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• JPMorgan debacle
• Modest economic improvements in a quiet week
• Joke of the week: What do you call a bad Spanish bank? A Spanish bank (heard on Bloomberg radio)

“And Max said NO!”

Farewell, Maurice Sendak

Capital Markets Recap

Top Stories

In the April 13, version of the Weekly Recap & Outlook, I mentioned the London Whale, the name of the JPMorgan trader who had amassed huge positions in derivatives. It went like this:

Messrs Dodd and Frank must have their undies in a bunch over news that JPMorgan has, “transformed the bank’s chief investment office [sic?] in the past five years [hmm...see chart below - GPS], increasing the size and risk of its speculative bets…” The Company hired a new Chief Investment Officer back in 2006 with the doomed-to-failure name of Achilles Macris (I am not kidding.) The same Bloomberg story goes on to say that, “some of Macris’s bets are now so large that JPMorgan probably can’t unwind them without losing money or roiling financial markets.” That refers to the positions of the so-called London Whale, a London-based derivatives trader who was given the moniker, presumably because he can upset the whole financial world with a flip of his metaphorical tail, which might give new meaning to the phrase, tail risk.

Whale, this week the whalers got the whale, as JPMorgan announced it had lost north of $2 billion as a result of trades in its Chief Investment Office. The daggers came out across the blogosphere. Here’s a sampling of posts from today (I’m not sure who’s being pilloried, JPM or Jamie Dimon):

• JP Morgan–Aaaaarrrrgggghh – Cumberland Advisors via The Big Picture
• JPM announces major losses on its “hedges” – The Big Picture
• Oppenheimer: The Damage to JP Morgan is ‘Mainly Psychological’ – Business Insider
• How Jamie Dimon Got To Be the Most Admired Banker in the World – Business Insider
• Jamie Dimon Should Resign in Disgrace – Clusterstock
• WSJ Names Two Hedge Funds That Profited from the JPMorgan Blunder – Clusterstock
• 5 Hedge Funds That Are Getting Smoked by JPMorgan – Clusterstock
• What JP Morgan’s Stunning $2 Billion Loss Means - Clusterstock
• Dennis Gartman: Jamie Dimon’s Pristine Reputation Has Been Irreparably Sullied – Clusterstock
• Why What Jamie Dimon Doesn’t Know is Plain Scary – Zero Hedge
• Does Jamie Dimon Even Know What Hedging Risk is – Zero Hedge

There’s this notion that if traders know another firm is in trouble, they’ll be like sharks smelling blood, and will start circling for the kill, which amounts to taking the other sides of trades the company’s involved in. In the Long Term Capital Management crisis, firms purportedly looking to buy the company came in to examine LTCM’s book and, in the name of due diligence, it was suspected noted the trades they had on, and took the other side, accelerating the company’s demise. I don’t mean to suggest this will lead to the company’s demise. Their capital level has 12 zeroes after it. In the conference call after the market closed, however, Jamie Dimon minced no words in one sense…”bad strategy…badly executed…egregious mistakes,” and minced plenty of words in another sense, namely, that the company’s results could “easily get worse this quarter and there will also be a lot of volatility next quarter.” That seems to indicate that the company hasn’t unwound all its trades related to the London Whale. That sounds like a foreshadowing of the foreshadowing highlighted above in nuclear red.

Jamie Dimon has been a vocal opponent of the Dodd Frank act–probably the Volcker rule in it, which is intended to prevent banks from trading their own funds, and as such, this would seem to be a poorly timed story, and should embolden proponents of Dodd Frank. This makes JPMorgan the poster child with what’s wrong with the biggest banks. As the Financial Times put it, “…the mark-to-market losses came in the bank’s chief investment office, a unit set up to invest excess deposits…” The same story quoted Carl Levin, Democrat senator, as saying the loss was “just the latest evidence that what banks call ‘hedges’ are often risky bets.”

The stock reacted horribly. Mind you, it was no Green Mountain Coffee Roasters (-40%+) overnight on May 3, but it fell by almost 10% on the largest trading volume in at least six years–and those six years include the bankruptcies of Lehman Brothers, Bear Stearns, and many others.

Certain moving averages tend to provide support (i.e. stopping/slowing declines) and resistance (i.e. stopping/slowing accents). Market technicians argue that case, and they–oh, include me–don’t really know why. The market faithful, however, the Fundamentalists, the Efficient Ominiscient Market Hyopthesis folks, insist that moving averages only work because people expect to work…whatever. The stock’s low today was $36.62; the 200-day moving average–arguably the most carefully watched–was at 36.6561…yesterday. See for yourself.

