Thursday, April 24, 2014

Thursday, April 24, 2014 - The Bridge From Bubbles to Prosperity

The Bridge From Bubbles to Prosperity
by Sinclair Noe

DOW unchanged 16,501
SPX + 3 = 1878
NAS + 21 = 4148
10 YR YLD unchanged 2.69%
OIL + .46 = 101.90
GOLD + 10.20 = 1294.90
SILV + .20 = 19.75

The Dow closed unchanged. That is just one of those freaky things that happens every few years. I remember it happened in 2008, and 1998 and 1996. I’m fairly sure there were other days where the Dow closed unchanged. I don’t know if there is any particular significance.

Orders to factories for durable goods rose 2.6%, adding to the 2.1% rise in February. The back-to-back gains followed two big declines in December and January, which had raised concerns about possible weakness in manufacturing. The earlier declines, however, were likely tied to bad winter weather.

On the jobs front, the number of people seeking unemployment benefits jumped 24,000 to a seasonally adjusted 329,000 last week. The four-week average of weekly unemployment claims decreased to 316,750, which puts us back to 2007 levels.

The big earnings report today was Microsoft, which posted income of $5.6 billion, or 68 cents per share, compared with $6 billion, or 72 cents, in the year-ago quarter. They beat estimates of 63 cents per share, but take it with a grain of salt; the estimates started the quarter around 80 cents per share.

Yesterday we talked about a tech bubble, and whether we were in one or not, and we looked at comments from Greenlight Capital manager David Einhorn; he says there is a bubble but it doesn’t necessarily mean the bubble will pop any time soon.

Today, Warren Buffet weighed in on whether stocks are too frothy. Buffett says, “we’re in a range, and it's a big zone always of reasonableness." He went on that "Stocks will become worth more decade after decade, not in any precise manner, not in an even manner or anything of the sort, but 10 years, 20 years, 30 years from now, stocks will be worth more than they are today."

A friend stopped by this morning and asked about bubbles; apparently this is a hot topic these days. How do you know you’re in a bubble? The most obvious answer is when it pops, but there are more helpful ways to address the issue.

The first indicator is that prices spike; a parabolic increase in prices. From March 1999 to March 2000, the Nasdaq rose 110%. Think of an airplane that climbs too fast; it stalls out, rolls over and plummets to the ground; same thing in most markets.

The next thing to watch is valuation. Prices can go up very fast, and if valuations also go up fast, we call that “growth”. When prices go up but valuations lag, we call that a divergence, and a bubble in the making. For stocks, this means that earnings need to keep pace with price.

Back in 2000, the P/E passed 44 based upon inflation adjusted 10 year average earnings, or what’s known as the Shiller P/E; now the Shiller P/E stands at 16. However, for some sectors, we are seeing a divergence; the P/E for internet stocks is up around 47. The P/E for utility stocks is 19, but that is significantly above the historical median of 16. One reason for that divergence might be the recent spike in natural gas prices combined with investors chasing dividend yield. A parabolic spike is relative to the underlying asset, which makes it a bit more difficult to identify, but some examples are not tough to spot.

Look at the spike in Bitcoin about 6 months ago; it went from around $150 to almost $1200 in about one month, and its underlying value was impossible to quantify; that was a bubble. It popped. Remember when gold prices jumped up in spring of 2011? Pop. How about bond prices right now in Spain and Italy? Up 1.1 percentage points in 12 months and just slightly above comparable US Treasuries. It might be a parabolic price increase in combination with a divergence from the underlying asset; or maybe it says something about US Treasuries. You decide.

Of course, the valuation of the underlying asset can change very quickly due to an exogenous event. For example, if Russia shuts off nat gas supplies to Europe, it would quickly change the underlying value of Italian or Polish bonds. When the tsunami hit Fukushima, it changed the value of nuclear sector stocks. When the Hindenburg exploded, it was a black swan event for manufacturers of dirigibles.

And then the other indicator to consider is the madness of the masses. As investors identify a price move, they jump in; when everybody has jumped in, there is no one left. Or as Joe Kennedy said in the winter of 1928: “You know it's time to sell when shoeshine boys give you stock tips. This bull market is over.” By the way, the shoeshine boy reportedly told Kennedy to buy stock in the Hindenburg.

