Thursday, August 21, 2014 - Rarified Air

Rarified Air

by Sinclair Noe

DOW + 60 = 17,039
SPX + 5 = 1992
NAS + 5 = 4532
10 YR YLD - .02 = 2.40%
OIL + .45 = 93.90
GOLD – 15.10 = 1277.30
SILV - .04 = 19.52

The S&P 500 broke two records during today's session, climbing past its previous intraday all-time high of 1,991.39 and ending above its previous record close of 1,987.98. Both had been set on July 24.

Family Dollar has rejected a $9 billion dollar buyout offer from Dollar General, opting instead for a smaller $8.5 billion dollar offer from Dollar Tree. The thinking is that a combination of the largest dollar store – Dollar General with the #2 Family Dollar, would be unlikely to win antitrust approval.

Once upon a time, Sears was the largest retailer in the nation. Today, Sears Holdings announce it lost $975 million in the first half of the year; $573 million in the second quarter. This was the 9^th consecutive quarter of losses, and the past quarter also marked the heaviest losses. Quarterly revenue dropped about 10%. The plan now is to close underperforming stores, or, in a classic example of corporate-speak “rationalizing our physical footprint.” The company successfully spun off Lands End earlier this year, to the benefit of shareholders. But its Sears Canada and Sears Automotive stores have been on the block for some time, indicating either a lack of interest on the part of buyers or an unwillingness by Sears to bend on its asking price.

Gap shares moved higher in after-hours trade after earnings topped expectations. With a few exceptions, retail earnings this quarter have been disappointing. Last week, Walmart cut its full-year earnings guidance, and a few days later, Target reported a disappointing quarter. It’s hard to get consumers to loosen their grip on the purse strings.

The National Association of Realtors said sales of existing homes rose 2.4% in July to a seasonally adjusted annual rate of 5.15 million, the fourth consecutive month of gains and the fastest rate of gain in 10 months. More people are buying homes compared to earlier in the year, but the sales pace is still down 4.3% from one year ago. The median existing-home price for all housing types in July was $222,900, which is 4.9% above July 2013. This marks the 29th consecutive month of year-over-year price gains.

In a separate report, the Labor Department said initial claims for state unemployment benefits fell 14,000 to a seasonally adjusted 298,000 for the week ended Aug. 16.

The Conference Board’s Leading Economic Index increased 0.9% last month after an upwardly revised 0.6% rise in June.

The Bureau of Economic Analysis, the BEA, has released its state by state analysis of quarterly gross domestic product. California has the biggest economy among the states, with about $2.1 trillion in GDP, followed by Texas at $1.4 trillion, and New York at $1.2 trillion. Vermont has state GDP of about $28 billion. Arizona comes in at almost $265 billion.

The latest numbers from the Census Bureau show the gap between Americans at the top of the economic ladder and those at the bottom is as wide as ever. Between 2000 and 2011, the gap expanded considerably. The net worth of the poorest 20% of US households fell by $5,124. At the same time, the wealthiest 20% posted a $61,379 increase in net worth. Looked at another way, the net worth of the richest 20% of families totaled $630,754 in 2011. The poorest had a negative net worth of $6,029. Altogether, the top 40% of households increased their net worth from 2000 to 2011. The bottom 60% lost ground.

Sentier Research has analyzed Census data on incomes. In June 2014, the median household income was $53,891, down from $55,589 in inflation-adjusted dollars when the economic expansion began in June 2009; that is a 3.1% drop in median income. Now, let’s clarify this report because you may have seen that the average inflation adjusted per-person disposable personal income is up 4.2% over the past 5 years. There is a difference between median and average; Bill Gates walks into a room with 80 other people and the average net worth of everyone in the room is about one billion dollars; while the median net worth is barely changed. The averages can be distorted by the strong income gains among the wealthiest; the median income numbers give a better sense of the majority of Americans.

And it’s not just the past 5 years; median income remains lower than back in January 2000; the middle income family is worse off than they were 14 years ago. The good news is that there has been some improvement in the past 3 years; since 2011, inflation adjusted household incomes are up 3.8%. We are starting to dig out of a hole, but we’re still digging.

