Tuesday, August 13, 2013 - Metric Disconnects

Metric Disconnects

by Sinclair Noe

DOW + 31 = 15451
SPX + 4 = 1694
NAS + 14 = 3684
10 YR YLD + .11 = 2.71%
OIL + .42 = 106.53
GOLD – 15.90 = 1322.40
SILV + .03 = 21.56

Retail sales rose 0.2% in July, following an upwardly revised 0.6% increase in June; retail sales are now up for 4 consecutive months. The retail sales report is important because consumer spending accounts for about 70% of the economy. We've heard that so frequently that it sounds like a cliché, but when we spend, that money circulates through the economy and it is the vital life blood of the economy. Areas showing gains included restaurants and bars, grocery stores and sporting goods outlets. Within general merchandise, department stores showed a 0.6 percent increase in sales last month

Another Commerce Department report today showed inventories at US companies were little changed. Merchants had enough goods on hand to last 1.29 months at the current sales pace in June.

Atlanta Federal Reserve bank President Dennis Lockhart says he thinks policy makers should move cautiously this year to scale back its bond buying program. Lockhart says the Fed might make its first reduction before the end of the year, maybe as soon as September, and that it should be thought of as a cautious first step. So, Lockhart was a bit more dovish than other Fed policy makers of late, and as he made the comments, small losses on Wall Street gave way to modest gains.

The equity markets have come to play an outsized role in the US from a policy and practical level. It’s never a good idea to try to assess complex phenomena with a single metric, yet for much of the public and the officialdom, the level and trend of the stock market is a proxy for the health of the economy. Fed policymakers now have a vested interest in keeping the stock market up, both to boost confidence and maybe out of personal vanity; if the stock market were to fall, that would mean they’ve done a bad job. Can’t have that!

Equity is a residual claim: payments to shareholders come after paying suppliers and employees, bondholders, leases and licenses, legal claims, and taxes. But our new ideology is that the last should come first. And to achieve that, companies in the US have abandoned the model of sharing the benefits of productivity gains with workers. Once upon a time increases in productivity moved up in tandem with increases in wages, but that changed in the 1970s. Since the end of World War II, productivity has increased by 254%, but real hourly compensation has only increased by 113%. As I say, they used to move in tandem; the disconnect happened about 40 years ago.

According to Bloomberg data, trailing 12-month earnings per share for the S&P 500 are 16 per cent above their level of October 2007 (when both earnings and share prices peaked before the financial crisis). On the same basis, earnings for the MSCI EAFE index, covering the rest of the developed world, are down 37 per cent. Those for the FTSE-Eurofirst 300 are down 42 per cent.

Earnings for the MSCI emerging markets index are up since October 2007 – but by only 13 per cent, having peaked and started to decline two years ago.

Look closely at the raw numbers for the US and they turn out to be less inspiring. S&P 500 companies are on course to increase earnings by 3.6 per cent year on year for the second quarter. But they have declined by 1.3 per cent once financials are excluded. During those 12 months, bear in mind, the S&P gained 18 per cent, and its financials index gained 33 per cent.

Companies are not generating that much in revenues but, over the past 12 months, they returned a record amount of it to investors. This is an admission that they see few opportunities to invest for growth. But, in an environment where investors take little on trust and are desperate for a yield from anywhere, it has helped the rally keep going. This is not a strategy that can last forever. At some point, companies must start generating more revenues and profits with which to make these payouts.

And if you still think its safe to jump back in;Apparently FINRA is looking into whether sell-side research analysts are doing some naughty things, which is an evergreen topic. It’s hard to tell if the analysts are doing naughty things but, probably, right? Basically the analysts are meeting with potential issuers before those issuers’ IPOs, which is fine. But at those meetings, which tend to be arranged by “so-called I.P.O. advisers” they might be talking about the IPO and the analysts’ views of the issuers, which is not fine. 

Yep, the IPO market is back in a big way. Initial public offerings are up 40% from a year ago; 126 companies have raised $27.1 billion, on track to $43 billion for the full year. Mark Hulbert at Marketwatch writes: "When companies are rushing to sell their shares, it often means that the overall stock market has become not just fairly valued, but actually overvalued.”

As Hulbert points out, companies aren't selling you stock out of the goodness of their hearts, but to make their executives, employees and bankers rich. What better time to get rich than when you think your stock is probably overpriced? The last big IPO boom featured dumb money chasing quick riches on first-day stock pops, a game that was heavily rigged in favor of insiders.

Hulbert's own inflation-adjustment of the IPO data suggests the market is on pace for the biggest dollar amount of IPO issuance since 2000, just at the popping point of the dot-com bubble. Estimates like these are going to vary depending on what sort of method you use to adjust for inflation; suffice to say there are a lot of IPOs these days.

IPOs may be back in fashion but mergers just took a hit.

