Thursday, August 21, 2014 - Rarified Air

Rarified Air

by Sinclair Noe

DOW + 60 = 17,039
SPX + 5 = 1992
NAS + 5 = 4532
10 YR YLD - .02 = 2.40%
OIL + .45 = 93.90
GOLD – 15.10 = 1277.30
SILV - .04 = 19.52

The S&P 500 broke two records during today's session, climbing past its previous intraday all-time high of 1,991.39 and ending above its previous record close of 1,987.98. Both had been set on July 24.

Family Dollar has rejected a $9 billion dollar buyout offer from Dollar General, opting instead for a smaller $8.5 billion dollar offer from Dollar Tree. The thinking is that a combination of the largest dollar store – Dollar General with the #2 Family Dollar, would be unlikely to win antitrust approval.

Once upon a time, Sears was the largest retailer in the nation. Today, Sears Holdings announce it lost $975 million in the first half of the year; $573 million in the second quarter. This was the 9^th consecutive quarter of losses, and the past quarter also marked the heaviest losses. Quarterly revenue dropped about 10%. The plan now is to close underperforming stores, or, in a classic example of corporate-speak “rationalizing our physical footprint.” The company successfully spun off Lands End earlier this year, to the benefit of shareholders. But its Sears Canada and Sears Automotive stores have been on the block for some time, indicating either a lack of interest on the part of buyers or an unwillingness by Sears to bend on its asking price.

Gap shares moved higher in after-hours trade after earnings topped expectations. With a few exceptions, retail earnings this quarter have been disappointing. Last week, Walmart cut its full-year earnings guidance, and a few days later, Target reported a disappointing quarter. It’s hard to get consumers to loosen their grip on the purse strings.

The National Association of Realtors said sales of existing homes rose 2.4% in July to a seasonally adjusted annual rate of 5.15 million, the fourth consecutive month of gains and the fastest rate of gain in 10 months. More people are buying homes compared to earlier in the year, but the sales pace is still down 4.3% from one year ago. The median existing-home price for all housing types in July was $222,900, which is 4.9% above July 2013. This marks the 29th consecutive month of year-over-year price gains.

In a separate report, the Labor Department said initial claims for state unemployment benefits fell 14,000 to a seasonally adjusted 298,000 for the week ended Aug. 16.

The Conference Board’s Leading Economic Index increased 0.9% last month after an upwardly revised 0.6% rise in June.

The Bureau of Economic Analysis, the BEA, has released its state by state analysis of quarterly gross domestic product. California has the biggest economy among the states, with about $2.1 trillion in GDP, followed by Texas at $1.4 trillion, and New York at $1.2 trillion. Vermont has state GDP of about $28 billion. Arizona comes in at almost $265 billion.

The latest numbers from the Census Bureau show the gap between Americans at the top of the economic ladder and those at the bottom is as wide as ever. Between 2000 and 2011, the gap expanded considerably. The net worth of the poorest 20% of US households fell by $5,124. At the same time, the wealthiest 20% posted a $61,379 increase in net worth. Looked at another way, the net worth of the richest 20% of families totaled $630,754 in 2011. The poorest had a negative net worth of $6,029. Altogether, the top 40% of households increased their net worth from 2000 to 2011. The bottom 60% lost ground.

Sentier Research has analyzed Census data on incomes. In June 2014, the median household income was $53,891, down from $55,589 in inflation-adjusted dollars when the economic expansion began in June 2009; that is a 3.1% drop in median income. Now, let’s clarify this report because you may have seen that the average inflation adjusted per-person disposable personal income is up 4.2% over the past 5 years. There is a difference between median and average; Bill Gates walks into a room with 80 other people and the average net worth of everyone in the room is about one billion dollars; while the median net worth is barely changed. The averages can be distorted by the strong income gains among the wealthiest; the median income numbers give a better sense of the majority of Americans.

And it’s not just the past 5 years; median income remains lower than back in January 2000; the middle income family is worse off than they were 14 years ago. The good news is that there has been some improvement in the past 3 years; since 2011, inflation adjusted household incomes are up 3.8%. We are starting to dig out of a hole, but we’re still digging.

