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Return of the POMO Junkies

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Most investors have been lamenting the recent stock market swoon.  The Dow Jones Industrial Average has given up all of the gains earned during 2012.  The economic reports keep getting worse by the day.  Yet, for some people all of this is good news  .   .   .

You might find them scattered along the curbs of Wall Street   . . .  with glazed eyes  . . .  British teeth  . . .  and mysterious lesions on their skin.  They approach Wall Street’s upscale-appearing pedestrians, making such requests as:  “POMO?”   . . .  “Late-day rally?”  . . .   “Animal Spirits?”  These desperate souls are the “POMO junkies”.  Since the Federal Reserve concluded the last phase of quantitative easing in June of 2011, the POMO junkies have been hopeless.  They can’t survive without those POMO auctions, wherein the New York Fed would purchase Treasury securities – worth billions of dollars – on a daily basis.  After the auctions, the Primary Dealers would take the sales proceeds to their proprietary trading desks, where the funds would be leveraged and used to purchase high-beta, Russell 2000 stocks.  You saw the results:  A booming stock market – despite a stalled economy.

Since I first wrote about the POMO junkies last summer, they have resurfaced on a few occasions – only to slink back into the shadows as the rumors of an imminent Quantitative Easing 3 were debunked.

The recent spate of awful economic reports and the resulting stock market nosedive have rekindled hopes that the Federal Reserve will crank-up its printing press once again, for the long-awaited QE 3.  Economist John Hussman discussed this situation on Monday:

At this point, the S&P 500 has achieved a cumulative total return of less than 10% since April 2010. Meanwhile, of course, there remains a great deal of faith in the “Bernanke put,” because even though it’s fairly obvious that QE has done nothing durable for the economy or the financial markets over the last couple of years, a hit of QE might at least be good for a few months of “risk on” delirium.  If the American public can’t get thoughtful economic leadership, at least Wall Street’s speculative junkies can hope for a little taste of Q from Sugar Daddy.

One of the problems with QE here, however, is that it would essentially represent fiscal policy for the benefit of speculators, at taxpayer expense.  To see this, note that the 10-year Treasury yield is now down to less than 1.5%.  One wonders how Bernanke would be able to argue, with a straight face, that this is not low enough.  Nevertheless, a 10-year bond has a duration of 8 years – meaning that each 100 basis point fluctuation in interest rates is associated with a change of about 8% in the price of the bond.  So if you buy the bond and hold it for a full year, an interest rate change of of 1.5/8 = .1875, or less than 20 basis points, is enough to wipe out the annual interest and leave you with a negative total return.

*   *   *

“QE3 – subsidizing banks and bond speculators at taxpayer expense” – there’s a pithy slogan.  That doesn’t mean the Fed will refrain from more of its recklessness (which will be nearly impossible to reverse when it becomes necessary to do so), but does anyone actually believe by now that QE would improve the economy, durably elevate risky assets beyond a few months, or materially relieve global debt strains?

Obviously, the POMO junkies have no such concerns.  Beyond that, the Federal Reserve’s “third mandate” – keeping the stock market bubble inflated – will be the primary factor motivating the decision, regardless of whether those asset prices hold for more than a few months.

The POMO junkies are finally going to score.  As they do, a tragic number of retail investors will be led to believe that the stock market has “recovered”, only to learn – a few months down the road – that the latest bubble has popped.


 

Those Smart Bond Traders

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There seems to be a consensus that bond traders are smarter than stock traders.  Consider this thought from Investopedia’s Financial Edge website:

Many investors believe bond traders understand the economy better than equity traders.  Bond traders pay very close attention to any economic factor that might affect interest rates.  Equity traders recognize that changes in bond prices provide a good indication of what bond traders think of the economy.

Widespread belief that Ben Bernanke’s Zero Interest Rate Policy (ZIRP) has created a stock market “bubble” has led to fear that the bubble may soon pop and cause the market to crash.  It was strange to see that subject discussed by John Melloy at CNBC, given the news outlet’s reputation for stock market cheerleading. Nevertheless, Mr. Melloy recently presented us with some ominous information:

The Yale School of Management since 1989 has asked wealthy individual investors monthly to give the “probability of a catastrophic stock market crash in the U.S. in the next six months.”

In the latest survey in December, almost 75 percent of respondents gave it at least a 10 percent chance of happening.  That’s up from 68 percent who gave it a 10 percent probability last April, just before the events of May 6, 2010.

