Wednesday, February 12, 2014 - Which Way the Wind Blows

Which Way the Wind Blows

by Sinclair Noe

DOW – 30 = 15,963
SPX – 0.49 = 1819
NAS + 10 = 4201
10 YR YLD + .04 = 2.76%
OIL + .33 = 100.27
GOLD + .90 = 1292.80
SILV unch = 20.34

After a four day rally, the stock market came back to a dose of reality.

Just a reminder that the Fed has started gradually reducing the amount of money it pumps into the economy. The move could hardly have been a surprise, because the Fed announced as early as last spring that it would begin doing so by the end of 2013. Now, it’s happening, and likely won’t change, and Janet Yellen said the rest of the world needs to adjust because the Fed has set its course. That has made for shaky markets around the world.

Remember that about a month ago, we started worrying about emerging markets. China said their economy was slowing down; that in turn will hurt the exports of commodity producers, weakening their trade balances. The big question now is how much further growth in China will slow. A serious cutback in China’s demand would not just harm emerging markets’ shipments directly to China, it would also cause further erosion in the already falling world prices for emerging markets’ coal, copper, palm oil and other commodities. China is also dealing with a shadow banking system ripe with potential defaults. But that isn’t the only problem in the world.

Many of those emerging markets also have unique economic and political problems that seemed to boil over at about the same time.  So, the hot money has been exiting emerging markets. This is the same hot money that flooded into emerging markets when the Fed had the printing press cranked up to QE3. This has happened before. It happens all the time. Back in the late 90’s the Asian economies vowed to avoid a repeat by building up trade surpluses and saving with a vengeance. They held back on investment and consumption; they hoarded foreign reserves, such as US Treasury bonds, which in turn lead to a speculative bubble in American subprime mortgages. Just to remind us all that we are not alone in this global economy.

The Federal Reserve says recent efforts by emerging markets such as Brazil, India and Turkey to stem investor flight from their economies are just “stopgap measures” that need to be followed by heftier policy actions. The Fed issued a report saying continued progress implementing monetary, fiscal and structural reforms will be needed in some emerging market economies to help remedy fundamental vulnerabilities, put them on a firmer footing, and make them more resilient to a range of economic shocks.

The Fed said in its report that many emerging markets learned from the financial crises in Asia and Latin America in the late 1990s and early 2000s and moved to flexible currencies, building cash reserves and cutting their dependence on foreign lending. Now, the response in the emerging markets seems to be slamming on the brakes by raising interest rates as they emerge, potentially sacrificing investment and jobs along the way. This is probably an imperfect reaction. I don’t know what was learned from the crises of the past, but those problems haven’t disappeared with a four day rally on Wall Street.

The Fed’s comments are likely to fuel debate at the upcoming meeting of finance officials and central bankers from the world’s 20 largest economies late next week in Sydney, Australia. The whole mess might even result in strategic shift from China to other developing Asian countries as the preferred locale for making export goods. And if the developing countries don’t step up, it raises the question of whether the EU or the US could fill the void.

I ran across an interesting article from Vanguard. It says financial data is notoriously easy to manipulate. You probably knew that, but the article says a difference of only one year can have a major effect on the five-year annual performance returns of U.S. stocks. If your starting point is 2013, this number is an impressive 18.7%, because it omits the big drop in 2008. But if you ran the numbers just one year earlier, from December 31, 2012, the five-year average return number dropped to 2.04%. Vanguard correctly concluded that basing investment decisions on "data-dependent snapshots" could be a big mistake.

Let’s talk about the weather. Not the Ice storm in the Southeast; you know about that; hundreds of thousands of people without electricity because the ice on the lines or on trees that fall into the lines; more than 3,000 canceled flights. Atlanta looks like some frozen wasteland in an apocalyptic science fiction movie. Soon, the storm will pass and meander up the seaboard and dump a foot or so of snow on New York City. Yesterday, Fed Chair Janet Yellen said the wild winter storms probably had an impact on the December and January jobs reports; probably knocked a smidge off the GDP as well. It’s important, but that’s not the weather I want to talk about today.

Today, I’d like to talk about the drought in California. Of course, last week a weather pattern known as the pineapple express dropped some rain on the state, and all it seems to take is one decent rainstorm to wash away all awareness of a drought. But it would take three months of nearly solid rain to get out of the current drought and that isn’t going to happen. Here’s what will happen.