The point is that the economic recovery has been pretty miserable for most Americans. Meanwhile, the Federal Reserve is holding its annual confab for the world’s most powerful financial players at Jackson Hole, Wyoming. The invitation only soiree includes central bankers, investment bankers, economists, and a various assortment of other bigwigs. Tomorrow morning, Fed Chair Janet Yellen will deliver the customary opening speech. ECB President Mario Draghi will speak at lunch. This year’s theme is “Re-Evaluating Labor Market Dynamics”.

In the mountains of Wyoming, the air is thin, and around Jackson Hole, it is rarified: One banker was quoted as saying: "It seems that conditions reflect the best of all worlds - US economic growth that is neither too slow, which would put pressure on earnings - nor too fast, implying inflationary pressures which could lead to (price-to-earnings ratio) contraction and possibly accelerate the Fed's move towards higher interest rates."

Kansas City Federal Reserve Bank President Esther George says the time has come for the Fed to raise rates, citing improvement in the labor markets. George said: "I don't want us to be behind the curve in beginning to normalize interest rates… When you see the economy getting as close as we are to full employment, to stable inflation, it would suggest to me that the time has come to do that… I think a very natural response when you get to this point is worrying that you might derail the recovery, but then again we've seen data come in stronger than we expected."

Fed officials are convinced that the economy is gaining strength after the years of false starts, but a majority of policy makers, led by Janet Yellen, favors a slow retreat from the Fed’s efforts to encourage job creation. They note that millions of people still cannot find jobs, while inflation remains relatively weak.

The theme is the labor market, and the Fed tracks wage trends closely because they're an important inflation indicator, and they're also a reflection of how close the economy is to full capacity. Also, in a well-functioning economy, wages should be rising particularly when productivity is going up. The Fed can't really do anything to get wages up; what it can do is wait to raise interest rates until the job market is healthier and that's what they're debating now - should they wait a while longer?

The latest government data show average hourly earnings adjusted for inflation have not increased at all in the last year, even though we're told the economy is getting better and other wage measures show similar trends. The problem with Jackson Hole is somebody like Bill Gates walks into a restaurant, and all the economist believe they are billionaires.

It is shaping up to be another good year in the equity markets, not as good as last year, but not a letdown; investors have ignored the calls for a correction, and this is still a risk-on market. Typically, when risk is not given much weight, this would be a good time to hedge one’s portfolio. And the reason for “risk-on” is a Federal Reserve that keeps interest rates at historic low levels; add in the demographics of most investors who have no choice but to stick what they have into higher risk assets such as stocks; plus the corporate world that is sitting on cash and the closest idea to innovation is to buy back their own stock, thus pushing prices even higher.

In this environment, weakness in the economy and even geopolitical events are being disregarded, with both being seen as buying opportunities. Investors might not have much choice but to hang onto the bandwagon, but you also should be keenly aware of when you need to get off because the markets could switch to risk-off in the blink of an eye.

The Bank of America settlement deal was announced today. BofA agreed to pay $16.65 billion to end federal and state investigations into the sale of toxic mortgage securities during the subprime housing boom; actually, it works out to $9.65 billion that will actually be paid, plus $7 billion in soft-consumer relief; minus about $600 million in tax deductions. About $5 billion of the cash portion of the settlement is paid as a penalty to the US Treasury. Other portions will go toward compensating investors, including state pension funds. Just under $1 billion will be split among six states.

Under the out-of-court settlement, Bank of America acknowledged that Merrill Lynch told investors in subprime mortgage bonds in 2006 and 2007 that the loans generally complied with underwriting guidelines, though reviews suggested as many as 50% did not. Bank of America also acknowledged that Countrywide did not generally tell investors the extent to which it made exceptions to its own internal guidelines. The settlement also covered some post-crisis conduct, including Bank of America's admission that from 2009 to 2012 it submitted loans for government insurance under the Federal Housing Administration that did not qualify.

