Further Market Correction Likely Ahead!

Further Market Correction Likely Ahead!

Yesterday I spoke with Jo Ling Kent on Fox’s Risk and Reward about what investors might expect for the rest of September and into the remainder of 2015. I suggested that after a rough September, further market correction is likely ahead.  Investing is all about probabilities, there is no sure thing, at least not legally, so as investors we need to look at what is most likely.

Historically the latter part of September has seen negative returns across on sectors, on average, with the one exception of Consumer Staples, which has a median return over the past 10 years of 0.1%, according to research from Bespoke Investment Group. All other sectors have negative median returns with reliable consistency as the percent of times they are positive is less than 50%. For example, Energy has generated positive returns only 20% of the time, (with a median return of -1.9%) and technology only 30%, (with a median return of -1.4%).

With that historical context, I also add in how concerned I am with the upcoming earnings season and what affect it will have on stock prices, given that we are already getting early warnings from companies ranging from Citibank to seeing further declines in Caterpillar sales, down 33 months in a row; an unprecedented decline.

2015-09-21

Now we need to look at the impact of the Fed’s decision last week to not hike interest rates. In the short-term what makes markets move is solely investor attitude toward risk. We’ve seen a lot of complacency and comfort with elevated levels of risk thanks to the prevailing narrative of a Federal Reserve put on the markets and a believe that loose monetary policy would pump life into the economy. What we are seeing now is an unraveling of that tale.

For those who were surprised that the market did not react positivity to the lack of a rate increase, you need to look at the market’s current attitude towards risk, which has shifted significantly towards risk-off. When investors are risk-on, easing tends to be very favorable for the stock market as investors hate sitting in a pool of excess risk-free, low-interest rate liquidity and so they buy, buy, buy! But once investors become risk-averse, Fed easing has no positive impact on aggregate stock prices because that pool of excess liquidity looks awful comforting when risk-off is in the air

The market right now is very confused. The Fed essentially to the market, “I love you, you’re wonderful, but I think we need to slow things down.” The only defense of the Fed’s inaction seems to be that nearly a decade of monetary perversion of interest rates hasn’t yet worked, so we are going to keep doing it! Naturally!

Going forward I expect that

  1. The headline economic numbers, both domestic and globally, will continue to weaken.
  2. The market and the Fed will realize that the opportunity raise rates passed them by.
  3. Unless something unexpected ignites a sustained risk-on mode in the markets, the Fed may even be pushed into another round of easing as pain form a strong dollar mounts while other major economies work to devalue their currencies.

Neil Cavuto: Fed Policy is the Problem

Neil Cavuto: Fed Policy is the Problem

This morning I spoke with Neil Cavuto on Fox Business about the Fed’s decision to not raise rates earlier this week; my view, Fed policy is the problem!

An economy grows when good ideas are able to get funding, find talented people to work on them and are able to operate in an environment that is conducive to their success; that means limited laws, regulations, and a tax code that are all easy to understand and not costly to follow. 

All the QE (Quantitative Easing) and ZIRP (Zero Interest Rate Policy) have kept interest rates super low. That forces people to put their money into riskier investments than they’d like. Riskier investments by definition have to generate higher rates of return to compensate for their higher level of risk. High levels of risk are also associated with ideas, that normally wouldn’t get funding, but manage to get it by promising really high rates of return. If investors are pushed into more higher risk/higher potential return investments than they’d normally like, that means more of these potentially bad ideas get funding.

This means the economy experiences a higher failure rate than would normally be the case. That means more investors lose their money and more resources get wasted, draining the economy. Add in that the U.S. economy is getting more and more complicated with respect to legislation, regulation and a tax code that even the IRS doesn’t understand and ever great ideas struggle under the burden of trying to jump through all those extra government hoops that just make it that much harder to be successful.

In my discussion with Neil I refer to how we have a record high level of job openings. The chart below is from the Federal Reserve, but can be researched in depth by looking up the JOLTS report from the Bureau of Labor Statistics.

2015-09-18 Cavuto - Job Openings

I also mentioned how the percent of the population actually employed is where it was nearly 40 years ago.  This data is also from the Federal Reserve.

2015-09-18 Cavuto Employment Population

ZIRP and QE are killing the economy

ZIRP and QE are killing the economy

Shocker! The Fed didn’t raise rates today.A Shocked Baby

I’ve been predicting the no-change decision for months!

It was pretty obvious, but that’s because I can see that ZIRP and QE are killing the economy.