The point is that the economic recovery has been pretty miserable for most Americans. Meanwhile, the Federal Reserve is holding its annual confab for the world’s most powerful financial players at Jackson Hole, Wyoming. The invitation only soiree includes central bankers, investment bankers, economists, and a various assortment of other bigwigs. Tomorrow morning, Fed Chair Janet Yellen will deliver the customary opening speech. ECB President Mario Draghi will speak at lunch. This year’s theme is “Re-Evaluating Labor Market Dynamics”.

In the mountains of Wyoming, the air is thin, and around Jackson Hole, it is rarified: One banker was quoted as saying: "It seems that conditions reflect the best of all worlds - US economic growth that is neither too slow, which would put pressure on earnings - nor too fast, implying inflationary pressures which could lead to (price-to-earnings ratio) contraction and possibly accelerate the Fed's move towards higher interest rates."

Kansas City Federal Reserve Bank President Esther George says the time has come for the Fed to raise rates, citing improvement in the labor markets. George said: "I don't want us to be behind the curve in beginning to normalize interest rates… When you see the economy getting as close as we are to full employment, to stable inflation, it would suggest to me that the time has come to do that… I think a very natural response when you get to this point is worrying that you might derail the recovery, but then again we've seen data come in stronger than we expected."

Fed officials are convinced that the economy is gaining strength after the years of false starts, but a majority of policy makers, led by Janet Yellen, favors a slow retreat from the Fed’s efforts to encourage job creation. They note that millions of people still cannot find jobs, while inflation remains relatively weak.

The theme is the labor market, and the Fed tracks wage trends closely because they're an important inflation indicator, and they're also a reflection of how close the economy is to full capacity. Also, in a well-functioning economy, wages should be rising particularly when productivity is going up. The Fed can't really do anything to get wages up; what it can do is wait to raise interest rates until the job market is healthier and that's what they're debating now - should they wait a while longer?

The latest government data show average hourly earnings adjusted for inflation have not increased at all in the last year, even though we're told the economy is getting better and other wage measures show similar trends. The problem with Jackson Hole is somebody like Bill Gates walks into a restaurant, and all the economist believe they are billionaires.

It is shaping up to be another good year in the equity markets, not as good as last year, but not a letdown; investors have ignored the calls for a correction, and this is still a risk-on market. Typically, when risk is not given much weight, this would be a good time to hedge one’s portfolio. And the reason for “risk-on” is a Federal Reserve that keeps interest rates at historic low levels; add in the demographics of most investors who have no choice but to stick what they have into higher risk assets such as stocks; plus the corporate world that is sitting on cash and the closest idea to innovation is to buy back their own stock, thus pushing prices even higher.

In this environment, weakness in the economy and even geopolitical events are being disregarded, with both being seen as buying opportunities. Investors might not have much choice but to hang onto the bandwagon, but you also should be keenly aware of when you need to get off because the markets could switch to risk-off in the blink of an eye.

The Bank of America settlement deal was announced today. BofA agreed to pay $16.65 billion to end federal and state investigations into the sale of toxic mortgage securities during the subprime housing boom; actually, it works out to $9.65 billion that will actually be paid, plus $7 billion in soft-consumer relief; minus about $600 million in tax deductions. About $5 billion of the cash portion of the settlement is paid as a penalty to the US Treasury. Other portions will go toward compensating investors, including state pension funds. Just under $1 billion will be split among six states.

Under the out-of-court settlement, Bank of America acknowledged that Merrill Lynch told investors in subprime mortgage bonds in 2006 and 2007 that the loans generally complied with underwriting guidelines, though reviews suggested as many as 50% did not. Bank of America also acknowledged that Countrywide did not generally tell investors the extent to which it made exceptions to its own internal guidelines. The settlement also covered some post-crisis conduct, including Bank of America's admission that from 2009 to 2012 it submitted loans for government insurance under the Federal Housing Administration that did not qualify.

The statement of facts failed to identify the amount of profit the bank gained, or show how the penalty will restore losses to investor victims. No individuals were charged. Maybe we can blame robots.

