Financial Review

Forget Complacency

Financial Review

DOW – 223 = 16,321
SPX – 31 = 1874
NAS – 62 = 4213
10 YR YLD closed 2.28%
OIL – .69 = 85.05
GOLD + 14.10 = 1238.10
SILV + .10 = 17.60

The major indices were up and then down; small moves earlier in the session; then, in the final hour stocks slipped and kept falling. The S&P 500 has fallen 6.8 percent from its Sept. 18 record, making this the worst pullback in two-and-a-half years. The Russell 2000 sank 4.7 percent last week. The small-cap index entered a correction after sliding more than 10 percent from an all-time high in March. The Dow Jones Industrial Average has dropped 5.5 percent from its record last month, while the Nasdaq Composite Index has slumped 8.3 percent from a 14-year high reached in September. The Volatility Index, or VIX, rose 13 percent today to 24, the highest level since June 2012. Forget complacency.

The final hour collapse coincided with a report that an Emirates Airline plane in Boston was surrounded by medical crews and they removed five passengers over concerns about Ebola. But there is more to today’s trading than an Ebola scare.

Oil prices continued to slide. Saudi Arabia is saying they are comfortable with oil prices in the sub-$90 range. The Saudis don’t necessarily want prices to slide further, but they are unwilling to shoulder production cuts unilaterally and they are prepared to tolerate lower prices until others in OPEC commit to action, and that probably won’t happen until oil hits $80.

Commodities have taken a beating recently, and it’s not just oil. Coal stocks were trashed last week when China announced that it would reinstate tariffs on certain types of imported coal that were scrapped a decade ago. The tariffs threaten to slash coal imports and boost China’s domestic coal industry.

And if you don’t like fundamental explanations and if you don’t buy exogenous events, you can just look at the charts; the technicals are breaking down. If you look at the Dow Industrials, you will probably see a rising wedge pattern. Let me explain; if you print out a chart for 2014, and draw a straight line across the tops (that’s your upper resistance line) and another straight line across the lows (that’s your lower support line), you will have a wedge that start out wide in January and narrows; until the past couple of days, where the Dow dropped below that lower support line. A rising wedge formation is pretty bearish. The next levels of support come in at 16,025 and then at 15,370. Last week, the Dow dropped below the 200 day moving average and we did not get a bounce today; that would be considered bearish.

The S&P 500 broke down below the 200 day moving average, which is your primary trend line. While it is possible to see a bounce, I don’t know that you want to hold your breath. You might think the S&P is oversold and a bounce is in order, but that doesn’t guarantee anything. The only positive is that today was a fairly light volume day, because of the Columbus Day holiday, which isn’t much of a holiday. The next levels of support for the S&P are around 1815 and then at 1740.

Sell-offs are always brutal and this past week is no exception. There are many things to cause concern but it seems the biggest red flag is the warning of a global depression, complete with deflation in the Eurozone. Over the weekend, Federal Reserve Vice Chairman Stanley Fischer and Chicago Fed President Charles Evans said, in essence that the Fed was in no hurry to raise rates and might be very patient and might wait a bit because of concerns about slow global growth. The International Monetary Fund cut its forecast for global growth last week and said the euro area faces the risk of a triple dip recession.

The catalyst last week looks to be the weak economic numbers coming out of Germany. One reason Germany had such bad export figures is because of the sanctions imposed on Russia, a major trade partner. And so now Germany will have to make a move, and the longer Germany waits to take fiscal action, the more the entire Eurozone will slip into Japanese style deflation, and that won’t just be the peripheral countries, but it will affect Germany as well. The thinking is that Germany would stick with the failed idea of austerity until the German economy contracts; that is now happening; plus we might hear tomorrow that Germany will cut its forecast for this year and next year, and it might be a sharp cut from the already weak 1.8% growth projections; plus, Germany in a weakened economic position actually serves the ECB’s interests. And today we are getting a test of German resolve for austerity.

