BONDS

INFLATION WATCH

Producer Prices Inch Downward The prices businesses receive for their goods and services fell in February, a sign of weak inflationary pressures in the economy.

The producer-price index, which measures price changes for everything from food to energy to transportation services, decreased 0.1% from the prior month, the Labor Department said Friday. That compared with the 0.2% rise forecast by economists and which the index registered in January.

Excluding trade services, as well as food and energy, which can also be volatile, the index rose 0.1%, the same rate of increase as in January.

The index rose 0.9% in February from the same period a year ago, down from a 1.2% annual increase posted in the prior month.

“Underlying inflationary pressures are clearly very tame, and we rule out that any substantial upward movement will be registered near term,” said Annalisa Piazza, an economist at Newedge Strategy.

Hmmm…”clearly very tame”? Strong statement that goes right along the main prevalent narrative. But I find that inflationary pressures are far from being clearly very tame.

Consider that:

• The old measure of producer prices, which excludes the categories included in its latest revamp, is now known as “finished goods.” The category rose 0.4% in February after rising 0.6% the prior month (+6.2% annualized).
• The new FD-ID system highlights the index for final demand, which measures price changes for goods, services, and construction sold to final demand: personal consumption, capital investment, government purchases, and exports. The composition of products in the final demand price index differs from that of the previous headline index, finished goods, in two major respects. First, it includes government purchases and exports. Second, it includes services and construction, which are not reflected in finished goods.
• The decline in February’s PPI was largely driven by final-demand trade services, a measure of changes in margins received by wholesalers and retailers. This volatile category fell 1%, its largest decline since May. Over 80% of the February decrease in the index for final demand services can be attributed to margins for apparel, footwear, and accessories retailing, which fell 9.3 percent.
• In contrast, prices for final demand goods advanced 0.4 percent, for the third consecutive months, a 4.9% annualized rate over the last 3 months. A major factor in the February advance in the index for final demand goods was prices for pharmaceutical preparations, which rose 0.9 percent. The indexes for dairy products, residential natural gas, liquefied petroleum gas, soft drinks, and eggs for fresh use also increased.
• Core goods (ex-food and energy) prices were up 0.2% totalling a 3.6% annualized rate of increase over 3 months.
• Moreover, there are rapidly rising prices in the pipeline. The index for processed goods for intermediate demand moved up 0.7% in February, following advances of 0.6% in January and 0.5% in December. This is a 7.4% annualized rate over the last 3 months. The broad-based rise in February 2014 was led by the index for processed materials less foods and energy, which climbed 0.6%. In addition, prices for processed energy goods and for processed foods and feeds increased 1.0% and 1.1%, respectively.

In other words, excluding government-related goods and services and declining retail margins due to weak demand, producer prices are rising at a high and accelerating rate. This during the very months when demand was apparently weak due to severe weather. Producer prices were not frozen, to say the least. And while services are a significant part of consumption and CPI, services prices are very sensitive to trends in wages which are also showing an inclination to accelerate (see Goldman Sachs chart below). If you “rule out that any substantial upward movement will be registered near term”, you may get very surprised near term.

Friday’s Good Read post (Identifying with a particular narrative can lead investors to make poor decisions) is particularly relevant here.

Euro-Zone Inflation Lower Than First Estimated

The European Union’s statistics agency Monday said consumer prices in the 18 nations that share the euro were 0.3% higher than in January, and 0.7% higher than in February 2013. Eurostat last month estimated that the annual rate of inflation was unchanged at 0.8% in February.

  Unfortunately, Eurostat does not make it easy to dig into the data. But a casual look at the table below reveals that core inflation has been accelerating in January and February. In fact, core inflation was +1.0% in February from +0.7% in December. Even services prices are accelerating. So, when the FT writes that “Revised figure adds to worries about threat of deflation”, it reinforces what seems to be a false narrative endorsed by most everybody..

This is in Draghi’s “island of stability”. And that too:

• German Firms Face Risk Over Russia German businesses and politicians for decades worked hand-in-hand to improve ties with Russia. But those common interests appear to be waning as Merkel threatens trade sanctions over Ukraine.

• Linde Pressured by Euro Strength

Yuan Weakens as PBOC Doubles Trading Band China’s yuan weakens after the central bank doubled the currency’s daily trading band against the U.S. dollar, a major step toward making the yuan a freer currency.

(…) The currency fell 0.5% to 6.1781 per dollar Monday, one of its biggest slides in a decade and on the first day of trading where it is allowed to trade in a 2% range. Losses on the offshore yuan accelerated as it hit a 10-month low of 6.1688 against the U.S. dollar, with a higher number meaning a lower yuan. The People’s Bank of China, the country’s central bank, widened the trading band from 1% a day on Saturday.