The labor market is still relatively weak, regardless of what the seriously misleading unemployment rate statistic tries to tell us. Job openings are at record highs (companies can’t find the right talent) while the percentage of the population employed is at levels last seen nearly 40 years ago. The three-month moving average for retail sales is at a level only seen during the Great Recession. Second quarter revenues for companies in the S&P 500 were down 3.4% year-over-year.  Second quarter earnings were also down year-over-year.

So what does this mean?

Nearly a decade of ZIRP (Zero Interest Rate Policy) and trillions in Quantitative Easing and still, the economy can’t get off what the Fed believes is life support!

Why?  Because while playing in all their models they miss the big picture!

Economists often make understanding the economy unnecessarily complicated. Part of it is reasonable in that this stuff can be complicated and it takes a lot of time and effort to communicate these topics in a way that doesn’t use terminology that only “big brained” economists understand. They’re busy and most just aren’t interested in putting in the time. Part of it is probably job security – we all like to give the impression that what we do is really difficult!

An economy grows when good ideas are able to get funding, find talented people to work on them and are able to operate in an environment that is conducive to their success; that means limited laws, regulations, and a tax code that are all easy to understand and not costly to follow.  It is that simple.

All this QE and ZIRP have kept interest rates super low. That forces people to put their money into riskier investments than they’d prefer. By definition, riskier investments have to generate higher rates of return to compensate for their greater level of risk. High levels of risk are also associated with ideas that probably shouldn’t get funding, but manage to get it by promising really high rates of return; sometimes really high returns…I’m sure you’ve heard of the hockey stick effect. If investors are pushed into more “higher risk/higher potential return” investments than they’d normally like, that means more of these bad ideas get funding.

In an ideal world only good ideas get funded because when bad ideas get funded, investors lose their money and resources like people, time and raw materials get wasted.  There’s a net loss to society. (I’m simplifying here a bit for the sake of clear communication as some degree of bad ideas is a relative good because they serve as a warning and provide a place of learning what not to do or avoid).

Putting all that together, extra low interest rates mean investors are pushed into investing in more higher risk investments which means more bad ideas get funded than would otherwise be the case, so the economy experiences a higher failure rate than would normally be the case.  That means more investors lose their money and more resources get wasted, draining the economy. Add in that the U.S. economy is getting more and more complicated with respect to legislation, regulation and a tax code that even the IRS doesn’t understand. Even great ideas struggle under the burden of trying to jump through all those extra governmental hoops that just make it that much harder to be successful.

Where do we go from here?

With respect to interest rates, there is no easy solution. We need to normalize, but today that is a bit like dreaming of a bright future for a 17-year girl who’s 8 months pregnant, dropped out of school 4 years ago, ran away from home, and has covered her body covered with skeleton tattoos.  It’s possible – but it is going to take a hell of a lot to get from here to there!  That being said, reducing the regulatory, legislative and tax complexity would go along way towards helping all businesses, whether they be a great ideas, so-so, or even marginal be more likely to succeed, which means more jobs and more money available to invest in the next idea.

 

 

 

To Raise or Not to Raise

To Raise or Not to Raise

To Raise or Note to Raise – The big question that has the attention of markets all over the world is, “Will the U.S. Federal Reserve raise rates in September?” We’ve discussed in both our June newsletter and July newsletter that we believe it is unlikely that the Fed will raise rates and continue to believe so.  As the year goes by, the market has come around to our way of thinking.  In early August the odds on a rate hike in September were 48%.  By Thursday it had fallen to 32% and by the end of Friday at 27%.  At this start of this week, it was down to 22%. That being said there are compelling reasons for the Fed to raise rates, so we don’t have a particularly high conviction level on our call. The Fed is made up of a bunch of human beings, and you can never be too sure about what a group of folks might do when they get together and start talking, particularly when reputations may be on the line.

The first reason many may cite for a rate increase is the significantly upwardly revised second quarter U.S. GDP estimate, from 2.3% to 3.7%. Yours truly has some, ahem, concerns with the second estimates.  Without getting too wonky, remember that earlier this year, the GDP estimates for 2012 to 2014 were revised significantly lower.  Problem is, if they don’t lower the estimate for current GDP, the growth rates for 2015 would have to be much higher.  Think of it this way, I’ve always wanted to dunk, but at 5ft 7.5”, (don’t laugh, that 0.5 is important to me!) a hoop 10 feet high is challenging despite my orangutang-like arms, (I know mom, what can you do? I got Dad’s!). If I jump up onto a platform that is 3 feet high, I only have to reach 7 feet up to dunk.  But if I jump up onto a platform that is 2 feet high, I need to spring up and reach 8 feet into the air! By revising the 3 years from 2012-2014 down, I moved from the 3 foot platform to the 2 foot, so naturally I have to jump higher. We also note that about 12% of current GDP, which translates into $2 trillion of the roughly $18 trillion, comes from a “trend” estimate, the same trend that had previously been used for the 2012-2014 growth rates prior to the downward revision.  Errrh what?  So they overestimated back then, but now that same trend assumption is accurate.   Hmmmm… could be, but methinks it prudent to be cautiously skeptical.

