Sunday, June 7, 2015

Margin Debt Reaches New All-Time High – Bullish or Bearish?

Money used to margin stocks on the NYSE grew to $507B in April 2015.  (see NYSEData.comFactbook: Securities margin debt)  Looked at in isolation, you might interpret the continued inflow of leverage to buy market assets as a bullish indicator.  Investors are confident in the future, therefore why not take cheap money and buy assets that seemingly just continue to rise.

The temptation to rationalize that margin activity is a positive indicator for stocks is a function of how highly correlated the level of margin debt and the major stock indexes (SPY) (DIA) have been over the past 50 years.  As shown in the graph below, the correlation factor between the NYSE margin debt and the level of the S&P500 is .97, almost a 1 for 1 correlation through time.

Correlation does not imply causation, but if interpreted relative to the situation, the riskiness of the amount of leverage being taken on by the market can be an important indicator.  For example, in both 2000 and 2007, the NYSE also set new all-time margin debt levels as the stock market set new all-time record highs for that point in time.  History shows that these were unsustainable high water marks for the stock market, and the ensuing break-down in stock valuations lead to a death spiral exacerbated by margin calls.

As market leverage continues to move to new highs, will the market continue to grind higher or are we about to experience another breaking point?

Saturday, May 23, 2015

Treasury Rates Up, Stocks Up - Will the Pattern Continue?

Since the U.S. Federal Reserve ceased its quantitative easing program at the end of October 2014, the stock market has been decidedly more volatile, while also in my view, trading in a pattern that is counter intuitive to many investors.  During the QE phase, stocks reacted to the increased market liquidity by catapulting higher, while rates across the board fell.  As rates went down, stocks and asset values in general went up.  The expected inverse relationship of asset values to interest rates held.  The major stock index correlation to the increasing size of the Fed balance sheet is virtually 1 to 1 for the period 2013 through mid 2014.

Take away the Fed supplemental diet of steady doses of new liquidity infusions, and as you might expect, U.S. stock returns have struggled.  However, they have not struggled as much as many investors may have expected.  In fact, just this week in May 2015, the DOW (DIA) and S&P 500 (SPY) traded to new all-time highs.  As new all-time highs have been set in 2015, the number of pundits making their predictions of doom in the market seems to get larger and larger. See article: Stockman: Stocks and bonds will 'crash soon'.

The 2015 contrary pattern of Treasury rates trending higher since a low reached in January and stocks moving to new all-time highs is very interesting.  The more investors worry about the impending doom that the Fed will create by raising short-term rates, or worse drawing down the size of its balance sheet, the more the stock market seems to trade higher.  In fact, as illustrated in the graph below, there is a new pattern to which the market is now trading.

As you can see in the graph, since the beginning of 2015, each stock market interim bottom has corresponded with a short-term bottom in long duration Treasuries.  Each short-term peak has corresponded with a peak in long-term Treasury rates.  The current move up in Treasury long duration rates and corresponding move higher in stock prices has not yet confirmed an interim peak, but my estimate is that the May month end close will likely confirm the next reversal point.

Thursday, April 30, 2015

Is “Secular Stagnation” causing poor U.S. economic performance?

The news headlines announced 1Q GDP growth of 0.2% on April 29, 2015.  Anemic would be a compliment.  Why isn’t the U.S. economic engine roaring ahead?  There is a large tailwind of lower energy prices.  The major market stock market indices recently reached new all-time highs (SPY) (DIA) (QQQ).  Apple (AAPL) and Amazon (AMZN) stocks continue to grind to higher and higher plateaus.  Why is the mainstream economy so “disconnected” from the stock market?  And why is the cost of money on government debt so low in the U.S. (0 to .25% on short-term Treasuries) and even negative in the Eurozone.

