March 2014 - One Month Closer
Conventional wisdom, as expressed through the noisiest channels (Federal Reserve officials' daily speeches, Wall Street TV experts), believes Quantitative Easing (QE) has been of negligible effect. As such, this opinion expresses little concern, indeed, little interest, in reversing the inflation of the Federal Reserve's balance sheet, which has increased in size from $900 billion in 2007 to $4.5 trillion today.
Conventional wisdom will state "it's only accounting." As every student of elementary accounting knows, a balance sheet has two sides: assets and liabilities. The Federal Reserve composition will be discussed below.
Conventional wisdom describes stock market gains as the fruit of great profits, and does not acknowledge the trillion dollars of QE in 2013 as boosting markets.
Conventional wisdom expresses confidence in the economy, since, in its view, the stock market is an expression of the economy.
Conventional wisdom believes QE has not done much of anything. The Fed's "liquidity" sits "inertly" as "reserves" on the banking system's balance sheet. This representation reminds Doug Noland, author of the weekly Credit Bubble Bulletin at the Prudent Bear website, of conventional wisdom (circa 1994-2004) that held the explosion of Fannie Mae and Freddie Mac's balance sheets were inconsequential because "only banks create credit".
In 1990, the combined balance sheets of Fannie and Freddie held $132 billion of assets: 5.6% of the single-family house market. In April 2003 (that month, alone), Fannie (alone) bought $139 billion of mortgages. By 2003, the two agencies' balance sheets held 23% of the U.S. home mortgage market. This interference pushed up house prices, created collateral, home-equity lines of credit (HELOC), boosted the stock market, Home Depot's profits, the employment of plumbers, electricians, and realtors. It inflated prices and instigated activity across and within the economy. Most of this busyness wilted when mortgage inductees failed the draft board. The German army raised the age of induction to 40- or 45-years-old by 1945. Whatever the age, the product could no more make a long march than late-stage mortgagees made their payments.
At that point, the temporary and illusionary portion of the economy receded, along with the temporary and illusionary asset prices, including stocks, houses, and bonds of such little merit, we were sure these derangements would not reappear in our lifetimes.
Doug Noland disagrees with the experts. He covers the ground in his March 28, 2014, Credit Bubble Bulletin. "It's only accounting" only tells us the "level" of reserves, but nothing about the "flows."
A transaction takes place in which the (a) Fed purchases securities from (b) financial institutions. The liabilities "by design are held by financial institutions that have a clearing relationship with the Fed, largely U.S.-operated financial institutions."
This purchase is a "deposit" in the banking system. Quoting Noland: "[T]he Fed "credits" accounts with new purchasing power as it consummates purchases of Treasury and MBS securities in the marketplace. Essentially, the Fed creates new electronic liabilities ('IOUs') that provide immediate liquidity/purchasing power ('money') to the seller of securities."
Graham Towers, Governor of the Bank of Canada from 1934 to 1954, described how modern, central banking-created "money" is no more than accounting: "Banks create money. That is what they are for...The manufacturing process to make money consists of making an entry in a book. That is all. Each and every time a Bank makes a loan... new Bank credit is created - brand new money."
The asset side of the Fed's balance sheet holds the securities it has bought (and about 12 ounces of gold). The liability side of the Fed's balance sheet acknowledges the dollars it has issued. The dollars are redeemable - each, into another dollar. This is not terribly interesting, but, is where the whirlwind of economic activity inspired by Fannie's and Freddie's expansion helps explain the financial and economic distortions driven by the Federal Reserve's expanding balance sheet.
After the QE operation described above, the Fed's dollar liabilities are matched by dollar assets on financial-institution balance sheets. Both have risen. Noland writes: "[T]he 'level' of 'reserves' informs us nothing about the 'flows' - flows that could be in the hundreds of billions or more on an intra-day basis (who knows?). And it is these transactional 'flows' that have profound impacts on market dynamics and pricing."
An example (from Noland): "[T]he Fed [purchases] Treasuries and MBS from a rather large "bond" fund ['that has a clearing relationship with the Fed," one that is among, as Noland writes, the "largely U.S.-operated financial institutions' - FJS] suffering redemptions. In this case, Fed liquidity would then be used to fund bond investor outflows that find their way to, say, a major U.S. equity ETF." This is one example of how Fed "liquidity" (a) forestalls market disruptions that (b) will eventually be much worse when the Fed sneezes.
