Tuesday, May 13, 2014 - Record Highs and Dow Theory

Record Highs and Dow Theory

by Sinclair Noe

DOW + 19 = 16,715
SPX + 0.8 = 1897
NAS – 13 = 4130
10 YR YLD - .03 = 2.62%
OIL + 1.38 = 101.97
GOLD – 1.00 = 1295.70
SILV + .03 = 19.63

Record highs are seldom pretty; they tend to be sloppy affairs, much like our celebrations. You would like a nice neat procession, but people are marching in different directions, candles blow out, hot wax is spilled.

It doesn’t seem like we should be having record highs in the first place, but there it is:  the S&P 500 hits 1900 for the first time ever; the Dow Industrials at record highs; the Dow Transportation Average confirms with record highs. This is important because it goes back to one of the more important technical indicators in the US stock market, the Dow Theory.

The Dow Theory is based on the writings of Charles Dow, the founder and editor of the Wall Street Journal, and dates back more than 100 years. There are actually several tenets of the theory that examine the major trends in the market and posit that the market is efficient, that it incorporates and discounts all news with greater accuracy than any individual. Once a trend is in place it is likely to continue until there is definitive evidence of a reversal; in this light, the slog through the first quarter might be considered as nothing more than market noise. Dow Theory also holds that volume confirms price trends.

And the theory also holds that the Dow Transports should confirm the Dow Industrials. The idea was that the Industrial average reflected the factories scattered around the country and the transportation average consisted of the companies that hauled the goods from the manufacturer to the market. If manufacturers are producing more, they have to ship goods to consumers, so if you want to know about the health of manufacturers, look to the performance of the companies that ship the goods. The two averages should be moving in the same direction; that is, they should confirm. So, if the Transportation average hits record highs, which it did, the Industrials should also hit new highs, which happened yesterday.

In mid-March, the transports broke above prior 2014 highs while the Industrials still lagged below their corresponding 2014 high. This could have been interpreted as a divergence, and even a signal to sell the industrials. However, Dow Theory tells us that industrials lag transports. It makes sense, because goods need to be transported before they can be sold.

Now, if you want to try and front-run Dow Theory, you want to pay attention to sales. Today, the Commerce Department released April sales figures, and they were flat, up just 0.1%, but this follows a revised 1.5% increase in March; that was the largest increase since March 2010 and reflected pent-up demand after a brutally cold winter. So, March sales were spectacular, and that was reflected in the Dow Transportation Average, and eventually the Dow Industrial Average confirmed the Transports. And now, the April numbers look weak despite data like employment, as well as manufacturing and services industries surveys, suggesting the economy regained strength early in the second quarter.

A second report from the Commerce Department showed that retail inventories excluding automobile stocks barely rose in March. The government had assumed a big increase in these stocks when it made its advance growth estimates last month for gross domestic product at 0.1% growth. March trade, construction spending and factory inventory data, which the government did not have in hand for the GDP estimate, suggest downward revisions to output; likely showing the economy contracting slightly. Core sales were down 0.1% in April; core sales strip out automobiles, gasoline, building materials and food services, and correspond most closely with the consumer spending component of the GDP.

Meanwhile, the Fed reported today that Americans racked up more debt in the first quarter, the third straight quarterly increase, thanks in large part to heftier mortgages. The report on household debt and credit showed however that mortgage originations dropped to their lowest level since the third quarter of last year. Outstanding household debt rose by $129 billion from the previous quarter, boosted by a $116 billion jump in mortgage debt and smaller rises in student and auto loans.

And in the sometimes twisted logic of Wall Street, this might be considered good news, the economy isn’t collapsing but it certainly isn’t growing enough to warrant a change in interest rate policy from the Fed. Any increase in interest rates could hobble consumers, businesses, and even the government.

Prices and wages been have sluggish since the 2007-2009 recession, and especially so in the past couple of years. Inflation remains low, and it undershot the Fed’s 2% target for the 23^rd consecutive month in March, based upon the personal consumption expenditures price index. Stubbornly elevated unemployment puts downward pressure on inflation. We still have slack in the labor market, so we’ll likely have very low interest rate targets for quite some time.

Meanwhile, we’re wrapping up earnings reporting season and according to Bloomberg research, almost 76% of the 453 companies in the S&P 500 that have reported earnings had results that were higher than analysts' estimates and approximately 53% of them exceeded revenue estimates. I know this is a rigged game between corporations and analysts, but companies are making money and sitting on piles of cash.

