Limits to Fed Printing?

February 25, 2013

In a shocking surprise, the S&P500 closed the week without its customary melt-up. Despite a valiant effort on Friday, the S&P closed down 0.28%. Volume was very light, partly due to the holiday shortened week. Volatility, as measured by the VIX, jumped notably, climbing almost 14%. Still, despite the jump, the overall level of the VIX is close to historic lows. Market breadth deteriorated slightly. The McClellan Oscillator, and the Summation Index, and the percent of stocks above the 50 day moving average all deteriorated for the week, suggesting that whatever strength there was came from a narrow band of leaders rather than a broad participation.

US macro news continues to disappoint. The housing market index missed the consensus prediction; what’s worse is that this was the first drop and miss since April 2012. Housing starts missed as well. Inflation, at least as measured by the ever changing metrics of the BLS, came in at mild levels. Initial jobless claims were slightly worse than expected. The flash PMI manufacturing index disappointed. Existing home sales essentially met expectations. The Philly Fed survey, in the most shocking number of the week, collapsed. Instead of rising to 1.1 as expected, it dropped to -12.5. And finally, leading indicators also missed.

Technically, the S&P—despite the miniscule drop—is still severely overbought, on both the daily and weekly resolutions. The US stock markets are near record highs, despite fundamental weakness in the overall economy and the corporate sector, and are extremely ripe for a 5%-10% technical correction, at the very least.

The question all the bull seem to be ignoring is—is there any reason that the Fed can’t just keep printing to infinity and as a result, keep pumping stock prices further, prices that even regional Fed president Dick Fisher admitted are artificially boosted by the Fed’s programs?

Well ZeroHedge has pointed to one key metric that seems to have shackled the Fed, somewhat, over the past few years, and will certainly be an obstacle going forward.

Since the Fed cannot perfectly control where it’s trillions of printed money flows, it must be careful not to inflate prices of consumables that the average person needs on a day-to-day basis.

And as much as the Fed wishes to pump, and has succeeded in pumping, the stock market (and the stock market alone) the Fed is pumping up the prices of critical items such as food and energy, the cost of which directly affect the well being of millions of average Americans who do not benefit by the endless melt-up in the stock market.

Specifically, ZeroHedge has noted that whenever the average price of gasoline has hit $3.80, the Fed has pulled back on its easing, allowing gas prices to deflate, as intended.

The unintended result is that stock markets have pulled back too….each and every time.

Last week, unfortunately, US gas prices have once again crossed over the dreaded $3.80 level. What’s worse is that this has happened as all wage earners have been hit with a rise in their payroll taxes.

Will the Fed respond the same way as it has in the past, by easing off the pedal, to allow gas prices—-and stock prices—-to fall back?

We’ll know soon. And if not, expect a huge wave of negative publicity as the depressed masses of the nation cry out over $4.00 – $4.50 gas.

One thing or another MUST give. The Fed can’t have it both ways—high stock prices and low gas prices.

Residential Real Estate: Update

February 18, 2013

The S&P 500 finished the week almost unchanged. Almost, because it technically inched higher by 0.1% on very weak volume. Volatility slipped 4% back down to multi-year lows, lows usually associated with extreme complacency. And risk complacency, along with bullishness about prices,  is certainly dominating the markets and the media.

While the US economy struggles (remember, it actually contracted last quarter), and much of the rest of the world is in outright recession, equity markets have continued to climb higher, ignoring all signs of fundamental weakness.

The risk markets are also ignoring signs of corporate slowdown. Sales are not climbing, on average, as the have over the last three years, and earnings are most certainly disappointing….across the board.

Markets are also ignoring event risks, whether it’s the US federal spending cutbacks that will hit in two weeks, or the threat of a credit event in Europe, or the threat of a financial crisis in Japan, or any other of the dozens of geo-political risks that we all know about.

Today, players in risk markets believe that nothing much can go wrong. This time IS different.