*   *   *

The Flash Crash Commission – containing members of the CFTC and SEC – made a series of recommendations for improving market structure Friday, including single stock circuit breakers, a more reliable audit trail on trades, and curbing the use of cancelled trades by high-frequency traders.  They still don’t know what actually caused the nearly 1,000-point drop in the Dow Jones Industrial Average in a matter of minutes.

*   *   *

Overall volume has been very light in the market though, as the individual investor put more money into bonds last year than stocks in spite of the gains.  Strategists said this has been one of the longer bull markets (starting in March 2009) with barely any retail participation.  Flows into equity mutual funds did turn positive in January and have continued this month however, according to ICI and TrimTabs.com.  Yet the fear of a crash persists.

Whether or not one is concerned about the possibility of a market crash, consensual ambivalence toward equities is on the rise.  Felix Salmon recently wrote an article for The New York Times entitled, “Wall Street’s Dead End”, which began with the observation that the number of companies listed on the major domestic exchanges peaked in 1997 and has been declining ever since.  Mr. Salmon discussed the recent trend toward private financing of corporations, as opposed to the tradition of raising capital by offering shares for sale on the stock exchanges:

Only the biggest and oldest companies are happy being listed on public markets today.  As a result, the stock market as a whole increasingly fails to reflect the vibrancy and heterogeneity of the broader economy.  To invest in younger, smaller companies, you increasingly need to be a member of the ultra-rich elite.

At risk, then, is the shareholder democracy that America forged, slowly, over the past 50 years.  Civilians, rather than plutocrats, controlled corporate America, and that relationship improved standards of living and usually kept the worst of corporate abuses in check.  With America Inc. owned by its citizens, the success of American business translated into large gains in the stock portfolios of anybody who put his savings in the market over most of the postwar period.

Today, however, stock markets, once the bedrock of American capitalism, are slowly becoming a noisy sideshow that churns out increasingly meager returns.  The show still gets lots of attention, but the real business of the global economy is inexorably leaving the stock market — and the vast majority of us — behind.

Investors who decided to keep their money in bonds, heard some discouraging news from bond guru Bill Gross of PIMCO on February 2.   Gus Lubin of The Business Insider provided a good summary of what Bill Gross had to say:

His latest investment letter identifies four scenarios in which bondholders would get burned.  Basically these are sovereign default, currency devaluation, inflation, and poor returns relative to other asset classes.

In other words, you can’t win.  Gross compares Ben Bernanke to the devil and calls ZIRP a devil’s haircut:  “This is not God’s work – it has the unmistakable odor of Mammon.”

Gross recommends putting money in foreign bonds and other assets that yield more than Treasuries.

I was particularly impressed with what Bill Gross had to say about the necessary steps for making America more competitive in the global marketplace:

We need to find a new economic Keynes or at least elect a chastened Congress that can take our structurally unemployed and give them a chance to be productive workers again.  We must have a President whose idea of “centrist” policy is not to hand out presents to the right and the left and then altruistically proclaim the benefits of bipartisanship.  We need a President who does more than propose “Win The Future” at annual State of the Union addresses without policy follow-up.  America requires more than a makeover or a facelift.  It needs a heart transplant absent the contagious antibodies of money and finance filtering through the system.  It needs a Congress that cannot be bought and sold by lobbyists on K Street, whose pockets in turn are stuffed with corporate and special interest group payola.  Are record corporate profits a fair price for America’s soul?  A devil’s bargain more than likely.

You can’t discuss bond fund managers these days, without mentioning Jeffrey Gundlach, who recently founded DoubleLine Capital.  Jonathan Laing of Barron’s wrote a great article about Gundlach entitled “The King of Bonds”.  When I reached the third paragraph of that piece, I had to re-read this startling fact:

His DoubleLine Total Return Bond Fund (DBLTX), with $4.5 billion of assets as of Jan. 31, outperformed every one of the 91 bond funds in the Morningstar intermediate-bond-fund universe in 2010, despite launching only in April.  It notched a total return of 16.6%, compared with returns of 8.36% for the giant Pimco Total Return Fund (PTTAX), run by the redoubtable Bill Gross  . . .

The essay described how Gundlach’s former employer, TCW, feared that Gundlach was planning to leave the firm.  Accordingly, TCW made a pre-emptive strike and fired Gundlach.  From there, the story gets more interesting:

Five weeks after Gundlach’s dismissal, TCW sued the manager, four subordinates and DoubleLine for allegedly stealing trade secrets, including client lists, transaction information and proprietary security-valuation systems.  The suit also charged that a search of Gundlach’s offices had turned up a trove of porn magazines, X-rated DVDs and sexual devices, as well as marijuana.

