Friday, August 22, 2014 - Be Careful Out There

DOW – 38 = 17,001
SPX – 3 = 1988
NAS + 6 = 4538
10 YR YLD un = 2.40%
OIL - .46 = 93.50
GOLD + 4.30 = 1281.60
SILV un = 19.51

All three major indices posted gains for the week, with the Dow up 2%, the S&P up 1.7% and the Nasdaq up 1.6%. It was the strongest week of gains for both the Dow and the S&P since April, and the third straight week of gains for all three indices.

There is a lot to cover before we can wrap up the week. First we go to Jackson Hole Wyoming, where the Fed has been having a friendly get together of economists. Janet Yellen kicked off the event with a speech this morning. She said what you might expect: "There is no simple recipe for appropriate policy," and she called for a "pragmatic" approach that gives officials room to evaluate data as it arrives without committing to a preset policy path. And she backed up her comments with a new tool, the Labor Market Conditions Index, which measures 19 labor market indicators, and it isn’t new data, just combining it all together, but it showed she is monitoring the data.

Yellen referenced the possibility that labor markets may be a bit tighter than they seem and that the Fed may consider having to raise interest rates sooner than expected. At the last FOMC meeting in July, the Fed was still saying there was “significant” slack in the labor market, and today she confirmed that slack remains, saying: “Five years after the end of the recession, the labor market has yet to fully recover.” Another area of slack is wage deflation. Employers cut some wages during the downturn, or eliminated raises, and they aren’t offering raises now. Yellen said: “wages could begin to rise at a noticeably more rapid pace once pent-up wage deflation has been absorbed.”

So, today Yellen didn’t say anything radically different, just a hint less dovish, or at least not as dovish as Wall Street might have hoped for.  

Just in case you were wondering, there have been some protestors at Jackson Hole; one group could be spotted wearing T-shirts printed with graphs showing wage inequality; apparently, an attorney representing the protestors got to talk with Yellen for a minute or two. Meanwhile, investment bankers were noticeably absent from this year’s symposium; the invitation list is mostly devoid of representatives from big private-sector banks. The Fed finally figured out that rubbing elbows and special access wreaks of cronyism.

The Jackson Hole Symposium featured more than Yellen. There was a variety of papers on multiple subjects. A professor from MIT presented a paper detailing how robots and computers don’t steal as many jobs as you might think. Seems the robots are not good at jobs requiring judgment and common sense. So we aren’t obsolete just yet.

Another bit of research says we are less likely to switch jobs, or there is less labor market fluidity, and the reasons are that the workforce is getting older, and there is a shift to older businesses, which means fewer startups, and more startups tend to fail, and more jobs require occupational licensing or certification.

Yet another research paper concluded that the problem of long term unemployment is not necessarily terminal. The thinking has been that if someone loses a job and is out of work for a long time they have a harder time finding work, and eventually they lose their skills and fall out of the labor pool; the idea is called hysteresis, or the idea that cyclical unemployment becomes structural. The new research says it is only a moderate problem. So, the good news is that we are not obsolete and we are adaptable.  

And then European Central Bank President Mario Draghi delivered a speech following lunch. Draghi said European central bankers and politicians each have a role to play in boosting demand and reducing joblessness. For its part the ECB is willing to take more stimulus measures if needed to keep low rates of inflation from becoming embedded in expectations of future price growth but the ECB can't do it alone and governments must join in efforts to reduce unemployment.

For Draghi, this was a bigger shift in policy; for years the ECB has been preaching that governments needed to shrink deficits and undertake economic reforms even during times of economic weakness. The austerity measures did not work; the result has been stubbornly high unemployment, stagnation, and disinflation or low-flation bordering on deflation, with a dollop of double dip recession.

Draghi admitted as much, saying the GDP data "confirm that the recovery in the euro area remains uniformly weak, with subdued wage growth even in non-stressed countries suggesting lackluster demand." And so Draghi called on combining monetary and fiscal policies to stimulate demand with efforts to make labor markets more flexible. He also proposed a significant boost in public investment.

In June, the ECB approved a stimulus package that includes record low interest rates, new 4-year loans to banks, and a step toward large scale purchases of asset backed securities, although no new QE announcement was forthcoming in today’s speech. Draghi said today: "The risks of 'doing too little'" and allowing temporary unemployment to become more entrenched "outweigh those of 'doing too much’, that is, excessive upward wage and price pressures."

So, while Draghi firmly planted an anti-austerity flag, he also felt the ECB’s June stimulus will be all that they can do, and he recognizes the real risk that monetary policy loses effectiveness, and somebody needs to wake up the government.

There is a long tradition of the Jackson Hole symposium giving a little bump to the markets; not today, and the reason had less to do with the doves and hawks on the Fed and more to do with geopolitics.

Ukraine says Russian artillery is being used against Ukraine's forces, both from across the border and from inside Ukraine. In addition, NATO said it has seen "transfers of large quantities of advanced weapons, including tanks, armored personnel carriers and artillery, to separatists." Moscow sent more than 130 trucks rolling across the border in what it said was a mission to deliver humanitarian aid. Ukraine called it a "direct invasion," and the US and NATO condemned it as well.

The trucks, part of a convoy of 260 vehicles, entered Ukraine without government permission after being held up at the border for a week amid fears the mission was a Kremlin ploy to help the pro-Russian separatists in eastern Ukraine. Russia claims the trucks are carrying food, water, and other humanitarian supplies. The city of Luhansk has been largely cut off for weeks and is without water and electricity as Ukraine forces fight rebels. Ukraine wanted the international Red Cross to inspect all trucks, fearful of a Trojan horse; but Russia lost patience and accused Ukraine of stalling. The Red Cross, which had planned to escort the convoy to assuage fears that it was a cover for a Russian invasion, said it had not received enough security guarantees to do so, as shelling had continued overnight.

Ukraine said they would not shell the convoy but rebel forces took advantage of that promise to drive on the roads being used by the convoy.

Meanwhile, Hamas-led gunmen in Gaza executed 18 Palestinians accused of collaborating with Israel. The executions were held in a public square. I suppose that has a certain deterrent effect. The ceasefire, like others before it, did not last long. Israeli Prime Minister Benjamin Netanyahu threatened to escalate the fight against Hamas after a four-year-old Israeli boy was killed by a mortar attack from Gaza. Shortly after his remarks, Palestinian officials said Israel had flattened a house in a Gaza City air strike, wounding at least 40 people. More than 80 rockets and mortars shot from Gaza hit Israel. Israeli forces carried out more than 25 air strikes in Gaza. Since the conflict began last month, 2,071 Palestinians, many of them civilians, have now been killed and around 400,000 of the enclave's 1.8 million people displaced. Sixty-four Israeli soldiers and four civilians in Israel have been killed.

Meanwhile, the quagmire in Iraq is sucking us in ever deeper. You will recall that just 2 weeks ago, President Obama announced “targeted airstrikes to protect our American personnel and a humanitarian effort to help save thousands of Iraqi civilians who are trapped on a mountain without food and water and facing almost certain death.” And it seemed to work, sort of. The Yazidis trapped on the mountain got off the mountain, most of them anyway.

And then there was the problem of ISIS controlling the Mosul Dam, and the threat of using the dam to flood the Tigris River valley, and that includes Baghdad; so there was some extra work to do there. And then there was the horrific beheading of American journalist James Foley, and yesterday Secretary of Defense Chuck Hagel called ISIS an “imminent threat to every interest we have,” while Chairman of the Joint Chiefs of Staff General Martin Dempsey conceded that attacks on ISIS could not be limited to Iraq but would also spread into Syria; and Secretary of State John Kerry said ISIS “must be destroyed and will be crushed”.

