Thursday, May 10, 2012

S&P Collapses on JP Morgan Emergency Announcement

from Zero Hedge:

Out of nowehere, JPM announced 40 minutes ago that it would hold an unscheduled 5pm call to coincide with the release of its 10-Q. Rumors were swirling as to why. The reason is as follows:

All of this is coming form the just filed 10-Q. The full link is here.Call dial in: (866) 541-2724 in the U.S. and Canada; (706) 634-7246 for international.
Stock now down 5% after hours dragging down ES 7 points with it.

What the Fed Bought in Stocks

Zero Hedge:
With the need for exponentially larger expansions of the central bank balance sheets - and most importantly, the rate of expansion (flow) not just the size (stock) - we thought it useful to see just how the Fed's actions had impacted the S&P 500. From the lows in March 2009, 1150 S&P points have been 'created-or-saved' thanks to central bank largesse. That is a cost of $2 million for every S&P 500 point since the Fed started to expands its balance sheet by $2.3 trillion. Money-well-spent, we are sure you'll agree. In the meantime, it is the printing-endgames that we care about and the horrible sense of deja vu that the following chart inspires should at minimum see investors scaling back (which it appears the sensible retail investor is) - despite the imploring of every long-only asset manager.
The S&P 500 overlaid with the various Fed experiments...

And it seems like the balance sheets of the central banks need to expand at an ever-increasing rate just to stand still in terms of asset prices...

Does make one wonder what the 'real' value of the S&P 500 would have been without all that assistance?
But we are heading towards the end of Operation Twist and given the previous examples we have seen, it seems we are echoing once again...

Charts: Bloomberg

Monday, May 7, 2012

Reinghart and Rogoff, And Our Debt Overhang

In a recent NBER paper, Ken Rogoff and Vince and Carmen Reinhart address the long-lasting consequences of high public debt loads. The authors findings are shocking to many - especially those who choose to look at 10Y Treasury rates as an indication of stress (as opposed to our earlier note on the stresses beginning to occur in the less financially repressed USA sovereign CDS market). Across 50 countries, they find 26 periods of public debt overhangs where the government has pushed gross public debt to GDP over 90% and held it there for at least five years. The stunning reality of their empirical work is four-fold: 1) the median duration of these overhang periods in 23 years (that's a lot of can-kicking); 2) real GDP growth averages 1.2% lower than trend during these overhangs; 3) real GDP drops by on average around 25% at the end of the deleveraging episode; and 4) most critically, "waiting for markets to signal a problem may be waiting too long because governments have the ability to suppress market signals." So while all the chatter of renewed growth in Europe has us ebullient with an unchanged US equity market today, the longer-term reality is - unless this time is different, there's a long and painful road ahead.

From Vince Reinhart's Morgan Stanley note:
Some Observations

Nations rarely move into a region where gross public debt is greater than 90 percent. Across 22 advanced economies since the early 1800s, there have been 26 such episodes lasting five years or more. When they get there, they stay there a long time. The median duration is 23 years.

The neighborhood is scary, in that economic growth averages 1.2 percentage points less relative to the years outside of debt overhang episodes. The duration and growth differential of those episodes compounds: In the typical experience, the level of real GDP is about 25 percent lower at the end of an episode than the experience outside the episode would have predicted.

The reason for this subpar economic performance is not always the force of market discipline pushing up real interest rates. Rather, high government debt induces some other form of crowding out of the private sector. This might include a reliance on distorting taxes to pay the interest service on the debt or more direct restrictions on finance that creates a captive market for government debt. The former concerns the dead-weight loss from taxation, and the latter is sometimes known as “financial repression”. Financial repression includes directed lending by captive domestic audiences, explicit or implicit caps on interest rates, regulation of cross-border capital movements, high reserve and capital requirements, and moral suasion applied to regulated entities.
In such circumstances, waiting for markets to signal a problem may be waiting too long because governments have the ability to suppress market signals. Despite the absence of market signals, or perhaps because of it, growth often suffers.