Food and electricity and water will all cost more. And then there will be additional costs to build up water systems because if we don’t then things will get really dicey. The scientists have been warning us for decades that droughts will become more common. Predicting any single season’s rainfall is tough but forecasters think this year may be the driest year in the last 500 years. Most of the state is experiencing “extreme drought”. About 10 percent of the state is experiencing "exceptional drought," the highest possible level. Several smaller communities are in danger of running out of water, soon and despite the rain last week.

Most of the computer modeling seems to predict that over the next 3 to 5 decades, the changing current patterns caused by melting sea ice will increase average annual precipitation in the Northwest by about 40%, and average precipitation in the Southwest will decrease by 30%, maybe faster. Those are big changes, but before we get there, we’ll get smaller previews of the future.

Let’s start with agriculture. California produces a good chunk of the nation's food: half of all our fruits and vegetables, along with a significant amount of dairy and wine. Many farmers who plant annual crops have already made plans to cut back on planting to conserve water.

Farmers who tend crops that grow on trees and vines are in a tougher position, because their plants have to be maintained year-round. The good news is that it usually takes more than one year of drought to kill a tree, the bad news is that one year of drought can wreak havoc with production, and the worse news is that we’re in the third year of drought.  An almond tree after one year of drought will lose 50% of production, and even if we get normal water levels next year, the production will continue to drop by 90% before returning to normal. So, this year will be bad and next year will be worse. The most vulnerable crops are probably stone fruits like plums, cherries, peaches, and apricots, which are adapted to wetter climates.

For California rancher’s the drought means less grass for beef and dairy cows to graze, and that means many ranchers are selling now. If you enjoy a barbecue, enjoy it now before you have to take out a loan for a steak.

Expect shortages and possible price increases for lettuce, broccoli, melons, citrus, and rice. Yes California is a major rice producer. Of course, rice is an international food stuff, but in China there has been a major drought as well. Citrus also comes from different parts of the world, but remember the southeast has had a crazy cold winter that has already caused damage to citrus crops.

Expect to spend more on electricity. Hydroelectric energy makes up about 14 percent of the state's power supply. With less water running through turbines, the grid may need to use more natural gas, which is more expensive. And the state is also running low on natural gas, in part because of the extra demand generated by Eastern states. Southern California has become increasingly dependent on natural gas-fired plants since the decision last year to shutter the troubled San Onofre nuclear power plant. When it was operating, the twin-reactor San Onofre plant produced enough power for 1.4 million homes. And there will be extra costs to clean up the San Onofre site, which will be passed on to you. And just last week there was a “flex-alert”, where state officials called for people to turn off the lights and anything else that was sucking power. A flex alert in the winter is strange indeed.

And don’t forget the fires. In Southern California, fire season really never ended. Seasonal firefighters in Southern California, usually employed only during summer and fall months, have stayed on staff all year long. And already this year, this winter, wildfires have been igniting all up and down the state. Cal Fire is considering expanding inspections to check compliance with "defensible space" rules, which require that residents have 100 feet of space free of flammable materials, like brush or other vegetation, around their houses.

And finally, water will cost more. Conservation will be increasingly important but it can be costly. One solution is desalination plants, but those use lots of energy and are very expensive. Transporting water is a possible option, again very expensive.  Major water projects can’t be constructed in 2 or 3 months. Planning and infrastructure involve a lot of lead time. There really isn’t much choice. It has to be done.

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.

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 - 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 whitehouse.gov/sotu

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 - 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. 

Monday, August 26, 2013 - And the Answer Is

And the Answer Is

by Sinclair Noe

DOW – 64 = 14,946
SPX – 6 = 1656
NAS – 0.22 = 3657
10 YR YLD - .02 = 2.78%
OIL + .29 = 106.21
GOLD + 7.20 = 1406.00
SILV + .25 = 24.43

President Obama awarded Army Staff Sergeant Ty Carter the Medal of Honor in a ceremony at the White House today. Carter is now the fifth living recipient of the decoration for heroic actions in Iraq or Afghanistan. The Medal of Honor, the nation's highest military honor was awarded for Carter's distinguished service on October 3, 2009 at Combat Outpost Keating in Afghanistan. More than 300 Afghan insurgents launched an attack against the remote, mountainous outpost; of the 53 fellow 4^th Infantry Division soldiers who defended the outpost that day, eight were killed and 25 others injured.

They were outnumbered six to one; the fact that anyone survived is a testament to the heroism of the day. In another part of the compound, former Staff Sergeant Clinton Romesha, battled against incredible odds. Romesha was the second survivor of that battle to receive the Medal of Honor. Carter risked his own life to resupply his fellow soldiers and to rescue a battle buddy; Carter was wounded but continued to fight; all this while under heavy and constant fire that lasted more than six hours. It is hard to imagine the hell those soldiers endured that day.

