Saturday, July 20, 2013

2013 Second Half Outlook: Stimulus Is Now Lifeblood Of The Global Economy

2013 Second Half Outlook: Introduction
2013 Second Half Outlook: How Rising Rates Impact The Overall Economy
2013 Second Half Outlook: Why The Fed Can Never Exit
2013 Second Half Outlook: What Is An Interest Rate Swap?
2013 Second Half Outlook: Stimulus Is Now The Lifeblood Of The Economy
2013 Second Half Outlook: US Stock Market Decline Coming
2013 Second Half Outlook: Real Estate Experiences Mortgage Rate Earthquake

Most of the people actively involved in the financial markets day to day, such as the operators of the high
frequency trading machines (which dominate close to 70% of all trading) and the large investment bank traders (which control almost everything else), have a clear understanding that behind all the smoke and mirrors there is just one simple summation of the current market structure:

Stimulus is now the lifeblood of the economy. It is the only thing sustaining the current artificial mirage we current live in.

Readers of this site understand this, but I think it is important to know that most professional participants in the financial markets as well as most intelligent business owners understand this as well. 

With that understanding, the obvious question is: why would these participants even be involved in the financial markets if they know this?

The answer is that they believe they will be the first person out the door when the building catches on fire. Some of the them will be, and they will make a lot of money trading these artificial markets until the building does catch on fire. Some of them will not. One thing both we, and they, are sure of is that the greater population will burn in the building when it catches on fire. Those that invest into stock and bond mutual funds “for the long run” will still be holding their assets strong . They will turn around when the building catches on fire to see that the 1% of the participants (that dominate most of the day to day activity) will have left already left the building before it was even possible to see or smell the smoke.


It is these unfortunate people, just as they did in 2008, who will feel completely duped when the collapse arrives. This time, as we will discuss in a moment, the collapse will come in both stocks and bonds. Those that think they are protecting themselves by hiding in the “safety” of bonds will find out just as they did in June, that their mutual fund which holds 60% bonds and 40% stocks for safety is seeing 100% of its value falling simultaneously.

At the same time the financial industry that sold them the mutual fund will still collect its 3% annual “maintenance fee” of the fund as well as profit from their assets falling as they take the short side of the position on their trading desks on the way down.

It will be horrifying to watch for those that understand what is coming.


I bring this up because we are about to discuss more of a fundamental conversation around the current (over)valuation of stocks and bonds (specifically in America). This helps show why there is no fundamental reason beyond “stimulus” for asset prices to be rising, and will help those that are witnessing the coming collapse understand why it occurred.

But the truth is that this understanding does nothing to help forecast the timing it occurs, which for some reason makes the situation extremely frustrating due to natural human psychology.

The music will stop when it stops, just as it is impossible to determine which snowflake will trigger the avalanche on a very unstable mountainside.

What is far more important than trying to find the specific snowflake is to understand that the mountainside is primed perfectly for avalanche. Then you can just relax from a distance, while drinking coffee, and enjoy the spectacle as it occurs.

With this understanding we will focus now on the instability of the mountainside.

Up Next: 2013 Second Half Outlook: US Stock Market Decline Coming

2013 Second Half Outlook: U.S. Stock Market Decline Coming

2013 Second Half Outlook: Introduction
2013 Second Half Outlook: How Rising Rates Impact The Overall Economy
2013 Second Half Outlook: Why The Fed Can Never Exit
2013 Second Half Outlook: What Is An Interest Rate Swap?
2013 Second Half Outlook: Stimulus Is Now The Lifeblood Of The Economy
2013 Second Half Outlook: US Stock Market Decline Coming
2013 Second Half Outlook: Real Estate Experiences Mortgage Rate Earthquake

It has been hidden from the eyes of the casual market observer, but since 2007 we have seen major tops in almost every major financial market on the planet. Many residential real estate markets topped in 2006, most commodities topped in 2008 (some in 2011), bonds peaked in 2012 (some in June 2013), and most stock markets around the world have not regained their highs seen in 2007.

In reality, we have seen a period of rolling tops and money has moved not with all asset classes pushing them higher, but focusing on one asset class that bursts higher and then fades. Where is this current focus of intense speculation?

The United States stock market.