The sudden move lower is heightening concern over financial derivative products turning sour. Traders and analysts say banks are asking clients that have taken out such trades to boost their collateral and are getting inquiries from companies’ about restructuring these leveraged bets.

The value of these derivative products come from complex calculations using the current exchange rate, volatility and time remaining on the options contracts. The bets were based on the assumption the yuan would stay on its steady path upward after rising 2.9% last year. But the yuan has dropped 2% this year, accompanied by wider price swings, meaning the contracts are worth less and for some are turning into losses. (…)

FYI:

    

SHARE BUYBACKS DO NOT BOOST INDEX EPS

Howard Silverblatt, S&P Senior Index Analyst, explains why, contrary to widespread belief, buybacks do not boost S&P Index earnings per share:

Buybacks do not increase S&P 500 Index earnings-per-share (EPS), the Dow is a different story.

On an issue level, share count reduction (SCR) increases EPS, therefore reducing the P/E and making stocks appear more ‘attractive’. SCR is typically accomplished via buybacks, with the vital statistic being not just how many shares you buy, but how many shares you issue. In the most recent Q4 2013 period we saw companies spend 30.5% more than they spent in Q4 2012, though they purchased about the same number of shares. The reason is (in case you didn’t notice), that prices have gone up, with the S&P 500 up 29.6% in 2013, and the average Q4 2013 price up 24.7% over Q4 2012. Many companies, however, appear to have issued fewer sharers, and as a result have reduced their common share count. The result is that on an issue level it is not difficult to find issues with higher EPS growth than net income (USD) growth. A quick search found that over 100 issues in the S&P 500 had EPS growth for 2013, which was at least 15% higher than the aggregate net income. The result for those issues, were higher EPS and a lower P/E.

On an index level, however, the situation is different. The S&P index weighting methodology adjusts for shares, so buybacks are reflected in the calculations. Specifically, the index reweights for major share changes on an event-driven basis, and each quarter, regardless of the change amount, it reweights the entire index membership. The actual index EPS calculation determines the index earnings for each issue in USD, based on the specific issues’ index shares, index float, and EPS. The calculation negates most of the share count change, and reduces the impact on EPS.

The situation, however, is the opposite for the Dow Jones Industrial 30. The Dow methodology uses per share data items. So if a company reduces its shares, with the impact being a 10% increase in earnings (as an example) with a corresponding 5% increase in net income, the Dow’s EPS will show the increase in EPS. Again, the impact would be mostly negated in the S&P 500. This is not to say that buybacks don’t impact stock performance, and therefore the stock level of the indices (and price is in P/E). It is only to say that the direct impact on the S&P 500 EPS is limited, even as examples on an issue level are becoming easier to find.

WINTER WOES

Searching through all earnings conference call transcripts for S&P 500 companies between January 1, 2014 and March 12, 2014, the term “weather” was mentioned at least once in 195 conference calls. This number reflects an increase of 81% over the year ago period (January 1, 2013 through March 12, 2013), when the term was mentioned in 108 conference calls. At the sector level, the Energy, Consumer Discretionary, and Industrials sectors not only had the highest number of conference calls in which the term was used, but also the highest year-over-year growth in absolute numbers. (Factset)

The count for the number of times economists have mentioned “winter” continues…

SENTIMENT WATCH

Haunted by the Bull That Got Away

The pain of missing out on the tripling of the U.S. stock market since March 2009 has become almost unbearable for many investors who have been watching from the sidelines, financial advisers say.

Some who got out of stocks five years ago are fixating on how much richer they would have been if they had stayed put. Others are suffering the social distress of listening to friends bragging about their bigger returns. (…)

Jim MacKay, of MacKay Financial Planning in Springfield, Mo., says two couples who are new clients of his firm both took nearly all their money out of U.S. stocks in late 2008 and early 2009 and have kept it in cash ever since.

After U.S. stocks returned 32% last year, Mr. MacKay says, these couples are asking themselves, “Uh-oh, what have we done?” They asked to put at least half their money back into stocks—all at once.

Several other financial advisers told me this past week about clients who are chafing to move most or all of their money into stocks. Often, those who lost the most in 2008 and 2009—and begged to be taken out of stocks entirely—are the most eager to pile back in now.

“Some investors have an overwhelming, self-defeating desire to adjust their asset allocation based on recent past results,” says Frank Armstrong, president of Investor Solutions, a financial-advisory firm in Miami. “While markets are reasonably efficient, many investors are hopelessly inefficient.” (…)

Recent gains or losses change how the human brain assesses risk, according to a study that will appear later this year in a well-regarded psychology publication, the Journal of Economic Behavior & Organization.

