The Cliff Has Arrived

Well, just when we thought the country was going to receive a special present for Christmas, it turns out the Grinch has other plans. It looks like we have arrived at the “Cliff” and we're going over it. It’s unfortunate but speaks to the state of affairs in Washington.

It's really too bad that a Republican or Democrat elected in New York (for example) to represent those state’s issues has to become part of their party’s voting block as soon as he or she arrives in DC.  Each state's representaive has a whole different set of priorities and concerns based on that states constituents.  However, once you arrive in Washington, you can’t think for yourself, vote on your own, or work with the other party to solve an issue facing the country because you have basically joined a tribe, and tribes don’t like other tribes.

The reason we have a fiscal cliff is because Washington has become tribal. To members of Congress, your tribe is more important than your country and keep your position in the tribe is second. It used to be true that people regarded a stalemate in Washington as a good thing, but this time the fiscal cliff was supposed to force action and good ole fashion compromise.  Sadly this didn't happen.  Is there anything the American people can do to breakup these two tribes? The contempt for Congress is readily seen in the low approval ratings, but most people seem to think their own representative is doing a good job.  Even though we probably should have voted them all out this past November, we didn’t.

As the host of Survivor often says - “The tribe has spoken.”

Sadly, the only way to force action on Congress is for the markets to drop in order for members of Congress and the Senate to begin to feel a sense of urgency to get a deal done.

This is not a good way to end the year.

FED Rate Decision

Below is an excerpt from an article published by Marketfield Fund on the Federal Reserve meeting held this past week.  While the language in the most recent statement has changed, the Fed's goal of providing plenty of liquidity has not.


"Just because something is expected does not mean that it is not remarkable, and the blithe nature with which the FOMC has ushered in two changes to monetary policy should not hide the radical nature of these changes. We assume that the FOMC waited until after the election to alter policy since, although the FOMC is nominally independent, it is also politically sensitive.

December's meeting has had two substantive outcomes; first, the FOMC elected to extend asset purchases after the expiration of Operation Twist. Starting in January, what had originally been a program of maturity extension designed to lower long-term treasury rates has now morphed into additional quantitative easing. The FRB will now purchase an additional $45 billion of long dated Treasury securities but will no longer sell short dated paper to sterilize these flows. This will come on top of the $40 billion of MBS purchases, meaning that the FRB's balance sheet will now grow at $85 billion a month, which would be an annualized rate of 35% based on the current size of the balance sheet.

This is despite the fact that since Chairman Bernanke's Jackson Hole speech last August, overall economic data has been robust, including the key employment metrics. Most obviously the unemployment rate, which has clearly been elevated into the statistic of the current monetary cycle, has fallen from 8.3% (using July's data) to 7.7% since this speech was made.

This brings us to the second and arguably more radical shift in policy. Rather than issue guidance based on a date for anticipated change in policy, the FOMC has started to tie policy explicitly to an unemployment rate, with inflation concerns coming in as a distant second, stating that current policy will remain in place:

"At least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored."

"The Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent."

However, in our experience, the market will pay much more attention to the first of these paragraphs, with asset prices now being very sensitive to the monthly unemployment rate, despite the fact that this is one of the least reliable metrics in the monthly data calendar. Moreover, our belief is that unemployment may continue to surprise observers by trending lower for the remainder of the favorable data season (which will continue until March). Although it seem highly unlikely that the magical 6½% could be reached by then, we could find ourselves close enough to 7% that the bond market starts to twitch nervously that the 2015 guesstimate for the expiration of current policy may be unpleasantly inaccurate.

In the meantime, the continued bloating of the FRB's balance sheet is really a signal to investors that the FRB is determined to force a recovery at all costs. Although the FRB is injecting substantial capital into long dated treasury and mortgage bonds, we assume that the success of this policy will ultimately come at the expense of the bond market. In particular, longer dated yields really should start to move higher as private capital starts to get the message that the FOMC is prepared to rewrite the rules as many times as it takes to win the game."

2013 Obamacare Changes

Each year since 2010 portions of Obamacare have been implemented.  Next year is no exception and starting in January 2013 there are several revenue provisions that will impact many Americans by direct taxes, reduced tax benefits or indirect additional health care expenses.

• Itemized Deductions for Medical Expenses

Increases the threshold for the itemized deduction for unreimbursed medical expenses from 7.5% of adjusted gross income to 10% of adjusted gross income; but waives the increase for individuals age 65 and older for tax years 2013 through 2016.

• Flexible Spending Account Limits

Limits contributions to a flexible spending account for medical expenses to $2,500 per year, increased annually by a cost of living adjustment. The 35 million Americans who use a Flexible Spending Account (FSA) at work to pay for their family’s basic medical needs will face a new government cap of $2,500 (currently the accounts are unlimited under federal law). 

• Increased Tax Rate on Medicare

Increases the Medicare Part A (hospital insurance) tax rate on wages by 0.9% (from 1.45% to 2.35%) on earnings over $200,000 for individual taxpayers and $250,000 for married couples filing jointly. This is a direct marginal income tax hike on small business owners, who are liable for self-employment tax in most cases.