The wounded soldier that Carter rescued, Specialist Stephan Mace, would later die. Carter blamed himself. For Carter, the battle also resulted in a ninth fatality. A fellow survivor who struggled with post-traumatic stress disorder committed suicide a year after the attack. When he returned stateside, Carter recognized that he was suffering from PTSD. His experiences led Carter to become active in helping veterans of the Iraq and Afghan wars deal with PTSD.

Sgt Carter's citation reads: "Carter's remarkable acts of heroism and skill... exemplify what it means to be an American hero."

During the ceremony, Mr Obama said he wanted to honor Sgt Carter for the "other battle he has fought" - coping with PTSD. The president said: "To any troops or veterans who are watching and struggling: look at his man, look at this soldier… he's as tough as they come, and if he can find the courage and the strength to not only seek help but to speak out about it [PTSD], to take care of himself and stay strong, so can you."

Whenever there is war, there is a terrible price to pay.

About an hour after the president presented the Medal of Honor to Sgt Carter, Secretary of State John Kerry read a statement about the situation in Syria. Kerry said the use of chemical weapons in attacks on civilians in Syria last week was undeniable and that the Obama administration would hold the Syrian government accountable for what he called a “moral obscenity” that had shocked the world’s conscience. Kerry accused the Syrian government of seeking to cover up the use of the weapons, and he rejected its denial of responsibility for what he called a “cowardly crime.”

Kerry also said the Syrian government’s refusal to allow immediate access to the attack sites last week was a telling indicator that it was trying to hide responsibility. Even though a United Nations team was finally permitted by the Syrian government to investigate starting today, he said, the government’s authorization was “too late” to be credible. Then came word that the UN inspectors had been fired upon by snipers; although there were no reports of injuries, some of the inspectors vehicles were disabled.

Meanwhile, Russia's foreign minister warned against prejudgment, and said bypassing the UN Security Council would be a violation of international law. He warned any Western intervention would be a serious mistake.

Defense Secretary Chuck Hagel told reporters today: “if there is any action taken, it will be in concert with the international community and within the framework of legal justification.”

The New York Times reports there is a list of potential military targets in Syria. The White House could take certain military measures without the approval of Congress. We saw that move in Libya. What Congress does control is the pocketbook.

Congress is on recess until Sept. 9; when they return they will look at raising the debt limit. House Speaker Boehner said last month the Republicans wouldn’t increase the debt ceiling “without real cuts in spending” that would achieve a further reduction in the deficit. Treasury Secretary Lew has said the Obama administration won’t negotiate on the debt limit. The Bipartisan Policy Center, a nonprofit research group, has estimated the government will reach the point where it is unable to pay its bills sometime between mid-October and mid-November unless Congress increases the limit. So, enjoy the final days of Summer because things might get scary around Halloween.

POP QUIZ: Everybody close your books and take out your pencils, unless you're driving of course.

First question: Name the world's biggest fast food chain. The correct answer is Subway, which has just opened its Subway store number 40,000. McDonald's only has 34,700 restaurants. Subway claims they still have room to grow.

Next question: name the second largest stock exchange in America. Of course, the New York Stock Exchange is the largest exchange, averaging 1.28 billion in average daily volume, for a market share of 23%. The second largest stock exchange is the BATS Global Markets, which is the new and not so catchy name for the combined exchanges of the BATS and Direct Edge, which averages 1.15 billion in daily share volume, or 20.6% of the total market. The Nasdaq falls to the third spot, with 18.1% market share.

The third question is: Name the best selling new car in California over the past year. Answer is: Toyota Prius hybrid.

Bonus if you can name the eight major car brands that Tesla Model S has passed in sales in California in the past year: Answer: Mitsubishi, Lincoln, Land Rover, Fiat, Buick, Cadillac, Chrysler, Jaguar, and Porsche. That’s especially impressive when you consider that those brands are selling multiple different cars, whereas the Model S is the only Tesla vehicle in production.

Put your pencils down and pass your papers to the front of the room.

Yep, it's school days once again.

Last week was a bore. Not much in the way of economic data, just the Federal Reserve officials making a point of not saying anything at the Jackson Hole confab. Typically there is a post Jackson Hole bounce in the markets, but we warned you against any such expectations. And in the absence of other noise or significant changes in the fundamental outlook for the companies that make up most of the US stock market, the market pretty much ended exactly at the same level it ended in the previous week.

Wall Street is paying too much attention to the “taper”, the prospect of a slowing of Fed asset purchases, and not enough attention to the economy in general or the looming game of debt-ceiling chicken in specific. The stimulus campaigns of the Federal Reserve and the central banks of Europe and Japan, by depressing domestic interest rates, have helped to push trillions of dollars into developing markets in recent years.