We also find it ironic that various Fed Presidents have mentioned, while at the annual Jackson Hole meeting this past week,schrdi1 that they are concerned with raising rates during a period of heightened market volatility.  Really!? Come on! A good bit of the market’s volatility can be attributed directly to the mixed messages coming out from various members of the Fed with a rate hike both reportedly necessary and imminent while also increasingly unlikely given current conditions, depending on which official is speaking, in a bizarre monetary policy version of Schrödinger’s cat. Conventional wisdom believes that a rate hike will hurt stock prices, so naturally hearing contradictory statements like that will increase market volatility. There was a time when the Fed’s actions weren’t dependent on the stock market and vice versa – oh for a return to those simpler times!

To put the Fed’s fears in context, we’d like to point out that the S&P 500 is currently 6.7% off its all-time highs, yet some Fed officials are claiming they are uncertain about raising rates for the first time in a decade because they fear the equity markets may react negatively?  To give that even more context, the S&P 500 is up almost 200% from its March 2009 lows and nearly 30% above its 2007 highs. Is the Fed telling us that the bull market needs their support?  Hmmm….

What very few are talking about is what just happened with China’s devaluation of its currency and how it could affect the U.S. going forward. When China loosened its grip, its currency fell relative to the dollar more than China wanted.  To stop the slide, the government sold assets and bought yuan to support the currency (a reverse QE). What asset do they have a hell of a lot of?  U.S. Treasuries!

In an earlier blog post I mentioned that China had accumulated over $4 trillion in assets starting from 2003, more than all the Fed’s QE programs combined. So if/as China finds it needs to support its currency as the rest of the world sees its economy slowing and puts downward pressure on the yuan, it will need to sell more Treasuries to support its currency, and it has a lot of Treasuries along with other assets available for sale. That will increase the amount of Treasuries on the market, which will push prices down and yields up, again a reverse of what we saw in QE, as we are on the cusp of entering the era of Quantitative Tightening!  I’ll have a lot more on this in the months to come.

The table below itemizes the primary arguments for and against.

HikeNoHike

 

What we do know is that looking over the history of the Fed, it does pay attention to the world around it. Combining current conditions with past behavior under similar circumstances, a rate hike looks unlikely.  The rising U.S. dollar will likely hurt export-oriented sectors without causing the overall equity market to be harmed as importers will conversely benefit and the Fed is more likely to hold its hand.  Lower bond yields coupled with a strong U.S. dollar will keep upward pressure on price to earnings ratio, (i.e. upward stock price pressures) and the drop in U.S. bond yields will help credit-sensitive sectors like housing and autos.  With around 70% of the U.S. economy being driven by consumer spending, the country is better positioned to withstand the ongoing global slowdown than those economies that are more dependent on exports.

What the Fed Did Not Say

What the Fed Did Not Say

The annoying truth that very few economists want to admit is that the field is more art than science – much like investing. If investing were as easy as simply looking at the past and extrapolating it forward, you’d not need us. When it comes to econElephant face downomics, the best we can do is to develop an idea of general future probabilities based on how events unfolded in the past.

The headlines have been heralding all kinds of economic triumphs lately, which has been giving yours truly much brow furrowing consternation; talk about heads in the sand! Let me walk you through what no one seems else seems to be talking about.

 

One: Q1 GDP has been revised into a contraction, falling 0.7%. It is important to note that this is the first time in recorded US economic data that the economy has contracted three times during a recovery. That seems like a noteworthy lack of strength, particularly given all the support the Federal Reserve has been supplying coupled with the mindboggling level of federal spending; recall that during the last seven years US debt has doubled, meaning the government overspent as much in the past 7 years as it did in the entire 230 years prior combined!

 

Two: June 15th we learned that Capacity Utilization for total industry in the United States fell for the sixth month in a row. This is measured by the Federal Reserve and represents, “the percentage of resources used by corporations and factories to produce goods in manufacturing, mining, and electric and gas utilities for all facilities located in the United States (excluding those in U.S. territories). This measure has fallen six months in a row ten times previously since 1967, the earliest recorded data. Every single time it has fallen in the past six times in a row, the economy has been in a recession. In fact, the economy has never been in a recession when the metric did not fall for at least six consecutive months. Think of it this way, the US economy has thrown a big old production party, but hardly anyone’s on the dance floor and everyone’s wondering when the crowd is finally going to arrive.