• Surtax on Investment Income

Creation of a new, 3.8% surtax on investment income earned in households making at least $250,000 ($200,000 single). This table below illustrates the new tax rates. These rates will become effective unless adjustments are part of a more comprehensive budget plan.
 

	Capital Gains	Dividends	Other*
2012	15%	15%	35%
2013+ (current law)	23.8%	43.4%	43.4%

While the increased tax rate on Medicare and investment income are geared toward the higher income brackets, the limit on flexible spending accounts and higher threshold for deduction of medical expenses are going to impact many Americans.

Bipartisanship Really Possible?

To those of you who may not believe that social mood matters to politicians, I bring to your attention the bipartisan press conference held today at the White House.  Because politicians are constantly running for office even if they have just been elected, policymakers respond to changes in social mood better than any other group. There is nothing like a quick 1,000 point drop in the Dow Jones Industrial Average over concerns about the impending "fiscal cliff" to bring players together in well-choreographed bipartisanship.  We shall soon find out whether or not this meeting was just for show or a more meaningful response to a very serious issue.

Unfortunately, as I mentioned last week, I am not optimistic that a compromise will be reached by the end of the year.  Raising taxes on the wealthiest Americans will generate an extra $100 billion in revenue.  Considering the government is running a trillion dollar deficit each year; where is the other $900 billion going to come from?  Higher taxes on the middle class?  Spending cuts? And according to the meeting today, this is all going to be accomplished by Christmas.  Sure is going to be an interesting few weeks! 

  

Election Results, More Of The Same

While I consider myself an independent with a rational viewpoint, conservative on fiscal issues and more moderate on social ones, this election showed just how polarized our country has become.  While the electoral vote was fairly one sided in favor of President Obama, the popular vote was much closer.  In the end nothing really changed - we have a Republican controlled House, a Democrat controlled Senate, and a Democratic President; same as it was on Tuesday morning.  Voters in general - regardless of party - just aren't happy with the way things are going in Washington.

There seems to be a notion that the markets declined this week because of the election results - a pure play between Obama and Romney's differing viewpoints on how to handle things - and the markets wanted Romney to win.  However, the economy, while definitely important, wasn't the main factor in this election.  Social issues, taxes, entitlement programs, the middle class, and foreign policy were also big components in the outcome.  The ideals of the country are changing and this may have an impact on how markets act in the future as well as how business leaders run their companies.

I am sure the Democratic leaders in both the House and Senate have to believe the election results are a mandate to raise taxes on the rich or at least close some loopholes.  With the Republicans in the House firmly against this, it seems that compromise is out of the question in the near term.  It's likely the markets are going to have to get panicky before a real deal gets done, similar to the bailout in the fall of 2008.  Unfortunately, I am not optimistic that a compromise will be reached by the end of the year.  I think an agreement will be reached but not until the new Congress comes into office in January.  Of course, it will take several weeks for some bill to be passed after new sessions begin. 

Taxes are likely going up to some degree and this is probably going to happen at exactly the wrong time.  Higher taxes of any kind in 2013 will most likely bring a US recession as the economy is just not growing fast enough.  At the same time, the cost of food and fuel will likely rise as central banks print more money to try to prevent the downturn.  This combination could bring about stagflation (inflation rises and growth slows) which is the least favorable type of investing environment.  Time to error on the side of being cautious.  The next few months are going to be interesting times indeed.

Election Humor

With the election less than three weeks away we thought we would add some humor to the process.  Below are a few links we hope you find enjoyable.


http://youtu.be/DSbxBQhzk3M


http://www.hulu.com/watch/409936


http://www.hulu.com/watch/412902

Economy Still Producing Jobs

This morning the Bureau of Labor Statistics (BLS) revealed the September Employment Report, which showed 114,000 non-farm jobs were added during the month and the unemployment rate dropped to 7.8% from 8.1% the prior month.  This compares to the consensus expectation of 113,000 jobs and an unemployment rate of 8.1%. While the number of non-farm jobs was essentially in line, the big surprise was the drop in the unemployment rate, which marks the lowest level in more than 40 months.

While the headlines associated with the BLS report will be met with enthusiasm as the August number was revised higher showing more jobs created, the underlying data continues to point to a tepid economic recovery. This employment report is at best acceptable, but it’s certainly not stellar. In other words, the economy is not quite out of the woods.

Per the BLS report, we find at least part of the drop in the unemployment rate to 7.8% was due to the continued decline in the number of people in the labor force.  More specifically, 211,000 people exited the labor force in the past month, which brings the trailing 12-month total to roughly 2.6 million people.

Move up http://i.forbesimg.com tMove downAverage hourly earnings in September for private non-farm private employees rose by only $0.07 to $23.58, and over the last 12 months, average hourly earnings have risen by 1.8%. This compares to greater increases in food, energy and other input prices and recent data points to further inflation ahead. That will continue to pressure disposable income and consumer spending.

Next month’s report will be released on November 2^nd, just a few days before the Presidential election.