Larry Summers, Former Secretary of the Treasury for the Clinton Administration and Former Director, National Economic Council for the Obama White House has put forth the economic concept known as “secular stagnation” as a significant factor in the current poor performance in the U.S. economy.  (See article - On secular stagnation: Larry Summers responds to Ben Bernanke)

Secular stagnation is defined as an economic situation created when there is a chronic excess of saving over investment.  The economic prescription proposed when this situation occurs is to expand fiscal policy in general and public investment in particular to promote growth.  Is the chronic saving situation real or is it just a consequence of prior political actions which now need to be corrected?  And if so, how did the U.S. and the world get into this predicament?

Wednesday, April 15, 2015

Oil Likely to Signal Next Major Market Correction, Eventually

The trading pattern of the major U.S. stock indices (DIA) (SPY) (QQQ) during since the beginning of 2015 is best described as sideways and volatile.

A review of the equity market indices shows the 50 day moving average of DOW and the S&P500 barely maintained a positive slope in the first quarter, while the trading range showed a loss YTD of almost 5% in early February only to recover to a positive 2% by early March, a range of 7%.  The tech heavy NASDAQ was a better performer in the first quarter, providing relative gains of 2% for the 1st quarter, and currently up 3% for the year.  This pattern is indicative of a market in which stock buyers are increasingly wary of the valuations of large capitalization stocks which are expected to suffer earnings hits in the coming quarters because of a strong dollar, while riskier bets on technology that derive benefit from lower overseas cost of goods paid off.

The market dichotomy of technology out-performance while more commodity based industries suffer is not unusual.  There are two instances in recent history where the major market indexes were driving to new highs while commodities, and in particular oil, suffered major corrections - the mid 1980s and the late 1990s.  The actual market characteristics are decidedly different today; for one neither of these last two points in history had a zero-bound interest rate policy at the Fed.  In addition, there is no major technological discontinuity today  such as the analog to digital transformation in the 80’s or the boom of the late 1990s.  However, the investment pattern is similar.  And the tendency of investors to see relative value in technology over alternatives is evident, not only in the U.S., but also in foreign markets, particularly China (U.S.Dot-Com Bubble Was Nothing Compared to Today’s China Prices – Bloomberg, April7, 2015).

Why are market investors currently bidding up the values of technology firms which are characteristically cash burning bets with a few big hit survivors, versus continuing to plow money into the more conservative stocks?  It is within the context of this market scenario that is beginning to play out in 2015 that investors need to continue to assess the likelihood that the U.S. equity market will “correct” from its lofty relative valuation levels before the new tech bets being placed can pay-off.

Friday, April 10, 2015

Zero Interest Rates - A Restrictive Monetary Policy for the Masses

When the zero-bound rate policy was implemented by the Federal Reserve after the 2008 financial crisis, it was readily accepted by investors that the policy was being implemented on the pretense of making monetary policy “easy”.  Six and ½ years into the policy, it is becoming increasingly clear that the interest rate policy is best described as “low”, but the term “accommodating” is not a proper way to described the actual policy which has been implemented.

Ben Bernanke has started a blog which I believe is an ingenious way for a former Fed Chairman to engender public discussion about financial market policy issues.  The first topic that he tackled was the question of why interest rates are so low.  (Ben Bernanke Blog - Why are interest rates are so low?)

After studying his very compelling arguments, it is now more apparent than ever that the current Fed zero bound rate policy (ZIRP), particularly given the extended length of time it has been utilized with only marginal results, is targeted to solve economic problems which in isolation the Fed does not appear to be best suited to solve.  The result has been a policy that has morphed into a restrictive monetary policy that is now taxing the mass U.S. market.

Why is Current Fed Policy Restrictive, Not Easy?

Saturday, January 10, 2015

Financial Relativity Metrics Signal Deflation Troubles for Stocks in 2015

The first full week of trading in 2015 has shown a trend that is likely to be the harbinger for the year as a whole – volatility fueled by a tug of war between deflationary fears and hyped growth expectations in the U.S. economy.  In this type of environment, option trading or taking short-term positions can make you a investing super-hero one day, and a goat the next.  Trying to stay the course as a long-term stock investor will be difficult for those who are more risk-averse.

