The Big Picture - Macro Perspective on the Capital Markets, Economy, Technology, and Digital Media

I think it’s likely that I introduced Bob Farrell’s Market Rules to Remember to the blogosphere (albeit to a smaller audience), as they’d been an integral part of my upbringing in the business and I was eager to share them when I started blogging.  (BR posted them here in August 2008.)

That said, let’s have a look at Farrell’s Rule #9 which states:

9. When all the experts and forecasts agree – something else is going to happen.

With the understanding that it’s early August, that there are almost five months left in the year, that the Trading Gods will frown upon what I’m about to do and that I’ll wind up with copious amounts of egg on my face, I offer up the following look at what the consensus was saying with regard to year-end S&P500 levels just a very short time ago (originally via a Bloomberg terminal and circulated liberally).  I simply do not have it in me to list any individuals’ names; I’ll leave it to the reader to figure out the who’s who.  Caveat:  There may have been updates to these forecasts since the time I first received them, but these were, in fact, the forecasts not all too long ago.  And I recently attended a meeting at which one strategist who’s officially in spitting distance of the mean provided attendees a “whisper” number closer to the high.  Oh well.

(We closed last year at 1257.)

So, the one thing that we could easily have inferred from this data when it was published was that the S&P would not close at (or near) 1400, which is now a cool 17% move from yesterday’s close in the context of an economy that is losing steam by the day.  1600 or 1200, yeah, but 1400, no way.

With that, I humbly ask the Trading Gods to be merciful in their punishment of me.  My intention — to demonstrate in real-time one of Farrell’s Rules — was noble.  Frankly, given our current circumstances, I find the prospect of a 17% gain between now and year-end fairly remote.  But I have been wrong a couple thousand times in my career.  Only time will tell if I should have waited until January 2012 to publish this, but that would evidence a total lack of cojones on my part; I’ll take my medicine at the appropriate time.

Obama had one shot at a stimulus package when the economy was reeling from the near economic collapse of 2008.  Some members of his team argued it needed to be bigger (it did), but for whatever reasons they did not prevail.  What was needed then — as now — was to put money to work in such a way as to get the best bang for the buck and put as many people to work as possible.  It’s been my long-held contention that infrastructure would have been an ideal use of stimulus funds.  Consider (much more data at the link):

With 45 percent of roads in less than good condition and 12 percent of bridges structurally deficient, the U.S. faces severe infrastructure needs that significantly impact the nation’s economy.

More than 150,000 miles—or 45 percent—of federal highways and major roads in the U.S. are not in good condition, according to the Federal Highway Administration.

More than 71,000 of the nation’s bridges—12 percent—are rated as structurally deficient. More than 78,000 are rated as functionally obsolete.

More than 20 states this year will likely reduce transportation investments because of federal inaction on a new surface transportation authorization bill.

So, perhaps we could have used some money to give our highways and streets some needed attention.  Other areas that come to my mind as good candidates for construction are:  Public Safety, Sewage & Waste Disposal, Water Supply, and Educational.  Sadly, it seems as though not much money went to these necessities.  Thanks to some data sets recently picked up by FRED, we can take a look at all of these areas.  First up, Highway & Street and Educational construction spending.  What I’d really like to see here is a spike — a big one — which would indicate stimulus funds had been allocated to these crucial areas.  Do you see a meaningful spike?  Neither do I, and what’s worse is that both series are now on the decline.

(NOTE:  These expenditures all have to do solely with construction spending)

Let’s look at the other areas I mentioned (I broke the data into multiple charts to keep similar dollar expenditure levels together and thereby render greater detail).

No signs of a meaningful spike here, either.

One last look, this time at Transportation (like, say, the high speed rail I’ve always hoped Obama would embrace):

So, nothing significant has really been done on any of these files, and now Obama’s out of bullets.  The beauty of construction spending is that you wind up with things — roads, bridges, tunnels, rails, schools, sewage treatment plants, power plants, airports, dams — that last for decades and get passed from one generation to the next.  Now that opportunity has been squandered — DC is in full-on austerity mode, and the states and municipalities are having their own issues.

I wrote in June 2010:  “And, for the record,  I’ll state here that I think Obama and his team badly misallocated the stimulus in ways that did little to create jobs, unarguably its most important objective.  And that will cost him dearly (as evidenced by yesterday’s third defeat of an unemployment benefits extension?).” Nothing that has happened in the past 14 months has caused me to waver from that position.