Total Capacity Utilization

Three: Industrial Production has now come in below expectations six months in a row, and has shown a rather concerning downward trend since January. Keep in mind that a contraction in GDP for two quarters in a row, i.e. six months, is the definition of a recession. Industrial Production used to be the metric for the economy before GDP started being measured after WWII. May’s number is also a bit of a blow to the hopes for a turnaround to GDP in Q2, as the level of production so far in Q2 is down 2.4% at an annual rate relative to the average for Q1, which was itself down 0.3% from Q4 2014. This means we are likely to see the first back-to-back quarterly contraction in production since Q1 and Q2 of 2009. Were this pre-WWII, this data mean an official declaration of a recession.

 IndustrialProduction2

Four: The three month moving average for US retail sales is at a level that is never seen outside of a recession, hat tip to Raoul Pal of Real Vision Television, (which I highly recommend for on-demand interviews with the best and brightest in the markets) for pointing out this one to me. While May retail sales were up from April, they were still 25% below March with an overall trend downward trend that is clear in the chart. So much for the return of the American consumer… not just yet.

US Retail Sales

Five: The talking heads on TV claimed that the contraction in Q1 was due to extreme weather conditions and the port closures/slowdowns due to the labor union kerfuffle on the west coast. First quarter earnings releases and analyst calls where abuzz with retail executive bemoaning the lost sales thanks to goods getting stuck at the west coast ports. Alrighty then… we were willing to give them some wiggle room here. However, the port situation was resolved some months ago, which should have led to a big jump up in transportation needs within the US to get goods to and from those congested ports. Errrh….. May… not looking so good. That phrase is starting to sound like Wall Street speak for, “The dog ate my homework.”

RailTransports

Not exactly inspirational; not only has rail traffic in 2015 been materially lower overall than in 2014, but May saw a sizeable decline both relative to April and to May 2014. This data is reinforced by the Cass Freight Shipping data, which was released on June 15th, showing that while shipments and expenditures rose in May from April, they are still below 2014 levels, which was the strongest year so far since the Great Recession. Both car-loadings and intermodal-loadings were declining by month’s end as well, indicating that June is likely to also be weak.

CassFreight

 

To emphasize the point with transports, earlier this week Federal Express delivered quarterly earnings and revenue that fell short of expectations, citing pension costs, the impact of the strong dollar and lower fuel surcharges. All reasonable claims except they are nothing new, thus the company’s guidance should have already taken those factors into account. To us this just gives further reason for concern.

 

Six: For all the talk about how the labor markets are heating up, getting tighter… whatever lovely catch phrase you like, June 18th the Labor of Bureau Statistics announced that real average hourly earnings decreased by 0.1% in May, seasonally adjusted. Real average weekly earnings also decreased by 0.1%. So much for all the talk about tightening labor markets inducing inflation, I keep scratching my head wondering what the heck the talking heads are looking at! On top of that, a recent report from Glassdoor Inc. revealed that job seekers had to wait about 22.9 days for an offer or rejection in 2014, up from 12.6 days in 2010 – again not an indicator of a tight job market.

 

To drive the point home, the chart below shows just how much of the incoming data has surprised to the downside. Does this mean that expectations are entirely out of whack with reality or does it mean that the economy is weakening? Well, putting it all together…

Surprise Index

Bottom Line: As I said earlier, economics and investing involve looking at the new data coming in, comparing it to earlier data and looking for correlations in an attempt to identify trends or causation. In other words, we seek to understand what’s going on now, what’s causing it and where are we going? The current recovery has stumbled an unprecedented three times into contraction, which gives concrete data on how week this recovery actually has been. Capacity utilization, Industrial Production and Retail Sales data all point to a recession. Transportation of goods is well below last year and not showing signs of improvement and if one looks under the covers of the labor market – it is much weaker than the headlines indicate. One of our primary jobs is to manage risk and when we put all that data together, it gives us cause for concern as to the direction of the economy. The chart below indicates that we aren’t the only ones noticing just how weak the economy has become, as executives increasingly decide to return money to shareholders directly rather than invest it in elusive future growth.

Cash Uses

 

RT Boom Bust with Erin Ade talking about the Fed, Greece and Italy

On May 28th, I appeared on RT’s Boom Bust  with Eric Ade, talking about about the Fed, Greece and Italy.

