Financial Review

Tuesday, April 08, 2014 – When Stuff Aligns

When Stuff Aligns
by Sinclair Noe
DOW + 10 = 16,256
SPX + 6 = 1851
NAS + 33 = 4112
10 YR YLD – .01 = 2.68%
OIL – .28 = 102.28
GOLD + 11.10 = 1309.00
SILV + .20 = 20.16
Every now and then the planets align. Tonight is one of those times; Mars, the Sun, and Earth will be aligned in opposition. And Mars is closer than normal, although still about 92 million miles away. I have no idea what this means in the cosmic scheme of things, but when the sun sets in the West, Mars will rise in the East; and it will be overhead around midnight. You should be able to spot it easily as it will look light a bright star with a red or burnt orange color. If you can’t watch tonight, you can look to the skies for the next week.  On April 14, there will also be a total lunar eclipse causing the full Moon to turn as red as the Red Planet itself.
Investor sentiment remains upbeat ahead of earnings and despite the smack-down in prices Friday and Monday. On Friday, the CBOE Volatility Index, or VIX, dropped down to a multi-month low of 12.6 and even after a few days of triple digit declines the VIX has only edged back into the mid-14 range. And although Alcoa is the official start of earnings season, a few companies have already reported, including Oracle, Nike, and Fed Ex; without inspiration. The floodgates on profit reports don’t open until April 15. A few retailers and banking names are due out with results this week.

Now we’ll see if the stars align for earnings season, which kicked off this afternoon with Alcoa. The aluminum producer was a long-time member of the Dow Industrial Average until last September, and with the ticker symbol AA, they held the alphabetical honor of the first blue chip company to report earnings each season. Today, after the close of trade, Alcoa reported profit of 9 cents per share on revenue of $5.45 billion. Wall Street analysts’ consensus estimates called for 5 cents per share. Alcoa was up in after-hours trading.
Now, let’s dig down. The earnings excluded restructuring costs and other one-time items, also known as the cost of doing business; including those costs, Alcoa posted a net loss of 16 cents per share compared with earnings of 14 cents per share for the same quarter last year. Sales fell to $5.45 billion from $5.83 billion a year earlier, trailing the $5.55 billion average estimate. So, revenue down and below estimates; earnings were actually losses but with a clever accounting team they show as profit and they beat estimates; stock price goes up. Now you know the Wall Street earnings game.
Wall Street doesn’t care about results in a vacuum. It cares about results vs. expectations. And Wall Street has set the bar so low for earnings that it should be easy to fly above forecasts, even when a company trips over the bar. That should set up plenty of opportunities for earnings reports to beat estimates, and trade higher even as the broader market suffers a year-over-year drop in profits. Ironically, while the S&P 500 is just shy of all-time highs, the number of S&P constituents that have lowered their quarterly EPS outlook is also at an all-time high.
As we have seen every quarter over the last several years, analysts have slashed their initially-too-optimistic forecasts ahead of earnings season. But estimates have come down more dramatically than usual for 1Q due to weather, concurrent with increasingly negative management guidance. It’s a game that Wall Street plays on investors, and so far, very early in the reporting season, it is playing out as 52% of the 21 early reporters have exceeded on both earnings and sales higher than last quarter’s 42% hit rate, and the best result from the early reporters since 1Q12.
That doesn’t mean the earnings reports are good, nor will they be good; S&P earnings are forecast to fall 1.2%. Of course earnings probably won’t fall 1.2% because enough companies will beat expectations by a wide enough margin to pull year-over-year profit growth into the black. Let the games begin.
Tomorrow the Federal Reserve will release the minutes of the March FOMC meeting. We already know the Fed is on track with tapering away from QE, and should be done with asset purchases sometime around October or December, and then they will look at the possibility of raising interest rate targets from the zero range, probably next year, give or take. And this week, several Fed policy makers are giving speeches to try and rein in Wall Street from getting ahead of the Fed.
Narayana Kocherlakota, president of the Minneapolis Federal Reserve said today that the US economy is wasting “lots of resources” by letting inflation stay too low and unemployment stay too high. Kocherlakota was the lone dissenting voter at last month’s FOMC meeting; he believes the Fed should do more to stimulate the economy and they should avoid specific targets for raising rates.
Kocherlakota believes the current unemployment rate of 6.7 percent probably overstates the health of the labor market, because it does not count those who have given up looking for work or those who are working part time but who would rather work full time. He says: “There is still significant underutilization of our country’s most important resource, its people.”
One idea is to cut the interest rate paid on excess reserves that banks keep on deposit at the Fed. This is more of a symbolic move than a big money game changer, mainly because the Fed pays only about 25 basis points on excess reserves. Still, reserves have grown over the past few years, possibly to as much as $2.6 trillion.
How did reserves get so big? The simple answer is QE. When the Fed buys private sector assets from investors, it not only creates new deposits, it creates new reserves. This is because a new deposit in a bank creates a liability which must be balanced by an equivalent asset. When banks create deposits by lending, the equivalent asset is a loan. When the Fed creates deposits by buying assets, the equivalent asset is an increase in reserves, also newly created. So it does not matter how much lending banks do, if the Fed is creating new deposit/reserve pairs by buying assets from private sector investors then deposits will always exceed loans by the amount of those new reserves. While the Fed continues to buy assets from private sector investors, excess reserves will continue to increase and the gap between loans and deposits will continue to widen.
Cutting interest rates on excess reserves might encourage some bank lending to compensate for the loss of earnings on the reserve-deposit spread; that would be logical but it also involves the actual work of lending and bankers are loathe to work and frequently illogical. So, the bankers could almost be counted on to do the wrong things; such as cutting deposit rates to from ridiculously low levels to stupidly low levels; increasing fees; or increasing interest rates on loans, which is not exactly an inducement for households and businesses to borrow. And so, as long as the Fed continues buying Treasuries and mortgage backed securities as part of Quantitative Easing, they will continue to grow excess reserves.
But what is the point if it just parks reserves with banks and doesn’t get the money circulating through the economy? The real question is how to get money moving through the economy. And this has been the major downfall of QE in the Fed’s ability to stimulate the economy and live up to its mandate of maximum employment.
Of course, the money parked in excess reserves is just part of the problem with sluggish money velocity. We also need to consider the nearly $2 trillion corporations have parked off shore, sitting there doing nothing. Congress cowers before the multinationals. There is nothing we as individuals can do. But last Friday, the legislature in the state of Maine passed legislation to end some of the games.
Companies can dodge taxes by shifting income to low-tax jurisdictions. Not only do they send the money to tax havens off shore, but they also set up companies to hide income in low tax states, such as Nevada and Delaware. Twenty-three states and the District of Columbia countered stateside tax avoidance by “combined reporting.”
Combined reporting requires companies to report their income in all states; then the combined income is taxed in proportion to the business’s activity in their state. That way, if large amounts of income that were produced by business activity in, say Maine, but were reported for tax purposes as belonging to Delaware, it would be included in the total income pie that Maine would proportionately tax.

But if combined reporting stops at “the Water’s Edge,” it only includes income reported within the United States. To get at offshore tax havens, the states can require worldwide combined reporting, or Water’s Edge plus a list of known tax havens. So the Maine legislature has passed a bill to close the “Water’s Edge” loophole, and require multinationals to pay up, no matter where they park their cash. The Maine legislators estimate they could collect an additional $5 million a year. The governor has 10 days to sign or veto, or the bill automatically becomes law. It’s is, admittedly a small step, but if the stars and the planets can align, maybe the states could also align. 
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