War Drums Beat to Drive Crude Oil Higher

from UK's Telegraph:

Battleships, aircraft carriers, minesweepers and submarines from 25 nations are converging on the strategically important Strait of Hormuz in an unprecedented show of force as Israel and Iran move towards the brink of war.

Western leaders are convinced that Iran will retaliate to any attack by attempting to mine or blockade the shipping lane through which passes around 18 million barrels of oil every day, approximately 35 per cent of the world’s petroleum traded by sea.

A blockade would have a catastrophic effect on the fragile economies of Britain, Europe the United States and Japan, all of which rely heavily on oil and gas supplies from the Gulf.

Crude Oil Blasts Through $100/Barrel

First time since early May. Thank you, Ben Bernanke!

Consumer Prices Surge

Just like wholesale prices yesterday. It has temporarily caused stock prices to slip from overnight highs. I predict stocks will close higher regardless.

Not just lethargic consumer. Lethargic economy!

Bernanke Fed Unleashes Infinite QE

The Bernanke Fed, as anticipated, unleashed infinite monetary debasement and monetization of the debt today by promising to buy $40 billion/month of MBS in addition to continuing its Operation Twist. It amounts to about $85 billion/month of monetary mayhem. Stocks closed up 200+ points!

Wholesale Inflation Surges Most in Three Years

from WSJ:
WASHINGTON—U.S. wholesale prices in August posted the largest one-month gain in more than three years, fresh evidence that advancing energy costs could create inflation pressures.
Meanwhile, the number of U.S. workers filing applications for jobless benefits rose last because of the fallout from Tropical Storm Isaac, which hit several Gulf Coast states late last month.
The producer-price index, which measures how much manufacturers and wholesalers pay for finished goods, increased a seasonally adjusted 1.7% in August from a month earlier, the Labor Department said Thursday. The biggest gain since June 2009 was largely a result of energy prices rising 6.4%

Corn Prices Modestly Lower On Supply Outlook

from WSJ:

By OWEN FLETCHER And BILL TOMSON

U.S. forecasters again cut their estimates for the nation's corn and soybean harvests as a widespread drought continued to take a heavy toll in the Farm Belt.
But the Agriculture Department made a smaller reduction in its forecast Wednesday for this fall's corn crop than analysts were expecting. Corn-futures prices, which hit a record last month, fell more than 1% after the report to trade at two-month lows. But soybean prices jumped as those forecast cuts were greater than expected.
Cool temperatures and rains improved growing conditions in parts of the Midwest last month, but came too late to improve yields for most corn growers.
The U.S. drought this year, by some estimates the worst since the 1950s, has stunted crops from Ohio to Nebraska and sent grain and soy prices soaring over the summer. The drought is raising the cost of feed for livestock producers and will ripple through food markets, eventually hitting consumers.
Now, as farmers start to harvest corn and soybeans, traders are paying keen attention to the latest estimates of just how low national production will be.

Reuters

Despite market expectations, the USDA didn't cut it is forecast for domestic corn inventories at the end of the 2012-13 marketing year. Above, fields at Sunburst Dairy near Belleville, Wis.