And that’s what makes them especially dangerous. Because in such extreme states, when everyone is on one side of the boat, it doesn’t take much of a disturbance to create a disaster. In the meantime, the party rages on.

US macro news last week was mostly disappointing. Small business optimism missed expectations. Business inventories also missed. Initial jobless claims beat expectations, but only because the BLS ‘estimated’ the results for several KEY states. Almost always, when the actual counts come in, the subsequent claims figures shoot higher (worse). Although the Empire State manufacturing survey beat expectations, industrial production missed badly—it fell when it was supposed to rise.

Residential real estate, according to the media and the realtors and the banks, has finally passed the bottom and has started its long-awaited recovery.

But is this really so?

Well, according  to the Case Shiller index (perhaps the most respected national and regional house price index), yes median home prices have been rising—on a year over year basis—since the spring of 2012.

But is this it? Does this mean that the bursting of one of the greatest bubbles in US history is over. and a durable recovery is in effect, as the housing proponents claim?

Very possibly, the so-called recovery is only temporary.

On the supply side, Fed-backed too-big-to-fail banks have been restricting the amount of inventory (from foreclosures) hitting the market. This has created significant upward price pressure over the last two years.

On the demand side, the Fed-suppressed interest rates have allowed organic buyers and pools of investors to borrow very cheap money (near historic low levels) that allows them to bid up prices and still be able to afford the properties.

So the question is—-can this demand and supply manipulation continue indefinitely, to create a self-sustaining recovery in housing prices?

The answer is most certainly not. And the Fed has publicly said so, by stating that its extraordinary measures (to support banks and to suppress rates) will not continue forever. And when these Fed programs subside, inventory may creep higher (the pool of foreclosed homes is nowhere close to being cleared in the market) and higher rates will mean that potential buyers will be paying more, much more, in mortgage rates.

In both cases, the end result is that median home prices will come under pressure again. The good news is that if they keep rising for another year or two, then the subsequent declines will begin by taking away the recently built up gains, and that it may take several years just to go back down to the lows hit in early 2012.

In any case, it’s certainly not clear that the ultimate bottom (especially in real prices) has been established. So buyer beware.

Market Temperature: Update

February 11, 2013

The S&P500, in an eerie continuation of a patter established six weeks ago, inched up another 0.3% on historically light volume. Volatility, diverging from the rise in price, climbed slightly, but still closed near record lows, levels that imply a prevailing belief that nothing can go wrong.

And in a nutshell, the sentiment in risk asset markets is precisely that—why NOT be bullish because the Federal Reserve will simply NOT allow markets to fall? As a result, bullish indicators are showing that investors in stock markets are as bullish as—or even more bullish than—they were in mid 2007. As a reminder, that was only months before the Global Financial Crisis exploded in August 2007, which then morphed into the financial meltdown in 2008 and the Great Recession.

Surely this time is different?

In US macro news, factory orders fell. That’s not good, especially when they were expected to rise. ISM services essentially met expectations. Initial jobless claims disappointed, rising more than expected. Productivity fell much more than expected—and this is bad because it suggests that labor costs, as a percentage of sales, are rising for corporations, and this will hurt corporate profits. International trade was less bad than predicted but wholesale trade disappointed. Bottom line—the US economy is still stagnating, and certainly not booming the way the risk asset markets, especially the stock markets, are.

Technically, the S&P500 is even more overbought than it was in the last two weeks. The VIX index is diverging (rising) which is a caution sign and internals (breadth indices such as the McClellan Oscillator) are also diverging to the bearish direction. Yet prices are still rising.

What about a broader assessment of the markets’ temperature? What are some of the long-term gauges reading and implying about the current state of the risk asset markets? Note that this is in no way an attempt to predict the future direction of market prices which is very hard to do consistently; it is, instead, an attempt to assess the current—actual—condition of the markets which is not very difficult to do.