For some time the Fed has been talking about raising rates, but the stream of economic data we’ve been seeing doesn’t give the FOMC, (Federal Open Markets Committee) much of an argument for raising rates.  Employment gains have also been exceptionally deceptive, with much of the gains in low paying industries.  However, if the Fed doesn’t raise rates, that significantly reduces the arrows in their quiver if/when the U.S. goes back into a recession, which given the normal business cycle timeline, would be reasonable to expect in the near-to-mid term.  That being said, with all the manipulations in the markets and the economies since the financial crisis, nothing is “normal” and the unreasonable has become the reasonable.  The single most important price in the economy is the price of money.  Once that is no longer priced freely  by the markets, which is impossible with all the interest rate manipulation by central bankers everywhere, the price of everything else gets seriously distorted.

We also discussed the prevailing narrative I wrote about in an earlier post surround Greece and the potential Grexit, which is based on the assumption that the nation’s problems stem from a workforce that is either lazy, stupid or worse.  Finally we discussed how much of what is happening in Greece, is present elsewhere in the world and in particular causing much of the economic angst in my second home, Italy.

 

Strong Economy, Really?

Strong Economy, Really?

Last week I pointed out that the data coming in wasn’t exactly painting a picture of an increasingly robust economy that would warrant the Fed tightening rates.

Last Thursday we learned that initial jobless claims rose again the last week of February to 320,000, significantly above expectations of 295,000. We also learned that US Factory orders fell 0.2% versus an expected increase of 0.2%. Friday we received impressive headline jobs data, but it didn’t exactly jive with much of the rest of what we are seeing in the economy and upon a closer look, the fall in the unemployment rate was driven more by people leaving the workforce than by new jobs, and those newly filled jobs were skewed towards lower paying industries.

Today we learned that retail sales fell for the third consecutive month in February as a mix of bad weather and consumer caution outweighed an improving labor market and cheap gasoline prices.  Sales at retailers and restaurants decreased 0.6% last month to a seasonally adjusted $437 billion, the Commerce Department said Thursday. Retail sales fell 0.8% in January and 0.9% in December.  We also learned that business inventories growth was flat in January versus expectations for 0.1% increase… but what is even more concerning is the sales to inventory ratio, which is back to where it was back in the depths of the financial crisis!

Inventory to Sales

So much for the economy getting back on track.

In fact, Tuesday the Wall Street Journal ran an article entitled “Recession’s Impact Lingers for Many States,” which pointed out that 30 states are still below their peak, pre-recession tax revenue receipts. The states that are actually above their last peak include North Dakota and Texas, which are likely to suffer going forward with the impact of plummeting oil prices. We’ve also seen US GDP expectations for Q1 tanking, (today’s retail numbers reinforcing this) with many forecasting in the 1.5% range, which given the increasingly soft data coming in, seems wise. Prior forecasts were north of 2% at the beginning of the year.

Additionally, inflation expectations remain firmly muted with yields indicating that investors expect US consumer prices to rise in the neighborhood of 1.7% a year for the next 10 years, dropping from 1.9% just last week – more of that dropping price thing. In addition, consumer credit growth is moderating, auto sales appear to be topping out and the Case-Shiller 20 city price index shows home price inflation has slowed to 4.5% year-over-year from 13.4% last year. So far, nothing screams out a need for tightening, particularly in light of the defacto tightening resulting from the rising dollar. In fact, if the Fed did tighten in June, it would be the first time in the past 30 years that it has done so with a rising dollar. We do see tightening also occurring on the fiscal side where the federal deficit is shrinking significantly.

The Euro has now dropped below $1.05 for the first time in about 12 years and is down around 33% from its highs against the dollar, last seen in April 2008 and down around 12% since the beginning of the year.

 

Tale of QE

 

As the ECB gets cranking on its 10-year sovereign debt purchases, yields have once again hit record lows yesterday in Germany, Belgium, the Netherlands, Italy, Ireland and Spain. The 10-year US Treasury rate at 2.2% is over 9.5x the 10-year bund, a phenomenon never before seen. With the US one of the few places to get any kind of yield on sovereign debt, it is unlikely that dollar strengthening will cease. So not only do foreign investors get better yields in the US, the dollar is most likely strengthening against your currency, jacking up returns even more.

 

Diverging monetary policies are continuing to affect domestic equity markets as we see the US materially underperforming Europe and Japan in 2015, which is a complete reversal from 2014. Monetary policy clearly continues to dominate equity markets post-financial crisis. We believe this is likely to continue further into 2015, making international market indices more attractive. Investors can access these market easily through ETFs such as the relatively new Recon Capital DAX Germany (DAX), iShares MSCI France Index (EWQ) or MAXIS Nikkei 225 Index ETF (NKY).

