Wednesday, June 11, 2014 - Nowhere to Hide

Nowhere to Hide

by Sinclair Noe

DOW – 102 = 16,843
SPX – 6 = 1943
NAS – 6 = 4331
10 YR YLD + .01 = 2.64%
OIL + .14 = 104.49
GOLD + .70 = 1261.60
SILV un = 19.30

The US posted a $130 billion budget deficit in May and the smallest shortfall for the first eight months of a fiscal year since 2008. The deficit last month was about $9 billion less than May of last year. For the fiscal year, which began Oct. 1, the government is running a budget deficit 30% smaller than it was a year earlier; or about $436 billion compared with $626 billion. Revenues for that period are 7% higher than a year earlier and outlays are 2% lower.

The Congressional Budget Office in April projected that the federal deficit will decline to $492 billion this fiscal year, the smallest in six years; down from $680 billion in 2013 and down from a record $1.4 trillion in January 2009. The CBO estimates that next year, the shortfall will decline further, to $469 billion. The 2014 deficit will be 2.8% of gross domestic product, compared with 4.1% of GDP in 2013.

The World Bank has cut its global growth forecast, predicting the world economy will grow 2.8% this year, below its previous forecast of 3.2% made in January. In its twice-yearly Global Economic Prospects report, the World Bank said tensions between Ukraine and Russia hit confidence worldwide.

The bank also cut its growth forecast for the United States to 2.1% from 2.8%, citing the bad weather at the start of the year that resulted in economic contraction in the first quarter. The good news is that the lower forecast is largely a result of things that have already happened, and the US economy appears to be rebounding.

The World Bank expects growth to quicken later this year as richer economies continue their recovery. It kept its global growth forecasts for the next two years unchanged at 3.4% and 3.5%, respectively. Provided the problems in Ukraine don’t get worse, or something else nasty doesn’t pop up.

In Ukraine, government forces and rebels claiming allegiance to Russia continue to clash in the east of the country. In Brussels today, the European Union served as broker for talks between Ukraine and Russia over future natural gas deliveries. Russia offered to supply gas for about 20% below the current price if Ukraine would settle its outstanding debts; Ukraine rejected that deal.

Maybe the World Bank is looking for trouble in the wrong place. Sunni rebels from an al Qaeda splinter group overran the Iraqi city of Tikrit; you remember Tikrit is Saddam’s hometown. The other day, the rebels captured Mosul, the second largest city in Iraq; now they’re closing in on the biggest oil refinery in the country.

The point is, we don’t know where the next black swan event will occur.

Maybe an app will backfire. Yesterday we told you about Uber, the ride-sharing app; now valued at $18 billion. Today, Uber brought the city of London to its knees. Actually, taxi drivers protesting Uber got fed up and parked their taxis on the streets, and London town suffered a massive case of gridlock. In Paris, taxis slowed traffic on major arteries into the city during the morning commute. Hundreds choked the main road to Berlin's historic center while commuters packed buses and trains, or just walked, to get to work in Madrid and Barcelona. Taxi drivers across Europe say Uber breaks local taxi rules, violates licensing and safety regulations and its drivers fail to comply with local insurance rules.

Mohamed El-Erian is the chief economic adviser at Allianz and the former co-chief investment officer of Pimco, and he says “investors might be surprised to learn that they have a lot riding on something that they pay very little attention to: macro-prudential regulation, or what central banks and other government agencies do to reduce the risk of systemic financial disasters.

“The aim of such regulation is to lower both the probability and potential costs of financial accidents. It does so by enhancing the resilience of the system, establishing circuit breakers to prevent problems in one area from contaminating others and, at the extreme, containing the detrimental impact on the broader economy when failures occur.

“Authorities around the world have imposed higher and more intelligent capital requirements, required financial institutions to value their assets more conservatively and to hold more easy-to-sell assets, placed constraints on allowable risk-taking, insisted on more stable funding, and demanded greater provisions against bad loans.

“The impact of the revamped regulation has gone far beyond the targeted banks and other financial companies. It has allowed central banks to be bolder in maintaining and evolving exceptional monetary and credit stimulus, which in turn has significantly bolstered the prices of stocks, bonds and other assets as a means of stimulating the economy.”

In other words, the Fed has pumped up financial assets in the hope it will trickle down to the rest of the economy and jumpstart consumer spending and jobs and wages and such. But what if the economic recovery doesn’t follow on the heels of the pumped up financial assets? This is the lasting question for investors. What to do when the prices of assets rise above what history and fundamentals warrant?

If you think that prices are too low, you can buy. But if you think prices are too high, what should you do?  One option is to sell short; borrow the security whose price you believe to be inflated, sell it and wait for the price to fall, then buy it back at a lower price and pocket the difference. That is a very dangerous move when the markets are trading at record highs. You might pick the exact top or prices may move higher for a while, and the markets can remain irrational longer than you can remain solvent.

