Monday, May 12, 2014 - More Milk and Cookies

More Milk and Cookies

by Sinclair Noe

DOW + 112 = 16,695
SPX + 18 = 1896
NAS + 71 = 4143
10 YR YLD + .03 = 2.65%
OIL + .63 – 100.62
GOLD + 5.60 = 1296.70
SILV + .35 = 19.60

Record highs for both the Dow and the S&P 500. We celebrate when the Dow hits a record high; there is no specific celebration for the S&P, which doesn’t really make sense. We have a party with milk and cookies. Today we have some lemon zest cookies and I think they have poppy seed sprinkles, which means we would all fail a drug test for the next few days.

The latest thing to worry about is the market divergence. The Dow hit record highs but the Russell 2000 index of small and midcap stocks closed below its 200 day moving average last week. The idea is that small caps will drag down the blue chips, or maybe the blue chips will lift up the small caps, but one way or another, something has got to give. Another consideration is the number of NYSE stocks making new highs minus the number of NYSE stocks making new lows continues to look mediocre at best even as the Dow and S&P make all-time highs. You don't typically want to see large caps struggling at recent highs with less underlying participation by individual stocks because narrowing of participation at highs is how tops are formed. You also don't typically want to see new all-time highs for the S&P while the more economically sensitive small caps are in a correction. These things can resolve in either direction, but the historical bias is toward a resolution to the downside.

The basic truth is that not all stocks are hitting record highs. That’s not how it works; there are winners and losers, even in a bull market, even in a bear market. The other reality is that we don’t make record highs forever, 2013 being the exception to the rule. At some point this market will roll-over, we don’t know exactly when, but rather than sticking our head in the sand, we remain vigilant.

Yesterday was Election Day in Ukraine. A preliminary count from eastern Ukraine showed 89% of voters in the Donetsk region and 97% in neighboring Luhansk voted for greater autonomy; which is to say they are voting to split from Ukraine and be more closely associated with Russia. The Russian government did not even say that it recognized the results of the voting, which the authorities in Kiev and their Western supporters all declared illegal from the start. The Kremlin issued a statement saying only that it “respects the will of the population of the Donetsk and Luhansk regions,” and that the crisis should be resolved through dialogue.

As part of that dialogue, Gazprom, the gas company controlled by the Russian government, announced it would send Ukraine an advance bill for natural gas deliveries in June. So the dialogue is “pay up or no gas.” The Euro Union is slowly tightening economic sanctions on Russia, but slowly, hoping they don’t have to face Gazprom turning off the spigot on supplies to the continent. This entire conflict could turn ugly fast, but each day that goes on without a meltdown is a good day for the markets.

Meanwhile, the Department of Justice is reportedly getting closer to actually enforcing the law, at least with respect towards a big bank. There are signs and last minute meetings that point toward possible criminal charges against two large European banks. No giant bank has been found guilty of criminal charges in the US for at least 20 years. Lawyers for BNP Paribas and Credit Suisse have been meeting with prosecutors to try and wrangle a deal for leniency. BNP is suspected of doing business with countries like Sudan and Iran that were on a US sanctions blacklist; Credit Suisse is suspected of offering tax shelters to wealthy Americans.

There have been criminal charges against subsidiaries of big banks, but the parent companies have been spared. Credit Suisse recently set up a subsidiary to house their US offshore business; the idea being that they could create a subsidiary to serve as a sacrificial lamb. Word is that US prosecutors are unwilling to criminally charge the newly formed unit.

Criminal charges could prompt regulators to revoke a bank’s license to operate, the corporate equivalent of the death penalty. When HSBC faced criminal charges a couple of years ago, the bank set up a subsidiary in Asia to take the fall. That deal was apparently accepted because the Justice Department is afraid of a criminal charge of the parent company could wreak havoc on the broader economy, far beyond the boundaries of France or Switzerland. The BNP and Credit Suisse investigations could lay the groundwork for actions against American banks as well. We may see how this strategy develops within the week.

There were no significant economic reports today, there was a fairly important weather report from NASA and some scientists at the University of California – Irvine. They say that glaciers and ices shelves along the western part of Antarctica are melting, and as they melt they’re releasing roughly the equivalent of the entire Greenland ice sheet into the ocean every year; enough ice to raise the world’s sea level by about 4 feet, which means my dream of owning oceanfront property in Arizona is alive and well. Eventually, they say the oceans will rise by about 14 feet, but that’s a long way down the road. The scientists say the melting process has passed the point of no return.

Now, why do we talk about it here on the Financial Review? Because it is changing the financial landscape. John Nelson, the chairman of Lloyd’s of London has posted an article in the Guardian explaining how climate change is changing the insurance industry’s catastrophe modeling. “According to the World Bank, weather-related losses and damage have risen from an annual average of about $50bn in the 1980s to close to $200bn. Lloyd's knows this all too well, the damage wrought on the US by the hurricanes Katrina, Rita and Wilma in 2005 and Superstorm Sandy in 2012 to name but a few all brought significant claims to the insurance market.”

And so, Lloyd’s is changing models to account for climate change, by building in forward projections, not just historical data. This will likely lead to changes in insurance pricing, and in this way, we will all be affected, but it doesn’t stop there. This means changes in environmental policy of course, and also housing and land use policy. And this is not just about insurance companies trying to jack your rates. “Ultimately, insurance exists to pick up the pieces and pay the claims” when extreme weather hits, but there may also come a time when insurance companies stop paying claims, and deem certain areas uninsurable, which is the equivalent of a financial death sentence. And that’s just the start; wait until the Environmental Protection Agency announces rules intended to slow the pace of climate change.

And what happens when the EPA moves on to regulation of greenhouse gas emissions? And it won’t be long before you start hearing more about cap and trade; and I predict that in the not so distant future we’ll all be familiar with the R.E.C. market, which is almost non-existent today. You don’t know about REC now, but you will.

Flood insurance will disappear for some areas, drought and crop insurance will vanish in other areas. And even if you live on a hill, it doesn’t mean you escape consequences, because this will also require massive investment in infrastructure; above and beyond updating outdated bridges. And this will eventually result in a complete revamp of our power structure. The days of coal fired power plants and flaring off natural gas in the oil fields are coming to an end just as surely as the days of whale oil lanterns passed into the darkness of history. And because necessity is the mother of invention, these are when we need, and I believe we will find imaginative and innovative solutions.