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

Ugly Day, Ugly Logic

by Sinclair Noe

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Monday, April 07, 2014 - I Don’t Know, They Don’t Know

I Don’t Know, They Don’t Know

by Sinclair Noe

DOW – 166 = 16,245
SPX – 20 = 1845
NAS – 47 = 4079
10 YR YLD - .03 = 2.69%
OIL - .44 = 100.70
GOLD – 5.40 = 1297.90
SILV - .09 = 19.97

The biggest 3 day drop in the markets in about 2 months. All of the sudden we start hearing the Wall Street stock peddlers waxing enthusiastic about the prospects for a correction or a crash or whatever will scare you. Fear sells; with talk about a 1987-like stock market crash, geopolitical unrest in Ukraine and the risk of a debt crisis in China, investors are starting to get jittery. I don’t know, they don’t know.

The big pullback so far has been in the Nasdaq, and especially biotech stocks. As always, you want an exit plan in place before you ever get into a trade; and if you don’t have an exit plan, get one now. You don’t make money by letting profits slip through your fingers.

Earnings season gets underway this week. Expectations have been ratcheted down; at the start of the year, S&P 500 companies were projected to have grown earnings at 6.5%, now that estimate has slipped to 1.2%. We could see companies beat diminished expectations and start a fresh rally or miss expectations and the markets could get a bit ugly. The simple rule of thumb is that when the trailing P/E ratios hit 10, the S&P 500 is likely undervalued; when the P/E hits 20, the market is likely overvalued and that means the market is vulnerable to pullback. Guess where we are on the scale? Does that mean that stock prices are about to roll over and play dead? Not necessarily. All we have to do is add some earnings to the P/E ratio and …

The S&P 500 recently, as in last week, tested highs, even though fewer than 10% of its components were making new highs individually. Despite the fact that the S&P touched new high territory last week, the average stock in the big index is actually down 7%. Then, you can look at volume; down on up days; up on down days, like today. Toss in the presidential election cycle, toss in the old but true idea of “sell in May”, and there are plenty of reasons for caution.

The past couple of years have been easy; buy the dips; buy good names with momentum and ride that pony to profits. Easy. But easy doesn’t last forever. The momentum names look like they’re rolling over. Investors are rolling over into safer sectors. We’ve gone nearly 2 years without a correction of at least 10%, so it just seems like we’re due. So, while there may be value to be found, this does not seem like a good time to load up when high flyers dip. They may bounce back, but they don’t have to; there is no law that requires a bounce. When a momentum play turns, it tends to turn fast and furious.

This continues to be a tale of two markets. While the high flyers stall, the safety of bonds has been drawing bids, and yields have dipped over the past few days, despite the Fed's clear intention to pull back on Quantitative Easing and bond buying. The utility sector has been outperforming, which might be a signal of future volatility. Emerging markets have seen inflows; maybe this is the idea that the US has been the cleanest dirty shirt in the hamper, but the other shirts aren’t ready to be scrapped; call it a reversion to the mean.

Maybe it’s just time to pause and ask why US stocks have priced in so much optimism. Job growth continues but it is not robust and it is not enough to propel the economy to escape velocity; the taper is underway; fiscal policy remains a mess and there is little hope for stimulus from DC.

Corporate America is sitting on a mountain of cash, somewhere between $1.6 and $1.9 trillion, but it’s offshore; they’re afraid to touch it because they might have to pay tax. They could bring that money back home and put it to work, but that would require innovation and sweat and labor. Much of corporate leadership is short-sighted and lazy, and besides, the offshore cash is still good enough to secure a bonus.

One of the key signs of a true recovery is sufficient business confidence to start investing more into their own operations. Many companies have shied away from investing in the future growth of their companies. Too many companies have cut capital expenditure and even increased debt to boost dividends and increase share buybacks. If you’re waiting for capital expenditures to revive the economy, don’t hold your breath.