Finally, to end this walk through this vale of tears, there were a couple of memorable quotes on Bloomberg radio today. The first came from Rich Yamerone, who trotted out an old saw, “there’s never just one cockroach,” but the better one came from a name I didn’t catch, and as you’ll gather, it came in the context of viewing JPMorgan Chase as the best of the banks, and Jamie Dimon as the best of the bankers:  “it’s like thinking your neighbor’s a Sunday School teacher and finding out he’s a lap dancer.”

It was in this context that we received notice of a conference call with Dr. David Kelly, Chief Market Strategist at JPMorgan Asset Management. The subject of the May 16 call is, “Market Call: Investing Through a Bumpy Ride.” While the irony of the timing is delicious, here are the bullet points of the call. They serve as a summary of the major concerns of investors:

• The impact of a deeper European recession on financial markets
• Whether softer growth in the U.S. should really raise recession fears
• Whether politicians have too much at stake to allow the “fiscal cliff” to occur
• The fact that a “sell in May” strategy has only really worked during the last two years [GPS: oh, really...?]
• The twin realities of overly conservative investors and valuation opportunities

4:34 pm…Fitch downgrades JPMorgan to A+ [from AA-] and puts it on Watch Negative, suggesting that the most likely direction of further ratings action is downward.

This Week

At least two economic sentiment indexes were released, the Small Business Optimism index, from the National Federation of Independent Business, and University of Michigan Consumer Confidence. Of course, there’s overlap between the two–at least theoretically–as, undoubtedly, some folks surveyed in the U of M survey are small business owners and vice versa. Still, it’s remarkable how similar they look, directionally. Consumers, however, are clearly more spastic.

The monthly JOLTS report (Job Openings Labor Turnover Survey) for March was released today. It showed a jump in the number of job openings, from an upward-revised 3.565 million in February to 3.737 million in March. As you can see below, it jumped to the top of the regression channel, which had been on the chart before this month’s figure. The biggest jumps were in Construction (+31.5%), but which is the smallest of the groups measured, and Manufacturing (+20.3%); the only shrinking openings were in Government (-6.5%). Here’s the overall index.

Initial Jobless Claims fell by a 1,000 this week, stabilizing a big drop from last week and returning the indicator to the bottom end of the range it’s been in since the beginning of the year. The closely-watched four-week moving average turned down, but it probably couldn’t help but turn down after last week’s–oh, I’ll say it–plunge. There is still the slightly postive upward–which is bad–trend to deal with, but it’s almost flat.

Next Week

Key indicators to watch

• Consumer Price Index
• Industrial Production
• Capacity Utilization
• Initial Jobless Claims
• Leading Economic Indicators
• Minutes of April 25, 2012, FOMC meeting

Regional surveys

• Empire State Manufacturing index
• Philly Fed

Housing indicators

• NAHB Housing Market Index
• MBA Mortgage Applications
• Housing Starts
• Building Permits
• Mortgage Delinquencies
• MBA Mortgage Foreclosures

As a reward for making it this far…

Graig Stettner, CFA, CMT
Chief Investment Officer
Tower Private Advisors

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He spent a fair amount of time rehashing the problems of Europe. He suggested that if you multiply its problems by a large number you get the world’s problems. Europe’s problems are:

1. Too little growth
2. Too much debt (in the wrong places, the weaker countries)
3. Too much economic dispersion (Spanish unemployment = 25%; Germany = 5.5%)
4. Lack of competitiveness

What follows is a stream of consciousness disjointed, badly-taken notes.

He described the problems with Europe as an infection in one’s toe. While it might be contained, it affects the body, and, left untreated, could leave the body on the operating table.

Range of outcomes for Europe is morphing from a bell-shaped distribution to a Bactrian camel–the two-humped kind–shaped distribution. Think of it as as high probabilities surrounding two outcomes–or two bell shaped curves. The one outcome is Europe becoming stronger; the other, weaker. PIMCO’s view is that Europe “tips” stronger, but that if it tips to the weaker, it tips hard that way. A stronger Europe is either a re-founded Europe or a smaller Europe( i.e. 14-15 countries.) A weaker Europe is a lower–albeit not de minimus–probability, a probability of fragmentation. Either way it’s a bumpy ride.

We’re living in the midst of a global realignment, a time of many Monty-Python-like flesh wounds. It’s not a time to go all to cash, but it is a time to think differently. Investors need to be able to navigate the “great escape.”

