Deep Thoughts from the Gurus

October 30, 2010

The S&P500 finished the week essentially unchanged.  Volume dropped off quite a bit, but the more telling signal was the VIX (or fear) index, which jumped up almost 13% in a sign that traders are getting nervous about the near-term outlook for the stock market.  So they’re willing to pay more for protection against a downturn in stocks.

The economic numbers were mixed.  September’s existing home sales, although slightly better than expected, were still the third worst of the year.  Median prices fell 2.4%, and 35% of all sales were distressed.  The Case Shiller August report was worse than expected.  All in all, housing is not recovering and on the verge of another significant downturn.  Durable goods orders  were better than predicted, but only because of airline orders.  When transportation was excluded, the drop in orders was worse than expected.  Initial jobless claims were better than expected, but still near the recession-level mid 400,000 range.  Even worse for employment, over 250,000 long-term jobless folks lost their benefits in the last week alone; these 99ers will severely affect consumption (eg. retail sales, personal spending, etc.) results over the next six months.  The first estimate for third quarter GDP came in as expected:  an anemic 2.0%, a rate that is consistent with a RISING unemployment rate.  The Chicago PMI was slightly better than expected; consumer sentiment was slightly worse.

Technically, the S&P500 is rolling over on the daily charts.  Virtually all the price indicators are strongly suggesting that a pullback is imminent.  And after the upcoming week’s election results, the Fed announcement, and jobs report, the S&P will have lots of highly charged news to serve as a possible catalyst for a sell-off.

Speaking of the Fed, several world-famous investment gurus recently offered their views of the Fed’s expected QE announcement and it’s implications.

Pimco’s Bill Gross put out a newsletter in which he stated “Check writing in the trillions is not a bondholder’s friend”, “it is , in fact, inflationary and, if truth be told, somewhat of a Ponzi scheme”.  Needless to say, Mr. Gross is highly doubtful that the Fed’s money printing scheme will get the economy out of its liquidity trap and return it to full employment.

Jeremy Grantham, of highly regarded GMO Asset Management, in a paper titled “Night of the Living Fed”, described QE2 as “the last desperate step of an ineffective plan to stimulate the economy through higher prices, regardless of any future costs.”  He argued that the “asymmetric policy of stimulating stock moves by setting artificially low rates” is dangerous, and will wind up creating a bubble that will burst.

Finally, Felix Zulauf, a member of Barron’s roundtable, was quoted in this week’s Barron’s magazine.  He started by noting that “Most of the banks are not sound.”  “The crisis has only begun; there will be a long-term process of one mini-crisis after another.”  He compared investing in the industrial world to ” moving chairs around on the Titanic” which could get hit by a number of global-macro icebergs.  Zulauf said that investors should worry about where they store their money because “you might not be able to get it out when you want it.” 


The takeaway?  The global financial crisis is not over.  The Fed will not fix the problem.  You need to worry about preserving wealth, not just chasing–the currently seductive–greater returns.

QE2 and the Stock Market

October 24, 2010

The S&P500 melted up another 0.6%, but the movement was not confirmed by volume which fell off.  In fact, the only day volume spiked last week was on the one day when the stock markets sold off badly.  The VIX (or fear) index was essentially unchanged.  Divergences are popping up everywhere–many indicators (aside from volume) have been weakening noticeably over the last few weeks.

There was very little in the way of macro news last week.  Industrial production came in well below expectations.  New housing starts were ahead of estimates; housing permits came in below.  Initial jobless claims were almost as expected; the prior week’s claims were revised higher (in fact, about 90% of the revisions for 2010 have been worse than initially reported, creating huge doubt about the validity of the initial claims report).  Leading indicators and the Philly Fed survey both came in exactly as anticipated. 

Technically, the S&P has become extremely overbought, on a daily basis, over the last several weeks.  There is virtually no doubt that the Fed’s much anticipated round of quantitative easing is being priced into the stock markets BEFORE the actual money is actually created by the Fed.  The stock market’s recent moves have been driven more by short-term monetary policy and less by fundamental valuations based on individual corporations and the overall economy, which are both struggling to grow.