And now Iraq has a new prime minister, Haider al-Abadi. The hope was that he could forge a new coalition government. Not exactly. Sunni lawmakers quit talks on forming a new Iraqi government after gunmen killed scores of worshipers at a Sunni mosque in a province neighboring Baghdad. Today’s strike took place after three roadside bombs targeted a Shiite political gathering.

Federal authorities today urged law enforcement across the country to be alert for possible attacks inside the United States in retaliation for US airstrikes against ISIS. In a joint bulletin issued to local, state and federal law enforcement, the Department of Homeland Security and FBI said that while they are “unaware of any specific, credible threats against the Homeland” and find most threats to the U.S. homeland by supporters of ISIS “not credible,” they cannot rule out attacks in the United States from sympathizers radicalized by the group’s online propaganda.

Be careful out there.

Retailers have taken a recent hit, with weak earnings reports from the likes of Wal-Mart and Sears. Today Ross Stores posted better than expected second quarter results. The S&P Retail Index gained 0.6%, which doesn’t sound like much but it was the best week since February. The heavy promotional environment has been forcing retailers to offer discounts to stay relevant even as they deal with the growing shift to online sales. The big brick-and-mortar retailers have been trying to adjust to this shifting landscape. The labor market is no doubt improving, but wage growth has been essentially stagnant, restricting households’ buying power. In a nutshell, it has been a tough backdrop for retailers. No doubt the stock-price performance of the retail sector in the S&P 500 has been one of the weakest in the index – up +0.9% vs. a gain of +8.6% for the index as a whole.

Total earnings for the 490 S&P 500 members that have reported already are up +8.1% from the same period last year, with a ‘beat ratio’ of 65.5% and a median surprise of +2.6%. Total revenues are up +4.4%, with a very impressive revenue ‘beat ratio’ of 62.2% and a median surprise of 0.8%. So, this has been a strong earnings season, with the minor exception that guidance has been a little less than satisfying.

Stock prices of small-cap stocks have been underwater this year, with the S&P 600 down -1.2% vs. a gain of +8.6% for the S&P 500 in the year-to-date period. This underwhelming stock price performance is getting confirmed by the group’s mixed results thus far in the Q2 reporting cycle. As of Friday, August 22, we have seen Q2 results from 555 S&P 600 members or 92.5% of the index’s total members. Total earnings for these 555 companies are up +12.1% from the same period last year on +9.5% higher revenues, with 48.6% beating EPS estimates and 38.2% coming ahead of top-line expectations. 

Total earnings in Q2 are on track to reach a new all-time quarterly record, surpassing the last record set in 2013 Q4. That brings a good news/bad news conundrum. Is it just a one-time bounce of the low levels of the first quarter? It’s always difficult to top a record.

The S&P 500 is trading at 18.5x forward earnings, above the historical average of about 16.5x. The Shiller cyclically adjusted P/E ratio is currently about 26x the historical average of 16x. No matter how you manipulate the numbers, stock valuations are closer to the high end than the low end, and then the question is whether those valuations are justified in view of the risks facing stocks.

The biggest risk to stocks is the Fed ending its unprecedented experiment in easy money. Stock market investors have benefitted from ZIRP, zero interest rate policy, far longer than anyone might have imagined, and maybe Draghi was right when he talked today about the risk that monetary policy can lose its effectiveness. Now, maybe the Fed can exit QE and ZIRP and the markets will achieve liftoff; I just don’t know where we’ll find the fuel for liftoff.

The second most significant risk is the geopolitical havoc occurring around the world. And most of that havoc seems to be in or near areas with oil. From the heady days of mid-2008 when it traded at nearly $150 a barrel, crude oil has had quite a rocky ride. After sliding down to the $30s and rallying back around $120, crude has settled in around the $90 to $110 range for the past two years.  Commodity traders have wondered why oil hasn’t gone higher. Geopolitical tensions abound across the world; the Middle East seemingly hasn’t been this unstable in years. There may be reasons why oil prices have moved lower, including the renaissance in oil and gas exploration and development in the US; lower demand brought about by great efficiencies and conservation; also, the big investment banks have exited the oil  trading business and the oil  marketing business, and they have not been replaced by new players. A dip in oil prices could send some smaller exploration companies to the mat. A spike in oil prices could send stock investors to the exits. Geopolitical stability is decidedly bad for stocks, particularly stocks that are trading at very high valuations.

A third risk to stocks is that earnings will not keep pace. Corporations may have squeezed about all of the cost savings they can out of their businesses. While companies continue to "beat" expectations, the truth is that they are more leveraged than they were in 2007 on the cusp of the financial crisis, and they live in fear that interest rates are going to rise and they will not be able to service their debt. Meanwhile, consumers tend to hold onto a dollar until the eagle grins.

And then there is always the possibility of a black swan event, which could pop up almost anywhere, including the financial markets where big banks are bigger than ever, and money markets are now poised to close their vaults rather than risk a run, which is  just the sort of thing that creates a run; or maybe it will be a geopolitical mis-step – a bomb that lands in the wrong place, or a crazy Russian who turns off the nat gas spigot for the Eurozone.

An expensive market is always vulnerable to bad news and sell-offs. And so it is now more important than ever to be diligent, and don’t be afraid to lock in the hard won gains of the past 5 years.

Tuesday, August 12, 2014 - Hype is Hurting

Hype is Hurting

by Sinclair Noe

DOW – 9 = 16,560
SPX – 3 = 1933
NAS – 12 = 4389
10 YR YLD + .02 = 2.44%
OIL - .15 = 97.22
GOLD + .60 = 1309.50
SILV - .10 = 20.02

The Dow Industrial Average has now gone negative year-to-date. Seven of the 10 main groups in the S&P 500 declined, with energy companies dropping 0.7 percent to lead the slide as Brent crude settled at the lowest level since July 2013. The International Energy Agency said a supply glut was shielding the market against threats in the Middle East.

As we wrap up earnings season, 73% of companies have beaten earnings estimates, slightly above the 1-year average of 72%, but “beating estimates” this time doesn’t mean what it did in recent quarters. For the past few years, analysts have ratcheted down their estimates in the run-up to earnings season, setting the bar lower and lower—and setting up an easy beat. Companies are beating by an average of 4.2%, above the 1-year average of 3.2%. Q2 earnings growth is 8.4%, up from an expected 4.9% on June 30. This is the second-highest earnings growth rate since Q4 2011. Revenues are now up for 5 consecutive quarters and at all-time highs, and it now looks like revenues might be driving earnings. The strongest sectors for upside earnings surprises have been telecom services, health care (especially biotech), and information technology; while consumer staples is the weakest. US banks and thrifts had their second best quarter in 2 decades, with more than $40 billion in net income.

Profit margins have soared. Net profit margins more than doubled from 4.6% in March 2009 to 9.8% at the end of the first quarter. Margins could come in just shy of 10% when all the second-quarter results are in. The problem is that high margins tend to mark a peak rather than a normal level of profitability. In other words, it’s tough to keep the margins high, and there are several reasons: most of the fat has been cut and it is difficult to further improve labor efficiencies and that’s confirmed by last week’s productivity report showing that the real output of nonfarm business has been hovering around 3% year to year since Q2-2010, consistently higher than real GDP growth; capital spending has been low, but is likely to rebound; and with interest rates near all-time lows, companies will find it difficult to find better financing to boost margins. As margins stagnate or slip, the best defense is to look for companies that are growing revenues.

Actually, the best defense might be to discount analysts’ expectations; something that Wall Street is doing with greater frequency. The problem is that analysts issue glowing earnings growth expectations for the next few quarters, based on pro forma estimates, minus the bad stuff, and heavily adjusted; which in turn drives up share prices. Traders buy in. As the distant quarters get closer and closer, the analysts ratchet down expectations, making for a bar that is easy to hurdle, and again the traders buy in.