PIMCO likes companies with:

1. Lots of cash
2. Low leverage
3. High operating margins
4. Exposure to growth markets

They do not like investing in broad markets unless the tail risk is hedged away.

PIMCO likes the countries that are the cleanest dirty shirts. If all your shirts are dirty you grab the cleanest one. Those countries are Germany (“it’s the AAA of AAAs”) and the U.S. for now.

His advice included getting rid of unconscious biases. He talked about a PIMCO session in which a video was shown of folks tossing a basketball around. While they were counting passes a gorilla walked through. Made to feel silly for missing the gorilla, the next time a similar video was shown, Mohammed was dialed in, looking for the gorilla. This time, he missed the child walking through with a red umbrella.

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He spent his time talking about the world’s debt problems, but particularly the U.S.’s. By his reckoning, our ratio of debt:GDP is 350%, and we’re headed toward Japan’s 450%. Since 2000, the U.S. has added 100% to the ratio, while real household incomes are no higher; we’re getting less and less bang for the buck (of leverage.) While the smart people said how fortunate we were to have a Depression expert–in Ben Bernanke–on the job in 2008. Lacy says we needed the expert in 2000, before the debt ramped up.

His solution is austerity. He gave no quarter in a question about whether the Keynesians were right in stimulating the economy in 2008. Well, he conceded that the economy had to be saved, but everything they’ve done since then has been harmful.

With respect to investing, he said that in past periods of overindebtedness, bonds outperformed stocks for 20 years, and he wouldn’t be surprised to see the 20-year period extend longer, given our extreme overindebtedness; therefore, he remains bullish on bonds.

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He began by talking about his reputation as a perma-bear–at least with repect to equities. Instead, he said his biggest focus is always on risk, as in risk-adjusted returns, thus earning himself the perma-bear moniker. In determining his outlook he looks at the “market’s message.” For example, what does the 3-month Treasury bill’s yield indicate? A market fraught with risk. In contrast, the mid-teens yields of the early ’80s signaled that equity risks were very low. Indeed, he remains very bullish about bonds. He said income is in short supply, and one should own what’s scarce.

He presented a slide showing the factors most correlated with bond yields, and number one on the list was Federal Reserve monetary policy. Thus, with the Fed on hold–with respect to the Federal Funds Rate–he sees a bullish view on bonds as a natural outcome. In response to the argument that bond yields are [too] low, he asks, relative to what? Because relative to the Fed Funds Rate they’re quite high. He expects the long bond to go to 2%, in which case its total return would be 25%. He also likes corporate bonds, where a 5% default rate is priced in instead of the more realistic 2%, which is the current experience.

He isn’t surprised at all that investors continue to favor bonds over stocks, as measured by mutual fund flows. It’s all about demographics, namely the demographics of retiring baby boomers, who need income. They’ve gone from needing capital appreciation to needing capital preservation. With less than 7% of household assets in bonds, he sees room for that to move higher.

In short, his investment motto is safety and income at a reasonable price.

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The U.S. has created six–as he called them–”killer apps,” a phrase he used to keep his teenage children engaged in the discussion. The trouble is that, since the late ’70s, the emerging world has downloaded them; China has downloaded five of six. The killer apps are:

1. Competitiveness
2. Innovation
3. Rule of law
4. Medicine
5. Consumption society
6. Work ethic

Regarding competitiveness, he pointed out that since 2004, a measure of global competitveness has seen the U.S.’s competitiveness decline while China’s has increased. In innovation, China and South Korea have developed more patents than Germany. Niall argued that the U.S. has not the rule of law, but the rule of lawyers. He called the Dodd-Frank bill a legal-community job creation law. Honk Kong, for example, exceeds the U.S. in 15 of 15 categories. As an aside, the worst of the countries are Italy and Greece. As evidence of the West’s decline in medical leadership, Niall pointed out the change in life expectancies; Russia’s is greater than Scotland (the country of Niall’s birth); Hong Kong and Japan are ahead of the U.S. In work ethic, the average South Korean works 1000 hours per year more than the average German. “if you go on vacation, the Germans are already there, and when you leave, it’s auf wiedersehn.”

He concluded with six questions he thinks are critical for the future.

1. Can the Rule of Law come to China? If not, it’s not out of the woods.
2. Can India go from an economic tortoise to the hare?
3. Will the Muslim world have a Reformation? Can it separate church and state?
4. Can the West overcome the clash of generations? He argued that the Occupy movement and youth, in general, would be better served in the future by becoming more conservative.
5. Can Africa overcome Malthus? Its population growth threatens to swamp its resources. 43% of population growth in the future will come from Africa.
6. Can the resource curse become a blessing? The history of resource-rich nations is not a good one.