Paul Krugman, in his blog on the New York Times website, offered a concise way to think about the Fed’s policy of quantitative easing.  He pointed out that the Fed’s newly created money will essentially be used to buy long-term government securities.  He wrote:

What happens when the Fed buys long-term government securities? If we consider the Fed and Treasury as a consolidated entity — which, for fiscal purposes, they are — then what happens is that some long-term federal debt is taken off the market, and paid for by issuing more short-term debt in the form of monetary base. It’s just as if Treasury sold 3-month T-bills and used the proceeds to buy back 10-year bonds.

As to his opinion on whether QE and this swapping of short-term debt for long-term debt would fix the ailing economy, he wrote:

…how much do we think federal management of its maturity structure matters for the real economy? I think if you put it that way, most people wouldn’t be terribly optimistic.

At least he’s being honest.

But what about the stock markets?  What’s a good way to think about the current state of these markets and their relationship to the government authorities? 

Charles Hugh Smith, in his blog Of Two Minds, succinctly describes what many long-time professional investors and market analysts are feeling these days:

The U.S. financial markets have been poisoned, with long-term negative consequences. Only crooks, fraudsters and “marks” (those who still believe the propaganda about the “recovery” and “stocks are cheap” poison) will be left in a stock market propped up by the same socialization of risk which keeps the flimsy facade of a mortgage market from crumbling. High-frequency trading machines create the illusion of a market, and State intervention via proxies and other corrupt games provides the liquidity needed to fund the facsimile of a “rising market” and a “recovery” in the U.S. economy. But the public isn’t buying the fraud any longer; they finally “get it”: The well has been poisoned and only a fool drinks from a poisoned well.

This is why we can safely anticipate a hollowed-out stock market which trades at a steep discount to its present propped-up levels in the years ahead–until the crooked players are indicted and the financial markets thoroughly cleaned.

So who’s been making money in the US stock market over the last several weeks?  Well if it’s not the trading machines, then it’s the investors and traders who’ve metaphorically gone skiing down the side of a mountain packed with a ton of snow, snow that’s vulnerable to killing anyone skiing on it with an avalanche that can occur at any time.

Some folks are clueless about the avalanche risk.  They’re skiing away and having a great time, making money.  Many others are well aware of the avalanche risk;  it’s just that they believe that they’re such expert skiers that they’ll be able to tell when the avalanche is about to hit, and that–at the last second before it starts–they’ll be able to ski off the mountain and out of harms way.

In short, they’re acting as if 2008 never happened and could never happen again.  Yeah sure, they all got killed in 2008, but that was a long time ago, and in their minds, there won’t be a next time.

Good luck with that.

The Fed: Killing the Dollar and Spiking Gold

October 17, 2010

The anticipated quantitative easing from the Federal Reserve’ continued to push equity prices higher last week.  The S&P500 rose another 0.95% to almost fully discount (or price in) the Fed’s next round of electronic money printing.  The VIX (or fear) index slumped to six month lows, as a new wave of complacency sets in among traders, traders who are betting with near certainty, that the Fed’s upcoming actions will do nothing but boost share prices.

In the real world, the economy continues to struggle.  Trade balances for August were worse than expected; the trade deficit near the highest level of the year.  Producer prices (as pretty much all commodities have been soaring of late) rose much more than expected.  Consumer prices were slightly lower than consensus, BUT look for them to rise soon, OR for corporate profits to shrink (as producers eat the commodity cost increases).  The Empire state manufacturing survey was stronger than anticipated; the consumer sentiment index was worse.  Retail sales were higher than expected, but this number can be highly misleading.  Same store sales are vulnerable to survivorship bias; if a chain’s original 10 stores drop down to 5 stores, the remaining 5 stores can easily show same store sales increases, but the total sales of the smaller chain are usually lower.  State sales tax collections support this theory; they are down 6% year over year.  If TOTAL retail sales were actually growing, state sales tax collections should rise too. 

