Thursday, August 14, 2014 - The Circular Capex Spending Problem

The Circular Capex Spending Problem
by Sinclair Noe

DOW + 61 = 16,713
SPX + 8 = 1955
NAS + 18 = 4453
10 YR YLD - .01 = 2.40%
OIL - .39 = 97.20
GOLD + .70 = 1313.90
SILV + .05 = 19.95

Iraqi Prime Minister Nouri al-Maliki stepped down today, a surprising reversal for a prime minister who a day earlier had assured his supporters that he wouldn’t step down unless forced out by Iraq’s high court.

President Obama says the US operations have broken the ISIS siege of Mount Sinjar. Thousands of Yazidi refugees were stranded on the mountain. Many of those displaced had now left the mountain and further rescue operations are not planned, however US airstrikes against ISIS will continue for now. And Iraqi and Kurdish forces fighting ISIS will continue to receive US military assistance.

Russian President Vladimir Putin said Russia would stand up for itself but not at the cost of confrontation with the outside world, which sounded like a softer, gentler Putin. Trust him about as far as you can throw him. Intense fighting continues as the Ukrainian military kept up its offensive to retake separatist strongholds in Eastern Ukraine.

A new, five-day truce between Israel and Hamas appeared to be holding despite a shaky start, after both sides agreed to give Egyptian-brokered peace negotiations more time. The second extension of the ceasefire, this time for five days rather than three, has raised hopes that a longer-term resolution to the conflict can be found; maybe.

The Missouri State Highway Patrol will take over the supervision of security in the St. Louis suburb that's been the scene of violent protests since a police officer fatally shot an unarmed black teenager.

Earnings season continued to wind down. WalMart reported earnings and revenue that met expectations, but the company cut its forecast for coming quarters. Last night, Cisco Systems offered a weak outlook for its current quarter and announced massive job cuts despite reporting revenue that beat expectations.

We’ve all heard of jobs offshoring; US jobs that once built the world’s biggest middle class, have been sent overseas, and it’s been going on for quite some time. The idea was heralded as free trade globalism and the argument was that it was merely mutually beneficial free trade; but American jobs have been lost and continue to be lost, not to competition from foreign companies, but to multinational corporations that are cutting costs by shifting operations to low-wage countries.

One result of offshoring is lower labor costs, but that also means lower wages. University graduates in the US are just as likely to be employed as bartenders or baristas as they are to get a job as a software engineer of plant manager. And there’s a good chance that recent grads are still living at home with their parents. More than half with student loans are having a hard time paying down student loan debt; 18% are either in collection or delinquent; another 34% have student loans in deferment or forbearance. And if they do find jobs, they find those jobs don’t pay well. Wages have stagnated.

Even though the economy has been adding jobs, it has not been enough to push a recovery in wages. In July, average hourly wages rose a penny to $24.45, a disappointing result after strong gains in June and May. In 23 of the past 24 months, the yearly increase in hourly pay has ranged from 1.9% to 2.2%, or about one-third less than usual during an economic recovery. The 12-month increase in wages as of July was just 2%; and inflation wiped out about three-fourths of that gain. There’s been no change since the start of 2014. While it might seem counterintuitive that wages are flat while jobs are being added, the likely reason is that there are a lot of poor paying jobs plus a few very good paying jobs. According to revised data from the Commerce Department, employee compensation, including wages and benefits, was lower for each year from 2011 to 2013 than previously calculated.

Jobs off-shoring, by lowering labor costs and increasing corporate profits, has enriched corporate executives and large shareholders, but the loss of millions of well-paying jobs has made millions of Americans downwardly mobile. Between October 2008 and July 2014 the working age population grew by 13.4 million persons, but the US labor force grew by only 1.1 million. In other words, the unemployment rate among the increase in the working age population during the past six years is 91%. Since the year 2000, the lack of jobs has caused the labor force participation rate to fall, and since quantitative easing began in 2008, the decline in the labor force participation rate has accelerated. Clearly there is no economic recovery when participation in the labor force collapses. In addition, jobs off-shoring has destroyed the growth in consumer demand on which the US economy depends with the result that the economy cannot create enough jobs to keep up with the growth of the labor force.

Some people argue that the problem with economic growth doesn’t start with wages and jobs, but rather with credit, and they point to graphs of the recent rise in auto loans; just as mortgages once fueled a housing boom, now, subprime lending is fueling a boom in auto sales. Credit tightened in the wake of the housing collapse and the housing market remains weak, while auto lenders have become aggressively permissive and US auto sales have made a huge recovery, leading some to argue that consumption depends on access to credit. This is wrong. Access to credit is the lubricant for the engine of economic commerce; it is not the engine. The real driver of the economy is good paying jobs.

There have been magnificent innovations in transportation, medicine, communication, and technology as commerce has spread globally. Credit did not create technological advances, people did. Money and credit could always be used to purchase the tools to make money in business, but money could never produce anything by itself; food, clothing, shelter, cars, and thousands of other worthwhile things were always made by the labor of people, not the sweat and intelligence of a coin or a plastic credit card.