Larry Fink is the CEO of Blackrock, the largest money manager, he says: “Companies only have a finite amount of cash to invest. Whatever gets spent on buybacks and dividends is that much less available to be spent on investments in employees, research and development, and capital expenditure. It's basic arithmetic. When will the next round of capital investment begin in earnest? As soon as you figure out the answer to that question, you will have gained significant insight into the direction of the economy as well as the next phase of this stock-market rally.”

Meanwhile, let’s look at banks behaving badly. Private banking is a staple of the Swiss economy and for decades, as wealthy Americans concealed their assets through clandestine accounts, US regulators turned a blind eye.

In 2011, federal prosecutors indicted 7 Credit Suisse bankers for abetting tax evasion, but the investigation into Credit Suisse dragged on. The quirks of international law prolonged the inquiry, requiring Swiss courts to review Credit Suisse documents before releasing them to the Justice Department. Ultimately, the Justice Department gained access to many of the documents and interviewed bank employees.

And by the time the Senate subcommittee convened its hearing in February, the Justice Department was closing in on a case. Bracing for a settlement, the bank announced last week that it had set aside roughly $528 million for legal expenses. In addition to the Justice Department investigation, Credit Suisse paid $200 million to settle a case with the SEC in February. In a separate matter, in late March the bank agreed to an $885 million settlement to resolve claims that it sold questionable loans to Fannie Mae and Freddie Mac. Apparently a slap on the wrist and a fine haven’t served as a deterrent.

Now, Benjamin Lawsky, New York State’s top financial regulator, has requested documents from Credit Suisse and is expected to demand additional records this week to try to determine if Credit Suisse lied to New York authorities about engineering tax shelters. In the Senate subcommittee hearings in February, Credit Suisse executives apologized for the misconduct and they also argued that the problems stopped in 2008 and were contained to a few low-level rogue bankers. The bank, which said it voluntarily adopted a number of controls against tax evasion, reported that there was no evidence that executive management knew of the problems.

Lawsky has also petitioned a Senate subcommittee for internal Credit Suisse documents.  The subcommittee questioned bank executives at a hearing in February, and produced a scathing report exposing “a classic case of bank secrecy.” In late March, the Senate agreed to release the internal Credit Suisse documents.

The escalating Credit Suisse probe, along with some recent shifts in international law, might also provide momentum to the government’s uneven effort to collect taxes and punish the banks involved. Typically the punishment has been a fine and a slap on the wrist, but that has drawn scrutiny from politicians lately, and so maybe this will be something more.

Meanwhile, federal authorities have opened a criminal investigation into a recent $400 million fraud involving Citigroup’s Mexican unit, one of a handful of government inquiries looming over Citi.

The investigation, overseen by the FBI and prosecutors from the United States attorney’s office in Manhattan, is focusing in part on whether holes in the bank’s internal controls contributed to the fraud in Mexico. The question for investigators is whether Citigroup ignored warning signs, as other banks have been accused of doing in the context of money laundering.

Federal prosecutors in Massachusetts have sent subpoenas to Citigroup, to examine whether the bank lacked proper safeguards against clients laundering money. Citi also faces a parallel civil investigation from the SEC. And it was just 2 weeks ago that Citi fell short in the Federal Reserve’s stress test. The Fed rejected Citi’s plan to increase its dividend based upon questions about the reliability of Citi’s financial projections.

And that brings us to the tale of Kenneth Lewis, the former chief of Bank of America. Back in 2008, as the global financial meltdown imploded, Bank of America rushed in to acquire Merrill Lynch. Lewis called it the “strategic opportunity of a lifetime” and he said the Fed did not pressure him into the deal. He later admitted he lied. Merrill Lynch was bleeding cash while paying huge bonuses. Bank of America required 2 bailouts from Treasury plus extraordinary lending from the Fed. It is a crime to knowingly deceive shareholders about the financial condition of your company.

Bank of America has paid several fines related to cases brought by various regulators, and there is still an outstanding suit, but the case of Kenneth Lewis wrapped up last week. Mr. Lewis agreed to pay $10 million, which was provided by Bank of America. He is barred from being an executive or director of a public company, but he already retired with a sizeable golden parachute. He did not have to admit or deny wrongdoing.