 

20150311Index2015

20150311Index2014

Just what data is the Fed seeing?

Just what data is the Fed seeing?

Funny-Images-33On Monday March 3rd, the NASDAQ closed above 5,000 for the first time since 2000, while the S&P 500 and the Dow Jones Industrial Average also reached new record highs, which would lead one to think that things are going pretty darn well. According to Chris Verrone of Strategas Research Partners, 70% of US stocks are currently in an uptrend. In comparison, at the NASDAQ’s previous March 2000 peak only 25% of stocks were in an uptrend.

Unfortunately outside of the US, central bankers don’t look like they are feeling quite as rosy as American equity investors. So far in 2015 at least 21 central banks have lowered their key interest rates in an attempt to strengthen their economies. China surprised the markets with a rate cut last weekend, after having early in February made a system-wide cut to bank reserves. India cut its main interest rates just last week for the second time in less than two months followed by Poland, which cut rates March 4th. So much for a growing global economy, and our view is if the guys in the center of it all think the punch bowl needs to be spiked, perhaps we need to look deeper.

Just what data is the Fed seeing?

Last week Janet-I’m-not-tellin-Yellen reported the domestic economy is looking better, not great, but better. We’re wondering just what data she was looking at because so far this week alone we’ve seen the following:

  • Monday we learned that Personal Income rose less than expected, (0.3% vs. expectations of 0.4%) while Personal Spending came in below expectations, (-0.2% vs. expectations of -0.1%) in January. That’s two in a row for spending whiffing it.
  • Markit Manufacturing PMI beat expectations, up from 53.9 to 55.1 vs. expectations of 54.3.
  • ISM manufacturing index fell in February to 52.9 from 53.5, for the fourth consecutive monthly decline
  • ISM non-manufacturing index beat expectations at 56.9 in February vs. 56.5 estimates.
  • Construction spending unexpectedly fell1% in January.
  • Six of the top seven auto manufacturers on Tuesday reported year-over-year sales increases in February, but all fell short of expectations.
  • This morning we learned private-sector job creation for February was below expectations with companies adding 212,000 positions versus expectations of 220,000 while also dropping from the 250,000 in January.
  • U.S. crude oil supplies rose to yet another record high last week, with crude-oil stocks at their highest level since 1982 on a weekly basis. Stockpiles rose by 46,000 barrels during the week versus expectations of a 1.8 million drop; keep in mind we’ve already seen operational oil rigs drop by about 1/3.

Well what about prior reports? From the economic data released during the month of February, forty-two were below expectations, (the aforementioned personal spending, construction spending, factory orders, retail sales, business inventories, housing starts, building permits, industrial production, and capacity utilization) while only six beat expectations, (including nonfarm payrolls, Case-Shiller Home prices and Markit Manufacturing PMI). Kinda makes one wonder exactly what Yellen was looking at let alone feeling good about.

Oh wait, there’s the love! Turns out there is no lack of (at least) self-love in the markets as companies last month announced a record $104.3 billion in planned repurchases, which is the most since TrimTabs Investment Research began tracking the data in 1995 and nearly twice the $55 billion from last year. To put that number in context, buybacks will amount to about $5 billion in purchases every day, which is about 2% of the value of all shares traded on U.S. exchanges, according to Bloomberg, which also estimates that earnings from S&P500 members will decline by at least 3.2% this quarter and next, with full year growth at 2.3% versus 5% in 2014.   With executive pay often linked to share price, it shouldn’t come as a surprise that companies in the S&P 500 spent about 95% of their earnings on repurchases and dividends in 2014… oh did we just say that out loud?

In the bond market, negative bond yields currently account for about $2 trillion of debt issued across Europe. Just this week Germany sold five-year bonds at a negative rate for the first time ever. Why would anyone buy bonds with negative yields? The ECB is set to begin rather large purchases of sovereign bonds in the coming months, which will likely push yields even lower. That could allow a negative yielding bond to actually experience a capital gain as bond prices are pushed lower. The ECBs move is also likely to push the euro even lower against the dollar, and as we discussed at the opening of this piece, central banks around the world are lowering their rates, which devalue their currencies… at least relative to currencies that aren’t lowering rates, which right now is basically the dollar. All this is a surreptitiousness form of monetary tightening, of which we are sure the Fed is well aware.

But what about last Friday’s (March 7th release) February Employment report.  The headline for the jobs report boasted 295,000 jobs being created during February, a big beat relative to the 240,000 jobs economist forecasted. The second headline pointed to a drop in the Unemployment Rate to 5.5%. That got everyone in an excited tizzy that the economy is finally really going strong and oh goody-goody-goody we can’t wait to see the next retail sales report!

