Edge and Odds

The enemy of knowledge is not ignorance, it’s the illusion of knowledge (Stephen Hawking)

It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so (Mark Twain)

Edge and Odds

Invest with smart knowledge and objective odds

NEW$ & VIEW$ (12 FEBRUARY 2016)

U.S. Jobless Claims Fall 16,000 to 269,000 The number of Americans filing for first-time unemployment benefits fell last week, another sign of the domestic job market’s resilience in the face of economic turmoil overseas.

021116 Initial Claims SA(Bespoke Investment)

Risk Grows of Markets Sparking Recession While current U.S. economic data show no recession, market turmoil speaks to deeper problems and could spark a recession, writes WSJ chief economics commentator Greg Ip.

Greg Ip enumerates the numerous uncertainties currently driving P/Es down.

Is the U.S. headed for recession? The markets suggest so.

With Thursday’s selloff, the Dow Jones Industrial Average is now down 14.5% from its all-time high last May. Yields on risky bonds continue to climb, while investors have sought safety in U.S. Treasurys, sending those yields lower. And oil has hit a nearly 12½-year low.

Yet the economic data show no recession. Job growth in January was healthy, and employers are having trouble filling vacancies.

This dichotomy is neatly captured by two indexes compiled by Cornerstone Macro. One, using financial indicators such as the stock market and corporate bond yields, puts the probability the U.S. is now in recession at 50%. The other, which adds in macroeconomic data such as loan delinquencies and inflation-adjusted income, puts the probability at just 28%.

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Of course markets often wrongly predict recessions. But in some circumstances they can help bring them about. Economic turning points are unpredictable because they are caused by changes in psychology, not just mechanical factors such as interest rates and wages and salaries. Markets influence that psychology by signaling to businesses whether they should invest or hire. Fear of recession can thus be self-fulfilling.

It’s not just anxiety about growth and oil prices that’s weighing on investor psychology. There’s also policy. Will the Federal Reserve press ahead with raising interest rates? Will China devalue the yuan again? Will Britain leave the European Union? Will Americans elect a populist president who seeks to overturn the existing economic order? Policy uncertainty has created a “risk premium” that reduces what investors are willing to pay for stocks and bonds. (…)

Market turmoil can, of course, dent economic growth by leaving consumers less wealthy and depriving business of credit. The Fed’s twice-annual Monetary Policy Report, released Wednesday, shows no evidence of the sort of crisis that would shut off credit to business: Short-term funding markets are operating normally. And for most families, the loss of stock-market wealth is less important than last year’s rise in home prices.

Yet yields on bonds such as those issued by energy companies have risen by more than likely defaults can justify, and banks have begun tightening underwriting standards.

Such shifts in financial conditions can then produce outsize shifts in consumer and business behavior.(…)

Declining markets, worsening psychology and economic weakness can feed on each other. If such a vicious spiral threatened to pull the economy into recession, central banks step in as circuit breakers. These days they are less equipped to do that. (…)

Still, the bigger worry isn’t whether the Fed will stop raising rates, but whether it can, if needed, cut them enough to make much difference. (…) Will negative rates actually help? Or will they just undermine bank profits?

Policy uncertainty hurts in other ways. European bank stocks are getting hammered in part over fears that regulators will force some banks to convert debt to equity, diluting shareholders, to maintain their capital buffers. Ironically, regulators made such conversions part of their tool kit for protecting taxpayers from bailouts in financial crises. But, as Krishna Guha of Evercore ISI notes, the result is “pro-cyclical,” meaning it aggravates rather than relieves stress. Banks whose stocks are getting pounded are less likely to lend.

Political uncertainty looks to get worse this year rather than better. The U.K. is likely to vote on whether to leave the European Union; if it decides to go, Scotland may then vote to leave the U.K. And the victories of Republican Donald Trump and Democratic candidate Bernie Sanders in the New Hampshire primary this week raise the odds that Americans may elect a populist president in November on a platform of radical economic change.

“Investors can’t dismiss the odds of an extreme election outcome that poses major risks to the stock market,” said Andy Laperriere, a political analyst at Cornerstone Macro.

Two views from Moody’s:

  • High-yield’s wider than 800 bp spread serves a warning

Though the latest swelling of the high-yield bond spread warns that the risks to business activity are to the downside, it offers no assurance of an impending recession. After averaging 776 bp in January 2016, the US high-yield bond spread has averaged 836 bp thus far in February.

The record shows that the high-yield bond spread’s month-long average has climbed above 800 bp on only four previous occasions: August 2008, July 2002, November 2000, and October 1990. In three of those four incidents, the US was about to enter or already in a recession.