The Department of Justice and several states has sued to block the proposed merger of American Airlines and US Airways. Arguing the combined airline would reduce competition for air travel in key markets. European regulators recently approved the deal after the companies agreed to give up two daily slots at London’s Heathrow Airport.

The airlines claim the merger would cut costs by streamlining operations and scaling back on unprofitable routes. They claim this would be good for customers because it could result in lower costs. However, the merger would also create a monopoly in several areas, such as nonstop service between Miami and Philadelphia or Nashville and Washington DC. The combined airline would also dominate some key hubs.

If not challenged by DOJ, the merged American would surpass United to become the largest U.S. passenger airline by several measures. While US Airways and American overlap on only 12 nonstop routes, no other nonstop competitors exist on 7 of those 12. The merger would also mean less competition along 1,665 other routes within the United States, while boosting competition along just 210 routes. According to the Justice Department, If the US Airways-American merger went through, the four biggest airlines would control more than 80 percent of the domestic air-travel market.

This doesn't mean the merger won't happen; it is still a possibility, but there would likely be some major concessions as talks continue.

Have you experienced a power outage lately? We had one at the studios about a week ago. It happens, and it is happening with greater frequency. The Department of Energy has a new report that shows the power grid is suffering more blackouts, a lot more over the past 20 years.

The report notes that “thunderstorms, hurricanes and blizzards account for 58 percent of outages observed since 2002 and 87 percent of outages affecting 50,000 or more customers.” The rest are caused by things like “operational failures, equipment malfunctions, circuit overloads, vehicle accidents, fuel supply deficiencies and load shedding — which occurs when the grid is intentionally shut down to contain the spread of an ongoing power outage.”

The report estimates that over the past 10 years, weather-related outages have cost an average of about $18 billion to $33 billion per year, adjusted for inflation. So, is severe weather the cause of the blackouts, or is the problem related to old infrastructure? Yes. The grid is old; there's been almost no new construction in the past 25 years, and that makes it vulnerable to severe weather. Grid resilience is increasingly important as climate change increasesthe frequency and intensity of severe weather. Greenhouse gas emissions are elevating air and water temperatures around the world. Scientific research predicts more severe hurricanes, winter storms, heat waves, floods and other extreme weather events being among the changes in climate induced by emissions of greenhouse gasses.

The Energy Department report says the grid should be modernized and made to tougher standards especially where severe weather may be a problem. Yes, it would be expensive to upgrade the grid, and it would be more expensive to wait.

Yesterday, we reported that a couple of lower-level traders at JPMorgan might face the possibility of arrests in connection with the London Whale trades. It doesn't look like Bruno Iksil, the actual London Whale will be arrested; he's cooperating with the investigators.

Almost everyone, from President Obama to his ideological foes in the Republican Party, wants the government out of the business of guaranteeing almost every mortgage loan made in the U.S. That's all well and good, but there is no reason to think that private investors will be willing to fund the types of mortgages people expect at rates they consider "affordable" in the absence of government guarantees. The government could help assuage investor fears by proving that it is committed to upholding the rule of law and punishing individuals who commit financial fraud.

The government, in turn, has shown almost no interest in charging individuals with criminal conduct. Somehow one of the most destructive and widespread frauds in recent history happened without anyone causing it; except for Fabrice Tourre, and that was a civil suit, not criminal. Bank shareholders have certainly spent money on settlements, but the actual perpetrators, whoever they were, have gone unscathed. Given this backdrop, who would pour money into a rejuvenated "private-label" MBS market in sufficient size to offset a large decline in government support?

From the perspective of investors, lying about the quality of the loans they were packaging into securities wasn't even the worst thing the banks did. In many cases, banks failed to ensure that the securities they were selling were even legal. And it now appears that many of the mortgage backed securities weren't really backed by mortgages, maybe more than $1 trillion dollars worth of the stuff.

Of course, the lack of proper documentation didn't prove much of an obstacle to banks that wanted to foreclose on delinquent (and current) borrowers -- they just forged the paperwork they needed.These fraudulent foreclosures harmed investors and the broader economy, although they boosted the earnings of the big banks.

State attorneys general and the Department of Justice eventually settled with the big banks over this practice. None admitted wrongdoing, and no individuals were punished. Far less money actually reached the victims of these fraudulent practices than was expected -- and many had to endue long delays before getting what little they were owed, and then many people received a check in the mail and it bounced; yep, the settlement checks sent out by the banks, bounced. As if that weren't bad enough, the court-appointed settlement monitor says that many of the banks are still breaking the rules. 

The government's failure to prosecute wrongdoing has created an environment of legal doubt that keeps investors away. Not only are investors unable to trust the government to enforce the law -- they can't even trust the government to tell them how bad a job it has done enforcing the law. It all leaves you wondering why anyone would buy private-label MBS until that changes.