In its latest report on earnings expectations and reported earnings, FactSet found a startling change in how the market reacts to these fabricated earnings beats. Over the past five years, companies with upside earnings surprises saw their stock prices rise on average 1% from two days before the announcement to two days afterwards; and downside earnings surprises were punished with a 2.3% decline in stock price over the four-day window. So far in the second quarter earnings season, companies have been crushing earnings, and the market is languishing. FactSet found that this time around the market didn’t reward these juicy earnings surprises at all. Stocks of these companies actually dropped 0.1% over the four-day window. And downside earnings surprises got hit with a 3% decline. The hype is hurting.

The share of unemployed Americans competing for each open job hit a six-year low in June. The Labor Department's monthly Job Openings and Labor Turnover Survey, or JOLTS report, showed the number of unemployed job seekers per open job fell to 2.02 in June, the lowest level since April 2008. Job openings, a measure of labor demand, increased to a seasonally adjusted 4.67 million in June, the highest level since February 2001. At the same time, hiring reached its highest point since February 2008. Much of the increase in employment growth since the 2007-2009 recession ended had been driven by a sharp decline in the pace of layoffs, as opposed to a higher rate of hiring.

Job growth has topped 200,000 in each of the past six months, a stretch last seen in 1997. The unemployment rate has declined to 6.2 percent from 6.7 percent at the end of 2013. The JOLTS report shows some of the slack is coming out of the labor market, and the next sign of a tightening labor market is if we start to see wage growth. Meanwhile, a gauge of small businesses’ intentions to hire has also surged to a fresh post-crisis high, with 13% of respondents to a survey by the National Federation of Independent Business indicating their intentions to hire. That’s the largest percentage since September 2007. The problem is they aren’t actually hiring. The JOLTs hiring rate is nowhere near as buoyant as the job opening rates. The US hiring rate, hires as a share of total employment, hit 3.5% in June. You might expect businesses to intend to hire before they actually hire, but there is also a disconnect; and it might be in a skills mismatch or it might be in a wages mismatch.

During the Great Recession and its aftermath, the federal government acted to help victims of the severe downturn by funding programs that extended unemployment benefits—to up to 99 weeks in some cases, up from the standard 26 weeks. As the economic recovery continued, weak as it was for many in the working class, many lawmakers on the right began to believe that these extended benefits were a drag on employment—the theory being that government checks reduced the incentive for recipients to find a job, and that cutting off this lifeline would compel unemployed workers to look harder for work and perhaps take jobs they may not have accepted if the benefits had continued. Relying on this premise, Congress allowed the federally-funded Emergency Unemployment Compensation program to lapse last December.

Now, more than seven months later, data are available to test this idea. Coming from perspectives that diverge greatly along the ideological spectrum, scholars at both AEI and EPI, the Economic Policy Institute and the American Enterprise Institute, a couple of think tanks at opposite ends of the spectrum, have come to the conclusion that this “bootstraps” theory is incorrect—curtailing jobless benefits did not boost employment. Because unemployment benefits are contingent upon the people who receive them proving that they are looking for a job, receiving jobless benefits appears to make recipients at least just as likely, and certainly not less likely, to rejoin the ranks of the employed.

The US budget deficit was $95 billion at the end of July, down 3 percent from the same period last year. The fiscal year-to-date deficit at the end of July was $460 billion, the lowest level since the same period in fiscal year 2008, compared with a deficit of $607 billion for the same period in fiscal year 2013.

The National Association of Realtors released metro area home-price data for the second quarter, and it looks like growth in home prices is slowing, especially in the East. Nationwide, the median existing single-family home price in the second quarter was $212,400, up 4.4% from the second quarter of 2013. The median existing home price for the Phoenix area is $198,600, up 8.6% from one year ago.

The inventory of all existing homes for sale rose 6.5 percent in June from a year earlier to 2.3 million, an increase from a 13-year low of 1.8 million in January 2013. That’s a 5.5-month supply at the current sales pace, less than the six months that is considered equilibrium between buyers and sellers. Breaking it down further, inventory tightened at the market’s low end and grew at the top. The number of U.S. homes for sale in the bottom third of the market -- below $198,000 -- fell 17 percent in June compared with a year earlier, according to a Redfin analysis of 31 large U.S. metropolitan areas. The supply was up 3 percent in the middle market and jumped 15 percent at the top. The rising inventory of more expensive properties is giving a boost to sales. At the bottom of the market, first-time buyers, even those with the credit, savings and income to overcome tougher underwriting requirements, must face off against other bidders. First-time purchasers accounted for 28 percent of all sales of previously owned homes in June, down from about 40 percent historically.

A funny thing happened in New York yesterday; Manhattan prosecutors filed criminal charges against a dozen payday lending companies and their owner, accusing them of making payday loans that defied New York's limits on interest rates, or usury laws. The defendants in the case tried to cover their tracks with a maze of offshore corporations, to make it look like they weren’t doing business in New York. Under New York state law, the maximum interest rate that can be charged is 9 percent annually and the general usury limit is 16%, with a bunch of exemptions. The defendants in this case are accused of charging between 300% and 700% interest. Remarkably, most states still have usury laws on their books, but not all. In Arizona the legal rate of interest is 10%.

You may very well have a credit card that charges more than 10%, and the reason that is not considered usury is federal court decisions and statutes have virtually exempted credit card companies by allowing them to charge customers, regardless of their state of residence, the interest rates allowed by the state in which they are incorporated. This means that there are no limits on credit card interest rates in practice, even if certain limits remain on the books, the only exception being the 18 percent interest limit for federally chartered credit unions. And so it is a very rare event when anyone faces a criminal charge of usury.

Tuesday, August 05, 2014 - Go Firgure

Go Figure

by Sinclair Noe

DOW – 139 = 16,429
SPX – 18 = 1920
NAS – 31 = 4352
10 YR YLD - .01 = 2.48%
OIL - .86 = 97.43
GOLD + .40 = 1289.60
SILV - .39 = 19.84

We start with a couple of economic reports: The Institute for Supply Management’s services index rose to 58.7 last month, the highest level since December 2005, from 56.0 in June. A reading above 50 indicates expansion. Orders jumped to a 9 year high. A sub-index gauging services industry employment also rose as did order backlogs, but export order growth moderated.

In a separate report, the Commerce Department said orders for manufactured goods increased 1.1% in June, more than reversing May's 0.6% decline. Orders for non-defense capital goods excluding aircraft hit a record high; this might indicate a renewal in business confidence and equipment spending plans. Factory orders rose across all categories, with bookings for electrical equipment, appliances and components recording their largest gain since November 2010. In another sign of strength, unfilled orders saw their largest rise in seven months.

So, a couple of good reports on the economy, and the stock market tumbles. Go figure.

The situation in Ukraine appears headed to a tipping point. Ukrainian forces have been pushing back against Russian backed separatists in eastern Ukraine. Meanwhile, Russia is massing troops on the border. Some 20,000 troops are now stationed about 50 kilometers from the border, closer than they had been stationed previously. In April, Russian President Vladimir Putin had briefly deployed about 40,000 troops at the border. The latest troops include Russian Elite forces, armored brigades, artillery and anti-aircraft units. Poland’s foreign minister thinks Russia is preparing to invade Ukraine; he didn’t flat out say an invasion was imminent, just that the Russians are getting ready.

