Will Anything Dent the Markets?

Today's headline on Business Insider: BANK OF AMERICA: "We're heading for an earnings

recession." This premise has been floated by more than a few analysts and business media personalities. At this point, it is the worst kept secret that a deceleration in earnings growth is being forecast by most stock analysts. The question being asked now is whether the first deceleration in earnings growth in six years will be enough to spark a correction in the stock market with other markets following suit.

It's the Economy Stupid

Since the depths of the recession, most observers of the stock market's six-year and counting rise, have viewed it with skepticism and a healthy dose of dubious acceptance. Record earnings growth and an accommodative Fed have contributed to the market's run with market bulls responding to the bear's cynicism by pointing out the strong earnings and low price-earnings multiples as reasons for continued optimism. Now the bulls are faced with a more sober reality: decelerating earnings and their correspondingly higher price-earnings multiples. What will the bulls point to now to justify an ever rising market? With multiples stretched beyond historical norms, asking for yet higher multiples seems unlikely. The chart to the right reflects the S&P 500 valuations (red line) versus declining

earnings (blue wave). There is a discernible departure between price and earnings growth. The only way to justify yet higher prices is a forecast for higher earnings growth going forward. But with forward earnings being reduced, how far out does the market have to look to find brighter skies? How much are investors willing to "pay up" for stocks based on distant earnings? One of the bull's popular refrains over the course of the market's recovery from its lows has been "the second half of the year looks better than the first." A recent concern, admitted by a popular market bull, was of second quarter earnings. The bull confessed that the market could get by with weak first quarter earnings but if second quarter earnings come in weak, it could present a problem for the market. Until now, each market hiccup has been offset by Fed support.

How Long Will the Market Rise on Continued Accommodation?

With earnings growth possibly turning negative, a rising market will look to Fed accommodation to provide bulls with more momentum and will give market bears fuel to feed their growing cynicism. Even market bulls concede that at least a 10% correction would be healthy. But each dip is met with more buying. When is the dip not met by sanguine buyers? Each hint that the Fed will postpone raising its rates is met with a market rally, the most recent happening after the long Easter weekend. A weaker than anticipated labor report was met with a triple digit gain in the Dow Industrials on the first day the market was open after the release of the labor report. How long can this response to the notion of lower rates for longer last? The Fed has already declared that it will be more accommodative for longer and will err on the side of caution and risk being too accommodative. It has tried to be as a transparent as possible and has avoided "surprising" the market with its policies. Although the Fed has expressed a desire to raise rates, it has also conveyed its "patience" to the market about its approach. There will come a point when investors will hit a wall and stop buying at ever higher valuations. That point is probably sooner rather than later. If earnings growth does not reverse and accelerate higher investors will baulk at paying correspondingly higher multiples as their risk profile is breached. What is the market's fair value in a permanent zero-rate environment? If investors never anticipated higher rates, what bid would they place on stocks? In a zero-rate world, a new metric would need to be used as a risk comparison. US treasuries would not be appropriate or adequate. Maybe a foreign bond rate or inflation (CPI) becomes the new risk barometer.

It's the Market Stupid

The Fed may choose not to raise rates based upon the performance of the economic data points they follow before the markets ultimately force their hand. The market has already disagreed with the rate forecast the Fed had been describing only to have their views confirmed by the Fed's actions to postpone raising. The same may prove to be true regarding when the Fed needs to raise rates. The market will be ahead of the Fed when they should raise rates. The market will not accept lower rates and will demand higher returns. This will cause rates to rise and stocks to pull back accordingly. When does this happen? As soon as the risk-return profile for investors shifts and capital flees US markets for greener pastures. Those greener pastures will have German, French, Spanish and Italian accents. As the Euro zone heals and growth improves, US capital will find its way over the Atlantic in a meaningful way. This process has already started. The ECB is in the nascent stage of its own QE program and has a ways to go, allowing for further easing and additional stimulus. If capital finds its way overseas in a meaningful way, the next dip in the US may not finds its fair share of buyers.

The Fed's Word Games

With the Fed meeting this week, attention is focused yet again on its statement, not its monetary tools. As many Fed followers correctly predicted, the Fed's arsenal of tools to combat weak growth and low inflation is waning, and has resulted on its increased reliance on the wording of its statements to influence and soothe markets. With rates at or near zero and the completion of its quantitative easing program (QE), the Fed has changed its approach to affecting markets focusing on communicating its intentions rather than implementing actual policies tools.

March 18, 2015 - Fed Releases Statement and Removes "Patient"

The Fed issued its statement on Wednesday and did not disappoint markets, as every market rallied as a result. Stock indices, energy, commodities, and bonds all rallied, some to record levels. What happened? Removing 'Patient' from its statement should have been bearish for markets, however, the Fed also lowered rate guidance in December, which helped soothe markets. Rallies like today's are often 'relief' rallies and can be short lived. As a result, the US 10-year treasury yield fell below 2.0%. Here is the Fed's March Dot Plot: Chart of FOMC participants of rate forecasts. The Fed cut its December rate forecast by 50 basis points. This alone has caused all markets to uniformly rally.

How Long Do the Fed's Words Alone Soothe Markets?

For the time being, the Fed is getting the benefit of the doubt. Its words alone have soothed market expectations and kept equity markets buoyed. Most analysts agree, at least, that markets are 'fairly' valued if not overvalued. At what point do values hit the proverbial wall? Is the market's magic number the reciprocal of the 10-year US treasury, the equivalent metric from the fixed income market? If the risk-free rate of return is 2.0%, then the equivalent equity multiple should be 50, a far cry from the current 16.5 that the S&P 500 trades at. Why aren't we there yet? The historical average multiple is what is holding the market back. That multiple for the S&P 500 is around 15, leaving markets a little 'pricey'. Six years in to the current bull market without a significant 10% pullback is leaving investors and analysts a little hesitant to place bigger bets on the largest indices. The latest 'story' from money managers are that small cap stocks are the next growth area within the equities universe. With lofty current multiples and in the face of higher rates, that window may be short lived, as small caps fare worse than their larger cap brethren when liquidity starts to dry up. As multiples across the investment spectrum rise, the search for yield will only intensify. No one knows when or at what levels markets seize up, but the Fed's words will not infinitely soothe away the concerns the market is bound to have. At the moment the market tunes out Fed-speak, the market will crack and the long-awaited market correction will follow.

