The Fed’s Report Card

February 25, 2012

The S&P500 crept up a fraction of a percent last week on fumes—volumes were near December holiday lows. This means, again, that there is very little conviction by the most traders and investors about the market’s current price levels. True bull markets develop on rising volume, not falling volume. Volatility, as measured by the VIX index, is approaching multi-year lows, levels that are usually associated with major tops in prices.

It was a quiet week for the economic data. Existing home sales disappointed. Instead of rising—as expected—home sales fell. To add insult to injury, median prices fell (year-over-year) as usual for the last six years running. Initial jobless claims remain in the mid-300,000 range. New home sales beat (barely) expectations, but the number is still sitting near multi-decade lows. Also, as with existing home sales, median prices fell, but in this case, they fell by a stunning 9.6%.

Technically, the equity markets remain over-bought, and over-stretched. While the uptrend on the daily charts is still in effect, prices are poised for a pullback. The question is, will the Fed (and other money printing central banks around the world) “permit” equity prices to fall?

Speaking of the Fed, this seems like a good time to assess the Fed’s two major monetary policies: ZIRP zero interest rates) and QE (quantitative easing).

More than three years after introducing these panic-driven emergency measures, lets look at a few key areas of the economy and see how well the Fed has done boosting them.

First, let’s look at prices. The problem with using the Fed’s preferred measure (core-PCE) is that key components—components, such as food and energy, that all folks need to buy to live and work—are excluded. This makes this inflation measure look much lower than what’s actually happening in the real world. So we’ll count them. And judging by the near record prices or oil and gas, the soaring prices of nearly all food commodities and end products, the Fed has failed here. Sure, they’ll point to “contained” core inflation measures, but in the real world inflation is soaring.

Second, comes employment, and here we’ll ignore the deceptive headline rate of unemployment (U-3) because it ignores millions of unemployed folks who are discouraged, working part-time because the can’t find full-time employment, and others who have left the workforce because getting a job is very difficult. So we’ll simply measure total employment relative to the working age population. And the results are horrible—today, virtually the SAME number of people are working today as there were 10 years ago, except that the population has jumped by about 30 million! Again, the Fed has failed here as well.

Next, let’s look at the values of the largest asset most households own (by far)—they homes. And we find that, based on the latest national Case-Shiller home price index, median home prices have FALLEN so far that they are today on par with where they were in 2003. Another failure by the Fed.

What about side effects? With near-zero interest rates, what’s happened to the incomes of savers and fixed income investors (such as pension funds, insurance companies, and educational endowments)? Needless to say, this income has collapsed, which has crushed the ability of savers to spend, and has created massive holes in pension funds (both corporate and public) and insurance funds that rely on reasonable interest rates to pay out claims in the future. Again, the Fed has failed.

Finally, there’s another side effect—the impact on stock markets. And what’s the obvious story here? Clearly a big win for stock owners, and the managers whose bonuses depend on rising stock prices. It’s just too bad that the average family owns very little stock. And it’s too bad that the average pension fund and insurance firm relies on bonds more than stocks. In short, it’s too bad that the goosed stock market has not benefited most folks in this country. So yes, here we finally see a strong grade for the Fed. But it’s one that the Fed was never asked to achieve (remember, the Fed’s two core goals are to maintain price stability and low unemployment), and it’s one that benefits a very small and elite slice of the general population.

So when the entire report card is considered, it’s hard to give the Fed a strong overall grade. In fact, it’s arguable that the Fed has generally failed.

What’s worse, is that by focusing attention on the stock market, the Fed has diverted public attention from the fact that very little (arguably nothing) has been done to address the root causes of the global financial crisis and the subsequent Great Recession.

This means that while we’ve been distracted by the rising stock market, the risks of another meltdown have never gone away, making another meltdown—at some point in the future—all the more likely to occur.


Germany and Greece Planning for Default?

February 18, 2012

While volume is melting away, prices keep melting up—the S&P500 crept up 1.4% last week.  Your average retail investor continues to refuse to play ball in an equity market now dominated by robotic trading, which, by some estimates, makes up over 70% of total daily trading. Real people are, instead, flocking to bonds and bond funds. This makes the bounce back in equities all the more difficult to accept as a legitimate bull market, which is always characterized by the reverse:  retail investors dumping bond funds and rushing into stocks on rising volume.