Chase van der Rhoer wrote in the April 2, 2014, edition of Bloomberg Economics Briefs: "[Federal Reserve Chairman Janet] Yellen presides over a Fed whose asset purchases currently equate to 42 Baring Brothers or 15 Long-Term Capital Management bailouts - $55 billion - each and every month." The April 2, 2014, Wall Street Journal published "Pimco Fund Sees March Outflow." We learned: "Bill Gross hasn't yet stemmed the flow out of the world's largest bond fund. Investors pulled $3.1 billion from Mr. Gross's Pimco Total Return Fund in March, marking the 11th consecutive month of outflows at the marquee fund for Pacific Management Group."
The March withdrawal approximates the amount of money that was needed to bail out Long-Term Capital Management. Jeffrey Gundlach, head of DoubleLine Capital LP, thinks such support operations are long in the touth: "The junk-bond bonanza that's doubled the market to almost $2 trillion since the credit crisis has Jeffrey Gundlach... trimming his allocations... 'They've squeezed all the toothpaste out of the tube,' the bond manager said... 'There is interest-rate risk that's just being masked by fund flows holding up the prices of junk bonds." (Bloomberg, March 19, 2014) Such observations are becoming more common: "Michael Hintze, chief executive and founder of CQS, one of Europe's largest hedge funds, has argued [the result] of too loose central banks have forced too much money into the same assets." Hintze warned: "Everyone is thinking the same and being driven into the same trade....It is not healthy to have a 'rigged' market."
So, what happens to these, brand new, hot-off-the-keypad, dollar liabilities of the Fed? "The ETF then uses this liquidity to buy stocks." The dollars, assets to the "the sellers of the liquidity [those who sold their positions in the ETF - FJS] can buy other securities (or things)".
These dollars can now head in a million directions, another reason the Federal Reserve and conventional wisdom pretense of the Fed being able to target anything, other than the operation described above, is nonsense. Noland gives another example: "Fed liquidity accommodating a rotation of hedge fund positions from bonds to equities. In this example, a hedge fund might sell an (underperforming) 10-year Treasury note to purchase an outperforming Facebook stock."
In the next step, these Federal Reserve liabilities, the Fed's "liquidity" that conventional wisdom so admires, might wind up in the hands of "Mark Zuckerberg [if he is the seller of the stock - FJS]." Next "a chunk of his sales proceeds will boost California and federal income tax receipts (quickly spent by both governments). Zuckerberg's employees can use stock sale proceeds to buy homes and luxury automobiles (and planes!). And Zuckerberg can use booming Facebook stock as currency to buy companies in a hotly contested industry acquisition boom."
Distortions engulf the economy, including companies. Some lose their heads. If they are in New York, they behave like the Yankees and hire heavy-hitters: 'Our customers already have everything they really truly need,' says Marigay McKee, Saks's [Fifth Avenue] new president. 'We really have to offer rarer, more unique things.'.... Ms. McKee, an energetic 48-year-old imported in January from London's Harrods, seems not to know the meaning of hesitation. She has pressed Saks buyers to add more emerging designers-a group whose inexperience and often-shaky finances scare off many retailers..... In a meeting last week, Ms. McKee asked the company's financial planners to relax their budgeting systems to give more leeway to buyers in the field, who she says must be able to buy fashion based on 'passion' and instinct. 'What I was telling them,' she says, 'is we have to buy from the gut.'"
The market capitalization of Facebook stock is (on April 1, 2014) $160 billion. The company is trading at a price-to-earnings ratio of 102:1. In March, Facebook used this liquidity (its common stock as money, or currency, or scrip) to buy What'sApp for $19 billion (of Facebook stock) and $2 billion for Occulus Rift.
Analysts project revenues that support such acquisitions. The analysts are at brokerage houses that want the investment banking business. (Looking back to such conflicts in 2001: An email that highlights the conflict of interest when the same firm (Merrill Lynch, in this case) prods analysts to boost "price targets" while bidding for the underwriting business: Kirsten Campbell, Merrill analyst, sent an e-mail to Henry Blodget, Merrill rock-star analyst: "I don't want to be a whore for f-king mgmt.If 2-2 means that we are putting half of Merrill retail into this stockbecause [Merrill is] out accumulating it then I don't think that's the right thing to do....")