Bank of America shares jumped 4.1% to $16.16; the thinking is that the worst is behind them. The bank had already set aside reserves to handle the legal problems and the thinking is that this settlement is the settlement to end all settlements. Ultimately it works out to about a half year’s profit, give or take; you know, the cost of doing business.

Tuesday, September 17, 2013 - Everything is on Hold at a Bad Level

Everything is on Hold at a Bad Level

by Sinclair Noe

DOW + 34 = 15,529
SPX + 7 = 1704
NAS + 27 = 3745
10 YR YLD - .02 = 2.84%
OIL + .22 = 105.64
GOLD – 3.90 = 1311.00
SILV- .08 = 21.84

Market players are focusing on the Fed right now. Yesterday, Larry Summers withdrew his name from consideration to be the next Fed Chairman; maybe it doesn't matter who the next Fed chair is, they are likely to continue on the same path. Today, Jim Rogers said the role of Fed Chair is nothing more than a lapdog for the establishment. Harsh, but not necessarily inaccurate. Still, the Fed Chair is a powerful role and it looks like a woman almost nobody knows will soon take over. Give yourself 3 points if you know her name and her current job title. (Janet Yellen, Fed Vice Chair)

The Federal Open Market Committee, the FOMC, was meeting today; they'll continue meeting tomorrow to determine monetary policy. It's widely expected the FOMC will announce taper, in part because of logistics. The FOMC meets tomorrow, another meeting in October, another meeting in December, and then Bernanke retires. Market participants are expecting taper, and the Fed usually avoids surprises. September and December are the two most likely times for an announcement, in part because the October FOMC meeting does not include a scheduled press conference to explain any significant changes; also October will be right in line with budget battles If there is a negative market reaction to taper, it's probably better to have it in September rather than December, heading into the holidays.

The decision to QE or not QE doesn't seem to be based upon economic progress; the economy has improved but it is still a long, long, long, long way from healthy, especially in the labor markets. A new report from the Census Bureau today confirms the economic weakness. Last year, for the first time in half a decade, median household income did not fall and poverty did not rise. The report depicts an economy that has failed to improve the lot of most households and left about 46.5 million Americans living in poverty in 2012.

Median household income, adjusted for inflation, fell slightly for the fifth straight year to $51,017, the lowest level since 1995. That is down about 9 percent from an inflation-adjusted peak of $56,080 in 1999, though the economy has grown by about 28 percent since then. Income is also down about 8.3 percent since 2007, when the economy started to contract. The census data shows that the top 5 percent of earners — households making more than about $191,000 a year — have recovered most of their losses and took in about as much in 2012 as they did before the downturn. But those in the bottom 80 percent of the income distribution are, on average, making considerably less.

More than 20% of homes headed by a college grad and 24 percent of Americans working full-time can't make ends meet. Those statistics indicate that economic insecurity extends beyond the unemployed or little-educated. It also indicates that poverty is a much bigger problem than you probably think. The good news is that everything’s on hold, but at a bad level. Don’t expect things to change until the American economy begins to generate more jobs. And tomorrow the Fed is probably going to whistle past that graveyard.

Instead the Fed, according to their minutes, is afraid of asset bubbles and frothy markets. Also, the FOMC recognizes that the efficacy of QE is fading; $85 billion a month in asset purchases just doesn't have the same punch it once delivered. One more consideration is that the deficit is shrinking. That means the Treasury issues less and less debt to cover government spending. Right now, purchases of government debt by way of QE account for the majority of new debt issued by the Treasury, and if the Fed continues buying at the current pace they could reduce the supply of Treasuries available to other market participants. This could be a problem because Treasuries are one of the few remaining Triple-A rated financial instruments, which is sometimes a requirement for collateral; and without that collateral a whole bunch of deals never get done. So, if the Fed keeps up QE they risk choking out the financial system's ability to lend and create possible destabilization in the Treasury market..

We'll see what happens tomorrow.