As always, it pays to dig a bit deeper.  When we do, we find a lot of people continued to drop out of the labor force in February and that was the real driver behind the drop in the unemployment rate. Tough to argue that the jobs situation is all champagne and roses when lots of people decide it just isn’t worth it.  The chart below says it all – unemployment rate falling right along with those who simply leave the workforce.

umeployment and participation

Additionally, wage growth was once again modest in February with a pittance 0.1% increase. Hours worked during February declined, which could be thanks to the snowy weather and port disruptions – we continue to hear from companies like Macy’s (M), Gap (GPS) and others that both will weigh on growth in the current quarter.  The number of construction jobs created in February fell 40% month-over-month.

Most importantly the quality of jobs created remains problematic as leisure & hospitality was the big winner in February, continuing the trend we’ve been watching for some time as a good portion of the post-crisis job creation has been of lower quality than the jobs that were lost. For example, mining/logging lost 8,000 jobs, (which tend to be higher paying) while retailers (which tend to be lower paying) contributed 32,000 jobs. Makes you think about just how many “Do you have this in a small” jobs it takes to replace one highly skilled mining job. On that note, if the job situation is so rosy, why has personal spending declined for two months in a row?

Damn It Janet, Yellen isn't tellin'

Damn It Janet, Yellen isn't tellin'

Last week Janet (I’m not tellin’) Yellen gave her annual two-day Congressional testimony, making it clear during Tuesday’s discussion that she wants to move away from the concept that Fed guidance is a pledge and appears to still prefer more tortoise than hare policy moves, assuring the markets that while the Fed will remove the word “patient” from its forward guidance at some point, that change in wording alone will be insufficient for investors to assume a hike is imminent, leave the markets fretting, “Damn it Janet, Yellen isn’t tellin’.”

Ms. Yellen reminded Congress of the Fed’s dual mandate under Humphrey Hawkins and pointed out that while employment has improved, the participation rate is lower than expected and wage growth remains sluggish, leaving room for improvement.

So according to Yellen’s testimony, part of the Fed’s dual mandate has made progress, but not enough. The dual mandate also refers to long-run growth and stable prices. For growth, Q4 was just revised down to 2.2% for 2.6% annualized. The exceptionally cold weather over much of the U.S. coupled with the West Coast port closures/work-slowdown give little hope for a strong Q1. For example, Macy’s (M) recently reported that while at year-end the port slowdown had not yet had a material impact, “Since then… inventory levels have been negatively impacted particularly in apparel and accessories. Approximately 12% of our first quarter merchandise receipts are being delayed and this will have some impact on our sales, gross margin and expense in the first few months of the year.” The recent posts on economic data, ISMs, retail sales, NAHB, NFIB, durables and even consumer sentiment have all lined up below expectations with payroll the only bright spot, but only time will tell if that was more reflective of a drop in productivity.

As for the stable price goal, which has evolved into a quest for around 2% annual inflation, the US Producer Price index is down 0.27% as of January on a year-over-year basis. US Core Producer Price index is up 1.76% as of January on a year-over-year basis. Consumer prices are also well below the target 2%.

2015-02 Inflation Indicators

While Ms. Yellen did say the Fed is becoming less patient with low rates, we continue to see this Fed as more dovish and the data isn’t screaming inflation or a potentially overheating economy. Additionally, once the Fed does start rate hikes, we don’t think it will follow its usually pattern of consistent hikes with every meeting after the increase is initiated. Lastly, even though the likely vector for rates is eventually higher, investors should focus on the velocity of those increases. The initial quarter point increase would only happen if the economy could digest it, how soon and how fast subsequent increases come is what will really matter.

What does this mean for investors? First, this time really is different. The Fed has never waited this long, (five years) into a bull market to raise rates, nor has the world ever seen so much monetary stimulus coming from so many of the largest central banks. Therefore, when looking at historical norms, they need to be discounted to a degree given just how far off the reservation we are this time…perhaps even as far as Peter Pan’s Never, Never Land.

Investors also need to take into account just how many central banks around the world have been cutting rates. In the past few months, 16 central banks have cut rates: Albania, Australia, Canada, China, Denmark, Egypt, Europe (ECB), India, Pakistan, Peru, Romania, Singapore, Sweden, Switzerland, Turkey and Uzbekistan! All of the G7 and China are moving towards easing while the US alone is contemplating tightening. Today government bonds of various maturities in about ten countries are selling at negative yields! People are buying guaranteed losses. While Ms. Yellen didn’t mention the strength of the dollar on Tuesday as she did in January, the Fed is most certainly aware that raising rates in the US, with so many negative yields around the world, would increase demand for the dollar, pushing the currency up even further, which while lovely for importers, is brutal for US exporters.

