I have a relative whose only ambition in life was to NOT work. It didn't matter what else he did in life, as long as it was NOT work. It was a negative ambition. I've struggled for a long time to understand but have failed.
A few years ago at a dinner in Florida, I sat next to a young entrepreneur, who had sold his internet company in 2000, right before the internet crash. At age 36, he had already netted $24 million. as he informed me in a too-loud voice. I asked him what kind of work he did now. He seemed terribly offended by that question, as it implied he might be a member of the working class and not a member of the aristocracy, I assume. Anyway, we skipped dessert, just to get away from this person.
Both as a society and as individuals, we have a complicated relationship with the notion of work or labor. Maybe, it is no more complicated than "idle hands are the devil's tools?" Maybe, we teach our kids that their only identity is their job? Maybe, we are afraid we'll spin-out-of-control if we don't work? Maybe, we prefer work to spending more time with our spouse? Maybe, we hope we won't die, if we don't retire? Maybe, retirement results in too much self-involvement? Whatever it is, I do believe that old maxim that "work never hurt anybody."
So, to those who work, whether they need to or not . . . To those who want to work but cannot find a job . . .
To those who want to work but have physical or mental limitations . . .
To those who retire but volunteer for charity work . . .
To those who carry the burden of family while others benefit . . .
This day is for you . . . enjoy it!
Since redistricting made barbarians out of politicians, I have not really cared what promises they make to win office. However, President Obama made one that I really care about, i.e., controlling loud TV commercials. In 2011, he did get Congress to pass the Commercial Advertisement Litigation Mitigation or CALM Act, which reduced the average volume level of commercials.
Did you notice?
The key word is average. Since CALM, advertisers introduced a few seconds of silence in their commercials and increased the volume of other seconds . . . pretty clever, huh?? The Federal Communications Commission (FCC) just ruled that a new "loudness measurement algorithm" will be employed, beginning June 4, 2015. It will eliminate the silent seconds in computing the average. My guess is that advertisers will introduce just the minimal measurement amount of sound into the formally silent seconds, to hold the average down. Next year, I'll bet you will not even notice the difference. After all, if they cannot make commercials loud enough to get your attention, why would they pay for our TV programs?
The advertising industry can stand up to Congress. It can stand up to the President. It can make children and their parents believe that unhealthy food tastes good. It is the single most powerful industry in the world.
It is often said that corporate earnings are the "mother's milk" of stock prices, which grow faster when the corporate earnings are flowing. While there are other secondary factors, corporate earnings growth is the primary factor . . . over the long term.
Over the short term, however, anything could happen. Which individual has the power to create billions of dollars in value on any given day? Or, destroy that much wealth on any given day? Actually, there are quite a few, but the most important one right now is Vladimir Putin. If a thousand points on the Dow is worth about $800 billion, how much value would be lost if Vlad formally invaded Ukraine and then embargoed natural gas to Europe this winter? Your guess is as good as any!
Of course, there are many other world leaders with this power. But, right now, tell me what Vlad is doing, and I'll tell you how the stock market is doing. Without him, I expect the market will continue to rise. With him, who knows?
But, don't blame your financial advisor for whatever Vlad does!
I have a client in Naples, Florida, and fret every time a hurricane slams into south Florida. I also have another client in Napa, California and have been fretting since she experienced her first earthquake last weekend. The Naples client is a big, macho ex-CEO type and doesn't need or want anybody worrying about him, but I do anyway! The Napa client is a tiny medical professional with worldwide experience, who is probably one of the best people to have around whenever there is an earthquake. We've heard from her once that she is okay, but I'll be glad when I actually talk with her again.
What is it about being an advisor that makes you feel so responsible for your clients? If you are very careful about whom you accept as a client, then maybe you fret because they are also good friends? Maybe, a client is more than a portfolio of numbers and is actually a real person with all those familiar hopes and fears? Or, maybe because you know them so well that you fret like a mother?
Assuming there are people-people and there are numbers-people, only people-people are impressed by the fact that the S&P 500 finally broke thru the 2,000 barrier. To numbers-people, that number is no more important than 1,999 or 2,001.