The US Mortgage Conundrum

The housing industry has been an economic driver for the US economy for over a century. Between

the materials needed to construct real estate and the services surrounding its marketing and sale, the economic impact is broad and far reaching. When the housing market struggles, the economy as a whole may struggle. One aspect of the housing industry that is as important as any is mortgage finance. Historically, American homeowners have financed their home purchases using a traditional 15 or 30-year fixed rate mortgage offered by most lending institutions. Adjustable, or variable rate mortgages, have always been available in the US market but have made up a smaller portion of the market, roughly 10%. However, this might change as the US financial industry is experiencing seismic shifts among the players and regulations that affect residential lending.

Characteristics of Other Developed Nations' Mortgage Industries

The mortgage industry looks very different outside of the US. Two things that stand out are the types of mortgages that are widely used and the structure of the mortgage industry. Variable rate mortgages are far more common outside the US as well as more short and medium term rollover features. Government support through institutions like Freddie Mac and Fannie Mae are unique to the US mortgage industry and are far less common overseas. Default rates are lower outside of the US, where variable rate mortgages are more common, defying evidence that these loans are inherently more risky. To think that the US could learn a lesson or two from foreign nation's mortgage markets is not consistent with the lead the US typically takes in areas of finance and credit.

Housing and Banking are Flagging, Is Mortgage Finance to Blame?

While US stock markets continue to enjoy the now 6-year old bull market, this success throws in to sharp relief the weakness found in the US real estate market. While there are patches of strength in popular markets in the west and the northeast, the broader real estate market is experiencing overall weakness. Away from the success of Silicon Valley and Wall Street, which support their real estate markets, the rest of the country is not as fortunate. There have been several theories about why real estate is floundering, from a weak labor market to a preference for rentals by 'Generation Xers.' However, an obvious place to look has been ignored by many: the lending institutions. After the collapse of the subprime market and the real estate market itself, lenders of all kinds found themselves under siege by regulators and legislators looking to place blame and attempt to recover losses. The response to the crisis was to pull back and restrict credit creation. The large banks that did not go bankrupt or get absorbed by competitors, pulled in their reins and started tightening lending standards and limiting their mortgage products, such as popular home equity loans, or HELOCs (Home Equity Line of Credit).
What no one was paying much attention to was how much lenders were limiting their credit and how strict they had become. Anyone who tried to get a loan during this time, 2009-2013, knows how difficult it had become. After several years separated the crisis from the recovery, and the real estate market continued to struggle, some other specter was at odds with the market. As the Fed maintained its zero-interest rate policy (ZIRP), margins for financial institutions continued to compress. Now, years later, profit margins for banks have tightened resulting in less incentive to make the loans that were once its bread and butter. This economic reality combined with increased scrutiny and tightened regulation, has caused lenders to make the rational and logical business decision to reduce loan origination. If the profits are limited and the penalties are severe, why pursue the business?

What Is to be Done?

What can be done to invigorate this market and incentivize lenders to originate more loans? Maybe this is the wrong question. Maybe the better question is: Who can step in and fill the void in lending left by traditional lenders? If we assume tighter profit margins are a reality going forward, the answer could lie in nontraditional sources of credit that can survive and thrive on the thinner margins that exist today. One such place could be lenders such as Kickstarter or the Lending Club. Investors accustomed to thinner returns could be enticed by these margins and provide the liquidity borrowers need to fund their real estate purchases. The application process could be similar to the traditional lenders, so it would not require re-invention. One obstacle to overcome is to gain an acceptance and comfort level in this type of credit creation by the masses. One way to achieve this acceptance would be a collaboration between existing brick and mortar companies looking to gain access to this market with these new lenders. One example of this would be a partnership between Kickstarter and E*trade.

Will QE Work in Europe?

After years of assurances and promises, Mario Draghi, the president of the European Central Bank (ECB) announced the passage of the European Community's version of quantitative easing (QE). The plan is an open-ended pledge of about 1 trillion euros to purchase both public and private bonds at about 60 billion euros per month until September 2016. Sovereign debt will require additional risk-sharing arrangements. Despite it's wide anticipation, markets from Europe and beyond cheered the move. Now that the monetary pledge has come to fruition, will it have the benefits the ECB and Mario Draghi hoped for?

Why Does Europe Need QE?

Europe needs QE for two simple reasons: to ward off impending deflation and to increase liquidity. The biggest danger the European economy currently faces are falling prices. The dangers of deflation have been well documented on this blog. Lower prices often beget lower prices which can then be disruptive to financial markets (ex: financial institutions rely on the value of underlying assets or inventory remaining stable or increasing).

Reasons It Could Work

Christine Lagarde, the president of the International Monetary Fund (IMF) has claimed that QE is already working. As she points out, the move lower in the exchange rate of the Euro proves that just the anticipation of QE has assisted the European community and its economy. The weaker euro allows European companies to be more competitive in the global marketplace. Additionally, any increase in inflation in Europe will help those economies associated with the Euro.

America as a Proxy

European bankers need only look across the Atlantic for a recent real life example of the effects of QE. The Fed initiated its version of QE in the fall of 2008. The Fed maintained its asset-purchasing program in some form over the following six years. The evidence is far from concrete but the program has been credited for keeping the American economy from slipping in to full blown depression. The main catalyst for implementing the unorthodox policy being the failure of Lehman Brothers. It is debatable whether the US would have suffered a more severe downturn in the absence of QE but most analysts concede that the program was helpful. The context under which both programs were implemented is different. The US economy was not trying to stave off deflation while that seems to be the European Union's biggest fear. Under American QE, asset prices increased creating a intended wealth effect, that helped encourage consumer spending and business capital expenditures. Despite the amount of stimulus the real economy in the US is struggling with low growth but is still the healthiest economy in a weak global environment.

Why It May Not Work

The European version of QE is more complex than its American counterpart. The European Union is comprised of 28 sovereign nations, each with its own banking system, whereas the US only had one central bank to work with. 28 different countries means 28 different political interests and clearly things get more complex from there. Figuring out how much sovereign debt to purchase from each country is a complex undertaking. Will each country benefit equally? Will each country feel the program has been handled equitably? The answers to these questions most certainly will be 'No'. How can Greece and Germany be treated equally? Adding to the complexity are the changing governments in each sovereign nation. It will be a struggle to keep up with the dynamic political terrain throughout the as of now 18-month program.

