Financial Review

Sparks Turn into Flames

Financial Review by Sinclair Noe

DOW + 38 = 18,135
SPX + 2 = 2101
NAS + 15 = 4982
10 YR YLD – .01 = 2.11%
OIL – .59 = 50.94


Productivity in the fourth quarter fell at a revised 2.2% annual pace. The Labor Department originally estimated that productivity fell 1.8% in the final three months of 2014.


The number of people who applied for new unemployment benefits climbed by 7,000 to 320,000 for the week ended February 28. New applications for unemployment benefits are 1.5% below year-ago levels.


Of course the big economic news is tomorrow morning when we get the monthly jobs report. A month ago, the report showed the economy added 257,000 net new jobs in January. The estimate for February is 235,000 new jobs. It would be a bit of a surprise if the number is stronger than expected. Earlier in the week the ISM report showed employment was still expanding, but at a slower pace; they cited the West Coast port slowdown. Meanwhile, the rest of the country has experienced bad weather in February. Overall, the labor market looks to be improving, slowly.


Last month, Walmart made headlines by announcing it would be hiking wages for a significant chunk of its hourly workforce, boosting its minimum hourly rate to $10 by next year. What was behind the move? Yesterday’s Beige Book may provide a clue. The report says employers are starting to have trouble attracting and keeping workers, and have been forced to raise their wages as a result, even for unskilled labor.


A couple of years ago, Mario Draghi, the President of the European Central Bank, promised to do “whatever it takes” to stimulate the Eurozone economies. He did basically nothing for 2 years. Then in January, Draghi announced a big quantitative easing program, which promised to stimulate the Eurozone economies. Finally, the European Central Bank will start a bond buying program next week. The ECB will buy about $66 billion a month. ECB President Mario Draghi also unveiled forecasts showing higher economic growth with an inflation outlook that puts the ECB on track to reach its inflation goal of just below 2 percent. And even though the stimulus plan hasn’t kicked in yet, Draghi claimed credit, saying: “Our monetary policy decisions have worked. It’s with some certain degree of satisfaction that the governing council has acknowledged this.”


And while it seems Draghi was overly exuberant and possibly putting the cart before the horse, the policy might already have had a beneficial effect. Market interest rates have been falling in anticipation of the bond-buying campaign. That is making it possible for companies to borrow money more cheaply than ever. What companies save on interest payments they can invest in expansion and hiring; at least that is the theory. We still have to wait to see if the money moves into the broader economy.


The Bank of England kept policy on hold. The BOE held its key rate at 0.50% and its asset-purchase program at 375 billion pounds. Brazil’s central bank hiked its key rate by 50 basis points to a six-year high of 12.75%. Inflation in the country is running at a 12-year high of 7.4%.


The Federal Reserve has released transcripts from 2009, after a standard 5 year waiting period. Exactly why that is standard, I don’t know, but it is. As you recall, 2009 was a sketchy time for the economy, and the performance of the Fed was also sketchy. Turns out the Fed moved with little confidence and much of what they did was sort of experimental in nature. There were many doubts and multiple doubters, but they recognized the need to do something, anything; throw something at the wall and see if it sticks. And it did, more or less. I haven’t seen much in the transcripts that could be considered new to our understanding of what happened. They did not have great expectations for success, and that is exactly what they achieved, but at least they achieved something.


And then the next step is to look at what has changed since the financial crisis; and the answer is “not much.” In January, Goldman Sachs CEO Lloyd Blankfein likened regulation to “background noise.” That’s probably overstating, since the regulators have made almost no noise at all; instead they got into bed with the bankers. The Dodd-Frank Act supposedly provides the Financial Stability Oversight Council with broad authorities to identify and monitor excessive risks to the US financial system arising from the distress or failure of large, interconnected bank holding companies. And they sent investigators and examiners into the banks. It turned out to be a recipe for capture. One New York Fed investigator, Carmen Segarra blew the whistle, she even made tape recordings. In response, the New York Fed pulled examiners out of offices at the banks they review.


The biggest banks are bigger than they were. Revenues are squeezed, but what about profits? Four of the six biggest banks were more profitable last year than they were in 2007, and that is after the legal fines. Combined, the top six made $73 billion last year, compared with $57 billion the year before the crisis. When it comes to fees extracted from the economy, they still get a pound of flesh, which means less available for productive purpose.