The one exception was July 2002. Despite how the high-yield spread’s month-long average eventually peaked at the 1,059 bp of October 2002, a then young economic recovery survived and would not expire until November 2007.

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The HY market sure looks like a candidate for “Buy Low”…

  • Equities have yet to signal recession

The market value of US common stock (Dow Jones’ “Total Stock Market” index) recently sank by -11.7% since year-end 2015 and by -13.6% from a year earlier. The record suggests that a recession is likely when the moving three-month average of the market value of US common stock plunges by at least -10% annually at least two years after the end of the latest recession.

Since 1968 for those spans more than two years after a business cycle bottom, April 1988 through October 1988 was the only episode where a deeper than -10% yearly drop by the market value of US common stock’s three-month average was not accompanied by a recession. Currently, the good news is that the latest moving 13-week average of the market value of US common stock is off by merely -3.5% annually. However, for the five-trading-days-ended February 10, the market value of common equity plunged by -10.8% year-over-year. Thus, vigilance is in order.

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More doomsayers:

“Global markets are now facing a significant ‘negative wealth effect’ that has a potential to result in a recession. This negative wealth effect of low commodity prices and a strong USD combined with the slowdown in China could be comparable to that of the 2008/2009 crisis (it involves diverse effects ranging from layoffs in the Global Energy sector to a lack of EM Sovereign wealth flowing into developed market equity hedge funds). While the economists were debating if the low-priced oil is good or bad for the economy, the equity markets never had any doubts – Oil and Equities were moving down together.”

Very far fetched to compare today with 2008-09.

  • Economists, CEOs: Recession Risk Rising A growing number of corporate leaders and economists see mounting risk of the U.S. tipping into a recession, a nod to headwinds posed by the global growth slowdown and early-year convulsions in financial markets.

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The odds of recession in the next 12 months have climbed to 21%, double the level of a year ago and the highest since 2012, according to the average estimate in The Wall Street Journal’s monthly survey of economists. Economists at Bank of America Merrill Lynchpeg the chance of recession in the next 12 months at 25%. (…)

Chuck Robbins, Cisco’s chief executive, said the company began hearing signs of caution among some customers in January, toward the end of the quarter. In response to developments such as declining stock prices, he said, companies began holding up orders on nonessential purchases such as some types of the switching systems used on corporate campuses. (…)

Interest rates are low, but for many American companies they may not be nearly low enough. (…) The effective yield on U.S. corporate bonds tracked by the BofA Merrill U.S. Corporate Master Index was 3.6%, and has been running above nominal GDP growth since the third quarter. (…)

U.S. Budget Deficit Falls to Lowest Level Since August 2008

The U.S. deficit fell to $405 billion over the 12-month period ended January, or around 2.2% of gross domestic product, boosted by a $55 billion surplus in January. The deficit figure was down from the year-earlier $495 billion, or 2.8% of GDP. (…)

The White House said on Tuesday that it expects the annual budget deficit to exceed $600 billion, or 3.3% of GDP, for the fiscal year that ends Sept. 30, driven largely by a package of tax credits that Congress and President Barack Obama agreed to extend or make permanent at the end of last year.

Eurozone economy shows sluggish 0.3% growth Italy’s recovery dims and German growth fails to pick up in final quarter of 2015

Eurostat, the European Commission’s statistics bureau, said the latest 0.3 per cent expansion meant the economy of the single currency area was 1.5 per cent larger than during the fourth quarter of 2014. The figure matched analysts’ forecasts. (…)

chart GDP growth

SENTIMENT WATCH
Global Stocks Entering Bear Market

021116 Bear Market

Nasdaq Bear Coming Out of the Cave

Nasdaq Composite March 2009 February 2016

J.P. Morgan’s James Dimon Pours $26 Million Into Shares

J.P. Morgan Chase & Co. Chairman and Chief Executive James Dimon bought 500,000 of his bank’s shares on Thursday, a person familiar with the matter said. (…)

Meanwhile, Citigroup Chief Financial Officer John Gerspach bought about $500,000 worth of Citigroup shares Tuesday, the New York bank disclosed Thursday in a regulatory filing. Citigroup CEO Michael Corbat and Chairman Michael O’Neill bought about $1 million shares each three weeks ago.

JPM got cheaper in 2011 and 2012 but its capital base is now much better (see below) (chart courtesy of CPMS/Morningstar):

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Deutsche Bank Ranks Last on Capital Gauge Where Citigroup Excels

Is The Top of the Art Market In Trouble?

NEW$ & VIEW$ (11 FEBRUARY 2016): All About Banks

Janet Yellen Signals Caution on Rates Federal Reserve Chairwoman Janet Yellen flagged risks to the economic outlook that could delay the central bank’s plans for raising short-term interest rates, in her semiannual testimony to Congress on U.S. monetary policy.