The USDA again projected the worst corn yields—or harvested bushels per acre—since 1995. It now expects corn yields to average 122.8 bushels an acre, down from its August forecast of 123.4.
The government forecasts total corn production of 10.727 billion bushels this year, down 0.5% from its August estimate. The nation's corn harvest would be the smallest in six years.
"The corn number is clearly the headline," said analyst Jack Scoville, vice president of Price Futures Group in Chicago. The USDA's corn-production estimate "is significantly higher than anyone was expecting."
The USDA cut its estimate for corn demand in the marketing year that ended Aug. 31, including by trimming its export estimate by 0.6% and its estimate for the "feed and residual" category, including corn used in animal feed, by 3.3%. That suggests that record corn prices have curbed demand for the grain more than analysts had expected.
The USDA also estimated greater corn supplies a year from now than analysts had projected.
Corn futures for September delivery fell 11.25 cents or 1.4% to $7.71 a bushel at the Chicago Board of Trade. Most-active December corn fell 8.25 cents or 1.1% to $7.6950 a bushel.
The USDA now expects soybean yields this year to average 35.3 bushels per acre, down from its August forecast of 36.1 bushels per acre. The USDA estimated that the overall soybean harvest will be 2.634 billion bushels, down 2% from its estimate last month.
The USDA is projecting that both soybean yields and the total soybean harvest will be the lowest in nine years.
The government's reductions in soybean yields and production were both greater than analysts expected. Soybean futures for September delivery, thinly traded ahead of the contract's expiration Friday, settled up 44.25 cents, or 2.6%, to $17.4075 a bushel. Most-active November soybeans rose 44.25 cents, or 2.6%, to $17.4575 a bushel.
Some analysts think the soybean crop will be larger than the USDA projects, partly because the agency's forecasts are based on a mix of physical crop measurements and farmer surveys.
In surveys, the farmer "doesn't have much of an incentive to tell the government the truth," said Chad Henderson, president of Prime-Ag Consultants Inc., a commodity brokerage based in Brookfield, Wis. "I think the bean number is too low.…You might not have big, big yields out there any places, but you just don't have the really poor crops in beans which you need to get a low national average yield."
About 15% of the U.S. corn crop has been harvested, which is higher than normal for this time of year, in part because warm spring weather led to early plantings.
Some farmers are trying to speed up their corn harvest to maximize yields after the drought battered their fields. "Because of the drought, our plants are not very strong and they're starting to fall over," said David Hardin, a 39-year-old farmer in Danville, Ind., who planned to start harvesting corn this week. "To salvage what bushels we can, we're going to start harvesting earlier."
Mr. Hardin and his father, who farm together, also raise hogs. In a normal year, they grow enough corn to feed their swine. But they don't think they'll have enough corn after this year's harvest, so they will have to buy corn at high market prices. This will lead to "significant red ink" next year, because the cost of raising the hogs likely will outstrip the price the Hardins can fetch from meatpackers, Mr. Hardin said.
In Emington, Ill., farmer Mike Haag said August rainfall may have helped the soybean crop he manages with his father, but that yields will be below average. "Some of these late rains probably helped some," the 45-year-old said, "but it hasn't by any means alleviated the problem."
The USDA didn't change its forecast for domestic soybean inventories a year from now, though the forecast of 115 million bushels would still be a nine-year low.
Globally, the government slightly boosted its forecast for corn inventories, on the expectation that reduced demand will make up for production shortfalls in North America and Europe.
U.S. forecasters made small trims to their estimates for world soybean and wheat inventories, due to demand reductions offsetting production cuts. For wheat, the USDA cut its output forecast for Russia by 9.3%, in line with analysts' concerns about drought-damaged crops there.
—David Kesmodel and Ian Berry contributed to this article.

P/E Ratios Reach the Stratosphere

At what point do we begin calling this another bubble?

from Zero Hedge:

Since The Dreme (Draghi Scheme) began shortly after the EU Summit, the P/E multiple on the S&P 500 has risen by a faith-defining 2x. This is the largest three-month rise in this indicator-of-indifference-to-reality since the initial burst rally off the March 2009 lows. Meanwhile, the actual earnings consensus is being marked down further, heading for an earnings recession as we pointed out last week. It seems investors are too afraid not to believe in P/E miracles or perhaps it is just faith that central banks have it all under control and their 'promises' are as good-as-gold.
The S&P 500 seems 'managed' to a certain level - no matter what that means for EPS or P/E multiples, the spice must flow market must rise... (a 2x multiple increase since Draghi's initial utterances post EU Summit


As if the divergence was not enough, the 3 month rise in the S&P's P/E ratio (lower pane) is its highest since the initial V-bottom recovery in 2009...


Charts: Bloomberg and JPMorgan

Plunge!

Sharp sell-off in the last two hours of the day!

HIgh Risk With More Fed QE

May I nominate this man for Treasury Secretary, or better yet, Fed Chairman?
John P. Hussman, Ph.D.
 

For investors who don’t rely much on historical research, evidence, or memory, the exuberance of the market here is undoubtedly enticing, while a strongly defensive position might seem unbearably at odds with prevailing conditions. For investors who do rely on historical research, evidence, and memory, prevailing conditions offer little choice but to maintain a strongly defensive position. Moreover, the evidence is so strong and familiar from a historical perspective that a defensive position should be fairly comfortable despite the near-term enthusiasm of investors.

