Tuesday, March 24, 2015

Housing bubble reincarnated as oil

We took my six-month old grandson to the park this weekend and put him into a baby swing for the first time. He couldn't decide if it was fun or not and took turns crying for a while then laughing for a while. I think of that when I read about the oil bubble.

The Fed has reincarnated the real estate bubble of the early 2000s in the current tsunami of oil. To see how, we need summon the help of the Austrian Business-Cycle Theory (ABCT). The ABCT says that Fed induced interest rates below  the rate that the market would naturally set causes excess borrowing and investment in capital goods industries, not a general over investment, but bad investments in particular industries. The market reveals those excess investments through falling prices that cut into profits, reduce employment and spark a recession in the economy.

Tuesday, March 17, 2015

Earnings stumble

Despite what mainstream finance and economics teach, the stock market is rational. Two things drive it - profits and risk tolerance, or as they say in finance, the discount rate. Both have advanced the stock market from its lows at the bottom of the latest recession to recent record highs as profit rates and risk tolerance soared so that investors have been willing to pay more for the same profits.

As of the writing of this post, the S&P 500 is down about 3% from its record set on March 2. Some of the selling could have come from profit taking or covering shorts, but much of it is due to concerns about future earnings. Last week I showed that profit rates are at record highs and reasonable investors would assume such rates are unsustainable based on the history. And that seems to be the case as Seeking Alpha's Brian Gilmartin wrote:
Looking at the first half of 2015, analysts are now projecting year-over-year declines in both earnings and revenues for both Q1 and Q2 '15, compared to expectations for earnings and revenue growth for both quarters back on December 31 '14.

Thursday, March 5, 2015

How high can profits go?

The market set new records this week. Some of the lift came from the European Central Bank printing new Euros. As the ECB buys bonds, the sellers are buying into the US stock market thinking that it is the safest repository. The ECB printing presses will impact stock markets for six months then, like any drug, the effect will begin to wear off. In microeconomics that’s called diminishing marginal returns.

The graph to the left shows profit rates from US domestic only earnings plotted in blue and labeled “Domestic Profit Rates” with the domestic profits that include foreign earnings plotted in red and labeled "National Profit Rates." The data comes the NIPA tables at the Bureau of Economic Analysis. Domestic profit rates are at their highest since 1965, but national rates are at their highest level on record. The high level of profits, and the records in the stock market in spite of a relatively sluggish economy, emphasizes the growing importance of foreign earnings. 

It's not likely that profits can continue to soar and many market watchers are pessimistic about future earnings. The Financial Times columnist Gavyn Davies reported recently that 
Albert Edwards, the market's favourite bear at Societie Generale, wrote last week that the rte of decline in analysts' forward profit expectations in the US is clearly associated with recession. According to MSCI data, profits downgrades are exceeding upgrades by a net 33 percent at present.
Some of the decline in expected earnings comes from falling oil prices and much of the rest from the rising dollar that reduces earnings from overseas. 

Schwab's Liz Ann Sonders estimates that the forward looking price-to-earnings ratio growth rate has actually gone negative:
Bespoke Investment Group (BIG) calculates the “guidance spread” each quarter, which measures the difference between the percentage of companies raising guidance and lowering guidance; so when the number is negative, more companies have lowered guidance than raised guidance. The spread for the most recent quarter came in at a “ridiculously low” -9.4 percentage points. That was the lowest guidance spread since the final two quarters of 2008, at the end of the financial crisis.
Psychologically speaking, pessimism like that coming out of the financial press is good for the market. If predictions turn out wrong and profits surprise by rising the market will soar.  On the other hand, it's hard to see where earnings growth will come from. Eventually, profits will fall as the Ricardo Effect kicks in and when it does the stock market will collapse as it did in 2000 and 2008. 

Thursday, February 26, 2015

Fed loses its mojo

The Dow hit another record high and the Japanese stock market rung the bell for a 15-year high this week following statements by Fed Chairman Janet Yellen before Congress that the she was losing patience. (Actually, she said the Fed would remove the word from its policy statement.) 

Both markets have been helped by the Big EZ's firing up its money presses. Much of the new issue of euros will swim the pond and dry out in the US stock market. Also, margin debt and debt by corps to buy back their own stocks are at record levels. 

Monday, February 16, 2015

Taking the market's temperature

Based on the popularity on my blog of the post The Dao of Investing - It's time to sell, I'm guessing investors are looking for indexes to help them take the temperature of the market. So this week I will revisit an indicator I developed in my book Financial Bull Riding.  

The method for building the index was based on a technique developed by James Estey in his book Business Cycles published in 1950. Estey included a chart of business cycles from 1790 through 1949 in which he plotted economic activity similar to GDP. Armed with dates for business cycle peaks and troughs, he de-trended the data by calculating the average for the series between peaks, then between troughs, then averaging the two series to obtain an average for each business cycle. Then he subtracted monthly figures from the cycle averages. 

Wednesday, February 4, 2015

China's slow growth omen

Reading the daily economic news in hopes of navigating our location in the business cycle reminds me of ancient priests trying to discern the movements of the gods by examining the contours of the liver of a sacrificed goat. Even the ancients priests understood that the more omens they could combine the better their predictions would be.

Another omen appeared this week when China announced that official China Federation of Logistics’ January purchasing managers’ index (PMI) slid to 49.8 from 50.1. The HSBC and Markit private sector PMI also fell from 49.8 to 49.7. Indexes like these are designed so that any outcome below 50 indicates contraction in the sector. In the worldwide division of capital, China is primarily a consumer goods manufacturing nation that supplies the US and the Big EZ (Euro Zone), which are the world’s largest manufacturers of producer and capital goods.

The Austrian Business-Cycle Theory (ABCT) at its simplest divides economies into raw materials, producer goods and consumer goods. Hayek’s version, employing the Ricardo Effect, says the turning point in an expansion comes when spending on consumer goods increases and the greater profits cause consumer goods makers to stop buying new equipment. That generates a profit crisis among producers goods manufacturers who begin to reduce employment and the recessions begins. The large jump in GDP, which mostly measures sales of consumer goods, in the third quarter was an omen of bad things to come from the producer goods sector. Sales of consumer goods (GDP) fall when enough workers in the producer goods sectors have lost their jobs.

Wednesday, January 28, 2015

Big EZ's QE Fail

The stock market climbed last week in anticipation of the European Central Bank's announcement of its program to purchase more bonds. The US press has dubbed it the ECB's quantitative easing, or QE. As with the several versions of QE in the US, the ECB's purpose is to reduce interest rates enough to persuade businesses to borrow and expand and consumers to borrow and buy cars and houses. Also, the bank hopes it will ramp up price inflation that will reduce debt.

The bank's QE effort will fail to achieve the goal as did those of Japan and the US. ECB president Mario Draghi admitted as much when he told politicians that credit expansion alone will not rescue Europe without "structural" changes by governments. In other words, Europe's problems are microeconomic, not macro. The structural changes needed include reducing taxes and rolling back regulations, especially rigid labor regulations that make it almost impossible for businesses to divorce employees. Businesses are not investing in the US because of high taxes and job-killing regulations, but the problem is much worse in Europe.