What if Consumers and Corporations Just Refuse to Spend and Borrow?

What no one seems to be addressing is the elephant in the room: What happens if Europeans are just different consumers and businessmen than Americans? Can QE really have a similar effect on different cultures? Europeans borrow and spend differently than Americans. Their mortgages are different and their housing is different. Adjustable rate mortgages are widely used and do not require being refinanced as often. Europeans aren't used to buying new cars every five years. Auto loan incentives may not induce buyers overseas like they do stateside. The corporate and business culture is different as well. European companies are restricted in their ability to fire their workers. High rates of unemployment, particularly among youth, is not unusual, so affecting employment will be muted. In the US, 10% unemployment was considered lofty, and getting it down to historical averages meant getting people back to work who could then become active consumers again. In Europe, it is harder to create more consumers from the ranks of the unemployed.

Boom or Doom?

The immediate fear in Europe regarding its QE program is that bond prices are so high the government will be buying bonds at elevated levels, not giving itself any cushion in the event of a down draft in prices. With rates at historic low levels, and in some cases negative, the ECB may not help but lose money on its purchases. The easy answer to this concern is the ECB can sit on the bonds until maturity.
Many of the concerns that will be analyzed and dissected over the next 18 months are moot. The ECB had to implement some strategy to fend off deflation and get the European Union and its economy back to growth. A weaker Euro should assist in that endeavor. Rates cannot realistically go any lower but the extra liquidity should find its way in to the economy in some form or another. Asset prices should rise and this in itself is a form of inflation and can lead to additional spending by consumers and businesses which ideally will lead to some inflation and hopefully economic growth. In the meantime, it's good theatre for the Americans.

The Oil Conundrum

Over the span of the last 7 months oil has fallen by over 40% and the bottom is still nowhere in sight. What has caused this epic decline and what are the implications, both financial and social, to the US and global economies?

On June 25, 2014, WTI (West Texas Crude Oil) was $102.53/barrel. Today, December 16, 2014, oil is trading under $56/barrel. The price of gasoline at the pump has fallen accordingly. One year ago the national average for a gallon of regular gas was $3.23/gallon. Yesterday that average had fallen to $2.53/gallon. The implications for US consumers is obvious. Gas price increases or decreases are widely considered either a tax or tax break for US consumers. In this case the decline at the pump is being described as a massive tax break for consumers. The questions most analysts are trying to answer is: "Are consumers spending more elsewhere now that they are experiencing some relief at the pump?"

Why Oil Prices Are Declining

Oil prices are delining because:

• Global demand is declining
• The US is producing an abundance of shale oil and gas
• Speculation in energy markets has soured
• OPEC refuses to adjust productions to today's market realities

Do the Benefits Outweigh the Costs?

Wait a minute, what costs? This is where things get cloudy for most people. How can there be costs associated with lower oil? Aren't lower oil prices a win-win for all involved? The short answer is "No." Those that sell oil and work in related fields suffer when the price of oil falls, not unlike purveyors of any product that falls in value. The tricky thing about oil is the broad benefit lower prices can have for all consumers and thus its potential economic impact nationally. The clue to whether consumers are increasing their discretionary spending to other areas could be found in the government's retail sales figures. Sales naturally will fall in the "service station" category and should increase in other categories. Will those increases be statistically significant? Will those possible increases help stimulate a moribund economy that is experiencing subpar growth for a "rebounding" economy? About those costs? A significant portion of the US economy is comprised of the energy sector. Those companies that rely on selling oil at a certain price based on their costs are adversely affected by falling prices. At some point lower prices cause these these companies to lose money which ultimately will hit their bottom lines. The result are falling stock prices and cut backs resulting in job losses and the elimination of exploration and drilling, as these become less viable endeavors to pursue.
Wall Street's biggest fear is the possible contagion associated with the banking sectors record amount of lending to the energy sector amounting to $465 billion, up 29% from the prior record in 2007, just before the "great recession". If these loans deteriorate the broader ramifications could be serious. Already equity markets are reflecting Wall Street's angst, with the S&P 500 down 3.5% this month. Flight to safety is showing up in higher bond prices, pushing the US 10-year treasury down to 2.06%. Where does this end? Presumably when oil stops falling.

The Social Implications

The reality is the social implications of falling oil are related to the financial implications. As nations (Russia and Venezuela, most notably) and individuals struggle financially from falling oil the spillover is social. Unrest has already been reported in Venezuela and how long until Russia experiences similar ills? Venezuela relies on oil revenues to make debt payments, which are coming due early next year. Putin and Russia are being simultaneously squeezed by falling oil revenues and US sanctions. How long until things break? Ostensibly, Russia has brought this on itself with its ongoing conflict with the Ukraine. Will they learn a lesson? Putin strikes me as particularly bull-headed. I would not count on him to throw in the towel for an extended amount of time, maybe when it's too late.

The Analysts' Spin

It is well understood that money managers and market analysts can never be outdone when it comes to market sanguinity, but even their "spin" is wearing thin...on each other. The story: When oil prices are rising it's because of strong global growth and markets cheer and rise. Today, while oil prices fall it's a boon for consumers and retail sales will benefit and markets cheer and rise. These stories are spooned to us from the same people. Are they speaking out of both sides of their mouths? Yes and no. Their explanation is that oil's decline is different this time. Have you heard that before? So have I. Their explanation is that oil's decline is not due to weak growth, it's due to how great America is at producing and using energy. Ok, that's fair. But, oh by the way, why is there a glut all of a sudden in oil? None of them deny that global growth has slowed and overseas demand is down. The magic wand they are using is "decoupling", that is what the US is doing. Therefore, we are immune to the global ills affecting the rest of the world. Don't believe it. We are part of the global economy and we are not immune to the world's problems. When the world coughs we will still catch a cold.

The Black Swan - No, it's NOT oil, it's actually Deflation!

