Tuesday, April 08, 2014 - When Stuff Aligns

When Stuff Aligns

by Sinclair Noe

DOW + 10 = 16,256
SPX + 6 = 1851
NAS + 33 = 4112
10 YR YLD - .01 = 2.68%
OIL - .28 = 102.28
GOLD + 11.10 = 1309.00
SILV + .20 = 20.16

Every now and then the planets align. Tonight is one of those times; Mars, the Sun, and Earth will be aligned in opposition. And Mars is closer than normal, although still about 92 million miles away. I have no idea what this means in the cosmic scheme of things, but when the sun sets in the West, Mars will rise in the East; and it will be overhead around midnight. You should be able to spot it easily as it will look light a bright star with a red or burnt orange color. If you can’t watch tonight, you can look to the skies for the next week.  On April 14, there will also be a total lunar eclipse causing the full Moon to turn as red as the Red Planet itself.

Investor sentiment remains upbeat ahead of earnings and despite the smack-down in prices Friday and Monday. On Friday, the CBOE Volatility Index, or VIX, dropped down to a multi-month low of 12.6 and even after a few days of triple digit declines the VIX has only edged back into the mid-14 range. And although Alcoa is the official start of earnings season, a few companies have already reported, including Oracle, Nike, and Fed Ex; without inspiration. The floodgates on profit reports don’t open until April 15. A few retailers and banking names are due out with results this week.

Now we’ll see if the stars align for earnings season, which kicked off this afternoon with Alcoa. The aluminum producer was a long-time member of the Dow Industrial Average until last September, and with the ticker symbol AA, they held the alphabetical honor of the first blue chip company to report earnings each season. Today, after the close of trade, Alcoa reported profit of 9 cents per share on revenue of $5.45 billion. Wall Street analysts’ consensus estimates called for 5 cents per share. Alcoa was up in after-hours trading.

Now, let’s dig down. The earnings excluded restructuring costs and other one-time items, also known as the cost of doing business; including those costs, Alcoa posted a net loss of 16 cents per share compared with earnings of 14 cents per share for the same quarter last year. Sales fell to $5.45 billion from $5.83 billion a year earlier, trailing the $5.55 billion average estimate. So, revenue down and below estimates; earnings were actually losses but with a clever accounting team they show as profit and they beat estimates; stock price goes up. Now you know the Wall Street earnings game.

Wall Street doesn’t care about results in a vacuum. It cares about results vs. expectations. And Wall Street has set the bar so low for earnings that it should be easy to fly above forecasts, even when a company trips over the bar. That should set up plenty of opportunities for earnings reports to beat estimates, and trade higher even as the broader market suffers a year-over-year drop in profits. Ironically, while the S&P 500 is just shy of all-time highs, the number of S&P constituents that have lowered their quarterly EPS outlook is also at an all-time high.

As we have seen every quarter over the last several years, analysts have slashed their initially-too-optimistic forecasts ahead of earnings season. But estimates have come down more dramatically than usual for 1Q due to weather, concurrent with increasingly negative management guidance. It’s a game that Wall Street plays on investors, and so far, very early in the reporting season, it is playing out as 52% of the 21 early reporters have exceeded on both earnings and sales higher than last quarter’s 42% hit rate, and the best result from the early reporters since 1Q12.

That doesn’t mean the earnings reports are good, nor will they be good; S&P earnings are forecast to fall 1.2%. Of course earnings probably won’t fall 1.2% because enough companies will beat expectations by a wide enough margin to pull year-over-year profit growth into the black. Let the games begin.

Tomorrow the Federal Reserve will release the minutes of the March FOMC meeting. We already know the Fed is on track with tapering away from QE, and should be done with asset purchases sometime around October or December, and then they will look at the possibility of raising interest rate targets from the zero range, probably next year, give or take. And this week, several Fed policy makers are giving speeches to try and rein in Wall Street from getting ahead of the Fed.

Narayana Kocherlakota, president of the Minneapolis Federal Reserve said today that the US economy is wasting “lots of resources” by letting inflation stay too low and unemployment stay too high. Kocherlakota was the lone dissenting voter at last month’s FOMC meeting; he believes the Fed should do more to stimulate the economy and they should avoid specific targets for raising rates.

Kocherlakota believes the current unemployment rate of 6.7 percent probably overstates the health of the labor market, because it does not count those who have given up looking for work or those who are working part time but who would rather work full time. He says: "There is still significant underutilization of our country's most important resource, its people."

One idea is to cut the interest rate paid on excess reserves that banks keep on deposit at the Fed. This is more of a symbolic move than a big money game changer, mainly because the Fed pays only about 25 basis points on excess reserves. Still, reserves have grown over the past few years, possibly to as much as $2.6 trillion.

