Wednesday, April 30, 2014 - Record Highs in First Gear

Record Highs in First Gear

by Sinclair Noe

DOW + 45 = 16580.84 (record close)
SPX + 5 = 1883
NAS + 11 = 4114
10 YR YLD - .04 = 2.65%
OIL – 1.59 = 99.69
GOLD – 4.60 = 1292.30
SILV - .29 = 19.25

Back on December 31^st, we finished the old year with a record high close on the Dow Industrial Average at 16,576; since then the index has bobbed up  and down, briefly hitting an intraday high of  16,631 on April 4^th, but on that day we finished in negative territory. Today, a record high close. The S&P 500 is closing in on the record high close of 1890, but not today.

Now, when you hear the Dow is breaking records, you might think the economy is roaring, cruising along the highway in fifth gear. You would be wrong; the economy is stuck in first gear and the clutch is slipping. The Commerce Department reports the economy expanded at a mere 0.1% annual pace in the first three months of the year, one of the weakest rates of growth in the nearly 5-year-old recovery.

A slowdown had been expected due to the harsh winter weather that froze business activity across a large swath of the country, but this report was worse than expected. The gross domestic product had been expanding at a 3.4% pace in the second half of last year. No worries, the weather has warmed and everything is returning to normal. Yeah, not exactly.

There has been a rebound in the monthly data for March but there have been some disappointments as well. On the positive side, households have pared down some of their debt, credit is a little more available, and consumer spending should bounce back. Even the 2% growth in consumption spending is not all that encouraging; 1.1% of that consumption growth, more than half, was attributed to higher household expenditures on health care.

Home construction is likely to pick up speed as the weather improves, but the housing market seems to be slowing down, with reports this week on new home sales turning soft and existing home sales turning negative in many areas. Residential investment has been negative for 2 quarters. The housing market probably won’t deliver much horsepower as the engine of economic growth but it should be a little better than the winter months, when many parts of the nation were frozen.

An area of concern is business investment, as company spending on equipment fell in the first quarter, and the 3 quarter average is barely positive. The change in inventories subtracted 0.57 percentage points from growth in Q1, exports subtracted 0.83 percentage points. The outlook for trade is soft; the US is not immune to weakness overseas; China’s economy has slowed; there are problems in the Eurozone; and emerging markets are still struggling. Meanwhile, incomes have flat lined and unemployment remains unpleasantly high.

On Friday we’ll get the monthly jobs report. Today, we got a preview from ADP, the human resources firm, and their data shows the economy added 210,000 jobs in April. The ADP report showed hiring picking up in nearly all industries and company sizes; it just isn’t picking up at a real fast pace.

The Federal Reserve FOMC wrapping up their policy meeting and they issued a statement that they will keep policy on the same track; interest rate targets are unchanged and the taper continues with another $10 billion in large scale asset purchases cut this month, to a mere $45 billion a month. The central bankers said that economic activity “slowed sharply” earlier in the year but noted it has “picked up recently.” And “The committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions.”

The disappointing reading on economic growth earlier in the day underscored how bumpy the road back to normal can be. The FOMC statement repeated language from its last meeting in March stating that it will consider the country’s realized and expected progress toward full employment and 2% inflation in determining when to increase rates. The Fed also reiterated that it will take into account “a wide range of information,” including the health of the labor market, inflation pressures and financial developments. In some ways, you could look at the continuation of the taper as a vote of confidence from the Fed. Fed policymakers have said that the phaseout of bond purchases is not on autopilot; the Fed can speed it up or slow it down, depending on how the economy progresses, but apparently the weak GDP number today was not convincing enough to alter expectations; or maybe GDP falls outside the Fed mandate of price stability and maximum employment, and maybe it isn’t something they should specifically pinpoint. Of course, if the economy turns south, they will have to deal with it.

Many Americans are still wondering when the recovery is going to start, but by economic measures, the economy stopped shrinking and started growing in June 2009, the official start of the recovery. That was 58 months ago. Since 1945, the average length of a business-cycle expansion has been 58 months. So if the current recovery continues, it will end up being longer than average, not to mention much weaker. And today’s GDP number was right on the edge of recessionary. The cold weather excuse only goes so far. Already in the second quarter we’ve had deadly and damaging tornadoes, and as the weather continues to warm, we’ll deal with the effects of drought. You have to wonder if the economy was plagued by more than just weather last quarter.

That doesn’t mean we are now entering a recession; we may be close but we aren’t there yet, and we may still rebound, but this affords a good opportunity to think about how you might handle the next downturn in the business cycle. The stock market was up today, and in light of the GDP report, you have to wonder about stock valuations; the earnings reports haven’t afforded much to cheer. Are you still buying or are you looking to sell into strength.