But, this graph means something even to numbers-people:
The stock market has been trading within a relatively narrow range and shows no sign of breaking out, either to the upside or to the downside. I understand the logic of "this time is different," but I also know the market averages one bear drop of 10% or more every 19 months, and we haven't had one in 34 months. We are definitely over-due.
Bears claim this graph merely documents the influence of quantitative easing, and the market will drop when the Fed begins raising interest rates, probably the middle of next year. However, history tells us the stock market handles the first few interest rate increases just fine, although the bond market doesn't.
The evidence remains overwhelmingly bullish to me that the bull run will continue . . . until it doesn't.
I've said many times that my favorite professor at Wharton is Dr. Jeremy Siegel and read his Weekly Commentary faithfully. Since it is so succinct, I am quoting the first paragraph of last week's commentary.
"This was one of the best weeks for economic news in months. Every single economic growth indicator came in above its estimate: The NAHB housing sentiment index at 55 against 53 estimate, Housing starts well above expectations (as well as permits); Jobless claims dipping below 300k, the Markit PMI estimate well above expectations, and existing home sales and the Leading Economic Indicators also above forecasts. To boot, the CPI came in at or below expectations. Furthermore, oil and commodity prices continued to decline. Gasoline prices have now retraced more than half of their 58 cent climb from $3.18 a gallon last November to $3.70 in May. Despite stronger growth indicators, interest rates remained tame. It is not at all surprising that stocks would rally sharply under these circumstances. There is a sense that the economy is now strengthening to a 3+% growth path and earnings are likely going to show a healthy increase this year. The rally is particularly noteworthy since August has been the weakest month for stocks over the last 20 years, eclipsing September, which is the weakest month when we include all the Dow data back to the late nineteenth century." Any questions?
It was 2:45 PM on May 6th in 2010. I was watching the stock market as usual, when the thoughts suddenly racing thru my mind were . . . everything is cool -- that was odd -- something is wrong -- no, something is very wrong -- now, RUN! That became known as the great "Flash Crash," when the Dow dropped a thousand points in 15 minutes . . . and then recovered before the close.
I didn't think this was "the big one," when the stock market utterly collapses, never to rise again. To be that severe, market jitters would have been rising in the days leading up to May 6th. Instead, market jitters had been decreasing since the market had bottomed-out 14 months previously. Still, I had to be in position to preserve as much of my clients' wealth as possible. As I prepared to sell their stocks, I worried that I would be locking in whatever losses they had already incurred that day. Plus, I would be creating a huge tax bill for them! Sweat creased down my forehead, tracing the eyebrows into my crow's feet and down my face. I tugged on my shirt collar to release the build-up in heat. If I sold their stocks, some clients would be happy, and some would be very unhappy. I hesitated . . . feeling this crash was not real and that reality would return.
Thankfully, the market recovered as it always has and went on to new record highs.
The SEC eventually determined that a trader had a "fat finger" and sold $4.1 TRILLION of derivatives in general and futures contracts in particular -- by mistake. This caused a cascade of automated selling. Market traders immediately suspected that. But, it took the SEC four long months before they figured it out.
In the four years since the Flash Crash, the SEC has been designing a new computer system to better track the market . . . four years . . . and they still haven't even estimated the cost, much less put the contract out for bid. Called CAT for Consolidated Audit Trail, it is not expected to function before 2018 at the earliest. (By comparison, it only took 16 months to construct the Pentagon.)
The goal of the SEC to protect the small investor is a vital part of capitalism. At some point, most organizations become too ossified or too constipated to function. I pray that is not true for the SEC, but suspect that it is! If there is another Flash Crash, don't be surprised . . . and don't lose sleep!
During my mother's final years, she was wracked with constant pain. One of her many ailments was acute arthritis. Every movement of her body caused pain. Naturally, we took her to a pain-management doctor. Unfortunately, the process of getting her into a wheel chair to be lifted into a van to be pushed into the doctor's office was extremely painful for her. I can remember vividly the tears in her eyes. He prescribed pain pills for her, which did help somewhat but made her sleepy. When her 30-day prescription was exhausted, we asked for a refill but were informed she had to return to the doctor's office for another examination. Thinking it was a money issue, I offered to pay the doctor for an office visit without the pain of actually transporting her to the office. I learned that it was necessary to cause pain in order to get pain relief. The first objective of pain-management doctors is to comply with drug laws. If they happen to also lessen pain, that is nice but secondary to compliance with drug laws. Unfortunately, my mother never received any more pain medicine and died a miserable death.
