Tuesday, July 08, 2014 - Everything Except Productive Purpose

Everything Except Productive Purpose
by Sinclair Noe

DOW – 117 = 16,906
SPX – 13 = 1963
NAS – 60 = 4391
10 YR YLD - .05 = 2.56%
OIL - .13 = 103.40
GOLD - .40 = 1320.60
SILV - .03 = 21.12

Down 2 days and already I’m seeing the financial talking heads asking if this is the start of a correction. Just a reminder that markets go up and down and sometimes sideways. The markets don’t need a big reason to move. Right now, we’re heading into earnings reporting season, and a few things happen; first, some investors might look at a position and determine that prospects for earnings are not so great, or some investors are taking the opportunity to put some cash in their pockets, just in case they see a bargain basement opportunity.

A trend in place is more likely to continue than it is to reverse, and it reverses when we can see clear evidence of a reversal. Yes, the market looks overvalued by many metrics, yes there seems to be irrational exuberance; but the markets can remain irrational longer than you can remain solvent; yes, we’ve seen a couple of down days but we’ve gone 33 months without a correction, but we’ve had a bunch of down days during that same time. Right now, we’re seeing a minor pullback into a trading range as we await earnings season.

Should you stay or should you go? The markets have hit recent highs, and so you have to wonder if you get out when the getting is good. After hitting record highs, the past 2 days have seen declines; let me be very clear, 2 down days do not constitute a trend; not unless you trade the minute bars. Still, it can be sickening to see profits melt away. Conversely, cutting exposure with the aim of putting cash back to work when valuations drop can be soothing at first, but maddening if stocks continue climbing. There is a fine line between adjusting exposure based on valuations and timing the market; and either way it’s a real trick heading into earnings reporting season.

With interest rates at historic lows and stocks climbing, holding cash in a portfolio has been costly, but on the flip side, cash can serve as a buffer against market pullbacks and corrections, and it provides flexibility to buy again if prices drop; in other words, you keep your powder dry. The real return on cash has to consider the idea that you can use it to make even more money down the road. Of course, for that strategy to work, you have to reinvest the cash; you have to look for bargains or look for other opportunities. If you aren’t willing or able to do that analysis then the risk is that you build up cash and don’t know when to get more invested.

This is where the idea of rebalancing comes in; it doesn’t require sophisticated analysis; you just sell high and buy low. If your risk tolerance points you toward a 60% allocation in stocks, and the stocks go up in price and now you hold 70% in stocks, cash out, to bring the equity allocation back to 60%; turn around and put that cash into a part of the portfolio that has dropped. The idea is that you are buying low; the unfortunate side effect is that you might be dumping your winnings into a losing position. A variation on the theme is sell high and buy something you don’t already hold.

But then the question is where do you go to find value? An article in the New York Times suggests that everything is in bubble territory. The chief investment strategist at BlackRock, one of the world’s biggest asset managers, spends his days searching for potential opportunities for investors to get a better return relative to the risks they are taking on, and he says there are very few cheap assets these days. At the current level of the Standard & Poor’s 500 index, every dollar invested in stocks buys you about 5.5 cents of corporate earnings, down from 7.4 cents two years ago, and lower than just before the global financial crisis in 2007-2008.

Bonds offer next to nothing in the way of returns, and if you want to chase yield in the debt markets, you’ll find some of the riskiest issues can’t even breach 5%. Real estate has spiked in many locations, even farmland has rocketed. It’s not that any one area is outrageously overvalued. Most people would agree that stock valuations are lower than 2000, and real estate peaked in 2006, and we haven’t really recovered to those levels. It’s just that everything that could be considered a financial asset has gone up. And of course, as prices go up, the potential future returns drop.

Maybe that’s a reflection of a slowing global economy. Maybe it’s a result of the central bankers printing lots of money, but not directing where the money would go; and so the money was parked on the sidelines, and not put to productive use, not being invested in things like factories or infrastructure. And then the risk is that folks chasing yield take on more and more risk until something pops.

Taking a look at economic data today, the Federal Reserve report on consumer debt for May showed debt increased $19.6 billion, not including mortgage or real estate related lending; that’s down from a $26.1 billion increase in April. Revolving debt, including credit-card balances, rose $1.79 billion in May following an $8.85 billion April advance that was the biggest since November 2007. Non-revolving debt, which includes car and education loans, gained $17.8 billion in May, the biggest increase since February 2013, after climbing $17.3 billion in the previous month. Car sales continue be show strength, reaching a 16.9 million annual rate last month, the fastest pace since July 2006.

The JOLT survey, or Job Openings and Labor Turnover survey shows that as of the end of May, companies increased the number of job openings almost back to pre-recession levels. Despite greater demand for workers, pay scales have not budged much.  Wages for all private-sector employees increased 2% in the year ended in June, according to the Labor Department, exactly where wage growth has trended through all of this recovery.

News from the small-business sector, however, suggests pay growth is ready to break out of the 2% range. According to the June survey of small firm owners by the National Federation of Independent Business, a net 21% of small businesses report lifting compensation in the last few months. That is the highest reading since the end of 2007. So, it looks like we are getting closer to seeing wage growth in the near future, but we’re not quite there yet. And since we aren’t seeing actual proof of wage inflation, it could be argued that the Fed should wait a bit longer before tapping the brakes. And for that matter, even if we start to see signs of wage inflation, that might be a good thing.

Federal Reserve Bank of Richmond President Jeffrey Lacker said in a speech today that “subdued productivity gains” along with “moderate” increases in consumer spending and “more tempered” growth in housing construction, will lead to economic growth in the range of 2% to 2.5%, well below the Fed consensus of 3% growth. Lacker says “broad-based advances in technology are far less likely than in the past, and that we should prepare for relatively stagnant productivity growth trends going forward.”

Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said today that inflation will likely stay quite low for about 4 or 5 years. Kocherlakota says the Fed is “undershooting its price stability goal” of 2% inflation and will likely continue to do so for some time to come; he sees the probability of inflation averaging more than 2% over the next four years as being “considerably lower” than the probability of inflation coming in less than 2% over the same time period. Kocherlakota is skeptical of improvements in the jobs market, saying “much of the decline in the unemployment rate since October 2009 has occurred because the fraction of people who are looking for work has fallen.” That means the Fed is also failing to meet its job creation goal, which is damaging for the economy.