The US stock market has become the new darling investment choice for investors almost everywhere you turn. You have heard that "there is no other option" or that the "great rotation" is here, two topics we discussed in a bonus section of the 2013 Second Half Outlook:

Bonus Section: The Great Rotation Meets No Other Alternative

Now we have heard that we are back in a Goldilocks scenario. The great David Tepper has come on CNBC during 2013 and told a mesmerized audience that stocks cannot fall for two very basic reasons:

1. The economy will improve which will push stocks higher
2. The economy will slow which will increase Fed purchases which will push stocks higher

David Tepper pictured below. He is the highest paid hedge fund manager in the world who does very well when the market rises and gets crushed when the markets fall. His fund lost 28% during 2008, and he lost 25% in just a few months during 1998 betting on a bullish turn in Russian bonds (which defaulted).


This of course is the same exact reason we heard stocks would rise forever back in March 2000 and November 2007. There was a "Fed put" under the market that would always keep stocks propped up and push them higher, like a lever, whenever they felt like kindly making people richer.

The market's view of the Fed is now well beyond the irrationality seen in at the previous peaks over the last 13 years. The Fed is truly now considered god-like, where most investment decisions are focused only on how much stimulus Bernanke will provide to save us.

Some go beyond the Fed irrationality and add that the market is now extremely "cheap." This is done using a price to earnings ratio (P/E). The market projects ahead what they believe earnings will be 12 months from now and they apply this outlook to the price of stocks today. This is of course insane for anyone with common sense, but it is exactly what you hear about on 24 hour mainstream news networks from paid financial professionals.

Market participants tell us that the market is currently trading at a 14.3x P/E ratio, which is cheap historically. In order to get to this cheap P/E ratio earnings just have to grow at 28% over the next 5 quarters. Should be no problems, right?

The chart below show the rate of earnings growth in red. The earnings growth rate, currently at 2.48%, has been falling steadily and is approaching negative territory at its current pace. A negative real growth rate in earnings could change the outlook for stocks rapidly, which have already priced in 28% fantasy growth.


This is why financial professionals are always so shocked at market highs. If you put an artificial number into your model then you can make any price look cheap.

The better metric to use is real earnings, or what has actually been taking place on the balance sheets of companies over the previous 12 months. Using this metric, we can see in the chart below that the trailing 12 month P/E ratio topped out at 17.7x earnings at the market peak in 2007. Where are we today? We have blasted past that point and now sit at trailing 12 month P/E ratio of 19x earnings.


We were told that the market was cheap in late 2007 because financial professionals then were using forecasted earnings for the future. In October 2007, forward projected earnings were at $110 a share - creating the illusion that companies were trading at only 16x earnings. Earnings ended up coming in slightly below that forecast the following year...at $55 a share or 50% below the forecast.

Let's now move back to where we began. As asset classes have topped and begun the process of rolling over around the world, why has the United States stock market launched higher into the stratosphere all by itself?

The answer is leverage driven by sentiment. Investors are so confident today that the Fed is in complete control today that they have borrowed more money than any time in history to bet that prices will go higher from here. It is like being so confident playing roulette in Vegas that the next ball will land on black that you borrow $100,000 from family and friends to bet on it. The following chart shows this new record setting margin at our current record setting stock prices:


Margin is a beautiful thing for market participants. If you have 90% leveraged on a trade (you have $10 of your own money with $90 borrowed) that a stock will move higher, a 1% move higher in that stock nets you a 10% gain on your money.

The problem we have seen is what happens when everyone moves in with all their cash and then borrows as much money as possible to bet even more on the stock market casino moving higher. If the trade reverses due to a small loss of faith, such as what we experienced with the utterance of the word "taper" in June, then you will experience a waterfall decline in prices. We have seen this process before during the rolling tops of the past 13 years:


Let's take a brief trip back to the 1920's. The PE ratio for the stock market was 17.5x earnings in 1929, just before the greatest crash in market history. Today the stock market is fundamentally more expensive than that monumental high.


How high can markets go before they face reality? Much higher. However, markets are already more dangerous at this exact moment in time than at any point in the history of the American stock exchange. That includes 1929 and 2007. High frequency trading now allows the possibility that the next collapse could mirror something closer to 1987 where the markets enter a panic free fall. The coming liquidation could be over in hours or days vs. the month long declines we have seen in the past.

