third quarter. Consumer spending rose at a 3.3 percent rate, the strongest since the fourth quarter of 2010. Inventories increased $127 billion, the most since the first quarter of 1998. That added 0.42 percentage point to GDP growth. Inventories had risen $115 billion in the third quarter, contributing 1.67 percentage points to output. Excluding inventories, the economy grew at a 2.8% rate, up from the third-quarter's 2.5% rate. We might reasonably expect inventories to decline again in the first quarter.

Consumption in the fourth quarter came at the expense of saving. The saving rate slowed to 4.3% in the fourth quarter from 4.9 % in the prior period. Income at the disposal of households after accounting for inflation rose at a tepid 0.8% rate. That was a sharp slowdown from the 3.0% pace in the third quarter. Income is one of the biggest constraints on growth.

Exports rose at their fastest pace in three years. Exports combined with declining petroleum imports helped narrow the trade deficit. Business spending on equipment accelerated at a 6.9% rate in the fourth quarter after rising at only a 0.2% pace in the prior three months, and there was a decline in business spending on nonresidential structures. Government spending contracted at a 4.9% pace, reflecting the 16-day government shutdown in October; and so austerity at the federal level subtracted 0.98 percentage points from 4Q growth. Overall, GDP growth of 3.2% seems pretty good, not really enough to propel the economy into escape velocity but decent.

In a separate report, the Labor Department said new applications for state unemployment benefits rose 19,000 last week to 348,000.

In another report, the National Association of Realtors (NAR) reported their pending homes sales index fell 8.7% to 92.4 in December. This is a forward looking indicator based on contract signings. The polar vortex likely contributed to the lower number, at least in the Northeast, but other parts of the country also posted declines.

We are still in earnings reporting season and we’ll touch on a couple of reports. Exxon Mobil posted lower than expected quarterly profits, blaming declining production and more expense to find fresh reserves. Fourth quarter profit still was just over $8.3 billion, but that was down from $9.9 billion a year earlier.
Facebook posted a 63% jump in 4Q revenue and better than expected profit of 31 cents per share. Pulte Homes posted net income of $220 million, up from $58 million a year ago. Companies in the S&P 500 probably increased their earnings by 6.6% in the fourth quarter and revenue likely increased by 2.6%; that’s the most recent guesstimate.

More than $7 billion flowed from ETFs investing in developing-nation assets in January, the most since the securities were created. The iShares Emerging Market ETF (EEM) is down 11%; Vanguard’s emerging market ETF will have the biggest monthly redemption since the fund’s inception in 2005, and the Wisdom Tree emerging market ETF will post its eighth consecutive month of redemptions.

Much of the problem for emerging markets starts with the Federal Reserve’s tapering; as the Fed cuts back its asset purchases there is less hot money searching out higher yields overseas. And it is now clear the Fed will continue with taper for the rest of the year, barring some big change. And after taper, we can reasonably expect that at some point the Fed will start to raise interest rates. That is also troublesome for US equities. Valuations expanded so much last year in anticipation of better earnings growth and in combination with very, very easy Fed policy. As Fed policy reverses, that could very easily increase volatility substantially and really compress the multiple.

The Fed seems to have come to the realization that QE didn’t really have much positive impact on the economy anymore, if it ever did. You could argue that QE was hurting by lowering interest payments on safe assets, while pushing the hot money in search of higher yield and exacerbating inequality. Now the regulators must think the banks are healthy enough to stand on their own, the economy is growing fast enough (even if it is not robust growth), and the emerging markets…, well the Fed apparently doesn’t give a hoot. Unfortunately, the Fed’s timing is on top of the slowdown in China and their efforts to constrain the shadow banking system, which may be an even bigger shock  to emerging markets than the Fed turning off the stimulus. The reality is that the taper, or the unwinding of QE will be painful, even if the Fed slowly removes the Band-Aid from the wound.

It has been volatile for emerging markets and Wall Street this month, the wildest market has almost nothing to do with central bankers, and much more with Mother Nature. For the natural gas market, volatility doesn’t even start to describe the action. Last week, nat gas prices jumped 20% - in one week. Prices broke through the $5 dollar level and ran as high as $5.68 per million btu; the highest close since June 2010.

We are now looking at prices in a condition known as backwardation, which means prices on the forward month futures contracts are higher than forward futures. Today, for example Nat Gas Futures for March closed at $4.92, the April contract at $4.36, and the May contract at $4.34. Backwardation occurs during periods of peak demand, either in cold periods during the winter or a long heat wave during the summer when gas-fired power plants run at near capacity in large parts of the country. The idea is that there are shortages now, but things will get back to normal in time.

Of course, much of the world would love to buy nat gas under $5. The low price of US natural gas has caused demand to creep up. In 2014, demand will likely be over 20% higher than it was in 2005, the year of the record price spike when natural gas reached $15.40 per MMBtu. The low prices of late caused many drillers to write off many projects and many billions of dollars.

During the years of the glut, much of the big money was lined up on the short side. But it has switched over to the long side, and those who got in early, say, in April 2012 near the decade-low of $1.92 per MMBtu, had a ferocious, vertigo-inducing rollercoaster ride during which the price of natural gas nearly tripled. Short sellers that underestimated demand growth and Mother Nature got crushed in an epic short covering supply squeeze. And winter is far from over. The meteorologists say we could see a few more weeks of freakishly cold weather. Energy traders are actually forced to look out their windows because they’re all betting on the weather.

But the Polar vortex and the frozen freeways around Fulton County might not be the biggest weather story of 2014. Seventeen rural communities in drought-stricken California are in danger of a severe water shortage within four months. Wells are running dry or reservoirs are nearly empty in some communities. Others have long-running problems that predate the drought.

The San Jose Mercury News reports that most of the water districts facing near term peril are small districts, with too few customers to collect enough revenue to pay for backup water supplies or repair failing equipment. In Cloverdale, where 9,000 get water from four wells, low flows in the Russian River have prompted the City Council to implement mandatory 25 percent rationing and ban lawn watering. The city raised water rates 50 percent to put in two new wells, which should be completed by July. Now they just have to hope they can make it through the summer. So far, larger urban areas haven’t really been impacted by the drought.