Analysts at UBS increased their price target of Facebook to $90, according to the March 11, 2014, Financial Times. The headline should have been good for $10 a share: "Facebook Lifted by Optimism on Ability to Charge More for Ads." That shares have fallen from an intraday high of $72.59 on that date to $62.62 at the April 1, 2014, close, is a warning of no floor below.
The Financial Times noted that eight out of ten analysts rated Facebook as a "buy," the projected growth in advertising revenue sounding like 1999. (UBS: "Our... channel checks suggest that the pricing strength... up 92 per cent year-on-year price-per-ad, has carried over into early 2014 and is likely sustainable for longer than our previous estimates....")
Doug Noland writes in his March 28, 2014, analysis: "QE1-3 liquidity has ensured that only more and bigger companies from Silicon Valley to China to 'Hollywood' provide a virtually limitless supply of smartphones, computers, tablets and electronic gadgets, along with a plethora of downloadable content and services. Throughout the markets and the real economy, it's all leading to unusual price instabilities (which the Fed is expected to counter - of course, with only more QE)."
From the March 7, 2014, Wall Street Journal: "In a scramble reminiscent of the 1990s Internet heyday, companies are going public at the fastest pace in years, hoping to take advantage of booming share prices and investor demand while they last. In the first two months of this year, 42 companies went public in the U.S., raising $8.3 billion and tying 2007 for the busiest start of a year for initial public offerings since 2000, when there were 77 in the period, according to Dealogic." There is no stopping them: "[I]nvestors are bidding more aggressively for newly minted shares this year than they have in more than a decade, paying a median 14.5 times annual sales, compared with six times in 2007...."
The volume is telling but not definitive. Later in the article, William Bowmer, Head of Americas technology-stock offerings at Barclays PLC observed the surge in interest "is bringing in lots of companies out of the woodwork that couldn't have gone public in the past.... Morgan Stanley analysts wrote in a recent research note: 'In many meetings we've had investors, really starting last fall... the word 'bubble' or 'year 1999' has been referenced as relevant.'"
On March 25, 2014, a headline alone could have been out of The Short-Sellers Handbook: "Why Trade Bonds When You Can Trade Ads?" The Wall Street Journal introduced Ted Yang. Two years ago, he launched a start-up in the fast-growing world of digital ad trading, after 15 years in the financial industry. The Journal quoted the budding billionaire: "'We're talking about a market that shares a lot of the same characteristics as the financial markets.' It is looking to apply investment banking tools and philosophies to online advertising."
This brings to mind "hollow swaps." As with today, the money (i.e. Federal Reserve dollar liabilities) poured into the New Economy. As long as the gadget could not be understood, the price went up. Companies built far more capacity and structure than a sane world could digest. The same is true today.
In March 2001, Andy Grove, Intel's wunderkind at its founding, reflected: "I don't expect the end demand to snap back ....For a number of years [the high-technology industry] had huge momentum - technology buying and manufacturing had a tremendous investment cycle going. I think people loaded up with not just physical inventory but got ahead of themselves in capacity building and network capacity building. We built in an overcapacity of all physical things."
Companies found themselves in an unstable position they had obviously never contemplated. How did they extract themselves? By calling their investment banks. Yang, you will recall, is "looking to apply investment banking tools and philosophies to online advertising."
Enron called J.P. Morgan and Citigroup. The banks swapped cash flows with Enron at the end of each quarter. Enron booked this profit on its income statement. Early in the next quarter, Enron swapped that flow back to the bank.
According to Yang: "Nowadays ad space, particularly websites, is auctioned on computerized exchanges." This has the odor of "hollow swaps." After the Internet moonshots dropped into Grove's sunless sea, hollow swaps were used to trade unused broadband fiber. The overinvestment in broadband fiber (the cable used to connect houses and businesses with the Internet) had grown to absurd proportions. Enron and other companies came up with the idea of trading unused fiber, known as "dark fiber." (Unlike the producing fiber which was "lit.") Enron sold $500 million of dark fiber to Qwest, which sold $500 million to Enron. Nothing changed hands and the fiber remained just as dark as before. Schematically, Federal Reserve open-market operations with financial institutions look similar.