There are few times in history when the S&P 500 has been within 1% or less of its upper Bollinger band (two standard deviations above the 20-period moving average) on daily, weekly and monthly resolutions; coupled with a Shiller P/E in excess of 18 – the present multiple is actually 22.3; coupled with advisory bullishness above 47% and bearishness below 27% - the actual figures are 51% and 24.5% respectively; with the S&P 500 at a 4-year high and more than 8% above its 52-week moving average; and coupled, for good measure, with decelerating market internals, so that the advance-decline line at least deteriorated relative to its 13-week moving average compared with 6-months prior, or actually broke that average during the preceding month. This set of conditions is observationally equivalent to a variety of other extreme syndromes of overvalued, overbought, overbullish conditions that we've reported over time. Once that syndrome becomes extreme - as it has here - and you get any sort of meaningful "divergence" (rising interest rates, deteriorating internals, etc), the result is a virtual Who's Who of awful times to invest.

Consider the chronicle of these instances in recent decades: August and December 1972, shortly before a bull market peak that would see the S&P 500 lose half of its value over the next two years; August 1987, just before the market lost a third of its value over the next 20 weeks; April and July 1998, which would see the market lose 20% within a few months; a minor instance in July 1999 which would see the market lose just over 10% over the next 12 weeks, and following a recovery, another instance in March 2000 that would be followed by a collapse of more than 50% into 2002; April and July 2007, which would be followed by a collapse of more than 50% in the S&P 500, and today.

The prior instances were sometimes followed by immediate market losses, and were sometimes characterized by extended top formations - which produce a sort of complacency as investors say “see, the market may be elevated and investors may be over-bullish, but the market is so resilient that it’s ignoring all that, so there’s no reason to worry.” Ultimately, however, the subsequent plunges wiped out far more return than investors achieved by remaining invested once conditions became so extreme. We are in familiar territory, but that territory generally marks the mouth of a vortex.

Based on ensemble methods that capture a century of evidence – from Depression-era data, through the New Deal, World War, the Great Society, the electronics boom, the energy crisis, stagflation, the great moderation, the dot-com bubble, the tech crash, the housing bubble, the credit crisis, and even the more recent period of massive central bank interventions – our estimates of prospective market return/risk have been negative since April 2010 and have remained negative even as new data has arrived. Since early March, those estimates have plunged into the most negative 0.5% of historical instances.

It’s worth noting that the S&P 500 posted a negative total return between April 2010 and November of last year. Of course, the market has also enjoyed a risk-on mode since then. Through Friday, the S&P 500 has achieved a total return of nearly 25% since our return/risk estimates turned negative in early 2010. Defensiveness has clearly been taxing in that respect. But this doesn’t remove the question of whether the market’s recent gains are durable, much less whether they will be extended. Corporate insiders certainly don’t seem to think so – their sales have tripled since July, to a rate of six shares sold for each share purchased.

Far from being some novel “new era” environment, present conditions – rich valuations, overbought trends, lopsided bullishness, heavy insider sales, and lagging market internals – are part of a historical syndrome that is very familiar in the sense that we’ve repeatedly seen it prior to the worst market declines on record. But as the chronicle above should make clear, this doesn’t make our short-term experience any easier, because these conditions can emerge, go dormant for a few months while the market retreats modestly, and then reappear as the market registers a marginal new high. The ultimate outcome has historically been spectacularly bad, but it still takes patience and discipline to stay on the sidelines during late-stage, high-risk advances. Of course, the present instance may turn out differently than every prior instance has – it’s just that we have no basis to expect that outcome.

Economic Notes

The most interesting feature of last week’s “decision” by the European Central Bank was the continued eagerness of investors to hear what they want to hear, rather than what is actually said. With little doubt, what investors think they heard was that the ECB has finally decided to launch a new program by which it will begin purchasing Italian and Spanish debt in unlimited – unlimited – amounts, putting an emphatic end to European debt strains, and decisively ensuring the future unity of the Euro.