The statement of facts failed to identify the amount of profit the bank gained, or show how the penalty will restore losses to investor victims. No individuals were charged. Maybe we can blame robots.

Bank of America shares jumped 4.1% to $16.16; the thinking is that the worst is behind them. The bank had already set aside reserves to handle the legal problems and the thinking is that this settlement is the settlement to end all settlements. Ultimately it works out to about a half year’s profit, give or take; you know, the cost of doing business.

Thursday, August 22, 2013 - Nasdaq Freezes, Goldman Expresses Interest

Nasdaq Freezes, Goldman Expresses Interest

by Sinclair Noe

DOW + 66 = 14,963
SPX + 14 = 1656
NAS + 38 = 3638
10 YR YLD + .07 = 105.10
OIL + .04 = 2.90%
GOLD + 9.30 = 1377.10
SILV + .30 = 23.29

A few weeks ago, I told you that August has a tendency to be a volatile month in the markets. Volatility can be positive or negative. So far it's been rough sledding. And even when the markets have an up day, it was a mess, a big frozen mess. The Nasdaq shut down for about 3 hours today; trading was halted. More on that in a moment.

The volatility has been largely tied to the Federal Reserve and the idea that they will taper off the $85 billion a month securities purchases known as QE. Probably. The best bet now is that they will start to trim purchases by $15 billion a month in September, and by the middle of 2014, they will try to stop the QE purchases. Once, we thought it would be tied to the unemployment rate or the inflation rate, but now that's just a technicality. Of course, the Fed might not actually stick to this course, but that's the betting for now.

Nasdaq said trading was halted in shares it lists because of problems at its Securities Information Processor, the feed that disseminates quotes and prices. So they stopped all transactions. Boom, a little after Noon Eastern. Buying and selling in some of the most heavily traded shares in the country ground to a standstill. During the halt, nearly every trading firm on Wall Street scrambled to determine what to do with orders for Nasdaq-listed stocks. Under normal conditions, if an exchange has problems, traders can direct their orders to other public exchanges. But because the problems involved the data feed from which prices are derived, all exchanges stopped trading Nasdaq stocks

Options markets were bombarded with erroneous orders two days ago when an internal computer at Goldman Sachs malfunctioned. Options officials at Nasdaq as well as NYSE Amex and CBOE Holdings spent almost a day reviewing orders for cancellation. Some kind of programming error triggered unintended option orders. And within 17 minutes after the markets opened, the damage was done. By some estimates, Goldman could lose up to $100 million.

Goldman’s computers sent “expressions of interest” down to the exchanges; that's what they called it - “expressions of interest”. However, the expressions of interest weren’t what was transmitted. What got fired instead were real orders. The orders were to buy and sell options. Of the estimated 400,000 contracts on 51 different stocks that got executed, and of the 500 biggest orders, 405 orders were sent down on targeted stocks whose tickers start with the letter H, I, J, K, or L. Of those 405 orders, some 130 orders were for 1,000 or more contract lots each. In other words, this was some type of “program.”

The options prices at which Goldman ended up buying and selling were so far outside where the options were actually trading that they lost maybe $100 million. Very un-Goldman-like trading. Goldman has gone a whole quarter without a single day of trading losses. They just don't lose $100 million in a day. And indeed they won't. They are canceling most of the bad trades; not all the bad trades, just most of them.

Now, about that “Expression of interest” thing. Maybe you have bought or sold stocks or even options. Did you ever send out an expression of interest? Nope. What Goldman really did was try to rig the market. They sent out ridiculously low sell orders, for example an order to sell for $1.00, when the current trade was $3.35. They never meant to send a real order though. They were pinging the market, sending fake bids and offers to get market-makers and traders to move their quotes to trigger trades. And ...ooops, somebody hit the trades. It's all part of the high frequency trading game played by the institutional investors and it has nothing to do with legitimate trading, just trying to fleece the unsuspecting sucker that wonders into the casino known as Wall Street.