Weekly Update

2012 is very quietly turning into a very good year for the US equity markets.  With almost three quarters of the year in the books, the SPX index has risen roughly 16% so far this year.  If the index was to finish the year at this level, it would qualify as the 2nd best performance since 2003 and the 3rd best since 1999. If the current pace of gains were to be continued through the 4th quarter, the index would post a gain of around 21%, which would eclipse 1999, but still leave it just behind 2003 and 2009. What is really interesting is most investors don’t believe the markets are up much this year.

Of course nothing is guaranteed in financial markets and it may be that the market has run ahead of itself, only to deliver a painful pullback in the weeks/months ahead.  We definitely believe this is a possibility, but with the open ended QE3 from the Federal Reserve, we do not expect things to play out this way.  If the market does sell off it will likely be short lived, unless there is some sort of external shock.  The market was resilient in the face of significant pressures during the summer and now that governments are continuing to provide significant liquidity, this should provide some support to market prices.

Moreover, it is becoming increasingly clear to the global investor that the US equity market represents leadership at the current time and it is the domestically focused sectors within this market that have generally offered the strongest returns in recent months.  We would expect the quarter end allocation process by institutions to reflect this understanding with the top sectors gaining the most in the final weeks of the quarter.

Our greatest concern regarding QE3 by the Federal Reserve was that it was not only unnecessary, but may in the end prove to be harmful to the long term fixed income marketplace and cause a significant rise in inflation in the not too distant future.

Who Will Win The Election?

With the U.S. election right around the corner and the ongoing debate over whether Greece (or any other country) may leave the Euro, we thought we would talk a bit about prediction markets which track the so called "wisdom of the crowd" theory.

The "wisdom of the crowd" theory is the process of taking into account the collective opinion of a group of individuals rather than a single expert (pundit) to answer a question.  A large group's aggregated answers to questions involving quantity estimation, general world knowledge, and simple reasoning has generally been found to be as good as, and often better than, the answer given by any one of the individuals within the group.  The often-cited explanation for this phenomenon is that there is personal noise associated with each individual judgment, and taking the average over a large number of responses will go some way toward canceling the effect of this noise.

With the information age has come the ability to gather the "wisdom of the crowd" via prediction markets. The most well known of the prediction market websites is Intrade (www.intrade.com).  Intrade is a site that allows users to make predictions on the outcome of hundreds of real-world events.  Stock markets find the price of stocks at any given moment, and futures markets find the price of commodities at any given moment.  Prediction markets, like Intrade, find the probability of something happening - a predefined, uncertain future event.

While not always 100% accurate, the site offers a way to watch the fluctuations of probability for various future events.  Elections are one of the main events on the site and it is interesting to see the fluctuations from week to week.

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A Discounting Dilemma

Financial markets, for the most part, are supposed to function as discounting mechanisms in which the future is reflected in current stock prices.  If the expectation for the future is better than the present, prices may rise even in the face of bad news.  If the expectation for the future is negative, prices may fall even in the face of very good news.  But because the markets are often driven by emotion, it doesn't always work that way.

The clearest example of this dilemma was in 2007 and 2008 when it was becoming increasing clear that there were problems in the US banking system.  These problems were so bad that they threatened the solvency of the global financial system and the global economy.  After a brief correction in the  summer of 2007 following the collapse of two Bear Stearns hedge funds that focused on sub-prime mortgages, the US equity markets went on to make new all-time highs in October of 2007.  What was even more amazing was that after JP Morgan purchased Bear Stearns in March of 2008 for just $10 per share, the markets rallied and were within 10% of those all time highs by May of 2008.  And we all know what happened a few months later.

The series of events to what has transpired in Europe between mid 2011 and today (mid 2012) are similar to the series of events that happened between the summer of 2007 and summer of 2008 in the US financial crisis.  By now it should be clear that a financial crisis in Europe cannot be avoided (most of Europe is already in recession) and the global fallout from this crisis could be very serious.  Despite this markets are rallying on the idea that the governments will be able to print more money and fix the problem.  While we can't totally dismiss the possibility of the problems getting fixed, ask yourself - when was the last time any government actually fixed a serious problem?  Exactly.

Ironically, perception is reality in financial markets until the reality becomes all too real. Once the reality hits there is the potential for a significant price adjustment in global financial markets.  Unfortunately it is extremely difficult to predict when this reality check may occur - it could be in 2 months or 2 years.  It will be important to keep an eye out for reality setting in.     

The New Healthcare Tax

Beginning in 2014 every American will have to carry health insurance or pay a penalty - a tax according to the Supreme Court.  What the ruling didn't resolve is how the individual mandate will be enforced.  This task, along with a list of others, is now the responsibility of the IRS.

Over the next 18 months the IRS needs to figure out a way to collect tax from an estimated 5 million people who are expected not to carry health insurance.  It also has to come up with a system for giving subsidies to those making less than $45,000 per year.  It has to start collecting tax on medical devices as well as add an additional Medicare surtax on those who make more than $200,000 per year. 

If this seems a bit daunting for the IRS to handle, it probably will be; considering the IRS is already having trouble keeping up with simple changes to the tax code each year.  Every year an estimated $400 billion goes uncollected because of some form of tax evasion.