Policymakers face a similar asymmetry.  It’s true that for a central bank, liquidity isn’t tied to solvency, so experiencing temporary losses is more a political than an economic or operational concern, but losses still matter. Central bankers can play with the value of a currency, making moves to keep a currency from falling or appreciating; happens all the time.

Sometimes policymakers are trapped in the box that they built. It is precisely investors’ belief in the commitment of policymakers that makes them willing to view some very risky investments so casually. However, when many such investments are made over an extended period without adequate compensation for risk, sharp investors expect a round of bubble trouble on the horizon.

One of the funny things that tends to happen in times like this is that investors rush into areas they think should be safe, looking for a place to hide. Largely ignored during much of last year's 30% rally in the S&P 500 Index, the stocks leading the US market this year rank among its usually sleepiest components.

The best sector in 2014 is utilities, including Consolidated Edison, about as staid a group as one can get. They're up 14.5% on a total return basis this year, compared with 6.4% for the S&P 500 as a whole.

What's happening is the opposite of what ordinarily happens in a moving market. It relates to an investing concept known as "beta," which refers to the amount of risk a particular stock adds to a portfolio. Stocks that tend to rise or fall with the market – but in a more pronounced way – are called "high beta." They generally outperform in up markets and fall the most in down markets.

Best Buy and Priceline, two discretionary stocks that were among the S&P's strongest in 2013, are good examples because their sales and profits rise along with the economy, and they led the way last year. This year, those stocks are lagging the more boring "low beta" stocks – those that tend to move less dramatically than the market. It's a signal that investors are worried about earnings growth and U.S. economic demand, and don't want to bet as heavily on the types of stocks that generally qualify as high beta – often cyclical names in the technology, discretionary and energy sectors.

To be sure, this may change if growth picks up, but after US GDP contracted in the first quarter for the first time in three years, investors are cautious. People are still scared. They're still more worried about protecting to the downside than accentuating the upside. That's helped drive equities' rotation into the more defensive, high-dividend paying names, also typically part of the low-beta camp.

So far this year, the 50 stocks in the S&P 500 with the lowest beta scores, a group that includes ConEd and McDonald's, are up on average by 12%. Meanwhile, the 50 highest beta stocks, which include Citigroup and Best Buy, are up an average of 7%. In 2013, the 50 highest-beta S&P 500 stocks rose an average of 51.4%, compared with 21.3% for the 50 lowest-beta stocks.

Investors who have pursued the high-beta contingent have suffered. Among them are hedge funds, which kept a heavy exposure to momentum-type names and the "beta" strategy. Hedge funds now have 3.8 times more net cyclical exposure to defensive stocks. In January, that measure was 4.7 times - bets that went sour as the market corrected through the first quarter. Once that trade began to break, that also accelerated a rotation back into more value-oriented names and sectors. So, what happens when these defensive plays get overvalued? I’m not saying it has happened; today was just one day after a string of record highs. I’m just posing the question.

Tuesday, June 10, 2014 - Equity Party in the Wormhole

Equity Party in the Wormhole
by Sinclair Noe

DOW + 2 = 16,945
SPX – 0.48 = 1950
NAS + 1 = 4338
10 YR YLD + .02 = 2.63%
OIL - .22 = 104.19
GOLD + 7.90 = 1260.90
SILV + .13 = 19.29

The Dow Industrial Average hit another record high close; the fourth consecutive record. How did the Dow manage to move higher? Who knows? It wasn’t a big move but any positive results in a new record. How now Dow? Maybe it has something to do with the Federal Reserve and the other central bankers vacuuming up all the toxic detritus from the world of finance, pushing rates to sub-zero; leaving investors with little choice but a move to equities. Maybe global corporations have found a way to squeeze extra value out of a bone dry economy. Maybe the major indices have entered a cosmic wormhole devoid of common sense.

Today’s case in point is Uber, which is an app designed to connect riders with cars and drivers; which sounds a lot like hailing a taxi, but this is different because you can hail the taxi and pay the taxi with your smartphone; which means it’s software that eats taxis. Uber is different mainly because it is worth about $18 billion; which means it is worth more than most of the companies in the S&P 500 index. It’s an equity party, and for now at least, nobody is turning out the lights.

Friday’s jobs report was run of the mill; the economy added 218,000 jobs and the unemployment rate held steady at 6.3%. Today, we get a positive follow-up from the Labor Department, saying there were 4.7 million hires in April, the most since June 2008. By comparison, before the financial crisis, we averaged about 5.04 million hires per month. And workers’ opportunities look to be improving, too. There were 4.46 million job openings in April, the most since September 2007, up 17% from a year earlier.

