Monday, April 07, 2014 - I Don’t Know, They Don’t Know

I Don’t Know, They Don’t Know

by Sinclair Noe

DOW – 166 = 16,245
SPX – 20 = 1845
NAS – 47 = 4079
10 YR YLD - .03 = 2.69%
OIL - .44 = 100.70
GOLD – 5.40 = 1297.90
SILV - .09 = 19.97

The biggest 3 day drop in the markets in about 2 months. All of the sudden we start hearing the Wall Street stock peddlers waxing enthusiastic about the prospects for a correction or a crash or whatever will scare you. Fear sells; with talk about a 1987-like stock market crash, geopolitical unrest in Ukraine and the risk of a debt crisis in China, investors are starting to get jittery. I don’t know, they don’t know.

The big pullback so far has been in the Nasdaq, and especially biotech stocks. As always, you want an exit plan in place before you ever get into a trade; and if you don’t have an exit plan, get one now. You don’t make money by letting profits slip through your fingers.

Earnings season gets underway this week. Expectations have been ratcheted down; at the start of the year, S&P 500 companies were projected to have grown earnings at 6.5%, now that estimate has slipped to 1.2%. We could see companies beat diminished expectations and start a fresh rally or miss expectations and the markets could get a bit ugly. The simple rule of thumb is that when the trailing P/E ratios hit 10, the S&P 500 is likely undervalued; when the P/E hits 20, the market is likely overvalued and that means the market is vulnerable to pullback. Guess where we are on the scale? Does that mean that stock prices are about to roll over and play dead? Not necessarily. All we have to do is add some earnings to the P/E ratio and …

The S&P 500 recently, as in last week, tested highs, even though fewer than 10% of its components were making new highs individually. Despite the fact that the S&P touched new high territory last week, the average stock in the big index is actually down 7%. Then, you can look at volume; down on up days; up on down days, like today. Toss in the presidential election cycle, toss in the old but true idea of “sell in May”, and there are plenty of reasons for caution.

The past couple of years have been easy; buy the dips; buy good names with momentum and ride that pony to profits. Easy. But easy doesn’t last forever. The momentum names look like they’re rolling over. Investors are rolling over into safer sectors. We’ve gone nearly 2 years without a correction of at least 10%, so it just seems like we’re due. So, while there may be value to be found, this does not seem like a good time to load up when high flyers dip. They may bounce back, but they don’t have to; there is no law that requires a bounce. When a momentum play turns, it tends to turn fast and furious.

This continues to be a tale of two markets. While the high flyers stall, the safety of bonds has been drawing bids, and yields have dipped over the past few days, despite the Fed's clear intention to pull back on Quantitative Easing and bond buying. The utility sector has been outperforming, which might be a signal of future volatility. Emerging markets have seen inflows; maybe this is the idea that the US has been the cleanest dirty shirt in the hamper, but the other shirts aren’t ready to be scrapped; call it a reversion to the mean.

Maybe it’s just time to pause and ask why US stocks have priced in so much optimism. Job growth continues but it is not robust and it is not enough to propel the economy to escape velocity; the taper is underway; fiscal policy remains a mess and there is little hope for stimulus from DC.

Corporate America is sitting on a mountain of cash, somewhere between $1.6 and $1.9 trillion, but it’s offshore; they’re afraid to touch it because they might have to pay tax. They could bring that money back home and put it to work, but that would require innovation and sweat and labor. Much of corporate leadership is short-sighted and lazy, and besides, the offshore cash is still good enough to secure a bonus.

One of the key signs of a true recovery is sufficient business confidence to start investing more into their own operations. Many companies have shied away from investing in the future growth of their companies. Too many companies have cut capital expenditure and even increased debt to boost dividends and increase share buybacks. If you’re waiting for capital expenditures to revive the economy, don’t hold your breath.