Congress has prohibited the IRS from using liens or garnishments against individuals who skirt the mandate.  So the only real way for the IRS to collect the funds is from withholding the amount of refund a taxpayers receives.  According to the Treasury Department, the implementation of this new mandate could cost upwards of $900 million, about a 7% increase over the current budget.  Of course, Congress has cut the IRS budget the past two years so it's unlikely they will allow the budget increase.  So we have to wonder how this new tax will ever get implemented by 2014.  

Healthcare Law Stands

It was a victory for President Obama and Democrats, affirming the central legislative achievement of Obama’s presidency.  The vote was 5 to 4 upholding the current law.  However, the President's claims that the penalty for not obtaining health insurance was not a tax was incorrect according to the Supreme Court. 
   

“The Affordable Care Act’s requirement that certain individuals pay a financial penalty for not obtaining health insurance may reasonably be characterized as a tax,” Chief Justice Roberts wrote in the majority opinion. “Because the Constitution permits such a tax, it is not our role to forbid it, or to pass upon its wisdom or fairness.”

       

At the same time, the court rejected the argument that the administration had pressed most vigorously in support of the law, that its individual healthcare mandate was justified by Congress’s power to regulate interstate commerce. The vote was again 5 to 4, but in this instance Chief Justice Roberts and the court’s four more conservative members were in agreement.

       

The court also substantially limited the law’s expansion of Medicaid, the federal-state program that provides health care to poor and disabled people. Seven justices agreed that Congress had exceeded its constitutional authority by coercing states into participating in the expansion by threatening them with the loss of existing federal payments.

       

The court’s ruling was the most significant decision since the New Deal and the most closely watched case since Bush v. Gore in 2000. It was a crucial milestone for the law, the Patient Protection and Affordable Care Act of 2010, allowing almost all of its changes to roll forward.  According to the law, in 2016, the first year the tax will be fully in effect, it amounts to $695 for an individual and $2,085 for a family, or 2.5% of household income - whichever is larger.  The biggest obstacle in 2016 for the Government will be figuring out how to impose the tax.

Interesting Weekend Ahead

A crazy few months in Europe are about to get even more interesting this weekend.  There’s a presidential runoff in Egypt, the Greeks will try again to decide which party should run the country, and France will hold legislative elections that will likely impact the current president’s ability to get things accomplished during his term.

Egypt

On Saturday and Sunday, Egyptians are going to choose between two leading presidential candidates: Muslim Brotherhood member Mohamed Morsi and Ahmed Shafiq, a former air force general and civil aviation official who served under Mubarak.  Some have argued that the choice is really between two men who are unlikely to bring about the kind of change protesters demanded in 2011 during the historic uprising.

Greece

In early May, voters didn't give either of Greece's two most established parties a majority, crippling the country's ability to form a government. This weekend's vote will hopefully end the stalemate. Greeks want it to happen sooner than later, as the debt crisis threatens the stability of the European Union's single currency. 

France

Much attention was paid to Socialist Party candidate Francois Hollande's presidential victory in May. It was the first time France had had a Socialist president in 17 years and brought promises of widespread change to France's political landscape. That's why this weekend's legislative election is crucial. In order for Hollande to meet his goals, he needs similarly aligned lawmakers to win seats. Though Hollande beat Nicolas Sarkozy, the former French president is still working against his successor in trying to get his followers elected into the legislature.

 

The Bubble in US Government Bonds

1.5% for 10 years.  Yes, that is what we are talking about this week.  We don't know of too many people who would find such a rate that attractive, (especially for the next decade).  But that is what you are signing up for if you decide to loan money to the United States government by purchasing a 10 year Treasury note.

Two years ago, the 10 year yield was above 3%, and 5 years ago, it was sitting at 5%.  And if you'd like to step back to the early 80's, you could get around 15% annually.  With rates at these levels now, we would be very cautious about putting money into Government bonds.  The incentive for investors to do so is just not there.  Why would you buy a 10 year bond yielding 1.5%, when you could purchase a dividend paying company that yields more than 1.5% and offer the potential for appreciation over time.  Sure, the "safety" factor exists in bonds compared to stocks, (since you know you're going to get paid back).  But are they really that safe when so many investors are bidding to own these things at a time when there exist so many more favorable risk/reward scenarios?

The following chart showing the rate of the 10 year demonstrates the 30 year bull run we've had in Treasury prices. Though bond prices could certainly go higher in the short to medium term, we are very skeptical when looking further down the road.

Employment Growth Slows...Again

Non farm payroll employment increased in May by 69,000, and the unemployment rate was essentially unchanged at 8.2 percent, the U.S. Bureau of Labor Statistics reported today.  The civilian labor force participation rate increased in May by 0.2 percentage point to 63.8 percent, offsetting a decline of the same amount in April. The employment-population ratio edged up to 58.6 percent in May.  Unfortunately total non farm payroll employment for March was revised from positive 154,000 to positive 143,000, and April was revised more significantly from 115,000 to just 77,000.  While the numbers are still positive and there is job creation happening in the economy, the numbers are beginning to trend lower.