Chris Whalen, of Institutional Risk Analytics, is one of the most respected financial and banking analysts in the country.  In a recently published piece in Business Insider, Chris attacks the Fed’s zero interest rate policy by pointing out for all the interest saved by borrowers (courtesy of near zero rates set by the Fed), consumers and businesses lose the ability and the will to spend the same amount of money–about $750 billion annually.  In other words, the Fed is essentially taking money from households and businesses and giving it to banks to repair they balance sheets. 

But according to Chris, in the end, these too-big-to-fail banks will still need to be restructured and broken up.  In the end, the Fed will fail to achieve its goals.

During the process, the US dollar will continue to erode in value.  Savvy investors, who are too scared to short the stock market (and fight the Fed) are expressing their bearishness by dumping the dollar altogether and buying gold, and lately silver. 

Without a positive return, there is no reason to hold financial assets.  So investors (households and businesses), by dumping the dollar, will raise the risk of a sparking dollar crisis. 

What should the Fed do?  Chris asserts that the Fed must raise interest rates immediately, nevermind not print any more funny money (quantitative easing). 

Otherwise, we should expect to see gold rise further, and when the Fed eventually fails to boost real GDP growth (and when the big banks begin to wobble again), the political will to challenge the Fed will escalate, perhaps leading the end of the Fed entirely.

Let’s hope the US survives before the Fed is finally restrained or ultimately killed.


October 9, 2010

The S&P500 melted up another 1.65% last week.  The rise is being fueled–explicitly–by the eagerly anticipated round of quantitative easing (or electronic money printing) by the Federal Reserve.  That’s pretty much it.  No real fundamental improvement in the economy (jobs and organic incomes), no strong sales growth of US corporations, no growth at all in US consumer borrowings.  Nope.  It’s all about another round of money printing and the debasement of the US dollar.  As the dollar falls, stocks rise.  So far.

As mentioned, the news from the economy was mostly bad.  Factory orders fell more than expected.  Pending home sales were down 20% in August vs. August 2009.  And distressed sales made up over 35% of these terribly low levels.  In other words, normal home buying is pitifully low.  ISM services were slightly better than expected, but–at 53.2–they were at the second lowest level of 2010.  Initial jobless claims were still stuck in the 450 thousand range normally associated with recessions.  Consumer credit shrank–again.  Nonfarm payrolls were worse than expected.  18,000 jobs were LOST in September, when economists were expecting that 70,000 jobs would be GAINED.  The headline unemployment rate did not change, but only because the hiring environment was so poor that people left the workforce (ie. they became discouraged, so they did not count as being unemployed).  The broader U-6 measure does capture these people, and this rate soared from 16.7% to 17.1%.  Average hourly earnings were unchanged; they were expected to rise.

Technically, on the daily charts, there are negative divergences everywhere.  While stock prices have been melting up over the last several weeks, several momentum and oscillator indicators are not rising as much.  In other words, they’re diverging from the price action and suggesting that this latest price increase is getting tired.

Seemingly out of nowhere, a new scandal–some are dubbing Foreclosuregate–has erupted.  Bank of America has suspended foreclosures in all 50 states.  Other mortgage originators, such as Ally/GMAC, have suspended foreclosures in almost half of the nation’s states. 

These too-big-to-fail financial firms are portraying this mess as mere set of technicalities:  poorly handled mortgage documents (from origination to MBS securities) and innocent errors during foreclosure proceedings.

The reality is far, far worse.

One financial expert has called this “the biggest fraud in the history of capital markets”. 

Why is this such a big deal?

One, thousands and even perhaps millions of homes may have been taken–via foreclosure–from homeowners by entities that did NOT have the right to foreclose.  It’s that simple. 

This has nothing to do with the fact that most of these homeowners failed to make their mortgage payments, in full and on time.  They failed to do so.’

What is does mean is that the rule of law was ignored.  Banks were essentially breaking the law to take back houses.  So banks could be found to be criminally liable for this.  They could also be liable for penalties.  At the very least, they will spend huge dollars addressing this part of the mess.