Putin has ordered his government to prepare retaliatory measures against US and European economic sanctions imposed on Russia. We don’t know what Putin means by retaliatory measures. Russia may limit or ban flights over Siberia by European carriers bound for Asia as a response to sanctions levied against the country. Russia has also called for the UN Security Council to hold an emergency meeting on the humanitarian situation in Ukraine. It isn’t a humanitarian situation when the pro-Russian rebels shoot a plane full of civilians out of the sky, but it is a humanitarian situation when the rebels start getting their butts kicked.

One thing that hasn’t happened yet is a disruption in oil and gas supplies from Russia to Europe. Russia derives half its tax revenue from the oil sector; Europe relies on Russian supplies. As the weather changes and winter sets in, Europe’s resolve, which has already been soft, will weaken further. For now, energy prices are moving lower, despite violence in Eastern Europe, Libya, and Iraq. Global oil demand has been running below supply over the last few months, building up a glut of high quality crude oil in the West African, European and Asian markets. The US Energy Information Administration reported last week that gasoline supplies rose by 400,000 barrels at a time when market bulls hoped to see a reduction. Oil prices are at their lowest levels since February.

Yesterday we told you about the collapse of Portugal’s Banco Espirito Santo; today we report on the fallout. The French bank Credit Agricole held a 14% stake in Banco Espirito Santo and two seats on its board. Crédit Agricole's ties to the Portuguese group go back to 1986 when it helped the Espírito Santo Group set up Banco Internacional de Crédito. Over the years, the French bank raised its stake in the Portuguese group, as part of a larger international expansion plan in southern Europe.The French bankers say they never detected any “slip or difficulties” at Banco Espirito Santo. The collapse of the Portuguese bank nearly wiped out all the second quarter profits at the French bank.

Standard & Poors today announced that it was dropping its 10-year estimate of annual GDP growth in the US from 2.8% to 2.5%, which over a decade amounts to a pretty significant reduction. Why are they cutting the growth forecast? Here’s what S&P says: "Our review of the data, as well as a wealth of research on this matter, leads us to conclude that the current level of income inequality in the U.S. is dampening GDP growth, at a time when the world's biggest economy is struggling to recover from the Great Recession and the government is in need of funds to support an aging population... At extreme levels, income inequality can harm sustained economic growth over long periods. The U.S. is approaching that threshold...."

S&P analysts say it basically boils down to the idea that high levels of income inequality cause more affluent households to save more of their increasing income rather than spend it, and as that cash is withdrawn the economy slows. At the other end of the economic scale, as income declines, households go into debt to try to maintain their standard of living, a strategy that is simply unsustainable over time. And when the unsustainable ceases to be sustained, you get a breakdown, much like that of 2008. In fact, S&P notes, as income inequality increases, an economic system becomes more and more vulnerable to a boom-and-bust cycle. It cites research demonstrating that income distribution plays a much more important role in sustaining long-term economic growth than any other factor.

Although the issue of income inequality is often addressed in moral terms, S&P concludes, at its foundation it is really an economic issue, saying: "A rising tide lifts all boats … but a lifeboat carrying a few, surrounded by many treading water, risks capsizing."

Earnings reporting season:

Retailer Target cut its second quarter earnings estimates due to higher promotions and more discounting; they also lost about $148 million related to that data breach, where hackers gained access to customer credit card info; that’s a small number compared to total sales at Target, but it apparently proved a costly distraction. Morgan Stanley reduced its second quarter earnings by 2 cents per share due to increased legal settlements. Disney posted better than expected earnings; shares moved just a smidge higher in after-hours trading. Cablevision cut back on its promotions and subscriber losses doubled in the second quarter. First Solar posted profits that missed estimates by a wide margin; they blamed project delays. Groupon fell in after-hours trading after posting a second quarter loss nearly triple the loss from a year ago. Zillow announced a second quarter loss, even as revenue increased; and they raised their full year revenue outlook. This was Zillow’s first quarterly report since they announced a $3.5 billion deal to acquire rival Trulia.

Time Warner and Fox both report earnings tomorrow, but the big news came today. Fox withdrew its offer for Time Warner. Game over. When Fox made the hostile bid, its stock dropped and Time’s stock soared; meanwhile Time’s board and management opposed the takeover and refused to discuss the offer. Now that Murdoch has dangled a huge windfall in front of Time Warner shareholders, only to take it away, one imagines that some of those shareholders may soon be venting their frustration to Time Warner's board and management.

Several America corporations have found a loophole in the tax code, which allows for a company to acquire a partial interest in a foreign company, and then change the address of its headquarters in order to evade US taxes; it’s called an inversion. There have been 22 such deals since 2011, most have been in the pharmaceutical industry, where overseas sales generate significant income that cannot be brought back to the US without suffering a major tax hit; but there have also been inversion deals in the media, consumer and manufacturing sectors. Some of those deals have collapsed, amid disputes over price and political scrutiny.

Walgreens was next on the list; closing in on a deal to buy the 55% of British pharmacy retailer, Alliance Boots; Walgreens already owns 45% of Alliance Boots. Walgreens will buy out Alliance Boots, but it won’t move its corporate headquarters abroad and it will not change its corporate citizenship to a lower tax country. They say they won’t do the inversion move because they would have had to renegotiate an existing agreement, and Alliance Boots wasn’t willing. There may also have been some political pressure.  President Obama has denounced tax inversions as unpatriotic and has urged Congress to stop them; which is like asking a Kleenex to stop a freight train. So, now the Treasury Department says there may be an executive order to provide a partial administrative fix, you know, until Congress gets back from its 5 week vacation.

As Ebola spreads, pharmaceutical giants are sitting this one out. That's mainly because treating a disease that affects a relatively small number of people who typically don’t have a lot of money doesn’t offer a great return on investment. It's unclear how much profit it would take to get Big Pharma interested in finding an Ebola cure, but right now such a project could well be a money-loser. Instead, small biotech firms, academics and government agencies are leading the search for an Ebola cure. And in a twist of fate, they may have found a way to treat the virus: tobacco.

A tiny San Diego-based company provided an experimental Ebola treatment for two Americans infected with the deadly virus in Liberia. The biotechnology drug, produced with tobacco plants, appears to be working. Mapp Biopharmaceutical produced an experimental drug called ZMapp, an antibody that had been tested only on infected animals; now it’s been given to human patients, and it seems to make a big difference. The antibody work came out of research projects funded more than a decade ago by the U.S. Army to develop treatments and vaccines against potential bio-warfare agents, such as the Ebola virus.

The tobacco plant production system was developed because it was a method that could produce antibodies rapidly in the event of an emergency. To produce therapeutic proteins inside a tobacco plant, genes for the desired antibodies are fused to genes for a natural tobacco virus. The tobacco plants are then infected with this new artificial virus. The infection results in the production of antibodies inside the plant. The plant is eventually ground up and the antibody is extracted. The whole process takes a matter of weeks.

Monday, July 21, 2014 - A Three Legged Stool

A Three Legged Stool

by Sinclair Noe

DOW – 48 = 17,051
SPX – 4 = 1973
NAS – 7 = 4424
10 YR YLD - .01 = 2.47%
OIL + 1.46 = 104.59
GOLD + 1.30 = 1313.20
SILV + .04 = 21.03

First leg:

Let’s start with earnings reporting season, which kicks into full gear this week with 140 of the S&P 500 companies posting results.

Netflix reported a profit of $71 million, or $1.15 a share, on revenue of $1.34 billion. This was in line with expectations, but for Netflix, an important component is how fast they are adding subscribers; turns out – pretty fast; 1.69 million new net streamers in the second quarter; 570,000 in the US and 1.12 million international subscribers; now topping 50 million worldwide.