Up Next: 2013 Second Half Outlook: Real Estate Experiences Mortgage Rate Earthquake

America's Choice: Working 75 Hours Per Week Vs. Collecting Free Money

McDonald's recently took the time to come out with a budget plan for its workers across the country. It shows a standard balance sheet for a typical employee and how they can budget their funds in order to survive every month.


In order to make the income in job 1, you would need to be making about $8 an hour working full time at McDonald's. This is probably a typical wage for a standard worker at the restaurant.

The first thing you'll probably notice is that McDonald's first strategy for success is to immediately get a second job on top of your 40 hour position. This tells you that it is impossible for an American to live off of a close to minimum wage full time position.

The second job would be in the range of 35 hours per week if they were making the same $8 an hour. Perhaps they can leave their McDonald's job in the afternoon and work at the mall at night.

The expenses are just as ridiculous, which is discussed in the video below.

This should clearly show why most of the unemployed youth in America will do everything in their power to get and stay on welfare instead of trying to work two full time jobs to survive. It is very easy to accumulate the same monthly funds though disability payments (which can be received now by telling a doctor your back hurts - something that is impossible to diagnose), combined with housing, medical, and food stamps. See:

The New America: It Is Better Financially To Collect Disability Than Take A Job

This should also show the danger of the Federal Reserve's monetary policy because if some of the trillions of dollars being created every year should be diverted away from the stock market and bond market, where they are all being funneled today, then a simple cost of living adjustment wipes out the survival of those now working two jobs to survive.



A simple solution to this problem would appear to be forcing the "greedy" corporations to raise the minimum wage. For more on why this is the worst strategy to pursue see:

How A Minimum Wage Increase Hurts Workers

For a real life recent example of this discussion taking place see:

Wal-Mart Says It Will Pull Out Of DC Should City Mandate Living Wage

Sunday, July 14, 2013

2013 Second Half Outlook: What Is An Interest Rate Swap?

2013 Second Half Outlook: Introduction
2013 Second Half Outlook: How Rising Rates Impact The Overall Economy
2013 Second Half Outlook: Why The Fed Can Never Exit
2013 Second Half Outlook: What Is An Interest Rate Swap?
2013 Second Half Outlook: Stimulus Is Now The Lifeblood Of The Economy
2013 Second Half Outlook: US Stock Market Decline Coming
2013 Second Half Outlook: Real Estate Experiences Mortgage Rate Earthquake

The derivatives market is an enormous off balance sheet completely unregulated global casino. The size of the market is so large and terrifying that political leaders around the world stay as far away from it as possible when potential regulations are discussed. They do not want to run the risk of awakening a sleeping giant.

77% of all derivatives are interest rate contracts, which is why we are discussing this topic again today. I would recommend walking through this very brief primer on interest rate swaps to get an understanding of the market:



You may be asking why someone would want to "swap" for a fixed rate when they could just keep the lower fluctuating rate? By doing so, they would not have to send the bank all that extra money every month for the fixed rate payment. The answer is peace of mind.

Imagine you are a small business owner who is willing to take on the risk of a fluctuating interest rate when you are first beginning. The reason is because you do not yet have a full understanding of your ongoing cost structure in the early stages of operations and your total debt burden is low. After about a year, you can begin to project forward both income and expense growth. 

You know that your business can withstand an interest rate on the debt of 5%, but if rates were to rise significantly above that amount you would begin to run into trouble. You then enter into a swap agreement that makes you pay a higher rate in the short term (5%), but you know that if rates cross above that level, the bank you entered the agreement with will cover those additional costs. It's like an insurance contract against market risk.

In the meantime, the bank loves the arrangement because they just pocket the spread between your current interest rate (say 3%) and the fixed 5%. It is free money the banks are creating, boosting bonuses month after month. 

Banks go out and enter into these contracts with state and local governments, corporations, and other banks around the world.

These banks have told us that they have "hedged" all their bets with other offsetting trades so that if rates were to rise significantly, they would be protected. There are two main problems with this.

The first is that there is no regulator in place to monitor the banks activities in these markets. The banks tell us that they are protected and we just believe them. We only find out if a bank was not fully hedged if something goes wrong. The largest banks in the country all had hedges in place to cover subprime mortgage losses back in 2008 to partially offset any potential decline in prices.