In last week's Wall Street Journal, there was an article about new rules to prevent abuse of Vicodin by making it more difficult to get. The article went on to note "most people who abuse prescription drugs illicitly obtain them from friends or relatives with legitimate prescriptions." So, we prevent abuse of this drug by inconveniencing or punishing the legitimate user, like my mother, and not the illegitimate user?
Last week, Bank of America joined the parade of banks paying hundreds of billions of dollars (yes, hundreds of billions in total) as fines for the Great Recession. The global financial crisis began with the big banks, so they must be punished, right? But, did anybody go to jail? Many crooked bond salesmen, who made millions every year leading up to the crash, are now sitting on beaches, sipping fruit drinks with umbrellas. Again, we punish the many shareholders who did nothing without punishing those bankers who knowingly sold trash-bonds. It is much easier to punish the many than the few.
Although I don't understand why 320 million Americans need 450 million guns, our attempt to reduce gun violence is aimed at inconveniencing the many lawful gun owners and not promptly executing those who use a firearm in the commission of a crime . . . any crime. Again,the aim of reducing gun violence is laudable, but our laws target lawful gun owners, not the bad guys.
To a hammer, every problem looks like a nail. In a nation ruled by lawyers, every problem looks like we just need more laws . . . instead of simply more executions.
Every year during the hot, miserable days of August, central bankers from around the world gather in the cool mountains of Jackson Hole in Wyoming for their Economic Policy Symposium. It is always a fascinating time for economic nerds.
This year, it looks like there will be friction over which priority of the Fed is most important right now. You'll recall the U.S. Federal Reserve System is the only central bank in the world with a dual mandate -- control both unemployment and inflation, which is more difficult than it sounds. Generally speaking, those policy moves to control inflation tend to increase unemployment, and those policy moves to reduce unemployment tend to increase inflation.
Janet Yellen is expected to stress the unemployment problem. Some of the regional Fed presidents are expected to stress inflation. I see it as a contest between good data and bad data.
It is clear that millions of people are still unemployed, but at 6.4%, we have already made a great deal of progress. However, the long-term unemployed present a special problem for policymakers, especially for monetary policymakers. Of course, there is lots of good data to document these problem, and this unemployment problem has dominated economic discussion for some years.
With respect to inflation, the data does not reflect any problem. In fact, the data suggests that deflation might be more of a problem, which is far more pernicious than inflation. Despite the data, a number of surveys have shown that consumers don't believe this, as they see actual inflation in consumer prices. In fact, inflation does seem to be more apparent in consumer prices than in industrial prices. The popular new term being tossed about is "Shrinkflation" where consumers still pay the same price for a product, but that product is now slightly smaller. For example, paying $1.59 for a 10-oz candy bar is cheaper than paying $1.59 for an 8-oz candy bar.
I hope Yellen is successful on keeping the focus off inflation. Keep the focus on the unemployment problem, which is backed with good data, by attacking the bad, inconclusive data on inflation. A little inflation is good for debtors, and the United States is the world's biggest debtor. There are always individual winners and losers with any economic policy, but the country-as-a-whole wins with a little inflation. Yes, breaking inflation later is more painful than breaking inflation before it takes hold, but that pain is less than the pain of not deflating our debt -- by allowing a little inflation now.
Some people might describe Goldman Sachs as the most highly self-respected company in America. I would argue their economics research department actually deserves to be respected. Here are some of their latest predictions:
1. GDP growth in the second quarter was a whopping 4.0%. For the full year, it will only be 2.9%, due to the lousy first quarter. Next year, full-year GDP growth will be a respectable 3.1%.
2. Unemployment will drop to 5.9% by year-end 2014 and 5.4% by year-end 2015. This is very close to full employment, which is normally described as 5% unemployment.
3. Inflation remains nominal, with core CPI growing a mere 2.2% next year.
4. The benchmark 10-year-Treasury rate will increase about half a percent before year-end 2014 and another half a percentage point next year. (I disagree with this.)