When you look at last week’s jobs numbers something doesn’t seem to add up, at least it gives pause to consider the numbers. GDP growth equals productivity growth plus job growth, or at least growth in hours worked. We’ve been adding jobs at a good pace, but the economy contracted 2.9% in the first quarter. That leaves productivity, and it turns out that there is a long term trend in decelerating productivity growth. And the problem with productivity is not that workers aren’t working hard; the problem is that we haven’t been investing in the right tools for the job.

Earnings season kicked off with a report from Alcoa. It was better than expected. Including all charges, the company earned $138 million or 12 cents a share during the quarter. That reverses the company’s $148 million loss in the same period a year ago. Revenue also came in ahead of expectations. Alcoa reported revenue of $5.8 billion, which is 2.6% higher than expected. Revenue is flat from the year-ago period.

Earlier Samsung issued an earnings warnings, claiming profits could fall as much as 26% from a year earlier. Smartphone and tablet sales took a pretty big beating. Samsung put out a statement that says tablet sales are slow because consumers are slower to upgrade tablets compared to upgrading smart phones. They also blamed the rising Korean won, which is up 9% against the dollar in the past 3 months; they blamed excess inventory in Europe, and competition in the mid and low-end of the market, and a few other excuses as well.

Monday, July 07, 2014 - Small Steps

Small Steps

by Sinclair Noe

DOW – 44 = 17,024
SPX – 7 = 1977
NAS – 34 = 4451
10 YR YLD - .03 = 2.62%
OIL - .67 = 103.39
GOLD - .50 = 1321.00
SILV - .10 = 21.15

It was a long holiday weekend that was over way too fast. And the problems of the world haven’t gone away. Let’s get caught up on some of the big stories.

In Iraq, the situation is deteriorating. There had been muted hope for some sort of an inclusive government to hold the country together. Don’t count on it. Iraq’s new parliament has called a recess and they won’t meet again for 5 weeks. So Iraq is now politically paralyzed. Meanwhile, a Sunni Islamist insurgency killed an army general near Baghdad.  It looks like Prime Minister Maliki is digging in his heels, raising the risk that Iraq will fragment along ethnic and sectarian lines.

ISIS, the Sunni insurgents are holding territory in western Iraq and just north of the capitol. The Iraqi military, backed by Shi'ite militias and volunteers, has yet to take back any major cities but is trying to advance on Tikrit. Kurds in northern Iraq have taken advantage of the chaos to expand their autonomous territory in northern Iraq. Most Sunnis and Kurds walked out of the last parliament, saying they believed the prime minister and president should be chosen along with the speaker as a package, not one at a time. They could not resolve the impasse, so the acting speaker postponed the meeting.

In eastern Ukraine, pro-Russian rebels built barricades in the streets of Donetsk and it looks like they will try to make a stand. Although most shops and businesses in Donetsk were still open, some were shut, and residents are concerned that government forces could soon attack. Rebels have been barricaded into government buildings in Donetsk, which they declared capital of an independent "people's republic", but until now the city mostly functioned normally.

You may recall there was an election in Afghanistan last month. They announced preliminary results today. The losing presidential candidate is now saying the results of the election were improperly counted and he is describing it as a “coup” against the people. His rejection of the election results sets the stage for a possible bloody standoff between ethnic groups or even secession of parts of the fragile country, which is already deeply divided along tribal lines. The vote to pick a successor to Hamid Karzai was intended to mark the first democratic transfer of power in Afghan history, a crucial step towards stability as the US prepares to withdraw the bulk of its troops by the end of the year. Not so great.

Hamas stepped up rocket fire at southern Israeli towns and Israel called up reserve troops today in anticipation of a possible escalation of hostilities. Hamas has vowed revenge for what it saw as Israel's deadliest attacks in which six Palestinian militants died, though Israel denied any involvement. The surge in violence has raged since the kidnapping and killing of three Israeli youths last month and a Palestinian teen last week. Israel said more than 40 rockets were launched as militants' funerals were held in Gaza. Thirty struck inside Israel and the rest were shot down by rocket interceptors. Air raid sirens wailed as far north as the outskirts of Tel Aviv and Jerusalem.

And then there’s Chicago, where the Fourth of July holiday resulted in widespread violence that left 80 people wounded and 14 dead.

On the economic calendar, Alcoa will kick off the earnings reporting season after the close of trade tomorrow. Alcoa has long held the ceremonial role for starting earnings season because it was in the Dow Industrials and it had the ticker symbol AA. Alcoa is no longer one of the Dow 30 stocks, but the tradition holds. Actually, we’ve already seen about 25 companies from the S&P 500 report earnings.

Second-quarter profit growth is expected to come in at 6.6% for the Standard & Poor’s 500-stock index, which would be an improvement over the 5.6% growth in the first three months of 2014. Revenues are expected to grow 3%. While negative second-quarter profit warnings have outpaced positive ones by a 4.2 to 1 margin — well above the 2.6 to 1 negative-to-positive ratio since 1995 — the future outlooks from CEOs are far more bullish than the first quarter, when there were nearly 7 negative profit pre-announcements for every positive one.

With stocks at all-time highs and no longer cheap after a five-year bull run, Wall Street wants to see companies deliver profit and revenue growth in the coming second-quarter earnings season sizable enough to warrant the market’s big move. Indeed, the bull market’s continued health will hinge on vibrant corporate profitability. Whether or not stocks continue trending higher will likely depend on second-quarter earnings reports, as well as management’s guidance of full-year earnings.

Currently, the S&P 500 is trading at nearly 16 times its estimated earnings over the next four quarters, which is a tad above the long-term average. Heading into the season, analysts are upbeat, with more analysts’ raising profit forecasts than lowering them for the first time since the first quarter of 2012, but more upbeat analysts could result in a more downbeat market reaction.

On Wednesday, the Federal Reserve will release the minutes of its last meeting, held June 17-18. Wall Street will again be looking for any clues related to the timing of the first interest rate hike by the Fed. After the strong jobs report Thursday, some Wall Street firms revised their rate-hike timetables, warning that rates could start rising earlier-than-expected next year. However, the Fed might not be so positive about jobs. There’s been concern about the degree to which a falling unemployment rate is overstating labor-market strength.  You’ll likely see general agreement that the labor market has been improving, but there will be difference in opinion about the drop in the unemployment rate. Officials have also been eyeing tepid wage growth.