*    *    *

He charges TCW with employing “smear tactics … to destroy our business.” As for “the sex tapes and such,” he says, they represented “a closed chapter in my life.”

That’s certainly easy to understand.  Porn just hasn’t been the same since Ginger Lynn retired.

Jeff Gundlach’s December webcast entitled, “Independence Day” can be found here.  Take a good look at the graph on page 16:  “Top 0.1% Income Earners Share of Total Income”.  It’s just one of many reminders that our country is headed in the wrong direction.


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Double Bubble

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I’m sure there has been a huge number of search engine queries during the past few days, from people who are trying to find out what is meant by the term: “quantitative easing”.  My cynical, home-made definition of the term goes like this:

Quantitative easing involves the Federal Reserve’s purchase of Treasury securities as well as mortgage-backed securities from those privileged, too-big-to-fail banks.

The curiosity about quantitative easing has increased as a result of the release of the notes from the most recent meeting of the Federal Open Market Committee (FOMC) which boosted expectations that there will be another round of quantitative easing (often referred to as QE II).  On October 15, Federal Reserve chairman Ben Bernanke delivered a speech at the Federal Reserve Bank of Boston.  After discussing how weak the economic recovery has been (as demonstrated by lackluster consumer spending and the miserable unemployment crisis) Bernanke pointed out that the Fed’s current predicament results from the fact that it has already lowered short-term, nominal interest rates to near-zero.  He then noted that the federal funds rate will be kept low “for longer than the markets expect”.  Bernanke finally got to the point that people wanted to hear him discuss:  whether there will be another round of quantitative easing.  Here is what he said:

In particular, the FOMC is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation over time to levels consistent with our mandate.  Of course, in considering possible further actions, the FOMC will take account of the potential costs and risks of nonconventional policies, and, as always, the Committee’s actions are contingent on incoming information about the economic outlook and financial conditions.

In other words:  They’re still thinking about it.  Meanwhile, former Secretary of  Labor, Robert Reich, wrote a great essay telling us that the Fed will go ahead with more quantitative easing.  After defining the term, Professor Reich added this important tidbit:

Problem is, it won’t work.  Businesses won’t expand capacity and jobs because there aren’t enough consumers to buy additional goods and services.

I’m sure that was a helluva lot more common sense than many people were expecting from a professor at Berkeley.  Beyond that, Professor Reich gave us the rest of the bad news:

So where will the easy money go?  Into another stock-market bubble.

It’s already started.  Stocks are up even though the rest of the economy is still down because money is already so cheap. Bondholders (who can’t get much of any return from their loans) are shifting their portfolios into stocks.  Companies are buying back more shares of their own stock.  And Wall Street is making more bets in the stock market with money it can borrow at almost zero percent interest.

When our elected representatives can’t and won’t come up with a real jobs program, the Fed feels pressed to come up with a fake one that blows another financial bubble.  And we know what happens when financial bubbles get too big.

Another bubble currently under expansion is the “junk bond” bubble.  Sy Harding wrote an important article for Forbes entitled, “Fed Still Blowing Bubbles?“.  Here is some of what he said:

The economy’s problems at this point don’t seem to be the level of interest rates, but the lack of jobs, dismal consumer confidence, and the unwillingness of banks to make loans.

However, just the anticipation of additional quantitative easing and still lower long-term interest rates has already potentially begun to pump up the next bubbles, as investors have moved out the risk curve in an effort to find higher rates of return. Money has been flowing at a dramatic pace into high-yield junk bonds, commodities, and gold.  And the stock market has surged up 12% just since its August low when talk of another round of quantitative easing began.  Meanwhile, the U.S. dollar has been trashed further on expectations that the Fed will be ‘printing’ more dollars to finance another round of quantitative easing.

Nevertheless, Sy Harding isn’t so sure that QE II is a “done deal”.  After making his own cost-benefit analysis, Mr. Harding reached this conclusion:

It’s a no-brainer.  Blow another bubble and worry about the consequences down the road.

Yet in his speech Friday morning Fed Chairman Bernanke did not go all in on quantitative easing, stopping short of announcing a new policy, saying only that the Fed contemplates doing more, but “will take into account the potential costs and risks.”

So uncertainty remains for a market that has probably already factored in a substantial new round of stimulus.

This raises an important question:  How will the markets react if the consensual assumption that there will be a QE II turns out to be wrong?