Now that the Fed has declared its intent to start easing up on the accelerator by the end of the year, some of that money is starting to slosh out of emerging markets and some might even return to the US.

Outflows from emerging markets have exceeded inflows since the Fed’s June announcement; Bloomberg calculates that emerging-market stocks have lost more than $1 trillion in value; emerging-market currencies are depreciating rapidly. The question of what to do about it was a big topic in Jackson Hole. The answers were pleasantly realistic, as the general consensus seems to be don't worry, be happy, it'll all work out over time.

And finally, P Morgan Chase’s co-head of litigation is leaving the bank as it faces a mounting pile of regulatory headaches, lawsuits and investigations, said people close to the situation. Michael Coyne, who is responsible for all litigation and government investigations affecting J.P. Morgan around the world, will become general counsel of UnionBanCal Corp, a San Francisco based bank.  Mr. Coyne’s departure comes as J.P. Morgan tries to work its way through a litany of legal problems and a heightened period of regulatory scrutiny. The bank disclosed recently that future legal losses could be as much as $6.8 billion above its existing reserves, more than any other U.S. bank.

And the answer is: how can you tell your ship is sinking?

Thursday, June 06, 2013 - The World is Changing

The World is Changing

by Sinclair Noe

DOW + 80 = 15,040
SPX + 13 = 1622
NAS + 22 = 3424
10 YR YLD - .03 = 2.07
OIL + .91 = 94.41
GOLD + 11.00 = 1414.70
SILV + .04 = 22.69

Today is June 6; on this date 69 years ago, nearly 200,000 Allied troops invaded the Normandy coast. Today is and will always be D-Day.

The world is changing. For the first time in modern times, the emerging markets now account for more than half of global GDP. And they are continuing to grow; the majority of global growth the rest of this decade will happen in the developing world. India and China alone will make up almost half of it. The growth in emerging markets is partly a matter of playing catch up. Emerging markets have more room to grow; developed markets have already experienced the growth. The center of world economics is shifting, and it is shifting to the east.

The International Labor Organization released its annual "World of Work" (PDF) report today. The employment rate won't return to pre-crisis levels in emerging markets until 2015, while advanced economies will have to wait until 2017 for their work woes to end. But even then, the number of unemployed people is still set to grow 4% to 208 million in 2015. How can the employment rate and unemployment levels rise simultaneously? Because the unemployed are dropping out of the work force: In more than half of the countries surveyed, labor force participation declined largely due to discouraged workers giving up the job hunt.

Perhaps worse: job quality is worsening around the globe, even where the unemployment rate is falling. The emerging markets are finding it easier to create more and better jobs because they're starting from a low base. It's easy to improve job quality in a country where most people make less than $10 a day; it's much harder in a country where the median income is $50,000 per year. For most advanced economies, the new jobs being created are of lower quality.

Based on the report, the trend is a boon for the wealthy. Top incomes in advanced countries have resumed their upward trend. Meanwhile, the middle class is shrinking due to the growing disparity between higher and lower incomes, which exacerbates overall inequality.

When Friday's jobs report is released, the unemployment rate and the number of new jobs will come in for close scrutiny. The market traders will examine the numbers and buy or sell or scratch their heads. The estimates call for a net 165,000 jobs added in May. Today, the Labor Department reported weekly initial claims for jobless benefits decreased by 11,000 to 346,000. The Federal Reserve will be watching; we know the Fed has set a target of 6.5% unemployment; that's the point, they say, when they will start raising rates and winding down their easy-money policies.

The unemployment rate started climbing from a low of 4.4% in the summer of 2007. I don't know why the Fed doesn't use that as their target. The rate topped out at 10.1% in October 2009. We started the year at 7.9%. The unemployment rate is currently 7.5% and it isn't expected to change with tomorrow's report. So, it looks like there has been quite a bit of improvement, unless you look at the employment rate; this is the proportion of the population that is working, not the proportion that isn't. In 2006, 63.4% of the working-age population was employed. That percentage declined to a low of 58.2% in July 2011 and now stands at 58.6%. By this measure, the labor market's health has barely changed over the past three years.

The headline unemployment rate, currently 7.5%, only measures people who are actively searching for work but don't have jobs. There is another measure of unemployment; U6 counts those marginally attached to the workforce—including the unemployed who dropped out of the labor market and are not actively seeking work because they are discouraged, as well as those working part time because they cannot find full-time work. The U6 unemployment rate in April was 13.9%; that's down from 17.1% in 2009, but still wicked high.