If you can give a reasonably simple definition of QE, congratulations. You are a very smart person. Slap a gold star on your forehead. A new Reuters Ipsos poll finds  just 27 percent of US adults could pick the correct definition of quantitative easing from among five possible answers. Quantitative easing, or QE for short, is when the Fed buys bonds in order to push down interest rates and boost the economy.

Fed officials have stressed how important it is that the public does not equate a reduction in quantitative easing with a rise in interest rates. Even though the Fed's well telegraphed intention to pare back its bond buying has raised interest rates over the last five months. Two conclusions: The Fed at times has not done a very good job of explaining what it is up to. Also, it's also fair to say that the state of financial literacy in the United States has room for improvement.

The other big news this week was the mass shooting at the Navy Yard in Washington D.C.; you've heard all about it and it is another tragic story and the only thing I can add is that nothing will change.

The other big news this week has been the flooding in Colorado; there are a few little sidebar stories here that you probably haven't heard. The rain and flooding washed out roads and bridges. To assess the damage a Colorado company that makes drones started flying the drones to photograph the damage, making maps. Within a couple of hours they were delivering high resolution, georeferenced maps; that's very helpful for emergency responders. Very helpful, especially because the drones can fly even when manned airplanes and helicopters can't fly because of bad weather. Or at least the drones could fly until last Saturday, when FEMA showed up and closed the drones down.

The other thing you haven't heard about from the Colorado floods is the natural gas rigs that were flooded. Some gas wells were submerged, some tanks were ripped from their stands. Leaking tanks have been spotted floating down rivers. There is a huge amount of toxic gas leaking into the water. I haven't heard anything about it on mainstream media.

The inflation adjusted U.S. gross national product, the most comprehensive measure of U.S. economic activity, grew by 2.5 percent in 2012, according to the Commerce Department. We're now getting some breakout by city. San Francisco had the fastest growing economy in the country, up 7.4%, and Houston grew at a 5.3% clip, followed by LA at 3.1% growth.

JPMorgan Chase has agreed to pay about $800 million to a host of government agencies in Washington and London — and make a groundbreaking admission of wrongdoing — to settle allegations stemming from a multibillion-dollar trading loss. This is technically accurate and shows some refreshing tough-mindedness among regulators in how they are negotiating with JP Morgan over its London Whale trades. JP Morgan had risk controls that were way way short of industry standards, and bank executives, including Dimon himself, lied flagrantly to the media about the nature and severity of the case for a troublingly long time after it became public. And we learned later that the bank was exceptionally high-handed and dishonest in its dealings with regulators.

The FBI and the Manhattan prosecutor’s office are still investigating criminal charges and the CFTC is continuing with its own probe. Unlike the SEC, the trading commission has examined whether JPMorgan amassed a position so large that it “manipulated” the market for financial contracts known as derivatives. And the proposed settlement opens the door for private litigation. But the big win for JPMorgan is that senior executives are avoiding charges despite blatant and well-recorded lies. Martha Stewart is probably foaming at the mouth.

A grand jury has indicted two former JPMorgan traders at the center of the bank's "London Whale" scandal. Javier Martin-Artajo and Julien Grout were accused of hiding hundreds of millions of dollars of losses within JPMorgan's chief investment office in London by marking positions in a credit derivatives portfolio at inflated prices. The two men were charged by prosecutors last month. Eventually, if the regulators maintain backbone, they will eventually find employees willing to cut a deal and roll-over on senior executives, but for now the code of “omerta” is alive and well in the banking industry.

Even with the settlements in the trading loss case, the bank’s regulatory problems are far from resolved. JPMorgan faces inquiries from at least seven federal agencies and two European nations. The authorities have cast a wide net, examining everything from the bank’s hiring practices in China to mortgage loans it sold to investors in the financial crisis. Prosecutors and the F.B.I. in Manhattan are also examining whether JPMorgan did not alert authorities to suspicions about Bernie Madoff's ponzi scheme. Then there's the probe by the Federal Housing Finance Agency, which has accused JPMorgan of selling shoddy mortgage securities to Fannie Mae and Freddie Mac. Then there is the comptroller's office and the Consumer Financial Protection Bureau's investigation into the way the bank collected credit card debt from customers. I'm sure there's something I'm forgetting, but that's enough for now.