Today, Governor Jerry Brown met with experts across Southern California. The best ideas seem to be old fashioned conservation. Brown says people shouldn't flush more than necessary or shower too long, and to turn off the water while shaving or brushing teeth.

The 2013 calendar year was the driest in 119 years of record-keeping. Today, the US Department of Agriculture’s Drought Monitor ratcheted up the concern, designating 9 counties throughout the Central Valley as “D4: Exceptional Drought”. More than 94 percent of the state is at least in some level of drought. January and February are often among the wettest months in California, but this month has been parched. The Bay Area has seen less than 10 percent of the rainfall it ordinarily sees by this point in the season. A storm system has been moving through Northern Cal but rainfall amounts have been tiny. It would have to rain every day through May to bring conditions back to normal. Mountain snow, which normally melts to feed the state's waterways and reservoirs, is at 20 percent of its normal level.

The California Department of Public Health is working to relieve some of the problems from the drought by constructing more wells, identifying additional sources such as nearby water systems or hauled water, and implementing other methods of water conservation.  The $45 billion agriculture business is also at risk. If you have ever driven along I-10 through Blythe, you may have seen a sign that reads: Food grows where water flows.

The drought, like the cold weather in other parts of the country, really shouldn't shock anybody, but it should make us wake up to the absolute necessity of being proactive. We've seen the price shocks from cold weather and poor planning on the price of nat gas; the result was extreme volatility. A similar story for Western waterways wouldn’t just result in volatility but in outright chaos.

Wednesday, January 29, 2014

Wednesday, January 29, 2014 - Benny Jets

Benny Jets
by Sinclair Noe

DOW – 189 = 15,738
SPX – 18 = 1774
NAS – 46 = 4051
10 YR YLD - .07 = 2.67%
OIL – 01 = 97.40
GOLD + 12.00 = 1268.70
SILV + .15 = 19.81

You’ve heard the old post office creed; “neither snow nor rain nor heat nor gloom of night stays these couriers from the swift completion of their appointed rounds.”

Generally true, however I bet some letter carriers are having a tough time delivering mail in Atlanta today. The Federal Reserve apparently has a creed. Who knew? Neither a disappointing December jobs report nor turmoil in emerging markets nor gloom of the US economy shall stay these central bankers from the incremental completion of their taper.

Don’t worry; nothing to look at here; keep moving, keep moving. No sonny, that’s not a train wreck on Wall Street, that’s just the debris and detritus stirred up by the whirlybird which will now carry Helicopter Ben into the sunset, or more accurately to the boardroom of some investment bank. Yes, this is the last FOMC meeting for Ben Bernanke. He promised he would set a course for exiting QE, and he has; the problem is that the set course is fraught with perils.

The Federal Reserve’s policy making Federal Open Market Committee wrapped up a two day meeting today by announcing they would cut back their bond buying program by $10 billion, to a mere $65 billion per month.  The FOMC added that it was “likely” to continue the pullback, suggesting a similar cut is probable at its next meeting, in March. The stock market fell for the fifth session out of the past six, wiping out yesterday’s gains, but stocks were already moving lower before the Fed announcement.

While noting recent weakness in the housing sector recovery the FOMC statement says the overall economic picture continues to improve. And then the statement included a little slap on the wrist for Congress: “Taking into account the extent of federal fiscal retrenchment since the inception of its current asset purchase program, the Committee continues to see the improvement in economic activity and labor market conditions over that period as consistent with growing underlying strength in the broader economy.
The Fed reiterated their view that "risks to the outlook for the economy and the labor market as having become more balanced," language they added to the statement for the first time in December. They reconfirmed that they will likely keep interest rates in the near zero range even if the unemployment rate drops below the target of 6.5%. And just remember your mantra: tapering is not tightening, tapering is not tightening.

And if taper leads to a little turmoil in emerging markets, well what’s it to you? The Fed pullback is contributing to a global shift in investments. That is causing problems for countries like Turkey, which would the example du jour.  The central bank in Turkey tried to bolster that nation’s currency yesterday by sharply raising its benchmark interest rate. The Turkish central bank increased the rate for one-week loans to banks to 10% from the previous level of 4.5%. The idea was to lure investors with a better yield, instead it may be causing collateral damage to the rest of its economy.

And today, the Turks learned the meaning of the old axiom, “don’t fight the Fed”, as the Turkish lira slumped, along with other emerging market currencies. The Russian ruble took another hit, the Argentine peso continued to plunge, and the South African rand could not be shored up. The South Africans raised rates a more subtle half-percent from 5% to 5.5%.

We used to identify the fast growing emerging markets as BRICS – Brazil, Russia, India, China, and South Africa. Now the new catch phrase is the “fragile five” and it refers to the emerging economies of Turkey, Brazil, India, South Africa and Indonesia as economies that have become too dependent on skittish foreign investment to finance their growth ambitions. The term has caught on in large degree because it highlights the strains that occur when countries place too much emphasis on stoking fast rates of economic growth.

Actually, the emerging market turmoil may be working in the Fed’s favor. Investors concerned about emerging market risk are seeking out the safe haven of Treasury bonds, bidding up prices and pushing down yields even as the Fed pulls back from bond purchases. But there are limits to how low the Fed can push emerging market currencies. The declines could come back to bite the developed economies of the US, Europe and Japan. Developing countries have served as engines of global growth, but now they find their purchasing power diminished and that equates to buying fewer exports. The direct effects of the recent emerging market foreign exchange turbulence, if contained, are not likely to prove substantial, but that’s based on the idea that things don’t deteriorate from here.

It makes for challenging times for the central bankers of emerging economies. The flight of foreign capital, which is a primary reason for the currency declines, is a result of investors’ putting money back into developed countries as their economies improve. To counteract the outflow of capital, the policymakers lure investors with higher interest rates but higher rates put the brakes on economic growth. And currency investors know this and bet that the central banks won’t be able to keep rates high for long. Sure enough, in today’s case of the Turkish central bank, the currency sharks smelled blood and they killed off the policymakers last vestiges off credibility.

All the blame for the problems in Turkey can’t be laid at the feet of the Fed; the Turks had a big mess before the taper. There has been an extensive corruption probe against the government and Prime Minister Erdogan responded by purging the judiciary and the police force.