Final note:  As I was wrapping up this post, I received an alert that the Philly Fed’s Leading Index series had been updated, so of course I took a gander.  The contours of our two “soft patches” are clear.  The difference is that last year at this time The Bernank was announcing QE2.  It remains to be seen whether or not Ben has another rabbit to pull out of another hat.

UPDATING, Aug 3, 10:24AM:  In his daily today, David Rosenberg makes the same point regarding the stimulus:

The overhang of excessive debt burdens is still with us today and the problem with the government stimulus programs that were put into place is that they were not designed properly; the multiplier impacts never did kick in.  So we can’t “grow” our way out.

Invictus writes:

I could not help but be struck by the different positions — both articulated on Friday –  on federal spending taken by two economists for whom I have the utmost respect — Paul Krugman and David Rosenberg.  In his daily missive Friday, Rosie went off on federal spending:

Government spending, in the United States, is simply out of control.

Over the past decade, federal expenditures rose at an average annual rate of 6% while the growth rate in the number of households has risen at a 0.8% annual rate.  At around 25% of GDP, spending is higher now than at any other time since 1946.  That is an outlier.  Admittedly, revenues at 15% of GDP are abnormally low as well, and while a partial by-product of the recession and sluggish recovery, loopholes galore and endless tax gimmicks are also at play — in the 1991 economic downturn that ratio was around 18% and in the severe economic decline in the early 1980s, it was 19%.  Revenues have to go up and there’s a cool trillion sittin’ right there in loopholes — oh, sorry, deductions and “tax expenditures,” we don’t want to offend anybody — that could be eliminated without sacrificing growth while reducing the ridiculous complexity of the tax code. [...]

But to think that the U.S. government cannot manage to deliver effective and essential services with a $2.5 trillion revenue base is absurd.  [...]  Isn’t 21 grand per household of government benefits enough?

You get the gist.

Krugman sees it otherwise:

Whenever someone like me or Bruce Bartlett points out how little Obama resembles the right’s portrait of a raging leftist, someone is sure to come back with the assertion that Obama has presided over a vast expansion of federal spending. Even people who really should know better, like John Taylor, do it.

So what’s the truth? I’ve written about this before, but here’s another take.

The fact is that federal spending rose from 19.6% of GDP in fiscal 2007 to 23.8% of GDP in fiscal 2010. So isn’t that a huge spending spree? Well, no.

First of all, the size of a ratio depends on the denominator as well as the numerator. GDP has fallen sharply relative to the economy’s potential; here’s the ratio of real GDP to the CBO’s estimate of potential GDP:

A 6 percent fall in GDP relative to trend, all by itself, would have raised the ratio of spending to GDP from 19.6 to 20.8, or about 30 percent of the actual rise.

That still leaves a rise in spending; but most of that is safety-net programs, which spend more in hard times because more people are in distress. The CBO breaks out “income security” (Table E-10 in Historical Budget Tables), which is unemployment insurance, food stamps, etc., and also gives us numbers on Medicaid; here’s what they look like as percentages of GDP:

That’s another 2 points of GDP, or about half the rise.

So we’re still left with a bit, around 1 point of GDP. That’s the stimulus, more or less. And there are two things you need to know about it. First, it’s temporary, and already fading out fast. Second, a large part of the stimulus “spending” was actually aid to state and local governments, intended not to expand spending but to avert a fall — that is, it was about maintaining government, not expanding it.

Now, pointing out the Obama spending binge is a myth generally produces rage: people know that it happened, because Rush Limbaugh and the Wall Street Journal say so. But that doesn’t make it true.

What I find most fascinating is that back in the period leading up to the recession, both Krugman and Rosenberg were spot-on in their assessments of what was unfolding.  Far from calling it in real time, they were way ahead of the curve and their peers (see here for Rosie’s prescient piece on the housing market; it’s just one of dozens).  They both brilliantly foretold of the coming crisis and the effects it would have on the economy, jobs, joblessness, liquidity, monetary policy, interest rates, etc.  Where they are diametrically opposed is on how to solve a problem they both so astutely saw coming. That two people could so precisely diagnose a problem, yet differ so totally on the solution, intrigues me greatly.  Would love to see the two of them side-by-side on a panel discussion.