Larry Fink is the CEO of Blackrock, the largest money manager, he says: “Companies only have a finite amount of cash to invest. Whatever gets spent on buybacks and dividends is that much less available to be spent on investments in employees, research and development, and capital expenditure. It's basic arithmetic. When will the next round of capital investment begin in earnest? As soon as you figure out the answer to that question, you will have gained significant insight into the direction of the economy as well as the next phase of this stock-market rally.”

Meanwhile, let’s look at banks behaving badly. Private banking is a staple of the Swiss economy and for decades, as wealthy Americans concealed their assets through clandestine accounts, US regulators turned a blind eye.

In 2011, federal prosecutors indicted 7 Credit Suisse bankers for abetting tax evasion, but the investigation into Credit Suisse dragged on. The quirks of international law prolonged the inquiry, requiring Swiss courts to review Credit Suisse documents before releasing them to the Justice Department. Ultimately, the Justice Department gained access to many of the documents and interviewed bank employees.

And by the time the Senate subcommittee convened its hearing in February, the Justice Department was closing in on a case. Bracing for a settlement, the bank announced last week that it had set aside roughly $528 million for legal expenses. In addition to the Justice Department investigation, Credit Suisse paid $200 million to settle a case with the SEC in February. In a separate matter, in late March the bank agreed to an $885 million settlement to resolve claims that it sold questionable loans to Fannie Mae and Freddie Mac. Apparently a slap on the wrist and a fine haven’t served as a deterrent.

Now, Benjamin Lawsky, New York State’s top financial regulator, has requested documents from Credit Suisse and is expected to demand additional records this week to try to determine if Credit Suisse lied to New York authorities about engineering tax shelters. In the Senate subcommittee hearings in February, Credit Suisse executives apologized for the misconduct and they also argued that the problems stopped in 2008 and were contained to a few low-level rogue bankers. The bank, which said it voluntarily adopted a number of controls against tax evasion, reported that there was no evidence that executive management knew of the problems.

Lawsky has also petitioned a Senate subcommittee for internal Credit Suisse documents.  The subcommittee questioned bank executives at a hearing in February, and produced a scathing report exposing “a classic case of bank secrecy.” In late March, the Senate agreed to release the internal Credit Suisse documents.

The escalating Credit Suisse probe, along with some recent shifts in international law, might also provide momentum to the government’s uneven effort to collect taxes and punish the banks involved. Typically the punishment has been a fine and a slap on the wrist, but that has drawn scrutiny from politicians lately, and so maybe this will be something more.

Meanwhile, federal authorities have opened a criminal investigation into a recent $400 million fraud involving Citigroup’s Mexican unit, one of a handful of government inquiries looming over Citi.

The investigation, overseen by the FBI and prosecutors from the United States attorney’s office in Manhattan, is focusing in part on whether holes in the bank’s internal controls contributed to the fraud in Mexico. The question for investigators is whether Citigroup ignored warning signs, as other banks have been accused of doing in the context of money laundering.

Federal prosecutors in Massachusetts have sent subpoenas to Citigroup, to examine whether the bank lacked proper safeguards against clients laundering money. Citi also faces a parallel civil investigation from the SEC. And it was just 2 weeks ago that Citi fell short in the Federal Reserve’s stress test. The Fed rejected Citi’s plan to increase its dividend based upon questions about the reliability of Citi’s financial projections.

And that brings us to the tale of Kenneth Lewis, the former chief of Bank of America. Back in 2008, as the global financial meltdown imploded, Bank of America rushed in to acquire Merrill Lynch. Lewis called it the “strategic opportunity of a lifetime” and he said the Fed did not pressure him into the deal. He later admitted he lied. Merrill Lynch was bleeding cash while paying huge bonuses. Bank of America required 2 bailouts from Treasury plus extraordinary lending from the Fed. It is a crime to knowingly deceive shareholders about the financial condition of your company.

Bank of America has paid several fines related to cases brought by various regulators, and there is still an outstanding suit, but the case of Kenneth Lewis wrapped up last week. Mr. Lewis agreed to pay $10 million, which was provided by Bank of America. He is barred from being an executive or director of a public company, but he already retired with a sizeable golden parachute. He did not have to admit or deny wrongdoing.