Click on chart for larger image

The chart below shows the current recovery compared to previous recoveries over the past century. As you can see it has more of a "U' shape rather than a "V" shape.  This shows the depth of the recent employment recession - worse than any other post-war recession - and the relatively slow recovery; mainly due to the lingering effects of the housing bust, financial crisis, and ongoing government intervention. 

 Click on chart for larger image

Week in Review

With Europe making the headlines again, it comes as no surprise that equities have been selling off considerably.  As of Thursday's close, the Dow has finished to the downside in 11 out of the last 12 trading sessions.  The "sell in May and go away" strategy appears to working, yet again, much like it did in 2011 and 2010.  The cause for concern now is that many people fear that Greece might exit the Euro zone.  As a result, this might cause a run on some of the other southern European banks, like in Spain, Portugal and Italy.  Some would even consider this as a Lehman Brothers type scenario unless some resolution is agreed upon before it gets to that point.  Regardless of stock valuations and fundamentals, investors have been motivated to take the “risk off” approach in the near term.  The markets have been in either full “risk on” or “risk off” mode for the last several months.

However, some have argued that this year should be one to stay invested.  Return data for election years in the past has actually proven to be quite rosy in most instances.  In prior election years, (2008 excluded), the markets have shown considerable strength, especially between the spring and autumn months.  See yearly results here.

S&P 500 Stock Market Returns During Election Years
Year	Return	Candidates
1928	43.6%	Hoover vs. Smith
1932	-8.2%	Roosevelt vs. Hoover
1936	33.9%	Roosevelt vs. Landon
1940	-9.8%	Roosevelt vs. Willkie
1944	19.7%	Roosevelt vs. Dewey
1948	5.5%	Truman vs. Dewey
1952	18.4%	Eisenhower vs. Stevenson
1956	6.6%	Eisenhower vs. Stevenson
1960	.50%	Kennedy vs. Nixon
1964	16.5%	Johnson vs. Goldwater
1968	11.1%	Nixon vs. Humphrey
1972	19.0%	Nixon vs. McGovern
1976	23.8%	Carter vs. Ford
1980	32.4%	Reagan vs. Carter
1984	6.3%	Reagan vs. Mondale
1988	16.8%	Bush vs. Dukakis
1992	7.6%	Clinton vs. Bush
1996	23%	Clinton vs. Dole
2000	-9.1%	Bush vs. Gore
2004	10.9%	Bush vs. Kerry
2008	-37%	Obama vs. McCain
2012	?	Obama vs. ?

Being that 2012 is an election year, there has been speculation amongst analysts that this year could surprise many in a positive way.  Unfortunately, the last three weeks have come to prove that a positive surprise might not come so easy.  Volatility has ticked up, and near term concerns seem to far outweigh any positive prospects for the longer term.  As long as issues in Europe continue, it will likely be on the mind of investors.   

At the same time, Facebook goes public today, (ticker FB).  This comes at an interesting time because it seems to be stealing a lot of the market’s thunder recently.  There seems to be less interest on the markets shifty movement and relentless emphasis on what will be the largest internet IPO in history. 

Liquidity and Markets

Many investors (and analysts for that matter) mistakenly believe that stocks are driven strictly by the underlying fundamentals, such as GDP, employment rate, interest rates, etc.  While it's true the economy can have an impact on the stock market, it's not the main reason stocks move higher or lower.  The main driver of stock prices is liquidity - either excess or lack of.

If there is excess liquidity in the system, some of that cash finds its way into stocks and other assets (real estate a few years back, remember that?).  One important by-product of a solid growing economy is a liquid market, which means stocks rise. However, the economy itself is only impacting the market indirectly. The reverse is usually true in a bad economy.  Poor economies lead to a liquidity crunch (think saving and paying down debt) and stocks usually fall. 

To understand the concept of liquidity vs. the economy as a driver of stocks, simply look at the Nasdaq Composite, which was recently trading above its 2007 high. So we ask ourselves is the economy as good or better now than it was in 2007? Obviously it's not better - so if the economy were truly the driver, then the markets would be substantially lower, since things are worse than in 2007. So why aren't the markets lower?  The answer is liquidity.

Since 2009, the massive money printing from the TARP bailout, the ECB's LTRO, QE1, QE2, Operation Twist, and so on, have provided the liquidity to keep stocks moving higher.  In addition, lower interest rates have allowed corporations and consumers to borrow funds, which in turn creates more liquidity. As far as we can see, this liquidity is one of the only factors driving stocks higher. The amount of liquidity injected into the system in recent years has been beyond comprehension - trillions and trillions of dollars. 
That liquidity usually gets confused with "real" money, and gets spent as actual money, which drives stocks and other assets higher.  "Real" money is actually money created when an economy produces more than it consumes.  In other words, real money comes from production and economic growth.  In the current world, there is limited production and growth; so the prime mover driving asset prices is the printing presses.

As long as the liquidity is there, it's supportive to global markets, especially with interest rates so low.  But what happens if the printing presses stop?  Where will the liquidity come from?  If we assume it will eventually come from production and growth, what happens when the global economy can't grow at a rate fast enough to produce the same amount of liquidity that governments are currently providing, then what?  Wish I knew the answer.