Allergan, the Botox company, posted better than expected 2Q profits and sales but also announced it is cutting 1,500 jobs in a restructuring.  BB&T, the southeastern financial company, posted weak 2Q results as mortgage activity lagged; this has been a theme among banks for the second quarter, but the bigger banks have been compensating with profits in investment banking and trading; smaller, regional banks find it harder to compete in that arena. Chipotle Mexican Grill, theme park operator Six Flags, oilfield services company Halliburton, Manpower Group, and chip-maker Texas Instruments all reported better than expected results.

Tomorrow we’ll get the earnings report from McDonalds; after the close we’ll get earnings from Microsoft and Apple. Wednesday’s results include Facebook. Thursday we’ll hear from General Motors and Amazon.com.

So far, earnings season has been strong, of the S&P 500 companies that reported through the end of last week, earnings are up 7.6% from the same period last year on 4.2% higher revenues, with 65.9% beating EPS estimates and 68.2% coming out with better than expected revenue. This is better performance than we have seen at this stage in other recent reporting cycles. The +7.6% earnings growth at this stage in Q2 compares to an earnings decline of -3% for the same group of companies in Q1 On the revenue side, the +4.2% growth thus far compares to growth rates of +1.7% and +3% in Q1. The earnings and revenue beat ratios for these companies are similarly tracking better relative to Q1.

Second leg:

Israel and Hamas continue to battle in the Gaza Strip and Russian separatists continue to impede Malaysia Airlines Flight 17 investigation efforts. President Obama delivered a statement this morning on the geopolitical hotspots. Secretary of State John Kerry was dispatched to Cairo to discuss cease-fire negotiations with international officials. Though Obama cited Israel’s “right to defend itself” against Hamas missile strikes that now number in the thousands, he said he has instructed Kerry to prioritize de-escalation.

Obama said investigation efforts into what caused the crash of Malaysia Airlines Flight 17 have been impeded by pro-Russian separatists, who have assumed control of the crash site and have begun removing evidence. “Unfortunately, the Russian-backed separatists continue to block the investigation,” Obama said of the militants. “All of which begs the question, what exactly are they trying to hide?” Obama said responsibility lies with the Russian government, and Russian President Vladimir Putin, to convince the separatists to cooperate with an international investigation.

A train carrying the remains of most of the almost 300 victims of the Malaysia Airlines plane downed over Ukraine left the site on Monday, after the Malaysian Prime Minister reached a deal with the leader of pro-Russian separatists controlling the area. The aircraft's black boxes, which could hold information about the crash in rebel-held eastern Ukraine, will be given to the Malaysian authorities.

At the United Nations, the Security Council unanimously adopted a resolution demanding those responsible "be held to account and that all states cooperate fully with efforts to establish accountability". It also demanded that armed groups allow "safe, secure, full and unrestricted access" to the crash site. It will be difficult to use the forensic evidence at the site to determine exactly what happened, but it is becoming increasingly obvious the plane was shot down with Russian weaponry.

Clearly Putin did not want nearly 300 civilians to die, but it happened and it probably happened because of things he set in motion. If Russia is even loosely tied to the destruction of the passenger plane, even if it was an accident, the incident could represent another escalation of Russian aggression and mark a major turning point in how Russia is perceived around the world.

British Prime Minister David Cameron will urge other European leaders to consider imposing tougher sanctions Russian oil, gas, defense, and banking sectors at an EU meeting tomorrow. However, EU diplomats made clear today that sectoral sanctions would still be extremely difficult for some of Europe's poorer nations. They are especially nervous about the energy sector, central to the Russian economy, but also to the European Union.

EU nations rely on Russia for about 30% of their gas demand and have intertwined interests based on decades of energy reliance. Russia exports around $60 billion a year in gas and the Netherlands was Russia's biggest export destination last year, mostly oil and metals. Energy sanctions would most likely derail the fragile European recovery in general and might even lead to a complete economic collapse in certain member states. Many Eurozone countries see sanctions as collective economic suicide that helps no one. What they should see is that dependence on imported fossil fuels has made them economically weak and subservient. As long as the Eurozone relies on Russian gas to heat their homes in the winter, Putin can get away with murder.

Third leg:

Financial markets have been largely whistling past geopolitical hotspots, with just the occasional jittery pullback. The simple fact is that the Federal Reserve and all other global central banks have been providing the markets with unusually accommodative monetary policy; which is to say, the central banks have been throwing easy money at the markets. And there is growing concern that the continuation of this “unconventional” and “extraordinary” state of affairs involves an entirely new set of risks.

Clearly the Fed would like to do what it can to prevent bubbles from forming while they hold off on raising rates; it’s a delicate balancing act. If the Fed raises rates too soon, it risks a downturn in the economy, just as the Fed expects the economy is ready for liftoff. If the Fed continues with its easy money policies it risks the chance of bubbles; already Fed Chair Janet Yellen has acknowledged pockets of overvaluation. Last week, during Humphrey Hawkins testimony of Capitol Hill, Yellen singled out social media stocks and biotechs.

What does Yellen know about social media and biotech valuations? Probably not a great amount, but that doesn’t devalue her perspective; there may be some kind of asset bubble taking shape in at least some corners of the financial market. And don’t think Yellen just tossed out the overvaluation comment in a flippant or offhand manner. She is well aware of Alan Greenspan’s notorious remarks about “irrational exuberance”. This was a chance for Yellen to jawbone the markets. The very fact that she’s doing so means that she probably sees good reason for speaking out.

Yellen knows she is walking a very narrow line as she tries to guide monetary policy back toward some kind of “new normal” for the first time since the 2008 financial crisis. Yellen seemed to be saying that if small corners of the market over-inflate and pop, well tough luck; it won’t change the Fed’s path toward escape velocity. You might want to buckle your seat belts and get ready for a bumpy ride.

One reason for the overvaluation has been that the Fed has pumped up markets to such a point where it has been a bad trade to try to fight the Fed, and this has removed normal checks on overvaluation. Under normal market conditions, short sellers provide the right amount of pessimism to temper the optimism that leads to a wildly overvalued stock market. Short positions help keep companies with weak earnings potential and bad management from riding the bull market herd mentality to unjustifiably high share prices. But this market is far from normal. The stock market has climbed to fresh new highs, not today, but the Dow has hit record highs 15 times this year, even with geopolitical hotspots and negative first quarter GDP.

Short sellers are in retreat. It’s hard to fight the Fed and a bull market. The proportion of shares in short positions is at its lowest level since before the collapse of Lehman Brothers, with short interest on the S&P 500 index hovering around 2%.

Shorting a stock involves borrowing it from a broker at one price with the promise to return those shares after a certain period of time. The short seller will then sell the borrowed shares, and if the stock price goes down, they can buy them back, return them to the broker, and pocket the difference. When shorting, the risk is that the price goes up and you have to buy back the shares at a higher price. Shorting can be a good way to make big money fast. If a stock drops 50%, the short seller stands to make 100% on the trade; and when a stock starts to fall, it can fall fast.

Some traders like to look at the charts for short targets, and that is important; you never want to short a stock that is in a strong uptrend; you want to wait for it to turn over. You can also look at the fundamentals, and earnings season is a great time to look for really high price to earnings ratios, heavy debt burdens, downward guidance, or anything else that might raise a red flag. It’s good to remember shorting, especially if one of the three legs starts to wobble.

Tuesday, July 15, 2014 - The Path We're On

The Path We’re On
by Sinclair Noe

DOW + 5 = 17,060
SPX – 3 = 1973
NAS – 24 = 4416
10 YR YLD + .01 = 2.54%
OIL - .74 = 100.17
GOLD – 13.20 = 1294.60
SILV - .19 = 20.82

We’ll start with a couple of quick economic reports.

The Commerce Department reports retail sales increased 0.2% in June. The sales figures from May were revised from a 0.3% increase to a 0.5% increase. The increase in June was below consensus expectations of a 0.6% increase; however sales in April and May were revised higher, so it all levels out and was fairly strong report. Sales were up 4.3% year to year.