In time, we may observe a comeuppance for the most hallowed firms of all. Jay Cooke in 1873; Goldman Sachs Trading Corporation in 1929; Drexel, Burnham, Lambert in 1990. Fortune rated Enron the most innovative company six years in a row. According to the Journal of Applied Corporate Finance: "Enron's business model differs in a very critical way from the other energy companies, that traditionally invest heavily in fixed assets. Enron focuses on leveraging its investments in human capital." Correct.
Finance grows larger and faster towards the end of a blowoff. The Internet silliness came a cropper in the spring of 2000. The telecommunications wave carried mutual fund managers into the fall, and the optical networking mania finally ran out of energy in the early winter. All came apart by January of 2001.
Bloomberg reported on March 28, 2014: "The megarich are dominating U.S. megadeals. Seven of the 15 U.S. takeover bids worth more than $10 billion since January 2013 were initiated by firms founded and controlled by one of the 200 wealthiest men in the world." Andreessen Horowitz, a Silicon Valley venture capital firm, closed a $1.5 billion fund in March 2014, its fourth fund of that size." The percentage of corporate buyouts that use equity as currency (i.e. Federal Reserve liabilities that run wild) has never been higher - 67%.
Doug Noland observed: "[W]ith 2013/early-2014 too reminiscent of Nasdaq 1999, one should not understate the role QE3 has played in stoking another historic Bubble and 'arms race' throughout the broadly-defined 'technology' sector. The mad dash for hits, clicks, likes, advertising dollars, and revenues throughout 'social media,' the 'cloud,' 3D printing, solar, etc. even surpasses 1999 - whether the bulls are willing to admit as much or not. At this point, it's a full-fledged mania (again). It's ironic - and I believe really important. The Bernanke Doctrine holds that the Fed's printing press can basically guarantee a rising general price level. Meanwhile, QE1-3 liquidity has ensured that only more and bigger companies from Silicon Valley to China to 'Hollywood' provide a virtually limitless supply of smartphones, computers, tablets and electronic gadgets, along with a plethora of downloadable content and services. Throughout the markets and the real economy, it's all leading to unusual price instabilities (which the Fed is expected to counter - of course, with only more QE)."
Noland thinks a comparison to 1929 is more apt. The 1920's Federal Reserve believed a stable price level (that is, consumer prices remaining still: a zero-precent inflation rate). Today, it aims to "basically guarantee a rising general price level."
John Maynard Keynes, a paid up New-Economy believer ("The market is very appealing, and prices are low.... We will not have any more crashes in our time."), wrote later he had been wrong: "Anyone who looked only at the index of prices would see no reason to suspect any material degree of inflation, while anyone who looked only at the total volume of bank credit and the prices of common stocks would have been convinced of the presence of inflation actual or impending...." (A Treatise on Money, 1930)
For those who are selling "hits, clicks, likes, and advertising dollars" another artifact of the 1920s was the role of credit. Between 1923 and 1929, worker's wages rose 11%. Corporate profits were up 62% and dividends paid to shareholders increased 65%. There came a point when credit swamped consumers who had been swept up in the euphoria, but whose salaries had not kept up.
The same is true today. It takes no intelligence to see, even if one does not read Census Bureau data, that incomes have been falling for years. House and HELOC credit kept the machine purring up to 2007. Since then, student loan, auto and truck financing, credit cards, and mortgages have propped consumer buying.
Prices have been rising at a ferocious rate, no matter what the government says. From an engaging chart on David Stockman's Contra Corner website: between January 2000 and March 2014, a barrel of oil increased 314% in price. Fuel oil per gallon: +242%; Gallon of gasoline: +176%; Dozen eggs: +106%; Annual health-care spending per capita: +104%; Ground beef per pound: +96%; Movie ticket: +95%; Average private-college tuition: +68%; Electricity per kilowatt: +59%; New car: +59%; Coffee per pound: 52%; Natural gas per therm.: +51%; Average home price: +50%; Postage stamp: +49%; Average monthly rent: +48%; CPI: +39%; PCE deflator (the Fed's measure, as it continues to tell us "inflation is not high enough"): +31%.