This is not a normal bull market.

In macro news, retail sales missed expectations. And once the massive spike in fuel costs sinks in, the next several consumer sales reports will probably miss as well. Industrial production also missed badly. Empire State manufacturing beat estimates. Initial jobless claims are settling into the mid-400 thousand range.  And the biggest surprise of the week  came from the inflation reports. Both core producer and core consumer prices were pointing to annual inflation rates above the 2.0% threshold that the Fed has staked out as its target. Of course, the Fed has officially announced that it will use the core-PCE figure, but last week’s results are related, and they suggest that the Fed has LESS room to launch another round of QE…..at this time. Clearly, should some unforeseen shock hit the economy or financial system, then the Fed will have the political cover to print again. But these results, combined with soaring oil and gas prices, make it far more difficult to do so.

Technically, the S&P is very stretched, in a way that usually makes a pullback very likely. Complacency is high, and so is bullish sentiment. Both of these also set up conditions where a seemingly minor spark could lead to a big wave of selling, even if it’s mostly done by robots these days.

What could cause such a spark?

One example is a blow-up in Greece. In a way that reminds folks of the Lehman collapse, the world is being told by experts in Europe that a formal default by Greece would be “contained”. These experts argue that with two years of preparation and notice, that the European financial system is now strong enough to handle such an event.

And such an event is looking more and more likely.

Today, The Telegraph (UK) ran a story titled “Germany drawing up plans for Greece to leave the euro”. And in it, European sources are quoted saying that the “German finance ministry is actively pushing for Greece to declare itself bankrupt”. The German finance minister “maintains that since Greece is already regarded by the financial world as bankrupt, a formal bankruptcy would have no negative consequences for other euro members.”

We’ll see about that. The US Treasury and other experts said something very similar about letting Lehman go bust in late 2008. It didn’t quite work out as expected.

In the meantime, per The Telegraph, “rumours are already circulating in Wall Street that banks are preparing for a “credit event” – a technical term used by credit agencies to mean default – in the days immediately following March 20, as Greece looks likely to be unable to meet its debts.”

And this is just Greece. Any number of other economic, financial, or geo-political surprises could create the spark that causes a significant correction in US stock markets, which are now certainly overbought and very likely prone to a correction.


Equities: Assuming that All Will be Well

February 12, 2012

The S&P500 dipped, finally, last week but only fractionally. Volume continues to be absent, making this dip in prices less meaningful. But volatility surged. The VIX index jumped almost 22%, suggesting that behind the scenes, traders are becoming worried about potentially larger price drops in the near future.

The macro news flow was light. Initial jobless claims was the strongest number of the week, coming in below 400,000 but still very much above levels associated with normal recoveries, especially recoveries three full years after the lowest point in a recession. International trade results disappointed; this means the US trade deficit was larger than expected and will hurt GDP growth in the first quarter. Also, consumer sentiment badly missed; instead of rising as expected, it fell.

Technically, the S&P is extremely stretched to the upside, in the near term. And last week’s price drop has done nothing to change this condition. Interestingly, stock prices are following a very similar path to the one we saw in early 2011–low volume melt-ups on declining volatility. And we all know what happened in 2011. Price rises hit a wall in March (with the Japanese earthquake) and then crashed in late July after the US federal debt crisis came to a head.

Will this year follow a similar pattern?

Well, while prices have methodically crept higher, we’re seeing several troubling signs developing behind the scenes.

One of the most important has to do with corporate earnings. The ratio of reduced estimates to boosted estimates for US firms is far higher today than in was this time last year. In fact, analyst downgrades are as high as they were in early 2008, and we all know what happened then.

Another troubling sign has to do with US gasoline usage. It’s been collapsing over the last 4-6 months, also at a rate that very closely mirrors the drop-off in usage in 2008.

With respect to international trade, the Baltic Dry Index has plunged to levels near or even below the lows reached in late 2008. This suggests that international trade is collapsing. Some of the decline comes from the jump in the supply of container ships, but this jump in supply did not all happen in the last three months, meaning that the bulk of this drop must me explained from a collapse in shipments.

