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Don’t Call Me Stupid

Equities eked out another small gain, and fixed-income bounced as well, as another patch of unseasonably-cold weather headed for the east coast. This weather itself has short-term economic implications, since it (and the unusually snowy and cold weather all this month) will tend to depress certain measures of activity (such as home sales) for January. The market implications are less clear. It may be that when disappointing numbers are reported, bonds rally and stocks decline as is the typical reaction to weak data. It may instead happen that investors take the weather as an excuse to ignore any bad data and attribute it to a passing storm. How the market reacts to the data will be a decent barometer of the underlying state of market psychology (at present, the latter reaction seems more likely, so the bad weather may turn out to be great for the market by providing a built-in excuse).

It bears noting, however, that in the medium-term this month’s weather won’t matter to the economy. Whatever bad data we get in January will likely be compensated for in future months and quarters. This is at best a trading observation, but if I wanted to trade weather than I’d be in the weather derivatives market or working for a utility company.

The vicissitudes of earnings are only somewhat more stable, but there’s no question they matter more for equity market reaction. To this point, the $1.24bln loss announcement by Bank of America was glossed over on Friday but General Electric had very good earnings. Stocks started the day strong and a good part of the solidity, I think, is that investors believe that a highly diversified company like GE is a good bellwether for the economy. This isn’t unreasonable, as long as the profits didn’t come mostly from its GE Capital unit that has hedge fund-like qualities and relies on cheap leverage, but GE is still a tiny part of the whole economy. The banking industry, taken together, is much larger and so you’d think that weak earnings there for the latest quarter would be concerning for some. I actually think we may be seeing the beginnings of the Finance Reform law’s effect on banking, so in my view this is more likely a problem specific to a targeted industry, and one which will continue to be a problem as long as the banks continue to deleverage, volumes continue to be slack, and customized products give way to vanilla products where margins are slimmer.

However, this isn’t to say that the stock market is cheap or that it should be booming. Dividends are still down 18.1% from the peak of 2006 (dividends/share are down 20.8%) as of year-end. Q4 earnings are down 6.6% from Q3 and the earnings for the 12 months ended in December are up a whopping 4.24% compared to the 12 months ended in September while the market leaped ahead 10.2% during that time (all of this data is as of 1/19/11 from the spreadsheet under “Index Earnings” available here). It is worth pointing out that those numbers do not include BOA’s $1.24bln loss since they include only numbers through Wednesday.

Readers can be forgiven if they are confused with the fact that S&P reports a 17.1 trailing P/E while Bloomberg says it is 15.64. The difference is that Bloomberg, and most other press, nowadays report the ratio as the market price divided by the sum of positive earnings. That is, they ignore in the denominator all losses, and only tote up positive earnings. This is, of course, ridiculous, since if you own the index you own the losses as well as the gains. (Barron’s correctly reports the P/E as of Friday at 17.86, which difference is mainly attributable to BAC I assume). The reason given for focusing on this or (only slightly better) focusing on the ratio of price to operating earnings, is that “a negative P/E doesn’t make sense” and/or “it is better to ignore one-time items.” But at I once heard Rob Arnott point out, it may be the case that ignoring “one-time items” is defensible when looking at a single company, but “one-time items” occur with fair regularity when you look at the whole index. If you own 500 companies, some proportion of them are bound to have losses, and some proportion of them are bound to have one-time items. Unless you have a strong reason to believe the proportions are out-of-whack and currently give a misleading picture, it is more reasonable to assume that bad stuff occasionally happens.

Of course the real reason that P/Es are exaggerated to the low side (people also love to use forward P/Es, as if analysts were as likely to underestimate earnings as to overestimate earnings a year ahead!) is that it makes it easier to sell stocks. And I assume we all know that.

On the other hand, there are some things that I thought we all knew by now and I keep finding out that there are holdouts. Someone just pointed out to me on Friday that former Chairman Alan Greenspan actually challenged his critics earlier this month to prove him wrong on any decision he made as Fed Chairman. I didn’t believe it when someone told me that the old gnome was still defending his legacy, but it’s true. The link to the interview is here.

Gee, Alan, does a whole book count? Good heavens, at least President Reagan’s family had the good sense to remove him from the public eye once his memory started to fail. Someone needs to give this old coot the hook (I say that with all due respect, of course) and get him off stage! May he have a happy and lengthy retirement. Soon, please.

The dollar declined again and commodities rallied again. The dealers who are still holding TIPS auction paper are doing fine, as the issue rallied about 4bps on Friday. The drippy dollar begins to look more and more as if it wants to re-test the November lows. I can’t imagine why anyone would want to be leaving the dollar. Maybe the fact that, according to the New York Times policymakers are looking for ways to let the sovereign states declare “bankruptcy” and legally jettison their debts as well as their (mostly underfunded) pension promises and (mostly unfunded) post-retirement medical benefits promised.

Humorously, the NY Times says this is being worked on because it’s only “a matter of time” before a state seeks a bailout.