Everywhere the average person turns there has been no relief. Their interest income has been confiscated. Even with the flagrant attempt to turn savers into speculators, public participation in the stock market is low. Maybe people do not trust it or maybe they have no money left. As for the fun and games pouring out of Silicon Valley, that, too, gets more expensive: "Wireless Bills go up and stay up" "Competition in the U.S. wireless market has increased over the past year, but so have Americans' overall phone bills.... [B]illings for the industries' lucrative postpaid [billed monthly - FJS] customers are continuing to rise. Average monthly revenue per postpaid customer across the industry rose from $55.80 in the first quarter of 2010 to $61.50 in the fourth quarter of 2013."
The only surprise is how slowly prices are rising. Uncle Obama is doing his best to prevent a consumer collapse. In the President's recent budget, 70% of all money spent by the federal government will be direct payments to individuals, an all-time record. This, as NewsInvestors.com said is: "a massive money transfer machine: taking $2.6 trillion from some and handing it to others."
There is a limit.
Yields will rise. The Bank for International Settlements (BIS) reports that global debt has risen 40% since mid-2007, from $70 trillion to $100 trillion. Marketable U.S. government debt outstanding has popped from $4.5 trillion to $12 trillion. Global corporate issuance has increased more than $21 trillion. In direct contradiction to the history of the world, more quantity has produced better quality: Bond yields, across the spectrum, have fallen from 4.8% to 2%. In an open market, bond investors handicap their purchases according to a calculated risk. This is a rigged market, though. The rising quantity has produced worse quality, but central planners disguise that fact.
The issuance recalls 2003 through 2007, as the Financial Times reported on March 20, 2014: "Second-lien corporate loans, a type of debt structure popular in the build-up to the financial crisis, are staging a comeback as a thirst for higher-yielding assets continues to drive investors into the riskier corners of U.S. credit market. Sales of second lien-loans, which are subordinated to the first-lien loans generally issued by companies, total $8.5 billion this year, more than double the amount in the same period of 2013, according to Standard & Poor's data. The resurgence follows a rebound of other financing tools that were popular in the years up to 2008, including dividend deals, payment-in-kind notes and 'cov lite loans,' which contain less lender protection."
In fact, the situation is worse than 2007. There is no backstop behind the central banks. Federal Reserve dollar liabilities will rise until they do not. Investors will demand Federal Reserve assets (dollars) and redeem shares, for instance, "from a rather large bond fund" at a speed for which we can thank Facebook and Twitter.
The situation is also worse because excesses that peaked in 2007 are now coming due. On March 25, 2014, the Financial Times reported: "Maturing 'HELOC' Loans Pose Default Risk for Banks." Citing Federal Reserve stress tests, the paper warns "a looming repayment wave" of "HELOCs and junior-lien debt that was lent against people's homes" are being repriced. Many HELOCs (and related contrivances) "were structured as 10-year interest-only loans that could be drawn on in." The problem is coming due now since "originations started to swell 10 years ago."
It was 10 years ago, on February 23, 2004, when Federal Reserve Chairman Alan Greenspan told Americans to buy adjustable-rate mortgages. ("[M]any homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages over the past decade.") Adjustable-rate mortgages went through the roof and by June 2005, the median California residential house price cost $542,720.
Alas, the U.S. government has learned no lessons from the abandoned housing projects in California. It continues to spend more than its revenue. In February 2014, Treasury receipts (mostly taxes) were $144 billion. The Treasury spent $337 billion. Tax collections covered 42% of expenditures. This was an unusually poor month, unless revenues have collapsed. The Federal Reserve's Quantitative Easing policy buys most of the Treasury debt issues. This permits the U.S. government to pay its bills, including transfer payments. One federal program pays cell-phone bills for those who cannot afford them. The click-and-clack advertising revenue projections at Facebook (we can be sure) do not address a contingency in which Treasury rates rise to 5% or to 8%. There is no instance, in the history of the world, no matter how battered and maimed, when the markets did not assert their provenance. The "creat[ion of] new electronic liabilities ("IOUs") that provide immediate liquidity/purchasing power" will swoon.
This discussion has been of tech stuff, but the corporate suffering will be broad and deep. In Wal-Mart's 10-K released in March 2014, the retailer noted the risk to revenues and profits should the government reduce supplemental food programs. Note: food. This, after five years of the central-banking experiment. Yet, each quarter, the commissars see green shoots. Any minute now, the QE injections will boost the world's economy to some pseudo-scientific "escape velocity."