Wednesday, May 29, 2013 - Behind the Curtain

Behind the Curtain

by Sinclair Noe

DOW – 106 = 15,302
SPX – 11 = 1648
NAS – 21 = 3467
10 YR YLD - .01 = 2.12%
OIL – 2.12 = 92.89
GOLD + 11.30 = 1393.70
SILV + .19 = 22.56

Earlier today, I listened to one of the talking heads on CNBC trying to explain why the markets were up yesterday and down today. It was very entertaining.

When mortgage interest rates fall, the probability that an individual will re-finance a mortgage increases. When mortgage interest rates increase, the likelihood of a re-financing of the mortgage goes down. Therefore, in a rising rate environment, the average life of a pool of mortgages increases. For example, if a bond fund held Mortgage Backed Securities (MBS) with an assumed 10-year average life, and interest rates rose, the average life of the MBS portfolio would be extended for a few years. The last thing that a bond manager wants in a rising rate environment is to have the average maturity of the portfolio extended, as this adds to the losses. As a result, MBS players hedge their portfolios against “duration risk” by shorting Treasuries. The higher rates go, and the speed that rates are increasing, forces more and more selling.

Is there a level of support that we can watch? There is, and it's probably 2.2% to 2.5% on the 10-year bond that will bring out an avalanche of selling. The 2.2% tipping point is very close to where the T-bond sits today. Others say we have a huge concentration of bonds that would go out of the money around 2.5% - again, very close to where we are.

The more the price on the 10-year drops, and the higher the yield climbs, the more selling is required. Is the Big Sell-off going to happen? That depends on the performance of the bond market, and on how the dealer community is positioning themselves against event risk.

There are risks: generally speaking, and in regards to ‘taper’ of QE, soon as the Fed pulls back, we will see a spike/knee-jerk higher in rates (which we are seeing in ‘anticipation’ of this happening). Remember, all the movement we've seen in bonds in the past two weeks is just from jawboning about the possibility of taper.

Bernanke has recently said that the Fed is in the process of  changing the monthly QE purchases. Here's a big question to be considered – does taper of QE indicate the economy is better? That would be the reason to raise rates; the economy is improving – raise rates; everything else is artificial, or just an attempt to tamp down an impending asset bubble.

Yesterday, we heard that consumer confidence was up, a big jump in May to 76.2. It sounds like everybody believes the economy is improving. And while the confidence numbers are up, they're not out of the gutter. The average consumer confidence number during a recession is about 79, and even with our recent boost, we're still lagging below that low bar. The May data shows the highest measure of consumer confidence since February 2008. That was a time in which a housing crash was already well underway, and only a month before before Bear Stearns collapsed and confirmed that the country was in a financial crisis.

Yesterday, we also had the S&P/Case-Shiller House Price Index posting a 10.9% increase year over year in March. Well, that certainly sounds like things are improving. Except, in nominal terms, the Case-Shiller National index (SA) is back to the third quarter of 2003 levels. Inflation adjusted, prices are back to the second quarter of 2000. The biggest price gains were noted in Phoenix, Las Vegas, and San Francisco; all areas that were smashed by the housing crash. So, in some ways, the great rebound in housing is just another stage in the foreclosure crisis. And that is a crisis that is not yet finished.

Last year $192 billion-dollars was lost as a result of foreclosures.  On average per household, this number equates to about $1,700 of loss in 2012. The foreclosure crisis is still ongoing despite the fact that foreclosure volumes are on the decline. Why are the number of foreclosures on the decline? Last month, three major banks, including Citigroup, JPMorgan Chase, and Wells Fargo, halted all their sales of homes in foreclosure; this also reduced the supply of homes on the market. The apparent problem is that the banks still weren't following the rules for foreclosures, in violation of the national mortgage settlement. The reduction in housing supply, then, is largely artificial.