When things don’t go your way it is really a learning experience – life is like that sometimes. We all have to accept that life isn’t fair and sometimes we lose despite what we think should happen, except for Goldman Sachs, which just goes in and cancels the trades, unwinding the position. And if Goldman was losing on that position, someone stood to profit, except now Goldman is canceling that guys profit, because Goldmann doesn't like to lose. The person who made the opposite bet of Goldman should give them the money back because Goldman was supposed to win. The market is never wrong, never.

Nasdaq has a long history of trading glitches, including squirrels touching off power failures and computer bugs crashing trades; and yes, they've been hacked, and flash crashed. In May, Nasdaq agreed to pay $10 million to settle Securities and Exchange Commission charges related to the initial public offering of Facebook. Regulators cited it for its “poor systems and decision-making” during the IPO in May 2012 that was delayed when software the collects orders fell into a loop. Nasdaq agreed to the settlement without admitting or denying the SEC’s findings. Part of the deal though was to shore up systems and try to avoid further problems. Yea, that didn't happen.

So, now the speculation begins. We've seen a bunch of websites going down over the past couple of weeks: NYTime, Washington Post, CNN. A security flaw is not out of the question. A hardware problem doesn't really make sense because of the redundant nature of the hardware systems.

So, August is normally a volatile month in the markets and this month the blue chips are getting shredded. Many stocks have dropped since the market peak a few weeks ago, but the Dow has managed to lead the drop. While the S&P 500 is down about 3.75% since the beginning of August, the Dow has dropped nearly 4.7%; that's more than 700 points, in case you're keeping track. After this month's hiccup, the Dow is now trailing the S&P on the year. Now the Dow is just 30 stocks, but they are big stocks and they are all down; all 30; every single Dow component has traded lower since August 2^nd.

That doesn't qualify as a catastrophe or a crash or anything nearly so dramatic; just some downside volatility.

So, I'm preparing for today's broadcast and I'm looking at all this nonsense about Nasdaq freeze up and Goldman Sachs trying to rig the markets and then refusing to pay when they screw up, and it hits me that most people really don't care about this. We just let the institutional traders play their games on Wall Street, and maybe this is why more and more people are moving away from the stock market; or getting squeezed out of the markets. It's a rigged game.

And there is a slow and steady movement away from the Wall Street casinos, toward what is sometimes referred to as alternative investments; things we can touch; things that are more local; things we can control. And then it strikes me that most people are just trying to get along from day to day, from paycheck to paycheck, and that's a tough job and getting tougher all the time.

The average American household is earning less than four years ago, which marks the official end of the recession. Based upon Census Bureau data, median household income, once adjusted for inflation, has fallen 4.4 percent in that time. The median, or midpoint, income in June 2013 was $52,098. That's down from $54,478 in June 2009, and it's below the $55,480 that the median household took in when the recession began in December 2007. Nearly every group is worse off than four years ago, except for those 65 to 74. Some groups have experienced larger-than-average declines, including blacks, young and upper-middle-aged people and the unemployed.

Of course, some groups have been extraordinarily fortunate during hard times, the CEOs. It may not be long before companies finally have to disclose the ratio of how much their average worker makes in comparison to their CEO. Reportsin recent weeks have said the long-delayed rule proposal, which was part of the Dodd-Frank law that passed three years ago, could finally arrive this summer. And speaking at a Senate Banking Committee hearing in late July, Securities and Exchange Commission Chairwoman Mary Jo White said she hoped the rule would be completed in the next month or two.

The rule in question is expected to require companies to report CEO compensation as a multiple of median worker pay, revealing the actual ratio between CEO pay and employee pay at individual companies. It is a number that has long been told in the aggregate.

The Economic Policy Institute released a report in June showing that CEOs recently made 273 times the typical 20-to-1 ratio that existed in 1965. (Those numbers are calculated using realized options rather than granted options to calculate executive pay.)

The AFL-CIO puts the multiple at 354 for what the average U.S. CEO makes compared to U.S. workers, and compares that number to other countries around the world. The ratio in France, for instance, is 104; in Japan, it’s just 67.