The problem was, unknown to all the banks when they entered the insurance agreements (called Credit Default Swaps), that many banks concentrated their bets heavily with an insurance giant called AIG. AIG wrote protection contracts that allowed them to take in huge annual insurance premiums. It was a perfect business model, until the storm arrived. Then investors, banks, politicians, and citizens found out that AIG had no capital in place to pay out losses when they arrived. The Federal Reserve stepped in and made the derivative payments out to the banks, which were close to $200 billion in size.

The AIG incident represents the second major problem. The "net exposure" thesis for banks is based on there being no break in the collateral chain for any entity that is supposed to pay another entity. If a bank or hedge fund has taken on a interest rate derivatives position that triggers their own bankruptcy, then every entity that had a contract in place with them is now no longer hedged

Think of the small business owner above. What if rates crossed above 5% and the bank called them up and said unfortunately they did not keep enough reserves available to make their payment. The bank is going to have to close its doors. 

The small business owner is still on the hook for the interest rate payments above 5%. Even though those losses were "hedged" on paper, when the break in the collateral chain occurs the losses become real. 

This very simple walk through shows why there will be no more failures moving forward. Lehman was the wake up call and it will never happen again. The market will continue to grow until a break in the chain becomes too large for even the governments and central banks to handle. Do you think that is impossible? Let's look at how large the market is.

The following table shows the derivatives exposure for just the four largest banks in the United States. Click for a larger image.


The third column shows the risk based capital available to cover potential losses in these markets. The markets would need to move 0.2% against JP Morgan's book for their capital base to be wiped out.

The total size of the entire United States economy is about $16 trillion. Remember that the United States has no cash available to cover losses. The government currently owes $16.8 trillion in debt and only survives off the kindness of the bond market (credit card) every month to stay alive. 

Who will come to the rescue of JP Morgan for losses on a $70 trillion derivatives balance sheet?

The following pie graph shows the total derivatives exposure the banks hold around the world, currently standing at $638 trillion. The entire global economy is just over $70 trillion in size. The derivatives market is 9 times the size of the entire global economy!


77% of all derivatives are interest rate contracts (the items just discussed above). After a 32 year steady decline in interest rates, everyone around the world now assumes that rates will either stay low or continue to fall forever. That was until last month when they unexpectedly spiked higher, sending shock waves around the world.

What if rates continued to rise, not for days, but for years? (Hint: they will). Do you think it is possible that there is one entity on the entire planet that may have taken on too much exposure to interest rate risks in the derivatives market? Remember AIG? 

This is just one of countless reasons why central banks will do everything in their power to artificially keep rates lower, and it is by far the most catastrophic event that will occur when they finally lose control of the markets.

 Up Next: 2013 Second Half Outlook: Stimulus Is Now The Lifeblood Of The Global Economy

Are Universities Worth It?

Many students graduating school today are finding that the high paying jobs they were promised in exchange for decades of debt repayment are not there waiting.



When Higher Education Doesn't Pay Back
Image source: www.cheaponlinedegrees.org

2013 Second Half Outlook: Why The Fed Can Never Exit

2013 Second Half Outlook: Introduction
2013 Second Half Outlook: How Rising Rates Impact The Overall Economy
2013 Second Half Outlook: Why The Fed Can Never Exit
2013 Second Half Outlook: What Is An Interest Rate Swap?
2013 Second Half Outlook: Stimulus Is Now The Lifeblood Of The Economy
2013 Second Half Outlook: US Stock Market Decline Coming
2013 Second Half Outlook: Real Estate Experiences Mortgage Rate Earthquake

The Fed's balance sheet grows in size when they print money to purchase an asset. They provide the printed money to the entity (called a primary dealer) who provides them with the asset. This process is known as Quantitative Easing (QE). The assets the Fed has purchased since the crisis began in 2008 have been exclusively US treasuries and mortgage backed securities.

When the Fed takes these assets back, it puts them on their balance sheet. As they accumulate more and more assets (currently at the rate of $85 billion per month), it causes the total size of their balance sheet to grow.

As of mid way through 2013, the Fed held approximately $3.5 trillion in assets. It is projected that they will cross $4 trillion by year end.