The known variables which can readily be used to grasp where stocks will gravitate in 2015 are much harder to decipher than the past two years.  The reason it is getting more difficult is that stocks have now entered what I call the “borrowed time” phase of valuation expansion.  Many of the economic variables that are strongly correlated with continued inflation of U.S. equity prices are now stressed and the signals are growing that a deflationary pressure release sell-off is in store for the U.S. equity markets.  The seven major metrics I use to make this assessment are highlighted in the table below, and are backed by on-going research explained in my book – Theory of Financial Relativity.

The financial metrics as 2015 begins are increasingly cautious, as exhibited by the number of yellow and red markers. The model over the past two years has become progressively more “colorful.”, another way of saying the trend is not your friend at the present time. Based on the research I have done in each categorical area, I expect more of the metrics to reach a red level before the stock market is likely to undergo a sustained severe downturn. The increased areas of caution in many of the metrics, however, set 2015 up in my opinion to be a very volatile year for equity values, with a likelihood of a major intra-year drop at some point.

Read more

Thursday, January 8, 2015

Saudi's Oil Shock Therapy Hits Permian Trust Hard

The price movement in Permian Trust units (PER) since the beginning of September 2014 thru the beginning of January 2015 has been dramatic, dropping from over $12 per unit settling at just above $6 per unit at the 1/5/2015 close.  The severity of the move can be traced primarily to an adjustment in the market to a radical downward shift in the expectations for future oil prices.  During the summer months as the price of oil spiked up above $110 per barrel on geo-political tensions, the market sentiment was that $100 oil was here to stay, and that there was an implied floor of about $90 per barrel below which spot prices in the market would probably not breech.  However, during September rumblings in the industry began to surface that the Saudi’s were going to change the playing field.  The resulting “oil shock therapy” reverberated throughout the industry, affecting most severely the drilling services and E&P companies in the U.S. shale oil industry. 

Permian Trust units, which are heavily dependent on the future price of crude oil, were driven down in traded value because of the expected price shift.  The price movement can be visibly traced in the following chart.

One of the more intriguing aspects of the chart is the defense of $6 as the current floor as the price of oil has approached $50 on the front month contract.  Is this a potential sign that the market is entering a bottoming phase?  Or, is there another leg down possible, and if so, what is the fair value of the Permian Trust Units if this happens?  This report provides insight about the expected change in intrinsic value of the Permian units as the price war continues.

Thursday, December 18, 2014

Linn Energy: A Shale Play Challenged at $55 Oil

Linn Energy (LINE) (LNCO) traded closed below $10 a unit on December 15, 2014, marking both a 52 week low, and lows not experienced since the December 2008 financial crisis.  During the 2008 crisis, oil reached a bottom in the $35 range, whereas currently we are just reaching the $55 per barrel range.  Why is the panic so much more acute today than the time period politically labeled as the “Greatest Recession since the Great Depression?”  Are we entering an even bigger Depression?  That question I may have an opinion, but will not attempt to answer in this article.  What I will provide readers is a clear nuts and bolts view of why there is a run on the Linn Energy units, and why as the market approaches $55 oil per barrel on the front-end of the curve, the investor sentiment is warranted. 
The big issue facing common unit holders of Linn Energy is the over-extended financial structure of the business, i.e. financial leverage.  While Linn Energy is well hedged with favorable $90 oil derivative contracts for the next several years of production, the reassessment of the value of its proven reserves is expected to severely stress its financing capacity in the very near future.  In addition, even with the hedge program, the drop in oil price will still place a burden on cash flow to pay distributions while continuing to maintain a steady capital expansion program.  If drilling is constrained for any period of time at Linn Energy, the current high oil production rate will decline rapidly given the characteristics of the proven undeveloped reserves that Linn Energy owns (light oil, high concentration of NGL and Natural Gas).  The cost structure of the company makes the oil production “cliff” a particularly onerous problem.  Based on an assessment of the financial position of the company contained in this article, investors should expect a radical down-sizing, or even complete elimination of the $.24 monthly distribution level which is currently a 28.76% yield.