Tuesday, June 17, 2014 - What Could Go Wrong?

What Could Go Wrong?
by Sinclair Noe

DOW + 27 = 16,808
SPX + 4 = 1941
NAS + 16 = 4337
10 YR YLD + .06 = 2.65%
OIL - .30 = 106.60
GOLD un = 1272.70
SILV + .09 = 19.86

The FOMC, the Federal Open Market Committee started two days of meetings today; tomorrow they are expected to announce more of the same. The FOMC is largely expected to taper its asset purchase program by $10 billion to $35 billion. Effective July 1, the Fed is expected to lower its asset purchases to $15 billion in agency mortgage backed securities (MBS) and $20 billion in Treasuries. The Fed is also expected to maintain its current forward guidance language on federal funds rate support; in other words, they will keep telling us that rates might increase sometime next year.

The committee is likely to make some upgrades to its description of the economic outlook in its economic projections. The committee will probably need to reduce its 2014 real GDP growth forecast to take into account the Q1 disappointment, and we can probably expect the committee to reduce its unemployment rate forecast and lift its inflation forecast slightly.

The consumer-price index climbed a seasonally adjusted 0.4% in May from a month earlier. It marked the fastest increase since February 2013 and doubled the pace of economists' forecasts. Excluding food and energy components, so-called core prices increased 0.3%, the fastest pace since August 2011. From a year earlier, core prices were up 2%, the most since February 2013, and now match the Fed's target.

Another inflation measure closely watched by the Fed, the core personal-consumption expenditure, has stayed far below 2%. Inflation at wholesale level unexpectedly dropped by 0.1% in May, but remember the PPI rose 0.6% in April, so this is just a leveling out process. Wage pressure remains stubbornly low and consequently, the pace of the economic growth remains uneven. In May, the real average hourly wage fell 0.2%. Real wages have fallen three straight months even as inflation has picked up slightly.

The average hourly wage for a typical American worker registered just $10.28 in May, adjusted for inflation and measured in constant dollars. The real hourly wage totaled $10.31 in June 2009, the last month of the 2007-2009 recession. This is part of a trend that stretches back about 30 years.

Still, with core prices up 2% on an annual basis, the Fed will need to address the topic of inflation tomorrow. Let’s hope they also mention the lack of wage gains.

Another report today shows housing starts posted a bigger-than-forecast 6.5% decline. Housing starts declined to an annual rate of 1 million units last month from 1.07 million in April. What’s more, permits for new construction fell by 6.4% in May to a 991,000 annual pace, the slowest in fourth months.

The situation in Iraq is still bad. The ISIS rebels are about 40 miles north of Baghdad and seem intent on the idea of attacking the capitol city. Or they might attack the major source of revenue for the ruling government, and that means oil. One of three major oil refineries has now fallen under control of ISIS; the other two are in Baghdad and the south and not considered to be threatened at this time. About 2.5 million barrels of oil a day are exported from Basra, Iraq’s main port, located in the south.

The world consumes about 92 million barrels a day, so that would be a major disruption, and it would not be surprising to see prices jump; with price levels increasing along with the severity of the given scenario, running anywhere from a few dollars per barrel to a worst case of $200 a barrel.

Not too long ago, Iraq was claiming that it would be producing 12 million barrels a day by 2017. That now seems a little too optimistic.  At best, the ISIS rebellion guarantees that any potential additional Iraqi oil output gains are not going to materialize in the near future. No oil companies are going to invest in Iraq until and unless the situation stabilizes.

Although the consequences for Iraqi oil production of what has happened so far appear to be minimal, all this comes at a time when the earlier and still ongoing conflicts in Libya and Syria have already disrupted nearly 2 million barrels a day in world oil production. If Iraq’s recent 3 million barrels a day was also taken out, we would be talking about a significant disruption in world oil supplies, and likely an oil price in excess of $150 a barrel.

The worst case scenario sees a regional conflict break out that pits the Middle East’s Shiites (Iran) against the Sunnis (Saudi Arabia), leading to a compromise of the Strait of Hormuz. Forty percent of the world’s exported oil is transported through this waterway.