The corporate cash pile reached $2.02 trillion in the latest quarterly filings of 2,300 non-financial companies in the Russell 3000 Index. According to Bloomberg, the total rose about 13% from a year earlier in each of the two latest quarters, the fastest six-month gain since mid-2011.  If investors aren't applying some sort of haircut to the valuations of companies with hefty amounts of cash overseas, perhaps they should be; that is the mantra of activist shareholders. And so companies are beginning to pick up M&A activity as well as share buybacks and dividend increases. Capital spending on structures, equipment and intellectual property by all US companies in 2013 increased 3.9%, the slowest pace in three years. Eventually there will be value in reinvesting in the company to grow revenue; we’re not there yet, but we’re getting closer.

Again, one of the tenets of Dow Theory is that a trend in place is likely to continue until there is definitive evidence of a reversal; we’re not there yet. The trend is bullish; the supporting data is only mildly positive. In this instance, you stay in the market and remain alert to possible reversals. The level of support for the Dow, now moves up to the 16,550 range. On the upper end, there really is no level of resistance when you hit new highs, with the possible exception of Fibonacci expansion levels, which could put a ceiling around 16,800.

Meanwhile, if you’re looking for a negative divergence, you need look no further than the Russell 2000 Index of small and mid-cap stocks. The Russell has been persistently below its 50 day moving average since early April, and last week it dipped below the 200 day moving average; yesterday it bounced up above the 200 day and remained above the average today, despite losing 12 points. So, if you are looking for an early warning, this is a good place to look. If the Russell can move above the 200 day average here, it would have to be considered positive and also confirmation of the blue chips. If there is a breakdown from here, it might drag the blue chips lower.

Now, even if the market moves lower from here, it doesn’t mean we’re crashing back down to the 2009 levels; there is no definitive evidence for that kind of a move; there is plenty of fear mongering; there are plenty of perma-bears and they are about as accurate as a broken clock. The world is not coming to an end, at least not today; the market is not crashing, at least not today. In fact, we’ve been going through one of the best five year bull runs in market history. The VIX, the volatility index is at its lowest levels in more than a year. The major trend is bullish but this is no time for complacency. One of the tricks to profitable trading is knowing when to let winners run, and when to lock in profits.

These are the days of milk and cookies. Enjoy it while you can.

Wednesday, May 15, 2013 - Have Another Cookie

Have Another Cookie

by Sinclair Noe

DOW + 60 = 15275
SPX + 8 = 1658
NAS + 9 = 3471
10 YR YLD - .01 = 1.94%
OIL + .18 = 94.39
GOLD – 33.30 = 1393.50
SILV - .82 = 22.69

More record highs on Wall Street. We celebrate with milk and cookies, and remembrances of the days of rice and beans and tins of tuna. Record highs are fleeting, almost ephemeral. I know the trend is your friend; don't fight the Fed; a rising tide lifts all boats; yada, yada. Why is this starting to feel like an asset bubble?

Stock Traders Daily did a comparison of quarter to quarter earnings and revenue growth rates for the S&P 500 and the Dow Industrials: “For the past two consecutive quarters, the Dow Jones Industrial Average has had zero growth. In fact, this quarter revenue growth declined by 2.65% (25 companies reporting thus far) and earnings have barely budged. Last quarter, there was negative earnings growth with revenue growth less than 1%, and since the third quarter of 2010, the EPS growth rate for the Dow has been declining steadily.”

So, the growth rate is at zero and the prices keep going higher. Don't worry, have another cookie; after 13 years in the market, you should be back to break even.

Meanwhile, the National Association of Home Builders/Wells Fargo housing-market index rose to 44 in May from 41 in April. The NAHB says builders are noting an increased sense of urgency among potential buyers as a result of thinning inventories of homes for sale, continuing affordable mortgage rates and strengthening local economies. Have another cookie.

Wholesale prices dropped in April. The producer-price index declined by a seasonally adjusted 0.7% to mark the biggest drop in more than three years. Wholesale prices over the past 12 months are up just 0.6%. In April, the cost of fuel fell 2.5%, led by a 6.0% drop in gasoline prices. Electricity and home-heating-fuel costs also eased, though natural-gas prices posted the biggest increase since mid-2008.

The price of food, meanwhile, fell 0.8% in April after jumping by the same amount in March. Vegetable prices plunged 10.6%, with the cost of squash, lettuce, celery and cucumbers all taking a dive. Meat prices also fell. Cookie prices were not included in the report.

The muted rate of inflation at both the producer and consumer levels gives the Federal Reserve more leeway to keep interest rates low and continue with QE. So, the talk about tapering off of QE might make more sense if the Fed was actually getting closer to its targets of 6.5% unemployment or 2.5% inflation. They aren't close.

