This is the story of my day and, thus, this blog posting…

Capital Markets Recap

Markets are behaving nicely, and I think this is why. The chart below shows three panels. In the first one is charted the cost to insurance against sovereign debt defaults by Italy and Spain (5-year debt, both). Since autumn, Credit Default Swaps on the two countries have settled down. In conjunction with, and reflecting that, the risk–implied volatility from option prices–of European stocks has been declining (panel 2). Behold, (panel 3) European stocks are rising. It appears that the market is confident the European authorities are committing to keeping a cap on rates. In addition, with inflation coming down in the region–a natural consequence of the deleveraging going on there–the European Central Bank, with its memories-of-the-Weimar-Republic focus on inflation, should be able to breath easier and–speaking of easier, make its monetary policy easier without having to worry about runaway inflation.

Top Stories

This S&P 500 earnings season is getting started slowly, just 47 companies reported results this week. Analysts have ratcheted down their numbers for the Q4 reporting season, but their overall number (+9%, I think) had the wrong sign on it for this week, when reported earnings were down, on average, by (-)8.58%. The worst results came from the Materials sector, but the sector has the highest positive surprise. Financials were just lousy, reporting -27% earnings growth and a hurdle that wasn’t low enough (-11% earnings disappointment.)

I think, though, that the season will prove to be a good one. No one will care that earnings in the period ended December 31 were lousy so long as the forecasts are rosier, and the environment seems rosier. Our internal economic strength numbers are reflecting that, as are the reports we get from our Key Strategy Providers.

This Week

There were a couple of economic series that stood out this week, and two of them were related to housing. First, the MBA Mortgage Application index increased by 23.1% in the last week. It’s a simple translation: mortgage applications were up by 23%. The trouble with this series is that it’s been driven largely by refinancings and not purchase applications. That was pretty much the case last week, too, although purchase applications did rise. Since the end of 2011 purchase applications are up by +20%; refi applications, +31%.

Next, the index that records sentiment of the homebuilders, themselves, the NAHB Housing Market Index, reached its highest level since 2007. I’m not sure what’s supporting that, however, as Housing Starts fell this week (-4.1%). It appears, though, that the sentiment index has some leading tendencies, so perhaps we’ll see a corresponding pickup in starts.

Here is what’s helping to bolster the morale of homebuilders–well, 25% of them, at least, which is what the index measures–Prospective Buyer Traffic and Current Sales. Odd, though, that the traffic isn’t feeding into future sales…

Here’s what we think the NAHB index implies for Housing Starts. At the current reading, starts ought to be north of 1,000. Yeah, it’s just maths (as the English say), but it’s maths.

The other, almost stunning, economic release came in the form of Initial Jobless Claims. They fell by a whopping 12.4%, or by 50,000 bodies. There are two caveats that need to accompany the figures, however. First, winter is a notoriously volatile time. Second, the week included the MLK holiday and that requires the states to estimate filings, which will, necessarily, be wrong.

Next Week

See the Guess Who song at the top.

Graig Stettner, CFA, CMT

Chief Investment Officer

Tower Private Advisors

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No, that’s not a tractor idled for lack of work. It’s what’s behind the picture above it…sorta.

In early December the Weekly Recap included a deeper-than-usual look into the U.S. employment picture, including a discussion of the Labor Force Participation Rate, which had reached its lowest level since 1984. There are a number of factors behind that and others

 indicative of a jobs problem we have here. I think the single-biggest culprit behind the job disappearing act is increased productivity. For example, at the main office of the Allen County Public Library, it’s now possible to walk in, find and check out books and videos, renew one’s library card, and validate a parking ticket–all without talking to anyone, something of which I’m especially fond. I mentioned the library’s culpability in our employment crisis to a staffer there, and, according to her, indeed, by means of attrition, those jobs will be vaporized.

‘Need more anecdotal evidence? We recently met with the Williams Inference Service folks and, amongst other–as-usual–intriguing articles, they featured one from the WSJ titled, “Teaching Drones to Farm.” The first sentence was this: “[m]akers of agriculture equipment are exploring a new frontier: farming without the farmer.”

All emphasis that follows is mine.

Kinze, with the help of Massachusetts-based Jaybridge Robotics, is developing two products aimed at easing the time and labor crunch farmers can face. The drone technologies can seem like ghost-like as a tractor crosses a field with no one in the cab.

Kinze’s autonomous planter would determine the most efficient route to plant a field and the do the sowing without a driver. A system of sensors ensures the tractor doesn’t run into any unexpected obstacles such as a fence post or stray farm animal. The technology has become feasible to incorporate into agriculture because of its growing use in automobiles where it has driven down costs.