Lacy Hunt on Debt Disequalibrium

Via Lance Roberts of StreetTalkLive,
May 3, 2012?
If you have not read the notes of the first three presentations here are the links to Niall Ferguson on "Civilization", Dr. Woody Brock on "American Gridlock" and David Rosenberg from Gluskin Sheff. The last presentation I will report on from Day 1 of the conference is Dr. Lacy Hunt from Hoisington Research. Dr. Hunt was a previous member of the Federal Reserve board and is the Executive Vice President of Hoisington Investment Management who has run arguably one of the best performing bond funds over the past 25 years. With that I present the notes from Dr. Lacy Hunt.
I want to begin by taking us back to the economic classroom. In any economic model there are two basic conditions - "Equilibrium" and "Transition"
For many years professors have drummed into students that equilibrium is the dominant condition and that transition occurs but it is generally smooth, unimportant and short. The commonest example is that of an airplane. When the airplane is on the tarmac it is at equilibrium. The takeoff and climb to altitude is the transition which is a generally short period relative to the overall trip. Once the plane reaches cruising altitude it is again back at equilibrium.
However, what we have learned is that equilibrium, in relation to economies, is very short. It is the transition periods that are long in nature. Economies consistently move towards equilibrium, achieve it temporarily, then began to transition again.
In the U.S. today, along with the rest of the world, we are currently engaged in "debt disequilibrium".
Currently, we simply have too much debt relative to GDP. This is not just a domestic problem. Excessive indebtedness is a global problem. Furthermore, as we take on consistently more debt, each additional increase in debt is becoming less effective, due to the law of diminishing returns, and eventually will produce a negative return. The reality is that for debt to be effective it must produce a positive return.
In the U.S. today the current debt to GDP ratio is roughly 360%. This is not the first time that debt to GDP has peaked. In 1875 the debt to GDP ratio peaked at 156.4% after the panic of 1873 following the collapse of the railroad boom. After that peak the economy remained in malaise for a very long period of time until the excess leverage was reduced. The process was repeated again in 1916 as debt to GDP hit 170.4%. This in turn led to the 1920-1921 depression where Federal spending was reduced by 50%, deleveraging happened very quickly and the economic cycle began to recover. However, this time the re-leveraging cycle quickly ensued in the roaring 20's which pushed debt to GDP to the next peak in 1933 at 299.8%.
Of course, the following gestation period and debt deleveraging cycle took a very long period of time as the psychological impact of the "Great Depression" changed behavior. It wasn't until 2003, 70 years later, before the debt to GDP ratio breached the 1933 peak at 301.4%. Debt since then has continued to soar rising another 80 points in 2009 to a peak of 382.8%. The debt deleveraging process has only just begun and if history is any guide it will be a very long and arduous process.
As stated previously by Dr. Woody Brock the addition of debt is acceptable as long as it produces a positive rate of return. Unfortunately, the U.S. has engaged in massive increases in the levels of debt but the average standard of living has not risen. The "debt disequilibrium" problem has now reached the point of producing negative impacts on the economy.
This is not just a domestic problem. It is a global problem. The Eurozone is at 450% of debt to GDP - which roughly 100 points higher than the US. The UK is at 470% and Japan is at 500% of debt to GDP.
Furthermore, Japan is the template of the US experience. This is not a popular view and is widely dismissed under various assumptions. However, Japan has done everything that the Keynesian and Freidmanite schools of thought have asked them to do. The results are not good. Yet, the current administration has failed to understand the consequences of those actions and have engaged upon the same path over the last decade.
The current debt problems occurred primarily between the years of 1998 to 2006. The issue that has yet to be realized is that you cannot solve a debt problem after the fact. It has to be resolved before it reaches critical mass.
In the early stages of a rising debt buildup it leads to both rising income and asset prices. It is in these early stages where actions should be taken to limit the debt buildup. However, since the corresponding increases in debt lead to a rise in incomes and asset prices - no one is willing to stop It The problem then becomes the crushing reality of declining prosperity as the negative ramification of excessive debt sets in.