I was being cute there. Sure it's oil's price decline that is the problem, on the surface. But it's really what the decline represents that is so debilitating in today's environment. Falling prices represent deflation and deflation is the enemy of capitalism and all those that live by its tenets. I have documented fully the evils of deflation on this blog but to reiterate: when prices fall people put off spending, companies can't make a profit and don't increase capital expenditures or hire people. It's nasty stuff to be sure.

The Bottom Line

As analysts come around and slowly concede that falling oil is not a completely benign event, they are assuring us that in the long run its benefits will outweigh its near term costs. I have a tendency to believe them in this regard. Given enough time, markets will acclimate to lower oil and markets will find equilibrium. This is true under any new circumstance. This is what markets do. They adjust to new realities and move on with a new calculus. This is what makes markets great. You will find few people who would argue this point.
For the time being, look for lower rates, lower commodities, and lower stocks.

A Strong Dollar Is A Good Problem

Money managers and TV analysts on business channels are fretting over the impact of a strong dollar
on earnings and therefore the stock market. However, a strong dollar is a vote of confidence for the US economy and should be viewed as such, with a longer term benefit to equity markets.

Why Is The US Dollar Strengthening In The First Place?

Nothing is as simple as it seems, or is it? Economies outside of the US are struggling and on a relative basis, the US economy is doing well. The US economy is not going gangbusters but the Fed is on the doorstep of tightening, whereas the rest of the world's central banks are in the midst of loosening policies. With other advanced economies like Japan and the Eurozone lowering interest rates and, as a result, devaluing their currencies, the dollar is strengthening by default. With the US dollar ostensibly acting as the world's currency, the US dollar cannot weaken itself against itself while other currencies can devalue themselves against it. As long as the US economy outperforms on a relative basis, the US dollar should continue to strengthen.

A Strong US Dollar is Good For The US Economy

Despite the consternation of myopic money managers and analysts, a longer term perspective of the economy is more favorable with a strong US dollar. It signifies a strong US economy which will ultimately feed the "virtuous cycle" the economy needs to grow and expand. A stronger economy means healthier companies, creating more jobs for consumers, who will ultimately benefit from a stronger currency in their pockets when they go to make purchases of all kinds. It means the paychecks they receive will go further, particularly considering the commodities that are part of the cost structure they live under, will be cheaper. For example, the consumers' stronger dollar means cheaper oil which equates to cheaper gas at the pump, leaving more discretionary income for these same consumers.

Whither Multinationals?

The primary debate revolves around the performance of large multinational corporations that make up the S&P 500 and the Dow Industrials. As the theory goes, a strengthening US dollar will make the products of US based multinationals too expensive for non-US consumers as those currencies weaken against the US dollar. As those products get more "expensive" abroad it will dent the demand and ultimately hit the bottom line of the large multinationals. This is not necessarily the case as these companies make the end product overseas and price them in the fiat currency of the host nations. To the extent that US multinationals are using the strong dollar to keep costs down, weaker sales should be mitigated accordingly.

Even Better For Domestic Companies

For companies that sell most of the their products and services domestically, a stronger US dollar is a boon. This narrative feeds right in to the "virtuous cycle" theory. A cheaper cost structure combined with a healthier consumer means improved margins and better sales.

History Is On Our Side

Historically, the greatest periods of prosperity in the US have been accompanied by a similarly strong US dollar. Strong global economies do not have weak currencies. Runaway inflation has never been associated with a healthy economy. Argentina is a good case study of a weak economy with runaway inflation. During times of financial crisis, foreign currencies will flow to the US dollar causing it to strengthen.

Back From Vacation, Will Senior Traders Take Control of Markets?

August is famous for senior Wall Street traders vacating their desks for their younger brethren and seeking the solace and serenity of the Hampton's and its beaches. Their return after Labor Day is regarded as akin to 'the adults are back' and the market will find its true direction as a result. Most analysts discount market behavior during their absence. Trading volume is typically thinner than the rest of non-holiday trading sessions and, as a result, market volatility can and does increase. As the more senior members of trading firms make their way back, volumes usually increase and the direction of stocks and bonds for the rest of the year can be better gauged. Will this year be any different or will tradition hold to form?

The Fed's Eventual Exit

This fall will be different than recent falls. This year will see the end to the Fed's Quantitative Easing program. In October, the Fed will eliminate its asset-purchasing program by reducing purchases by $15 billion. The market has not had a fall season without some form of Fed intervention since 2008. Already, the market is witnessing some turbulence. Yields on the US 10-year treasury have backed up about 25 bps, and since hitting the 2,000 milestone in late August, the S&P 500 has hit the proverbial wall. This year, the only evidence reflecting the return of senior staff may be increased volumes. The other dynamics in the market make it very difficult to isolate the influence of senior traders. Between the Fed, overseas conflicts, and moves made by the European Central Bank (ECB), not to mention that 2,000 reflects the upper end of most analysts equity forecasts for the S&P 500, differentiating between junior and senior traders will be difficult.

Improving Economic Data

Since Labor Day, economic data has been coming in positive. One of the market's more frustrating aspects is its ability to behave in a counter-intuitive manner. As economic data improves, the expectation would be that markets behave accordingly, with equities benefiting the most. However, this is not always the case, and since Labor Day, equities and bonds have stalled as the data continues to improve. This "good news is bad" is one of the markets quirks. As mentioned above, equities have stalled around 2,000 in the S&P 500 and yields have backed up on US Treasuries. One of the results of higher rates are their impact on mortgage application volume. The Mortgage Bankers Association (MBA) has reported that their index for mortgage applications is at a 14-year low, with refinance applications taking the biggest hit followed by purchase applications. The average conforming 30-year fixed mortgage loan rate is 4.27%, up only modestly since Labor Day, but enough to dent applications. This reflects how "tight" the refinance market is, when a small change in yields is enough to affect total loan volume.

A More Sober Approach?

Dusting the sand from their shoes, will traders take a more measured approach to the final quarter of the year? With conflicts in the Ukraine and the middle east, and President Obama's handling of the ISIS crisis in Iraq squarely in focus, senior traders may decide to adjust their ebullience, and rein in expectations for further market gains. With many analysts moving up their expectations for a rate hike by the Fed, yields are moving up in anticipation. If the market is a discounting mechanism and looks forward six months, a rate hike should start to be priced in to markets and the impact on equities and other markets could be felt for the remainder of this year. With the markets rebounding from a slight malaise in early August that saw the S&P 500 test 1,900, traders seem satisfied with current levels. The perspective from here is that further gains in the markets will be limited and mild at best, as the reality of the end of the Fed's unprecedented intervention settles in.