As for the harvest, a farmer still would need to operate a combine, but a cart positioned next to the combine to receive grain would be autonomous. The cart would keep pace with the combine, and once full, proceed to a waiting truck at the edge of th

e field being harvested. Ultimately the farmer would need two people, rather than three, to harvest the grain.

You can shake your head as you [gotta] watch the video below. At first it appears to be a rural version of one of the Speed movies–just to prove they could be worse–until the tractor carefully turns around.

 And Williams Inference popped back into me mind as I read a blog post on “For The Win; Random musings on venture capital, among other things.” The chap that keeps up the blog claims that we worked for Mitt Romney (“I started my investing career doing leveraged buy-out deals at Bain Capital, working directly for Mitt Romney”). In his post, Job Creationism–once you get past the lurid picture of Adam and God that adorns the Sistine Chapel–he provides an interesting perspective on job creation–from the viewpoint of one who was creating jobs:

“For the first 3 years of my venture career, until the spring of 2000, I did indeed “create jobs” right, left and center. All of my companies were hiring anyone who had a pulse. Fortunately, I was lucky enough to exit many of those investments before the music stopped, but by the summer of 2000, it was clear that all of us in the venture industry had created a few too many jobs, frankly.

He later cites some statistics supportive of my contention, above, and certainly the contention of the article that follows, below.

Let’s look at the newspaper industry (just in case I haven’t depressed you enough already.) In 1990, the industry employed 460,000 people. Today it employs 250,000, and is projected to shrink to 180,000. The two companies who sucked all of the profits out of that business, Google and Craigslist, collectively employ about 25,000 people (Craigslist makes up 30 of that number. Not a typo.) So, did the heroes who founded and funded Google and Craigslist create 25,000 jobs, or did they destroy a quarter million jobs?

In a recent meeting with the Williams Inference service, their folder titled “Ghost in the Machine,” featured an article, which I highly recommend, from the McKinsey Quarterly (‘The Second Economy; Free registration required) After walking through the modern airport flight process equivalent of my library example, the author posits that there is a second economy that is unseen, lurking behind the scenes. He calls it digitization, and he estimates that if–based on what seem like reasonable assumptions–it continues to grow as it has since 1995, it’ll overtake the size of the 1995 physical economy by 2025. He likens this second economy to what is unseen below an acre of Aspen trees.

If I were to look for adjectives to describe the second economy, I’d say it is vast, silent, connected, unseen, and autonomous (meaning that human beings may design it but are not directly involved in running it). It is remotely executing and global, always on, and endlessly configurable. It is concurrent–a great computer expression–which means that everything happens in parallel. It is self-configuring, meaning it constantly reorganizes itself on the fly, and increasingly it is also self-organizing, self-architecting, and self-healing.

These last descriptors sound biological–and they are. In fact, I’m beginning to think of this second economy, which is under the surfae of the physical economy, as a huge interconnected root system, very much like the root system for aspen trees. For every acre of aspen trees above the ground, there’s about ten miles of roots underneath, all interconnected with one another, “communicating” with each other.

Skipping ahead by several pages…

Physical jobs are disappearing into the second economy, and I believe this effect is dwarfing the much more publicized effect of jobs disappearing to places like India and China.

There are parallels with what has happened before. In the early 20th century, farm jobs became mechanized and there was less need for farm labor [GPS: and now we can digitize the mechanization!], and some decades later manufacturing jobs became mechanized and there was less need for factory labor. Now business processes–many in the service sector–are becoming “mechanized” and fewer people are needed, and this is exerting systematic downward pressure on jobs. We don’t have paralegals in the numbers we used to. Or draftsmen, telephone operators, typists, or bookkeeping people. A lot of that work is now done digitally. We do have police and teachers and doctors; where there’s a need for human judgment and human interaction, we still have that. But the primary cause of all the downsizing we’ve had since the mid-1990s is that a lot of human jobs are disappearing into the second economy. Not to reappear.

 All the soundbytes and voter-pandering press conferences aside, that’s going to make the job of one of these cats very difficult when it comes to “creating jobs.”

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1. Commercials
2. Non-Commercials (clever)
3. Non-Reportable

Over time, the parties have become known as hedgers and speculators, so the groups can be re-grouped as follows:

1. Hedgers
2. Large speculators
3. Small speculators

Furthermore, because they tend to be wrong at turning points, the speculators have become known as the Dumb Money, leaving the hedgers as the Smart Money. In the case of traditional commodities, like gold or corn, the hedgers are the producers–in our case the mining company and the farmer. To generalize a lot, the speculators tend to be trend followers, thus, they buy/sell as trends continue, leaving themselves over-exposed when the trend changes.