Some people claim our CEOs are worth it, but actual research proves that is not the case; it really boils down to the idea that they can get paid disproportionately more because the tax laws allow it, and they have set it up that way.

Wednesday, May 29, 2013 - Behind the Curtain

Behind the Curtain

by Sinclair Noe

DOW – 106 = 15,302
SPX – 11 = 1648
NAS – 21 = 3467
10 YR YLD - .01 = 2.12%
OIL – 2.12 = 92.89
GOLD + 11.30 = 1393.70
SILV + .19 = 22.56

Earlier today, I listened to one of the talking heads on CNBC trying to explain why the markets were up yesterday and down today. It was very entertaining.

When mortgage interest rates fall, the probability that an individual will re-finance a mortgage increases. When mortgage interest rates increase, the likelihood of a re-financing of the mortgage goes down. Therefore, in a rising rate environment, the average life of a pool of mortgages increases. For example, if a bond fund held Mortgage Backed Securities (MBS) with an assumed 10-year average life, and interest rates rose, the average life of the MBS portfolio would be extended for a few years. The last thing that a bond manager wants in a rising rate environment is to have the average maturity of the portfolio extended, as this adds to the losses. As a result, MBS players hedge their portfolios against “duration risk” by shorting Treasuries. The higher rates go, and the speed that rates are increasing, forces more and more selling.

Is there a level of support that we can watch? There is, and it's probably 2.2% to 2.5% on the 10-year bond that will bring out an avalanche of selling. The 2.2% tipping point is very close to where the T-bond sits today. Others say we have a huge concentration of bonds that would go out of the money around 2.5% - again, very close to where we are.

The more the price on the 10-year drops, and the higher the yield climbs, the more selling is required. Is the Big Sell-off going to happen? That depends on the performance of the bond market, and on how the dealer community is positioning themselves against event risk.

There are risks: generally speaking, and in regards to ‘taper’ of QE, soon as the Fed pulls back, we will see a spike/knee-jerk higher in rates (which we are seeing in ‘anticipation’ of this happening). Remember, all the movement we've seen in bonds in the past two weeks is just from jawboning about the possibility of taper.

Bernanke has recently said that the Fed is in the process of  changing the monthly QE purchases. Here's a big question to be considered – does taper of QE indicate the economy is better? That would be the reason to raise rates; the economy is improving – raise rates; everything else is artificial, or just an attempt to tamp down an impending asset bubble.

Yesterday, we heard that consumer confidence was up, a big jump in May to 76.2. It sounds like everybody believes the economy is improving. And while the confidence numbers are up, they're not out of the gutter. The average consumer confidence number during a recession is about 79, and even with our recent boost, we're still lagging below that low bar. The May data shows the highest measure of consumer confidence since February 2008. That was a time in which a housing crash was already well underway, and only a month before before Bear Stearns collapsed and confirmed that the country was in a financial crisis.

Yesterday, we also had the S&P/Case-Shiller House Price Index posting a 10.9% increase year over year in March. Well, that certainly sounds like things are improving. Except, in nominal terms, the Case-Shiller National index (SA) is back to the third quarter of 2003 levels. Inflation adjusted, prices are back to the second quarter of 2000. The biggest price gains were noted in Phoenix, Las Vegas, and San Francisco; all areas that were smashed by the housing crash. So, in some ways, the great rebound in housing is just another stage in the foreclosure crisis. And that is a crisis that is not yet finished.

Last year $192 billion-dollars was lost as a result of foreclosures.  On average per household, this number equates to about $1,700 of loss in 2012. The foreclosure crisis is still ongoing despite the fact that foreclosure volumes are on the decline. Why are the number of foreclosures on the decline? Last month, three major banks, including Citigroup, JPMorgan Chase, and Wells Fargo, halted all their sales of homes in foreclosure; this also reduced the supply of homes on the market. The apparent problem is that the banks still weren't following the rules for foreclosures, in violation of the national mortgage settlement. The reduction in housing supply, then, is largely artificial.