Are All Asset Bubbles Created Equal?

A recent New York Times article claimed that the world is full of asset bubbles. Follow this link to the article:  http://www.nytimes.com/2014/07/08/upshot/welcome-to-the-everything-boom-or-maybe-the-everything-bubble.html?_r=0

The article and its message received a lot of play in the media and pundits debated endlessly whether there was any merit to its content. An endless parade of economists and money managers were trotted out on the most popular of the business programs to give their opinions on the article, and as is usually the case, they were across the board. So what is it? Is the world experiencing a global asset bubble?

Past is Prologue

Based on historical precedent, asset bubbles are a fact of life in financial markets, and are unavoidable. That is one point all of the pundits universally agree on. Beyond that basic premise, opinions diverge, sometimes dramatically, typically by individual motives and self interests. The definition of an asset bubble is a nebulous thing. What constitutes a bubble? Is it based on some percentage over accepted fair value? If so, what is fair value and what methodology is used to ascertain that fair value? It can get complicated fast. It seems people start to speak of bubbles more from a gut feel perspective than from a firm technical perspective. Technicians will point to charts and graphs to illustrate and define a asset bubble. Market analysts will often point to historical precedent to indicate that a bubble is forming, for example, a extended period of time between corrections in an asset class, like stocks. But oftentimes, claims that a bubble exists is simply based on a 'feeling'.

The Asset Bubbles

One of the prime culprits are bonds. The fixed income market is comprised of many types of bonds from junk bonds of low quality to high quality US treasuries. All are considered to be in bubbles but junk bonds typically get the most press as they are the most likely to default whereas treasuries are considered the least likely to default. With the Fed's unprecedented level of monetary action, it is understandable that this market looks inflated. This is one asset class that is widely regarded as in a bubble. The more heated debates surround assets like real estate, art, commodities, and stocks. The latest extreme example is that of CYNK, a technology company based in Belize, that recently garnered headlines from going from a penny stock to a $20 stock in short order, resulting in a market cap of $6 billion. This is with one recorded employee and modest assets. Trading has been halted in this stock as of July 11, 2014. CYNK is regarded more as a case of a 'pump and dump' scheme than an asset bubble.

Are All Asset Bubbles the Same?

As mentioned above, there are many opinions on the subject of asset bubbles. Most opinions seem to be a function of perspective and self interest. Many of the opinions are based on bubbles of the past compared to todays markets. In this regard, many point to extreme asset values from as a recently as the 2000 dot com  stock bubble to the 2006 real estate bubble. This argument claims that today's values do not match those past extreme values and therefore preclude today's assets from being in danger of popping. Money managers that favor stocks are firmly in this camp. Their interest in seeing stock values rise and therefore their management fees rise makes their opinions dubious. In fact, the very nature of their position ironically contributes to the formation of stock bubbles. The same holds true for managers of other asset classes such as commodities (precious metals) and real estate. It is difficult to separate fact from opinion from money managers with ulterior motives. What few of these folks point out in their rebuttals of the existence of asset bubbles is the unprecedented level of Fed intervention in our current economic climate.

It is this unusual intervention that makes, what are considered today's asset bubbles, difficult to compare to those of the past. This is where I think most arguments against the existence of asset bubbles fall down. The Fed's extreme monetary policy has suppressed yields and increased liquidity prompting investors to globally search for yield and allocate funds. The absence of the Fed's intervention would cause yields to be more market driven and the level of liquidity to contract. Rising yields would limit the amount of stock buybacks that corporations are executing. The elimination of this financial engineering tool would cause the popular P/E metric from appearing to look benign compared to the past. The contraction of liquidity would reduce the amount of capital chasing assets for yield. Most money managers use low yields as the justification for high stock multiples (P/E ratio), when in reality, the artificial nature of these low yields should dispel that theory, if not in the short term, at least in the medium to long term. For this reason, not all asset bubbles are created equal and their use as a benchmark for today's asset valuations is not valid.

If and when the Fed normalizes its monetary policy (as of this writing the Fed's asset purchases (QE) are expected to end in October) yields and liquidity should adjust. Assets should re-price and their levels should fall accordingly. The delta between todays valuations and those adjusted valuations should represent the current premium in asset values.

Is the Fed's Growing Balance Sheet a 'Free Lunch'?

One of the hallmarks of the "Great Recession" has been the Fed's easy money policy, which has manifested

itself in low interest rates (ZIRP) and, the now famous, QE (Quantitative Easing or money printing).

As we entered the Great Recession in 2008, the Fed seemingly had few options to assist the economy and stave off what could have been a more severe depression. In an effort to stoke growth in the economy, the Fed cut interest rates to near zero and ultimately implemented QE, that expanded the money supply and has since led to the rise in value of risk assets, like equities, among others (at the time of this article most US stock indices sit at record levels). The concept behind raising the value of assets, like equities, was to create a "wealth effect" that would start a virtuous cycle of more consumer spending and more capital investment. As a result of the Fed's policy, its balance sheet has expanded at an unprecedented pace.

Are there ramifications to the Fed's growing balance sheet? Is the Fed inflating another bubble like we saw in 2000 and 2007? Or, is there such a thing as a 'free lunch'?

Growing Balance Sheets

As seen in the image above, the Fed's balance sheet grew steadily from 2001 until 2008, showing a balance just shy of $900 billion. Then, over night, its balance sheet experienced a dramatic increase

only to be followed by an endless run of quantitative easing. However, the US Fed is not alone in its endeavor to kick start the economy through asset purchases. The second image reflects a global policy of asset purchases resulting in increasing balance sheets. What impacts might be felt as a result of this global policy, specifically, to the U.S.? Is there comfort in the knowledge that the U.S. is not alone in its policy of QE? Or is there concern that we are now the leader in this effort? The U.S. Fed's balance sheet shows the most dramatic change of all of those represented in the attached image.

Another Bubble Inflating?

