The stock market rally that started in March 2009 – the one that’s taken us out of the Great Recession and to new highs, the one that’s driving sentiment indicators of people who benefit from rising financial assets directly, peripherally, or because they hope all boats rise with the market – that rally has never been loved.
The thing is, equity markets don’t need love go twice as high from here, or three times as high in the next 20 years. If they get what else they need, they’ll keep going higher.
We could be on the verge of a generational bull market. That’s if deficit-plagued, interconnected global sovereigns deleverage and, at the same time, re-capitalize middle and rising classes by making “recourse-sound” capital available and simultaneously reconstituting entirely the notion of taxation.
Too bad the likelihood of that happening is somewhere between slim and none.
That’s one reason why I’m an increasingly “reluctant” bull.
But there’s another reason too.
The other reason I’m increasingly reluctant is because governments have been running their printing presses non-stop. What will happen if they don’t stop? What will happen if they do stop?
Besides printing on account of deflationary fears, printing money globally to keep up with the Federal Reserve’s massive quantitative easing experiment has been necessary to offset the Fed’s intended consequences to depress the U.S. dollar.
Everyone wants to export their way out of slow growth. The U.S. is no exception.
But printing money, in an articulated policy, to pump up asset prices (which benefit from low interest rates), a depressed dollar that benefits exports, and positive overseas revenue translations, has been fuelling asset price inflation for five years. It’s also been leading a beggar-thy-neighbor campaign. Neither of those are sustainable.
When stimulus slows – or if it stops being effective – we’ll see whether there’s sufficient global growth and fiat trust to avoid deflation.
That’s what central banks worry about, a lot more than asset bubbles.
So, is deflation coming? Yes and no.
It’s not coming in the way most people think about it – at least not at first.
The deflation that’s coming first is coming to financial assets.
That’s what I worry about. I worry about asset bubble deflation.
I worry that we’re now 10% above where stocks (as measured by the Dow Industrials) were at their 2007 peak. That just means we’ve made back all those credit crisis and Great Recession losses (theoretically) and may have started a new bull market.
And a 10% up-leg doesn’t impress me when it’s built on leveraging a zero interest rate policy.
So we just had a better-than-expected jobs report where 204,000 people landed jobs instead of the 120,000 analysts expected? So what if the previous two months saw slight upward revisions?
The unemployment rate still went up. Not down.
The labor participation rate fell by 0.04% (to 62.8%) in October. That’s the lowest rate since March 1978. It means fewer people are looking for work. More people are disenfranchised.
Speaking of analysts’ revisions, so what if 70% of half the companies in the S&P who’ve reported earnings for the third quarter beat analysts’ expectations? They all lowered them after last quarter to make them easier to beat. And they’re lowering them again now because CEOs are guiding future expectations down again.
These days, revenues are rising a lot slower than earnings, it they’re rising at all. Which begs the question, if the rate of change of revenue growth slows and earnings growth from buybacks (which by some measures could have added 40% to rising prices), productivity gains, and cheap debt financing slows down, aren’t stocks fully priced? What’s left for them to feed on?
So what that consumer sentiment is rising with stock prices? It’s been rising because of rising home prices too. How many stocks and how many homes do most people own? Oh, that would be a lot fewer than before the housing bubble broke and stocks crashed.
So what if volatility is at historic lows and seemingly resting comfortably there? That goes hand in hand with margin debt being at record levels.
It’s all just one big party as long as there’s punch in the bowl and revenue to feed profits.
And that’s where we are. We’re at the intersection where asset price inflation (driven by stimulus) meets the real economy’s ability to produce goods and services to sell to people who can afford them, as opposed to being redistributed to them.
Tapering, when it comes, will be scary. Not that it’s coming soon. But it is coming.
That’s good news. Because there’s going to be plenty of time, maybe a few more quarters if we’re lucky, to get sufficiently defensive and put on strategic short positions. Do that now, just in case global growth isn’t there to augment the soon-to-be-diminishing returns of quack-itative easing.
The market has upward momentum. We’re going into the holiday season where spending picks up. There’s a better than even chance if the market moves higher a lot of institutional managers will buy up the winners to window-dress their fourth-quarter and full-year returns. It’s unlikely that Helicopter Ben will slow down QE right before he leaves office next year. He’ll let his successor make her own policy decisions. Why would Ben risk wrecking the rally that he engineered when he’s on his way out the door?