Since Q4 2011, the average peak-to-trough pull-back on the Dow has been roughly -6%, with no correction exceeding -10%. One may ascertain that a "buy-on-the-dip" mentality remains pervasive among equity investors. So why not add to long, risk-on positions once again? Could this pull-back be different? Aren't stocks "the only game in town" with the excessively accommodative Fed monetary policy?

And while you consider market risk, don’t forget the old idea of the best and worst six months in the stock market; we’re entering the worst six months by the way. The old adage "Sell in May and Go Away", warning investors of a seasonal decline in equities, is often attributed to summer vacations and decreased investment flows relative to winter months. According to the Stock Trader's Almanac, since 1950, the Dow Jones Industrial Average has had an average return of only 0.3% during the May-October period, compared with an average gain of 7.5% during the November-April period. 

When we look at the 13 cases since 2001, the strategy of selling out just before May would have given rise to successful trades in 9 cases, or about 70 % of the time. Moreover, we observe that the "Sell in May" strategy has not failed in two consecutive years since 1992-1993. Given that "Sell in May" failed in 2013, we estimate the odds for a seasonal decline are even higher for 2014. This is not a perfect indicator, but there are not perfect indicators. You have to think that anybody who doesn’t recognize the odds is just trying to sell you something.

And on the question of valuations, at 18 times forward earnings for the S&P 500 and 36 times forward earnings for the Nasdaq, US stocks are generally closer to the high end of their range; that seems a bit pricey compared to emerging markets with 12 times forward earnings. Still, somebody was buying today, at least enough to push the Dow to a record high close. Investor optimism for US stocks has been trending up since the end of 2011, reaching an extreme level in January. Of course that would be a contrary indicator. There are plenty of voices telling you to stay the course, or even buy, and then buy some more. I’m just saying it is important to consider the possibility of selling into strength. 

Monday, July 15, 2013 - Lazy Days of Summer

Lazy Days of Summer

by Sinclair Noe

DOW + 19 = 15484
SPX + 2 = 1682
NAS + 7 = 3607
10 YR YLD - .04 = 2.55%
OIL + .52 = 106.47
GOLD – 1.60 = 1284.20
SILV + .01 = 20.03

On a quiet Monday in the middle of the summer, in the middle of July, stocks pulled out modest gains today, but it was good enough for another record for the Dow Industrials and the S&P 500. The S&P posted its 8^th consecutive advance. The Nasdaq 100 posted its 14^th consecutive advance. Volume was light, the slowest trading session of any full trading day this year. So, this record setting rally is looking a little long in the tooth.

The Commerce Department reports retail sales rose a seasonally adjusted 0.4% last month, that was less than expected. Let's break it down: Sales got a big lift in June from the auto industry, with purchases up 1.8%. That’s the biggest gain since last November. Gasoline sales, meanwhile, climbed 0.7% on a seasonally adjusted basis.  Sales also rose for home-furnishings, pharmaceuticals, personal care, clothes and hobby items. Sales fell 2.2% at home-improvement stores, by 1.2% at bars and restaurants and by 1% at department stores.

The auto sector generates about one-fifth of all retail spending. Excluding autos, sales were unchanged. So, here's what is happening; the price of gas is going up; people are trading in their old gas guzzlers for more fuel efficient cars; the savings on gas pay for the newer car. Take away autos and higher gas prices and sales were negative.

Consumer spending is the main engine of economic growth, so if retail sales drop, that means we probably need to revise expectations for gross domestic product. The estimates are that second quarter GDP would be about 1.4%, now we can probably lower that to 1%. Without stronger growth in consumer spending, businesses won’t invest as much.

Remember that oil prices are a huge economic driver in this country. Rising oil prices, probably more than the sequester or most other issues, tends to affect consumer behavior about as much as anything. The basic reason is that prices are posted on the street corner. We are all acutely aware of prices and for most of us we have to drive. One of the few options is to get a new fuel efficient car. If a person (or state government, or other organization that cannot easily pass through its costs) faces an increase in oil costs, it has a tendency to cut back in discretionary spending, since many oil expenditures are for necessities, like commuting to work. 

Also, food prices tend to rise at the same time as oil prices. This occurs because oil is used very extensively in raising crops (operating farm machinery, herbicides and pesticides, irrigation, fertilizer) and in food transportation and packaging.  Higher oil and food prices directly affect the inflation rate. Furthermore, if prices of other types of goods rise because of higher transportation costs, this also tends to raise inflation rates.

In the 2004 -2006 period, when oil prices rose, the Federal Reserve raised target interest rates, from 1% to over 5%, specifically mentioning rising oil prices, and their expected impact on inflation rates as a problem. To the extent that these higher interest rates affected consumer loans, the higher interest costs also acted as a reduction to income, over and above higher food costs.