Here is what the European Central Bank actually said:

“A necessary condition for Outright Monetary Transactions is strict and effective conditionality attached to an appropriate European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) programme. Such programmes can take the form of a full EFSF/ESM macroeconomic adjustment programme or a precautionary programme (Enhanced Conditions Credit Line), provided that they include the possibility of EFSF/ESM primary market purchases. The involvement of the IMF shall also be sought for the design of the country-specific conditionality and the monitoring of such a programme.”

If you wondered why Angela Merkel and the whole of Germany was not immediately up in arms, it is because prior to transactions by the ECB, the receiving country would have to submit to an adjustment program, ideally involving the IMF. This is nothing like what Spain has been asking for, which is for the ECB to make unconditional purchases. To benefit from the proposed OMT program, these countries have to subordinate their fiscal policy to outside conditionality.

What if they don’t?

“The Governing Council will consider Outright Monetary Transactions to the extent that they are warranted from a monetary policy perspective as long as programme conditionality is fully respected, and terminate them once their objectives are achieved or when there is non-compliance with the macroeconomic adjustment or precautionary programme.”

But assuming these countries accept the adjustment programs, at least they can be assured that the ECB will buy their debt in unlimited amounts, can’t they?

“No ex ante quantitative limits are set on the size of Outright Monetary Transactions.”

Read carefully – the ECB did not promise “unlimited” financing. Rather, it refused to specify an amount in advance (ex-ante), because it doesn’t want the markets to look at some inadequately small and fixed number and begin to speculate against the ECB as soon as that particular number is approached. By refusing to set a specific amount in advance, Draghi said in his press conference that he wanted the policy to be perceived as fully effective. But perception substitutes for reality only for so long. If Merkel, Monti and Rajoy were stranded on a mountaintop and Merkel was the only one with a bag of muesli, she might offer some to the other two without specifying an amount in advance, but there’s no doubt she’d be slapping it out of their hands if things got out of control.

Finally, “The liquidity created through Outright Monetary Transactions will be fully sterilised.”

This last provision is likely to both calm Germans and inflame them. Sterilization means that for every euro of Spanish or Italian bonds the ECB buys (creating new euros in the process), it will drain euros by selling some other security – most likely bonds of Germany, Holland, Finland, or other stronger European nations. This will help to calm Germans because it indicates that the overall supply of euros will not expand. It will also inflame them, however, because the existing stock of euros will now have been created to provide fiscal support to Spain, Italy and other troubled countries, while Germany, Holland, Finland and stronger countries will not have benefited at all from the money creation.

It will be interesting how this plays on September 12, when the German Constitutional Court is set to decide on the legality of the European bailout funds, the EFSF and the ESM (technically, the Court will rule on an injunction against even passing it into law, but will not formally rule on constitutionality until possibly next year). My expectation is that they will rule that these mechanisms are in fact allowable and consistent with the German Constitution. Where it gets interesting is whether they will rule that it is allowable to leverage these mechanisms or operate with a banking license (which would make Germany’s existing contribution “capital” that could be wiped out, leaving Germany on the hook for much, much larger amounts - which essentially cedes fiscal authority from the German people to the ESM). I suspect that there is a fair chance that the Court will add language in their ruling to reject that possibility, which may force the idea of a “big bazooka” back to square one. We’ll see.

---

Here in the U.S., Friday’s August employment report was surprisingly weak relative to Wall Street’s expectations, though hundreds of thousands of workers abandoned the labor force, which allowed the unemployment rate to decline. Relative to our own expectations, the figure was elevated, as I expect that the August employment figure will ultimately be revised to a negative reading. This would be consistent with revisions that we’ve seen around prior recession starting points.

For example, if you look at the originally reported data for May through August 1990, you’ll see 480,000 total jobs created (see the October 1990 vintage in Archival Federal Reserve Economic Data). But if you look at the revised data as it stands today, you’ll see a loss of 81,000 jobs for the same period. Look at January through April 2001, at the start of that recession. The vintage data shows a total gain of 105,000 jobs during those months, while the revised data now shows a loss of 262,000 jobs. Fast forward to February through May 2008, and though you’ll actually see an originally-reported job loss during that period of 248,000 jobs, the revised figures are still dismal in comparison, now reported at a loss of 577,000 jobs for the same period. As other good economic analysts have recognized, economic time series tend to be revised after-the-fact, with upward revisions in periods just before the recession begins, and downward revisions in periods just after the recession begins. I continue to believe that the U.S. joined an unfolding global recession, most probably in June of this year.