The Federal Reserve Bank of New York reports households reduced debt during the first quarter by 1 percent to the lowest level since 2006. Household debt fell to $11.2 trillion in the first quarter compared with a peak burden of $12.7 trillion in the third quarter of 2008. Consumers reduced debt by $110 billion after increasing their borrowing by $31 billion in the fourth quarter of 2012, while delinquency rates fell across the board. Student debt bucked the trend, rising to a record $986 billion.

Households in the first quarter improved their debt payment patterns as delinquency rates on mortgages fell to 5.4 percent from 5.6 percent, on home equity loans to 3.2 percent from 3.5 percent, on credit cards to 10.2 percent from 10.6 percent and on student loans to 11.2 percent from 11.7 percent. One way to look at this is that reducing debt results in a better vintage of debt. Student lending has surpassed credit cards, auto loans, and home equity loans, and is now the largest form of consumer debt after mortgages.

Last week, Fed Chairman Ben Bernanke said “the Fed could push banks to maintain a higher leverage ratio, hold certain types of debt favored by regulators, or other steps to give the largest firms a ‘strong incentive to reduce their size, complexity, interconnectedness.’

“The Fed chairman acknowledged growing concerns that some financial companies remain so big and complex the government would have to step in to prevent their collapse and said more needs to be done to eliminate that risk.”

And Fed Governor Jeremy Stein said pretty much the same thing; and Fed Governor Daniel Tarullo also picked up on the talking point.

James Kwak raised a vital question about these talking points: Too-big-to-fail banks enjoy implicit subsidies and impose externalities on the rest of us; therefore those subsidies and externalities should be priced; and then those banks can decide whether they want to absorb those costs or make themselves smaller. 

Here’s what they are saying: Too-big-to-fail banks are too big and complex and pose a systemic risk to all of us; therefore they need to become smaller and less complex; and the Fed will tweak the regulations until they become smaller and less complex.

What’s remarkable about this? These three men—probably the three most important on the Board of Governors when it comes to systemic risk regulation (as opposed to monetary policy, for example)—all say that they know that the megabanks are too big and complex. They all say that accurate pricing of subsidies and externalities is not an end in itself.* They all say that the goal is smaller, less complex banks.

If the goal is smaller, less complex banks, why not just mandate smaller, less complex banks? Why beat around the bush with capital requirements and minimum long-term debt levels? Those tools might be appropriate if you think huge, complex banks should exist but you want to make them safer. But if you’ve already concluded that banks need to be smaller and less complex, then they’re just a waste of time.

They also betray a frightening naivete regarding corporate governance. The theory is that higher capital requirements, for example, will lower banks’ profits, which will upset shareholders, who will eventually force the board of directors to eventually convince the CEO to break up his empire. This scenario, unfortunately, depends on the premise that American corporations are run for the benefit of their shareholders, which is only roughly true, and even that often requires long, expensive, and messy shareholder activist campaigns.

Instead, there’s an obvious solution: rules that limit the size and scope of financial institutions. But Bernanke has ruled out “arbitrary” size caps in favor of his cute regulatory dial-tweaking.

Again, Bernanke’s position might be defensible if he wasn’t already sure that today’s banks are too big and complex. Then it might make sense to tweak the incentives and see how the market reacts. But if he knows they are too big and complex, he should eliminate that risk in the simplest, most direct way possible. If he’s not sure how much smaller and simpler banks need to be, he can do it in steps: set one set of size and scope limits, see what he thinks about the outcome, and then set another set of limits if he’s still unhappy.

To use a crude analogy, let’s say we’re concerned about guns on airplanes. Ben Bernanke thinks, like I do, that guns on planes present an unacceptable risk to the safety of air travel. But his approach is to charge a $100 fee for anyone who wants to bring a gun onto a plane. If people keep bringing guns on board, he’ll raise the fee to $200, then $300, and so on until people stop. The sensible, obvious solution is to just ban guns on planes. But that would be “arbitrary.”

It is theoretically plausible that one should simply price the subsidies and externalities and then let the market determine whether big banks provide enough societal benefit to offset the costs they impose on the rest of us. But that is not what Stein, Tarullo, and Bernanke are saying.

Meanwhile, Attorney General Eric Holder was speaking before the House Judiciary Committee hearing today on another subject, but he was asked about comments he made back in March about the idea that the big banks are too big to jail. He said his comments were misconstrued and he added that there is “no bank, there’s no institution, there’s no individual who cannot be investigated and prosecuted by the United States Department of Justice.”

And that was the straightest answer he gave in testimony today. Have another cookie.

Meanwhile, a few years ago, I wrote a book about breaking up the too big to fail banks; Eat The Bankers: The Case Against Usury: The Root Cause of the Economic Crisis and the Fix