So let them seek a bailout from Congress. And Congress, just say no. Or Mr. President, just refuse to sign the bailout. I don’t see the problem. Just kidding. Obviously the problem is that we don’t elect adults to Congress, but children who are guided by their passions and mainly have their own self-interest in mind. Perhaps we begin to see why the dollar is really might be in long-term trouble.

Other central banks are trying to help, though. While QE2 would ordinarily be expected to send the greenback significantly lower (if you increase the supply of dollars relative to other currencies, then its price should fall just like with any supply/demand relationship), it helps that other central bankers are working on keeping their own currency supplies up as well. On Friday Adam Posen of the Bank of England dismissed the surge of UK inflation (RPI is running at 4.8% y/y while the UK CPI calculated by Eurostat rose in December to 3.7%, matching its post-2008 high), saying that he expected it to plunge back to the bank’s 2% target. Even investors who don’t think they care about UK inflation and the actions of the BOE should consider what would happen if Chairman Bernanke were in the same seat, confronting a rise in inflation while Unemployment was still above 9%. I suspect the response would be similar. The strength of the stock market, and especially the strength of the bond market, is predicated to some degree on the idea that the Fed will respond in a timely way to keep inflation from running away once it begins to rise. After all, they have said that they will. But what if they say “well, it rose but it actually isn’t going to keep rising because ‘expectations are anchored’?

Speaking of the Fed, one last headline from last week: “Accounting Tweak Could Save Fed From Losses.” The Fed has apparently changed how it accounts for losses on portfolio securities and other items so that the loss won’t impact the central bank’s stated capital – instead, it will increase a liability account and be paid off from future earnings. Therefore, the story goes, the Fed can’t be insolvent! This would be a wonderful outcome if the story wasn’t based on what I think is a flawed understanding of accounting. If instead of sweeping losses into “retained earnings” or “accumulated losses” and decreasing the capital account, the Fed accumulates a large liability that isn’t balanced by its assets…how is that not insolvency, even if the capital account says the bank has $1 in capital? Good old CNBC even paints the headline to say that this would actually save the Fed from losses. Can someone tell me how I can do that with my trading account?!

What is most disturbing about all of these stories, as well as all of the Eurozone machinations to try and make it appear that the entire EU stands against the tides of the market (aka “greedy speculators”), is that they really think we’re stupid. Inflation isn’t really a problem in the UK. The Fed isn’t losing money on the trillions of securities it has bought, no matter where the price of the securities goes. Greenspan thinks that there is no one who is smart enough to point to a single bad decision he made as Chairman. Ireland and Greece are certainly going to be able to pay off the massive debts they have accumulated without defaulting, even though they are hogtied by not having a floating currency. The New England Patriots are going to win the Super Bowl. Oh, wait, scratch that last one.

There is no economic data due on Monday, and so once again the salient economic point is going to be: it’s cold. Lows Sunday night are supposed to be in the single digits in NYC and subzero in the colder ‘burbs, with wind on top. But the bigger story is that the forecast for mid-week calls for a possibility of another 1-foot-plus blizzard in our area on Wednesday and Thursday, depending on the storm’s track. Weather.com is calling one of the two most-likely scenarios “Somewhat similar to Christmas Weekend blizzard.” So get your trading in early this week!

Categories: Economy, Politics
  1. Brynjo
    January 23, 2011 at 2:12 pm

    As a proponent of a rule based fed, and one that limits it’s scope, rather than expands it; I’m a fan of Greenspan.

    Face it, he managed inflation as defined by the rule. I’ve heard people complain about inflation calcs, but Greenspan did his best.

    Regarding housing (Including Greenspans comments on it) blame the miscreants for their misdeeds. Those whose job it was to buy, sell, or create product. Blame speculators who failed to profit, and instead lost, politicians who made incompetent executives rich. Don’t blame a CB who adeptly managed inflation.

    • January 23, 2011 at 6:35 pm

      My complaint with Greenspan isn’t about his management of inflation. He landed that bird, although it was almost impossible NOT to do so since the huge amount of private debt virtually assured disinflation.

      My complaint with him is much more that he worked too hard to make the world safe, and by so doing he managed to make it much less safe because the transparency and the perennial ad-hoc rescues made the optimal leverage much much higher (smaller margin of safety).

      As a policymaker, he took gambles that amount to selling policy options: big chance of a small gain, small chance of a massive problem. Even if he’s successful, writing options all the time is horrible central banking, and we are seeing now what happens when some of those options expire in-the-money.

      I am much more inclined to a pure rule saying that money supply growth = 4% every year, no matter what…or to do away with the Fed entirely and let investors and businesspeople protect themselves by keeping a margin of safety. What to do next is arguable, but it seems incredible to me that the guy would actually suggest he made NO errors. What arrogance, even if he was the greatest ever! But on a par with Bernanke, who proclaims 100% certainty about his decisions.

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