The world can be chaotic at times, but we usually muddle through, except when it gets too crazy. Whenever we talk about emerging market turmoil, we’re reminded of 1997, when the Fed raised rates just a little and a few months later, the hot money went flying out of the developing Asian markets, then Russia defaulted, Long Term Capital Management missed that bet, and wham, bam, it was a meltdown man.

Of course, back then we didn't have hundreds of trillions of dollars in derivatives to contain the risk. Nowadays we have more than a quadrillion in derivatives to protect us. What could go wrong?

And that brings us to our next question of the day: what the heck is a MyRA?

Did you catch that last night during the State of the Union speech? A quick and stumbling reference to My-aye-aye-aye-RA. Obama promised to use executive action to create a new middle class savings vehicle, although he didn’t explain what it was. So, the White House issued a briefing sheet to explain that the MyRA, or My Retirement Account, is a new simple, safe and affordable “starter” retirement savings account that will be available through employers and help millions of Americans save for retirement. This savings account would be offered through a familiar Roth IRA Account and, like savings bonds, would be backed by the US government.

The administration noted that many private-sector providers don’t allow “smaller balance savers” to open accounts; providers who do allow such accounts often charge fees that can eat up a proportionately high percentage of their balances. In his address, Obama described the myRA as “a new savings bond” that “guarantees a decent return with no risk of losing what you put in.”

Today, Mr. Obama signed a presidential memorandum to create the "myRA" program, which he told employees would go toward "making sure that after a lifetime of hard work you can retire with some dignity." The retirement accounts can be opened with as little as $25, and monthly contributions can be as little as $5, automatically deducted from paychecks. The program will operate like a Roth IRA, so contributions would be made with after-tax dollars. That means account-holders could withdraw the funds at any time without paying additional taxes.

The funds would be backed by US government debt, similar to a savings option available to federal employees, and earn the same variable interest rate return as the Thrift Savings Plan Government Securities Investment Fund accounts that federal employees enroll in. Investors could keep the accounts if they switch jobs or convert them into private accounts, and once the account reaches $15,000 funds must be withdrawn or it can be rolled over into a private sector Roth IRA. Treasury Secretary Jack Lew will be in charge of setting up the program and it should be available through some employers by the end of the year. Workers can invest if they make less than $191,000 a year. Businesses will not administer or run the accounts. They will simply offer them to their employees if they decide to participate.

There are still some details of the plan that are not quite clear. The Federal Thrift Savings Plan caps contributions to 10%, and there are rules on what investments are made. Already we are hearing the loons come out with conspiracy theories. This is not – repeat NOT – an effort to confiscate existing IRAs. It is a little like the old Savings bonds that you used to buy, which were actually a decent deal; not a big wealth builder but a decent savings vehicle.

There was plenty more to the State of the Union speech, but you probably slept through that part, so I’ll give you a quick recap: The state of the union is absolutely fantastic for the top 1%, and for about 25% it’s decent, and for the rest of the country things are pretty lousy. Fifty years after the declaration we can now announce that the War on Poverty has been won. The poor and the middle class have been defeated. 

Tuesday, January 28, 2014

Tuesday, January 28, 2014 - If I Had a Hammer

If I Had a Hammer
by Sinclair Noe

DOW + 90 = 15,928
SPX + 10 = 1792
NAS + 14 = 4097
10 YR YLD - .02 = 2.75%
OIL + 1.50 = 97.22
GOLD - .80 = 1256.70
SILV - .13 = 19.66

The State of the Union is… tonight.

President Obama will describe how he will use his pen and phone to overcome the Do-Nothing Congress, and the Republicans have ironically lined up not one, but three responses to refute the idea they are nothing more than obstreperous obstructionists.

Everybody from the Pope to the big wigs in Davos have been talking about inequality and it will likely be a major theme in tonight’s speech. Job and wage growth has been broken since the 1990s. Median family incomes grew very slowly from 1979 to 1999, peaked that year, and have fallen 13% since. The economy has recovered since the near financial meltdown of 2008, but it has been the weakest recovery since the Great Depression, and one of the reasons it has been such a slow recovery is that the spoils of recovery have been unevenly distributed.

Even though we have seen job growth in the past 54 months, 6 of the 10 fastest growing job categories are in low paying service sector positions, such as retail clerk and home health care aids. Middle class income is sinking; the ranks of the poor are rising; and the economic gains only go to the top, or 95% of all economic gains in the “recovery” have gone to the top 1%. For the fourth year in a row, the real median weekly earnings for full-time workers fell slightly. Profits, on the other hand, have been putting on a show. As a share of national income, corporate profits were 14.6% in the third quarter of 2013, the most recent quarter for which we have data. In the history of these data going back to 1947, there was only one quarter higher than that, the last quarter of 2011.

These trends are moving in opposite directions but they are related. Profit is simply revenue minus expenses, and so there are two ways to grow profits: increase revenue or cuts expenses. Profits have been propelled by squeezing costs rather than growing demand. The strength of profits is directly related to the weakness in hourly wages. In a normal business cycle, you would expect profits to increase before wages. During the good times, we tend to get fat and lazy. During a downturn, businesses get lean and mean and they start running at high productivity again. But that hasn’t happened. Real compensation has grown more slowly than productivity.

One way to look at this is to compare labor costs against the unit profit costs, and even after accounting for increases in productivity, profits have outpaced workers earnings. Compensation net productivity growth is up about 10% since 2000, while profits net productivity growth has doubled in the same time.

In the US, there is no job security. The share of working age Americans holding jobs is now lower than at any time in the last 30 years, and three-quarters of those working people are living hand to mouth. Advances in technology are just going to make job prospects even more challenging. A recent McKinsey Global Institute survey found that 230 million service jobs representing some $9 trillion in salary globally could be transformed by computers by 2025. Forget about outsourcing manufacturing jobs overseas, the robots are coming.

So, there is really nothing to drive wages higher because demand for jobs outweighs supply of jobs. It is hard to demand higher wages when your replacement is filling out an application in the lobby, or when your replacement is a robot.

