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
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 10th, 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.