5. Corporate profits per share will rise 7.8% next year.
6. The S&P 500 will end this year at 2,050 or up another 3%. Next year, it will end at 2,100 or another 2.5%, which is a significant slowdown in growth.
7. Oil will continue to fall both this year and next year.
8. Gold will fall to $1,050 per ounce by year-end 2014 but bounce back to $1,200 by year-end 2015.
9. The dollar should continue to strengthen.
10. Small-cap stocks are very attractive now.
There is no mention of distant fires or bubbles building. It is a bullish set of predictions. Maybe, it is safe to go to the beach after all, but watch out for the "great vampire squid wrapped around the face of humanity," as Goldman Sachs was described in Rolling Stone magazine.
I'm not sure it is human nature, but we always seem inclined to fret about how bad the economy is. Does anybody ever rejoice about how good the economy is?
Consider the case of Finland: It was one of the rapidly-growing Scandinavian bears until 2007 when Apple introduced the iPhone. Huh? What does the introduction of the iPhone have to do with the decline of Finland, you ask? Well, Nokia was 4% of the country's GDP, and that company got killed by Apple and Samsung. Over-reliance on any one company is begging for trouble, and they got it.
In addition, the country was overly-reliant on another industry -- paper. Their two paper companies were two of the largest companies in Europe. However, with the shift to digital media, the demand for paper has dropped worldwide. Countries dependent on paper have suffered, like Finland.
Also, Finland is geographically flush against Russia, who is sinking into recession. Ten percent of Finland's exports go to Russia and will be further hurt with the imposition of trade sanctions. The future is not bright.
Instead of falling, unemployment is at 9.8% and rising. Unemployment claims are up 15% over last year. Their GDP fell 8.3% during the global financial crisis (much worse than the U.S.) and their economy is still stalled -- seven long years later. I doubt there is a person in Finland who would not love to have an economy like the U.S.
The next time you're sitting around with people, fretting about the American economy, tell them to move to Finland. At least, they still make the world's greatest vodka!
Have you ever seen such a divergence between the mainstream media and the business media? CNN and MSNBC are covering the Ferguson riots non-stop 24/7? (Fox News is a little more balanced but not much.)
On the other hand, CNBC, Fox Business News, and Bloomberg allocate no more than 10% of their air time to Ferguson, instead spending their air time on geopolitical risks that actually matter to business and stock markets, such as the Ukraine, ISIS, Chinese purges, or even the spread of Ebola. Most of their air time is allocated to corporate earnings, M&A, and other business matters.
Does that mean the business community does not care about any alleged injustices in Ferguson? No, of course not! It just means that this story of racial injustice is not new and certainly not news-worthy. We've seen this story many times over the last 50 years without ever causing a recession or stock market crash. It is just business-as-usual. Is that right-or-wrong? Well, you already know that answer!
It is just one of those times when the only place to hear "fair & balanced" news is on the business channels.
My late mother always told me to be positive. You can do anything you want in life, as long as you're positive. A positive life requires a positive mind. A glass is always half-full, never half-empty. Frankly, I always thought that was good advice and have tried to follow it, which is not normal for an existentialist.
However, The Wall Street Journal had a disturbing article this week about the emerging scientific consensus that negative people are actually more happy than positive people. It seems that happiness is inversely-related to disappointment, which is the real happiness-killer. Since negative people already expect negative outcomes, they are not disappointed. Since positive people already expect positive outcomes, they are much more likely to be disappointed and therefore unhappy.
Groucho Marx often begged the question: Who are you going to believe? Me or your lying eyes?
So, who should I believe: Mom or The Wall Street Journal ?
During the last century when I took my first course in economics, we were required to list both the advantages and disadvantages of capitalism. Once done, it was almost always clear that capitalism had numerous advantages over socialism. But, there were disadvantages! First, Karl Marx was right that "the sins of management are visited upon the worker." In other words, capitalism can be cruel. It is efficient but cruel. Second, capitalism does not price-in social costs. In other words, the price you pay for gas at the pump includes the acquisition cost and processing of oil, the distribution of the product, plus the marketing and corporate overhead. It does not pay for the environmental damage, which has very real costs. Society as a whole pays part of your cost whenever you fill up. Why don't you pay for the environmental damage your gas consumption causes?