In the first of two days of semiannual testimony before House and Senate committees, Ms. Yellen on Wednesday said falling stock prices and other financial-market turbulence could impede economic growth, as could stresses in China and other foreign economies.

Further complicating matters for the Fed, she also pointed out that market expectations for consumer prices are sinking, a sign investors might be losing faith in the Fed’s ability to lift inflation to the 2% target it has undershot for more than three years.

“Financial conditions in the United States have recently become less supportive of growth,” Ms. Yellen said, pointing to stock-market declines and higher interest rates for riskier borrowers, among other events. (…)

While the official unemployment rate has receded to 4.9%, Ms. Yellen acknowledged labor markets are still heavy with part-time workers who want full-time employment and discouraged individuals who want work but aren’t looking. (…)

She brushed off worries that the U.S. is heading back into recession, and pointed to the benefits households are reaping from low gasoline prices and steady job growth. The average American household is saving $1,000 a year from low gasoline prices, she estimated. Moreover, she pointed to tentative signs that worker wages are picking up.

“Let’s remember that the labor market is continuing to perform well, to improve. I continue to think that many of the factors holding down inflation are transitory,” she said. (…)

Not only gasoline as Doug Short illustrates:

Sweden cuts rates deep into negative territory Move rattles markets on fears of global race to lower rates

(…) “There is excessive debt everywhere and negative interest rates are dangerous… My number one fear? That’s the same as asking me where it will start. When you view the economy as a complex, adaptive system, like many other systems, one of the clear findings from the literature is that the trigger doesn’t matter; it’s the system that’s unstable. And I think our system is unstable... Central Bank models are just wrong” (…)

U.S. Crude Slips Below $27 a Barrel
Global Stocks Swoon as Investors Seek Havens Global stocks staged a sharp retreat as a cautious tone from the Federal Reserve, downbeat company news and a fresh fall in oil prices fueled anxiety about the health of the world economy. U.S. futures point to a sharply lower open. Stoxx Europe 600 fell as much as 3.9% as banking and mining shares tumbled.

The bank said that because of difficult market conditions and tighter regulation it may not reach its targeted 10% return on equity in 2016.(…)

European bank shares have suffered sharp losses since the beginning of the year due to concerns over sometimes thin capital levels and low profitability.

“There’s a disconnect between what we’re seeing in the markets and the real economy,” said Mr. Oudea.

European bank shares continued to slide Thursday, with the Stoxx Europe 600 index down 5% late morning. (…)

The bank said its core tier one ratio, which compares top quality capital such as equity and retained earnings with risk-weighted assets, stood at 10.9% in December, up from 10.5% in September.

Société Générale said it targeted a core tier one ratio of 11.5% to 12% by 2019.

The bank’s leverage ratio, which measures capital held by the bank against its total assets, also rose to 4%, from 3.9% at the end of September.

From Bloomberg’s Gadfly:

SocGen’s quarterly results, which missed forecasts, were a microcosm of the unknowns facing Europe’s banks. The lender saw loan-loss provisions surge at its corporate and investment bank, citing “cautious” provisions on the bank’s oil and gas lending and also on one unidentified European company. An extra litigation charge effectively soaked up all of the gains from selling its stake in asset manager Amundi. The bank also said it was going to be difficult to hit profitability targets for 2016 because of “headwinds” — in other words, things may get worse. (…)

Here’s a deeper analysis (my emphasis):

What seems to be driving the 2016 bank stock sell-off is a re-evaluation of how equity markets account for the book value of financial institutions in a world of NNIM (negative net interest margins) and eurodollar outflows.

But also, we should think, the degree to which NNIM itself is influenced by the sound of a giant vacuum cleaner sucking petrodollars out of the non-US banking system, the commodity-credit feedback loop of hell and the general subpriming of commodities through the repo collateral markets.

To cut a long story short: if we’ve arrived at a point where commodity collateral is no longer considered safe, that’s one less safe asset in the system, and a helluva lot more pressure on the remaining safe assets (government bonds) to protect par value.

Which ever way you look at it, banks don’t do well in this framework(…)

Negative rates are and remain an inevitable precursor to the death of the banking model (which includes fintech). Or at least to the realisation that protecting economic par value for investors is really really hard if you favour rent extraction investments over ones in productivity.

(…) The Euro Stoxx bank index is down 27% this year and 42% since its April 2015 peak. The drop has been accompanied by sharp moves in bank credit markets, not least steep falls in the prices of a previously obscure form of bank debt called a contingent convertible, or CoCo, which is a bond that stops paying its coupon or even converts into a share if the regulator thinks the bank is running low on capital.