That’s one of the strange things about the jobs report; it does a poor job of measuring the strength of the jobs created. When we try to measure performance in the stock market, we don’t look at the number of new stocks available to investors, instead we measure the price of the stocks, the value of the stocks. But when we look at jobs, we don’t look at the value those jobs bring. One of the things we’ve seen is that many of the jobs being created are part-time.

So, it's interesting that the recent news of job market "improvement" doesn't mention that of the 10 occupation categories projecting the greatest growth in the next eight years, only one pays a middle-class wage. Four pay barely above poverty level, and five pay beneath it, including fast food workers, retail sales staff, health aids, and janitors. The job expected to have the highest number of openings is "Personal Care Aide" – taking care of aging baby boomers in their houses or in nursing homes. The median salary of an aid is under $20,000.

We’re starting to see some improvement as the job market gains traction; more than half the jobs the economy has added so far this year are in positions that pay higher than the hourly wage. Some 58% of the new jobs created in 2014 pay above the average hourly wage of $24.45. By contrast, about 48% of the new jobs created in 2013 paid above the national average. Businesses in 2014 are hiring more white-collar employees, construction is on the mend (at least compared to the first quarter), health care is going strong and even the long-downtrodden financial industry is finally getting into the act. About 42% of the new jobs, meanwhile, fall into categories that pay less than the average wage.

Still there is a general lack of upward wage pressure; workers demanding more money as the labor market improves and the pool of potential employees shrinks. Wages have risen just 2% over the past year and weekly wages have actually fallen in the past two months. Part of the problem is part-time work; part of the problem is that the good paying jobs are limited to certain sectors. The bigger problem is that the increase in the number of jobs is not translating to higher wages and that, in turn does not translate to faster economic growth.

This week’s economic calendar also includes reports on small businesses, job turnover, and consumer credit. There was a 10.2% surge in consumer credit in April. The growing dependence on debt could prolong consumer spending a few more months, but in the absence higher real wages, this type of consumption cannot last much longer, certainly not if we see both gas prices and inflation-driven interest rates edge higher later this year.

It’s unlikely we’ll get any big pronouncements from the Fed. They probably talked about how the economy has rebounded from the terrible slump of the 1^st quarter, but if you read the minutes for any major move on interest rates, don’t hold your breath. Neither short-term nor long-term rates will go significantly higher in the next few years. More likely, modest increases that might even be quickly reversed. The implications of another extended period of depressed rates would be bad news for savers and pension funds, but it should help the stock market.

After the Fed’s June meeting, they made clear that they expected to finally begin lifting their benchmark rate in 2015, if the economy continues to expand and unemployment continues to decline. Even so, 12 of the 16 members of the policy committee expected the Fed's rate to be no higher than 1.5% by the end of 2015 — a full 18 months from now. Asked for their rate prediction for the end of 2016, the majority of the Fed panel expected 2.5% or less. And because the Fed's rate influences all other interest costs, that would suggest still-low rates across the board.

What we are learning about this version of the Fed is they move slow and in small steps.

Monday, April 08, 2013 - Cat Food Futures Soar on Chained CPI

The Wealth Protection Conference was a bundle of fun. The whole thing was recorded on 9 CDs. You can order the CD recordings (or MP3 recordings are less expensive). Call Resource Consultants at 800-494-4149.

Cat Food Futures Soar on Chained CPI

by Sinclair Noe

DOW + 48 = 14,613
SPX + 9 = 1563
NAS + 18 = 3222
10 YR YLD + .04 = 1.79%
OIL +.82 = 93.52
GOLD – 9.60 = 1573.70
SILV - .05 = 27.40

The S&P 500 fell 1 percent last week as US payrolls had the smallest gain in nine months in March. The economy added 88,000 jobs in March, even though prior month job gains were revised higher; the unemployment rate dipped to 7.6%, mainly because more people left the labor market and are no longer counted for one reason or another. The idea is that some people just retire, or other people just can't find a job, so they drop out of the workforce.

One reason that so many people are just dropping out of the workforce now is the shortening of the period of extended unemployment benefits. As long as people are receiving unemployment insurance they have to be looking for work. When their period of eligibility ends, most people just drop out of the labor force. The period of extended benefits was shortened in most states at the end of 2012. As a result, many people went from being classified as unemployed (no job, but looking for work) to being out of the labor force (no job and not looking for work). They are still unemployed; they still need a job; most of them would still like to get a job; some of them have moved into an underground economy; but you know, we just stop counting some people.

There are a large number of people who do not respond to the Bureau of Labor Statistics' Current Population Survey (CPS), the standard survey used to measure labor force participation. In recent years the non-response rate overall has been close to 12 percent, as opposed to just 5 percent three decades ago. The non-response rate varies hugely by demographic group. For older white men and women it is 1-2 percent. By contrast, for young African American men it is close to one-third.

The Bureau of Labor Statistics effectively assumes that the people who don't get picked up in the CPS are just like the people who do. This assumption may not be plausible. The people who don't respond may be more transient or may have legal issues that make them less willing to speak to a government survey taker. For these reasons they may be less likely to be employed than the people who do respond to the survey.

The earnings reporting season kicks off today; it needs to be strong to support the recent run-up in the equities market. Alcoa kicks off the earnings reporting season, alphabetically it leads the pack among the Dow Industrial stocks. After the close, Alcoa reported an increase in quarterly profit , but revenue fell short, and share prices dipped in after hours trade.

JPMorgan, Wells Fargo, and Bed Bath & Beyond are among nine companies in the S&P 500 scheduled to report earnings this week. Analysts project profits at S&P 500 companies fell 1.8 percent in the latest quarter, which would the first year-over-year drop since 2009. Analysts had predicted a 1.2 percent increase when surveyed in January. They'll revised estimates even more, and probably downward.

Meanwhile, President Obama is sending his budget to Congress on Wednesday. We know that the controversial part of the budget includes a reformulation of the way Social Security payments are calculated. In general, the chained CPI would lower the cost of living adjustment increases for Social Security recipients. The way chained CPI works, is when inflation increases, the government figures that the American people are mighty clever, and we'll just roll with the flow and we'll adjust our spending.