See also:

Mokito Rich, NY Times, The Role of Government Spending, July 29, 2011

The Chicago Fed’s National Activity Index (CFNAI) printed this week.  The CFNAI is among my favorite indicators that no one seems to follow (though it is covered monthly by Calculated Risk and usually David Rosenberg).  It is an amalgam of 85 distinct economic indicators that gives a very accurate read on the economy.  The folks in Chicago tell us to focus more on the three month moving average than the month-to-month number, and tell us further that, ”When the CFNAI-MA3 value moves below –0.70 following a period of economic expansion, there is an increasing likelihood that a recession has begun.”

So, where are we as of this month’s print?  Try -0.60, a mere 10 bps from what is likely recessionary terrain:

Source:  Chicago Fed. Red line denotes likely recession threshhold.

I’ll outsource the commentary to Rosie (while noting for the record that I’d Tweeted about this in advance of his piece, lest I be accused of appropriating his work):

Note that the worst we got last summer was -0.28 so indeed, this is a different “soft patch” and perhaps a more pernicious one than we experienced in last year’s “head fake.”  Also note that we hit -0.60 on the CFNAI index in January 2001 and March 2008, both times the major equity indices were off the highs but still close enough to be keeping the bull market psychology alive.  Only in December 1991 and in April 2003 did we slip to -0.60 and actually not slip into contraction mode in the real economy; however, the former was still very close to the prior recession so it wasn’t even clear at that point that it was over; the latter was all about the Iraq war and proved temporary.  It is debatable as to whether the similar move through -0.60 in July 1989 provided a false signal as it did lead the recession (again, a recession that nobody saw coming at the time) — at the very least it marked the nearing of the end for that long cycle of the 1980s and gave an early signal for investors to start trimming risk.

For the curious, next month’s print would have to be -1.09 to achieve a sum of -2.10 for three months (and hence a 3-mo ma of -0.70).  While a drop from this month’s -0.46 to a -1.09 is rather large for this index, it is in the realm of historical experience.  If I had to guess, I’d say we won’t hit the -0.70 three month moving average next month.  But we are in dangerous territory to be sure.

Oh, and for the inflationistas in the audience, there’s this from the Chicago Fed:

When the CFNAI-MA3 value moves above +0.70 more than two years into an economic expansion, there is an increasing likelihood that a period of sustained increasing inflation has begun.

Translation:  Don’t hold your breath.

Stay tuned.

A Bank of America Merrill Lynch research note on the abysmal nonfarm payrolls number for June contained this graph:

A February 2010 Big Picture post on slack in the labor market contained this graph:

My comment at the time, which holds true today:

I’d postulate that only when this gap starts to close meaningfully will we have to consider the possibility that the Fed will tighten and/or that inflation might be somewhere out there on the horizon.  Until then, it’s very hard to envision they’ll consider moving off their ZIRP.

A mention by David Rosenberg in a recent note sent me scurrying to find this report from the San Francisco Fed in August of last year.  The report — remember, it was almost one year ago — used the Leading Economic Indicators to assess the probability of another recession within the next 24 months (from that date, obviously):

Statistical experiments with LEI data can mitigate these limitations and suggest that a recessionary relapse is a significant possibility sometime in the next two years.

The most interesting aspect of their work is the authors’ removal of the yield curve spread (after all, the yield curve simply cannot invert with short rates at the zero bound) from their LEI-based analysis of recession probabilities.  The result (emphasis mine):

The last experiment drops the spread between the Treasury bond and the federal funds rate from the 10 LEI indicators. Historically, this spread, which summarizes the slope of the interest rate term structure, has been a very good predictor of turning points 12 to 18 months into the future. Specifically, an inverted yield curve has preceded each of the last seven recessions. However, the term structure may not presently be an accurate signal. Monetary policy has been operating near the zero lower bound to provide maximum monetary stimulus. In addition, the Greek fiscal crisis has generated a considerable flight to quality that has pushed down yields on U.S. Treasury securities. Indeed, the thick red line in Figure 3 shows that omitting the rate-spread indicator generates far more pessimistic forecasts. For the period 18 to 24 months in the future, the probability of recession goes above 0.5, putting the odds of recession slightly above the odds of expansion.