Through its efforts, is the Fed simply creating another bubble from which we will suffer yet another dramatic decline and an additional assault on the fragile psyche of most investors? "This time is different" is a popular, and to many investor's ears, chilling refrain, often used to explain away concerns regarding the latest dramatic rise in some asset class's value. So, can the Fed orchestrate a slowly recovering economy and rising asset prices without a costly glitch? The short answer is "maybe". If the economy progresses to a more healthy level of growth and the fundamentals better match the performance of stock indices, record stock levels could be sustainable. However, another recession, and or, runaway inflation could knock markets from their highs. The unanticipated contraction in first quarter GDP and the rise in inflation has some analysts and money managers on yellow alert. They're not quite at red alert, yet. The popular and tiresome weather excuse has provided cover for bulls so far, but that excuse is losing some luster as data collected for the winter months is replaced by spring and summer data. If these concerns manifest themselves and markets take a hit, what implications does this have for a Fed with an inflated balance sheet?

Foreign Creditor Confidence?

With the Fed claiming that it can and will hold the securities it purchases until maturity, it only signifies that the market will not have to absorb the supply at some point in the future, but that does not relieve the Fed from the effects of rising interest rates. The cost of holding securities in the face of rising interest rates is material and significant. The impact of inflation on the value of the U.S. dollar and on interest rates is a two-pronged financial sucker punch. Because commodities are priced in U.S. dollars, a falling dollar means higher costs for U.S. corporations. Rising interest rates make the debt the Fed is holding less valuable as an asset and rolling over the debt becomes more expensive. One implication is that foreign governments might be less inclined to hold U.S. debt in the face of a falling dollar. Until now, the Fed gets the benefit of the doubt from its creditors. If foreign investors were to lose confidence in U.S. fiscal and monetary policies, an already bloated Fed balance sheet would be challenged to absorb more debt from the secondary market. As the balance sheets of other nations grow, combined with falling dollar-denominated assets, foreign governments will be less inclined to add more U.S. debt on to their balance sheets, choking off an avenue of funding for the Fed. Additionally, if a large holder of U.S. debt were to liquidate suddenly, this would serve to drive up interest rates and drive down the value of the U.S. debt.

Market's Love-Hate Relationship with Inflation

On the one hand, markets rely on some level of inflation. Without inflation, capitalistic economies do not function properly. Some level of inflation allows the successful use of debt financing. Inflation, in this case, represents growth. It allows the prices of products that companies sell to go up and it degrades the value of debt used to finance that production. At a minimum, it keeps the price of products from falling below the cost of production. As the cost of debt is fixed, inflation provides margin for profit. However, inflation also reduces the value of cash flows, which in turn reduces the value of the underlying company or asset. Too much inflation will creep in to income statements in the form of higher production costs at the same time as reducing the value of dollar-denominated assets. The Fed's large balance sheet could be the cause of a spike in inflation for the reasons noted above, and if that inflation were to get out of control, markets would react negatively and a large sell-off in both the equity and fixed income markets could follow.

Summary: Is There a Free Lunch?

So far, it's hard to say that investors have not enjoyed something akin to a 'free lunch' as the Fed has successfully orchestrated lower costs of capital and rising asset prices. What's unknown, however, is how long the current environment of low volatility and rising asset prices can last. The current bull market is five years old and counting. As values get extended and the market does not experience a traditional correction, the prospects of a more severe correction grow. In the absence of some catalyst that would alter current trend, this condition can last for years. However, the degree of Fed intervention and market manipulation has most professionals uneasy. This unease from the street can have its own effects. Unfortunately, most folks on Wall Street, do not subscribe to the notion of a 'free lunch' and are skeptical that current conditions controlled by the Fed, and its money printing (QE), will go on ad infinitum. In the absence of higher growth and a healthier consumer, that very fact could be the spark that causes the flame.

The European Central Bank Eases. Will it Help?

In an effort to stimulate a lethargic economy and stave off impending deflation, on Thursday, June
5th, the European Central Bank(ECB) cut its main rate from 0.25% to 0.15%, cut its marginal lending facility from 0.75% to 0.40%, offered its longer-term refinancing operations (LTRO) and imposed a negative interest rate on bank deposits(from 0.0% to negative 0.10% - the first ever by a major global central bank). In an odd and unexpected twist, the Euro actually rose after the move. The rising Euro, if it were to continue, would act to defeat the efforts by the ECB. Despite the moves made by the ECB, and the resulting impacts on currencies and markets, will they have the desired benefit of stimulating the European economy?

The Deflation Threat

The ECB has targeted 2.0% as its desired inflation rate. Last month inflation was running at around 0.5% in the Eurozone. One of the biggest fears of advanced economies is the specter of deflation, which we have covered extensively on this blog because of its debilitating nature to an economy. In a nutshell, deflation dampens economic activity for various reasons, not the least of which, is causing the consumer to put off purchases in the face of falling prices. If the ECB is to be successful in stimulating economic growth, it must first combat deflation.

Austerity to Blame?

To combat the global recession, the European Union adopted austerity measures in hopes that it would allow them to reduce the amount of debt overhanging its members. While certain levels of austerity are helpful when recovering from economic recession, an overwhelming amount can harm growth and limit the speed of a recovery. The most efficient response to the economic weakness was not to curtail borrowing as much as it was to provide the environment for healthy borrowing through lower rates and solid credit policies. Cutting back credit would only serve to limit growth potential and spur further deflation.

Draghi to the Rescue? The New Bernanke?

With austerity measures fully in the rearview mirror, the ECB's head, Mario Draghi, has unleashed the aforementioned measures in one fell swoop, but came just short of implementing US style asset purchases. The assumption here is that they're coming, and Mr. Draghi is simply biding his time. If the recently implemented measures fail to accomplish the desired results, a healthy round of asset purchases will inject liquidity in to the economy creating the necessary 'wealth effect' and in effect buying yet more time for things to improve. With the US as a proxy, the Eurozone can use this blueprint and better anticipate the results. Rising equity markets is one expected outcome. Will this be enough to stimulate economic growth and lead to a hiring boom, something the US claims to be experiencing? It's difficult to tell, as Americans and Europeans are alike, and they're not. The employment rate in Europe is significantly higher than the US, indicating a more severe structural problem, maybe not easily solved through liquidity.

