Thursday, July 31, 2014 - Ugly Day, Ugly Logic

Ugly Day, Ugly Logic

by Sinclair Noe

DOW – 317 = 16,563
SPX – 39 = 1930
NAS – 93 = 4369
10 YR YLD un = 2.55%
OIL – 2.12 = 98.15
GOLD – 14.00 = 1281.50
SILV - .23 = 20.48

Well, this was just ugly. The worst day for the Dow Industrial Average in about 4 months. Back on April 10^th, the Dow dropped 267 points; that same day, the S&P 500 was down 30 points. Today wiped out the gains from July, with July marking the first negative month for the Dow and the S&P since January.

The S&P is still up about 5% for the year to date, but the Dow started the year at 16,576. All those record highs for 2014 have just been washed away. That’s how it goes; the markets scratch and claw, higher and higher, inch by inch it’s a cinch, until the cinch breaks. A couple of weeks ago, we talked about shorting, and the advantage of shorting is that the moves can be quick and severe. Sure enough. And while this might just be one bad day, long overdue, the Dow dropped below its 50 day moving average, which is one of the major measurements of a trend.

So, the question is why did the stock market nosedive today? One recurring theme I’ve been hearing is that traders are afraid the Fed will pull away the punchbowl. Yesterday’s GDP report showing better than expected 4% growth in the second quarter combined with today’s employment cost index, which rose 0.7% in the second quarter, made people nervous about the prospect of an improving economy and the possibility of wages pushing inflation higher.

Now wait just a minute; that doesn’t sound so bad; the economy is expanding at a 4% pace which is certainly better than a contracting economy which we saw in the first quarter; and workers are being paid a little more – not much just a little - and that’s certainly better than watching the middle class shrink into oblivion. If you look at this explanation for the market decline, it is an example of perverse logic, where the stock market traders are in opposition to economic prosperity and are only happy in the face of hardship; other people’s hardship, not their own.

There might be something to that interpretation. Beginning in 2008, the Fed cranked up a series of programs to stimulate the economy. Of course, the Fed didn’t really stimulate the economy but they did stimulate certain financial sectors, such as housing, and very clearly the stock and bond markets. During that time, the Fed added over $3.5 trillion to their balance sheet, which now holds nearly $4.5 trillion. The basic mechanics were that the US government borrowed money by selling Treasuries, and the Fed bought a large portion of those Treasuries with freshly printed money. Since 2013 the Fed’s balance sheet has grown even faster than government debt, which has leveled off, almost. Overlay a chart of the S&P 500 with a chart of the Fed’s balance sheet; the similarities are more than coincidental. A big chunk of the money the Fed was printing sloshed over into the stock market. When the Fed stops printing all that money, who is left to buy stocks?

The accumulated “surplus” of printed money will only last a couple of months. Sooner or later (probably sooner), the stock market will start to feel the pain of this monetary tightening. Of course the Fed isn’t really exiting the money printing business. They won’t sell off the assets held on their balance sheet; they will let those treasuries and mortgage backed securities mature and expire, maybe even roll over a few. And government debt hasn’t disappeared, so the Fed will continue printing money. We don’t know how the Fed taper and eventual increases in interest rates will turn out; neither does the Fed know. It’s a big experiment; the Fed might throw a curveball or two along the way; the stock market traders might throw a tantrum, knocking down your IRA in the process. The recurring theme today was that the Fed might pull away the punchbowl; the Fed hasn’t actually done that; they said this week they would not do that anytime soon. There has been considerable consideration given to a Fed exiting. Imagine when they actually do it.

The big institutional traders may already be headed for the doors. Last week, investors added $379 million into equity mutual funds, the kind that’s popular with retail investors. At the same time, exchange-traded funds focusing on equities; the kind of securities traded by institutional investors because of their liquidity and lower cost, saw a whopping $7.97 billion in outflows. That’s the biggest outflow seen since February.

