Monday, February 10, 2014 - Set the Tone

Set the Tone

by Sinclair Noe

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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