Would seem that the economy is beginning to track as forecast by Mssrs. Berge and Jordà.

Tons of talk and pixels being spilled over the imminent inflation threat.  It bears an eerie resemblance to what we heard from the likes of Jerry Bowyer and Art Laffer two years ago.  I’d fade it now, exactly as I suggested back then (here and here, the latter piece co-authored with Bonddad):

Exhibit A — The Chicago Fed National Activity Index (PDF)

When the CFNAI-MA3 value moves above +0.70 more than two years into an economic expansion, there is an increasing likelihood that a period of sustained increasing inflation has begun.

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Current read of CFNAI-MA3:  +0.11, and that with three of the four subcomponents doing the heavy lifting while one — Consumption & Housing — remains mired near multi-year lows and shows no signs of recovering any time soon.  We might actually get a good call out of Bowyer or Laffer before we get to +0.70 on CFNAI-3MA — it’s gonna be a while.

Exhibit B — The Money Multiplier — all that heavy breathing about the flood of liquidity that was going to pour into the system.  Hyper-inflation!  Except not so much, apparently.  As David Rosenberg (who was spot-on in his assessment of the last bogus inflation scare) put it in his Monday note:

Fully 100% of both QEs by the Fed merely was new money printing that ended up sitting idly on commercial bank balance sheets. Money velocity and the money multiplier are stagnant at best.

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Those who still think the credit spigots are going to open any moment now, consider this:  We know that consumer credit, ex-student loans, is still contracting.  And we know from National Federation of Independent Business that “the vast majority of small businesses (93 percent) reported that all their credit needs were met or that they were not interested in borrowing.”

Exhibit C — This remarkable chart that I’ve cribbed from Minyanville, though the original source is Bloomberg.  What happens if there’s no QE3?

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(The chart above was really a stunner.)

Exhibits D and E

Two more reasons with a couple of homemade charts:  Inflation has a very high correlation to the labor market.  Indeed, the roots of inflation are generally found in higher labor costs.  We are just not seeing upward pressure on labor costs — there is simply still too much slack in the system and the Unemployment Rate is too high.  Unit Labor Costs and CPI sport a high +0.88 correlation:

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Average Hourly Earnings and CPI have a +0.79 correlation:

The Fed is on the record with their assessment that any bout of inflation will be “transitory.”  I concur, as does this new Chicago Fed paper, and our old friend David Rosenberg (last week):

The key to the outlook for inflation is not commodities — it is the labour market.  We have a situation where wages in nominal terms are running at +1.7% on a year-over-year rate and productivity is running at +2.0%.  So we have unit labor costs fractionally deflating as they have been consistently since 2009 Q1.  Go back to the 1970s, and guess how many quarters unit labor costs deflated?  Try none.  By the end of the 1970s, unit labor costs had surged at nearly a 7% annual rate for the decade as a whole; not sub-zero as is the case today.

And the last word to Rosie (from Monday’s note):

And it remains a legitimate question as to how we end up with inflation as credit contracts. Not just in the consumer and housing sectors, but in the government sector too. The state and local government sectors have dramatically cut back on bond issuance this year and are cancelling capital projects in the process. We see on the front page of the weekend WSJ this headline ― Inflation Drives a Shift in Markets and right above it is Deadline Drama Over Budget. Not only is household credit contracting, but the same is happening at the government level. This is deflationary, not inflationary, and once commodities settle down ― they are volatile and self-correcting as we have seen in the past ― all this talk of inflation is going to subside pretty quickly.

Finally,  on a semi-related matter, the NY Times ran an interesting piece that follows up nicely on my recent post highlighting the growth in student loans.

Invictus here.

I’m halfway through Greg Farrell’s Crash of the Titans: Greed, Hubris, the Fall of Merrill Lynch, and the Near-Collapse of Bank of America. Perhaps I’ll post a thorough review when I’m done with it. So far, so good, though I’ll confess it’s a bit like watching one’s own funeral — very morbid; sad memories of a deeply troubling time.