Anyway, the Wall Street traders’ logic is flawed; the 4% growth in second quarter GDP really isn’t as good as it seems. The 4% growth implies the economy is on a very slow growth path when averaged in with the -2.1 contraction in the first quarter. Taken together, the economy grew at less than a 1.0% annual rate in the first half of 2014. That is hardly cause for celebration on Main Street or trepidation on Wall Street. Also, the strong growth in the second quarter was in direct response to the weak growth in the first quarter. Inventory growth was very weak in the first quarter, subtracting 1.16% points from the quarter's growth, and so a reversion to the mean, or a return to a more normal pace of inventory accumulation in the second quarter was a strong boost to growth, adding 1.66 percentage points. Final sales grew at just a 2.3% annual rate in the second quarter. Even that rate was likely inflated to some extent by the weakness from the first quarter.

But that wasn’t the only demon plaguing the stock market today. If it’s not one thing, it’s another. And there have been a lot of other things.

The bond market has its own demons. Fitch warns a jump in US high-yield default rates looms. There have been 10 LBO related bond defaults thus far in 2014, compared with nine for all of 2013. While most sectors remain relatively calm, the utilities and chemicals sectors are seeing huge spikes in defaults. Since the Fed pushed rates down near zero people have been chasing yield and that means the high yield market has become crowded, and that means the yield on risky debt has dipped to a little less than 6% on average, compared to a more typical yield of a little less than 9% for junk  debt. If or when the Fed starts targeting higher rates, who will be looking for the junk with the not so high yield? A reversion to the mean would result in big capital losses, and it could turn ugly if people start running for the exits and can’t find a bid.

And then we can’t forget the geopolitical problems of the world. A negative July in stocks was matched by a negative July in Ukraine, and Israel, and Gaza, and Iraq, and Syria, and Libya. Toss in sanctions on Russia, which will also hurt the European Union.  And then late yesterday, Argentina put a cherry on top.

Argentina has defaulted, or as S&P described it, a “selective default”. A quick recap: In 2001 Argentina defaulted on its debt and it forced most of its creditors to take a haircut, that is a lot less money than the face value of the bonds. After the default, Paul Singer, a hedge fund manager of NML Capital, bought a lot of the bonds at a big discount, pennies on the dollar, and then demanded the bonds be paid in full. Argentina refused to pay the vulture hedge funds. So Singer took his case to the courts – not in Argentina, but in the US. The case was heard by a judge who didn’t really understand all the fancy talk about bonds, and so he ruled against Argentina. About a month ago, the US Supreme Court said they would not interfere. So now, Argentina can’t pay off the bondholders who accepted the discount, unless they also pay off the hedge fund vultures who demand full payment; which basically negates the whole idea of the default in the first place. So, the US courts have essentially told the sovereign country of Argentina that it is more important to pay off the hedge funds, than it is to default and reboot the Argentine economy on a fresh start.

While Singer’s firm has yet to collect any money from Argentina, some debt market experts say that the battle may already have shifted the balance of power toward creditors in the enormous debt markets that countries regularly tap to fund their deficits. Countries in crisis may now find it harder to gain relief from creditors after defaulting on their debt.

The big question, however, is whether Argentina will ever pay Singer and his vulture fund fellows what it wants. If the firm fails to collect, that would underscore the limits of its legal strategy. There is no international bankruptcy court for sovereign debt that can help resolve the matter. Argentina may use the next few months to try to devise ways to evade the US courts. In dire economic crises countries need to be able to slash their debt loads. The idea is similar to bankruptcy for individuals, a chance to restructure debts and start fresh because we long ago learned that throwing people in prison for the debts didn’t help anybody. The legal victories of the holdouts may embolden creditors to drive harder bargains after future defaults, which in turn could prolong or postpone debt restructurings and extend the economic misery of over-indebted countries. So, the problem in Argentina is not unique to Argentina, it affects the global economic system, we just don’t know to what extent.