For example: if you used to spend $3 for a hamburger and french fries, but the price goes up to $5, you might not be able to afford that, so you'll switch to a hot dog and chips; if the price of gasoline goes up, you'll start riding a bicycle; of the price of your medications goes up, you'll either get healthy or maybe you'll die – in which case you Social Security payment is completely eliminated. The chained CPI would result in about 3% less benefits for Social Security beneficiaries, and that is each year going forward. A little quick math and we see that in 24 years, there won't be any payouts, and Social Security will be saved. Brilliant! Cat food futures are soaring on this news.

Obama's budget also calls for cuts in Medicare by reducing payments to health-care providers and drug companies and imposing more costs on high-income beneficiaries. While the White House hasn’t yet released specific dollar figures for the budget, administration officials said the plan puts the country on a path toward lower deficits, cutting the gap by $1.8 trillion over the next 10 years.

In exchange for cutting Social Security and Medicare, Obama is calling for tax increases; the quid pro quo is being called the Grand Bargain. Among the tax proposals: a limit of $3 million in an IRA or 401k or other qualified retirement account, a new tax on cigarettes and other tobacco products, a cap value of itemized deductions. Normally a taxpayer multiplies their top tax rate by the amount of a deduction to calculate the taxes saved. But Obama would cap that rate at 28%, which is below the top two income tax rates. Also, Obama is calling for an increased tax rate on investment fund manager income: Managers of private equity, venture capital and hedge funds are taxed 20% on the portion of their compensation known as carried interest, essentially paying the long-term capital gain rate. Obama would like carried interest to be treated as ordinary income, which means those managers would pay a rate as high as 39.6%, or more than 2.5 times the rate they pay now. And the other idea is to close loopholes, which sounds good but we don't have details on that yet.

How this all plays out will be fun to watch. South Carolina Senator Lindsey Graham on Sunday became the first prominent Republican to publicly praise the budget proposal. Actually, Graham said the plan is overall bad for the economy, but "there are nuggets of his budget that... are optimistic."

On Friday, House Speaker Boehner said: “If the President believes these modest entitlement savings are needed to help shore up these programs, there's no reason they should be held hostage for more tax hikes.”

Meanwhile, the Democrats hate the entitlement cuts offered up. There is a chance nobody will vote for the budget. So, when Obama's budget hits Congress on Wednesday, the fun part will be to see which side shreds it first.

Meanwhile, last week we told you about the Japanese monetary stimulus plan. You recall that Japan has been dealing with a banking crisis since the 1990's, its economy stuck in a generation of economic stagnation and low-level but persistent deflation.

A new government took office the day after Christmas, led by prime minister Shinzo Abe, pledging to, in effect, go whole-hog on the Keynesian remedies for Japan’s long recession, particularly by pushing for a combination of fiscal stimulus on a mass scale, and, through appointment of Haruhiko Kuroda as governor of the Bank of Japan; he has pledged to do “whatever it takes” to get annual inflation to 2 percent in a country where inflation has averaged -0.3 percent since 2000. The Japanese stock market is on a tear and the yen has been falling steeply on currency markets, exactly the kind of reaction the BOJ hopes to see.

If everything works as planned, Japan’s industries will rebound on the back of a weaker yen, an improving economy will improve its deficit picture, and the nation will soon have a seamlessly balanced economy of prices rising about 2 percent a year and debt to GDP levels coming down. If things go bad, we could soon be staring at the mother of all sovereign debt crises. Whatever path the Japanese economy takes, it is one that will have lessons and implications for all of us.

Meanwhile, on the continent of Europe, austerity impoverished countries aren't waiting for the results from Japan. Spanish prime minister Mariano Rajoy has called for the European Central Bank to follow other central banks with extra stimulus measures. Portugal's constitutional court rejected part's of the country's austerity budget and issued a ruling that recent deficit cuts to payments for pensioners, civil servants and unemployment benefits were unlawful and should be reversed. US treasury secretary Jack Lew used a visit to Brussels to urge top officials to relax austerity programs and drive growth. Two of Greece's biggest banks risk being nationalized after admitting they were unlikely to raise enough cash from private investors and seeing their merger blocked by the country's international lenders. Greek government officials have said deposits in the banks will not be touched; this is a big concern in light of the recent Cyprus Bank Heist; where the banks robbed the depositors.

Plenty to watch and it's just Monday.

Tuesday, January 08, 2013 - Thank You, America

Thank You, America

DOW – 55 = 13,328
SPX – 4 = 1457
NAS – 7 = 3091
10 YR YLD -.03 = 1.87%
OIL +.06 = 93.25
GOLD + 13.20 = 1661.10
SILV + .24 = 30.50

Some people have debated what we should do if the banks get into trouble again; should they be bailed out? The Too Big to Fail Banks of 2008 are even bigger today, and if one collapses, then there would likely be a cascading effect through the global financial system. So, if a big financial institution gets into trouble, should there be a bailout, or do we just say “tough luck”? You probably have an opinion, and reasonable people can debate the issue, or at least there could be room for reasonable debate, until now. As of today, there is no more debate.

If you go to Webster's Dictionary and look up the word “ingrate”, you will find a picture of Maurice “Hank” Greenberg; the guy who founded American International Group, AIG, the huge insurance company that in 2008 accepted a $182 billion dollar bailout from the Treasury. Hank Greenberg, the former CEO of AIG is contending in a lawsuit that the government treated the company’s shareholders too harshly when carrying out its 2008 rescue of the insurance giant. AIG is weighing whether to join the lawsuit, filed by Mr. Greenberg’s investment firm, Starr International Company, which owns about 12% of AIG. In addition to founding AIG, Greenberg gained notoriety for a high profile fraud case in 2005 that pushed him out of his CEO role at AIG. Greenberg was accused of using sham transactions to mask the company's financial position.

So far, AIG has not joined in the suit with Greenberg. The choice is not a simple one for the insurer. Its board members, most of whom joined after the bailout, owe a duty to shareholders to consider the lawsuit. If the board does not give careful consideration to the case, Mr. Greenberg could challenge its decision to abstain. Should Mr. Greenberg snare a major settlement without A.I.G., the company could face additional lawsuits from other shareholders. In other words, the board of directors may have a fiduciary duty to sue the government.