Over in my patch, we’re adding selectively to positions that pay nice dividends, and we’ll be happy to add more to those positions if the market falters. We’re playing in the hot technology patch, and we’re starting to put on some defensive positions in the Capital Wave Forecast portfolio too.
You don’t have to love this market, but you do have to be in it. And you have to understand that, love it or hate it, the market can’t go up in a straight line forever.
Last week I told you I was going to break maybe the biggest investing story of the year.
I told you global capital markets are facing structural changes on a scale that’s so huge, virtually every big bank, and in fact almost all banks, and every major trading institution will be affected.
You aren’t hearing about this anywhere else, because it’s not obvious – yet.
Quantitative easing has masked the problem so far. But, as QE is tapered out and if deficits are reduced, we will face unforeseen capital markets dislocations, economic uncertainties, global volatility… and, of course, tremendous trading opportunities.
I’m excited. I love disruptions like this, because there’s always money to be made when the capital waves start rolling.
You heard it here first…
In the next 12 to 24 months, capital markets are going to struggle on account of… are you ready?… not enough government debt.
It sounds crazy, but it’s not.
The problem of not having enough government bonds, notes, and bills might seem like a good problem because it assumes the government is balancing budgets and reducing deficits.
But any significant reduction in the issuance of Treasury securities would directly impact lending in the U.S.
Interest rates would rise, and capital markets would become distorted.
Don’t get all hung up on the fact that our deficits are huge and unlikely to be tamed any time soon. That’s probably true.
But then again, we thought massive deficits were incontrovertible and the budget impossible to balance. Then it happened under Clinton. Treasury issuance was greatly reduced as a result.
Something happened in the capital markets because there weren’t enough Treasuries, something that fuelled the credit crisis. I’ll get to that.
Long before budgets are balanced and deficits reduced, the soon-to-be vastly ratcheted-up demand for Treasury securities will be felt in the U.S. and globally.
The demand will come from banks, trading houses, and financial institutions of all stripes.
What’s happening now – and will accelerate over the next few quarters and couple of years – is that regulatory changes are going to force banks and financial institutions to hold more Treasuries, a lot more Treasuries.
New Basel rules will eventually be implemented. New Dodd-Frank rules, those already written and the hundreds more that may get written, will eventually be implemented. And other regulators are imposing their own rules and requirements. The net result is that financial institutions are going to have to hold more and better capital and make themselves more liquid. They’ll do that by owning more “risk-free” Treasuries.
Typical of the new proposed rules, Ben Bernanke, chairman of the Federal Reserve, came out last Thursday with new liquidity requirements for banks and systemically important financial institutions. The “liquidity reserve ratio” he proposed isn’t his idea. It’s already written into delayed-again Basel III rules. Institutions will have to hold high-quality liquid assets to cover (anticipated) total net cash outflows over a 30-day period.
As with virtually all the new proposed rules, the question “What constitutes high quality assets?” is answered in a word: Treasuries.
If you have to have liquid assets that aren’t going to fall off a cliff in a financial crisis that you can liquidate, meaning there have to be buyers, U.S. Treasuries are it.
On top of filling liquidity requirements, Treasuries will be in huge demand as marginable collateral for credit default swaps, once the final language in Dodd-Frank is written and swaps are exchange-traded and trades are settled through clearinghouses that guarantee counterparty obligations.
To do trades through a clearinghouse that’s taking on counterparty risk, margin has to be posted by traders. Collateral used for margin is only good if it can be quickly sold, especially in a multi-trillion dollar market where collapsing prices could implode global markets.
Again, “Who are you gonna call?” Treasuries are the answer.
The next best thing to Treasuries are agencies. Agency paper refers to debt instruments not issued by the U.S., but guaranteed either explicitly or implicitly by the U.S. Like debt issued by Fannie Mae and Freddie Mac. Those two giant Government Sponsored Enterprises (GSE) are the best example of issuers of agency paper.
But wait, what will happen if these two monsters are dismembered?
They are in Congress’ crosshairs right now. There are at least four proposed bills floating between the Senate and the House that all envision the disintegration of Fannie and Freddie. When that happens, assuming it will, there will be a lot less agency paper to be used as liquid collateral. The two GSEs, along with the Federal Home Loan Banks, have almost $7 trillion in debt outstanding that are considered safe assets.