The Empire State Manufacturing Survey for July was up 6 points to 25.6, a four year high.

The state of California released its monthly cash report for June; the state’s General Fund ended the fiscal year with a positive cash balance for the first time since 2007, so the state won’t have to borrow to meet all of its payment obligations.

Federal Reserve chairwoman Janet Yellen delivered her semiannual Humphrey Hawkins testimony before the Senate Banking Committee today. Tomorrow, Yellen will repeat the process with the House. Yellen said progress has been made to restore the economy to health and strengthen the financial system, yet too many Americans remain unemployed and inflation remains below targets and there hasn’t been enough financial reform.

After prepared remarks, Yellen fielded questions from the senators, and this is where it gets a little interesting. Yellen said, “equity valuations of smaller firms as well as social media and biotechnology firms appear to be stretched.” Some folks felt this was an “irrational exuberance” moment for Yellen. Social media and biotech stocks declined immediately after her comments. Yellen has a good reputation on forecasting. Back in 2006, when she was president of the San Francisco Fed, she gave a speech pushing back against former Fed Chair Alan Greenspan’s claim, with respect to the housing crisis, that the “worst of this may well be over.” Greenspan was wrong, Yellen was right, or at least not as bad as Greenspan.

Yellen said the Fed is still concerned about the housing market: “While this sector has recovered notably from its earlier trough, housing activity leveled off in the wake of last year’s increase in mortgage rates, and readings this year have, overall, continued to be disappointing.”

The housing market slowed last year when mortgage rates spiked on the possibility of taper. Yellen said that while the rise in rates is “the most obvious explanation for the weakness in the housing market over the past year,” it “seems unlikely that interest rates are the whole story.”

Yellen says the Fed is keeping a close watch on what it sees as potentially excessive risk-taking in the market for leveraged loans, but downplayed the possibility that its policies of ultra-low interest rates could be fueling asset bubbles. Still, there are some areas of financial markets, such as lower rated corporate debt, that are showing looser underwriting standards. Yellen and her Fed colleagues seem generally unfazed by concerns of bubbles and she said in testimony that the prices of real estate, stocks and corporate bonds “remain generally in line with historical norms.”

Yellen said most officials expect rates to start rising in 2015 and to finish the year around 1%. “That gives you a feeling for what participants thought would be appropriate given their projections in June,” she said. “What will actually happen clearly is going to depend on the progress the economy makes.”

Yellen seems pleased with the trajectory of the economy; investors seem complacent. She reiterated the Fed’s view that the economy will continue to grow at a moderate pace, and that the Fed is in no hurry to start increasing short-term interest rates.

All in all, Yellen’s testimony didn’t reveal much new. The Fed has been telegraphing this information for some time. The idea is that they can float information, and if the trial balloon gets shot down, they aren’t stuck in actual policy; if the trial balloon is accepted they can slowly implement the policy. It’s called forward guidance, and it seems to be working. The problem with forward guidance is that the Fed doesn’t know the future, and so they keep the guidance a little on the vague side, and then everybody fills in the blanks based upon their own particular bias.

It is earnings season and a couple of the big banks posted today.

JPMorgan reported a profit of $6 billion, or $1.46 a share, down from $6.5 billion, or $1.60 a share, a year earlier. Goldman Sachs posted net income of $2.04 billion, compared with year-earlier net income of $1.93 billion. Both banks saw share prices move higher after the reports.

These earnings came during a quarter in which fixed-income trading and mortgage refinancing were weak; so in that regard, the banks performed well. More likely the banks managed earnings expectations.

Johnson & Johnson reported higher-than-expected quarterly results on strong sales of its new hepatitis C drug. J&J said it had earned $4.33 billion, or $1.51 per share, in the second quarter. That compared with $3.83 billion, or $1.33 per share, a year earlier. They also raised guidance for the full year.

Intel posted better than expected Q2 revenue and profit; then they raised their Q3 revenue forecast well ahead of expectations; then they announced they would increase their share repurchase program. Intel posted a profit of $2.8 billion, or 55 cents a share, from a year-earlier profit of $2 billion, or 39 cents a share. Gross margin widened to 64.5%, compared with 59.6% in the first quarter. Intel still makes most of its profits from chips for computers; they’re still trying to get into the mobile market, but this past quarter they made more than a half billion in profits making chips for the internet of things, which is basically the idea that all of our mundane possessions will eventually be connected devices.

A study by the International Data Corporation calculates the internet of things market will grow to $7.1 trillion in the next 5 years. More than 1.9 billion once-inert devices are already connected to the internet, from parking meters to home thermostats, and by 2018 that number will top 9 billion.

The Federal Communications Commission website has crashed. Today is the last day to submit comments on the FCC’s proposal to regulate the internet. The proposal at issue would allow internet providers to charge content companies for more direct connections to their customers. These so-called “fast lanes” have sparked a vehement reaction from internet activists, who claim that the new policy could turn the web into a plutocracy where companies that are willing to shell out cash receive premium treatment. As of last week, the FCC had received almost 650,000 comments, mostly in favor of net neutrality; which is another way of saying no toll booths on the information superhighway.

Real highways are another matter. This afternoon the US House approved an $11 billion plan to replenish the federal fund for highway and mass transportation projects, but just through next May. Passage of the bill only puts off a larger debate over raising taxes to pay for long-term infrastructure financing. This was a stop-gap measure, as federal funds were 2 weeks from drying up which would have resulted in work stoppages during the peak of the summer roadwork season.

The Department of Transportation has said that without an agreement in Congress, federal payments to states will begin to slow by the end of the month. Also, the existing two-year law authorizing about $50 billion in highway and transit funding annually expires on Sept. 30; and with it the ability of the government to levy the 18.4-cent-per-gallon gas tax that finances the work.

Longer term plans have been dragged down by disagreements on how to fund projects. The short-term proposal signed today, raises money through an accounting gimmick called pension smoothing, which allows for a delay in the payments that corporations make to their pension funds resulting in a higher corporate tax bill. It’s a temporary, inadequate response to a long-term problem, better than nothing, even if it doesn’t do what it needs to do; which seems to describe everything in Congress these days.

The road ahead may be full of potholes, but on the road of life, most people think the ride will be smooth. A new survey conducted by the National Council on Aging, Untied Healthcare and USA Today finds that older adults are pretty optimistic; 89% say they’re confident they can maintain a higher quality of life through their senior years. On the financial front, 45% of the older group surveyed said they wished they had saved more money; almost one-third (31%) said they wished they had made better investments. The new survey finds more financial optimism than last year, but still almost half (49%) of the 60-and-older respondents say they're concerned that their savings and income will be sufficient to last the rest of their lives. In 2013, 53% expressed that concern.

So what is behind the optimism? The reasons vary, but support of family and friends is at the top, followed by being happy about their living situation, and being in good health.

There seems to be something to the good health part of the optimism equation. The medical journal JAMA released a study today showing people are having fewer strokes and dying less often in the wake of strokes. It’s still a big problem, striking 800,000 people a year and killing 130,000, but the numbers are down.

Another study released this week says better heart health and more education means the onset of Alzheimer’s begins later in life now than 30 years ago in developed nations. One trial in Finland suggested the body can be conditioned to hold off mental decline with gym exercising, good food choices and cognitive training.

It is good to have an end to journey towards, but it is the journey that matters in the end.