Impact of share repurchases

Impact of share repurchases

I’ve discussed before on this blog the trend for companies to issue debt then use the proceeds to buy back their own shares.  Today I’m going to look at the impact of share repurchases on equity markets.  The chart at right shows the increase in share repurchases.2015-02 Share Repurchase

When the interest rate paid on the bonds is lower than the dividend yield on the shares being repurchased, this is a cash-flow positive strategy. Here’s the math, using small numbers just to keep it simple.

A company’s stock is trading at $100. The current stock dividend is 4% on an annual basis, which means it is paying $4.00 in dividends on every share per year.

The company issues $1,000 worth of bonds yielding 2.5%. This means that if you bought $100 of this bond, you would receive $2.50 a year in interest payments. The company uses the proceeds of the bond issuance, (the $1,000) to repurchase 10 shares of its own stock (10 * $100/share = $1,000). Now the company is paying only $25 a year in interest versus the $40 it was paying previously.

Looking at those equations one can see how low interest rates, (a la Federal Reserve Quantitative Easing) could make it more attractive for companies to buyback their shares and would put downward pressure on dividend yields. So let’s look at the magnitude of share buybacks.

2015-02 Biggest Repurchasers

Well that sure seems like a lot of money going into share buybacks, and that is just the top 12 by volume (number of shares).   Let’s look at the top 10 companies by dollar-value and their share returns.

Repurchasers by dollar

Looks like overall, this proved to be a strategy that is at the very least, correlated to shareholder-pleasing stock price gains. (Keep in mind that executives often have their compensation tied to improvements in share price.) How could these share buybacks affect share prices and not just reduce the amount of money companies pay out in dividends?

The price of a stock on any given day is just a function of supply and demand. The greater the demand (buyers) the more the stock price is pushed up until no more buyers are interested at the higher price. The converse is also true, the more that want to sell, the lower the price will go until no more sellers are interested in selling. (Real world example – when home prices are high, lots of people consider selling their homes, but when home fall, more people are happy to stay just where they are.)

So how big of an impact do these share buybacks have on demand? We can answer this buy looking at fund flows, meaning money going into and coming out the markets.

2015-02 Equity flows

The chart above shows that the single largest source of funds going into the equity markets came from corporations.   Households on the other hand were net sellers. This chart shows that in 2014, household took $183 billion out of the stock market while corporations put $415 into the equities market. If no corporations had purchased equities, there would have been a net outflow of $237 billion dollars! Talk about a reduction in overall demand.

Now let’s go back to the company making the decision to issue bonds, (borrow money) and use the proceeds to buyback shares of their own stock. There are a few things to keep in mind:

  • This is not a sustainable process. Companies cannot endlessly issue debt then use the proceeds to buyback shares – rather intuitive, but something to keep in mind as it is not a long-term way for a company to generate returns for shareholders.
  • If stock prices fall, then the entire equation we did above falls apart. How’s that? Well I left out the impact of share price and the company’s balance sheet in that analysis. (Tricky aren’t I!)   So let’s revisit that equation taking share price into account.

The company issues $1,000 worth of bonds and immediately buys $1,000 worth of stock, or 10 shares since the stock was trading at $100/share. So on the company’s balance sheet there is now a liability worth $1,000, but an asset that is worth $1,000 counters it.

If the company’s stock were to decline by say 15%, then those shares would be worth $850. The company now has a liability worth $1,000 that is countered by an asset worth only $850. This negative change in the company’s net worth makes it less attractive than before the share price decline, so now it has a double hit. Its shares have been falling and now its balance sheet looks less attractive. That can put further downward pressure on the company’s share price, which results in an even less attractive balance sheet and so on. This is another example of how debt can exacerbate problems when asset prices fall.

Now that I’ve mentioned asset prices… well that brings up the Fed and for that matter, most all central banks these days. The goal of loose monetary policy is to induce borrowing which is intended to generate economic activity and drive asset prices up, so if there is a material decline in asset prices, we wouldn’t be surprised to see the Fed step in to try and push prices back up… that is if/until monetary policy is no longer capable of doing so. As the saying goes, “We live in interesting times.”

One more little bit to contemplate is the relationship between company profits and the growth of the economy.  The chart at right shows how the six-month change in 12-month forward earnings per share is closely correlated with changes in real GDP. Notice how most every time the change in EPS goes negative, the economy contracts – again we work with probabilities, not certainties, but one must always keep an eye on the data and the correlations.

2015-02 EPS to GDP