There is one thing that housing prices do accomplish, however: the so-called "wealth effect." Along with a booming stock prices, higher property values make people feel rich. This then encourages them to go out and spend money. Here's the problem with the wealth effect, you have to realize your gains. In other words, you would have to sell your stocks and your real estate and put the profit in your wallet, otherwise the wealth effect is so much smoke and mirrors, and you're spending money you don't really have. Which is one thing that Americans have apparently mastered.

Half of working Americans now earn less than they did 10 years ago, adjusted for inflation. Middle class incomes have barely budged in 44 years. Around 12 million people are unemployed, about 40% of whom have been out of work for six months or more. Remember the Summer of 2012? All the politicians were talking about jobs, jobs, jobs. Now, they can't even spell it. Poverty is on the rise, and it would be in your face and on the sidewalks except that now we have food stamps, so we don't have to look at the lines of people waiting outside soup kitchens like in the Great Depression. Still, 15% of the country depends on foods stamps.

For people who do have jobs, the quality of the jobs continues to decline, and if you were thinking about retiring, well, you probably are having to re-think your personal exit strategy. According to a recent Gallup survey, 37% of nonretired Americans claim that they will quit working after age 65. A decade ago, that percentage was 22, and in 1995, only 14% guessed they'd be retiring after 65. Is it possible that work is now more fulfilling for so many more people? Were so many employers discriminating against willing 65-year-olds a couple decades ago? Not likely. People are working longer to keep food on the table and a roof over their head.

Besides not having saved enough, today's would-be retiring baby boomers have more debt. The Census Bureau reports that from 2000-2011, the largest percentage increases in median household debt were in the 55-64 age bracket (up 64%, to $70,000) and the 65-and-over bracket (more than doubling, to $26,000). And while many were taking on more debt, median net worth (assets minus liabilities) for all age groups fell. In 2000, median net worth was $81,821. In 2005, median net worth had jumped to $106,585, before dropping to $68,828 in 2011 (in 2011 constant dollars).

In 1985 taxable money market funds were yielding 7.71%. A one-year CD was yielding 8.53%. Nowadays, CD's and money market funds offer rates that start with a decimal point. The Fed has been forcing people into the equity market and if you just don't have the stomach for stocks, you've been forced into the bond market.

The Fed's bond holdings alone have almost tripled since March 2008. And since last fall, the Fed has purchased mortgaged-backed securities and bonds by $85 billion each month. As a result, Fed's holdings in securities will amount to $4 trillion by the year-end of 2013. At the same time, the balance sheets of the big four central banks (the Fed, European Central Bank, Bank of Japan, and People's Bank of China) have more than quadrupled from $3 trillion to more than $13 trillion during the past half a decade.

As rounds of QE have pushed nominal interest rates below the rate of inflation in the United States, it was hoped that negative "real" interest rates would encourage lending and borrowing, and thus to stimulate economic activity. But this is growth by addiction, not growth by fundamentals.

Ben Bernanke knows this economy is not strong. This is no time to back away from trying to prop up the economy. Or as Bernanke said: “A premature tightening of monetary policy could lead interest rates to rise temporarily but would also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further.”

Is the economy in better shape than a couple of years ago? Yes, but it's a little early to break into a chorus of “Happy Days are Here Again”. While economic growth has picked up, it remains anemic at 2.2 percent real GDP growth on average since the end of the recession in mid-2009. As long as the US is growing well below potential; about 2.2 percent since the Great Recession/depression, inflation risks remain low and disinflation is the new normal, which serves as a still another reason to keep interest rates low. A lot of people would like to press the idea that the economy is improving; Congress can keep ignoring the unemployment and equality crises and enjoy ginning up imaginary problems.

“The loss of output and earnings associated with high unemployment reduces revenues and increases spending on income-support programs, thereby leading to larger budget deficits and higher levels of public debt than would otherwise occur.” At least that's what Bernanke claimed in his recent testimony to Congress. Maybe Winston Churchill said It better: “Americans can always be counted on to do the right thing, after they have exhausted all other possibilities.”

A mythical recovery gives cover to a lot of irresponsible people hoping that Americans won't look behind the curtain.