The Federal Reserve just released a report showing that two-thirds of American households have no savings set aside for an emergency, and 40% are unable to raise $400 cash without selling possessions or borrowing from family and friends. Offshoring, by lowering labor costs and increasing corporate profits, has enriched corporate executives and large shareholders, but the loss of millions of well-paying jobs has made millions of Americans downwardly mobile. In addition, jobs off-shoring has destroyed the growth in consumer demand on which the US economy depends for expansion. Corporations are borrowing money not to invest for the future but to buy back their own stocks, thus pushing up share prices.

A new report from Morgan Stanley shows the average age of industrial equipment in the US is now almost 10.5 year old. That’s the oldest since 1938, at the height of the Great Depression. Nonresidential capital expenditure; in other words, spending on equipment, nonresidential buildings like factories, and intellectual property, has fallen short of the long-term trend by 15% per year. That means businesses have pumped into the economy $400 billion less than they normally would have every year. That's $1.6 trillion over the past four years, and it's affecting every sector. Spending has been down 14% on buildings, 16% on equipment, and 6% on intellectual property.

Instead of investing that money, corporations have been hoarding cash; by some estimates, corporations are sitting on a pile of almost $2 trillion. Occasionally they dip in for share buybacks. S&P 500 companies bought back an estimated $160 billion in stock in the first quarter; that would lag only the $172 billion in the third quarter of 2007, shortly before the worst bear market since the Great Depression. Repurchases are all the rage, but are all too often made for an unstated and ignoble reason: to pump or support the stock price. Another corporate incentive for buybacks is that a pumped-up share prices make the stock grants and options held by senior executives more valuable. Occasionally they dip into the cash pile for mergers and acquisitions. North American M&A activity stands at $1.2 trillion year to date, up 83% from last year. This year is almost certain to be the best year for M&A since the crisis. Boosting growth and returns through long-term investment in their business hasn't registered nearly as highly.

The problem then becomes circular: weak demand holds back capital expenditures, which drags on growth, which depresses demand. Productivity growth in the United States, the rate of growth in the level of output per worker, is near a 30 year low. Spending on research, development and technology, would surely improve this trend. Productivity alone does not spur capex spending. Rather, spending increases when demand increases. You don’t buy a new factory or new equipment unless your customers are spending. However if your customers are spending, you will happily invest in the facilities to fill their orders. But real median household income fell 10% between 2007 and 2012. And since the financial crisis, demand across the US economy as a whole has been far below trend.

Several of America’s great cities, such as Detroit, Cleveland, St. Louis have lost between one-fifth and one-half of their populations. Real median family income has been declining for years, an indication that the ladders of upward mobility that made America the “opportunity society” have been dismantled. So, now we face a tipping point, where we either start to reinvest in industrial production or watch the infrastructure turn to rust, and the US becomes a third world country.

The good news is that we are making progress in some areas. We add jobs every month, more than 200,000 jobs per month for the past six months. Capacity utilization is now up to 79%. US exports now top $2 trillion, the highest level in history. Despite the numerous false dawns since the Great Recession, analysts still expect capex to pick up. If it does, then the broader economy should benefit. Factories and equipment will have to be replaced, eventually. It might represent an opportunity; if we’re lucky.

Monday, October 28, 2013 - Markets Are All About the Fed

10282013 Script

Markets Are All About the Fed

by Sinclair Noe

DOW – 1 = 15,568
SPX + 2 = 1762
NAS – 3 = 3940
10 YR YLD + .01 = 2.51%
OIL + .69 = 98.54
GOLD + .30 = 1354.20
SILV - .09 = 22.61

The Federal Open Market Committee, the FOMC, is the Fed's policy making arm; they will meet on Tuesday and Wednesday to determine possible changes or adjustments to monetary policy. The broad consensus right now is that nothing will change. The government shutdown and a mixed batch of economic data convinced many the Fed would delay any move to begin trimming its stimulus into next year.

The longer the Fed keeps its policy loose, the longer US yields will stay low, making the dollar less attractive. The dollar index was just a smidge higher today, but still trading very close to a 9 month low just under 79, reached on Friday, while the euro has been trading near 2 year highs. As long as the Fed's easy money policy remains in effect it provides abundant liquidity for Wall Street. Last week the S&P 500 hit records and many global stock markets were also near record highs. The MSCI world equity index has been moving higher for 4 consecutive sessions and is near records of January 2008. The Fed's easy money policy has served to support gold and other metals markets. After all the recent bullish movement, you might think the Fed's dovish policy stance has been well priced into the markets. Maybe.

If you want to see the graphic definition of an uptrend, just look at the S&P 500 chart over the past year. With the exception of a few minor whipsaws, the chart is a good progression of higher highs and higher lows depicting a gain of more than 400 points. It hit record highs, at least on a nominal basis, but if you look at the index in inflation adjusted terms, the high was in August 2000, and the purchasing power of a dollar invested in the S&P 500 is still more than 12% below the August 2000 level; and to get to a new high, we would need to top 2000 on the index. The price to earnings back in 2000 were much higher than today, meaning relative valuations today are more justifiable, but that doesn't tell us whether or not we'll advance to a new high in this cycle. There are some positive, almost bullish considerations: Corporate balance sheets are in excellent shape, which could prompt elevated returns for shareholders; shareholder-friendly M&A driven by still low borrowing costs could add another boost to the market rally.