It comes from France. Eurozone finance ministers are trying to avoid a clash with France, which must formally submit its budget for scrutiny by the European Union authorities. The French government has recently announced a “no austerity” budget for 2015, even if that means missing the EU mandated deficit target by a wide margin. Over the next couple of weeks France will likely make its case that a weak economy, including the threat of deflation is creating exceptional challenges.

We are seeing that monetary policy is getting worn out. The publication of the FOMC minutes last week managed to pump up the equity markets for one day, then the bloodletting continued. The ECB also tried to goose markets, and failed miserably. And so the markets have swooned, and investors have turned their back on the “buy the dip” mantra of the past couple of years. For the past few years, QE and ZIRP managed to pump up stocks and junk bond funds and asset backed securities and housing and whatever the Fed was selling, but at a certain point they seem to have run out of buyers.

It’s time now for today’s edition of “Banks Behaving Badly”. Today’s bankster is the Royal Bank of Canada, and specifically the investment banking arm, RBC Capital Markets. Today’s story is a familiar story of conflict of interest and playing clients against each other. While advising the ambulance operator Rural/Metro on its $440 million sale in 2011, RBC was also pitching to finance the buyer, the private equity firm Warburg Pincus. The lure of loan and advisory fees and the potential for promoting the transaction to win similar clients led the bank to advocate a lowball offer. A judge in Delaware has ruled that Rural/Metro shareholders deserve an extra $76 million. The theory behind the fine is that the adviser aided and abetted the board’s breach of a duty to shareholders.

This is not the first example of conflict of interest and breach of fiduciary duty. Barclays Bank had a conflict advising Del Monte on a sale while also financing the buyers. In 2011, the bank and Del Monte paid some $90 million to settle. And in 2012, Goldman returned its $20 million fee for helping pipeline operator El Paso sell itself to Kinder Morgan. Turns out Goldman owned a $4 billion stake in the buyer. In the case of RBC, a $76 million dollar fine is small potatoes, but it is a stain on reputation and a warning to companies in the future to demand transparency.

Meanwhile, the data breach at JPMorgan finally caused Jamie Dimon to wake up from his London Whale induced slumber (he was napping at the time) and he now realizes the bank needs help. JPMorgan will spend $250 million a year to increase security and prevent future breaches. He also pointed out that JPMorgan was not the only bank to have this problem.

There were no domestic economic reports today due to Columbus Day. This week’s economic calendar includes a report on Retail Sales on Wednesday, also the Fed will publish its Beige Book; Friday brings a report on housing starts and consumer sentiment. Also, earnings season kicks into gear.

Jean Tirole, a French economist, has won the 2014 Nobel in economic science for his work on the best way to regulate large, powerful firms in industries including banking and communications. Tirole has called for increased regulation of the banking industry. In an interview broadcast after the announcement, he applauded new liquidity regulations and said that governments needed to pay particular attention to the connections between regulated banks and unregulated parts of the financial system.

In an interview with Bloomberg Television, Tirole said that banks receiving government support should face tougher rules; calling for strong rules “to prevent banks from gambling with taxpayers’ money,” adding that “if they are to be bailed out, they have to be regulated”.

Tirole has done work on many, many areas of the market, yet one of the concerns is the idea of monopolistic power. The government worries mainly about “horizontal” mergers in which one company buys another that does the same thing. But there’s also risk in vertical combinations. A monopolist in one part of the production chain; such as a computer operating system, might be able to extend its market power to neighboring links on the chain.

The Chicago School of antitrust economics, personified by the likes of failed Supreme Court nominee Robert Bork, argued in the 1970s and 1980s that attempts to extend a monopoly “vertically” would be irrational because a company could get all the benefits of its market power without merging with one of its customers or suppliers. The Chicago School’s theory was so influential that it caused the Justice Department to remove “vertical integration” from the things to watch out for in its official merger guidelines. Tirole was among a group of economists who showed, using game theory, that it was in fact possible to make a bigger profit by extending a monopoly to higher and lower links on the production chain. And the result is we now have banks that are too big to fail and communication companies that have snuffed out competition, resulting in higher prices and worse service.

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