If there is one bone I will pick with Farrell’s work — and I was making this point about Stan O’Neal’s incompetence long before this book came out — it’s that he makes no mention of the fact that Merrill had a Chief North American Economist, David Rosenberg, who saw the housing bubble moving on to his radar screen, like a gathering storm, in August 2004.  Had Merrill heeded its economist’s advice, things would have turned out much differently.  The piece below is, I believe, the first in which he raised the specter of trouble on the horizon; many others followed in the same vein.  That O’Neal ignored his own chief economist and plowed ahead in the CDO market, in addition to buying subprime originator First Franklin in late 2006 at the absolute pinnacle of the market, shows three things:

1. O’Neal was an awful CEO, ignoring his own Institutional Investor top ranked economist and, according to Farrell, squashing any dissent by unceremoniously dismissing any employees who raised concerns about the direction the firm was taking (see:  Kronthal, Jeff, et. al.);

2. He was an incompetent risk manager, who never should have been running a BD.  And he relied on a similarly inept risk manager in Ahmass Fakahany;

3. The compensation structure in corporate America is a joke (admittedly not exactly breaking news).

But back to Rosie’s call. For those who have not seen it, below is his August 6 2004 Market Economist. Pages 5 – 14 are prescient, and that section on the housing market, with an assist to Ron Wexler, deserves a place in the Research Hall of Fame (along with only a handful of other calls in the entire history of research).  Parenthetically, it also puts the lie to comments made by then-CEA Chair Ben Bernanke at this presser in August 2005, in response to a question about the “housing bubble”:

There’s a lot of good news on housing. The rate of homeownership is at a record level, affordability still pretty good [Invictus:  The first half of the second sentence was true, the second half an outright fabrication]. The issue of the housing bubble is one that people have — whether there is a housing bubble is one that people have raised. Housing prices certainly have come up quite a bit. But I think it’s important to point out that house prices are being supported in very large part by very strong fundamentals.

Anyone who read Rosie’s piece (not saying Bernanke did) and came away thinking the housing market was trading on “very strong fundamentals” was, in short, delusional.  In retrospect, this report may have been the seminal work that propelled Rosie on to much greater (and deserved) recognition.

So grab a second cup of coffee and enjoy — it’s a quick read with some straightforward chartwork that even Stan O’Neal should have understood. (In my fantasy world, the one where CEOs and their co-conspirators are actually held accountable for their gross negligence and misdeeds (beyond being drummed out with $161MM parachutes), a document like this would be referred to as “Exhibit A”).

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Duly noted in a research piece by Merrill Lynch, the wealth gap continues to widen, poverty grows:

The following article caught our attention on the Wall Street Journal Online, “Millionaire Population Soars – Again.” The Wall Street Journal is reporting on a survey performed by Phoenix Marketing International’s Affluent Market Practice. According to the survey, the number of American households with investible assets of $1 million or more rose 8% in the 12 months ended in June. In total, according to this survey, there are more than 5.55 million US households with investible assets of $1 million or more. The millionaire count has now returned to 2006 levels, but is still below the peak reached in 2007 of 5.97 million.

In stark contrast to the previous article, the Census Bureau released its annual snapshot of American living standards. The Census Bureau found that the fraction of Americans living in poverty rose sharply to 14.3% in 2009, up from 13.2% previously. This is the highest level since 1994. In total, 43.6 million Americans were living in poverty last year. To read more, check out the Wall Street Journal Online article, “Poverty Rate Rises To 14.3%.”

The Census snapshot also indicated that the gap between the best-off and worst-off Americans widened a bit more in 2009, a long-standing trend, but not by much. The top fifth of households accounted for 50.3% of all pre-tax income; the bottom two-fifths got 12%. In 1999, the top fifth claimed 49.4% and the bottom got 12.5% of the income. Have a look at page A1 of the WSJ, “Lost Decade for Family Income.”

I hope to have more on the Census Bureau’s just-released report early next week,  as it’s chock full of good data (as will be today’s release of the Fed’s Flow of Funds).  Suffice to say the news is not good; it is saddening to see the poverty rate on the rise and engulf almost 44 million Americans.

It is a very hot August and the heat seems to be getting to people on Wall Street. In Washington the greater heat stems from fears about the impact of the economy and housing on the mid-term elections. As a result, Wall Street is expecting a big “surprise” in the form of a massive GSE refinancing plan, an unbridled expansion of the unsuccessful HARP program.

Don’t hold your breath.