In addition to providing all the wonderful effects to the economy that we have already discussed (lower interest rates due to their demand in the bond markets), the Fed receives income on the assets they purchase. They return 95% of their profits to the US treasury, which shows up as income and reduces the annual deficit. This wonderful arrangement is similar to the one currently taking place with Fannie and Freddie, where they return their profits to the government, also reducing the deficit.

If this is such a magical process, why has the Fed not always purchased 100% of the US treasuries issued and 100% of the mortgages purchased through the government sponsored entities Fannie and Freddie? Asking yourself this simple question, which I hope is easy to answer, explains how devastating the reversal of this process will ultimately be for the economy when either the Fed stops the program (they won't) or the market forces them to stop (it will).

We're going to move beyond that issue for a moment and look at another looming problem the Fed faces down the road. It is the well touted "exit strategy" that the Fed has told us about since the first round of QE began.


Additional money in the system takes on the form of inflation. This does not always mean it leads to the price of computers, clothes, or food rising. Inflation can come in the form of financial asset appreciation (currently seen in the US stock and bond market bubbles) where new money has flooded instead of entering the actual economy.

If the money velocity were to rise again (which it will), then inflation will move beyond the current bubbles in the financial markets and enter the economy. Then you will see a significant rise in what consumers pay at the gas station, grocery store, doctor's office, clothing stores, utility bills, and everything else needed to live day to day.

While the Fed loves the asset bubble inflation it is currently creating, it does not like the real world inflation that is coming. So far the Fed has experienced only the good inflation, which is why they are considered god like. If consumer prices were ever to begin rising at a rapid rate (they are currently only rising about 1% annually), then the Fed has told us they would reverse the QE process and bring the money they have created back out of the system.

In a 60 Minutes interview, Ben Bernanke has told us he can reverse this process in 15 minutes. This is lunacy. When the money is printed and enters the bloodstream of the economy, it is letting the genie out of the bottle. The Fed has no control over where money flows once it leaves the printing press. It can only hope and pray that it goes somewhere productive. Beyond this idea that the money will just be waiting in a garage for them to pick up (it won't), they face another major problem.

The Fed's balance sheet discussed above is composed almost exclusively of treasury and mortgage bonds. If interest rates rise, then the Fed takes losses on its portfolio. The Fed is structured as an entity that is never forced to market their book to market as long as they do not sell the asset on their portfolio and just let it run to maturity.

In other words, imagine the Fed has $100,000 in 30 year government bonds and rates double cutting the value of those bonds close to $50,000. The Fed is not forced to show a $50,000 loss because they tell us they can just hold the bonds for the full 30 years and collect the full $100,000 at maturity. This is true.

The Fed has told us that they can reverse their QE process in 15 minutes. How do they do this? Instead of printing money to purchase assets, they sell assets on their portfolio in exchange for cash in the system. This drains liquidity from the system.

Did you see the important part of that process? Selling assets on their portfolio. If they sell an asset before maturity they will be required to report it as a loss. The Fed holds very little capital to cover losses and would need to request a loan from treasury in order to cover the shortfall. Instead of lowering the annual deficit, the Fed would be an addition the total debt burden.

The issue becomes even more concerning with the rippling effect into other areas. If the market knows that the Fed is a seller, instead of a buyer, it will front the Fed's trades and dump US treasuries and US mortgages causing rates to spike further, creating greater losses, and making it even more difficult for the Fed to sell assets.


The treasury will need to issue more money to cover the losses, causing the deficit to grow higher, creating even more selling in the treasury market. On top of that, as the Fed (and market) are selling assets it is causing rates on US treasuries to rise and increasing the total annual debt burden. For every 1% move in US treasuries higher, it creates an additional $170 billion just in annual interest payments ($17 trillion deficit). What if rates moved up 3, 4, or 5% back to a normal level? (Hint: they will).

This is why the Fed has painted itself in a corner. If they lose control of the markets, their only option is the nuclear strategy to increase QE further and further and further. The bond market will eventually reject this level of stimulus as further debasement to the underlying asset.

How far away is this process from occurring? It could have begun in June with the first rate shock higher or it may be years away. Its ultimate arrival is inevitable.

Up Next: 2013 Second Half Outlook: What Is An Interest Rate Swap?