So, in addition to a pen and a phone, the President has a bully pulpit, and he will use it tonight. It remains to be seen if he will use it to put important ideas in people’s minds by shaping public discourse. We know he's going to talk about economic inequality, as he should. He will probably mention worker salaries, which haven't risen in 30 years.

One of the ideas we will hear tonight is the President will to use an executive order to raise the minimum wage in new federal contracts.  The order about the minimum wage and federal contracts will raise the pay from the national minimum of $7.25 an hour to $10.10 an hour. The change applies only to new federal contracts, and not to renewals of existing agreements. So, he’s using a pen and a phone to raise the minimum wage, but nobody will see an increase in their next paycheck.

And for college age students, who you might expect would raise a ruckus about all the inequality, well they don’t have jobs; they do have mountains of student debt and so they don’t dare take to the streets. Besides, nobody really thinks you can change government anymore. Pete Seeger is dead and nobody can find a hammer, much less figure out how to use a hammer. Cynicism is stifling, not motivating. It’s hard to get people worked up to change something that seems irreparably dysfunctional. Maybe we’ll just have to wait until the whole mess to topple under its own weight. And things right now are pretty lopsided. Even the high rollers at Davos acknowledged that just 85 people now hold as much wealth as 3.5 billion people.

Whatever the economic costs of inequality, the social costs are even greater. Research shows that unequal economies are more fragile and prone to financial crisis and that they have higher levels of social unrest, poor health, anxiety and a host of other problems. Inequality also reduces social mobility—the very foundations of the American Dream—and it’s a voting issue. A new Gallup Poll shows that two-thirds of adults are dissatisfied with wealth distribution in the US. It’s also a global problem and it is certainly at the core of the volatility we’ve seen in emerging market economies in the past couple of weeks.

The problems in emerging markets are not just related to the monetary policy of central bankers, although that is a big part of the equation; the problems are related to economic inequality and subsequent political problems which tend to crop up when there is economic inequality. After 5 down days on Wall Street, you might think the markets were waking up to the problems; then we have a modest gain and we are lulled into a sense of complacency. The financial markets in 2012 and a much of 2013 were moving in lockstep, in a “risk on-risk off” pattern, with high yielding emerging markets as the preferred “risk on” trade. Investors were chasing yield and finding it in emerging markets, where the yield was much higher than here, where the Fed has engineered negative real yields.

And in our complacency, we might have overlooked the similarity in emerging markets today with the similarities of 1997.  In the 1990s Asian crisis, the rapid withdrawal of hot money triggered combined liquidity and exchange rate-regime crises. Then and now, capital flight merely served to exacerbate homegrown problems. The initial flight of capital needn’t be prompted by a crisis anywhere at all. It might simply be a ‘rotation’ of short-term capital from one set of opportunities to others elsewhere: game over, move on. That means that as emerging countries tried to enter into the global economy, they set up to allow capital to flow in with ease, which also meant capital could flow out with ease. Emerging market economies that had nurtured reasonably liquid domestic capital markets were among the worst hit.

Even though the Fed’s taper talk sent a shudder through emerging markets last year, at least as big a culprit has been slowing growth in China, since lower demand for commodities hits many smaller economies hard. China is trying to engineer a transition from an export/investment driven economy to a consumer oriented one, and no country has managed that transition smoothly. Even worse, China’s consumption share of GDP has generally been declining in recent years.

Remember that Lehman, which had a large emerging markets desk, nearly went bust in the 1997 Asian markets crisis. Our big banks now look better diversified, but if a large bank bet wrong on enough trades, it could take a meaningful hit to its balance sheet. And more weakly capitalized Eurobanks are less able to sustain this sort of blow well. So while the emerging markets wobbles may not evolve into a full-blown crisis, it’s likely we’ll have a sustained period of roller coaster volatility before conditions stabilize.

There have been 14 Federal Reserve Chairmen; Janet Yellen is about to become the fifteenth. The transition of the Chair is cause for some trepidation. Market makers rightly wonder about the direction of monetary policy and the markets may act in a skittish manner. The first year of a new Fed Chair is not necessarily bad for the markets. By a 9 to 4 ratio, the first year of a new Fed chair leads to positive gains in the Dow Jones Industrial Average. The most recent and notable exception being the first year under Alan Greenspan (1987), where the Dow tanked more than 30% and finished the year down about 20%. Under Paul Volker, the Dow was volatile, with significant moves from negative to positive territory, but after one year of trading under the guidance of Volker saw the Dow in positive territory. Bernanke took the reins in 2006, which you may recall was a very good year for the Dow. Yellen? Well, time will tell.  Tune in tomorrow. 

Monday, January 27, 2014

Monday, January 27, 2014 - Sniffing Out Weakness

Sniffing Out Weakness
by Sinclair Noe

DOW – 41 = 15,837
SPX – 8 = 1781
NAS – 44 = 4083
10 YR YLD + .04 = 2.76%
OIL - .94 = 95.70
GOLD – 12.50 = 1257.50
SILV - .22 = 19.79

Last week was rough for the Dow Industrial, and today started with the blue chips in the red but not by much; it even looked like we might finish in positive territory. Nahh. The markets have been trending downward over the last week due to a mix of concerns. Emerging market strains, anxiety over tapering by the Federal Reserve, and weak manufacturing data from China likely contributed to a pullback. Also, new home sales were weak in December.

The international problems started with a report that Chinese manufacturing may contract for the first time in 6 months. Then Argentina’s central bank limited dollar sales to preserve international reserves that had fallen to a seven-year low. Then there were concerns about a default in the shadow banking system in China. Then there concerns about a corruption scandal for Prime Minister Erdogan’s cabinet in Turkey. Protesters occupied municipal buildings in the Ukraine. Then the South African rand dropped big. Then the whole thing spread. I don’t know what happened in Mexico but the peso took a hit. Bank of America analysts recommended buying the Mexican peso on Nov. 24 as one of their top two Japan-related trades for this year, predicting a rally that would have boosted the currency’s value to 8.4 yen. Instead, the peso slumped 3.5% last week. More than a third of the most-traded emerging-market currencies have already fallen below forecasts.