So, markets can get frothy and remain frothy, prices fluctuate, and the market can remain irrational longer than you can remain solvent. Spotting bubbles is possible, but tricky; so it’s important to remember you won’t go broke taking a profit.

Some things seem pretty straightforward. You accept that some things will work in very specific ways. You drive over a bridge and you expect that bridge to not fall into the river below. Yea, good luck with that. A report, released today by the American Road and Transportation Builders Association, warned that there are more than 63,000 bridges in this country in need of urgent repair; the dangerous bridges are used some 250 million times a day by trucks, school buses, passenger cars and other vehicles.

 Pennsylvania led the list of structurally deficient bridges, with 5,218, followed by Iowa, Oklahoma, Missouri and California. Nevada, Delaware, Utah, Alaska and Hawaii had the least. Overall, there are more than 607,000 bridges in the United States, according to the DOT's Federal Highway Administration, and most are more than 40 years old, and more than 10% are considered structurally deficient.

States rely heavily on federal funds to pay for road and bridge projects. The Fed collects 18.4 cents-a-gallon tax on gasoline and 24.4 cents-a-gallon tax on diesel to fund the Highway Trust Fund, which then pays out to the states. The Highway Trust Fund may be insolvent by this time next year unless Congress extends a temporary funding measure which is scheduled to expire in September.

The American Society of Civil Engineers estimates it will take $20.5 billion annually to clear the bridge repair backlog, up from the current $12.8 billion spent annually. That’s just the backlog; to really make a difference, it will take an investment of $3.6 trillion by 2020 to keep the transportation infrastructure in a good state of repair.

Meanwhile, we’ve been watching the Fed’s quantitative easing plan for some time and wondering why it hasn’t really helped the broader economy; it has helped banks, but not much beyond Wall Street. This is not to say the large scale asset purchase program hasn’t had an impact; it has. There is fairly concrete evidence that it has led to lower long-term interest rates; which in turn helped lift some real estate markets that were battered after the housing bubble burst. Some real estate markets are downright hot. Home values in San Francisco and Honolulu are at least 20 times as high as estimated rents. In other words, prices have jumped up and there is a divergence with the underlying asset, which has the makings for a bubble, but that just a couple of markets.

The broader real estate market has experienced a slowdown in the recovery and one cannot help but wonder about the extent to which Fed actions to pull back on their large scale asset purchases is implicated in the said slowdown. When former Fed chair Bernanke set off the "taper tantrum" in a press conference in June of last year by pointing out that at some point, the Fed would start scaling back the LSAP, bond and mortgage rates spiked. The 30-year fixed-rate mortgage went up about a point around then from the mid-threes to the mid-fours and has stayed there.

The Fed has tried to explain away the housing slowdown on the bad winter weather, but that’s just part of the problem. The other part of the problem is that the housing recovery only helped recover lost equity, it didn’t help create equity. In other words, it was a recovery effort not a wealth creation effort.

Kind of like the situation right now with bridges. From the day President Eisenhower signed the Federal-Aid Highway Act of 1956, the Interstate System has been a part of our culture; as construction projects, as transportation in our daily lives, and as an integral part of the American way of life.  Every citizen has been touched by it, if not directly as motorists, then indirectly because every item we buy has been on the Interstate System at some point.  President Eisenhower considered it one of the most important achievements of his two terms in office, and historians agree.  Economists recognize that this enormous public works project helped propel the economy, and still does.

Right now, interest rates are low; they won’t stay low forever. Right now, people need jobs; a massive infrastructure project would provide jobs, especially for long-term unemployed workers. Putting more people to work would mean more money moving through the economy, increasing demand, improving productivity. It seems like a no-brainer, until you remember that the problem rests squarely with our elected officials. Maybe the Federal Reserve could stop its insane and ineffective large scale asset purchases; stop the helicopter drops over Wall Street and instead make helicopter drops of cash strategically, directly over about 63,000 bridges. 

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