A dramatic reduction in agency paper will further increase the demand for Treasuries.
Money market rule changes are coming, which will additionally increase the demand for Treasuries
What will happen if the rising demand for Treasuries slams into reduced supply?
In the 1990s, as a result of those two opposing dynamics happening, capital markets filled the void by manufacturing increasing amounts of guess what? AAA-rated mortgage-backed securities and other then highly rated asset-backed securities (ABS).
Only they weren’t the same thing as Treasuries.
Are we headed down that path again? We sure are.
Because the demand for Treasuries will result in institutions hoarding them, lending against less liquid collateral will cause interest rates to rise and credit conditions to tighten.
Quantitative easing has masked the problem so far. But, as QE is tapered out and if deficits are reduced while at the same time new regulations to make banks safer increases demand for Treasuries, we will face unforeseen capital markets dislocations and economic uncertainties.
There will be tremendous trading opportunities amidst all these disruptions, which we’ll be ever-ready to take advantage of.
I’ve been in this business, trading the capital markets, for more than 30 years, and in all that time, I have to say, I can count the number of worthwhile brokers I’ve known on one hand. And I’ve known thousands.
While there are good and even great financial advice-givers out there, they are the exception rather than the rule.
Most of these “brokers” are salesman.
That’s what they do; they sell you on the services their firms offer. They sell you on the cookie-cutter advice they shoehorn you into. They put you into one-size-fits-all “programs” (which is one of the fancy terms they use to describe the program they’ve devised for you) that are mere templates for suitability measures that you fall into.
You’re this age, make that much money, have that many children, want to retire at 65, and BINGO, they have a custom program to put you into to make all your dreams come true.
Because most brokers are salesmen, not market experts, their job is to sell their services, not construct individual investment programs for you, or you, or you, or you. They can’t. They don’t have the time and they don’t have the expertise.
These people who are supposed to be expert advice-givers are often clueless. And worse, there are different standards by which they are supposed to render their advice to you.
I’m going to tell you the truth… It’s a story and isn’t representative of all brokers, by any means. But you deserve to hear it.
There Are Three Basic Types of Brokers.
First, investment advisor representatives (IARs) must pass the Financial Industry Regulatory Authority (FINRA) Series 65 exam, or the Series 7 exam in conjunction with the Series 66 exam.
While the Investment Advisors Act doesn’t consider an investment advisor a fiduciary, the United States Supreme Court has ruled that investment advisors are fiduciaries with “an affirmative duty of ‘utmost good faith and full and fair disclosure of all material fact,’ as well as an affirmative obligation ‘to employ reasonable care to avoid misleading’ clients.”
Registered investment advisors must, by law, put clients’ interests first.
Then there are the financial advisors, or registered representatives, or financial planners, or whatever neat job titles they come up with.
Tens of thousands of these brokers or “advisors” who must pass the Series 7 (General Securities Representative) and Series 63 (Uniform Securities Agent State Law Exam) must be employed by or associated with a broker-dealer firm, such as Merrill Lynch or Morgan Stanley, or any number of smaller broker-dealer shops.
These brokers are held to a much lower “suitability” standard than investment advisor representatives. Under the law, as long as these brokers don’t sell an 80-year-old widow exotic derivatives that tie up their money for years, they’re pretty much bulletproof.
Determining suitability isn’t the same thing as having a fiduciary responsibility to put the client’s interests first.
A recent American Banker opinion piece said, “Few clients know this fiduciary-suitability gap exists. The suitability crowd has worked tirelessly to keep the standard low and the distinctions murky. The cost to the public is incalculable but huge.”
Lastly, there are Certified Financial Planners, not to be confused with mere financial planners. Certified financial planners pass tests too. Only the tests they have to pass are a lot harder than any of the tests the regulatory bodies require of brokers they license.
Someone I know very well is a broker at a big-name firm. He’s becoming a Certified Financial Planner to prove to his clients he’s got that expertise. He’s been a broker for 10 years. He thinks he understands a lot about the brokerage business and he talks a good game when it comes to economic data, where the market has come from, where it might go and why. He’s actually impressive.
But it’s all superficial. His knowledge of what’s really going on is suspect, and worse.