And if that isn’t enough, focus you attention on Ukraine. Yesterday, Russia announced it was cutting off natural gas shipments to Ukraine; today an explosion destroyed one of Ukraine’s main pipelines for gas headed to Western Europe.

EU-brokered talks failed to reach a compromise between the countries, which remain far apart on a “fair” price for gas. Ukraine’s state-run gas operator filed a suit in an international arbitration court, claiming $6 billion in overpayment for gas since 2010. Its Russian counterpart filed a suit of its own, alleging unpaid debts worth $4.5 billion on gas delivered since 2009. Until these cases are resolved, Ukraine will receive only gas it pays for upfront, and must not impede the flow of gas destined for the EU, which gets around 15% of its gas via pipelines that pass through Ukraine. There is another pipeline running from Russia directly to Germany, but still, the global energy picture looks less and less stable.

On Friday we reported that Tesla, the electric car company started by Elon Musk, was freeing up its patents, making its technology available to competitors. Now Nissan and BMW are considering negotiations for cooperation on charging networks; basically using and enlarging Tesla’s existing network of 97 charging stations in the US. Nissan already produces the electric Leaf and BMW last week unveiled the electric i8 in Germany.

So, why design new chargers and invest in building a whole new infrastructure for BMW and Nissan drivers? The Tesla network already stretches from coast to coast and is expected to expand rapidly over the next year. And Tesla leads in battery technology, with a gigafactory planned to start production in 5 years, which will be the biggest battery making facility in the world, producing 500,000 lithium-ion battery packs per year; more than enough for Tesla and its competition.

SolarCity, the largest US installer of residential solar panels whose largest shareholder is entrepreneur Elon Musk, announced that it plans to acquire solar panel maker Silevo and expand into manufacturing with new panel factories, likely including the world’s largest high efficiency solar panel plants in New York. At a conference call announcing the move, Musk said: "We expect to have to install 10 gigawatts [of high-efficiency panels] a year. If you look at the current capacity in the world, we're not able to do that right now."

It's not just a supply question. Solar panel prices have been falling in recent years thanks to a production boom in China; and the panels getting produced, though cheap, aren't terribly efficient and prices have begun bottoming out anyway. Prices might start climbing soon. Government subsidies for renewables start getting phased out in 2016, and the political environment for rebooting subsidies remains unstable at best. Plus, recent moves by the US to slap tariffs on Chinese panels likely served as a catalyst for looking into building the Silevo plant.

According to a study by two professors at the Stern School of Business at New York University and one professor from McGill University, a quarter of all public company deals may involve some kind of insider trading. The professors examined stock option movements, when an investor buys an option to acquire a stock in the future at a set price, as a way of determining whether unusual activity took place in the 30 days before a deal’s announcement. They determined statistically that the odds of the trading “arising out of chance” were “about three in a trillion.” [...] But, the professors conclude, the Securities and Exchange Commission litigated only “about 4.7 percent of the 1,859 M&A deals included in the sample.”

The study also says: “While the SEC has taken action in several cases where the evidence was overwhelming, one can assume that there are many more cases that go undetected, or where the evidence is not as clear-cut, in a legal/regulatory sense.” Plus another finding from the abstract: “Historically, the SEC has been more likely to investigate cases where the acquirer is headquartered outside the US.”

A new survey by Greenberg Quinlan Rosner, on behalf of Better Markets, finds voters regard Wall Street and big banks as “bad actors. A 64% majority believes the “stock market is rigged for insiders and people who know how to manipulate the system. Another 55% believes “Wall Street and big banks hurt everyday Americans by pouring money into ’get rich quick schemes’ rather than real businesses and investments. A 60% majority favors “stricter regulation on the way banks and other financial institutions conduct their business” and just 28% oppose. Support for stricter regulations inspires bipartisan support; most notably voters who own stocks are more likely to support stricter regulation than voters overall. And there is urgency in the issue because 83% of voters believe another crash is likely in the next 10 years.