There is one thing that housing prices do accomplish, however: the so-called "wealth effect." Along with a booming stock prices, higher property values make people feel rich. This then encourages them to go out and spend money. Here's the problem with the wealth effect, you have to realize your gains. In other words, you would have to sell your stocks and your real estate and put the profit in your wallet, otherwise the wealth effect is so much smoke and mirrors, and you're spending money you don't really have. Which is one thing that Americans have apparently mastered.

Half of working Americans now earn less than they did 10 years ago, adjusted for inflation. Middle class incomes have barely budged in 44 years. Around 12 million people are unemployed, about 40% of whom have been out of work for six months or more. Remember the Summer of 2012? All the politicians were talking about jobs, jobs, jobs. Now, they can't even spell it. Poverty is on the rise, and it would be in your face and on the sidewalks except that now we have food stamps, so we don't have to look at the lines of people waiting outside soup kitchens like in the Great Depression. Still, 15% of the country depends on foods stamps.

For people who do have jobs, the quality of the jobs continues to decline, and if you were thinking about retiring, well, you probably are having to re-think your personal exit strategy. According to a recent Gallup survey, 37% of nonretired Americans claim that they will quit working after age 65. A decade ago, that percentage was 22, and in 1995, only 14% guessed they'd be retiring after 65. Is it possible that work is now more fulfilling for so many more people? Were so many employers discriminating against willing 65-year-olds a couple decades ago? Not likely. People are working longer to keep food on the table and a roof over their head.

Besides not having saved enough, today's would-be retiring baby boomers have more debt. The Census Bureau reports that from 2000-2011, the largest percentage increases in median household debt were in the 55-64 age bracket (up 64%, to $70,000) and the 65-and-over bracket (more than doubling, to $26,000). And while many were taking on more debt, median net worth (assets minus liabilities) for all age groups fell. In 2000, median net worth was $81,821. In 2005, median net worth had jumped to $106,585, before dropping to $68,828 in 2011 (in 2011 constant dollars).

In 1985 taxable money market funds were yielding 7.71%. A one-year CD was yielding 8.53%. Nowadays, CD's and money market funds offer rates that start with a decimal point. The Fed has been forcing people into the equity market and if you just don't have the stomach for stocks, you've been forced into the bond market.

The Fed's bond holdings alone have almost tripled since March 2008. And since last fall, the Fed has purchased mortgaged-backed securities and bonds by $85 billion each month. As a result, Fed's holdings in securities will amount to $4 trillion by the year-end of 2013. At the same time, the balance sheets of the big four central banks (the Fed, European Central Bank, Bank of Japan, and People's Bank of China) have more than quadrupled from $3 trillion to more than $13 trillion during the past half a decade.

As rounds of QE have pushed nominal interest rates below the rate of inflation in the United States, it was hoped that negative "real" interest rates would encourage lending and borrowing, and thus to stimulate economic activity. But this is growth by addiction, not growth by fundamentals.

Ben Bernanke knows this economy is not strong. This is no time to back away from trying to prop up the economy. Or as Bernanke said: “A premature tightening of monetary policy could lead interest rates to rise temporarily but would also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further.”

Is the economy in better shape than a couple of years ago? Yes, but it's a little early to break into a chorus of “Happy Days are Here Again”. While economic growth has picked up, it remains anemic at 2.2 percent real GDP growth on average since the end of the recession in mid-2009. As long as the US is growing well below potential; about 2.2 percent since the Great Recession/depression, inflation risks remain low and disinflation is the new normal, which serves as a still another reason to keep interest rates low. A lot of people would like to press the idea that the economy is improving; Congress can keep ignoring the unemployment and equality crises and enjoy ginning up imaginary problems.

“The loss of output and earnings associated with high unemployment reduces revenues and increases spending on income-support programs, thereby leading to larger budget deficits and higher levels of public debt than would otherwise occur.” At least that's what Bernanke claimed in his recent testimony to Congress. Maybe Winston Churchill said It better: “Americans can always be counted on to do the right thing, after they have exhausted all other possibilities.”

A mythical recovery gives cover to a lot of irresponsible people hoping that Americans won't look behind the curtain.