While the unemployment rate has fallen over the past 3½ years, the employment-to-population ratio has stayed almost constant at about 58.5%; historically low. Jobs are always being created and destroyed, and the net number of jobs over the last 3½ years has increased, but the working-age population has also increased. Job growth has been just slightly better than what it takes to keep the employed proportion of the working-age population constant.

We won't be getting back many of the jobs that were lost during the downturn. At the present slow pace of job growth, it will require more than a decade to get back to employment levels we had before the downturn. The Federal Reserve's quantitative easing monetary policies may have helped, but certainly not enough; they are still a very, very long way from their mandate of maximum employment. The Fed may want to taper off QE, but that is more like to hurt than help. Better would be redirecting QE. Pumping money into the banking system has not been effective at achieving maximum employment and it risks the possibility of asset bubbles, which threaten price stability – the Fed's second mandate.

The argument has been that more direct attempts to stimulate the labor market are the responsibility of fiscal policy, but that doesn't dismiss the Fed from its dual mandate.

One thing the Fed has accomplished is to bring down mortgage rates over the past 5 years. Each year, rates inched lower and lower, until the last month. The 30-year fixed rate mortgage has now bounced from just under 3.5% a month ago to 4.16% this week. Not surprisingly, there has been a big drop-off in refinancing applications. We might see a little bounce in new purchases, as some people will try to jump in before rates move any higher. Now refis provided some stimulus, since lower mortgage payments means more money to spend. But the effect is likely not as great as you might think. The big winners are the banks; they make money when you refinance.

Now how much any borrower benefitted from a refi depends on how big a rate reduction he got. People who refied repeatedly on the way down would give away a lot of the gain. The people who may have fared the best, ironically, were those who had been barred from refinancing in the early years of the rate decline by being underwater but later got access via HARP. HARP refis were just shy of 1.1 million in 2012 and were 440,000 in 2011.

Remember that personal income fell in January, and the growth in subsequent months has been so weak as to be insufficient to make up for the decline, and the sequester is putting a further brake on the economy. So the rise in rates is yet more drag, and more reason why the Fed is likely to avoid taper.

Those low mortgage rates were a big part of the housing recovery; they enabled a lot of people to stay in their homes, even if they were underwater; they enabled others to purchase; and they enabled investors to swoop in. Remember that price spikes in most markets usually occur on the margins, and the renaissance of the real estate investor was certainly a compelling component for big price swings in the recovery. Investor buyers have been coming in and filling the void, but they’ve also been outbidding buyers who are actual families. In markets where it’s heating up, non-investors are getting frozen out.

So the recent rise in rates, when you add that to the very conversion of home to rentals already leading to more tenant-favorable conditions in some of the hottest market, is certain to put a damper on speculator appetite. On the one hand, the cooling of appetite by investors will aid some end-buyers who are mortgage financed and have been unable to compete with “cash” buyers (who may also be using leverage, just not via a mortgage). But higher rates means less buying power, unless lenders start loosening terms. They’ve been pretty stringent up to now. Are they going to help facilitate this investor pump and dump?

And now it looks like the recent rise in rates is affecting the big dog investors. A couple of big operators had planned initial public offerings: Colony Capital’s IPO of a portfolio of nearly 10,000 homes, expected to fetch $260 million looks to be on hold for now, and a new filing by American Homes 4 Rent looking to raise $1.25 billion seems to be moving forward. But the Financial Times reports those liquidity events may be running into a roadblock of higher rates:

“Colony American Homes has postponed a US float as the sudden jump in market interest rates has damped investor appetite for newly issued shares in real estate investment trusts…

“Colony had garnered enough interest from investors to price its shares near the low end of a $11.50 to $13 per share range...

“The company decided that an IPO fundraising was not vital to its day-to-day operations and felt it could hold off until the credit markets stabilise, the person added. Colony declined to comment…

“Bankers have said the recent downturn in shares of publicly traded Reits would hurt valuations for companies in the sector preparing for initial public offerings and secondary share placements….

“That pressure has been acutely felt by newly issued shares in Reits with similar business strategies to Colony. Silver Bay Realty Trust has fallen 6 per cent since raising $281m in December, while American Residential Properties has dropped 11.7 per cent since it raised $287.7m from a May float.”

Of course, the Fed might commit to keeping the punchbowl on the table for a while and the party might continue for a while, but you've got to think that the exit strategy for these moderately large investors, and even for the bigger players was to find a liquidity event and make a fast and profitable exit. Do they really want the long grind of collecting monthly rental checks?