Monday, February 10, 2014 - Set the Tone

Set the Tone

by Sinclair Noe

DOW + 7 = 15,801
SPX + 2 = 1799
NAS + 22 = 4148
10 YR YLD + .03 = 2.69%
OIL + .12 = 100.00
GOLD + 7.90 = 1276.00
SILV + .07 = 20.18

A little bit of follow up to last Friday’s jobs report, which you recall came in at 113,000 jobs added in January and the unemployment rate dropping to 6.6%. There was a huge discrepancy between the household survey and the business establishment survey; the household survey showed 616,000 new jobs. The household survey can be a bit volatile and is considered less reliable. There is also a discrepancy between the establishment survey and a couple of earlier reports from ISM and ADP. The Institute for Supply Management services index came in at 56.4% in January, indicating a strong month for service jobs. The ADP, or Automatic Data Processing, employment report indicated 160,000 private sector service jobs were created in January, or about 100,000 more jobs than the government reported. It will be very interesting to watch revisions to the jobs report next month.

The major stock indices just loved the lousy jobs report, and this is a head scratcher for many people. Why would bad news on jobs be good news for stocks? Well, a weak job market gives employers the upper hand because most workers will accept lower wages, which translates into higher profits for corporate America. I know that is short sighted because the workers are also customers, but in the short term world of Wall Street, it makes sense.

The other reason is the Fed; and the Fed will likely continue its Zero Interest Rate Policy (ZIRP) as long as the labor market is lethargic. Continued low interest rates encourage corporations to borrow money to buy back their own shares, pushing up values and prices. Buy backs are the last refuge of innovation challenged companies unwilling to invest in research and development in favor of short-term stock performance.

The low interest rate environment also leads to a fairly straightforward comparison between stocks and bonds, with the nagging idea that low rates don’t pay anything now, and when rates go up, prices will go down. And finally, in a bad job market the Fed will be slower to back away from quantitative easing, and Wall Street just loves to see the free flow of easy money.

And so, we’ll all be watching the new Fed Chair, Janet Yellen this week as she goes before Congress for her first Humphrey Hawkins testimony tomorrow before the House and Wednesday before the Senate, and we’ll try to determine if the need for extraordinary measures has abated or not. Likely, we’ll hear something along the lines of, steady as she goes. Don’t expect any big changes, but as a new Fed Chair, she may set the tone a bit.

Before Yellen’s testimony tomorrow, House Republicans will hold a meeting tonight to address raising the debt ceiling. House Republican leaders will try to use the meeting to sell their members on voting for a bill that raises the debt limit but also reverses changes to military retirement benefits. Reversing these changes would add to the deficit, so Republicans would have to find ways to pay for it. One way Republicans are considering paying for the change is to extend the sequester for mandatory spending for one more year. Senate and House Democrats have been firm in demanding a clean debt limit bill — one without additional policy concessions.

There isn’t much time. On Friday, Treasury Secretary Jacob Lew said extraordinary borrowing measures aren’t likely to last past Feb. 27. And the House adjourns Wednesday so Democrats can go to their annual issues retreat. Lawmakers don’t return for a full workday until Feb. 26.

Earnings season has moved into its latter stages, with 54 S&P 500 companies expected to report results this week. Of 343 companies in the S&P index that have reported earnings through Friday, 67.9% beat Wall Street expectations against 67% over the last four quarters, and ahead of the 63% rate since 1994.

Of course, when you hear anything about earnings, you must take it with a grain of salt, or maybe you should just buy a great big salt lick. Public companies are notorious for lowering earnings guidance so they can claim to beat the easier targets. Toss in little tricks like stock buy backs and the earnings season looks less and less like a buying signal and more and more like a management ruse to increase already lofty pay levels.

The dark side of earnings season can be found in the revenue growth numbers. For 2013 it looks like the healthcare sector led the way for revenue growth, up 7.6%; consumer discretionary grew revenue by 3.8%; consumer staples grew revenue by 1.9%.  Industrials up 2.3% and utilities up 4.2%. Technology, the high-growth sector where American ingenuity is still leading the world, revenues rose just 5.4%. And telecom services eked out a barely visible 2.2% revenue gain. Not exactly breath-taking growth figures. Then there were the third and fourth largest sectors: revenues in the energy sector dropped 3.4%; and in the financial sector, they plunged 11.4%.