OPEC is meeting in Vienna this week. The oil production cartel, which controls about 40% of global oil supplies, has imposed a 30 million barrel-per-day production ceiling for all 12 members’ output for the last two years. And the current price range of $100 to $110 a barrel seems to be the sweet spot; not too high to reduce demand; not too low to cover costs and national budgets. North American crude oil production is expected to be a major topic of discussion.

Estimates of North American oil supply have increased to 18.5 million barrels a day from 18.2 million six months ago, driven by US production at 11.4 million barrels a day. In 2012, the International Energy Agency (IEA) forecast that the US would outpace Saudi Arabia in oil production thanks to the shale boom by 2020, becoming a net exporter by 2030. The forecast was seen by many as decisive evidence of the renewal of the oil age and the end of peak oil. Not so fast.

This week, the IEA released its World Energy Investment Outlook which says that US oil production, drawing largely from the Bakken in North Dakota and the Eagle Ford in Texas, will peak around 2020 before declining. The US government’s Energy Information Agency recently downgraded its assessment of the Monterey Shale oil fields by 96%. The shortfall will make the US, and countries in Europe looking to import from America, increasingly dependent on Middle East supplies.

The report states: "… there is a risk that Middle East investment fails to pick up in time to avert a shortfall in supply, because of an uncertain investment climate in some countries and the priority often given to spending in other areas."

The IEA report reveals that over 80% of oil company investment is going into making up for exhausted fields where production is in decline. The agency also calls to ramp up investments in renewables and increasing efficiency, along with regulatory reform to incentivize investments, as part of the package. This is where we are headed.

Warren Buffet’s Berkshire Hathaway has been expanding its utility business in Nevada and Canada; and Buffet plans to increase the investment in renewable power. At the Edison Electric Institute’s convention in Las Vegas yesterday, Buffet said, “We’ve poured billions and billions and billions of dollars in retained earnings, and several billion of additional equity, and we’re going to keep doing that as far as the eye can see.”

Berkshire Hathaway Energy has $70 billion in assets and more than 8.4 million customers worldwide, according to its 2014 brochure. It has more than 34,000 megawatts of power generating capacity owned or under contract. Wind, solar, hydro, geothermal, and other renewable plants account for about a quarter of capacity, representing about $15 billion.

Yesterday Buffet said: “There’s another $15 billion ready to go, as far as I’m concerned.” Unlike other utility-holding companies, Berkshire Hathaway Energy retains all of its earnings. That probably will continue, Buffett said yesterday, estimating that the unit could reinvest about $30 billion into its business in the next decade.

Investments in renewable energy will be needed as the US seeks to reduce its reliance on fossil-fuel generation. Electric utilities face cuts of 30% in carbon dioxide emissions by 2030 compared with 2005, based on proposed regulations issued by the EPA on June 2.

Yesterday we talked about a Merger Monday. It has been a busy year for mergers and acquisitions. Some of the deals are all cash, as many corporations are sitting on piles of cash; but many deals are still done the old fashioned way, with leveraged lending. The Wall Street banks are more than happy to overload companies with too much debt for the simple reason that it is one of the most profitable forms of loans for the banks. Banks’ fees on US junk-rated loans stand at $4.9 billion so far this year, a year-to-date record and up 10% from the same period last year.

The Federal Reserve, the Office of the Comptroller of Currency, and the FDIC have issued guidelines to restrict banks making loans in deals like leveraged buyouts that would leave a company with debt levels that are more than 6 times its annual cash flow. Wall Street banks immediately started looking for loopholes, and the newest trick is to issue bonds that would split the overall debt load between a holding company and its operating subsidiary.

Companies typically borrow at the operating company level through loans. Since the loans can be secured against the company's assets, they are cheaper than other options. They can also borrow through the holding company by issuing bonds. Payments on those securities are made from the cash that remains after the liabilities of the operating company are met, making them riskier than operating company loans.

Many holding company bonds are structured as payment-in-kind (PIK) notes that pay interest by adding to the outstanding principal rather than returning cash to the bond's holder. Such bonds are expensive for the issuer and the risk involved makes the investor universe limited, but the market has been growing as investors chase yield.

We’ve seen this story before. You may recall the case of the $48 billion leveraged buyout of Texas power utility Energy Future Holdings in 2007, the biggest LBO in history. The deal's $40 billion debt was equal to 8.2 times adjusted EBITDA (earnings before interest, tax, debt and amortization). Energy Future filed for bankruptcy earlier this year, one of the largest bankruptcy cases ever.

For now, the banks are violating the 6 times annual cash flow limit, most of the time, but it’s a tactical decision. Three longtime banks for private equity firm KKR snubbed a request for a $725 million buyout loan for Brickman over concerns it was too risky to pass muster with US regulators, in spite of the firm’s strong track record of leveraging up and then reducing debt quickly. Others banks are trying to guess how big the fines could be, and weighing that up against the fees for underwriting such deals.

Welcome to the wormhole.