To repeat, once this process of listing advantages and disadvantages of capitalism was completed, it was clear that capitalism was superior. Facing the disadvantages did not change our conclusion!
John Komlos of the conservative University of Chicago just authored What Every Economics Student Needs to Know and Doesn't Get in the Usual Principles Text. He argues that capitalism is now presented as "God's gift to humanity." It is not! It is an economic system that allocates resources efficiently, despite certain shortcomings. But, it has become more like "that old-time religion" than analytic economics. For example, all taxes are bad and damage the economy. There are no exemptions, not even for research, nor Social Security, nor healthcare, nor anything else. No revenue extracted from taxpayers can ever have any multiplier impact on GDP.
I have written often about Hyman Minsky and his Minsky Moment, which is no longer taught to economics students. Instead, they are taught mathematical models. Even the admission of Greenspan that his model didn't work -- failed to reduce reliance on econometrics. The Fed has 300 Ph.D. economists on its payroll and still failed to see the global financial crisis, because they were fine-tuning their mathematical models.
One million students take an economics course every year and are taught about super-rationality, where all consumers of all products have 100% knowledge and never make irrational decisions. (This is mirrored in investment theory where it is called the "efficient market.") But, the world is not perfect. Consumers/investors never have perfect information nor make perfect decisions. Why teach a world that only exists in theory?
According to Dictionary.com, the definition of endogenous is "proceedingfromwithin;derivedinternally." The definition of exogenous is "originatingfromoutside;derivedexternally." This neat division helps one to understand the value of investment predictions. Endogenous factors affecting the stock market include economic data, such as unemployment, and market fundamentals, such as advance/decline lines and market multiples, as well as the all-important corporate profits. There is one set of analysts who can speak intelligently on endogenous factors. Exogenous factors are primarily geopolitical events but also weather events or natural disasters, such as earthquakes. For example, if Putin flagrantly invades Ukraine, the stock market will object by selling off. To some extent, that uncertainty is already priced into the market, limiting the market's reaction. However, if something from "left field" or totally unexpected happens, such as a Chinese invasion of Japan, it would produce an absolutely violent drop in the stock market. There is a different set of analysts who can speak intelligently on exogenous factors. The astute investor must listen to both sets of analysts and then synthesize their observations. That is what I try to do. Some try to take advantage of the tumult by "betting ahead" of the event. If you are confident Putin will invade Ukraine, you could short the ETF for European stocks, but your potential losses are unlimited whenever shorting. Or, you can simply increase your cash levels to match your personal level of uncertainty. When struck by an exogenous factor, limiting loss should be more important than profiting from it. Converting to cash has a 100% probability of successfully limiting loss in the short run. The probability of successfully betting ahead on exogenous events is much less than 100% and is much more risky.
An old Wall Street adage is that "nobody is smarter than the market." Likewise, nobody is smart enough to out-smart exogenous events. Smart people know that!
I was wrong! When Putin took Crimea, I expected it would only be a week or so before he invaded Ukraine. After all, why wouldn't he? Sure, it would be slightly more difficult than taking Crimea, but the Ukraine didn't have a chance against the superior Russian forces. And, the West was merely being bellicose and nothing more. But, he hesitated. Then, it turned into a trade war - a trade war that has spooked markets worldwide, especially their own in Russia.
The Russian stock market is down 20%. Their currency has lost 10% of its value against the dollar, contributing to an outbreak of inflation. That inflation is easily visible in food costs, as Russian nonsensically announced trade sanctions against importing food. To combat inflation, the Russian central bank has sharply increased interest rates. Retail spending growth has dropped 50% since the Crimea annexation. Investment spending has actually turned negative. GDP growth was 7% from 2003-2007 but has already dropped to less than 1%. It is hard to describe the Russian economic prospects as anything other than a train wreck!
There could have been a brief hot war when Russia took the Ukraine, with no American lives at risk. Instead, we have a trade war, with the Russian people paying the price. Sure, there would probably have been minor trade sanctions if he had invaded earlier but not a full blown trade war. While this has spooked our market, the U.S. will be fine. Sooner or later, our stock market will realize that.