Facebook IPO

While I don't have a Facebook account, I do realize that almost 1 billion people across the globe use Facebook in some form.  With so many people connected via Facebook, I thought it made sense to discuss its upcoming venture into the public marketplace.

According to recent reports, Facebook set the price range for its initial public offering at $25 to $35 a share, in a landmark deal that would raise as much as $13.5 billion for the social network and its insiders.

The preliminary price range would value the company at $75 billion to $100 billion. It puts the social network on track to become the most valuable U.S. Web company at the time of an IPO, exceeding Google's $23 billion valuation in 2004. It would also put Facebook just behind the market capitalization of Amazon and ahead of other tech giants like Hewlett Packard.

Chief Executive Mark Zuckerberg's stake in Facebook is valued as high as about $18.7 billion. Mr. Zuckerberg will also hold or have the ability to control approximately 57.3% of the voting power of our outstanding capital stock following this offering.

The social network is now about two weeks away from a final pricing and the first trading of its shares under the symbol FB.  The planned price range of $25 to $35 is on the lower side of what some analysts and investors had expected. On the private-company exchange SharesPost, Facebook shares were last trading at roughly $40 per share.

 

Associated Press

Facebook CEO Mark Zuckerberg

Facebook's reach is unprecedented. The company, founded by Mark Zuckerberg and some Harvard University students, is now fast approaching an audience of one billion, and it continues to draw users from numerous demographics and international markets. It's now expected to enter the sensitive—but massive—Chinese market.

Still, some recent financial disclosures by the company put a damper on enthusiasm about its impending IPO. Unlike many other Web companies that recently went public, Facebook is profitable. But the company recently disclosed that its profit and sales dipped in the first quarter of this year, compared with the prior period.

Sales in the period fell 6% from the fourth quarter to $1.06 billion, while profit slumped 32% to $205 million. In 2011, Facebook posted a profit of $1 billion and $3.7 billion in sales, compared with a loss of $56,000 and $272 million in sales as recently as 2008.

While Facebook makes money, which can't be said for many other Internet companies like Groupon, for example; it faces the significant challenge of exponentially growing revenues and earnings over the next few years in order to fully live up to the hype and justify its lofty valuation.

Macro Environment Thoughts

One of Doubleline's bond mangers Jeff Gundlach had a conference call last week and made some interesting macro observations we thought we would share with readers.

Below is a summary of his thoughts:

• There’s been no real household income growth since 1970, which is why people still feel like the US is in a recession. 

• Household debt has quadrupled over the past few decades and has formed a scheme of borrowing to keep up nominal income growth.
 
 
• Similar to the Roman Empire, R&D as well as infrastructure spending have been declining.

• The debt ceiling raises from 2011 were supposed to take us past the November election, but it looks like, due to increased spending, the ceiling will be breached before the election.
 
 
• He thinks taxes are too low.  Top earners pay an average of 34.2% today, compared to 70% in the 1950's.

• Incredibly, 60% of the US population has seen taxes rise since the 1950’s while top earners have seen declines.

• Exploding Central bank balance sheets have helped prop up global equity markets. 

• To make serious money in the market you need to wait for single digit PE on the broad market and we are not there yet. 

• Says the Federal Reserve will only raise rates if there is real inflation. 

• Biggest risk to the economy and assets is skyrocketing interest rates.

First Quarter Real GDP up 2.2%

Real gross domestic product -- the output of goods and services produced by labor in the United States -- increased at an annual rate of 2.2% in the first quarter of 2012 (from the fourth quarter to the first quarter), according to the "advance" estimate released by the Bureau of Economic Analysis.

The increase in real GDP in the first quarter primarily reflected positive contributions from personal consumption expenditures (PCE), exports, private inventory investment, and residential fixed investment that were partly offset by negative contributions from federal government spending, nonresidential fixed investment, and state and local government spending. Imports, which are a subtraction in the calculation of GDP, increased.

The deceleration in real GDP in the first quarter primarily reflected a deceleration in private inventory investment and a downturn in nonresidential fixed investment that were partly offset by accelerations in exports.

The GDP report was weaker than expected, however, on the bright side, final end demand was good.  Personal consumption expenditures increased at a 2.9% annual rate in the first quarter, and residential investment increased at a 19.1% annual rate. Weather probably provided a boost to GDP.  However, growth at this rate is not sustainable longer term without more personal income growth.

China Growth Expected to Slow in 2012

China's gross domestic product grew 8.1% in the January-to-March period from the prior year according to the National Bureau of Statistics - slower than 8.9% in the fourth quarter and the median 8.3% forecast by economists.

The first-quarter growth was the slowest on a year-on-year basis since the 6.6% in the first quarter of 2009. It was also disappointing on a quarter-on-quarter basis, slowing to 1.8% compared with the fourth quarter's 2%.

Chinese Premier Wen Jiabao said yesterday China faced rising inflation risks amid the growth headwinds, adding that Beijing would continue to improve and fine-tune macroeconomic controls and policy to deal with the challenges.

In sharp contrast to the quarterly GDP reading, data for industrial production, retail sales and bank lending showed momentum picking up in March.  Chinese production of steel, cement and automobiles - which had recently triggered concern of an economic hard landing - accelerated last month. Industrial production rose 11.9% in March from a year earlier, and topping the 11.6% median forecast. Retail sales rose 15.2% from a year earlier, also up 0.5% and beating the forecast gain of 15.1%.