In conclusion, “you need to work on your bow.” 500 years of western dominance is over.

In the Q & A session, session, Niall made a few salient points.

Deflation is the dominant force, at present.
The Euro is not doomed. We won’t see the Lira and Drachma come back. The Europe situation is like the worst soap opera ever.
Regarding the possibility of technology rescuing the U.S., Facebook does not equal the Manhattan Project.

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• Earnings season
• Apple
• Economics

Capital Markets Recap

I’ll be at a timely John Mauldin conference next week, and while I won’t be sending out an e-mail alerting you to a new post, I will do some posting of good stuff from the conference. If you check back next Thursday and Friday, I should have some good stuff here. Click on the “Home” button in the upper right-hand corner of this webpage…bookmark it and check back next week.

I’m not smart enough to know what’s going on, but something doesn’t smell right about this week’s market action. The volatility index fell by 10%+; the Gartman Risk On index beat the Risk Off index, and in the U.S. high beta stocks (e.g. small cap) beat low beta (e.g. large cap), and yet Emerging Markets turned in a negative week.

Top Stories

That the problems in Europe are widely digested was evidenced in the markets’ reactions to news that France’s President Nicolas Sarkozy was trailing a challenger who threatened to throw off the shackles of the austerity program foisted upon it by others. It turned out that the Others was Germany. The French CAC index was up 3.83% this week, as was the Spanish IBEX.

We’re in the thick of the Q1 earnings reporting season. With 271 companies having reported, we’re a bit more than halfway through. It starts to taper off now, with 126 companies reporting next week; just 33, the following. The positive surprises total 74.9% of the releases. The biggest surprises are coming from Telecom and Finance, while the biggest earnings disappointments are coming from Utilities and Energy. The best earnings growth is, not surprising, from Information Technology (+23.22% yoy), where Apple resides, and Industrials (+12.93% yoy).

The current run rate of positive surprises looks pretty good on an historical basis, as shown in the chart below.

…but it seems to be as much a function of companies drinking the Kool Aid they’re serving to analysts. The latter group has been ratcheting down earnings expectation, usually in response to company guidance, or the hand-holding they give analysts in meetings and on conference calls. The chart below shows the number of companies raising their outlooks (green line, top chart) and lowering (red line, top chart). The bottom panel shows the difference between the two, suggesting that company sentiment has driven analyst sentiment, and both company and analyst have been surprised by the actual results.

Almost forgot about Apple… Judging by some of the bears on the stock, this was to have been it, the quarter that Apple disappoints Wall Street. Instead, the company crushed the ball. Wall Street expected quarterly earnings per share of $10.045, and the company produced $12.30, a mere 22.45% besting of the analysts. Many had glommed on to the story put forth by one analyst or more that the cell phone companies weren’t going to take it any more, as they were tired of losing money on iPhones, were going to begin charging for early upgrades, etc. Instead, the company sold 88% more iPhones than the same quarter last year; iPad sales more than doubled. Importantly, Apple sales in China made up 20% of its sales in the quarter. A Chinese consumer quoted in a Bloomberg news story “didn’t need it for work,” and “wasn’t planning to use many of its features.” Instead, she bought it because people in her office said she should. Apple’s not-Steve-Jobs CEO, Tim Cook, said that, “it was an incredible quarter in China. It is mind boggling that we could do this well.” Practically speaking, the market yawned. Sure, as you can see below, it rallied by 10%, but that left it well below its April 10 high of $644.

It’s pretty easy to see how analysts have put $1,000+ price targets on the stock. At it’s nose-bleed-inducing price, it’s only selling for 14.7 times trailing earnings. Nike’s P/E…23.05x (56% higher than AAPL). Oh, you say, it’s not a consumer stock? Okay, the average P/E of the First Trust Technology ETF (FXL)? 19.12x.

This Week

There were a number of housing datapoints this week. First, with respect to home prices, the index with the widest coverage, the House Price Index, rose slightly, holding above early-2011-low levels. The Case-Shiller index continues to search for a bottom, as evidenced in the chart below. Both reflect February data.