Second, and perhaps more devastating to the banks, is the issue of selling DEFECTIVE mortgage-backed securities to investors–pension funds, insurance companies, endowments, and many other institutional investors in the US and around the world.

These too-big-too-fail mortgage originators knowingly created MBS securities that they knew were out of compliance–with the security terms–and sold them to investors as if they were good.  On top of all, the terms of these securities permit only 90 days from origination to FIX any defects.  Since these securities are almost all one to five years old, they CANNOT be fixed.  And if they cannot be fixed, IRS tax-exemption benefits could be rescinded.  So defrauded investors AND the IRS could be filing claims against these banks.

How large could the damages get?  Assuming even 50% loss rates on the underlying mortgages, some analysts have estimate that total losses and claims could exceed $3 trillion.

That would instantly bankrupt all of the too-big-to-fail banks.  They have far less than $3 trillion in equity capital.

Luckily the new Frank-Dodd financial regulation bill provides for the break up of these banks in situations such as this one.

Are we looking at the possibility of seeing a firm like Bank of America getting broken up and sold off in pieces, wiping out all shareholders and some of the debt holders?

The odds are getting stronger every day.

This scandal could be “bigger” than the original sub-prime crisis.  This scandal could trigger another global financial panic.  Yikes!

Why the Economy will Stumble—Guaranteed

October 2, 2010

The S&P500 slipped about 0.2% last week in a relatively quiet trading week.  Supporting the price drop was the small jump in volatility–the VIX index crept up by almost 4%.  The week’s price behavior is suggesting that the strong movement in early September is getting exhausted.

The week’s economic data were mixed to weak.  Consumer confidence was much worse than expected.  Second quarter GDP growth, at 1.7%, was a bit better than expected, but still highly indicative of an economy that’s slowing dramatically.  Initial jobless claims were still stuck above 450,000.  Personal spending hit projections, and personal income was slightly higher than the consensus estimate.  But the majority of the increase in income was the result of government provided unemployment benefits–benefits that are not sustainable.  ISM manufacturing was slightly worse than expected, but as the analysis below will show, the underlying components of ISM were far uglier.

Technically, the upward momentum of early September is clearly petering out.  The US stock market, while oversold, is showing multiple hints of an imminent pull back–on a daily charts.  The weekly charts are also not strongly bullish.  The 50 day moving average is still below the 200 day, and the signs of weak or limited upside are numerous.

So what drove the big September rally, despite the clearly poor economic fundamentals? 

Simple, the Fed, and promises of another round of quantitative easing.  Perversely, market analysts became bullish on stocks precisely because economic data got worse.  Why?  Because the more the economy stumbles the more likely the Fed will print dollars (electronically) to pump into the capital markets, which will be supportive for stocks.

So what could go wrong? 

Well if it were so easy, the Fed would never have allowed the devastating crash of 2008 to happen.  But it happened, despite the market’s hopes for a Fed rescue.

What can and very likely will overwhelm the efforts of the Fed is the the imminent downturn in the US economy–an unexpected downturn is exactly what led to the crash in 2008.

Consider this:  starting in August of 2010, between 500,000 and 1,000,000 people who’ve been collecting unemployment benefits for almost TWO years (99 weeks to be precise) will lose their benefits. 

Typically, a person collected something around $2,000 per month.  This “income” will either disappear or downshift to $400 per month, if people apply for and qualify for welfare benefits.

Consumer spending, which makes up 70% of the economy, will hit a wall beginning this fall. 

What will businesses do?  Well, last week’s ISM report offers a clue.  Beneath the headline number, several key components collapsed.  New orders plunged.  Inventories piled up.  And prices paid spiked.  All together, this means that businesses will be hitting the brakes–laying workers off, cutting back on production and suffering from lower profit margins.

The bottom line?  The economy looks like it’s about to hit another wall.  Corporate profits will follow.

Could this be the reason why Obama’s vaunted economic team has been running for the hills, by quitting in droves?