How did reserves get so big? The simple answer is QE. When the Fed buys private sector assets from investors, it not only creates new deposits, it creates new reserves. This is because a new deposit in a bank creates a liability which must be balanced by an equivalent asset. When banks create deposits by lending, the equivalent asset is a loan. When the Fed creates deposits by buying assets, the equivalent asset is an increase in reserves, also newly created. So it does not matter how much lending banks do, if the Fed is creating new deposit/reserve pairs by buying assets from private sector investors then deposits will always exceed loans by the amount of those new reserves. While the Fed continues to buy assets from private sector investors, excess reserves will continue to increase and the gap between loans and deposits will continue to widen.

Cutting interest rates on excess reserves might encourage some bank lending to compensate for the loss of earnings on the reserve-deposit spread; that would be logical but it also involves the actual work of lending and bankers are loathe to work and frequently illogical. So, the bankers could almost be counted on to do the wrong things; such as cutting deposit rates to from ridiculously low levels to stupidly low levels; increasing fees; or increasing interest rates on loans, which is not exactly an inducement for households and businesses to borrow. And so, as long as the Fed continues buying Treasuries and mortgage backed securities as part of Quantitative Easing, they will continue to grow excess reserves.

But what is the point if it just parks reserves with banks and doesn’t get the money circulating through the economy? The real question is how to get money moving through the economy. And this has been the major downfall of QE in the Fed’s ability to stimulate the economy and live up to its mandate of maximum employment.

Of course, the money parked in excess reserves is just part of the problem with sluggish money velocity. We also need to consider the nearly $2 trillion corporations have parked off shore, sitting there doing nothing. Congress cowers before the multinationals. There is nothing we as individuals can do. But last Friday, the legislature in the state of Maine passed legislation to end some of the games.

Companies can dodge taxes by shifting income to low-tax jurisdictions. Not only do they send the money to tax havens off shore, but they also set up companies to hide income in low tax states, such as Nevada and Delaware. Twenty-three states and the District of Columbia countered stateside tax avoidance by “combined reporting.”

Combined reporting requires companies to report their income in all states; then the combined income is taxed in proportion to the business’s activity in their state. That way, if large amounts of income that were produced by business activity in, say Maine, but were reported for tax purposes as belonging to Delaware, it would be included in the total income pie that Maine would proportionately tax.

But if combined reporting stops at “the Water’s Edge,” it only includes income reported within the United States. To get at offshore tax havens, the states can require worldwide combined reporting, or Water’s Edge plus a list of known tax havens. So the Maine legislature has passed a bill to close the “Water’s Edge” loophole, and require multinationals to pay up, no matter where they park their cash. The Maine legislators estimate they could collect an additional $5 million a year. The governor has 10 days to sign or veto, or the bill automatically becomes law. It’s is, admittedly a small step, but if the stars and the planets can align, maybe the states could also align. 

Thursday, May 23, 2013 - Premature Punch Bowl Withdrawal

Premature Punch Bowl Withdrawal

by Sinclair Noe

DOW – 12 = 15,294
SPX – 4 = 1650
NAS – 3 = 3459
10 YR YLD un = 2.02%
OIL + .01 = 94.29
GOLD + 21.80 = 1392.50
SILV + .36 = 22.73

Yesterday, Fed Chairman Bernanke delivered testimony before the Joint Economic Council and then the minutes from the most recent FOMC meeting were released. The Fed policymakers seem concerned about bubbles. Stock markets have been hanging out near record highs, the S&P is up about 15% year to date. Look back to earlier this year. The boring stocks led us higher. Your mega-cap, super-safe, dividend-paying names were the stocks to own. These stodgy companies sprinted higher for weeks. Safe became the new speculative.

Next, the rally broadened. First, it was short squeezes. Then, the rally focused on the more cyclical names. Energy stocks have found a second wind. Small-caps were. Technology names began pushing the market higher. Bloomberg reports that the most indebted US companies are rallying more than any time in almost four years compared with the rest of the market.

The bulls argue that stocks will keep going up,even if the Fed takes away the QE punchbowl; the argument is that there are record corporate profits. But then we have to ask why there are record corporate profits. The answer is the Fed's accommodative monetary policy. The Fed is effectively subsidizing earnings by providing cheap credit for the federal government. Government spending replaces paychecks as a source of income for consumers to consume. Corporations cut wages and operate lean and mean, and they report record profits. The top line, revenue, has been weak but it hasn't collapsed because the government has been providing just enough to keep the economy moving. The government provides income to citizens and they are still consuming.

Beyond that, corporations benefit from extremely low interest rates, which allows companies to refinance debt and pocket the difference. Or, in the case of Apple, they can borrow at extremely low rates, pass out the cash as dividends, and it's still cheaper than repatriating profits from offshore and paying the taxes. The debt to equity ratio for S&P 500 companies is now 57% above historical averages.

The Fed's accommodative monetary policy has allowed income to be detached from employment. Corporate America has been slowly and surely eroding its own customer base and the government has been picking up the slack with social safety nets. At the end of the day, a safety net is a stopgap measure, not a permanent solution. Without more jobs, without real income, the equity markets will eventually revert to lower valuations.