Every Tuesday, futures participants report to the CFTC whether they are long (expecting higher prices) or short (expecting lower prices) and by how many contracts. The CFTC makes this Commitments of Traders (CoT) report available on its website, and Bloomberg makes it all available for charting and other analytics. As a result, we can see how all the groups are positioned, specifically, whether they are, in aggregate, long or short a particular commodity. And by the way, financial futures (e.g. stock indexes) are commodities, too. Also, the corrolary to the farmer in financial futures are the big money center and investment banks.

They’re an important group to watch because, while they all have spokesman/strategist types who tell you what you should do with your money, they never tell you what they’re doing with their money. The CoT report, however, gives us an idea of what their firms are doing at least.

Enough of the background…

Right now, the Commercials/Hedgers/Smart Money have the largest net-long position in almost four years. They’re not infallible, as they’ve been wrong in the past, but it presents a far better picture for the market than were they net-short to a record degree.

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Here’s what the picture looks like.

There is still plenty that can go wrong in the world, and investors are on high alert for them. I’ve maintained for a while that the problem is Europe, and what’s seen as an eventual blow up there is being increasingly referred to as a Lehman Bros. moment, the period of time begun on September 15, 2008, when the market went into freefall. It appears that Greece is circling the toilet bowl, and the sooner the country can be allowed to default–in whatever form it takes–the better. That it might not be the worst thing was on evidence today in the Greek stock and bond indexes. While the 1-year Greek note now yields–I AM NOT MAKING THIS UP–89.18%–yesterday it yielded a mere–I AM NOT MAKING THIS UP–80.483%. That’s a bond that’s not going to get paid back. At the same time, the Greek stock exchange was up by +8%. The fine folks at Miller-Tabak mused that some bond pain might be good for the economy; therefore, bonds down, stocks up.

Please note the +14.5% and +8% (today) pops. To me, those are indications of a severely oversold market. Perhaps one thing that happened over the past month’s equity volatility is that market participants are geared up–maybe inured is a better word (no, not injured, although that, too)–for the worst case scenario in Greece. Anything better than worst would be good (huh?)

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On a daily, and perhaps weekly, basis, security prices reflect a whole host of influences, not the least of which are fear and greed. Over longer periods of time, however, security prices and trends should reflect fundamentals, and the most basic fundamentals are the economy–or economies. So, generally, stocks should rise as the economy improves and fall as it deteriorates. Non-fundamental factors can trump fundamentals for quite some time, however. One thing should be added at this point. The Surprise Index can rise while the economy is deteriorating if it’s doing better relative to economists’ forecasts.

In the chart below I’ve freshened up the chart–and complicated things by reversing the order of them. The top panel shows the Citigroup U.S. Economic Surprise index, while the bottom panel shows the S & P 500 as a proxy for stocks. I’ve divided the chart into three zones and will proceed to spill more electronic ink than necessary to explain the zones and the possible implications of where we are now, which is zone C.

• Zone A – in this zone everything is as it should be. The economy is doing better than economists expect. As that plays out economists will be forced to raise their estimates for the economy, which eventually translate into improved overall earnings for companies that comprise the economy.
• Zone B – all is not right. In this zone economists –for at least three months–overestimate the strength in the economy, yet stocks don’t reflect it, although the flattened trajectory seems to acknowledge that something isn’t right.
• Zone C – stocks play catch up, as talk of recession heats up. On August, The Economist magazine features the cover below, where recession is lurking just below the surface. Note, though, that in this zone the economic surprise index has turned up.

So, if a falling Economic Surprise Index heralded a decline in stocks, is it possible that a rising index might herald a rise in stocks? Maybe the gradual upward trajectory of the line suggests that a recovery in stocks won’t be vigorous, but if nothing else this should tell us that economic Armageddon or Financial Crisis 2.0 is not yet upon us. That’s sort of how we have portfolios structured at present. Within a modestly overweighted portfolio structure our portfolios are positioned defensively.

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As you might have guessed, the picture above is of a dog lying down beside the casket of his master, a Navy SEAL, who was shot down in a helicopter over Afghanistan on August 6. You can click on the picture above to be linked to the TAH blog post. Click here for the original–or at least a story–that appeared in the Des Moines Register.

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Exactly what rumors are they categorically denying? ‘Not sure, but the cost of insuring against a SocGen default is up by 10% today. I’m guessing the market’s speculating they own some toxic Italian or Spanish debt.

Still, what happened to Bear Stearns’ CDSs makes the chart above look positively tame:

Here’s a comparison of the action.

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