In the US stock markets, a select few market “generals” have been disproportionately pushing up overall index prices. In the NASDAQ, for example, Apple’s rise has boosted the index tremendously. The same can be said for IBM in the Dow. These are not the types of market rises that  normal bull markets are built on. When a very narrow sub-segment of the markets is responsible for most of the market advance, bad things often happen.

Finally, Europe is definitely in recession, no doubt about it. The only question is how badly will growth contract and how long will it last. In 2008, the US (whose economy is about the size of the EU’s economy) led the world into recession, even though optimists were holding out hope that the rest of the world would “decouple” and escape the US contraction. This time, as Europe contracts, and Japan and China slow, the market optimists are holding out hope that the US will “decouple” and escape the slowdown in the rest of the world. Will it happen? Nobody knows for sure, but history suggests that this is not a sure bet.

And the list of disturbing trends does not end here. But the US equity markets are ignoring these warning signs. Instead, they’re assuming that all will be well, that this time is different.

If so, then that’s good news, but the news is essentially already priced in, leaving limited upside in near term price appreciation.

If not, then that will be disastrously bad news, because this type downside is not priced in, which would lead US equity markets to correct significantly.


Greece on the Brink?

February 4, 2012

While the S&P500 gained another 2% last week, the gains were built on fumes. Volumes were far below the levels seen in January 2011. Why does this matter? Simply because all sustainable bull markets are built on expanding—not contracting—volumes. In a nutshell, current anemic volumes suggest that the bull run is unsustainable. Another concern is the utter lack of fear in the equity markets. VIX and other measures of volatility have collapsed. It’s as though investors have concluded that there’s very little to worry about…..what could go wrong when the Fed will virtually guarantee that risk markets will go up, right?

In macro news, the news was mixed, and the good parts were as good as they appeared. First, the bad parts. Personal spending stalled in January, showing no growth at all. Case-Shiller’s home price index (through November) is in the process of crashing…again…in slow-motion. Prices fell across the nation, far more than expected. The 20 city index has now fallen to a new post-peak low. And the really bad months (December, January and February) for home prices are yet to come. The Chicago PMI disappointed. Consumer confidence plunged; it was supposed to rise. ISM manufacturing disappointed, as did factory orders. Initial jobless claims pretty much hit expectations.

The big positive number was jobs. The Bureau of Labor Statistics reported a gain over 200 thousand jobs for January. But here’s the catch, the reason this number was essentially a lie:  ACTUAL jobs fell in January (naturally in the post-holiday season, retailers cut back on all the extra help they brought on in November and December) by about 2.7 million. But the BLS added back—via a mysterious seasonal adjustment—2.9 million jobs, creating a REPORTED gain of about 200 thousand.

The problem is that the BLS added back FAR MORE in this January than it did in all the other January’s over the last three years. Had they simply added back the average of the last three years, the reported jobs gain would have DISAPPOINTED.

What’s worse is that the BLS will not reveal, at all, how it calculates and applies its “seasonal adjustment”.  For some reason, this year’s positive January adjustment surged, and the public should just applaud the good news?

Now that the equity markets have priced in perfection and an almighty Fed, the markets are not worrying too much about things that could go wrong. And to test this confidence and complacency, the Greek default risk is again returning.

After the markets closed on Friday, the Greek government suggested that it will NOT be able to meet the latest round of austerity measures demanded by Europe, measures needed for Greece to get another round of bailout money and avoid default in March.

The European leaders also hinted that Greece is NOT meeting expectations, and will NOT get any more money if it doesn’t comply with severe cutbacks in spending. And the European leaders will not accept promises, letters, etc.; this time, they want a law passed ASAP to ensure that the austerity measures are put into effect.

So two years after Greece first began to teeter fiscally, and after two years of kicking the can down the road, Greece is literally on the edge of a disorderly default, an official bankruptcy.

Keep in mind that Greece has effectively defaulted already, but since many private creditors voluntarily accepted reductions in the value of their bonds, this problem was  not called a “default”.

But if this current obstacle isn’t overcome, then an official default will be declared. And the default would be the first in 60 years for a developed nation.

Will the markets worry then? We’ll see.

In the meantime, market prices are generally high. So risks are higher. And prospective returns are lower. Bargains can still be found, especially overseas and in US small caps. But given the generally high-priced environment, it’s best to maintain larger cash balances.