---

Ahead to QE3. A week ago, The Wall Street Journal ran a piece by Jon Hilsenrath titled Will Fed Act Again? Sizing Up Potential Costs. The article reviewed concerns about additional quantitative easing, noting that inflation has remained muted and the dollar has remained firm. Both of those outcomes were presented as evidence counter to Fed Governor Charles Plosser’s concern that “Without appropriate steps to withdraw or restrict the massive amount of liquidity that we have made available… the inflation rate is likely to rise to levels that most would consider unacceptable.”

There is strong evidence to suggest that this is little but false comfort. While we don’t expect material inflationary pressures until the back-half of this decade, the Federal Reserve has increasingly placed itself into a position that will be nearly impossible to disgorge without enormous disruption. Specifically, the U.S. economy could not achieve a non-inflationary increase in Treasury bill yields to even 2% without requiring a nearly 50% reduction in the Federal Reserve’s balance sheet.

This point is easily demonstrated in data from 1947 to the present. The relationship between short-term interest rates and the amount of monetary base per dollar of nominal GDP is very robust, and is widely recognized as the “liquidity preference” curve. We are already way out on the flat part of this curve. Note that Treasury bill yields have never been at even 2% except when there was less than 10 cents of base money per dollar of nominal GDP. There are only 3 ways to get there from the current 18 cents – dramatically cut the balance sheet, keep interest rates near zero for the next decade (assuming nominal GDP growth of 5% annually), or accept much higher rates of inflation than most would consider acceptable.

Moreover, with a portfolio duration that we now estimate at about 8 years, historically low yields on Treasury securities, and a Fed balance sheet currently leveraged about 53-to-1 against the Fed’s own capital, an increase in long-term yields of anything more than 20 basis points a year would produce capital losses sufficient to wipe out interest income, making the Fed effectively insolvent, and turning monetary policy into fiscal policy.

On the subject of Fed leverage, it is one thing to purchase long-dated bonds when yields are high. It is another to purchase them when yields are at record lows and very small yield changes are capable of wiping out all interest income and leaving the Fed in a loss position when it is already levered 53-to-1 (2.9 trillion of assets on 54.6 billion of capital, according to the Fed’s consolidated balance sheet). At a 10-year Treasury yield of just 1.6% and a portfolio duration of about 8 years (meaning that a 100 basis point move causes a change of about 8% in the value of the securities held by the Fed), it takes an interest rate increase of only about 20 basis points (1.6/8) to wipe out a year of interest on the portfolio held by the Fed and push it into capital losses. It would then take another 24 basis points to wipe out all of the capital on the Fed’s balance sheet. Of course, they don’t mark the balance sheet to market. So the public might not be aware of those losses, but that would only mean that we would have an insolvent Fed printing money on an extra-Constitutional basis to fund its own balance sheet losses instead of public spending.

Based on a report from UBS (h/t ZeroHedge), the Federal Reserve now holds all but $650 billion of outstanding 10-30 year Treasury securities, with UBS warning “a large, fixed size QE program could cause liquidity to tank”, with a similar outcome in the event that the Fed pursues mortgage-backed securities instead. A couple of years ago, Bernanke asserted in a 60 minutes interview that “We could raise interest rates in 15 minutes if we have to. So there is really no problem in raising interest rates, tightening monetary policy, slowing the economy, reducing inflation, at the appropriate time.” Really? Tell that to Paul Volcker, who had to deal with enormous inflation at unemployment rates even higher and a monetary base dramatically smaller than we observe at present.