Effects on US Markets

One of the conundrums facing the US market was falling interest rates, leading some economists and analysts to worry that a recession was in the offing. However, more likely, it was a result of the impending Eurozone stimulative measures. In addition to falling US rates, equity markets have responded favorably to the moves, with US equity indices at record and historical levels. Most global equity indices are following suit with European markets are equally reaching record levels. Are these record equity levels a boon that should be enjoyed or are they indicative of the effects of rampant global liquidity injection and should investors be wary? Only time will tell, but an old cliche can provide some perspective: "There are no free lunches..." In other words, if rising equity markets seem too good to be true, they probably are.

Are Bond Yields Trying to Tell Investors Something?

The latest concern on the tips of investors tongues is: what, if anything, are falling bond yields trying

to tell the market? The concern is legitimate, as falling interest rates typically precede a recession, and with the major stock indexes flirting with historic highs, a correction could be in the offing. Are investor's concerns justified? Depending on who you listen to, investors may or may not need to worry.

Why Are Yields Falling?

The only reason falling rates is raising a red flag, in the first place, is that it does not jibe with a recovering and growing economy. Falling yields, or rates, are typically associated with a poor economic outlook. As an economy strengthens, and its outlook improves, long term interest rates typically rise as inflation becomes a concern. The fear of inflation is associated with falling bond prices as yields rise. Investors anticipate Fed intervention to cool a overheating economy which leads to rising yields. It's a self-fulfilling prophecy: investors expect the Fed to raise rates so they beat them to the punch and start to sell bonds. The logic and disposition of investors when the opposite is true is that something must be wrong with the economy when yields are doing the opposite. It is a justifiable concern. The reality is that although money manager insist that the economy is on the mend, the data doesn't support this position.

Economic Data

After heating up, real estate seems to be faltering, despite higher than anticipated housing starts on Friday. Most other metrics are not as robust. Another housing market concern: weakening demand. Fewer young folks are seeking homeownership, nor can they afford it. In addition to real estate, the consumer is another concern. The anticipated rebound on retail sales has not materialized as some had predicted. One suspect to look at for a weak consumer is prices at the pump. There is no way around $4 a gallon at the pump. Consumers have to fill their tanks to get to work and that eats in to discretionary income, and therefore less spending on other items.

The Fed

Economic data aside, the Fed is still in play regarding asset purchases. It may be purchasing less but it is still buying upwards of $40 billion in bonds each month. That's a lot of assets. So, there is still downward pressure on yields, from the Fed alone. The fall in yields has been associated with a bump in mortgage refinance applications as reported by the MBA. This is a desired result of the Fed as it eases stress on the consumer.

Is Something Else at Play in The Market?

The famously ebullient Jim Cramer, of CNBC's Mad Money fame, offers another option as to why yields are rising: an investor mentality paradigm shift. The host of Mad Money may be on to something. After two significant market declines, investor's timidity is understandable. The retail investor just has not embraced this bull market, in fact, has resisted this market recovery, viewing the disconnect between Wall Street and Main Street as their main concern. Are investors favoring the security of US treasuries over equities more now than in the past? An argument could be made that, in fact, they are, despite historically low yields. The mentality being: a little gain is better than a big loss. An interesting observation this year versus last year: all the talk of a "Great Rotation" last year is completely absent from todays news stream and headlines. Is there even such a thing as a rotation to even consider it as a possibility? Some analysts say it was never an option. What is interesting this year, however, is that no one is suggesting one. This could mean different things, but it, at the least, suggests investors are not anticipating large sales of fixed income securities.

What Does it All Mean?

The real concern might be the divergence that is occurring in the equity markets in addition to falling bond yields. High tech, high momentum, small cap stocks are skidding while investors are seeking the safety of large caps, thus we see historical highs in the Dow and S&P 500. Also, when large players, like David Tepper, start suggesting caution, it warrants attention. Is it time to take some money off the table? Maybe "sell in May and walk away" is justified this year.

Large Housing Investors: An Unforeseen Consequence

One of the largest catalysts of the Great Recession was a collapsing housing market. To be sure, prices had gone too high and some air had to be let out of the balloon. The subsequent collapse of CDO securities exacerbated the financial collapse that nearly sank the global economy. Once the long process of healing finally set in, one area that most analysts and economists anticipated would lead the recovery was the housing market. The only problem was that housing didn't get the memo. What went wrong? Why were so many folks off the mark regarding housing's eventual lethargic recovery and near stall? Enter the large institutional investors.

Large Institutional Investors Fill the Void

To take advantage of a market opportunity, which is what large institutional investors do, they came in with cannons loaded to the tune of billions of dollars. They bought wholesale large swaths of single family residences in the worst hit markets hoping for a bounce back. With access to cheap money and cheap inventory, the buying bonanza began. This phenomena helped the housing market stage an initial recovery. Prices started rising and with so many former owners looking to rent, properties could be rented for income purposes. But renting was never a long term goal for the large investors, as property management wasn't their business or goal. The inevitable buying ended once the cheap money ran out and the inventory eventually ran out. A big reason the inventory dried up was because all the while homebuilders had been sitting on the sidelines and to this day have not resumed past building patterns.

Squeezing Out the Few Little Guys

In economics there is a phenomena known as 'squeezing out'. This is when one form of capital displaces another form of capital. In the case of housing, the large investor has squeezed out the smaller more organic buyer. Large investors targeted the niche market that would normally have been available for the first time homebuyer. After driving up the value of this market, sopping up the inventory, in conjunction with rising interest rates, large investors contributed to a perfect storm that has all but eliminated a large part of the demand side of the market. This, combined with a still weak and slowly recovering economy, has resulted in a more anemic recovery in housing, confounding most analysts and economists.

Ukraine: Is A Russian Conflict Discounted In To Global Stock and Bond Markets?

Is A Russian-Ukraine Conflict Discounted In To Markets?

After a brief flight from risk and run for cover, equity markets and bond markets are adjusting to the idea of conflict on the Crimean peninsula. But are these markets accurately accounting for the rise of a real conflict between Russia and its former territory? Given the growing hostilities between the two nations, and US equity indices heading back toward record levels, it is hard to accept that a real conflict is priced in to markets.