Saturday, I visited the National World War Two Museum in New Orleans. While not exactly a pleasure, it was time-well-spent! There was the usual array of weapons from pistols to tanks, of course. There were also old airplanes, both fighters and bombers. As the famous Higgins boats or "landing boats" that were used to deposit men on the beaches of Normandy were built in New Orleans, there was quite a bit of interesting information on that as well.
My strongest visual takeaway is an actual glider that crashed into one of the numerous hedgerows across northern France. It was smaller than I expected and extremely flimsy - little more than canvas over plywood and no engine. It is no wonder they were called "flying coffins."
My strongest intellectual takeaway is that Operation Overlord or the Normandy invasion had no contingency plan. When I attended Infantry Officer Candidate School, we were trained to ALWAYS have a Plan B for every Plan A. The biggest military operation in history had no backup plan! Doesn't that imply Hitler would have won World War Two if the Normandy invasion had failed? It is hard not to wonder how the world would be different.
My strongest perception inside the buildings of the Museum was the age breakdown of the visitors. Certainly, the percentage of visitors in their 80's and 90 was far greater than their percentage of the general population. This is not surprising since they can actually remember that war. Also, the percentage of visitors in their 20's and 30's was far greater than their percentage of the general population. They probably brought their children, as they should, to learn about their grandfathers and great-grandfathers.
However, visitors in their 50's and 60's were rare. They are the Korea and Vietnam veterans. Far fewer in numbers, they increasingly resent the continual accolades poured onto the older veterans from World War Two. On an individual basis, their experiences are just as compelling, terrifying, and heroic as those in World War Two . In fact, the greatest resentment exists among veterans of "black ops" or clandestine operations.
More interestingly, there were few visitors in their 40's. This generation of "Gen-Xers" is increasingly resentful of paying their tax dollars for the many Medicare recipients who don't actively manage their own individual health care with diet, nutrition, and exercise. The "Greatest Generation" to them, unfortunately, implies the greatest wasters of government money in history.
Veterans of the Greatest Generation rightfully deserve the greatest respect, but not all of it. After all, the distance between respect and resent is only a bayonet's edge.
The President has announced new airstrikes in Iraq. The ceasefire in Gaza limped to an end. Putin has launched economic sanctions against the West. And, the authorities has declared the Ebola outbreak in Africa is now out-of-control. As a result, portfolios worldwide will suffer, for awhile.
But, something worrisome did NOT happen! Just like Sherlock Holmes taught us, a "dog that doesn't bark" can be telling the real story.
One of the sure signs that a stock market is" hot" is a high level of mergers & acquisitions (M&A). So far this year, global M&A has been $2.2 trillion. At this time last year, the level was only $1.3 trillion. This year will probably be the best year for M&A since 2007, just before the global financial crisis. In fact, one finds M&A highs are invariably indicators of both economic recessions AND financial crisis. (Remember: fear a financial crisis, not a garden-variety economic recession!) An economic recession will be preceded by several large corporate acquisitions that do NOT happen. An financial recession is predicted by the failure to finance one or more large corporate acquisitions.
Last week, a surprising number of M&A deals collapsed, and my crisis radar came out. The bad news may be that the deals fell apart, but the good news is that they did NOT fall apart due to a lack of financing.
And, the rates on Argentina's credit default swaps have stabilized, another quiet dog that is good news for investors.
So, as you worry, be thankful for the quiet dogs and think about them as you fall sleep!
A market correction, an economic recession, and a financial crisis are very different things. A market correction is routine in a healthy stock market and is a necessary step for the market to go higher. An economic recession is a routine part of business cycle and is a necessary step for the economy to continue growing. A financial crisis is much more sudden and severe. Originating in the financial sector of the economy, it quickly cripples the entire economy and stock market. Remember the Great Recession of 2009? It started as the Global Financial Crisis of 2008.
I have no fear of market corrections nor economic recessions. But, I am scared-to-death of a financial crisis, which will likely first appear as a derivative blow-up.