In the movie Ninotchka (1939), a Parisian (Melvyn Douglas), encounters the Russian agent, Ninotchka (Greta Garbo).
Ninotchka: I have heard of the arrogant male in capitalistic society. It is
having a superior earning power that makes you that way.
Leon: A Russian! I love Russians! Comrade. I've been fascinated by your Five-Year Plan for the last fifteen years. Ninotchka: Your type will soon be extinct.
Their assumption of revival is preposterous. We read otherwise: "Only 11% of U.S. long-term unemployed find jobs in any one year." "Since 2008, the number of Americans who call themselves middle class has fallen by nearly a fifth, according to a survey in January by the Pew Research Center, from 53% to 44%. Forty percent now identify as either lower-middle or lower class compared with just 25% in February 2008."
They are sinking, thanks to our policy makers errors, or, perhaps not.
Also from Ninotchka:
When Ninotchka is asked about the latest news from the Soviet Union: "The last mass trials have been a great success. There are going to be fewer but better Russians."
From the April 4, 2014, Wall Street Journal: "For decades, Americans' purchases of basics like laundry soap and toothpaste roughly kept pace with the rate of growth in the overall economy. But that rule of thumb no longer applies, which is bad news for billion-dollar brands like Tide and Colgate."
One might think this is worse news for Google, Twitter, and Facebook, should they not only produce fewer sales from the advertising they sell, but lose the base of gadget-subscribers who (1) cannot afford an i-thing and a "postpaid" monthly bill, but also (2) resent their straightened circumstances, cannot put their finger on why, but can exact mild redress by not transferring their sinking income to Silicon Valley or Hollywood or the bloated, money-hungry sports industry. (Opening day tickets for bleacher seats at Fenway Park (Boston Red Sox) this year are $40.00. In 1974 they cost $1.25.)
In the April 4 story, the Journal quotes Jim Craigie, CEO of Church & Dwight - twice. The two statements show the bind companies find themselves. First, the owner of Arm & Hammer brands (and many others) states: "Price wars don't help growth and are not good for the industry." Mr. Craigie notes later: "It's still a tough time for the average American. There's nothing wrong with the industry. You just have an economy that's stagnant and people are having to trade down." How does a CEO who discovers his customers cannot afford baking soda make money? How will he satisfy shareholders when the $2.6 trillion of annual transfer payments to potential Church & Dwight customers shrinks?
And yet, after five years, the portion of the economy that might inject some "escape velocity" (capital spending) is shriveling: "The latest data on business spending remains sluggish....The numbers suggest [nondefense capital goods contributed] contributed almost nothing to first quarter [GDP} growth....New orders for core capital goods fell 1.3% in February, the second large decline in three months. Demand for machinery, communications equipment and electronics, appliances and parts declined in January and February...."
Goldman Sachs expects the downward trend to continue. In the words of Andy Lees (February 14, 2014): "(Goldman) no longer expects a recovery in US or developed market capex. Aggregate capex to sales have fallen in Europe from 10.7% in 2000 to 5.2% today, while US capex to sales has fallen from 8.8% to 5%. It expects these ratios to fall further to 4.7% and 4% respectively by 2017."
The combination of stock-option mania and the negligible returns on investment a company gets when interest rates are close to zero will prolong current practices. There is little incentive for capital investment. The liquidation process has been discussed here before: Investment-grade companies issued over $1 trillion of debt in 2013. Share buybacks, in 2013, accounted for 75% of the increase in S&P 500 earnings per share (fewer shares). In the third quarter of 2013 alone, companies bought back $128 billion of shares: the most for any quarter since 2007. Buybacks and dividends for the third quarter were $207 billion, also the highest in any quarter since 2007. The higher the profits per share and dividend payouts (per share), the share price trades higher, then higher. During the 1923 to 1929 period discussed above (worker's wages rising 11%. corporate profits up 62%, and dividends paid to shareholders increasing 65%), there were zero net manufacturing jobs added to the U.S. economy. In fact, this is true of the period from 1919 to 1929. This may have been a victory of productivity, which is most certainly not the reason today. Cheap assets that remain orphans are the precious metals, the real stuff and the common stocks.
Frederick Sheehan writes a blog at www.aucontrarian.com