As of this writing, Russia is amassing troops and running exercises near Crimea and the Ukraine has "eliminated" some "terrorists" that had set up road blocks. These are, so far, relatively minor incidents. However, wars have been started for less, especially, if one party is motivated by hostilities. Through referendum, Crimea has voted for its secession from Ukraine, which Russia acknowledges but the European Union and the United States do not. The US accuses Russia of inciting unrest in the region which Russia strongly denied. Over half of the Crimean population is of Russian ethnicity, accounting for why a referendum would be successful. So why the hostilities, why now? Russia, and Putin, its leader, could well be motivated by both economic and military interests. The ports in Crimea represent access points that represent maritime routes to the Mediterranean and to key Russian military bases in Crimea. As Ukraine distances itself from Russia, Russia may fear losing access to these strategic routes and its military bases. The area also has significant energy reserves in the form of gas. Is this incentive enough to start a potential military conflict with a heavily nuclear-armed opponent? It could be if Putin's ego is large enough, and the recent winter Olympics reflect at least that much.

Why Do Markets Care?

Markets dislike uncertainty. It could be its most detestable concern. Markets can handle most any issue that arises and discount it in, or price it in, accordingly. What markets struggle with mightily, is the unknown. How do you price in something you cannot evaluate or measure? That's what markets struggle with the most and why political and military hostilities pose such a threat to markets, both equity and fixed income. Typically, uncertainty is reflected in markets by a flight to quality, which is reflected in a sale of risk assets and the purchase of US treasuries, seen as a safe haven. The implications are immense. The importance to money managers is return performance, and to consumers is interest rates. A flight to quality can lower mortgage rates which benefit homeowners and homebuyers.

Is the Possibility of a Conflict Priced In to Markets?

The point of the article is to explore whether or not the possibility of conflict is accurately reflected in both equity and fixed income markets. Given elevated equity levels near all time highs and relatively high interest rates, as of now, it seems markets are not truly reflecting a real conflict is on the horizon. Where should equities and interest rates be? It's hard to say what would reflect a proper accounting for this possibility but some risk premium should be evident in both markets to account for possible hostilities. Equity indices should reflect some spread below where they could be absent any conflict whatsoever, and fixed income assets should show some spread above where they should be. The inherent problem with this logic is that, since the economic recession and extreme Federal intervention to stabilize markets, it's difficult to ascertain whether markets again expect Federal intervention in markets if a real conflict emerges and therefore is not discounted in properly.

Conclusion: The Fed Saves the Day...Again.

After a nearly unstoppable five year run, the bull market continues its stampede with the Fed tailwind behind it, and no conflict is insurmountable from the markets perspective. The possible Russian-Ukraine conflict will prove this again. Investors will cavalierly place their bets that any hiccup caused by geopolitics will be swept away by more liquidity and more artificial stimulus. This observation is not cynical but based on the past five year history of how markets are behaving in the current environment. What is unknown, and the market should despise is, what will be the cumulative effect of looking past all of these market hurdles, that the Fed has offered a soft landing, when it steps back?

Corporate Earnings Are Coming: Is Weather A Built-In Excuse?

George R.R. Martin has given life to the phrase "Winter is coming" in his expansive fantasy series

Game of Thrones. However, this phrase seems to have caught on with corporate America as it is being used as a scapegoat for weaker than expected earnings

Alcoa kicked off earnings season after the market close yesterday, the first of many earnings to come out over what seems like an endless parade, blurring the end of one earnings season and the beginning of another. After what has been a stellar period of earnings, corporations are challenged to maintain robust earnings growth. One challenge has been difficult comparisons. Earlier earnings easily hurdled prior weak earnings. But as earnings rose and after implementing financial engineering (read: stock repurchases via low cost borrowing) to continue the strong results, corporations are running out of growth and strategic options to paint a strong picture, all in an effort to justify and add to historic equity levels. Enter the excuse parade, and what better after a difficult winter than to trot out the weather excuse? Is weather a reasonable excuse for poor earnings? If the weather were mild would sales have been more robust? Did this winter more adversely affect U.S. businesses than past winters? Is there a typical winter effect?

The Growth Challenge: Revenue, the Bottom Line

The stock market gets its juice from discounting higher future earnings growth. Without it, earnings are simply an annuity with a value attached to them, the only variable changing is some chosen discount factor. Otherwise, the math is pretty straight forward. For the value of a company to go up, and therefore its stock to rise, earnings forecasts must constantly rise. This is the challenge corporate America faces today. Revenue growth is stagnant, so, corporations elected to reduce the number of outstanding shares to reduce the denominator in the earnings/share ratio to make earnings look better. Once corporations run out of either stock to buy back or cheap money to do it with (what we will be seeing more of as interest rates rise) earnings growth will have to come from somewhere else. This is where we will see if the economy is healing or if the stock market has gotten ahead of itself. To sustain a rising equity market, investors will look to earnings and forecasts to make investment decisions on whether to remain bullish or become more cautious.

Enter the Blame Game

The most convenient excuse for earnings disappointments is bad weather. The problem with this excuse is that when earnings surprise to the upside weather is never trumpeted by CEOs as the reason. At least if this were the case sometimes, investors could buy the excuse for poor earnings. When corporate earnings for companies located in moderate weather climates disappoint it also flies in the face of using the weather excuse. What weather excuse do Californian or Arizonan companies use? Rain? There is currently a drought in California. Floods? There are floods in Arizona every year. This winter the east coast has suffered through a severe winter, to be sure, and weather will be used as a legitimate excuse in some cases. But as winter becomes a distant memory and we move further in to spring those excuses will ring hollow. And what of bad weather every winter? Retail sales dip each year when the weather turns cold and stormy. Is each year identical from a weather stand point? No, they are not. Therefore, companies will continue to use the blame game as it is impossible to compare one year to the next. It would prove extremely difficult to accurately show how much weather affects results from year to year. No baseline exists to look at.

Conclusion: Investor Tolerance

Ultimately, it is up to investors, that put up their hard earned dollars, to decide whether disappointing earnings are an anomaly and are not a cause for concern of a larger problem. Investors will look around and decide if an entire industry has been affected by some common factor and allocate their dollars accordingly. If investors find that certain corporations have been disingenuous about the reason behind disappointing earnings, they will penalize those corporations with their investment decisions.