Not long ago, I asked him some questions about why he wasn’t doing some things for his clients, some very basic things. He said he couldn’t, his firm didn’t allow him to do that.
It doesn’t matter that the “that” thing he couldn’t do was so basic to buying and selling stocks that he hadn’t even looked into doing it. The truth was, he didn’t know how to do it himself, because he had never done it.
What was it? Shorting stocks.
Here’s a broker of 10 years who is always telling me this stock is a piece of junk and that one is going to tank, and never made a penny for his clients shorting them. All his clients are long-only, meaning he puts them into the “programs” that fit them according to the general parameters of the boxes they fit into. In the 2008 crash, his clients all crashed.
Did he make any money personally in the crash? No. He didn’t short anything. Why? Because he didn’t know how.
I made him call his firm’s compliance officer and ask if he could short on behalf of clients who might want him to make those trades. They said, of course you can. He hung up and said he didn’t know he could.
He didn’t know he could because his knowledge is superficial. He never shorted a stock, even for himself, because the truth is he didn’t know how shorting works.
He’s been a broker for 10 years. He got his license and he’s an expert. It made me sick.
So if you use a broker, of any stripe, with however many licenses or designations, I urge you to do three things:
First, ask them how much they trade for themselves.
What’s important in the advice-giving game is that the person giving the advice is an expert. They have to have real-world experience, and a lot of it. They have to have traded extensively. Otherwise they really don’t know how markets work.
It doesn’t matter what license you hold – though to me, a Certified Financial Planner has to pass more and harder tests to prove they studied the material that makes them “experts” than Registered Investment Advisors, who are themselves held to a higher standard than mere old-fashioned brokers. (See the sidebar for my breakdown.) But either way, passing a test or tests doesn’t make you an expert.
Second, ask them if they customize the investment advice they give you, or if they are shoehorning you into a template investment dream box that’s supposed to work for everyone who resembles you and your life. (As if that’s possible.)
Lastly, you should be getting different advice from different people. Use multiple brokers or multiple trading services. Get advice from people who are in the markets themselves, from people who have traded the markets for themselves for years, and done it successfully.
Brokers tell you when your account is suffering that the market did that and everyone is in the same boat, because as you know the market did that to us all.
Traders take more personal responsibility for the trades they recommend. Their egos are bigger. For real traders, it’s about proving that they are good traders and that they can and do make money in all kinds of markets, especially down markets.
Be careful of brokers. They can make you broke.
P.S. Brokers who don’t know how to short stocks – or say “shorting isn’t allowed” – are depriving their clients of opportunity. And it’s a shame. You can make a ton of money flipping the trade. That’s why I’m going to show you how to do it yourself. Stay tuned…>
Besides the “indictments” levied here on a regular basis, offering market “insights” is part of what we’re all about. And today it’s time for a little insight.
The markets have been on a tear.
Where are they going next?
Looking in the rearview mirror, we see a 150% move up from the 2009 lows. On a compounded basis, stocks have risen at about a 23% annualized appreciation rate over the post-crisis period. That’s phenomenal.
Putting aside the Fed’s stimulus efforts for a moment, the appreciation on corporate earnings gains – which have risen 32% in the same period (albeit from exceptionally knocked-down 2008-2009 crisis levels) – looks really good.
But “Houston, we have a problem.”
Here’s the “problem” I see and exactly what you can do about it…
First of all, the market rising 150% while earnings have risen only 32% is a mismatch.
It’s hard to justify the overall market’s appreciation rate on an annualized basis and the total appreciation of earnings. Don’t forget, the market is supposed to be a forward discount modeling vehicle. So, it’s saying it expects earnings to continue growing to fill the gap.
The problem with the mismatch and the market’s expectation that earnings will continue to grow robustly is glaringly apparent when you view these earnings we are looking at (since 2009) through the prism of the Fed’s stimulus programs – namely quantitative easing.
The best analysis I’ve seen regarding the Fed’s impact on earnings comes from Robbert van Batenburg, director of market strategy at Newedge USA LLC. Basically, his work attempts to strip out the Fed’s influence by looking at what impact their quantitative easing efforts (to lower interest rates) has had on earnings.
He estimates that the lower cost of capital enjoyed by corporations in the S&P 500 accounted for 47% of the S&P’s earnings growth since 2009.
