Wednesday, May 28, 2014 - Reflecting the Economy

Reflecting the Economy
by Sinclair Noe

DOW – 42 = 16,633
SPX – 2 = 1909
NAS – 11 = 4225
10 YR YLD - .08 = 2.43%
OIL – 1.03 = 103.08
GOLD = 4.70 = 1259.60
SILV - .01 = 19.13

The major stock market indices were lower, but it wasn’t a big move, and we’ve been 4 up days, so today’s pullback was nothing but a pause. What was interesting today was the move in the bond market. The yield on the 10 year treasury dropped all the way to 2.43%; that’s the lowest rate in almost a year. The 10 year treasury has dropped 22 basis points this month, meaning treasuries are on track for the best month since January. Now, remember that the Federal Reserve is supposed to be tapering, cutting back on large scale purchases of treasury bonds.  

What’s fueling the move? It’s hard to pinpoint one thing. Europe is facing some sort of monetary stimulus package from the ECB next week; meanwhile, a report showed German unemployment rose and that pushed yields on the 10 year bund to 1.28%; that trade then spilled over to the US markets, toss in end of month window dressing and there was likely a short squeeze. There are some big short positions on treasuries right now; more shorts than longs.

At the end of the day, the bond market is supposed to reflect the economy; not an exact image but rather a mirror image. And the US economy is probably not as strong as expected. Tomorrow, we’ll get a revised look at first quarter GDP. The initial estimate on GDP showed just 0.1% growth; a pathetic rate blamed on bad weather; the revision is expected to show the economy contracted by 0.6%, maybe worse. Since the recession ended in June 2009, US GDP growth has dipped into the red only once: the first quarter of 2011, when economic output contracted at a 1.3% rate. It appears likely to happen again. The economy was repeatedly disrupted by cold and snowy weather in the first quarter and much of the activity that did not take place then is occurring now during the warmer spring months. Wall Street expects second-quarter growth to snap back with a 3.8% gain.

But where will the springtime burst of growth come from? Exports? Not to Europe and not to emerging markets. The initial GDP report said net exports subtracted 0.83 percentage point from the GDP growth rate in the first quarter. It may be a bigger drag on growth in Thursday’s update. Construction? A bit, yes, but we continue to see the housing market looking soft. Construction lending is seeing a slow, steady recovery, but it remains 66% below its boom-era peak of $631 billion in outstanding loans in early 2008. Companies restocking their shelves? Not likely. Inventories subtracted 0.57 percentage point from GDP growth, according to the first estimate, and that could grow with this week’s revision; inventories remain high and consumer spending sluggish. Corporate profits? Yes sir that is an area of strength but it’s also a two-edged sword.

The Commerce Department is starting to release a new report on corporate profits. Pretax profits adjusted for depreciation and the value of inventories climbed 1.9% in the fourth quarter to a record $2.13 trillion on a annualized basis. Corporate profits as a percentage of GDP stood at 10.2% in the fourth quarter, just a touch below a record high. Corporate profits are now higher than they’ve ever been before.

Here’s the problem; whenever profit margins reach a high, they tend to peak and then rollover, with the stock market and the economy dragging behind in like manner. It’s tough to keep pumping out record profits, in part because profit margins often depend on cost cutting, not just revenue; there are limits to how much fat a company can trim and there are limits to how much a company can increase sales while simultaneously cutting back on R&D and capital expenditures. Right now, stocks are priced to reflect very high corporate profits. Any disappointment would shake that pricing structure and translate into big stock market losses.

Like any individual indicator, this is not an absolute. Corporate profit margins can remain at elevated levels anywhere from a single quarter to multiple years and don’t typically present an imminent warning threat to the stock market or economy until forming a major peak and sudden decline. Profit margins peak on average before the stock market by more than a year and before recessions by more than two years. It doesn’t work out this way all the time; in the early 70’s profits peaked with the market, and in the early 80’s profits peaked after the stock market, and it is possible that the lag time stretches out so far as to make the indicator more or less worthless.

The point is that there are other factors that must be considered. Think of profits as one measurement of the business cycle. So, despite the Fed taper, there is increasing likelihood that interest rates will remain low and possibly decline a bit; if rates decline, stocks are likely to move up with bonds, as we’ve seen can happen; and if falling long-term yields flatten the yield curve, that would increase the risk of a market crash. In a low-yield, low inflation environment, there is a good opportunity to grow profits and so those crashes tend to be preceded by periods of very strong returns. So the current bull market is likely to remain in place until inflation picks up or low-flation/deflation drags down profits.

Falling yields tend to be somewhat more bullish than bearish, but it’s a poor indicator for how the stock market will react. Falling yields are good especially when we are in a bull market, but they can be dangerous if they should drive down the yield curve spread to an unusually low level and then there is the lag effect I mentioned earlier. When the long end of the yield curve comes down that is good for stocks for a while; it can even result in parabolic increases in the short term, but it also indicates bad news for the broader economy, and eventually the bill comes due.