Argentina now poses such a risk, as they have been declared in technical default. This is not a case of Argentina saying they will not pay their obligations. They are saying that past bondholders demanding payment are NOT entitled to any payment now, as those bonds were "crammed down" to a lower value over a decade ago. Then, a U.S. court said that U.S. banks acting as agents for the current bondholders may not pay out interest that is due on new bonds, unless certain past bondholders are repaid the full face value of the bonds. Argentina has ample funds to keep the interest current but not to pay previously crammed-down bonds. They have now been declared in technical default. So, why is that important?
Bondholders who are afraid Argentina will never pay the bonds are free to buy insurance against a credit default. This insurance is usually expensive but not outrageous. Early last week, it would cost you $2.7 million to insure $10 million of Argentine bonds, which is outrageous enough. By Friday, it would cost you $4.2 million. This insurance is called a credit default swap. If I sell you a credit default swap, I get $4.2 million but am still exposed for $5.8 million, because I may have to pay you $10 million. To protect myself, I then buy a credit default swap from somebody else. So, a credit default swap stands behind another credit default swap.
If I am a bondholder and bought the first credit default swap, I know who is responsible for paying me. But, if he is unable to pay, I don't know who is behind him, if anybody. The big picture is that we don't know who is on the hook for how much. Who is holding the bag?
If you see any announcement next week that some financial institution has defaulted on a credit default swap, consider decreasing your equity exposure and increasing your cash. There is a huge difference between a bond default and a derivative default. Keep your antenna up this week! I certainly will !!
The stock market was ugly yesterday, with the Dow losing 317 points. To be trite, the "straw that broke the camel's back" was the news report that a major bank in Portugal had some major unexpected losses, and their stock dropped a whopping 24%. That's bad news but not necessarily big news. But, it came when the market was already nervous about Putin's intransigence over the Ukraine and the resulting damage to Europe of trade sanctions. The market was already nervous about Israel's invasion of Gaza and the possible damage to the world's energy markets. Did I mention that Argentina has clouded the whole market for international finance? Most of all, the market was nervous that the Fed was planning to hasten their withdrawal of monetary stimulus and doing so because of a good thing, i.e., the whopping 4% GDP growth rate in the second quarter. If Friday's "Jobs" Report is good, the market is afraid that report might seal the fate of monetary stimulus.
While the Fed deployed numerous tools to combat the Global Financial Crisis (GFC) of 2008/9, only two are still effective. One is quantitative easing, which has been tapering and will be ended in October. Do you remember last year's "Taper Tantrum," when the market was overly-terrified that the amount of QE each month would start decreasing. After that hissy-fit, the stock market recovered nicely and went on to record levels. The other remaining tool is extremely low interest rates. I don't think the Fed will start raising interest rates before the latter part of next year. The stock market is now afraid the Fed will raise interests rates very late this year or early next year. Once that announcement is made, I expect another hissy-fit, with the market dropping dramatically and scarily, before recovering to new record highs once again.
While the stock market is always "climbing a wall of worry," that wall is very tall at the moment. There are many reasons to be anxious right now. Unfortunately, that increases market volatility, and today's "Jobs" Report will likely cause an over-reaction or under-reaction.
Lastly, like an expectant woman waiting to deliver her baby becomes more and more anxious as the baby is later and later, the stock market averages a 10% correction every 19 months and hasn't had one for 33 months. The correction is past-term. Delivery might be induced by all this anxiety overload! I hope so, because more record highs are on the other side.
The Dow was up slightly when the news hit The Street that GDP growth was a whopping 4% in the second quarter. That's good news, right? But, the Dow promptly drops a hundred points on that good news. Why, because a stronger economy means the Fed is more likely to raise interest rates sooner, instead of later. And, that's bad news . . . huh?
The Argentine government announces they will default on their debt. Yet, the Argentine stock market went up, while the U.S. stock market went down. Does that make sense? As a result, Argentina will likely be locked out of the world's capital markets for years, but their country will NOT be stripped of all its liquidity right now, which was a big relief in that country, fueling their rally. In the U.S., however, an Argentine default means the whole arena of international finance, which is dominated by the U.S., will now be clouded by this default, which is not really more than a technical default, but it greatly increased uncertainty. And, we know that increased uncertainty is bad for the stock market.
Maybe, there is pure good or pure evil in this world . . . but, it is not that simple on Wall Street.