Tuesday, July 08, 2014 - Everything Except Productive Purpose

Everything Except Productive Purpose
by Sinclair Noe

DOW – 117 = 16,906
SPX – 13 = 1963
NAS – 60 = 4391
10 YR YLD - .05 = 2.56%
OIL - .13 = 103.40
GOLD - .40 = 1320.60
SILV - .03 = 21.12

Down 2 days and already I’m seeing the financial talking heads asking if this is the start of a correction. Just a reminder that markets go up and down and sometimes sideways. The markets don’t need a big reason to move. Right now, we’re heading into earnings reporting season, and a few things happen; first, some investors might look at a position and determine that prospects for earnings are not so great, or some investors are taking the opportunity to put some cash in their pockets, just in case they see a bargain basement opportunity.

A trend in place is more likely to continue than it is to reverse, and it reverses when we can see clear evidence of a reversal. Yes, the market looks overvalued by many metrics, yes there seems to be irrational exuberance; but the markets can remain irrational longer than you can remain solvent; yes, we’ve seen a couple of down days but we’ve gone 33 months without a correction, but we’ve had a bunch of down days during that same time. Right now, we’re seeing a minor pullback into a trading range as we await earnings season.

Should you stay or should you go? The markets have hit recent highs, and so you have to wonder if you get out when the getting is good. After hitting record highs, the past 2 days have seen declines; let me be very clear, 2 down days do not constitute a trend; not unless you trade the minute bars. Still, it can be sickening to see profits melt away. Conversely, cutting exposure with the aim of putting cash back to work when valuations drop can be soothing at first, but maddening if stocks continue climbing. There is a fine line between adjusting exposure based on valuations and timing the market; and either way it’s a real trick heading into earnings reporting season.

With interest rates at historic lows and stocks climbing, holding cash in a portfolio has been costly, but on the flip side, cash can serve as a buffer against market pullbacks and corrections, and it provides flexibility to buy again if prices drop; in other words, you keep your powder dry. The real return on cash has to consider the idea that you can use it to make even more money down the road. Of course, for that strategy to work, you have to reinvest the cash; you have to look for bargains or look for other opportunities. If you aren’t willing or able to do that analysis then the risk is that you build up cash and don’t know when to get more invested.

This is where the idea of rebalancing comes in; it doesn’t require sophisticated analysis; you just sell high and buy low. If your risk tolerance points you toward a 60% allocation in stocks, and the stocks go up in price and now you hold 70% in stocks, cash out, to bring the equity allocation back to 60%; turn around and put that cash into a part of the portfolio that has dropped. The idea is that you are buying low; the unfortunate side effect is that you might be dumping your winnings into a losing position. A variation on the theme is sell high and buy something you don’t already hold.

But then the question is where do you go to find value? An article in the New York Times suggests that everything is in bubble territory. The chief investment strategist at BlackRock, one of the world’s biggest asset managers, spends his days searching for potential opportunities for investors to get a better return relative to the risks they are taking on, and he says there are very few cheap assets these days. At the current level of the Standard & Poor’s 500 index, every dollar invested in stocks buys you about 5.5 cents of corporate earnings, down from 7.4 cents two years ago, and lower than just before the global financial crisis in 2007-2008.

Bonds offer next to nothing in the way of returns, and if you want to chase yield in the debt markets, you’ll find some of the riskiest issues can’t even breach 5%. Real estate has spiked in many locations, even farmland has rocketed. It’s not that any one area is outrageously overvalued. Most people would agree that stock valuations are lower than 2000, and real estate peaked in 2006, and we haven’t really recovered to those levels. It’s just that everything that could be considered a financial asset has gone up. And of course, as prices go up, the potential future returns drop.

Maybe that’s a reflection of a slowing global economy. Maybe it’s a result of the central bankers printing lots of money, but not directing where the money would go; and so the money was parked on the sidelines, and not put to productive use, not being invested in things like factories or infrastructure. And then the risk is that folks chasing yield take on more and more risk until something pops.

Taking a look at economic data today, the Federal Reserve report on consumer debt for May showed debt increased $19.6 billion, not including mortgage or real estate related lending; that’s down from a $26.1 billion increase in April. Revolving debt, including credit-card balances, rose $1.79 billion in May following an $8.85 billion April advance that was the biggest since November 2007. Non-revolving debt, which includes car and education loans, gained $17.8 billion in May, the biggest increase since February 2013, after climbing $17.3 billion in the previous month. Car sales continue be show strength, reaching a 16.9 million annual rate last month, the fastest pace since July 2006.

The JOLT survey, or Job Openings and Labor Turnover survey shows that as of the end of May, companies increased the number of job openings almost back to pre-recession levels. Despite greater demand for workers, pay scales have not budged much.  Wages for all private-sector employees increased 2% in the year ended in June, according to the Labor Department, exactly where wage growth has trended through all of this recovery.

News from the small-business sector, however, suggests pay growth is ready to break out of the 2% range. According to the June survey of small firm owners by the National Federation of Independent Business, a net 21% of small businesses report lifting compensation in the last few months. That is the highest reading since the end of 2007. So, it looks like we are getting closer to seeing wage growth in the near future, but we’re not quite there yet. And since we aren’t seeing actual proof of wage inflation, it could be argued that the Fed should wait a bit longer before tapping the brakes. And for that matter, even if we start to see signs of wage inflation, that might be a good thing.

Federal Reserve Bank of Richmond President Jeffrey Lacker said in a speech today that “subdued productivity gains” along with “moderate” increases in consumer spending and “more tempered” growth in housing construction, will lead to economic growth in the range of 2% to 2.5%, well below the Fed consensus of 3% growth. Lacker says “broad-based advances in technology are far less likely than in the past, and that we should prepare for relatively stagnant productivity growth trends going forward.”

Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said today that inflation will likely stay quite low for about 4 or 5 years. Kocherlakota says the Fed is “undershooting its price stability goal” of 2% inflation and will likely continue to do so for some time to come; he sees the probability of inflation averaging more than 2% over the next four years as being “considerably lower” than the probability of inflation coming in less than 2% over the same time period. Kocherlakota is skeptical of improvements in the jobs market, saying “much of the decline in the unemployment rate since October 2009 has occurred because the fraction of people who are looking for work has fallen.” That means the Fed is also failing to meet its job creation goal, which is damaging for the economy.

When you look at last week’s jobs numbers something doesn’t seem to add up, at least it gives pause to consider the numbers. GDP growth equals productivity growth plus job growth, or at least growth in hours worked. We’ve been adding jobs at a good pace, but the economy contracted 2.9% in the first quarter. That leaves productivity, and it turns out that there is a long term trend in decelerating productivity growth. And the problem with productivity is not that workers aren’t working hard; the problem is that we haven’t been investing in the right tools for the job.

Earnings season kicked off with a report from Alcoa. It was better than expected. Including all charges, the company earned $138 million or 12 cents a share during the quarter. That reverses the company’s $148 million loss in the same period a year ago. Revenue also came in ahead of expectations. Alcoa reported revenue of $5.8 billion, which is 2.6% higher than expected. Revenue is flat from the year-ago period.

Earlier Samsung issued an earnings warnings, claiming profits could fall as much as 26% from a year earlier. Smartphone and tablet sales took a pretty big beating. Samsung put out a statement that says tablet sales are slow because consumers are slower to upgrade tablets compared to upgrading smart phones. They also blamed the rising Korean won, which is up 9% against the dollar in the past 3 months; they blamed excess inventory in Europe, and competition in the mid and low-end of the market, and a few other excuses as well.

Monday, July 07, 2014 - Small Steps

Small Steps

by Sinclair Noe

DOW – 44 = 17,024
SPX – 7 = 1977
NAS – 34 = 4451
10 YR YLD - .03 = 2.62%
OIL - .67 = 103.39
GOLD - .50 = 1321.00
SILV - .10 = 21.15

It was a long holiday weekend that was over way too fast. And the problems of the world haven’t gone away. Let’s get caught up on some of the big stories.