The Fed never ordered the big banks to downsize. Big banks do have higher capital ratios; which is to say, they have a cushion if something goes wrong again; but nobody knows if the cushion is really enough to prevent failure. And nobody is quite sure how to deal with the failure of a big bank. And the short-term money market is still vulnerable to a freeze. And the big banks still write the laws. And they still gamble in exotic, highly leveraged markets.  The same five companies that dominated bond underwriting in 2007 dominated it again in 2014. In equity underwriting, the top five’s share rose by 1 percentage point. The big five continue to dominate leveraged loans, and trading in currencies and derivatives. So, despite some changes, and some regulations, and some overhaul, and several billions in fines. Not much has changed.


The Fed now conducts stress tests on banks to determine how they would perform or survive in a worst case scenario, but these are pro forma calculations and the Fed seems to grade on a curve. Last year Zions failed the test. No matter. Bank of America miscalculated its capital ratios, and they didn’t get permission to raise their dividends, but otherwise no repercussions.


Last week, staff of the Office of Financial Research, a unit of the Treasury Department, issued a paper questioning the ability of banks to prep for the tests in such a way as to make the results less meaningful.


After the close of trade today, the Fed said all 31 banks tested passed; they all exceeded minimum requirements. We’ll get further details next Wednesday, but for now the banks are all right.


The bull market on Wall Street is about to celebrate an anniversary; the bottom occurred on March 9, 2009; and the markets have been moving higher since. It’s one of the longest running bull markets ever; the average bull market lasts a little over 4 years. And so investors are now questioning how much longer it can run. US investors have pulled $16.8 billion from equity-based ETFs in 2015 and sent $16.9 billion to bonds. That’s the biggest divergence in quarterly data going back to 2000. With nine straight quarters of stock-market gains, equity valuations at a five-year high, and the Fed bracing to raise interest rates, investors may be rethinking the $240 billion they’ve pumped into U.S. stocks over the past two years.


Of course, that doesn’t mean the market is going to crash, just that investors are getting a little nervous, which in a twisted way is good for the bull. You’ve heard the old saying that the markets climb a wall of worry. One person who is worried is Mark Cuban, the billionaire owner of the Dallas Mavericks basketball team; Cuban claims the tech industry is in bubble territory, and the bubble we are in now is even worse than the tech bubble and bust of 2000/2001.


Why? He writes:  “Because the only thing worse than a market with collapsing valuations is a market with no valuations and no liquidity. If stock in a company is worth what somebody will pay for it, what is the stock of a company worth when there is no place to sell it?”


Here’s some explanation: Almost everyone (including Cuban) agrees that if there is a tech bubble today, the risk is concentrated in the hands of private market investors, rather than stock market investors, as was the case in 2000. That’s because startups and other privately held companies are waiting much longer to go public now. And when private equity doesn’t get the job done, liquidity becomes an issue.


Of course, Cuban talks about a crash in tech because that’s what he knows. If he were an oilman, he might talk about the crash in corporate debt in the oil patch. Just this week, BPZ Resources and American Eagle Energy defaulted on notes and bonds. They join a parade of oil companies going belly up. Debt funded the fracking boom. Now oil and gas prices have collapsed, and so has the ability to service that debt. And these bonds – they’re called “junk bonds” for a reason – are already cracking. Busts start with small companies and proceed to larger ones. A spark turns into a flame, a flame becomes a conflagration.


And you could probably make the case that we are in a bond bubble, or some other bubble if you prefer. The point is that the fear mongers have been selling this bubble stuff for a few years, and they have been wrong for a few years. Will we see another bubble? Sure. Maybe Cuban is right. Maybe the junk bonds in the oil patch will burst into flames. Or maybe the stock market will move sideways for a while. Maybe the markets will go higher. I don’t know, Mark Cuban doesn’t know, you don’t know. That’s why we watch the markets and the economy daily.


For now, a few sparks but no serious flames. Today, the Dow and the S&P 500 and the Nasdaq all moved higher; not much, just a little. The bull may be old but it’s not dead yet.






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