People were roughly 20% more likely to take a gamble after either a gain or loss than after a neutral outcome, the study shows. During the experience of profits and losses alike, several regions of the brain involved in emotion became more active, while activity dwindled in areas devoted to executive decision-making.

“The experience of gain or loss appears to reduce your deliberation, how much you think about and pay attention to your decisions,” says neuroeconomist Kaisa Hytönen of the Aalto University School of Science in Espoo, Finland, the lead author of the study. “That relative lack of deliberation may be driving you to take more risk in your future choices.”

In this experiment, a loss didn’t mean going into the red—just missing out on a bigger gain. Earlier research has demonstrated that a near miss can prod you into taking much bigger risks than you might otherwise have been willing to run.

How can you take some control over your investing regrets?

First, engage in what Eric Johnson, a psychologist and director of the Center for Decision Sciences at Columbia Business School, calls “therapeutic reframing,” or looking at the same evidence from a different angle.

If you are kicking yourself for having gotten partly out of stocks, focus on the fact that you didn’t get out entirely. Instead of lamenting how much higher your returns would have been over the past five years if you hadn’t reduced your stock exposure in 2008 or 2009, take a moment to calculate how much lower your performance would have been had you sold out completely.

And if you feel you absolutely must buy more stocks to catch up, do so gradually by tiptoeing in over the next year or two in equal monthly installments—as Mr. MacKay, the financial planner, is doing for his clients.

That is especially important when you bear in mind that U.S. stocks fell 57% between 2007 and 2009; if you couldn’t stand that pain then, you have no business clamoring to buy stocks now.

Tiptoeing your way back in, rather than plunging in with both feet, will leave you with a lot less regret if the market goes off a cliff like that again.

Another way, get some cortisol:

Talk about animal spirits. Researchers in the U.K. and Australia have found that a sustained increase in cortisol, a stress hormone that surges in the face of a hungry tiger or a menacing stock market, makes people much more risk-averse financially.

The finding is built in part on previous research involving professional traders in London: Those with higher levels of testosterone in the morning racked up higher profits for the day. But the scientists also found that eight days of market volatility raised the traders’ cortisol levels by 68%. (…)

The findings suggest that the human endocrine system, which secretes hormones, may play an important role in magnifying the effects of financial panics, such as the one of 2007-2008, by making people temporarily more risk-averse—possibly against their own better judgment. Cortisol at such times could fuel a flight to safety among investors and damp buying, further driving down prices and exacerbating a crash. (“Cortisol Shifts Financial Risk Preferences,” Narayanan Kandasamy, John Coates, seven other authors. Proceedings of the National Academy of Sciences (Feb. 18) (WSJ)

Or, if cortisol is not readily available, simply read this:

The Inside Scoop: Officers and Directors Are Bearish Corporate insiders are far more pessimistic than they were last summer, and that could bode badly for the stock market.

Corporate insiders are more bearish than they have been at least since 1990. (…)

Note: This record bearishness isn’t evident from the insider indicator that gets widespread attention on Wall Street—the ratio of shares of company stock that insiders have recently sold to the number they have bought.

According to the Vickers Weekly Insider Report, published by Argus Research, this sell-to-buy ratio, when applied to transactions over the previous eight weeks, is higher than average but no higher today than it was one year ago—when the S&P 500 was poised to produce an impressive double-digit gain.

And in late 2003, just as the 2002-07 bull market was gathering steam, the insiders’ sell-to-buy ratio rose to even higher levels than it is today.

But this measure is misleading, says Nejat Seyhun, a finance professor at the University of Michigan who has extensively studied insider behavior. That is because it uses a government definition of insiders that includes a group of investors whose past transactions, on average, have shown no correlation with subsequent market moves: those who own more than 5% of a company’s shares. (…)

Mr. Seyhun strips out the largest shareholders from the sell-to-buy ratio, and that adjusted figure shows the current record level of insider bearishness. According to his calculations, corporate officers and directors in recent weeks have sold an average of six shares of their company’s stock for every one that they bought. That’s more than double the average adjusted ratio since 1990, when Mr. Seyhun’s data begin.

One year ago, Mr. Seyhun’s adjusted ratio was solidly in the bullish zone, he says. And in late 2003, the ratio was more bullish still.

The current message of the insider data “is as pessimistic as I’ve ever seen over the last 25 years,” he says. What makes this development so ominous, he adds, is that, while no indicator is perfect, his research has shown that “the adjusted insider ratio does a better job predicting year-ahead returns than almost all of the better-known indicators that are popular on Wall Street.”

There have been two prior occasions when the adjusted insider ratio got almost as bearish as it is today—early 2007 and early 2011. (…)

Given that there is a lot of gray area in the application of the insider-trading laws, insiders often sell well in advance of perceived trouble coming down the pike to avoid the appearance, and potential legal liability, of selling right before bad news about their company hits the market. So it doesn’t mean the market as a whole is set to decline immediately.