Meanwhile, an unexpected surge in new loans last month showed the ruling Communist Party was trying to avoid a deeper growth slide. The People's Bank of China said on Thursday that new loans made by the country's banks trumped forecasts to spike to 1.01 trillion yuan last month from 710.7 billion yuan in February.

One area where there was little to cheer about was the property sector. Investment growth in the first quarter was the slowest since the government started its property market tightening campaign two years ago and home sales continued to shrink.

JOBS ACT 2012 Signed Into Law

The Jumpstart Our Business Startups (JOBS) Act was passed by The U.S. Congress and signed into law by President Obama on April 5, 2012. The JOBS Act represents the most significant change to our capital formation regulatory framework since Securities Offering Reform in 2005. The JOBS Act will affect private companies considering an IPO or alternative capital raising approaches, as well as existing public companies, and, of course, the financial intermediaries that advise companies in connection with capital raising.

The most important belt that the Jumpstart Our Business Startups Act loosens concerns the amount of capital a new company may raise through the sale of securities in a 12-month period. Previously $5 million, the securities sales cap will be raised to $50 million. That cap will now specifically apply to a broader group of small companies: those with annual gross revenues of $1 billion or less (adjusted for inflation), within a five-year interval from the sale of its first security.

A new phrase is getting used, emerging growth companies (EGCs). It's the term proposed by the National Venture Capital Association (NVCA), and is now codified into law. It refers to this specific, new group of young, low-revenue companies for whom some of the normal reporting regulations will no longer apply.  The NVCA recommended the five-year period as part of what it called the "IPO on-ramp." As the proposal read, "We recommend that companies with total annual gross revenue of less than $1 billion at IPO registration and that are not recognized by the SEC as 'well-known seasoned issuers' be given up to five years from the date of their IPOs to scale up to compliance. Doing so would reduce costs for companies while still adhering to the first principle of investor protection."

Lastly, the JOBS Act removes many of the restrictions placed upon research analysts involving their ability to comment on issues. An investment banking firm participating in a proposed public offering of common equity of an Emerging Growth Company may publish research relating to that issuer at any time, whether before the filing of a registration statement, during the waiting period or after it is declared effective, without that research being treated as an offer to sell a security. Whether or not this new Act "jumpstarts" the economy through a lessening of business startup regulation remains to be seen.

Q4 GDP

Yesterday morning the BEA released the third estimate of Q4 GDP. The BEA reported that Real gross domestic product "increased at an annual rate of 3.0 percent in the fourth quarter of 2011", the same as the previous estimate.  Also in the release, the BEA reported the real gross domestic income (GDI) increased at a 4.4% annualized rate in Q4.

There are really two measures of GDP: 1) real GDP, and 2) real Gross Domestic Income. Some economists believe that  that GDI is often more accurate than GDP.

During the worst period of the last recession, GDI fell more than GDP. In subsequent revisions, GDP was revised down showing the economy contracted more than originally reported - and closer to the original GDI reports, which may mean the GDI could be a more accurate measure of economic growth.

The opposite has happened over the last two quarters - GDI is showing stronger growth than GDP - and this suggests that 2nd half 2011 GDP might be revised up with the next annual revision that will be released on July 27th (Revised Estimates will be provided for years 2009 through 2011).

With its third revision of fourth-quarter GDP, issued Thursday, the agency also released its GDI estimates. Here’s what they show:

GDP Q4 2011 up 3.0%
GDI Q4 2011 up 4.4%

GDP Q3 2011 up 1.8%
GDI Q3 2011 up 2.6%

FULL 2011 GDP: up 1.7%
FULL 2011 GDI: up 2.1%


Hopefully this means that actual GDP growth moving forward could be higher than actual numbers reported assuming of course that GDI continues to grow at a faster pace.  We hope this trend can continue through the balance of 2012.

Pulse of Commerce Index

While there are a number of economic indicators used to gauge the economy, one of the more interesting is the Pulse of Commerce Index.  The index seeks to measure real time economic activity by tracking diesel fuel purchases across the country. 

The Ceridian-UCLA Pulse of Commerce Index derived by UCLA Anderson School of Management is based on real-time fuel consumption data for over the road trucking and serves as an indicator of the current state and possible future direction of the U.S. economy. By tracking the volume and location of diesel fuel being purchased, the index closely monitors the over the road movement of produce, raw materials, goods-in-process and finished goods to U.S. factories, retailers and consumers. Working with economists at UCLA Anderson School of Management and Charles River Associates, Ceridian publicly releases the Index monthly and also offers companies access to customized reports and data.  The index has been relatively flat since the middle of 2010, which confirms the slow level of US economic growth.  The link to the index is below.


http://www.ceridianindex.com/

Quantitative Easing Revisited

We thought it would be great to revisit the US monetary base to see how QE has impacted the stock markets.