If oil and food prices are higher, some of the more marginal buyers are likely to find it difficult to keep up their payments, and miss payments, creating an increase in debt defaults.

Now remember back to economic slowdowns in this country and there has typically been a hike in oil prices in the general vicinity. A Financial Times blog by Gavyn Davies says something very similar:

Each of the last five major downturns in global economic activity has been immediately preceded by a major spike in oil prices. Sometimes (e.g. in the 1970s and in 1990), the surge in oil prices has been due to supply restrictions, triggered by Opec or by war in the Middle East. Other times (e.g. in 2008), it has been due to rapid growth in the demand for oil.(or speculation.)

But in both cases the contractionary effects of higher energy prices have eventually proven too much for the world economy to shrug off.

Most economists reckon that the price of oil would have to rise to at least $120 a barrel, and stay there, to threaten the recovery. Or maybe the level is $110 a barrel. It's tough to determine exactly; the figure used to be $80 a barrel. At any rate, we start to feel the slowdown long before we hit the specific price level.

If there were no problem with oil prices leading to recession, prices could keep on rising as much as they need to, to encourage additional production and to encourage alternatives. It is the fact that high oil prices cause recession, and the fact that recession tends to cause oil prices to drop, that prevents oil prices from continuing to rise, in a fashion that would allow oil companies, and makers of alternatives to be able to rely on the higher prices. This hampers the continued growth of oil supply.

So, there is a balancing act between production and recession, and included in that balancing act is that much of our oil comes from oil exporting countries, and they have specific oil prices that they require, not just for exploration and drilling but also to maintain their state budgets and their own economies.

So, on a slow summer day we can look at earnings. S&P 500 companies' second-quarter earnings to have grown 2.8 percent from a year earlier, with revenue up 1.5 percent from a year ago. The big earnings announcement today from Citigroup; its second-quarter profit rose 41%. Net income rose to $4.2 billion compared with $2.9 billion a year ago. Big revenue gains in emerging markets and Citi's securities business; profits improved with cost cutting measures.

On Wednesday, Fed Chairman Bernanke is scheduled to delivery his semi-annual Humphrey Hawkins testimony on Capitol Hill, and following all the ruckus past comments caused, we can expect the most non-committal, bland, boring testimony you can imagine.

And there is some expectation that the second half will pick up, but there isn't much to indicate a big increase. The global economy isn't going to drive economic growth in the US. The global economy may no longer be able to rely on China to be the growth engine it’s been in the past. China’s official statistics agency announced the world’s second largest economy grew 7.5% in the second quarter as industrial production and fixed asset investment continued to dip.  While the slowdown came in line with expectations, it presages further slowdowns, as China’s GDP will probably average 7.5% this year, falling to 6.9% next year, which given the size of China’s economy has important implications for global growth going forward. No hard landing for China, but continued growth contraction for several quarters to come.

A final note on Citigroup today:

Last week, four senators unveiled the 21st Century Glass-Steagall Act. The pushback from people representing the megabanks was immediate but also completely lame -- the weakness of their arguments against the proposed legislation is a major reason to think that this reform idea will ultimately prevail.

The strangest argument against the Act is that it would not have prevented the financial crisis of 2007-08. This completely ignores the central role played by Citigroup.

It is always a mistake to suggest there is any panacea that would prevent crises -- either in the past or in the future. And none of the senators -- Maria Cantwell of Washington, Angus King of Maine, John McCain of Arizona, and Elizabeth Warren of Massachusetts -- proposing the legislation have made such an argument. But banking crises can be more or less severe, depending on the nature of the firms that become most troubled, including their size relative to the financial system and relative to the economy, the extent to which they provide critical functions, and how far the damage would spread around the world if they were to fall.

At its peak in 2008, Citigroup's assets were around $2.5 trillion -- we can call that over 15 percent of GDP. It was the largest bank in the U.S. and arguably the largest bank in the world. As a result of the crisis and the bailout measures put in place by both the Bush and Obama administrations, we have five groups of firms (with a holding company at the core) that resemble Citi in the run-up to 2007: JP Morgan Chase, Bank of America, Goldman Sachs, Morgan Stanley, and Citigroup itself.

All of them are now undoubtedly too big to fail.

The point of the New Glass-Steagall Act is to complement other measures in place or under consideration.

Nothing can completely remove the risk of future financial crisis. We can have a safer financial system that works better for the broader economy -- as we had after the reforms of the 1930s. Or we can have a system in which a few relatively large firms are encouraged to follow the model of Citigroup and to become ever more careless and on a grander scale.