Bond guru, Mohamed El-Erian of PIMCO,  recently wrote a piece for the Financial Times, in which he asserted his conclusion that judging from the FOMC minutes, “it is virtually a foregone conclusion” that the Fed will proceed with QE II.  El-Erian described this anticipated action by the Fed as an effort to “push” investors “to move out on the risk spectrum and buy corporate bonds and stocks”.

Getting back to my earlier question:  If the Fed decides not to proceed with QE II, will the bubbles that have been inflated up to that point make such a large pop as to drive the economy toward that dreaded second dip into recession?  On the other hand, if the Fed does proceed to implement QE II:  What will be the ultimate cost to taxpayers for something Robert Reich describes as a “fake” jobs program “that blows another financial bubble” and accomplishes nothing else?

As Professor Reich has pointed out, the Fed itself is the one being “pushed” to take action here because “our elected representatives can’t and won’t come up with a real jobs program”.  Unfortunately, any “jobs program” initiated by the government has become a “third rail” issue with mid-term elections looming.   As I stated previously, if the economic crisis had been properly addressed two years ago, when the political will for an effective solution still existed, the Fed would not be faced with the current dilemma.  But here we are   .  .  .   just blowing more bubbles.


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An Ominous Drumbeat Gets Louder

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August 13, 2009

Regular readers of this blog (all four of them) know that I have been very skeptical about the current “bear market rally” in the stock markets.  Nevertheless, the rally has continued.  However, we are now beginning to hear opinions from experts claiming that not only is this rally about to end — we could be headed for some real trouble.

Some commentators are currently discussing “The September Effect” and looking at how the stock market indices usually drop during the month of September.  Brett Arends gave us a detailed history of the September Effect in Tuesday’s edition of The Wall Street Journal.

Throughout the summer rally, a number of analysts focused on the question of how this rally could be taken seriously with such thin trading volume.  When the indices dropped on Monday, many blamed the decline on the fact that it was the lowest volume day for 2009.  However, take a look at Kate Gibson’s discussion of this situation for MarketWatch:

One market technician believes trading volume in recent days on the S&P 500 is a sign that the broad market gauge will test last month’s lows, then likely fall under its March low either next month or in October.

The decline in volume started on Friday and suggests the S&P 500 will make a new low beneath its July 8 bottom of 869.32, probably next week, on the way to a test in September or October of its March 6 intraday low of 666.79, said Tony Cherniawski, chief investment officer at Practical Investor, a financial advisory firm.

“In a normal breakout, you get rising volume. In this case, we had rising volume for a while; then it really dropped off last week,” said Cherniawski, who ascribes the recent rise in equities to “a huge short-covering rally.”

The S&P has rallied more than 50 percent from its March lows, briefly slipping in late June and early July.

Friday’s rise on the S&P 500 to a new yearly high was not echoed on the Nasdaq Composite Index, bringing more fodder to the bearish side, Cherniawski said.

“Whenever you have tops not confirmed by another major index, that’s another sign something fishy is going on,” he said.

What impressed me about Mr. Cherniawski’s statement is that, unlike most prognosticators, he gave us a specific time frame of “next week” to observe a 137-point drop in the S&P 500 index, leading to a further decline “in September or October” to the Hadean low of 666.

At CNNMoney.com, the question was raised as to whether the stock market had become the latest bubble created by the Federal Reserve:

The Federal Reserve has spent the past year cleaning up after a housing bubble it helped create.  But along the way it may have pumped up another bubble, this time in stocks.

*   *   *

But while most people take the rise in stocks as a hopeful sign for the economy, some see evidence that the Fed has been financing a speculative mania that could end in another damaging rout.

One important event that gave everyone a really good scare took place on Tuesday’s Morning Joe program on MSNBC.  Elizabeth Warren, Chair of the Congressional Oversight Panel (responsible for scrutiny of the TARP bailout program) discussed the fact that the “toxic assets” which had been the focus of last fall’s financial crisis, were still on the books of the banks.  Worse yet, “Turbo” Tim Geithner’s PPIP (Public-Private Investment Program) designed to relieve the banks of those toxins, has now morphed into something that will help only the “big” banks (Goldman Sachs, J.P. Morgan, et al.) holding “securitized” mortgages.  The banks not considered “too big to fail”, holding non-securitized “whole” loans, will now be left to twist in the wind on Geithner’s watch.  The complete interview can be seen here.  This disclosure resulted in some criticism of the Obama administration, coming from sources usually supportive of the current administration. Here’s what The Huffington Post had to say:

Warren, who’s been leading the call of late to reconcile the shoddy assets weighing down the bank sector, warned of a looming commercial mortgage crisis.  And even though Wall Street has steadied itself in recent weeks, smaller banks will likely need more aid, Warren said.