I cannot remember the last time that Consumer Confidence increased 4.5 points in one month, but it did this month. That means more people are optimistic about their current financial position as well as their future financial position. There is a close relationship between the labor market and consumer confidence. As the labor market improves, consumer confidence increases, and both have.
Of course, the Confidence Survey was taken on July 17th, which was the day the Russian separatists shot down the Malaysian passenger jet, as well as the same day the Israelis invaded Gaza again. Therefore, many analysts are suggesting a survey taken on July 18th would not be nearly so healthy. I disagree and don't think many Americans are losing any sleep over foreign tragedies so far away.
As consumer confidence increases, consumer spending increases. Consumer spending is almost 70% of GDP, suggesting GDP growth will increase. And, lo and behold . . .
I cannot remember the last time that GDP growth was a whopping 4% during the second quarter. That may sound miserly compared to China's 7.5%, but it is very strong for a mature economy like the U.S. Of course, it was expected to rebound nicely after the winter-crushed first quarter GDP growth, which was a negative 2.9%. But, it was not expected to grow at 4%. Before we rejoice too much, let's wait until we see next month's revised estimate.
Nonetheless, economic data continues to look strong. Most analysts believe the stock market is 6-12 month leading indicator of the economy, and that certainly seems to be the case again.
The Federal Reserve System is the only central bank in the world that has a dual mandate, i.e., combating both inflation AND unemployment. With inflation virtually non-existent, the focus is on unemployment. The closely-watched monthly "Jobs" report will be released this Friday. Absent some exogenous factor, the stock market will just churn around the flat line until then.
For all of 2013, we created 195 thousand jobs each month, on average. So far this year, we have created 230 thousand each month, which is a significant improvement. It is even more remarkable if you consider that GDP growth in the first quarter was a whopping, negative 2.9%.
With the job creation "machine" functioning so well, attention is turning to wage growth. Normally, at this point in the business cycle, wages would be increasing 3.9% annually. However, wages are growing at only 2.3%. This confirms that inflation is non-existent. It also reflects just how severe the recession was and how much negotiating strength that workers lost.
Wells Fargo wrote an interesting piece on how big companies don't feel any need to raise wages now, since they didn't reduce them during the recession -- having just reduced the number of employees instead. With the government's JOLTS report showing employees are increasingly confident in changing jobs, big companies may want to re-think that position.
One final caution on this Friday's highly anticipated Jobs reports. It is normally issued on the first Friday of the month. For August, it falls on August 1st, providing less time to massage the numbers, which increases the likelihood that it will be substantially adjusted in September. This is not a bad thing, as it reduces the volatility following release of the report on Friday.
Since political considerations pollute and contaminate everything, one political consequence of an improving job-creating-machine is that it tends to benefit the incumbent President. Fortunately or unfortunately, the President is not on the ballot this year.
The Old Ebbitt Grill at 15th & New York in Washington, D.C., is one of those classic old steakhouses frequented by Congressmen, bankers, and other shady characters. I had lunch there one day with two analysts who got into an uncomfortable argument about whether Pfizer or Merck was a better investment. They were even quoting footnotes from the annual statements of both companies?!?!
Sitting in the political capital of the world, I was amused that the subject of politics didn't even come up. The best laid plans of mice, men, and analysts are easily waylaid by politicians. That risk rises and falls, unrelated to any analysis of corporate balance sheets.
Here is the definition of Political Risk from Investopedia:
The risk that an investment's returns could suffer as a result of political changes or instability in a country. Instability affecting investment returns could stem from a change in government, legislative bodies, other foreign policy makers, or military control. Obviously, that risk is quite high right now, but I am not overly concerned about it. If Russia overtly invades the Ukraine, taking the eastern half, the stock market will drop. If Isis holds it's position in Iraq and invades Jordan, the stock market will drop. If Saudi Arabia issues an oil embargo due to the Israeli invasion of Gaza, the stock market will drop. And, of course, there are other events that could cause the market to drop. This too will pass! I don't recommend selling stocks and going into cash unless there is a derivatives fiasco, which I don't see on the horizon. Rejoice: we still have time for uncomfortable arguments in fancy restaurants about things that don't really matter anyway.