Second, New Home Sales rose from the figure that was reported last month, but that figure was subsequently revised higher. So, the 328,000 homes sold was less than the upwardly-revised 353,000; the figure was better than the 319,000 that analysts expect, but I suspect they weren’t in on the revision. Pending Home Sales grew by 4.1% in March, well above the 0.4% of the month earlier and the 1.0% that economists expected. The housing picture continues to look quite grim, but there is some hope expressed in a graph of Existing Home Inventories, shown below. We have, essentially, worked off all of the inventory spike that occurred in the housing bubble. There is, however, still some question of the so-called “shadow inventory,” the homes that could become part of the inventory, were banks to initiate foreclosure proceedings.

Some folks have suggested that the unseasonably weather we had been enjoying provided an unexpected but passing boost to the economy. Here it is, sort of quantified. As you may know, it’s possible to buy and sell futures contracts based on weather. Featured below is a related index, U.S. Average Temperature Variance from Normal (bottom chart), along with weekly Initial Jobless Claims (top chart). In the bottom chart, the red portion is where the weather was warmer than normal; green, where cooler than normal. Notice how much warmer 2012 has been than average and compared to 2010 and 2011. How many times did you hear global cooling jokes this winter? That allows a lot of weather-dependent work to be moved up in the year, and just like a sugar buzz, it can fade quickly. Notice the spike in jobless claims (the second chart below.)

The first release of Q1 2012 Gross Domestic Product was released today. It came in at an annual rate of 2.2%, below the consensus estimate of 2.5%, and below the fourth quarter’s 3.0% pace. Consumer Spending grew by 2.9%, well above the 2.3% expected and the prior 2.1%. Lowered Defense Spending and Inventory Stocking were offsets to the strong consumer performance. We wrapped up the week with University of Michigan Consumer Confidence, which rose from 75.7 (economists expected a repeat of that) to 76.4.

Next Week

Key indicators to watch

• Personal Income, Spending, and Saving
• ISM Manufacturing
• ISM Non-manufacturing
• ADP Employment Change
• Non-farm Payrolls (already?!)
• Initial Jobless Claims

Regional indicators

• Chicago Purchasing Manager
• NAPM – Milwaukee
• Dallas Fed Manufacturing Activity
• ISM New York

There will be no formal WR&O next week, but you can check back for some updates late in the weeek.

Graig Stettner, CFA, CMT
Chief Investment Officer
Tower Private Advisors

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• New indexes
• First bit of useful information published on this blog
• JPMorgan entering the anti-Christ league along with Goldman Sachs

Capital Markets Recap

Just one lone patch of green up there, the globe’s largest issuer of debt, the country with almost the world’s worst demographics. Whatever. Please note the addition of two indexes I stumbled across today, the Fisher-Gartman Risk On/Risk Off indexes. At a glance one can see what the market’s mood was for the week. When the Risk On index is up then the switch was set to risk on; if it was down–or, conversely, the Risk Off index was up–then investors dialed down their risk appetite. We’ll be able to look for divergences between those two and the Volatility Index. (They should mimic each other. If they don’t, something might be afoot.)

Top Stories

How would you like to deal with a 35% pay cut? I thought so. Well, you ought to have loads of sympathy for the Blankfein household. Lloyd Blankfein, Chairman and CEO of Goldman Sachs, saw his 2011 pay package decline by a whopping 35% to…well…a whopping $12.4 million (having declined from $19.1 million.) But, hey, it’s all relative; surely you can imagine the terse moments over dinner in the Blankfein home… “well, dear, we’re just going to have to hold off on the new place in the Hamptons–I know, I know, I promised…”

There’s a big slowdown underway in China–at least in relative terms, but which of the G10 countries wouldn’t kill for the problem China has? Data, from the country whose data most people view skeptically, showed that its growth in the first quarter was at an 8.1% run rate, down from 8.9% in the fourth quarter. (The timeliness, alone, of the data makes it suspect. In the U.S., we don’t get the first iteration of quarterly GDP growth until a full month after its end. China’s was available just 13 days after.) Anyway, here you can that the run rate was in the lower half of the last 20 years of data.

That left some economists in a Bloomberg article guessing that the Chinese authorities might yank on the fiscal policy lever to boost the country’s growth. It had previously put on the brakes to slow down inflation there.

Quick–name a stock! Apple. Right. The stock has 59 analysts covering it, and the first sentence of a Bloomberg story sums it up pretty well:

It’s the most intriguing investment question of our time: How high can Apple Inc.’s stock go?

The story goes on to talk about an analyst from [Minneapolis-based brokerage] Piper Jaffray who has been mostly right about the stock. He thinks the stock hits $1,000 in 2014, making it the “first U.S. company worth $1 trillion.” He claims that investors will eventually recognize that Apple is where “tech is headed,” and they’ll move their technology exposure to the stock. Another analyst–obviously a clueless fool–downgraded the stock on April 9 because he thinks that wireless carriers will wise up, realizing they’re losing money with their contract subsidies, and cut the same, hurting sales of iPhones.