And so yesterday, Chairman Bernanke continued to beg for fiscal policy, or at least fiscal policy that doesn't embrace austerity. Bernanke has to be worried about the imbalances and he is aware the lesson the Great Depression taught many is that the principal symptom of internal economic imbalance was unemployment; a big enough problem to create a grand market failure. The equilibrium that economies find routinely is one where aggregate demand and output are not enough to ensure that the available labor force is working; that's why the Fed has a mandate of maximum employment, not just a target of 6.5% unemployment. The idea is to ensure internal balance by having the government increase spending, thereby boosting demand, which in turn, increases output, which means more jobs. It's a virtuous cycle. Except it isn't working quite like planned.

Apple is parking money offshore; same with GE, Starbucks, Google, and almost all of the big multinationals. Somewhere along the way, the idea of an economy that maximizes aggregate utility has given way to maximizing profits for a small minority who possess capital. And the idea of the government safety net being utilized to provide capital to increase consumer spending and crank up the virtuous cycle, well that is running into a brick wall in the form of austerity.

The pace, depth and breadth of the stock market rally is certainly not justified by economic fundamentals alone. Investors continue to buy because they are in a desperate search for returns in a low-return world and feel that cheap money will keep them 'whole' if they invest in risky assets, such as stocks.

Yesterday, Bernanke was asked a question that suggested the Fed's super loose, accommodative monetary policy might be creating asset bubbles, which might end very badly. Bernanke responded that “there's no risk free strategy right now.” And that risk is not restricted to the stock market. His all-consuming concern right now must be to avoid the kind of bond market carnage that was created in 1994 when the Fed raised rates unexpectedly, and I suspect that the debate within the FOMC is becoming much more heated with regard to how to achieve some scaling back of asset purchases without causing a similar bond market rout.

Bernanke started yesterday's testimony with prepared remarks by pronouncing: "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." It seemed a clear signal that the Fed would continue QE to infinity and beyond.

Then, in the Q&A session, he commented that the Fed could cut the pace of asset purchases "in the next few meetings." It seemed a complete about face.

So, we're back to watching the Fed's targets for inflation and unemployment. There are good economic arguments for inflation to become extremely sticky to the downside at these low levels; just over 1 percent. We'll keep an eye on the next few jobs reports, where good news could be bad news. Also, keep a look at global unemployment numbers. In 14 out of the 35 advanced economies covered by the IMF’s World Economic Outlook dated April 2013, the unemployment rate in 2012 was at its highest since 2007. In terms of jobs, in many countries the crisis is intensifying, not retreating.

The problem is not just that the incidence of unemployment is uneven across the advanced countries. It is also that it is extremely uneven across age groups, or more importantly, generations. The generation that has entered the labor force over the last five years is the hardest hit. These numbers are important because they represent systemic failure in labor, and the Fed can't operate in a vacuum with its monetary policy. It would be strange to see the Fed tightening, while the ECB is loosening. If you want to create problematic global imbalances, all it will take is a gear-shift by the US Federal Reserve and the inevitable dollar surge that follows. Remember that it was the Volcker Fed that set off Latin America's defaults in the early 1980s. It was the mighty dollar that set off Mexico's Tequila crisis, and then the East Asian tiger economies, chain-reaction in the 1990s.

Foreigners have pumped more than $8 trillion dollars into the emerging markets of the BRICS. European banks have lent another $4.4 trillion to the BRICS. If the Fed tightens, the dollar soars, the BRICS freeze, the defaults follow.

I'm not sure what the possible exit plan is for the Fed, maybe for now, it's nothing more than jawboning, trying to gauge the possible responses. So, there is widespread, deep-seated cynicism about the ability of democratic governments, once engaged in stimulus, to change course in the future. Ending stimulus has never been a problem; in fact, the historical record shows that it almost always ends too soon. What needs to happen before we start talking about ending stimulus is a good strong look at fiscal policy; the kind of policy that allows corporations to shovel profits offshore, and erode their long-term customer base in pursuit of short-term profits.

Global corporations have no allegiance to any country; their only objective is to make as much money as possible — and play off one country against another to keep their taxes down and subsidies up, thereby shifting more of the tax burden to ordinary people whose wages are already shrinking because companies are playing workers off against each other.

The total corporate contribution to federal revenue, including employers' share of payroll taxes, has dwindled from 32 percent in 1950 to about 17 percent today. Employer contributions to payroll taxes make the unfairness of the tax code slightly less unfair, but the trend is still clear and dramatic: Corporations are paying a lot less than they used to.

So, Tim Cook of Apple went before the Senate this week and explained the problem, and the problem isn't Apple; it's our tax laws. Apple is only doing what the laws allow. Apple and the other big companies are trying to lower their tax bill, and you would probably do the same thing if you were as big as Apple, and had a fiduciary duty to your shareholders. The problem is the laws allow them to keep billions offshore, which does nothing to create jobs in this country, which does nothing to repair infrastructure, which does nothing to create aggregate demand, which does nothing to crank up the virtuous cycle; which instead puts us on a downward spiral. When you hear outrage about the IRS scandal, don't get distracted; the real scandal shouldn't be whether some low-level IRS employees were taking shortcuts; the real scandal; the multi-trillion dollar scandal was on full display this week.