In Iraq, the situation is deteriorating. There had been muted hope for some sort of an inclusive government to hold the country together. Don’t count on it. Iraq’s new parliament has called a recess and they won’t meet again for 5 weeks. So Iraq is now politically paralyzed. Meanwhile, a Sunni Islamist insurgency killed an army general near Baghdad.  It looks like Prime Minister Maliki is digging in his heels, raising the risk that Iraq will fragment along ethnic and sectarian lines.

ISIS, the Sunni insurgents are holding territory in western Iraq and just north of the capitol. The Iraqi military, backed by Shi'ite militias and volunteers, has yet to take back any major cities but is trying to advance on Tikrit. Kurds in northern Iraq have taken advantage of the chaos to expand their autonomous territory in northern Iraq. Most Sunnis and Kurds walked out of the last parliament, saying they believed the prime minister and president should be chosen along with the speaker as a package, not one at a time. They could not resolve the impasse, so the acting speaker postponed the meeting.

In eastern Ukraine, pro-Russian rebels built barricades in the streets of Donetsk and it looks like they will try to make a stand. Although most shops and businesses in Donetsk were still open, some were shut, and residents are concerned that government forces could soon attack. Rebels have been barricaded into government buildings in Donetsk, which they declared capital of an independent "people's republic", but until now the city mostly functioned normally.

You may recall there was an election in Afghanistan last month. They announced preliminary results today. The losing presidential candidate is now saying the results of the election were improperly counted and he is describing it as a “coup” against the people. His rejection of the election results sets the stage for a possible bloody standoff between ethnic groups or even secession of parts of the fragile country, which is already deeply divided along tribal lines. The vote to pick a successor to Hamid Karzai was intended to mark the first democratic transfer of power in Afghan history, a crucial step towards stability as the US prepares to withdraw the bulk of its troops by the end of the year. Not so great.

Hamas stepped up rocket fire at southern Israeli towns and Israel called up reserve troops today in anticipation of a possible escalation of hostilities. Hamas has vowed revenge for what it saw as Israel's deadliest attacks in which six Palestinian militants died, though Israel denied any involvement. The surge in violence has raged since the kidnapping and killing of three Israeli youths last month and a Palestinian teen last week. Israel said more than 40 rockets were launched as militants' funerals were held in Gaza. Thirty struck inside Israel and the rest were shot down by rocket interceptors. Air raid sirens wailed as far north as the outskirts of Tel Aviv and Jerusalem.

And then there’s Chicago, where the Fourth of July holiday resulted in widespread violence that left 80 people wounded and 14 dead.

On the economic calendar, Alcoa will kick off the earnings reporting season after the close of trade tomorrow. Alcoa has long held the ceremonial role for starting earnings season because it was in the Dow Industrials and it had the ticker symbol AA. Alcoa is no longer one of the Dow 30 stocks, but the tradition holds. Actually, we’ve already seen about 25 companies from the S&P 500 report earnings.

Second-quarter profit growth is expected to come in at 6.6% for the Standard & Poor’s 500-stock index, which would be an improvement over the 5.6% growth in the first three months of 2014. Revenues are expected to grow 3%. While negative second-quarter profit warnings have outpaced positive ones by a 4.2 to 1 margin — well above the 2.6 to 1 negative-to-positive ratio since 1995 — the future outlooks from CEOs are far more bullish than the first quarter, when there were nearly 7 negative profit pre-announcements for every positive one.

With stocks at all-time highs and no longer cheap after a five-year bull run, Wall Street wants to see companies deliver profit and revenue growth in the coming second-quarter earnings season sizable enough to warrant the market’s big move. Indeed, the bull market’s continued health will hinge on vibrant corporate profitability. Whether or not stocks continue trending higher will likely depend on second-quarter earnings reports, as well as management’s guidance of full-year earnings.

Currently, the S&P 500 is trading at nearly 16 times its estimated earnings over the next four quarters, which is a tad above the long-term average. Heading into the season, analysts are upbeat, with more analysts’ raising profit forecasts than lowering them for the first time since the first quarter of 2012, but more upbeat analysts could result in a more downbeat market reaction.

On Wednesday, the Federal Reserve will release the minutes of its last meeting, held June 17-18. Wall Street will again be looking for any clues related to the timing of the first interest rate hike by the Fed. After the strong jobs report Thursday, some Wall Street firms revised their rate-hike timetables, warning that rates could start rising earlier-than-expected next year. However, the Fed might not be so positive about jobs. There’s been concern about the degree to which a falling unemployment rate is overstating labor-market strength.  You’ll likely see general agreement that the labor market has been improving, but there will be difference in opinion about the drop in the unemployment rate. Officials have also been eyeing tepid wage growth.

That’s one of the strange things about the jobs report; it does a poor job of measuring the strength of the jobs created. When we try to measure performance in the stock market, we don’t look at the number of new stocks available to investors, instead we measure the price of the stocks, the value of the stocks. But when we look at jobs, we don’t look at the value those jobs bring. One of the things we’ve seen is that many of the jobs being created are part-time.

So, it's interesting that the recent news of job market "improvement" doesn't mention that of the 10 occupation categories projecting the greatest growth in the next eight years, only one pays a middle-class wage. Four pay barely above poverty level, and five pay beneath it, including fast food workers, retail sales staff, health aids, and janitors. The job expected to have the highest number of openings is "Personal Care Aide" – taking care of aging baby boomers in their houses or in nursing homes. The median salary of an aid is under $20,000.

We’re starting to see some improvement as the job market gains traction; more than half the jobs the economy has added so far this year are in positions that pay higher than the hourly wage. Some 58% of the new jobs created in 2014 pay above the average hourly wage of $24.45. By contrast, about 48% of the new jobs created in 2013 paid above the national average. Businesses in 2014 are hiring more white-collar employees, construction is on the mend (at least compared to the first quarter), health care is going strong and even the long-downtrodden financial industry is finally getting into the act. About 42% of the new jobs, meanwhile, fall into categories that pay less than the average wage.

Still there is a general lack of upward wage pressure; workers demanding more money as the labor market improves and the pool of potential employees shrinks. Wages have risen just 2% over the past year and weekly wages have actually fallen in the past two months. Part of the problem is part-time work; part of the problem is that the good paying jobs are limited to certain sectors. The bigger problem is that the increase in the number of jobs is not translating to higher wages and that, in turn does not translate to faster economic growth.

This week’s economic calendar also includes reports on small businesses, job turnover, and consumer credit. There was a 10.2% surge in consumer credit in April. The growing dependence on debt could prolong consumer spending a few more months, but in the absence higher real wages, this type of consumption cannot last much longer, certainly not if we see both gas prices and inflation-driven interest rates edge higher later this year.

It’s unlikely we’ll get any big pronouncements from the Fed. They probably talked about how the economy has rebounded from the terrible slump of the 1^st quarter, but if you read the minutes for any major move on interest rates, don’t hold your breath. Neither short-term nor long-term rates will go significantly higher in the next few years. More likely, modest increases that might even be quickly reversed. The implications of another extended period of depressed rates would be bad news for savers and pension funds, but it should help the stock market.

After the Fed’s June meeting, they made clear that they expected to finally begin lifting their benchmark rate in 2015, if the economy continues to expand and unemployment continues to decline. Even so, 12 of the 16 members of the policy committee expected the Fed's rate to be no higher than 1.5% by the end of 2015 — a full 18 months from now. Asked for their rate prediction for the end of 2016, the majority of the Fed panel expected 2.5% or less. And because the Fed's rate influences all other interest costs, that would suggest still-low rates across the board.

What we are learning about this version of the Fed is they move slow and in small steps.