Neither China, Turkey, Argentina, nor any other country has anything to do with consumer stocks, or most other equities, badly underperforming following an excellent year for the US stock market which was supposed to help consumers through the wealth effect. If you haven’t received your trickle down just yet, don’t hold your breath.

Tech stocks, which by extension are a type of consumer stock, have started to look weak, after being so strong last year. After the close today, Apple whiffed on earnings because they really whiffed on iPhone sales. The company reported that it sold 51 million units, a 6.7% jump in sales, year-over-year, which is lower than sell-side expectations of 54.7 million. The good news is that Apple beat expectations on the top and bottom line, despite weak iPhone sales. Revenue was $57 billion, up 5.6% on a year-over-year basis. EPS was $14.08, up 2% year-over-year. If the market is going to catch a second wind, don’t look for tech, at least not tomorrow.

Has the correction begun? Check back in a few months and we’ll know for sure. If you don’t want to wait that long I understand; waiting for clarity is risky, and we all know you can’t go broke taking a profit. So, some folks are looking at this as a chance to get out while the getting is good. At the very least, make sure you have a prevent defense in your portfolio playbook. And then there’s the whole January Barometer, which posits that as January goes, so goes the rest of the year. We know that January has been ugly, and if you need further confirmation, the financial press has been clinging to thin straws in their never-flinching belief that any decline is a buying opportunity.

A core principle of both fundamental and technical analysis is "a rising tide lifts all boats." If the economy is strong and growing, the vast majority of companies should benefit. We should expect to see this show up in both quarterly earnings reports and higher stock prices. And when prices don’t move higher, that might be an indicator that the financial markets are sniffing out economic weakness in advance. When it comes to the possible end of a bull market though, we need to remember the real driver behind the move in the first place – the Fed. And the Fed is meeting this week to determine policy.

There’s growing evidence that things aren’t as good as the Fed anticipated, but I don’t think we’re at the point where the Fed is going to pull back and stop their tapering, and they certainly won’t reverse the taper. The Fed will probably cut its purchases in $10 billion increments over the next six gatherings before announcing an end to the program no later than December. Treasuries fell today, pushing the 10-year yield up from almost a two-month low.

The state of emerging markets has very little impact on the Fed’s decision to continue taper. Charles Plosser, president of the Philadelphia Fed, said in a January 14 speech: "When we started QE ... there were many economies and emerging markets and other places that were very critical of our policy. Now that we're trying to stop it, they've been very critical of our policy."

Minneapolis Fed President Narayana Kocherlakota, a voting Federal Open Market Committee told the New York Times there are other ways to offer accommodative monetary policy, other than buying bonds. He talked about the Fed providing forward guidance, which is a far cry from cranking up the printing press. And just for the record, Kocherlakota is one of the Fed guys who thinks the Fed needs to do more to expand its efforts to reduce unemployment.

Now that the tapering has begun, the idea of less Federal Reserve stimulus combined with slower Chinese growth and specific concerns in some countries led last week to a full-scale flight from emerging-market assets that could continue this week. Emerging markets have been inflated in recent years by huge amounts of cheap cash created by the Federal Reserve, much of which found its way into developing economies in the hunt for better returns. If it all seems vaguely familiar, it’s because it looks a lot like the wildfire that spread through the developing world and resulted in currency runs that hit the Asian Tiger economies, or Russia,  or Latin America.

There are a few reasons for concern about this latest conflagration. The scale of money that has moved to developing markets over the past decade and now dwarfs the sums which fled in panic 15 years ago. Lending into emerging markets has increasingly been through bond markets, rather than in the direct bank loans that dominated previously and which involved longer-term relationships between banks and the firms and countries. And the growth of index tracking exchange traded funds over the past decade has increased the liquidity and also the volatility, meaning money that flowed in can flow out very, very, fast. Emerging markets have attracted about $7 trillion since 2005 through a mix of direct investment in manufacturing and services, mergers and acquisitions, and investment in stocks and bonds. That was considered hot money, stoked by the Fed’s QE.

The State of the Union is…tomorrow. The State of the Union speech will likely be light on legislative agenda and long on optimism. We have a budget, there probably won’t be another government shutdown, at least until October; there is a chance for immigration reform, maybe. And that’s about it. Don’t look for big legislative vision because it won’t happen. There is an election later in the year and so lawmakers will be yelling at each other for most of the year and trying to highlight their differences rather than creating consensus. That means tomorrow’s speech will likely be long on optimism and framing the national conversation.

These annual updates have become more and more predictable, and less and less inspiring. There will be a new piece of technology; the President’s communications team is urging us to watch what they call the “Enhanced State of the Union” online with a live stream of the address and a split screen format with graphics and charts to highlight key points and statistics. Well, that should be fun. The site is

One chart you won’t see comes today from the Green Party in the European Parliament; it estimates the cost of the implicit guarantee that governments will back large financial institutions, known as “too big to fail”; the price tag in 2012 was 234 billion euros. That is the corporate welfare dished out to big banks in the form of free benefits. The estimates were based on eight academic and institutional studies focused on implicit subsidies. Most of the studies arrive at a figure by quantifying the lower lending costs that large financial institutions enjoy from the market because of governments’ willingness to prop up failing national financial institutions, called the funding advantage approach. Others use a more complex option-pricing theory model.

There may actually be more costs than the studies have calculated. Government backing also creates moral hazard, or the willingness of banks to take outsize risk, knowing there is a lender of last resort. At the World Economic Forum meeting in Davos, Switzerland, last week, Mario Draghi, president of the European Central Bank, said he did not know whether any banks would need to be closed as a result of the central bank’s examination but that the system was prepared to deal with the consequences if any significant problems materialized. Draghi said, “The banks that should go, should go.”

Yea, you won’t hear that in the State of the Union speech, or in the response.

Friday, January 24, 2014

Friday, January 24, 2014 - Bulls, Bears, and Bonuses

Bulls, Bears, and Bonuses
by Sinclair Noe

DOW – 318 = 15,879
SPX – 38 = 1790
NAS – 90 = 4128
10 YR YLD - .04 = 2.73%
OIL - .41 = 96.91
GOLD + 4.40 = 1270.00
SILV - .11 = 20.01

The Dow has fallen every day this week, leaving it down more than 3%. That decline is the Dow's worst weekly performance since mid-May 2012. Meanwhile, the S&P 500 is down 2.5% since last Friday. That's the index's worst weekly slide since early November 2012.