"Debt is a two-edged sword. Used wisely and in moderation, it clearly improves welfare. But when it is used imprudently and in excess, the result can be a disaster." Stephen Cecchetti
Let's take a look at the U.S. versus China
    Debt To GDP = 16.3%
    Hidden Liabilities as % of GDP = 144%
    Total Debt and Hidden Liabilities as % of GDP = 160%
    PCE as % of GDP = 30%
    Investment as % of GDP = 70%
    China's growth target for 2012 = 7.5% - slowest in 22 years
    Debt to GDP = 102%
    Hidden Liabilities as % of GDP = n/a
    Total Debt and Hidden Liabilities as % of GDP = 102%
    PCE as % of GDP = 71%
    Investment as % of GDP = 16%
China is an unsustainable model. The critical danger is their rapid deceleration in growth. While many people are looking at external factors to influence China's economy the reality is that the system can be disrupted purely by internal factors. It has clearly happened in the past.
4 Archetypes of the Deleveraging Process - McKinsey Global Study of 32 Countries.
There are only 4 major ways for a country to deleverage itself based on the study of 32 countries.
    "Belt Tightening" — most common. (50% of countries studied)
    "High Inflation" — (25% of countries)
    Massive Default
    Growing Out of Debt
Types 2-4 were relatively rare and occurred in conditions that are not present today in the mature economies. The record suggests that today's mature economies are most likely to deleverage through a belt tightening process as deflationary forces keep a lid on inflationary pressures even as currency printing increases.
The massive increase in debt in the U.S. economy over recent years is now having deleterious effects on the consumer. The personal savings rate is declining as consumer debt is being made available. In recent quarters we have seen huge increases in debt to fuel consumptive spending due to the stagnation of incomes and rising cost pressures.
What is very interesting to look at is the massive surge in student loan debt that is now becoming another concern. Student loans are increasing but not because there has been a sudden increase in the number of people attending colleges. The student loans have been going to fuel consumption.
If you want to know how weak the economy really is all you need to do is look at the 30-year bond. It is one of the best economic indicators available today. If economic conditions are robust then the yield will be rising and vice versa. What the current low levels of yield on 30 year bond is telling you is that the underlying economy is weak.
"The 30-year yield is not at these low levels DUE to the Federal Reserve; but in SPITE OF the Fed," Hunt said.
The actions of the Federal Reserve have continued to undermine the economy which is reflected by the low yield of the 30 year bond
The "cancerous" side effects of nonproductive debt are being reflected in real disposable incomes. Just over the last two years real disposable incomes slid from 5% in 2010 and -0.5% in 2012 on a 3-month percentage change at an annual rate basis.
This is critically important to understand. While the media remains focused on GDP it is the wrong measure by which to measure the economy. A truly growing economy leads to rises in prosperity. GDP does NOT measure prosperity — it measures spending. It is the measure of real personal incomes that measures prosperity. Prosperity MUST come from rising incomes.
GDP, on the other hand, can be distorted through government spending, which masks the effects of declining prosperity through weaker incomes. GDP does NOT lead to a increase in prosperity.
This brings us to the issues with various debt driven stimulus and liquidity programs. While they may have a short term positive effect they ultimately all have a diminishing rate of return over time. Take a look at the effect of the QE programs on the stock market.
    QE1 - stocks increase 36.4%
    QE2 - stock rise 24.1%
    Operation Twist (Stealth QE 3) - stocks gain 12.9%
While the liquidity interventions by the Fed have increased stock prices — it has also continued to create pressure on the average American by deteriorating prosperity.
The Velocity of Money
The velocity of money is at what speed is money moving through the economic system. The commonest measure is: GDP (nominal) = Money X Velocity
The velocity of money tells you the effectiveness of debt relative to the overall economy. From 1953 to 1980 the velocity of money was stable which was showing that the loans being made by banks to individuals and businesses were being put to productive uses. Today, as debt is taken on, it is no longer the case as additional bank lending produces little return. In other words there is relatively little return for each dollar lent.
The increases in debt without a productive return will ultimately lead to a larger proportion of government debt in the economy, versus private debt, with no relative increase in GDP. To put this into perspective - without changes to the current system government spending will reach 40% of GDP by 2050. This will not happen as the system will collapse long before then.
While we should be in the process of working off debt and deleveraging the system — in actuality we are doing the opposite and in 2013 we will be at 110% of debt to GDP.
To put this into an investment perspective let's take a look at "20 Year Periods With A Negative Risk Premium" A negative risk premium is when there is a negative return between the total return of stocks versus the total return of bonds. This will not be the first time this has happened.
    1874-1894 = S4.4% in stocks vs. 5.4% in bonds = -1% equity risk premium
    1928-1948 = 3.1% vs. 3.9% = -0.8% equity risk premium
    1991-2011 = 7.8% vs. 8% = -0.2% equity risk premium
The bad news is that with the massive total increases in debt combined with the current policies being implemented under the current administration it is very likely that could extend the current 20 year cycle much longer. This has profound investment ramifications for individuals going forward.