Starting with corporate profits, they are still near record highs. Interest rates, while rising lately, are still near record lows. Bond yields, both investment grade and high yield, are hugging historically low levels. Real ten-year Treasury rates are actually slightly negative. S&P optimism is near record highs. Asset owners are buying (as opposed to holding, much less selling). Capital is plentiful (the opposite of scarce). Asset prices are high, relative to recent and not so recent history, and the market psychology is certainly optimistic, as measured by multiple bullish percentage indicators.

Where does this leave the markets, today?

There is very little doubt that markets today are priced at levels implying that prospective risk is HIGH and that prospective returns are LOW.

Could prices rise further? Of course, but over the next five to ten years, any investor fully invested in risk asset markets must be prepared for historically lower returns.

Sadly, most—including experienced professionals—are not.

Gold: Still Bullish

February 4, 2013

Another week of Fed printing, another week of stock prices melting up. This time the S&P inched up 0.68%, on the typical light-to-moderate volume. Volatility, still pinned to multi-year lows, barely changed. To state that the US stock markets are ripe for a pullback is a huge understatement. Arguing that this is not the case means that you’d have to  believe that simple and normal market fluctuations have been permanently eradicated from risk asset markets and that typical and normal economic fluctuations either will not happen anymore, or if they do, then they will not affect stock markets anymore.

If so, good luck with that.

The US macro picture continues to stay weak. While durable goods orders beat expectations, all of the beat came from a jump in the usually volatile aircraft orders. Pending home sales fell much more  than predicted. Consumer confidence plunged to its lowest level in 13 months. Fourth quarter GDP was expected to clock in at a mere positive 1.0%. Instead the actual result was a shocking NEGATIVE 0.1%. While personal income beat expectations (mostly due to year end dividend pull forwards), personal spending missed. Initial jobless claims jumped back up—not surprisingly—back to the upper 300 thousand range. The payrolls report generally disappointed. Fewer new jobs were added (vs consensus). Headline unemployment rose, instead of falling as predicted. The average workweek also fell, instead of remaining steady.

Technically, the S&P is extremely overbought on the daily charts. As noted above, unless the Fed has permanently eradicated normal market forces and has become the sole driver of stock market prices, then stocks are well overdue for at least a modest drop. But if the continue to creep higher, then the ultimate correction will only be that much more devastating. Because as the world saw in 2000 and in 2008, the Fed is most certainly not able to manipulate risk asset prices forever, and when it does inevitably lose control, then modest corrections tend to turn into violent plunges.

Meanwhile, one asset that continues to enjoy steady annual appreciation (now over ten years running) is gold.

And the fundamentals that have been driving the price higher all these years look as bullish as ever….. also courtesy of the Fed.

Most casual observers of gold’s appreciation cannot understand why it’s been rising in an environment where headline inflation has been firmly under control. In other words, the rise in the dollar price of gold doesn’t make sense to them when inflation has been falling, not rising over the last decade.

What they fail to understand is that the correlation between the price of gold and headline inflation is not strong at all. As detailed in an academic paper by none other than the former Secretary of the Treasury Larry Summers (when he was an economics professor at Harvard), the price of gold is driven primarily by real (nominal less inflation) interest rates. And real interest rates have been falling consistently for the last ten years.

How’s that possible when inflation is so low? Because nominal interest rates are even lower. Recently, when the five year US Treasury was yielding 0.75%, the inflation rate was roughly 1.75%. This means that the REAL rate of return on that Treasury was actually NEGATIVE 1.0%.

This drives smart money to gold, which tends not to preserve value when those holding Treasuries are losing value.

And what about the prospects for gold going forward? Well the Fed has all but guaranteed that interest rates (not just ultra short term rates, but even longer term rates) will be pinned down for at least the next two years.

This strongly suggests that the upward pressure on gold will be very strong for…….at least the next two years.

Of course, the price of hold is much higher than it was even five years ago, but it’s very probable that as the Fed continues its program of rate suppression that gold’s run is far from over.