All of the sudden, everybody seemed concerned about political and economic problems in Turkey, Argentina, and of course, China. The Turkish lira hit a record low and the South African rand fell to five-year low against the dollar. The Argentine peso had its sharpest decline in 12 years, going back to the 2002 financial crisis in that country; and the government abandoned its long standing policy of intervening to support the peso currency. Such moves are crucial factors for big, institutional foreign investors because exchange rate losses can easily wipe out any gains in stocks and bonds of emerging countries.

Right now, the losses haven’t turned into a rout, but there is concern that the turn may push big institutional investors to cut losses and run as the effect of falling currencies becomes too painful to bear. Every emerging market crisis is first-and-foremost a currency crisis. For example, South African government debt was slightly positive in rand terms in 2013. But in dollars terms, it lost more than 18%. Fund tracker EPFR estimates emerging equity and bond funds have seen outflows of almost $5 billion so far this year, on top of $58 billion of losses seen in 2013. EM equity funds have had 13 consecutive weeks of outflows, the longest run in 11 years.

What we haven't seen in emerging markets is major currency devaluation, a run on government debt or ratings downgrades. Any combination of those would suggest a major move where developing countries could experience sudden stops in their access to global capital, or some event that throws economies into a balance of payments or financial crisis. What we have seen and might continue to see is emerging market currencies falling, possibly big drops, as the yield on the 10 year Treasury note moves higher; which is expected to happen as the Fed cuts back QE3.

For several years, the world’s emerging markets seemed to be the main beneficiaries of two global trends: very rapid growth in China and the Federal Reserve’s various accommodative monetary policies, which injected huge amounts of capital into global markets. Since the Fed officially announced in December that it would ease its bond-buying stimulus, investors in emerging markets have been cautious. There are fears that rising interest rates will choke off growth in countries dependent on foreign lenders.

And for many years emerging markets have been able to sell resources to China, as China emerged as the world’s biggest producer and biggest market for everything from steel to coal to cars, the demand from China for raw materials soared year after year. Investors have committed tens of billions of dollars to emerging market projects aimed at meeting China’s voracious demand, and now Chinese demand is softening. Chinese economic growth slowed to 7.7 percent last year and the latest surveys of manufacturers in China show that with the exception of a few exporters, expectations about future sales are falling. The result in recent days have been waves of cash flowing out of emerging markets and into industrialized countries, notably the United States; but the  money has been going into the safe haven of Treasuries, rather than into the stock market.

It was just a few days ago that most people were bullish. Even the Fed’s taper at the December meeting was hailed as proof that the economy was improving. Earnings season has been less than exciting but we haven’t had massive misses, except for maybe IBM, Best Buy, Coach, Intel, Citigroup, and a few others; but nothing out of the norm. For the most part, Wall Street continues to pump up expectations, and there are still a few high flyers like Netflix, even if they are selling at 326 times earnings with almost zero in actual free cash flow. The Fed FOMC meets next week to determine their next moves on monetary policy and they are expected to continue with more tapering. Equities on Wall Street seem to have been shaken by the same fears that have hit the global equity markets; or maybe that’s just an excuse for a long overdue pullback. Your guess is as good as anybody.

In a TV interview today, Attorney General Eric Holder said no American financial institution is too large to indict and no bank executive immune from criminal prosecution. Holder cited the case of JPMorgan, which in November agreed to a civil settlement under which it would pay $13 billion to end a series of government investigations into its sales of toxic mortgage backed securities. It was an interesting case for Holder to cite because you may recall JPMorgan was not indicted and no major JPMorgan bank executives have faced criminal prosecution.

In December, Holder said the Justice Department plans to bring civil mortgage fraud cases against several financial institutions early in 2014, using the JPMorgan case as a template. Civil not criminal. Today, Holder said: "There are no institutions that are too big to indict," and "There are no individuals who are in such high level positions that they cannot be indicted, criminally investigated." Holder’s timing is delicious.

Jamie Dimon, JPMorgan’s chief executive, just got a big raise. Dimon’s pay increased to $20 million for 2013, up from $11 million the year before. The bank’s board of directors approved the increase even though a steady stream of scandals and a raft of regulatory actions have in recent months cast doubt on Dimon’s leadership at the nation’s largest bank. The big raise for 2013 came in the face of opposition from a vocal minority of board members.

Over the course of the year, the bank agreed to a series of high-cost legal settlements, including the $13 billion claim. Dimon led JPMorgan while it committed what government investigators have identified as over 15 frauds, most of them massive. These frauds represent the greatest financial crime spree the government has ever identified. In January of last year, the Federal Reserve and the Office of the Comptroller of the Currency imposed sanctions on the bank for weak risk and financial controls, as well as deficient safeguards against money laundering and violations of the Bank Secrecy Act, over the 2012 derivatives loss; total legal expenses topped the $20 billion mark.

The bigger the frauds committed by JPMorgan under Dimon’s watch, and the larger the settlements, the greater the value that Dimon brings by way of getting the government to settle cheap, and not tear down the bank and put people in jail. JPMorgan’s board must be really satisfied with Dimon’s ability to negotiate a deal with regulators. The directors don’t bear the cost of Dimon’s bonuses. Dimon negotiations with the government ensure that the shareholders bear all the losses of the obscenity of giving Dimon a raise to reward the crime spree that occurred while he was both the CEO and chairman of the board of JPM.

The regulatory and prosecutorial response to JPM’s crime spree has failed to hold a single senior officer or director personally accountable either civilly or criminally. The officers who control the bank are delighted to use bank funds to negotiate deals in which there are large fines, but the government does not prosecute the officers or seek to claw bank their compensation and seek damages from them. The DOJ treats JPM as “too big to fail.” This means that the DOJ will never require JPM to pay the full cost of its frauds and disgorge the full extent of its fraud proceeds if doing so could even come close to creating a concern that JPM would lack adequate capital. This gives Dimon a crushing negotiating leverage.