Despite the lemming analysts on the stock mostly saying buy, buy, buy, the stock–other than its parabolic rise–doesn’t have the hallmarks of a bubblicious stock. That’s not to say that a parabolic rise isn’t cause for concern. After all, if a rising 200-day moving average defines a company’s secular trend, then Apple could fall to $432, a 29% drop, and still be considered to be in a bullish trend. On the other hand, the stock’s valuation is far from lofty. It’s trading at 17.38x trailing 12 months earnings and just 13.85x the [same lemming] analysts’ earnings estimates. Here’s the first free bit of information on this blog that will actually be valuable to you:

You do not want to pass on your Apple shares to your grandchildren. The obsolescence risk inherent in technology, alone, virtually assures the stock’s relative demise. Some kid in a garage somewhere in California is working on the technology that will do an end-run around Apple. After all, this winsome lass is sporting glasses from Google’s Project Glass, which glasses purport to display the internet an inch in front of one’s eyeball.

Speaking of Google, the company saw its stock pummelled today on news that it would be issuing a stock dividend of non-voting shares. Of course, it also had other news, like sales growth slowed, but that’s aside from the point I want to make here, which has nothing to do with company fundamentals or the stock dividend, but rather that Google is run by two nerdy guys who are unconventional–the company didn’t have an IPO; it had a dutch auction for its shares–because that’s what nerdy guys do: unconventional things. And that’s how Apple will get knocked off its lofty perch. When, is anyone’s guess, however.

Messrs Dodd and Frank must have their undies in a bunch (e-mail Mike Cahill, Tower’s CEO, if that was objectionable to you) over news that JPMorgan has, “transformed the bank’s chief investment office [sic?] in the past five years [hmm...see chart below - GPS], increasing the size and risk of its speculative bets…” The Company hired a new Chief Investment Officer back in 2006 with the doomed-to-failure name of Achilles Macris (I am not kidding.) The same Bloomberg story goes on to say that, “some of Macris’s bets are now so large that JPMorgan probably can’t unwind them without losing money or roiling financial markets.” That refers to the positions of the so-called London Whale, a London-based derivatives trader who was given the moniker, presumably because he can upset the whole financial world with a flip of his metaphorical tail, which might give new meaning to the phrase, tail risk.

In the “past five years…bets are now so large…London Whale” Surely, this is just coincidence, then.

Okay, now before reading further, put all sharp objects out of reach. There. Gary Shilling is an old guy who writes an investment newsletter, and he’s been hugely correct about one investment call he made back in the ’80s. He told his readers to buy a zero-coupon Treasury bond back in the ’80s. He has continued to pound the table on owning the long bond–and he still likes it. Had you taken his advice back then you would have handily beaten the return of stocks. Had you begun subscribing to his newsletter in late 2010 and only had the courage to buy a 30-year zero-coupon Treasury on New Year’s Eve 2010, you would have made a cool 61.6% return in 2011. I am not kidding. Anyway, this silly old man thinks it’s reasonable that stocks could lose 43% in 2011, as the U.S. enters recession and corporate earnings come in at $80 per “share” of the S&P 500. A “likely” P/E ratio of 10 multiplied by the $80 produces an S&P 500 at 800, about 43% below where we are now. On the other hand, this is the same guy who characterizes Apple as being in a speculative bubble, but has no problem recommending a 30-year United States Treasury obligation that pays no interest until 2042. Still…61.6%.

This Week

Reflecting the current soft spot int the economic data, the NFIB’s Small Business Optimism index’s March reading came in below February’s reading (92.5 v 94.3) and well below what economists had expected (95.0). Inflation data was released this week in the forms of the Consumer Price Index (CPI) and the Producer Price Index (PPI). The former showed that prices for all goods and services measured rose at a 12-month pace of 2.7% in March versus the 2.9% pace recorded in February. At the Core level (excluding food and energy prices), prices rose at a 2.3% pace (2.2% in February.) The PPI recorded a 2.8% pace (3.3% in February); exluding food and energy prices, 2.9% (3.0% in February.) Initial Jobless Claims showed an unexpected jump this week (+25,000 versus economists’ expectations of a (-)2,000 drop). Finally, University of Michigan Consumer Confidence fell from 76.2 to 75.7.