Ongoing rumors of a streamlined GSE induced refi wave began last week with notes from Morgan Stanley and Bank of America. Folks at these firms proposed that borrowers could benefit, resulting in increased consumer spending, if only the GSE’s initiated a streamlined and broad program to allow those of their mortgagees who are current on their mortgages to instantly refinance from their higher rate mortgages to current market rates.

The argument is, since the GSEs own the credit risk anyway, they should change the refinancing requirements and lower or eliminate appraisal requirements and LTV requirements for refinancing. Doing so would, it is suggested, lower the burden on borrower cash flows, as they would benefit by lowering their rates by about 150bp. The pitch was ‘it would be a costless plan with real benefits’. Nice theory, too bad it doesn’t work and isn’t possible.

Beside the small consumer stimulus there could be another argued benefit to such a plan. By increasing the ability of borrowers to pay their primary mortgage, the plan would appear to help Treasury’s ongoing process of creating disparate benefits to second lien holders.

There are several and significant problems with this plan:

- As a result of another prepayment-shock and the inability to model future prepayment shocks, investors would become even more unwilling to invest in MBS gong forward, or would begin to demand higher yields going forward; unwilling to invest in MBS going forward, or would begin to demand higher yields going forward;

- The interest rate risk that this would cause, as banks and the GSEs themselves all had to re-hedge their books at the same time, could precipitate a systemic risk issue;

- The prepayments would cost investors more than half a trillion in lost interest income;

- Such a “streamlined” refi program would cost state and municipalities billions of dollars in transfer fees that they would normally be able to charge on a refinancing;

- Keeping borrowers in their homes with rate reductions could be argued to be consistent with maximizing value under conservatorship. A streamlined and across the board refi program that treats all borrower LTVs and other features the same would appear to violate the conservatorship;

- The GSEs, according to their trust agreements, are prohibited from soliciting prepayments. If they were in receivership these agreements could be abrogated but they would still have to pay value on the contracts; and

- Servicer’s could solicit borrowers to prepay on the program but it would be a nightmare to operationalize and oversee such a massive program.

We have heard absolutely no serious discussion of this hare-brained idea in regulator or policy circles. While we do not expect the GSE rumor to prove correct that doesn’t mean the situation is static.

We will soon see the implementation of their previously announced HAMP and FHA short-refinancing programs. Even though initial HAMP results will not be reported until you can expect the Administration to “sell it hard” and play it up. The Principal Reduction Alternative in the “new” HAMP is voluntary¹ but does state “participating 2MP servicers must forgive an amount of principal on 2nd liens in equal proportion to the amount forgiven on the first lien loan by the 1st lien servicer.”² The fact that about half of all second liens and HELOCS are owned by the same banks that service the firsts on behalf of mortgage investors, and that those banks continue to hold the value of their seconds at prices that far exceed a fair mark, you can expect that this voluntary approach will be generally left unused.

Also, as early discussions on the FHA short-refi program were happening, there were questions of whether the GSEs would be involved. At the time we were hearing the GSEs were developing their own short-refinancing program. It remains unclear am what that would be but it is important to remember that the Federal Housing Finance Agency is acting as “conservator” to the GSEs. “The FHFA, as Conservator, may take all actions necessary and appropriate to (1) put the Company in a sound and solvent condition and (2) carry on the Company’s business and preserve and conserve the assets and property of the Company.” This suggests any short refi program would have to be narrow, as drawing it too broadly would cause the dissipation of assets from the conservatorship.

Those who would suggest this view of the conservatorship ignores that politics will trump legality in a difficult mid-term election cycle should remember that politics are a two way street and the Republicans would make hay with any significant violation of the conservatorship. It is in large measure the public’s weariness from random interventions into market function and ineffective programs which continue to advantage banks ahead of market participants and the real economy that have caused so much unhappiness with this Administration. A new and massive program that crams losses onto investors rather than addressing fundamental problem³ will not be well received.

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Previously:
Morgan Stanley: More Irresponsible Mortgage Lending, Please (July 28, 2010)

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1 Note: The Special Inspector General for TARP, in his Quarterly Report to Congress states “PRA does not require servicers to forgive principal, even when doing so is deemed to offer greater financial benefit to the investor.”

2 https://www.hmpadmin.com/portal/docs/hamp_servicer/praoverviewnongse.pdf

3 http://bradmiller.house.gov/index.cfm?sectionid=53&sectiontree=46,53&itemid=928