Holder has zero prosecutions of the elite bankers whose frauds drove the worst financial crisis since the Great Depression. Holder has zero civil cases, and the banking regulators have zero enforcement actions, that bankrupted an elite bank officer or director whose frauds helped drive the crisis. JPMorgan, Washington Mutual, and Bear Stearn’s boards of directors made the officers who led the frauds wealthy for over a decade through their compensation and bonus deals.

So, I’m not sure what Attorney General Holder was really talking about. There are no criminal indictments; JPMorgan has violated multiple laws with impunity; Jamie Dimon gets a big bonus.

Meawhile, the Financial Stability Board, which coordinates regulation for the Group of 20 leading economies, is reported investigating manipulation in the foreign exchange markets, or Forex, and is working on a reform of interest rate benchmarks after the Libor interbank rate-fixing scandal. Britain's Financial Conduct Authority (FCA) and the US Department of Justice have been investigating allegations that traders at some of the world's biggest banks manipulated the largely unregulated $5 trillion-a-day foreign exchange market. In the foreign exchange probe, groups of senior traders are alleged to have shared market-sensitive information relevant for London fix, which is set at 4 p.m. London time, using actual trades.

Just a reminder that so far, we haven’t fixed anything, and everything, every market is rigged. 

Thursday, January 23, 2014

Thursday, January 23, 2014 - They Must Think We’re All Morons

They Must Think We’re All Morons
by Sinclair Noe

DOW – 175 = 16,197
SPX – 16 = 1828
NAS – 24 = 4218
10 YR YLD - .09 = 2.77%
OIL + .47 = 97.20
GOLD + 26.30 = 1264.10
SILV + .22 = 20.11

We have economic reports to cover, some interesting news out of China; lots to talk about today. But what is the top story on most major news outlets? Justin Beiber was arrested in Miami for DUI and drag racing his Lamborghini from strip club to strip club. Seriously. We could spend the whole hour talking about it…, if we were brain dead. That is the biggest story in the country, because they must think we’re all morons.

This has been a very quiet week for economic data but today we got a few economic reports.

Initial jobless claims held steady last week at a nearly 2-month low as 326,000 people filed for first time unemployment benefits.

The Markit Flash US Manufacturing Purchasing Managers' Index (PMI) fell to 53.7 for January, its slowest growth in three months. A reading of 53.7 still indicates growth in manufacturing, and the researchers say we shouldn’t read too much into the report because cold weather has to play into the results. According to the economist from Markit: "After allowing for companies that saw production and sales disrupted by the cold weather, the rate of growth of output and orders remained as strong, if not stronger, than seen late last year.”

In another consequence of the weather, natural gas prices jumped more than 5% during yesterday's session, pushing prices to levels not seen since late 2011. This morning, it's close to cracking $5. The government cut its gas inventory forecasts. Also, gas delivery to consumers in New York and Boston set records yesterday as the most recent snowstorm buried the Northeast. Nat gas is a common way to heat homes, especially in the Northeast, and we’ve had some serious storms this winter.

If you’re looking for ways to trade the move, there are funds and ETFs; among the best known is UNG, which is not to be confused with a trade on the oil sector in general. There is a tendency to chase anything that moves fast. I don’t know where the price of nat gas will go from here; I do know the storms will pass.

The Federal Housing Finance Agency reported home prices ticked up 0.1% in November, and were up 7.6% from the year-earlier period. The National Association of Realtors reports sales of previously owned homes rose in December for the first time in 5 months, and capping the best year since 2006. A total of 5.09 million U.S. previously owned houses were sold in 2013 compared with 4.66 million the prior year.

The index of US leading indicators rose in December. The Conference Board’s gauge of the outlook for the next three to six months climbed 0.1 percent after a revised 1 percent gain the prior month that was larger than previously estimated. The report noted progress in the labor market, rising equity prices, rising home values, continued strength in consumer spending, and rising orders to manufacturers. Five of the 10 indicators in the leading index contributed to the increase.

The biggest economic report today came from China. Activity in China's factory sector contracted in January for the first time in six months. Weighed down by weaker domestic and export demand, the flash Markit/HSBC Purchasing Managers' Index (PM) fell to 49.6 in January from December's final reading of 50.5, dropping below the 50 line which separates expansion of activity from contraction. The reading points to a further slowdown in manufacturing and the entire Chinese economy, which then has implications for the US economy. Chinese leaders have pledged to push reforms to unleash new growth drivers as the world's second-largest economy loses steam, burdened by industrial overcapacity, piles of debt and soaring house prices.

And this has been another area of concern about China. China’s growth model appears to be built on a mix of investments and exports and debt; the dependence on debt has been producing diminishing returns. Lending has in recent years been the driver of growth, but each yuan of new borrowing now produces 1/4 the amount of GDP increase that it did five years ago, and now there are concerns about an imminent default in its shadow banking system, or investments made off balance sheet.

The Chinese cabinet is seeking to increase government oversight of lending by companies that currently face little or no supervision. The shadow system has grown in recent years because the Chinese government has too tightly controlled traditional banking. It keeps the interest rates that conventional banks pay to depositors extremely low and gives out cheap loans to state-owned enterprises and favored companies that might not be able to repay the money.

And now it looks like one of those companies might not be able to repay. The China Credit Trust Company has told investors that it may not make a January 31 repayment on what would amount to the equivalent of about $500 million; that’s a big chunk of money but not a scary number, in itself. The problem is that nay significant defaults could shatter the widespread assumption that off-balance-sheet investments carry an implicit guarantee from state banks and their partner institutions. Regulators have warned that investors must assume the risks from high-yielding investments and not expect protection from losses unless such guarantees are explicit. Local governments have largely ignored these injunctions and have stepped in repeatedly in recent years with bailouts for local firms facing default on corporate bonds and trust loans.

The low rates, of course, have led savers to invest money in speculative real estate projects or dubious investments known as wealth management products offered by banks and finance companies that promise higher rates of return. Much of that money is then lent to private businesses and local governments, which cannot get conventional bank loans because regulated banks are required to give preferences to state-owned companies.

If there is a credit crunch, it would be very different from the Lehman contagion we experienced 5 years ago, and so we probably won’t see any Western style back crashes because the financial system is still an arm of the Chinese government. So, it will likely end in an entirely different way, and we’re not sure what that is.