Next Week

Key indicators to watch

• Industrial Production
•  Capacity Utilization
• Initial Jobless Claims
• Leading Economic Indicators

Regional surveys

• Empire Manufacturing
• Philadelphia Federal Reserve

Housing indicators

• NAHB Housing Market Index
• Housing Starts
• Building Permits
• Existing Home Sales

Graig Stettner, CFA, CMT
Chief Investment Officer
Tower Private Advisors

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• Spain
• Oil
• Jobs

Capital Markets Recap

Top Stories

Portugal seems like a lost cost, and no ones seems too worried about it. Ireland was dealt with a while ago. Italy is sitting on the sidelines. Greece is done for now, although its bonds yield something like 16%, which isn’t exactly a confidence-inspiring interest rate for a sovereign nation. Spain, however, is quickly becoming the country to worry about. Here is what its Prime Minister had to say this weeek:

April 4 (Bloomberg) — Prime Minister Mariano Rajoy said Spain’s situation is one of “extreme difficulty” and signaled that his budget cuts are less painful than a bailout would be, as demand for the nation’s debt slumped at an auction.

“Spain is facing an economic situation of extreme difficulty, I repeat, of extreme difficulty, and anyone who doesn’t understand that is fooling themselves,” Rajoy told a meeting of his People’s Party today in the southern coastal city of Malaga.

Rajoy raised the threat of an international bailout for the second time this week as he sought to defend the deepest austerity moves in at least three decades. While “no one likes” the budget presented last week, he said “the alternative is infinitely worse.”

As you know, Credit Default Swaps are insurance against default, and their pricing–for CDSs of equivalent tenor (e.g. 5-years)–allows for apples to apples comparisons. Recently default insurance on Spanish sovereign debt exceeded that on Italian debt, reversing the normal pattern of the two, which can be seen below.

With that, Spain moved into the #3 slot in the world’s list of nations most likely to default on their 5-year debt, as can be seen below. Do you notice something incongruous? Spanish debt is rated A by S&P, A3 by Moody’s, and A by Fitch, while its PIG peers are rated BBB. I think some downgrades are coming.
Something isn’t right in the oil patch. This week, data released for last week showed that crude oil inventories nearly reached their highest levels since before the first Gulf War, as can be seen below, yet there’s talk of releases of petroleum from strategic reserves. What’s that all about? Votes? Awww, come on…

Using a simple linear regression fitted to the relationship between inventories and crude oil prices, shown below, we can see that West Texas Intermediate crude oil ought to be selling for little more than $80, indicated by the red arrow. It’s called a simple regression for a good reason, however: it leaves out a lot of stuff. The R2 figure in the lower right-hand corner of the chart indicates that inventory levels explain just 24.5% of prices.

Historically, inventory levels have not been predictive of oil prices, as shown in the chart below; they’re just one factor. The thing that will be a catalyst for oil moving either direction will be Iran.

This Week

It’s the first week of a new month, and that means it’s time for the monthly Nonfarm Payrolls report. For a while now–basically, since the beginning of the year–economists have been too optimistic; they’ve been overestimating the strength of the economy. That’s shown below where the Citigroup Economic Surprise index has rolled over and is heading downhill.

That really came home to roost today, when economists totally whiffed on the release. Instead of the 205,000 that the lemmings had expected, the actual release was 120,000. (The most bearish economist expected 175,000 jobs to have been added.) Instead of 215,000 Private Payrolls increase, the release was 121,000. (Who can blame them? ADP’s Employment Change index, released on Wednesday, said 209,000 private payroll jobs had been added, better than the expected 206,000.) Initial Jobless Claims hit another four-year low this week, as shown below.

There is no joy in Mudville today, as it’s difficult to put a positive spin on things. The Average Work Week declined modestly. The Household Employment survey showed a decline of (-)31,000 jobs, in marked contrast to February’s 428,000 gain. To be fair, there was good news in Manufacturing Payrolls, which rose by 37,000 versus an expectation of 20,000, but that’s just 0.026% of the number of folks employed.

Through the magic of math, however, the Unemployment Rate fell to 8.2%, from 8.3% in February. Here the formula, in all its conspiratorial glory:

Of course, U.S. stock markets are closed today…sorta. So while they are, let’s conduct a thought experiment, something of which Einstein was fond. The talking heads of financial television and other outlets attributed Wednesday’s drop in stocks (and bonds) to the minutes of the March 13 meeting of the FOMC. Those minutes apparently threw cold water on the notion of Quantitative Easing, Round 3 (aka QE3).