So, while inflation was 1.5%, the S&P 500 companies that have reported so far, all put together, triumphed with year-over-year revenue growth of 1%. Revenue growth was negative when considering inflation. And don’t forget that last year the S&P 500 was up nearly 30%; it was a great year, as long as you don’t look at top line growth, or lack thereof. Ingenious accounting is one element, financial engineering another. Corporations can borrow nearly unlimited amounts of money in the short-term markets and through bond sales, at little cost, thanks to the Fed’s policies, and load up their balance sheets with borrowed cash, that they then plow into share buybacks.

The doctored EPS growth, and particularly the analysts’ estimates for doctored EPS growth for distant future quarters is bandied about as illusory justification for the gravity-defying ascent of stocks. Eventually the double digit estimates for future quarters is ratcheted down right before earnings are reported, and then the companies can beat the diminished expectations.

Business success, as defined by growth in revenues and net profits and not by financial engineering and fabricated EPS, is crucial to the economy. But for a quarter of a century, corporate profits have been rising at a faster rate than GDP and are now “dangerously elevated by all reasonable measures.

Remember that $13 billion settlement JPMorgan Chase worked out with the Justice Department last November? At the time, we raised some questions about how the deal was worked out between JPMorgan CEO Jamie Dimon and Attorney General Eric Holder. The $13 billion was a record fine for a bank, but just a fairly small fine compared to JPMorgan’s profits, and even though the settlement does not release JPMorgan from potential criminal liability over the mortgages it packaged into bonds, Jamie Dimon seemed eager to act like the matter was a thing of the past; the board of directors at JPMorgan even voted him a big fat bonus, apparently for navigating the legal challenges.

Well, now the non-profit group Better Markets has filed a lawsuit against the Justice to block what it called an "unlawful" $13 billion settlement with JPMorgan Chase over bad mortgage loans sold to investors before the financial crisis. They say they are appalled that the settlement gave the bank "blanket civil immunity" for its conduct without sufficient independent judicial review. In effect, the DOJ acted as investigator, prosecutor, judge, jury, sentencer, and collector, without any check on its authority or actions. And because the DOJ has declared its intention to use the Agreement as a “template” in future similar cases, it is imperative that the DOJ’s unlawful and secretive approach in the settlement process be subjected to judicial review.  

In its complaint, Better Markets alleges the settlement with the bank lacks critical facts that can help justify the deal, such as failing to name any individuals responsible for the wrongdoing, how much damage investors suffered or even "which specific laws were violated."

Of course, this is not the only bad behavior by JPMorgan Chase. A confidential email has emerged that shows a top Chinese regulator directly asked Jamie Dimon, the bank’s chief executive, for a “favor” to hire a young job applicant. The applicant, a family friend of the regulator, now works at JPMorgan. The email was one of several documents that JPMorgan recently turned over to federal authorities as part of an investigation into hiring at the bank. Federal authorities are now investigating whether the hiring at JPMorgan and at least six other big banks, was done explicitly to win business from Chinese companies. The authorities could decide to bring charges against individuals or a bank if they find such activity to be in violation of anti-bribery laws, in connection with the Foreign Corrupt Practices Act.

In recent months five top insurance companies with headquarters in mainland China or Hong Kong have become JPMorgan clients, although there is no direct link between the hiring and the new deals. Until now, it was unclear whether any well-connected job applicants ever met JPMorgan executives in New York.

Meanwhile, the really big investigations are still underway. Remember the Libor rate rigging scandal?  Well maybe something will eventually happen there, but already the investigations have moved over to the Forex, foreign currency exchange markets. The British FCA, or Financial Conduct Authority, are heading up that investigation, as the Forex is centered in London; the FCA says 10 banks are now cooperating in the investigation into how Forex traders colluded in setting certain key exchange rates in the $5.4 trillion a day forex market. The FCA says the allegations are every bit as bad as they have been with Libor.