If you look at the end of 2009, corporate earnings averaged $20 per share per quarter, and corporate interest expenses amounted to about $4 per share. Today, earnings are $26.70 per a share on a quarterly basis, and their corresponding interest expense is down to $1.50 per share. That’s a whole heck of a lot of savings.
That’s why talk about the Fed tapering their binge bond-buying program is worrying markets.
That’s the market’s primary concern. But certainly not its only concern.
Most of the companies in the S&P 500 get an increasingly disproportionate share of their earnings from overseas sales. Those earnings have been helped by stimulus efforts in China, Europe, and across emerging markets.
We’re seeing some capital flight from several emerging markets. A good amount of that capital is finding its way into the euro in anticipation that Europe is on the mend and corporate shares there are a value proposition. And some of that flight capital is coming into the dollar. That’s because the U.S. remains the cleanest dirty shirt in the laundry.
What concerns me is that the market discounting model has run too far ahead of realities.
Fed tapering will cause rates to rise, if only on account of the expectation that they will rise. But rates may not rise too much… for a lot of bad reasons.
If capital flight accelerates out of emerging markets and if Europe doesn’t bounce convincingly, and if U.S. GDP growth doesn’t get above 3% and stay there, we’re probably in for a rude awakening as markets will correct and the “flight to quality” trade will be a support for slipping bond prices and put a lid on rising rates.
We’re in theoretical land. We don’t know what the world is capable of if the market support provided the Fed – and it’s been a global support net first initiated by the Fed then actively followed by every other central bank – is ratcheted down.
The big worry I have is what would happen if the global economy double-dips on account of slowing growth compounding the perception that central banks are running out of blankets to warm tepid growth everywhere.
Without the free market’s ability to freely deleverage from excesses and let capital find its natural course into productive endeavors, we’re going to remain hostages to artificial government papering-over of the real dislocations still hampering economies across the globe.
That’s what we have to worry about.
But as the old Mad Magazine character Alfred E. Neuman used to say, “What, me worry?”
There’s a difference between being worried and being worried to the point of inaction.
It’s possible the markets can continue to move higher. Just because there are serious worries out there doesn’t mean investors should be on the sidelines. There’s no money on the sidelines. That’s no-man’s land.
At my Capital Wave Forecast trading service, we’re pretty fully invested. We’re putting on more defensive positions for sure, including two brand-new ones on Friday. But we’ve enjoyed a great run running with the bulls. We don’t worry about what we can’t control, we just see it and talk about it.
One thing we do that works beautifully is to make sure we have stops on our positions. And they’re trailing stops, so of course we keep raising them as we accrue more profits. I recommend everyone do the same.
So back to the original question… Are the markets going down?
I don’t know, but I do worry about that.
That’s why I have the Capital Wave portfolio set up this way. We can’t lose.
If the market corrects, we’ll get stopped out and be sitting on plenty of profits in the form of dry capital. And our defensive plays will kick in, and we’ll make money on the way down.
If the markets go higher, we’ll get stopped out on our defensive positions and take our small “insurance premium” losses and watch our long positions appreciate. And we’ll raise our stops higher as our positions appreciate to make money on the way up.
Worrying is a good thing. But not as good as being in the market and having a plan to not have to worry about all the worrisome things that plague sidelined investors.
P.S. If you want to see the full Capital Wave Forecast portfolio, just click here.
It’s about how things really work on the inside of a bank.
Any big bank – any big bank with an incentive to make money, which of course would be all of them.
This is one lesson you won’t ever forget…
Banks have “assets,” otherwise less technically defined as “stuff.”
The stuffing in the stuff banks own (meaning they have a position, or are the beneficiaries of a stream of income) is stuff like loans, like real mortgages, like mortgage-backed securities, like derivatives.
Let’s talk about derivatives.
Why? Because they amount to a huge pile of stuff banks own.
Why? Because derivatives aren’t exchange-traded, for one thing. And that’s where I’m going to be going in a second, so stay with me.
Banks can create derivatives to do pretty much anything they want them to do. After a while, all the banks end up copying each other’s good derivatives “product” ideas, so though they are far from standardized, they are close enough to be traded between them all with a mutual level of confidence as to what they are. And they are created to be amped-up proxies for other stuff, like default insurance on corporate bonds or government bonds, and a ton of other things.