These moves have been particularly unsettling for all those analysts who for much of the past year have been recommending bank shares as a way to play the European recovery story—as well as for the investors who took their advice. For many, the scale of the slide in bank shares has been a surprise. Bewilderingly, the world is once again asking whether the European banking system is on the brink of meltdown, heading for a repeat of 2008 or 2011. (…)

Bank analysts have long warned that negative interest rates could be highly damaging to the banking system, forcing banks to choose between accepting lower profits or passing on the cost to customers, which would amount to a tightening of financial conditions, which in turn could hurt the recovery. One would expect that the scale of this week’s market reaction will certainly be prompting some urgent thinking in Frankfurt

Other factors have also clearly been weighing on bank shares. Investors are worried about the possible scale of losses on energy-related exposures given the collapse in the oil price. European banks have an estimated 38% of a $371 billion global pot of energy-related loans and could face losses of up to $27 billion, according to Alastair Ryan of Bank of America Merrill Lynch.

But this would account to around 6% of industry pretax profits over the next three years, which should be manageable for most banks. At the same time, sharp falls in Greek, Portuguese and Italian bank shares reflect particular challenges in those markets, relating to high levels of nonperforming loans still sitting on bank balance sheets.

Taken together, these factors certainly justify recent bank earnings downgrades and some adjustment in share prices. But do they point to a European banking sector once again on the brink of a systemic crisis? Hardly.

The industry today has far more capital, much more stable funding, greater access to central bank facilities and faces a much more stable regulatory system than at any time in the past seven years. The solvency of the overwhelming majority of banks isn’t in question.

This week’s panic over Cocos appears to have been largely born of confusion over how these instruments work, with the market extrapolating from what turned out to be unwarranted fears that Deutsche Bank might be obliged to miss a coupon on one bond for one year into generalized fears that European bank bond investors faced a mass bail-in.

In fact, the biggest risk that the market faces is that the recent panic becomes self-fulfilling: that rattled or distressed investors—including sovereign wealth funds forced to dump assets into illiquid markets as government budgets come under pressure from falling oil prices—continue to dump bank shares, spooking depositors and credit markets, pushing up bank funding costs, causing banks to rein in lending and push up loan prices, which squeezes the economy and their own earnings.

Of course, it could happen. Alternatively, investors may decide that at a time more than $6 trillion of global debt is trading at negative yields, the chance to buy well-capitalized banks operating in a growing European economy at yields of over 5% is a risk worth taking. After all, that is how market corrections usually end: when there are more buyers than sellers.

Worst still ahead for mining industry hit by $1.4 trillion loss.

(…) The industry’s 73 percent plunge from a 2011 peak is far beyond the oil industry’s 49 percent loss during the same time. (…)

This year may be the worst yet with prices trending lower for longer, according to Anglo American Chief Executive Officer Mark Cutifani, who says his company should be better prepared “for the winter that inevitably comes after the summer.” (…)

Rio Tinto Group is also preparing for a tough year, with CEO Sam Walsh predicting on Bloomberg Television on Thursday that distress from the commodities rout will spread to majors. (…)

“Excess supply is awash in most commodities and as painful as it is, economically and rationally it needs to leave the market to create a long term sustainable future,” said Graham Kerr, CEO of South32 Ltd., the spin-off of BHP Billiton. (…)

EARNINGS WATCH
  • 353 companies (82.2% of the S&P 500’s market cap) have reported. Earnings are beating by 4.4% while revenues have met expectations.
  • Expectations are for a decline in revenue, earnings, and EPS of -3.3%, -4.7%, and -2.8%. EPS is on pace for -2.1%, assuming the current beat rate for the remainder of the season. This would be +4.1% excluding Energy.
Bull Markets vs. Bear Markets

Good stuff from Ben Carlson:

Bull Markets: Fear of missing out.
Bear Markets: Fear of being in.

Bull Markets: Everything I buy is going up — I’m a genius.
Bear Markets: Everything I buy is going down — I’m an idiot.

Bull Markets: See, fundamentals always win out.
Bear Markets: See, technicals and sentiment rule the markets.

and many more…

(…) “My attitude is that both Piketty and Sanders are a little nuts,” Munger said. “If you want to look at what non-egality brings us,” people should look at the Soviet Union, Communist China and North Korea, he said.

Munger said he understands resentment about what he called “undeserved” fortunes, like the wealth that some money managers can accumulate through tax advantages. Yet Munger said that for a democratic country, inequality is a natural outcome.

“As an intellectual he’s a disgrace,” Munger said of Sanders. “Now, I don’t think he’s any worse than some of our Republicans. But at least they’re crazy in a different way.”