Yesterday we talked about the proposed new EPA regulations on coal fired power plants. Today we’ll talk about the backlash to those proposals; which, by the way, have not been officially proposed yet. It’s anticipated that the new EPA guidelines will try to reduce the percentage of US electricity generated by coal to 14% by 2030 from about 37% right now. Coal is the single biggest source of electricity generation in the US and has been for more than 60 years. The amount of electricity generated by natural gas would rise to 46% by 2030 from about 30% now under the EPA plan. That would make it the biggest generator of the nation’s electricity.

Meanwhile, opponents of the plan say it will increase the cost of electricity and cost jobs. The US Chamber of Commerce released a study showing it would cost the economy $50 billion a year and destroy a quarter million jobs. Sometimes they just pull numbers out of the air; these reports tend to overlook the externalities associated with a dirty fuel like coal, and also overlook the positive impact of cleaner fuels. Anyway, the mudslinging has started.

And a follow-up on the Detroit bankruptcy story. A task force has issued the most detailed study yet of blight in Detroit and recommended that the city spend at least $850 million to quickly tear down about 40,000 dilapidated buildings, demolish or restore tens of thousands more, and clear thousands of trash-packed lots. It also said that the hulking remains of factories that dot Detroit, crumbling reminders of the city’s manufacturing prowess, must be salvaged or demolished, which could cost as much as $1 billion more.

If carried out, the recommendations by the Detroit Blight Removal Task Force would drastically alter the face of the nation’s largest bankrupt city. They would also cost significantly more than the approximately $450 million that the city already plans to spend on blight, raising questions about the feasibility of the vast cleanup effort, which is part of its larger campaign to emerge from bankruptcy by fall and begin remaking itself.

The blight study, which is perhaps the most elaborate survey of decay conducted in any large America city, found that 30% of buildings, or 78,506 of them, scattered across the city’s 139 square miles, are dilapidated or heading that way. It found that 114,000 parcels — about 30% of the city’s total — are vacant. And it found that more than 90% of publicly held parcels are blighted. The report also made several recommendations for preventing blight in the future, including changes to property tax and foreclosure laws, and heavy fines for scrap metal theft.

The basic plan is to clean up the city, but nobody really knows how to go about the task. Do you clean up by tearing down or do you clean up by building or rebuilding? For years, some have contemplated consolidating some of the city’s neighborhoods to allow the city to provide services to a smaller area, more suited to its shrunken population; Detroit has gone from 1.8 million to about 800,000. And if they don’t get this right this time, it will likely revert to farmland. 

Tuesday, May 27, 2014 - Currently Trending Here

Currently Trending Here
by Sinclair Noe

DOW + 69 = 16,675
SPX + 11 = 1911
NAS + 51 = 4237
10 YR YLD - .02 = 2.52%
OIL - .24 – 104.11
GOLD – 29.20 = 1264.30
SILV - .40 = 19.14

The S&P 500 Index closed at another record high. The Dow Industrial Average is just a little below the May 13 record of 16,715. The Russell 2000 index of small and mid-caps confirmed the uptrend. The Russell had been lagging and there was a concern that small caps might drag the blue chips lower. While the Russell is still down about 2% year to date, on Friday it moved above its 200 day moving average.

Any time the market is trending, it makes sense to look for divergences, or any indicator that might signal a change in trend, but the most important thing to watch is still the trend itself; in other words the market scorecard is measured in price. And right now the trend is up.

Let’s start with some economic news. The S&P/Case-Shiller Home Price Indices continued to show gains in prices for existing home sales; the 10-city composite was up 0.8% and the 20-city composite was up 0.9% month over month; and respective year over year gains of 12.6% and 12.4%. Nineteen of the 20 cities showed positive returns in March; New York was the only city to decline. As of March 2014, average home prices across the United States are back to their mid-2004 levels. Measured from the 2006 peaks, home prices are down 19%.

Mortgage rates started rising in May 2013 as the market speculated about when the Federal Reserve would start pulling back on its large scale asset purchase program, at the same time inventories of new and existing homes dropped, pushing prices higher and affordability was pushed down. One positive for home sales is that mortgage rates have recently dropped with the average 30 year fixed at 4.14% and the average 15 year fixed mortgage at 3.25% the lowest levels since last October.

The Conference Board said its consumer-confidence index rose to 83 in May from a downwardly revised 81.7 in April. The survey shows 20% of respondents expect their incomes will improve in the next 6 months; that doesn’t sound like much but it’s the highest reading since 2007. Other key elements of the survey: A net 18.2% said jobs were hard to get vs. being plentiful, compared with 19.8% in April and 26.5% in May 2013. Those who plan to buy a home within six months fell to 4.9% in May, the lowest since July 2012; that compares with a percentage of 5.6% in April. Those who plan to buy major appliances within six months fell to 45.1%, the lowest since September 2011.

Durable goods orders increased 0.8% in April. Durable goods are products designed to last 3 years or longer; so this is a broad category that includes everything from toasters to cars to nuclear submarines. In April, the Navy inked a $17.6 billion contract for 10 nuclear-powered attack submarines; and while that will be money that will circulate through the economy over several years, it skewed the report. Non-defense capital goods orders fell 1.2%. Business are placing fewer orders while working through a stockpile of goods amassed in the second half of 2013. Last month, durable goods inventories rose 0.1% after increasing 0.2% in March.