One of Starr International’s major arguments is that AIG’s bailout terms were far tougher than those granted to other large financial firms. Greenberg has accused the New York Fed of using the rescue to bail out Wall Street banks at the expense of shareholders, and of being a "loan shark" by charging exorbitant interest of 14.5 percent on the initial loan. 

The Treasury did force AIG to do things which were against their very nature. AIG was forced to pay full settlement on credit default swaps; one-hundred cents on the dollar, to the tune of more than $12 billion to Goldman Sachs alone. Now remember these credit default swaps were a form of insurance but they weren't insurance, and they were and remain largely unregulated. CDS is not like insurance in that it does not require reserves be held to pay off claims. The whole idea behind CDS was to collect premiums without ever paying claims. To force AIG to make full payment on a CDS claim was unprecedented and now Greenberg claims it was cruel and unusual punishment.

AIG’s cash needs and internal failings were in many ways far more serious than those of other institutions. In fact, the company was in such dire straits after the rescue that the government eased up on the terms. The concessions were considerable.

In early 2009, the Federal Reserve cut the interest rate on a big loan to AIG, saving the company about $1 billion a year in interest. Then the Treasury exchanged $40 billion of preferred shares for new ones that effectively paid no cash dividends to taxpayers. If it had paid the originally agreed 10 percent dividend on all these and other preferred shares, the insurer would have paid roughly $20 billion from the beginning of 2009 to the end 2012. Instead, the preferred shares were converted into common stock, which the government later sold, purportedly turning a profit of about $22 billion.

The bailout eventually worked out for AIG. After losing half its value in 2011, the stock rose more than 52 percent in 2012, tripling the gains of the broader S&P insurance index. Things worked out so well for AIG that they are now running a television ad campaign called “Thank You, America” in which it offers its gratitude for the bailout.

Mark Twain was right; truth is stranger than fiction because fiction is obliged to stick to possibilities.

Seriously, thank you, America.

There has been a lot of talk about breaking up the big banks, cutting them down into smaller banks that don't threaten the global financial system. The Dallas Federal Reserve has called for breaking up the biggest banks. Texas Republican Jeb Hensarling, the new Chairman of the House Financial Services Committee has expressed concern about the Too Big to Fail banks. Elizabeth Warren was elected in Massachusetts and she will sit on the Senate Banking Committee. Even Sandy Weill and John Reid, co-founders of Citigroup, which originally pushed through legislation which destroyed Glass-Steagall; they are now proposing that Glass-Steagall be reinstated and the biggest banks be broken up. The timing would seem to be right. Don't hold your breath.

The bank lobby will fight any attempts to break up the banks. Eventually, we will come back around to a big bank or insurance company on the verge of collapse and begging for a bailout; it's inevitable; the banksters continue to gamble in the derivatives markets, and eventually all gamblers lose, and when they lose.., please, please remember the story of Hank Greenberg and AIG.

Alcoa has kicked off the fourth quarter earnings reporting season by posting a profit of $242 million, or 21 cents per share, compared with a net loss of $191 million, or 18 cents per share, in the year-ago period. Excluding one-time items, net income was $64 million, or 6 cents per share, in line with average analysts' expectations of 6 cents.

Alcoa is supposed to provide clues about earnings, but I've never found a good correlation. Instead the earnings season has become little more than an exercise in obfuscation. Take the phrase “excluding one-time items”; that means the cost of doing business. Lucy Kellaway at Financial Times has come up with what she calls the Golden Flannel Awards, a mock celebration of corporate malarkey. Here's an example from one annual report: “In the wholesale channel, Burberry exited doors not aligned with brand status and invested in presentation through enhanced assortments and dedicated customised real estate in key doors.” I don't know what that means, but it might surprise you to learn that Burberry sells raincoats and they don't manufacture doors. Another company, called Record, does manufacture doors, which they call “entrance solutions”.

Sometimes companies create new words, such as: solutioneering, sustainagility, or innovalue. Sometimes, companies say things that are just designed to hide reality; for example, Citigroup issued a press release that talked about “optimizing the customer footprint across geographies,” which means they fired 1,100 workers. Citigroup also got the top prize by declaring that from now on they would offer “client-centric advice”. Sounds good until you think about what they've been offering up to now.

I still think it will be hard to top AIG's “Thank you, America.”

Anyway, welcome to earnings reporting season.

So, I was away on vacation over the holidays, but I'm catching up on the fiscal cliff deal. It has some interesting provisions; lots of little and not so little special deals, especially in the form of tax breaks. For a bunch of lawmakers who were supposedly so busy and so involved in "negotiations," they were remarkably productive when it came to special interests.

There's $9.7 billion over the next 10 years on additional subsidies for student loans or $5.6 billion for adoptions, although both those figures seem like a lot considering that employer-provided childcare is getting only $209 million. More money is at stake in subsidies for various businesses, $46 billion, and $18 billion for alternative energy. 

There's a special 50% tax credit for maintaining railroad tracks is projected to cost $331 million over the next two years.

Tax benefits for certain motorsport racing track facilities, such as Nascar, will cost more than $100 million over the next seven years.

Business property on Indian reservations will receive $660 million in tax breaks over the next three years. Indian employment tax credits will total $119 million over the next four years. Tax breaks for Alaskan Natives receiving trust income will add up to $46 million over 10 years.

More favorable deductions for contributions of food to charities will cost $314 million over two years. For contributions of property, the benefit will be $225 million over a decade.

Film and television production got the last-minute extension of tax write-offs worth $430 million over the next two years.

Businesses in Puerto Rico will receive $358 million over the next two years. In addition, a temporary increase in the excise tax rebate on rum production will give Puerto Rico and the U.S. Virgin Islands $222 million, much of which will go to benefit local rum distillers.

Regulated Investment Companies, such as mutual funds and real estate investment trusts, are to receive $211 million in tax benefits over the next two years. Some of that pertains to dividends paid to foreign investors.

Over the next two years, additional economic development credits for American Samoa will cost $62 million.

Over the next three years, $7 million will go to expand credits for plug-in electric vehicles to include motorcycles. That's a 10% rebate, up to $2,500 for buying an electric scooter.

$59 million in credits for fuel made from algae and expanding benefits for certain other biofuels.

Tax credits for renewable diesel fuel and small agricultural producers of biodiesel will total $2.2 billion over the next five years.

Asparagus growers will get $15 million.