This suggests there isn’t any need to immediately sell your stocks. However, you might want to get ready to sell any of your current holdings if and when they reach the price targets you set when purchasing them and park the proceeds in cash rather than immediately reinvesting them in other stocks.

Among the stocks you should be looking to sell are those in industries whose officers and directors are selling particularly aggressively. These sectors, according to Mr. Seyhun, include capital goods, technology, consumer durables (such as automobiles, construction and appliances) and consumer nondurables (food and beverages, clothing and tobacco).

If you nevertheless insist on putting new money to work in the stock market, you might want to favor those sectors whose insiders aren’t especially pessimistic, including the aforementioned energy, industrials and financials. (…)

There you go! You just saved money on psychologists and cortisol.

BTW, being less uncertain does not make one more optimistic (chart from WSJ)

And now, this other hot stuff:

Fresh Corporate Debt Sparks a Feeding Frenzy Buyers of Recent Deals Able to Flip Bonds for Quick Profits

(..) Once sedate affairs, large corporate-bond sales increasingly resemble hot initial public offerings, featuring investor jockeying, first-day price pops and frenetic aftermarket trading. The strong demand has fueled record issuance, aiding borrowers by enabling them to negotiate low rates even when raising large amounts, while boosting the finances of banks that arrange the deals.

Many buyers of recent jumbo deals—including Apple Inc. AAPL -1.12% ‘s $17 billion offering last April, Verizon Communications Inc. VZ +0.11% ‘s record-setting $49 billion issue last September, and even struggling municipal borrower Puerto Rico’s $3.5 billion bond sale this month—were able to flip some of the debt for quick profits, bolstering their returns and leaving left-out fund managers steamed. (…)

A record $1.47 trillion of corporate bonds were sold into the U.S. market last year. The week ended March 7 was the second-busiest ever in the U.S., behind only the week of the Verizon deal last September, in Dealogic records going back to 1995.

Many investors “routinely settle for being under-allocated,” or receiving fewer bonds than they sought, said Christopher Sullivan, chief investment officer at the United Nations Federal Credit Union, which oversees about $2.25 billion.

Back to the future:

Adjustable-Rate Mortgages Make a Comeback Adjustable-rate mortgages, one of the main culprits of the housing crisis, are back in vogue. But banks say this time is different.

(…) Financial groups are sweetening terms to entice customers to take out these loans, known as ARMs, whose rates can jump after a few years. Some ARMs are cheaper, when compared with fixed-rate mortgages, than they have been in more than a decade.

The tactics are reminiscent of the period before the 2008 crisis, when ARMs exploded in popularity as banks and mortgage brokers touted their low initial rates to consumers.

Now, though, financial executives say they are focusing on borrowers with strong credit who are using the loans to take out large “jumbo” mortgages—and not so-called subprime borrowers, who used the loans to stretch their buying power as far as it could go.

ARMs comprised 31% of mortgages in the $417,001-to-$1 million range that were originated during the fourth quarter of 2013, according to data prepared for The Wall Street Journal by Black Knight Financial Services, formerly Lender Processing Services, a mortgage-data and services company. That is up from 22% a year earlier and the largest proportion since the third quarter of 2008.

On mortgages of more than $1 million, 61% were ARMs, up from 56% a year earlier. (…)

Banks are betting rates will rise high enough for them to offset any interest they give up in the first few years. Borrowers are betting rates will either stay relatively low, or that they will sell their homes before their interest adjusts higher. (…)

Some smaller lenders such as credit unions are targeting retirees and other borrowers who are looking for superlow rates. And banks increasingly are offering interest-only ARMs, which require customers to make payments only on the interest for as long as 10 years, and which were among loans that caused problems for subprime borrowers during the crisis. (…)

Citi Private Bank says about half of the ARMs it is originating are interest-only, and the Bank of New York Mellon Corp.’s wealth-management group says most clients who sign up for ARMs receive the interest-only feature. (…)

Many banks hold ARMs on their books rather than sell them to government-backed finance firms, as they often do with more conventional mortgages. That means that when the loans’ rates eventually reset, they stand to reap the benefits of larger interest payments from borrowers.

(…) The average credit score for borrowers who took out ARMs in the fourth quarter of 2013 was 762, compared with 693 in the same period in 2006, according to Black Knight Financial. (…)

The average rate on one type of jumbo ARM was 2.91% for the week that ended March 7, or about 1.5 percentage points lower than for the 30-year fixed-rate jumbo, according to mortgage-info website HSH.com. That difference, which has mostly held since November, is the largest since 2003.

Rates on some of the most popular ARMs can increase by a maximum of six percentage points after the fixed-rate period ends, depending on how high their benchmark rate rises.