Roughly half of the $700 billion bailout, Warren added, was “don’t ask, don’t tell money. We didn’t ask how they were going to spend it, and they didn’t tell how they were going to spend it.”

She also took a passing shot at Tim Geithner – at one point, comparing Geithner’s handling of the bailout money to a certain style of casino gambling.  Geithner, she said, was throwing smaller portions of bailout money at several economic pressure points.

“He’s doing the sort of $2 bets all over the table in Vegas,” Warren joked.

David Corn, a usually supportive member of the White House press corps, reacted with indignation over Warren’s disclosures in an article entitled:  “An Economic Time Bomb Being Mishandled by the Obama Administration?”  He pulled no punches:

What’s happened is that accounting changes have made it easier for banks to contend with these assets. But this bad stuff hasn’t gone anywhere.  It’s literally been papered over. And it still has the potential to wreak havoc.  As the report puts it:

If the economy worsens, especially if unemployment remains elevated or if the commercial real estate market collapses, then defaults will rise and the troubled assets will continue to deteriorate in value.  Banks will incur further losses on their troubled assets.  The financial system will remain vulnerable to the crisis conditions that TARP was meant to fix.

*   *   *

In a conference call with a few reporters (myself included), Elizabeth Warren, the Harvard professor heading the Congressional Oversight Panel, noted that the biggest toxic assets threat to the economy could come not from the behemoth banks but from the “just below big” banks.  These institutions have not been the focus of Treasury efforts because their troubled assets are generally “whole loans” (that is, regular loans), not mortgage securities, and these less-than-big banks have been stuck with a lot of the commercial real estate loans likely to default in the next year or two.  Given that the smaller institutions are disproportionately responsible for providing credit to small businesses, Warren said, “if they are at risk, that has implications for the stability of the entire banking system and for economic recovery.”  Recalling that toxic assets were once the raison d’etre of TARP, she added, “Toxic assets posed a very real threat to our economy and have not yet been resolved.”

Yes, you’ve heard about various government efforts to deal with this mess.  With much hype, Secretary Timothy Geithner in March unveiled a private-public plan to buy up this financial waste.  But the program has hardly taken off, and it has ignored a big chunk of the problem (those”whole loans”).

*   *   *

The Congressional Oversight Panel warned that “troubled assets remain a substantial danger” and that this junk–which cannot be adequately valued–“can again become the trigger for instability.”  Warren’s panel does propose several steps the Treasury Department can take to reduce the risks.  But it’s frightening that Treasury needs to be prodded by Warren and her colleagues, who characterized troubled assets as “the most serious risk to the American financial system.”

On Wednesday morning’s CNBC program, Squawk Box, Nassim Taleb (author of the book, Black Swan — thus earning that moniker as his nickname) had plenty of harsh criticism for the way the financial and economic situations have been mishandled.  You can see the interview with him and Nouriel Roubini here, along with CNBC’s discussion of his criticisms:

“It is a matter of risk and responsibility, and I think the risks that were there before, these problems are still there,” he said. “We still have a very high level of debt, we still have leadership that’s literally incompetent …”

“They did not see the problem, they don’t look at the core of problem.  There’s an elephant in the room and they did not identify it.”

Pointing his finger directly at Fed Reserve Chairman Ben Bernanke and President Obama, Taleb said policymakers need to begin converting debt into equity but instead are continuing the programs that created the financial crisis.

“I don’t think that structural changes have been addressed,” he said.  “It doesn’t look like they’re fully aware of the problem, or they’re overlooking it because they don’t want to take hard medicine.”

With Bernanke’s term running out, Taleb said Obama would be making a mistake by reappointing the Fed chairman.

Just in case you aren’t scared yet, I’d like to direct your attention to Aaron Task’s interview with stock market prognosticator, Robert Prechter, on Aaron’s Tech Ticker internet TV show, which can be seen at the Yahoo Finance site.  Here’s how some of Prechter’s discussion was summarized:

“The big question is whether the rally is over,” Prechter says, suggesting “countertrend moves can be tricky” to predict.  But the veteran market watcher is “quite sure the next wave down is going to be larger than what we’ve already experienced,” and take major averages well below their March 2009 lows.

“Well below” the Hadean low of 666?  Now that’s really scary!