There’s a provision that allows workers to convert conventional 401(k)s into Roth 401(k)s at a cost of $12.2 billion over the coming decade.

There were big breaks for private equity firms and hedge funds, including the

the continuation of the “carried interest” which in effect allows sophisticated investment managers to postpone their earnings from a deal and then often pay taxes at capital gains rates that are lower than the rates for fee income.

And a $9 billion tax break for big banks and manufacturers related to "active financing." Active financing is a special transaction tax break that specifically allows multinational companies to avoid paying US taxes on foreign earnings if those profits resulted from "actively" financing a deal or activity on foreign soil. Not surprisingly, big businesses claim it helps them be more competitive abroad.

Thank you, America.

Diminished Expectations

by Sinclair Noe

(to listen to Financial Review audio visit MoneyRadio.com)

DOW – 110 = 13,473
SPX – 14 = 1441
NAS – 47 = 3065
10 YR YLD - .03 = 1.72%
OIL - .23 = 92.16
GOLD – 11.60 = 1764.90
SILV - .08 = 34.00
PLAT – 8.00 = 1692.00

On this day five years ago, the Dow and S&P 500 hit record highs; the Dow closed at 14,164 and the S&P 500 closed at 1,545. The Dow is currently 4 percent below that peak, the S&P is 7 percent below its record. So, will the current cyclical bull market end tomorrow? It's not a crazy question; it happened on this date 5 years ago. It looked a little like it today.

It's earnings reporting season. Back in July, analysts said they expected Alcoa to report earnings of 12 cents per share, then expectations were lowered and now the hope was for break even. Alcoa reported a net loss of $143 million, or 13 cents per share, compared with a profit of $172 million, or 15 cents per share, in the same quarter last year. Revenue decreased 9 percent to $5.83 billion from $6.42 billion a year ago. The first report I read on Alcoa earnings after the close said, Alcoa reported quarterly earnings and revenue that topped analysts' expectations. Excluding charges from the settlement of a civil lawsuit and environmental remediation of a New York state river, earnings were 3 cents per share. Here's the thing; lawsuits and environmental remediation are part of the business model, not exclusions.

Overall earnings for the 500 companies in the S&P 500 are expected to grow slower. It should be an ugly earnings season. The companies have cut costs to the bone; they can't cut more. While most companies plan to keep a lid on spending, lower expenses aren’t leading to the same kinds of increases they reported earlier this year. The executives have been afraid to take on new projects because that involves some investment even if the results are positive net value; they're afraid of any investment if it would lower current earnings expectations. The captains of industry are, in truth, deer caught in the headlights of shareholders.

US and European economies are more integrated than most think; 25% of S&P earnings come from Europe. The International Monetary Fund had been predicting back in July that the world economy would grow by 3.5%, now they say the global forecast is 3.3%. They also say next year there will be 3.6% growth, but over the summer they said it would be 3.9% growth; back in the spring they said it would be 4.1% growth.

The IMF said that evidence from 28 countries shows that so-called fiscal multipliers, used by governments to assess the impact on growth of fiscal cutbacks, have underestimated the damage to the economy. The multipliers used in generating growth forecasts have been systematically too low since the start of the great recession. It turns out that austerity tends to slow growth in an economy. It's like the person who wants to lose weight could cut off their leg and lose 40 pounds immediately, but it turns out that amputation is not considered part of a healthy diet. And it turns out that a contractionary policy results in contraction. Who knew?

Are you sensing a pattern? Expectations get ramped down.

The IMF says the fate of the global economy lay in the hands of US and European policymakers; somehow this has been reported without any trace of irony.

The IMF forecast that Greek public debt will rise to 171% of gross domestic product this year and 182% next year; and they say Greece must restructure and that it will still be almost impossible to reduce the country's debt levels to a target of 120% debt to GDP by the year 2020. The IMF says the beatings in Europe will continue until morale improves.

So, today, German Chancellor Angela Merkel visited Greece to offer words of support. Still don't know if she'll offer cash. The Greeks did not welcome her warmly, which seems to be a traditional Greek welcome for German leaders. There were signs that said not welcome; there were protesters that brought up that whole Nazi thing; there were rocks thrown and tear gas was lobbed. Merkel wore the same green jacket she was wearing when the German soccer team beat the Greeks in the European Football Championship. Probably just a coincidence.

Spaniards continue their protests to decry tough austerity measures as the protest movement gains momentum, with signs it could culminate in a general strike in November. There has been a series of protests staged by hundreds of thousands of Spaniards almost on a daily basis over the past few months. The protests have presented the center right government with a headache as it is due to hold regional elections. Spanish labor unions said they would call a general strike if the government did not hold a referendum on unpopular spending cuts. Prime Minister Mariano Rajoy unveiled $16.9bn in additional savings in a tough budget last month. In the wake of violence during a protest in Madrid on September 25, Rajoy urged a business audience in New York last week to focus on the "silent majority" of Spaniards who do not protest. But a survey in El Pais newspaper on Sunday showed 77 per cent of Spaniards support the protesters, while more than 90 per cent think protests will become more frequent. Poverty is returning to Europe and the Spaniards are not happy, so the ruling political class is now being punished, sort of, by the people; something that would never happen in the US, unless the referees missed a call that cost the game.

Over most of history, most countries have wanted a strong currency, or at least a stable one. In the days of the gold standard and the Bretton Woods system, governments made great efforts to maintain exchange-rate pegs, even if the interest rates needed to do so prompted economic downturns. Only in exceptional economic circumstances, such as those of the 1930s and the 1970s, were those efforts deemed too painful and the pegs abandoned.

In the wake of the global financial crisis (vintage 2008), though, strong and stable are out of fashion. Many countries seem content for their currencies to depreciate. It helps their exporters gain market share and loosens monetary conditions. Rather than taking pleasure from a rise in their currency as a sign of market confidence in their economic policies, countries now react with alarm. A strong currency can not only drive exporters bankrupt, it can also, by forcing down import prices, create deflation at home.

QE’s effect on other currencies has not always been what traders might at first have expected. The first American round was in late 2008; at the time the dollar was rising sharply. The dollar is regarded as the “safe haven” currency; investors flock to it when they are worried about the outlook for the global economy. Fears were at their greatest in late 2008 and early 2009 after the collapse of Lehman Brothers. The dollar then fell again once the worst of the crisis had passed.