The Memorial Day holiday signals the unofficial start of summer and the summer driving season, and that usually equates to higher gasoline prices at the pump. Usually, but not always. According to the Energy Information Administration, prices at the pump are going to fall from today’s levels. This forecast is based on increased crude-oil production and declining global demand.  Rising oil production has boosted US crude-oil inventories to some 398 million barrels. That’s the highest level since way back in 1931. Demand is down, in large part because of better fuel efficiency forced by government MPG mandates. Demand has been declining since 2007. In many areas, gas prices are the lowest since 2011. Each penny decline in gasoline puts $1 billion back into people’s pockets.

Speaking in Portugal today, European Central Bank President Mario Draghi warned that prices in the countries in the euro zone's stressed periphery were falling too sharply, due to the combination of belt-tightening and a high exchange rate. He also cited evidence of a debt trap in stressed countries: the cost of finance for many companies has risen since the crisis, while falling prices mean they can't generate the profits to service their debts. Draghi said that the share of viable small businesses that can't get a loan is only around 1% in Germany or Austria, but around 25% in Spain and 33% in Portugal; Draghi called this imbalance a “credit gap” and blames it for up to a third of the economic slack in the crisis economies and acting as a brake on economic recovery. And so Draghi says the ECB will take action June 5th to ward off deflation and support economic recovery; what precisely will be done is still a matter of speculation.

It is widely anticipated the ECB will cut interest rates combined with an attempt to boost credit to small and medium sized businesses by providing long-term funding to banks provided they deploy that capital to expand business credit. The main lending rate will likely be cut from 0.25% to 0.1% or so. Meanwhile, the deposit rate paid to banks on overnight deposits will likely be cut from zero to a negative 0.1% or so, in effect charging the banks for funds they leave with the central bank.

The Federal Trade Commission has issued a report on the data brokerage industry. The nine data brokers examined in the FTC report were Acxiom, CoreLogic, Datalogix, eBureau, ID Analytics, Intelius, PeekYou, Rapleaf and Recorded Future. Data brokers analyze data collected about consumers to make automated assumptions about them. Consumers are placed in data-driven social and demographic groups for marketing purposes. The commission says that the same data that identifies a motorcycle enthusiast could both get him a discount on a biking magazine and make it easier to charge him more for car insurance. Another way to look at this is that the consumer is not the customer, rather the consumer is the product.

And yes, the data brokers know whether you drive a motorcycle, or smoke cigarettes, or if you are overweight, and how many bathrooms you have in your home, and if you travel or just like to read magazines about travel; that’s all in addition to the basics like name, address, social security number, age, and the bluntly termed “ability to afford products”.

According to the FTC, the firms have done a great job of finding data to crunch. One firm has information on 1.4 billion consumer transactions; another one adds 3 billion new records to its databases each month. While the report doesn’t address credit scores, the framework of the debate is much the same. What really worries the FTC is the impossibly opaque way the data is collected and managed. The data brokers gather their data from other data brokers rather than directly from an original source.

This is where the commission thinks the government should get involved. It suggests a law that would mandate the creation of a centralized portal where data brokers explain themselves, disclose their sources, and give people the opportunity to opt out; or for more sensitive data, require consumers to opt in before data could be sold. The commission hints it might call for some version of the idea that people have a right to have some things be forgotten, but they don’t actually recommend that data brokers cull their data, even when that data may be very old and inaccurate. And there is talk, but nothing concrete, about giving consumers access to their own data, and the ability to call for some of that data to be corrected or deleted.

President Obama today outlined a plan to withdraw all but 9,800 American troops from Afghanistan by the end of the year and withdraw the rest by the end of 2016. Under his plan, 9,800 US troops would remain behind into next year. By the end of 2015, that number would be reduced by roughly half. By the end of 2016, the U.S. presence would be cut to a normal embassy presence. The United States now has about 32,000 troops in Afghanistan.

At some point in the next week, President Obama is expected to announce Environmental Protection Agency mandated cuts intended to reduce carbon pollution by regulating carbon dioxide emissions from about 600 existing coal fired power plants. Obama could not get Congress to take action to address climate change during his first term, so he changed his tack and is using his executive authority under the 1970 Clean Air Act to issue the EPA regulation.

As currently drafted, the rule would cut greenhouse-gas emissions from the utility sector by 25%, the individuals said, but the baseline for that reduction has not been finalized. The EPA plan resembles proposals made by the Natural Resources Defense Council, which would allow states and companies to employ a variety of measures, including new renewable-energy and energy efficiency projects “outside the fence,” or away from the power plant site, to meet their carbon- reduction target.

Usually when the EPA regulates pollutants under the Clean Air Act, the agency sets an emission limit for each facility. By contrast, under a “mass-based system,” which the EPA is poised to adopt, states would have to meet an overall target for greenhouse-gas emissions and ensure that power plants either make those reductions at their facilities or finance efforts to achieve them in other ways, such as conservation or “green” generation or possibly through some variation of the cap and trade system.