The Fed now holds virtually no Treasury debt of maturity of less than 3 years, as Operation Twist and other efforts have been designed to force investors to choke on short-dated paper yielding next to nothing, in hopes of forcing them into riskier securities. The chart below shows the distribution of Fed holdings (dark bars) versus private sector holdings of Treasury debt, at various maturities. Of course, in equilibrium, someone still has to hold the short-dated Treasury securities, in addition to about $2.7 trillion in zero-interest cash and bank reserves, until those securities, currency, and reserves are retired. To believe that an unwinding of the Fed’s present balance sheet would not be disruptive is full-metal make-believe.

Good economic policy acts to relieve some binding constraint on the economy. How does the Fed argue that base money is a binding constraint? At present, there are trillions of dollars held as idle reserves on bank balance sheets. While a “portfolio balance” perspective may well suggest that additional zero-interest reserves will force more investors into risky assets at the margin (which has been most effective after significant market declines over the prior 6-month period), so what? There is no historical evidence that changes in stock market value have a significant effect on GDP. Indeed, a 1% change in stock market value is associated with a change of only 0.03-0.05% in GDP, largely because individuals consume off of their expectation of “permanent income”, not off of transitory changes in volatile securities.

In regard to why inflation has remained low, a useful way to see the relationship between the monetary base, interest rates, GDP and inflation is the “exchange equation”: MV = PQ, where M is base money, V is velocity, P is prices, and Q is real output. As is evident from the liquidity preference chart, base velocity (PQ/M) is tightly related to short-term interest rates. In fact, as long as short-term interest rates fall in response to increases in the monetary base, those increases have virtually no effect on real output, but instead translate almost directly into declines in velocity. Again, some data from 1947 to the present:

If the decline in velocity exactly offsets the increase in base money, inflation is not going to explode overnight. But this happy outcome is brought to you by the passive response of short-term interest rates and the willingness of the public to accumulate zero-interest assets, which is in turn the result of strong and legitimate concerns about credit risk, default risk, and economic weakness. But remove any of those factors, or allow any other exogenous upward pressure on short-term interest rates, and the result will be upward pressure on velocity. Barring enormous rates of real GDP growth, the only way to counter that, as the first chart suggests, will be through either massive (and potentially disruptive) contraction of the Federal Reserve’s balance sheet, or acceptance of undesirable rates of inflation.

As hedge funds often discover, and JP Morgan recently learned, it is very easy to get into a position that later turns out to be nearly impossible to exit smoothly. A significant reduction in the Fed’s balance sheet is unlikely to be achieved at long-term interest rates nearly where they are now, which implies capital losses on the Fed account, which implies that in contemplating a further round of quantitative easing, the Federal Reserve is effectively contemplating a fiscal policy action.

Unfortunately, they’re likely to do it anyway.

From an investment perspective, it’s important to consider the potential effect of additional quantitative easing. As I noted several weeks ago (see What if the Fed Throws a QE3 and Nobody Comes?), the effect of prior rounds of quantitative easing both in the U.S. and abroad has generally been limited to little more than a recovery of the loss that the stock market sustained over the prior 6-month period. Presently, the S&P 500 is at a 4-year high, valuations are rich on the basis of normalized earnings, and advisory sentiment exceeds 50% bulls – over twice the number of bearish advisors according to Investors Intelligence. In recent years, each round of QE emerged closely on the heels of a significant market loss that produced a spike in risk premiums. In that environment, expanding the stock of zero-interest rate assets had the effect of bringing those risk premiums back down to those observed over the prior 6-months or so, and more recent interventions have shown diminishing returns. At present, risk-premiums are already depressed and there is no 6-month loss to recover.

In short, even the evidence of the past several years does not support the automatic assumption that stock prices will advance in the event of another round of QE at present levels. With little doubt, the market is likely to enjoy some immediate cheer from that sort of move, particularly if the Fed refrains from providing a specific ex-ante limit on its purchases - allowing investors to rejoice in the perception that the Fed had launched “unlimited” QE. Still, that cheer may be short-lived. If we examine the way that QE actually operates, and how and why risk premiums have responded to prior rounds, it is entirely unclear that a further round will have much effect beyond an initial spike of enthusiasm. That is, unless one adopts a superstitious faith that stocks will rise in response to QE, since QE makes stocks rise, because QE equals stocks rising, with no further analysis needed.

The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse. Only comments in the Fund Notes section relate specifically to the Hussman Funds and the investment positions of the Funds.