Next week, the Federal Reserve FOMC meeting will take center stage. It will be Ben Bernanke’s final FOMC meeting. And although we see signs of an improving economy, (or as the Fed said: “cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions.")  We have also seen a wobbly start to the trading year on Wall Street; and this came on the heels of the December FOMC meeting in which the Fed announced the first stage of tapering, curtailing asset purchases by $10 billion per month to just $75 billion per month. There is consensus that the Fed will take the next step in tapering next week; announcing an additional $10 billion a month in asset purchases.

The thinking has been that if things get bad, the Fed will simply ride to the rescue by postponing the taper and resuming or increasing asset purchases. We have to start by looking at what it means by “bad”. Economically speaking, it would be bad if unemployment were to spike; another credit collapse such as we saw in 2008 would be  bad; an economic  meltdown of any sort, domestic or international (think China, at least for today) – that would be bad. How about a 10% correction on Wall Street?

Stock market corrections are common, and we are overdue for some sort of correction, just based on past performance. The Fed’s taper announcement may very well serve as a catalyst or just an excuse for a correction. So, will the Fed jump in to clean up?

Not likely. The Fed has set a new course, and they will most likely have to stay the course, at least for the foreseeable future. There has been a concerted effort to emphasize forward guidance as the primary policy tool. Backtracking now would undermine the Fed's credibility. The Fed might like to talk about the importance of its independence and any reversal of taper would be seen as political. And any backtracking would be a serious blow to the Fed’s economic forecasting abilities and the Fed’s credibility.

And then there is the idea that the Fed’s balance sheet has grown too large, too fast. Increasing asset purchases would be seen as increasing the risks of future imbalances given the surge in stock prices that coincided with prior QE programs. In other words, there is the concern that QE could lead to bubbles, especially QE without an exit date would surely end badly. And a final reason, backtracking on taper and jumping back into the markets might not work this time. Each round of QE has resulted in slightly diminished returns. What if the Fed announced new stimulus and it failed to stimulate?

If the Fed is compelled to go back to the QE well, though, the cyclical sectors would be at heightened risk of underperforming as optimistic expectations get wrung out of stock prices. But this would only happen if things get bad (a subjective term) and we would likely see that coming.

The economic data have remained supportive of the Fed's tapering announcement in December. The December jobs report was weak, but it will be revised. Investor expectations are that the economy is stronger; not really strong but certainly not as weak as it was. So the Fed will likely continue with the taper, slowly and surely. And if the economy falters or something melts down, well they still have some other tools in the tool belt.


It’s still earnings reporting season and the big report today came after the close of trade as Microsoft posted net income of $6.5 billion, or 78 cents a share, compared with $6.3 billion, or 76 cents a share, in the year-ago quarter.  Revenue rose 14% to $24.5 billion, partly reflecting the release in November of a new Xbox videogame console and a fresh version of Microsoft’s Surface tablet computer ahead of the holidays. The results topped analysts’ guesses. No word on a replacement for CEO Steve Ballmer, who has announced his retirement.

Treasury prices rallied today. In part it was a safe haven move, with the weak data out of China; maybe some rebalancing or even an old fashioned short squeeze. Mortgage rates fell, decreasing borrowing costs for homebuyers. The average rate for a 30-year fixed mortgage was 4.39 percent this week, down from 4.41 percent and the lowest since November. The average 15-year rate slipped to 3.44 percent from 3.45 percent.

I mentioned earlier that we had a couple of reports on housing today. The Federal Housing Finance Agency reported home prices ticked up 0.1% in November, and were up 7.6% from the year-earlier period. The National Association of Realtors reports sales of previously owned homes rose in December for the first time in 5 months, and capping the best year since 2006.

Another report shows that the housing recovery has reached a level where it is increasingly unaffordable. You guessed it, California topped the list. The salary you have to earn to  be able to buy the median home in San Francisco is just over $125,000 as of November, and the median cost of a home in San Francisco is somewhere between $705,000 and $813,000, depending on what data source you look at; best guess is that home prices in San Francisco are up 24% over the past year. San Francisco tops the list of the most unaffordable cities. Next are San Diego and Los Angeles – the California trifecta – then New York City, where a mere $71,245 in income suffices to buy the median home. Households earning the median income of $51,000, well, forget it.

The reason San Francisco tops  the list is fairly simple, the tech bubble has attracted billions in fresh money, and one reason it has gravitated to San Francisco is past history and also tax incentives handed out to tech companies.

San Francisco may be extreme, but housing bubbles are now re-cropping up across the nation – and so are the very factors that helped inflate the prior housing bubble and then magnified the ferociousness of its implosion.
Helocs, or home equity loans, were up 30.8% in the first nine months of 2013 from prior year and are expected to reach $60 billion for the year, the highest level since 2009 when the market was in collapse mode. But it’s still a far cry from 2006, when such loans hit an all-time crazy record of $430 billion. Using the home as an ATM cranks up consumer spending. If the money is plowed back into the house, such as remodeling a bathroom, it adds some value to the house and lowers the risk of the loan. If it is used to buy gadgets, cars, or vacations, it still cranks up the economy in the US and other countries. But when home prices decline, homeowners and banks get slaughtered.

Also, the housing boom has seen the return of creative financing. Interest only home loans are back and they’re especially popular for jumbo loans. In a number of high-cost counties, including San Francisco, these are loans over $625,500 that banks can’t sell to Fannie Mae and Freddie Mac but have to keep on their balance sheets. Bank of America said that 36% of its fourth-quarter mortgages were jumbo loans, up from 23% in the first quarter. And adjustable rate mortgages, or ARMs made up 22% of all purchase loans in December, up from 11% in December 2012, the highest ratio since July 2008.

The result of higher prices has been slowing sales. In December sales volume was down 17.7% in San Francisco and 12.7% in the Bay Area from a year earlier. In California, volume dropped 12.1% to 34,949 sales, the worst December since 2007 – and 19.7% below the average for all Decembers since 1988.

In Palo Alto, at the center of the techie induced price hikes, home prices are now 40% above the prior bubble peak. But don’t call it a bubble, it’s a housing recovery, at least until it pops.