David Rosenberg at Strategic Investment Conference

Submitted by Lance Roberts of Streettalk Advisors
Guest Post: Strategic Investment Conference: David Rosenberg
If you haven’t read the notes from the first two speakers, Niall Ferguson and Dr. Woody Brock, I encourage you to do so. The next speaker at the conference is a friend of mine and one of the most widely regarded economists today. David Rosenberg was previously the Chief Economist at Merrill Lynch and is now the Chief Economist and Investment Strategist at Gluskin-Sheff.   Here are his thoughts.
The 3-D's Deflation, Deleveraging and Demographics
“People continually label me a “perma-bear” which is very inaccurate. I have been a perma-bull on fixed income for a very long time. The reason that Gluskin-Sheff hired me is that my job is to take the economic data points and put them together in a structure from which investments can be made.”
"A Forecast is nothing more than the midpoint of a distribution curve."
When you talk about risk often enough you get classified as a “perma-bear”. The corner stone of asset management is not capital "appreciation" but capital "preservation".
In the second year of this economic recovery (2011) the economy was growing at 1.6%. This is important to understand because in a “normal” recovery the economy should be growing at 5-6% at this same point.
Bob Farells' 10 Market Rules: The 10 Commandments To Remember

  1. Markets tend to return to the mean over time
  2. Excesses in one direction will lead to an opposite excess in the other direction
  3. There are no new eras — excesses are never permanent
  4. Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways
  5. The public buys the most at the top and the least at the bottom
  6. Fear and greed are stronger than long-term resolve
  7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names
  8. Bear markets have three stages — sharp down, reflexive rebound and a drawn-out fundamental downtrend
  9. When all the experts and forecasts agree — something else is going to happen
  10. Bull markets are more fun than bear markets.
These are the ten commandments of investing. Not understanding this is what leads to individuals losing large amounts of money over time.
Rules #1 and #9 are the most important to conversation today.
The markets tend to return to the mean over time. Understand this. Just this year there have been two very important covers from Barron’s.
February 2012 - Barron's Dow 15000
April 2012 - Barron's - Outlook Mostly Sunny.
Barron’s has an absolutely horrible track record of putting on their covers bullish sentiment at just about the peak of the market. (He showed many examples of Barron’s covers going back over the past decade.)
At the point of peak bullishness by investors and money managers is when the “reversion” effect will occur. In other words, whatever Barron’s puts on their cover you are wise to do the opposite.
The “Fiscal Cliff”
Under status quo at the end of 2012 roughly 42 tax benefits will expire at the end of 2012. At that point there will be record drag (roughly 4%) on GDP from reduction of those tax benefits to spending. Since the economy is currently barely growing at 2% do the math – a negative 2% economic growth rate is a very large recession.
Ben Bernanke - the Fed has NO ability to offset the impact of the “fiscal cliff.” By the way - recessions tend to happen in the first year of the Presidential cycle.
The last two times, 1960 and 1969, that there was a fiscal retrenchment of the same magnitude both ended in recessions. If there is any one thing to worry about it will be this particular event more than just about anything else.
What about government spending? US government spending runs at approximately $1.50 for every $1.00 brought in. This level of spending is unheard of outside of WWII and is very unsustainable. Furthermore, the longer that this excessive level of debt based spending occurs the more that it becomes a structural problem. Interest payments are at a record share of total revenue as well as the debt as a share of GDP. The high level of debt to GDP, and the subsequent servicing of that debt via interest payments, reduces economic growth. This leads to the real problem facing the U.S. today…Deflation.