And there is still cash on the sidelines. Plenty of people burned back in 2008 have been parked in cash reserves, but every now and then the market temptation becomes too great. The rotation from cash to stocks typically takes longer than most people imagine, and just about the time that cash comes back into the markets, we might expect yet another rotation; after all, earnings have a lot of work to catch up to valuations, and there are still strong fiscal headwinds. Plus, it's been about 6 years since the start of the last recession and about 4 years since the recovery (if we can call it a recovery), and these things tend to repeat with regularity; it's called a business cycle.

Today, we had economic reports showing manufacturing output inching slightly higher in September, while contracts to buy previously owned homes posted the biggest drop in more than 3 years. Manufacturing production edged up 0.1% last month after advancing 0.5% in August. The National Association of Realtors said its Pending Homes Sales index, based on contracts signed last month, dropped 5.6% to the lowest level since December. The decline was the largest since May 2010.

The index, which leads home resales by a month or two, has now dropped for four straight months. Realtors believe home resales, which dropped in September, peaked in July and August. The reports come on the heels of data last week showing a gauge of business spending tumbled in September. That data, combined with a disappointing reading on hiring released earlier this month, has offered a dull picture of economic activity.

Rates on 30-year fixed rate mortgages rose to an average of 4.49 percent in September from an average of 3.54 percent in May, according to Freddie Mac. But a surprise decision by the central bank in mid-September not to cut its purchases and soft economic data have pulled rates lower since then. With politicians in Washington still to agree on a budget, uncertainty over fiscal policy may also continue to hinder growth

Over the next couple of days we'll see reports on producer prices and consumer prices, retail sales and home prices, the ISM manufacturing report and more. It probably won't matter. The Fed's keeping the digital printing press running and the economic data is not compelling enough to change the QE, not yet, likely not this year.

Quantitative Easing, the Fed's $85 billion a month debt purchase program has has caused significant inflation (even if the inflation isn't reported in the official economic reports) and made national debt soar (even if much of that debt now rests on the Fed's balance sheets); it has made the bond markets fragile and volatile. The value of bonds look nice on balance sheets but unless one plans to cash them in like growth play stocks, their worth as income producers has been lousy. Income investors look for “risk-free returns” but QE creates a "return-free risk" scenario. If you are heavily weighted in fixed income, it is with a grip white-knuckled by the real, perhaps inevitable fact that at some point QE will end or simply fail to keep yields low and asset values high. And the whole idea of income investing is a stable buy and hold approach that makes it difficult to pare gains, just as it is painful to accept losses. Classical measures of value have been destroyed. It is very difficult to find true price discovery or a reasonable degree of certainty about these markets except that they are artificial and fragile, and increasingly vulnerable to exogenous influences. Just as the Fed force-feeds liquidity to the equity markets, it also provides the essential sustenance for the bond markets, and this seems the major lift, maybe the only justification for rising markets.

In this context, if you "buy the market" you're betting on continuing QE and an absence of crises that have lingering effects. While QE is likely to continue so long as policy-makers prefer to keep the markets climbing for whatever reasons happen to suit them, and remember policy-makers change from time to time, we still have geopolitical, and economic, and fiscal, and political crises ready to explode. So if you simply develop an allocation, buy and mainly forget about it, the chances for painful surprises are high.

And the longer the markets rally without a pullback, the more delicious that uptrend chart looks, the more the warning signs point toward the latter stages of a bull market. There is for instance the narrowing of the rally to a handful of 'story stocks' that trade at ever more absurd valuations and seem to be able to inexorably rise into the stratosphere, discounting a glorious future that may or may not arrive. Similarly, the pace of IPOs has vastly increased. Whereas IPOs were in 'slumber mode' for much of 2009-2012, issuance has really taken off this year and is at the highest level since 2007. Not only that, but many stocks are once again soaring by up to 100% on their first trading day, which is strongly reminiscent of the insanity that reigned in 1999 to early 2000.

And as we look at earnings, don't forget the buyback effect, which helps earnings per share to increase even as revenues slip. In fact, since corporate leverage is often increased in order to finance buybacks, shareholders in many cases will ultimately end up worse off. In the short term everybody loves the effects of buybacks of course, but be warned: buybacks tend to peak when stock prices are near a peak.

And one more consideration is margin debt, which provides leverage to increase profits in a bull market but is worse than salt on a wound in a bear downturn. NYSE margin debt has soared to a new record high, exceeding $400 billion for the first time ever. The risk-reward situation in the market is dangerously skewed toward risk. Investors are skating on ever thinner ice. Once the risk becomes manifest, forced selling will exacerbate the decline in prices. The stock market keeps levitating on the promise of more money printing. It remains possible that the advance will enter a blow-off stage or a panic buying type advance during which prices rise almost vertically, increasing considerably in a very short time. That would be a clear indicator to take profits and run, but there is no guarantee of a parabolic chart pattern; a 'blow-off' doesn't have to happen. Whether or not it happens misses the point, which is that risk has increased enormously.