NEW YORK (Dow Jones)–The Treasury bond market Tuesday suffered the biggest selloff in nearly three weeks as a report from the Federal Reserve put a damper on the prospects of a new bond-buying program to stimulate the economy.

The Federal Open Market Committee minutes for the Fed’s policy-setting committee’s March meeting showed no rush to add to its unconventional monetary stimulus that has been a key supporter of the Treasury bond market. As a result, bond prices tumbled across the board, led by the seven-year to 10-year maturities.

The benchmark 10-year Treasury yield, which moves inversely to its price, shot up to as high as 2.299%, the highest in more than a week, from 2.18% right before the release.

“There are definitely quantitative easing bets being taken off the table,” said Anthony Cronin, a Treasury bond trader at Societe Generale SA in New York, who correctly bet that bond prices would fall on the minutes.

If you’re from Mars, here’s what quantitative easing is. In short, the Federal Reserve buys stuff, usually bonds, and interest rates decline. Two things just happened. First, somebody’s now got cash, which earns zero. Second, savers are earnings less on their deposits. That cash presumably goes in search of higher yields. Perhaps the folks with cash go and buy corporate bonds, for example. That results in lower corporate bond yields and, all else equal, as it never is, it now costs corporations less to borrow, thus stimulating the economy. Faithful savers get tired of earning 0.01% on their deposits and, in a fit of madness, go and buy junk bond funds. As in our example above of all-else-equal-but-it-never-is the economy is stimulated.

Here’s a far better–and far more entertaining–explanation of what quantitative easing. If you’ve heard the phrase, “The Ber-nank,” this is where it comes from. It’s old, circa 2010, so you might already have seen it. It’s not new.

Now, back to our thought experiment. The market allegedly sold off on Wednesday because the Federal Reserve thought the economy was too strong to merit another dose of QE. If the economy’s weak, therefore, the Federal Reserve ought to favor more QE, and that ought to be favorable for stocks, right? Wrong. While markets are closed today, the S&P e-mini contract traded until 9:30 this morning, and it was off by 15.3 points (-1.101%), while the Dow Jones Industrial Average was down by (-)131 points (-1.009%). It went straight down after the payrolls figure was released.

Once again, the commentators got it wrong. There was also news, Wednesday, of trouble brewing in Spain, yet the FOMC Minutes got the credit/blame. Covering for itself, Bloomberg news reported today that the reason that stocks (futures) fell today was because of weakness in the economy.

Faster employment growth that leads to bigger wage gains is necessary to propel consumer spending that accounts for about 70 percent of the economy. Today’s data also showed Americans worked fewer hours and earned less on average per week, helping explain why Fed policy makers say interest rates may need to stay low at least through late 2014.

Next Week

Key indicators to watch

• NFIB Small Business Optimism
• JOLTS – Job Openings Labor Turnover Survey
• Federal Reserve Beige Book
• Producer Price Index
• Consumer Price Index
• University of Michigan Consumer Sentiment

Graig Stettner, CFA, CMT
Chief Investment Officer
Tower Private Advisors

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This post is intended to provide good sources of investment information–from both internet and other resources. It’s intended, primarily, for a class of handpicked students in the International Business course at Indiana University – Purdue University, Fort Wayne. It will be periodically updated and will be found in the IPFW Post Category.

Cumberland Advisors, while not presently maintaining a blog, makes periodic e-mails available at no charge just for signing up here. While not a blog, the Market Commentaries link will take one to commentaries going back to April 2010.

The Economist, while one of the driest magazines–or newspaper as the Brits call it–has the best coverage of international goings on. Its online presence isn’t bad either, as evidenced by its Daily Chart blog. The magazine’s website is available here.

The McKinsey Quarterly is a publication of McKinsey & Company. Some of the issues in its dispatches deal with international matters, including this one on India, in particular.

Barry Ritholz’s Big Picture blog is one of the more widely followed blogs, and careful use of the search function can turn up postings valuable to a study of international investing. Ditto for John Mauldin‘s website. In addition, John’s weekly e-mail distributions are more than worth the price. It’s one of the best internet freebies I’ve found.

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I’ve been seeing this one a lot, especially in relation to various national economies. This is how The Economist magazine used it in last week’s issue in an article titled, Unmired at last:

But it has also been due to the hangover of the recession: consumers have been shedding debt, lenders have been reluctant, housing markets have been moribund, and state and local governments like Mr. Fesler’s have been cutting budgets in the face of prohibitions on deficits.

‘Thought you ought to know what it means.

Graig Stettner, CFA, CMT
Chief Investment Officer
Tower Private Advisors

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