Outside of commodity based inflation there is deflation running in everything else from incomes to real estate. This deflation impacts the base of the consumer and the economy. Take a look at the current output gap which is still at some of the largest levels on record. The current economic growth rate is too weak to offset the current slack in the economy.
This is why QE3 is coming and is just a matter of timing.
The deflation in housing is going to continue. Housing is only about 40% through its reversion process. In fact, along with housing, the entire household debt deleveraging process is still in progress and still has a tremendous way to go. This deleveraging cycle will remain a dead-weight drag on the economy for quite a long time.
It is important to understand that the debt bubble didn't happen in 3 years and it won't be cured in three years either.
According to the recent McKinsey study the debt deleveraging cycles, in normal historical recessionary cycles, lasted on average six to seven years, with total debt as a percentage of GDP declining by roughly 25 percent. More importantly, while GDP contracted in the initial years of the deleveraging cycle it rebounded in the later years.
A further pressure on the economy remains excess unemployment. There are roughly 20 million still unemployed versus the long term average of about 13 million. The excess capacity of labor suppresses wages and economic growth. In other words, excess employment leads to deflationary economic pressures.
In regards to employment the only real report to watch is the U-6 report, versus U-3, because it is the most inclusive measure of unemployment. If two full time employees are converted to part time they are not included in the U-3 report but will show up in the U-6 report. The U-6 level of unemployment is still at a higher level than at any other recessionary period.
As I stated, high levels of unemployment, or excess slack in the labor market, leads to deflation in wages. Deflation is wages is very problematic and has a lot do with deflationary prices in the economy.
So, deflationary pressures are why I am still bullish on bonds versus stocks.
Here is an interesting side note. What correlates with bond yields?
88% Fed Policy
75% Core CPI
64% CPI inflation
With the Fed keeping yields at zero through 2014 there is NO rate risk in owning bonds. When bond yields jump up for any reason it is a buying opportunity UNTIL the Fed starts taking the punch bowl away.
Historically, the average yield curve spread between the short and long dated maturities is about 160 basis points. Currently, that spread is about 330 basis points. That spread will revert to the average over time which means that the long bond yield is going to 2%. Buy Bonds and you will get a better return than owning stocks with dramatically less risk.
What type of bonds? I like corporate bonds. Corporate balance sheets are great and have been cleaned up tremendously since the recession. The current corporate default rate is 2% and companies that are BB or BBB rated that have an A rated balance sheet make a lot of sense. There is no debate between stocks and bonds. Bonds are a contractual agreement to pay interest and repay principal over a specified period of time.
Stocks are currently priced for a 10% growth rate which makes bonds a safer investment in the current environment which cannot deliver 10% rates of returns. We are no longer in the era of capital appreciation and growth. The “baby boomers” are driving the demand for income which will keep pressure on finding yield which in turn reduces buying pressure on stocks. This is why even with the current stock market rally since the 2009 lows - equity funds have seen continual outflows. The “Capital Preservation” crowd will continue to grow relative to the “Capital Appreciation” crowd.
Investment Stategy - Safety and Income at a Reasonable Price
  1. Focus on Safe Yield - Corporate bonds
  2. Equities - Dividend growth and yield, preferred shares
  3. Focus on companies with low debt/equity ratios and high liquid asset ratios. The balance sheet is more important than usual.
  4. Hard assets that provide an income stream - oil and gas royalties, REITS.
  5. Focus on sectors or companies with low fixed costs, high variable cost, high barriers to entry, high level of demand inelasticity.
  6. Alternative assets - that are not reliant on rising equity markets and where volatility can be used to advantage.
  7. .Precious Metals - hedge against reflationary policies aimed at defusing deflationary risks.