The chart below is a chart of the US monetary base. In simple terms, it illustrates how much money the Fed has pumped into the financial system. So it’s a kind of visual of what the Federal Reserve is doing.   Given the events of the past several years, we can assume when the monetary base explodes higher, the Fed is concerned about stability in the system and therefore pumps liquidity into circulation.

On the chart, you can observe that during the financial crisis the Fed didn't do much until the autumn of 2008 when it pumped nearly $1 trillion into the system - the first vertical spike.  In the middle of 2010, the monetary base declined which corresponded to a decline in the stock market.  In response, the Federal Reserve injected more liquidity into the system via QE2 at the end of 2010 into the first half of 2011 - the second vertical spike.  The stock market followed suit rising sharply in December of 2010 and through the first several months of 2011.  The monetary base then declined in the into the fall of 2011 at the same time the stock market declined.  Since the beginning of 2012 (the last little spike up on the chart), the Fed has increased liquidity in the system that has, no doubt, been responsible for the stock market's 10% increase so far this year.

What's concerning is that it now takes huge spikes in liquidity to have the desired affect.  Any slowdown in liquidity injections seems to negatively impact economic growth, which in turn causes the stock market to decline.  At what point will the Fed stop injecting liquidity into the system?  Will they ever be able to stop?  Nobody really knows.
  
That being said, as long as the money is flowing freely, we can expect the cash will find its way into the stock market, especially with interest rates at zero.  We expect this process can't continue forever, but we can't completely rule out the possibility.  Unfortunately, if the Fed continues on this path it will have unforeseen consequences.

Market Milestones

There has been an abundance of talk regarding specific market "milestones" throughout recent weeks. We have listened to analysts discuss the Dow reaching the 13,000 level again......and again, as well as the Nasdaq, which happens to be closing in on the 3000 level, (a mark not seen since the tech bubble from over a decade ago). We have also heard some well deserved chatter about Apple, (ticker AAPL). With it's recent run-up in share price, it's current market cap is roughly $500 billion. Investors are discussing the possibility of it one day becoming the first trillion dollar company in existence. Although these "milestones" are fun to talk about amongst fellow investors and market gurus, we really don't believe that they represent anything more than psychological hurdles.....or numbers to be completely blunt. With all that being said, we thought that posting this article from SmartMoney.com would be a fun way to point out some of the various market milestones from the mid 1990's till now.

http://www.smartmoney.com/invest/markets/a-brief-history-of-market-milestones-1330108112563/

Housing Market Recovery?

“Shadow inventory” is considered the number of homes that are either in foreclosure or likely to end up in foreclosure held on banks’ balance sheets.  This inventory creates substantial pressure on housing prices and potential losses to banks.   If the number is manageable, it usually means waiting for the market to digest the overhang. But if shadow inventory is large, housing prices could experience further declines before they hit bottom, which of course has dire consequences for communities, homeowners, and the economy.

Estimates of shadow inventory, and even the definition of what constitutes shadow inventory property, vary widely.  Current estimates vary from 1.6 million to 8.2 million homes, depending on which database of loans and criteria are used to determine possible foreclosure rates.  Mostly likely, the shadow inventory is probably in the range of the numbers above. Regardless of the actual number, the sooner this inventory gets worked through the system, the sooner we will see an improvement in the housing market and the broader economy.

While the actual shadow inventory numbers are a wild card in the housing recovery, we may be starting to see the first signs of the housing market stabilizing.  While sales of homes are still historically very low, regular housing inventory is on the decline and fell to its lowest level since March 2005 in December 2011, according to NAR.  The NAR reported inventory fell to 2.31 million in January. This is down 21% from January 2011. This decline in inventory was a significant story in 2011 and may continue to accelerate in 2012.  In addition, total existing home sales increased 4.3% in January from December and are slightly about the January 2011 figures.

It may be that we are finally starting to see stabilization in home prices and a meaningful decline in inventory; which is the first phase to a lasting housing market recovery.

That Was Then, And This Is ???

We would like to just point out the fact that so far this year, the stock market’s performance has a strikingly close resemblance to the performance it had this time last year. In both years, the SPY (S&P 500) began at 1257. Last year, the market gained 6.8% to a peak on February 18 at 1343. Bullish investor sentiment reached a peak of 51.5% during the month according to the American Association of Individual Investors (AAII). Similarly this year, the stock market has gained 6.8% YTD to close on February 15 at 1343 on the S&P 500. Bullish investor sentiment recently peaked at 51.6% during the month according to the latest data from the AAII.

In 2011, the stock market faced problems in late February due to a variety of circumstances. There was widespread social unrest in Libya and Egypt, an earthquake and devastating tsunami in Japan, political gridlock on raising the debt ceiling, and a European crisis that added to the abundance of “headline risk,” (which we spoke about in October). This led to a “risk off” scenario that resulted in drastically lower stock prices and a volatile trading range from early August to the end of the year. To sum this all up, we think it is safe to say that there still exist plenty of political, global, and natural risks apparent in today’s landscape. But much of the market behavior seems to be more influenced by political factors and unforeseen events rather than your basic macro-economic data and corporate earnings. Barring any catastrophic or too many unforeseen events, are we back to climbing a new wall of worry? We will likely know in the coming weeks.