The second round of QE had more straightforward effects. It was launched in November 2010 and the dollar had fallen by the time the program finished in June 2011. But this fall might have been down to investor confidence that the central bank’s actions would revive the economy and that it was safe to buy riskier assets; over the same period, the Dow Jones Industrial Average rose while Treasury bond prices fell.

After all this, though, the dollar remains higher against both the euro and the pound than it was when Lehman collapsed. This does not mean that the QE was pointless; it achieved the goal of loosening monetary conditions at a time when rate cuts were no longer possible. The fact that it didn’t also lower exchange rates simply shows that no policies act in a vacuum. Any exchange rate is a relative valuation of two currencies. Traders had their doubts about the dollar, but the euro was affected by the fiscal crisis and by doubts over the currency’s very survival. Meanwhile, Britain had also been pursuing QE and was slipping back into recession. The Bank of Japan has seen ongoing QE. And the ECB spells QE, OMT.

And that is my best explanation for why gold slipped again today.

The government filed a civil mortgage fraud lawsuit today against Wells Fargo, the latest legal volley against big banks for their lending during the housing boom. The complaint, brought by the US Attorney in Manhattan, seeks damages and civil penalties from Wells Fargo for more than 10 years of alleged misconduct related to government-insured Federal Housing Administration loans.

The lawsuit alleges the FHA paid hundreds of millions of dollars on insurance claims on thousands of defaulted mortgages as a result of false certifications by Wells Fargo.

The complaint alleges, yet another major bank has engaged in a longstanding and reckless trifecta of deficient training, deficient underwriting and deficient disclosure, all while relying on the convenient backstop of government insurance. The bank denied the allegations. We've seen similar cases in the past year, including one against Citigroup' CitiMortgage Inc, which settled the case for $158.3 million in February, and against Deutsche Bank, which paid $202.3 million in May to resolve its case. The US Attorney's office in Brooklyn brought the biggest such case, against Bank of America's Countrywide unit, which agreed in February to pay $1 billion to resolve the allegations.

The joke of the day comes from David Einhorn via Barry Ritholtz: “What do you call a stock that’s down 90%? A stock that was down 80% and then got cut in half.” 

Tuesday, April 10, 2012

DOW – 213 = 12, 715
SPX – 23 = 1358
NAS – 55 = 2991
10 YR YLD -.05 = 1.99%
OIL +.09 = 101.11
GOLD + 19.30 = 1661.60
SILV + .08 = 31.94
PLAT – 14.00 = 1605.00

Today marked the start of the first quarter earnings reporting season. The Dow and the S&P have now dropped for 5 consecutive days. The S&P 500 dropped below its 50-day moving average of 1,372. The Nasdaq also slid below its 50-day moving average and closed below 3,000 for the first time since March 12. Volume finally increased today, confirming the bearish move. The Standard & Poor's 500 Index is still up 8 percent so far this year - compared with its gain of 12 percent at the end of the first quarter, but the benchmark index has fallen 4 percent in the past five sessions, its worst streak since November.

Earnings reporting is actually well underway; with 5 percent of the S&P 500 components having already reported, profits are seen rising 3.1 percent in the quarter. Symbolically or alphabetically if you really want to be accurate, Alcoa kicks off the earnings season. Alcoa is one of the 30 stocks in the Dow industrial Average and the ticker is AA. After the close of trade, Alcoa said income from continuing operations in the first quarter was $94 million, or 9 cents per share, compared with a profit of $309 million, or 27 cents per share in the same quarter last year. Revenue rose slightly to $6 billion.

Alcoa's CEO Klaus Kleinfeld said: "Performance rebounded strongly this quarter due to our proactive cash sustainability actions ... focus on profitable growth, and stabilizing markets," but he said: "Challenges remain in this economy." And even with an bounce in after hours trading, Alcoa is still down more than 40% over the past 12 months.

The results beat expectations of a loss of 5 cents per share. This is part of the funny game among Wall Street analysts and corporations to ratchet down expectations and then beat the diminished estimates. Earnings for the last quarter of 2011 surprised investors by being better than expected, with 63 percent of S&P 500 companies beating earnings estimates. And that's how the game works; surprise, we beat expectations. The current expectations are for 2 percent earnings growth for the S&P 500. Surprise!

And so the games begin.

As we work through earnings, one of the big themes is figuring out why earnings are slowing. Is it because there has been hiring, and labor costs have gone up? If that's the reason, then it is actually positive for the economy. Jobs are an expense for companies against the bottom line but jobs also mean more customers with money to spend, and the long term outlook is positive.

Meanwhile, It was a bad day for European stocks, especially the banks. Within the past few weeks the European Central Bank pumped in more than $1 trillion to prop up local banks, but it might not be enough, as concerns are growing that countries like Spain and Italy will not be able to pay their debts. The banks hold billions of state-backed debt. Spanish banks, for example, increased their holdings of government bonds by 68 billion euros ($89 billion) from November to February. Italian firms bought 54 billion euros ($71 billion) of government securities over the same period.

The yield on Spanish 10-year bonds, for example, rose to nearly 6 percent despite an announcement from the country’s prime minister about an additional 10 billion euros ($13 billion) of budget cuts. Shares in Banco Santander dropped 3.9 percent, while the stock in BBVA fell 3.6 percent.

The pain was most acute in Italy. Shares in UniCredit, the country’s largest bank, fell 8.1 percent, while the stock of its local rival Intesa Sanpaolo slipped 7.9 percent.

The declines came after reports the Italian government would cut its growth forecast for 2012. Italy is expected to grow by 0.4 percent – so now it might be negative.

Federal Reserve Chairman Bernanke was speaking last night. He said the banks need more capital in order to ensure the financial system is stable. Yeah, that's the answer, give the banks more money. How's that been working out for ya?

Bernanke said regulators were taking steps to force financial institutions to hold higher capital buffers, even if they allow for a long period of implementation. Bernanke said the U.S. economy has yet to fully recover from the effects of the financial crisis, and regulators must continue to find new ways to strengthen the banking system. He said financial stability matters had historically played second fiddle to monetary policy issues in the list of central bank priorities, but the crisis changed that.

Bernanke said recent bank stress tests will become a regular feature of the supervisory landscape, and for that reason the latest round of tests is being reviewed to identify possible areas of improvement in "execution and communication."

He reiterated a worry that he and other top policymakers have expressed about the continued vulnerability of money market funds.

"Additional steps to increase the resiliency of money market funds are important for the overall stability of our financial system and warrant serious consideration," Bernanke said.

"The risk of runs ... remains a concern, particularly since some of the tools that policymakers employed to stem the runs during the crisis are no longer available."

Let's clear this up. Bernanke isn't talking about the old-fashioned run on the bank, after all bank deposits are insured by the Federal Deposit Insurance Corporation, and, as a last resort, the Federal Reserve can back deposits by printing money.

The new complication is that bank deposits are no longer the dominant form of modern short-term finance. The modern bank run means a rush to withdraw from money market funds, the disappearance of reliable collateral for overnight loans between banks or the sudden pulling of short-term credit to a troubled financial institution. But these new versions are in some ways still similar to the old: both reflect the desire to pull money out of an endeavor — and to be the first out the door. And both can set off a crash.

These newer forms occur in the so-called shadow banking system, involving short-term financial credit not guaranteed by the deposit insurance umbrella.  shadow banking accounts for about $15 trillion in assets — more than the traditional banking system. But as recently as 1990, the shadow-banking total was much lower, at less than $4 trillion. The core problem is that the growth of short-term credit has been outracing our ability to protect it, and since 2008 most investors have realized that these shadow-banking transactions are not risk-free. The quantity of open derivatives amounts to trillions, and these positions are another source of short-term credit risk. So a need for sudden payouts could also prompt a run on a financial institution.

It now seems that the 21st century will resemble the 19th and early 20th centuries, with periodic panics and runs on financial institutions, perhaps followed by deflationary collapses. In the euro zone, these problems have plagued banks and entire countries, like Greece and Portugal. The “country as bank” is a new and not entirely reassuring catch phrase, and it shows that the problem goes beyond the private sector.

The European Central Bank has stemmed a financial collapse for now, but only by lending large amounts to banks at 1 percent for a three-year window, but there is a lingering doubt that it might not be enough. Should governmental guarantees be extended beyond traditional bank deposits? That would check the problem, but at what cost? In a larger financial crisis based on insolvency, government would face intolerable financial burdens, as happened in Ireland when its government guaranteed bank debts.

There is no stomach for bank bailouts, shadow or otherwise; the economy may be showing some signs of improvement but we never fixed the banking system, and if you're looking for a weak link – this might be it.

The Federal Reserve is going on tour. It seems every voting member of the FOMC has a speaking engagement this week. Federal Reserve policymakers last month kept their ultra-easy monetary policy in place, reiterating expectations they will need to keep U.S. interest rates near zero through late 2014 to nurse a slow recovery. So, what have they been saying?

DALLAS FED PRESIDENT RICHARD FISHER, APRIL 10

"To a person that I speak to, I am pleaded with, 'Please no more liquidity."

ST. LOUIS FED PRESIDENT JAMES BULLARD, April 5

"The 2014 language in effect names a date far in the future at which macroeconomic conditions are still expected to be exceptionally poor. This is an unwarranted pessimistic signal for the (Fed) to send."

* SAN FRANCISCO FED PRESIDENT JOHN WILLIAMS, April 4

"The arguments for doing another dose of monetary stimulus aren't nearly as strong....Relative to a few months ago, I think the downside risks to the U.S. economy have lessened."

* CLEVELAND FED PRESIDENT SANDRA PIANALTO, April 2

"With my current outlook, I think our policy stance is still the one best suited to foster steady gains in output and employment and to maintain stable prices."

FED CHAIRMAN BEN BERNANKE, March 29

"As always, we have to look at the inflation side and be comfortable that price stability will be maintained and that inflation will be low and stable. ... There's no simple formula, but as the economy strengthens and becomes more self-sustaining then at some point ... the need for so much support from the Fed will begin to diminish."

PHILADELPHIA FED PRESIDENT CHARLES PLOSSER, March 29

"If growth continues to improve, the unemployment rate continues to fall, then there will be increasing pressure on us to begin easing off of our policy stance. ... We've never been in this situation. ... We don't know how rapidly we might have to raise interest rates."

ATLANTA FED PRESIDENT DENNIS LOCKHART, March 29

"I don't see too much danger coming from Europe through real economy channels and I would say the potential for something coming through financial channels has actually reduced recently."

 NEW YORK FED PRESIDENT WILLIAM DUDLEY, March 27

"At this time, although I do not anticipate further efforts by the Federal Reserve to address the potential spillover effects of Europe on the United States, we will continue to monitor the situation closely."

Around the beginning of the month we started talking about the old adage “Sell in May and stay away”; so, that was a very good call but I must admit, the past five days have been a little sharper and swifter decline than I thought. April typically is a strong month for the U.S. stock market, but not in presidential election years. Since 2006, stocks have risen every April, gaining an average of 4.2%, and April is the best month for the Dow. Election year April has been about half as good with the Dow up only about 1% back to 1950 and Nasdaq actually going negative in election years. There tends to be quite a bit of selling in April after you have a better idea of who the contenders will be for the national election.

Rick Santorum received a calculator in his Easter basket. He did the math and he has suspended his campaign.

Best Buy CEO Brian Dunn has quit. There was an audit committee investigation of Dunn; he quit before the investigation was completed.

Crude oil futures dropped to their lowest prices in 2 months.

The newly formed Consumer Financial Protection Bureau outlined details of a measure that would require mortgage servicers to provide regular monthly statements to borrowers with a breakdown of each payment so borrowers know how much they are spending on fees, interest and what amount is going to reduce the principal they owe.

Delinquent borrowers would be required to receive alerts and information about counselors to help in their efforts to avoid foreclosure. Another proposal would require servicers to provide borrowers with advanced notice that their interest rate will change for homeowners who have adjustable-rate mortgages.

Ed DeMarco, the head regulator for Fannie Mae and Freddie Mac says a preliminary analysis shows that it might make financial sense for the government-backed mortgage giants to reduce the loan balances of struggling homeowners. New data shows Fannie and Freddie could save an estimated $1.7 billion by taking advantage of enhanced incentives from the Treasury Department to write down the principal for some homeowners, but he said more study is warranted before making such a move. Sure, that's the answer – wait a few more years. Nobody thought of this in the past five years; let's cogitate, let it stew; don't rush into anything.