The purpose of creating these derivative things is to give banks stuff to bet on, and bet on in a big way.
Derivatives offer “exposure” to some banks, meaning they want risk exposure to, say, the direction of prices of mortgages, or leveraged loans, or government bonds, or sovereign country exposure. Exposure means they want to bet on it. And sometimes banks use derivatives to hedge against other bets they have on when they are exposed to potential losses.
Here’s the thing about that. It’s a lesson you won’t forget. If you take a position in something, anything, for instance, Microsoft stock, and you think it’s going to go against you, you’d probably just sell it and be done with it.
But what if you bought so much Microsoft stock that if you alone were going to sell all your stock, your action alone would force the price down because of how much stock you have to sell?
Instead of selling your stock, you might want to hedge it. A hedge is another position that you take that will make you money at the same time your Microsoft stock position is losing money. The thing is, now you have two “risk” positions on, not one. Kinda wish you were just able to sell the stock and be done with it, right?
That’s what happens with banks. They have to hedge because the size of the positions they take. The economies of scale they have and all the money they have to play with and all the leverage they can apply to that money (including our money, our deposits are at their disposal) forces them to make giant bets. And of course, when they fear their giant bets are going to go against them, they make a giant hedge, which, if you’re following me, amounts to another giant bet.
Now they have two giant bets.
That’s what happened over at JPMorgan Chase’s London office, the one where “the Whale got harpooned. The bank had huge exposure on a few giant derivatives positions and decided to hedge those positions with some other positions.
Here’s what happened next, and what you’re reading about in the news now, which is that two London traders are being sued criminally for “fraud.” The original bets were so huge that JPM had essentially all the marbles in its vault. Needless to say, other traders knew that, because those other traders were the ones selling JPM their bets, their exposure.
The big trades weren’t going so swimmingly. The problem now was that the positions were so massive (like your giant Microsoft position) they couldn’t just start selling those positions off. The traders on the other side of them, the blokes who sold JPM the positions in the first place, weren’t interested in buying them back.
Why? Duh, because they’re the ones who sold them, but not really. In reality they “shorted” them by selling JPM stuff they didn’t own but made up to sell to JPM. (I told you banks can make up derivatives.)
That’s right; the traders on the other side of JPM’s trades were short. Being short means you want the price of the thing you’re short to drop, so you can buy it back at a much lower price.
Now that it can’t sell, JPM wants to hedge. But the cat is out of the bag. It then starts to put on some hedges, which are trades, and who is taking the other side of JPM’s hedge trades? Why, a lot of the same traders who sold them their big position. They quickly realize JPM is in trouble with their big position, can’t sell it, and is trying to hedge it.
So what do they do? They stop selling them any hedge positions and start trying to knock down the price of JPM’s big positions, to get JPM to cry “Uncle!” and sell their positions, which would crash the price and give the short-sellers a huge profit when they could buy back their positions from JPM at bargain basement prices.
Now, here’s where it all comes together.
Because JPM’s positions were too big to be effectively hedged, and too big to sell, as the price was falling and they were losing money (on paper) on their big exposure, the trading desk couldn’t let on how big the losses were.
One reason, and big one, is that they didn’t want other traders to know how much they were losing.
And just as important, in order to hide their mounting losses from their bosses (who I have to believe knew about them) and not have the losses hit the bank’s P&L (profit and loss statement), which would signal to other traders that losses were mounting at JPM and if they got bad enough the bank’s managers might say, “Sell the position, get out!” And that would be a windfall for the blokes who shorted derivatives to JPM.
Interestingly, and conveniently, derivatives aren’t exchange traded. (I told you I’d get to that.) The prices at which they trade are determined by the people trading them. Sometimes they don’t trade at all.
So, how do you price them? If you have a huge position and you want to know if you’re making or losing money (in JPM’s case it was losing big time) you have to “mark” your positions – you have to price them.
If you’re losing big time and you don’t want anyone to know, not your bosses and not the traders trying to destroy you to enrich themselves, and there are no exchange prices because these things aren’t exchanged traded, you make up the prices yourself.
About the bosses knowing or not knowing… Think about this a second. If you are a boss and you know the score and it’s your bonus and your job on the line too, mightn’t you want to go along with traders marking their positions to not make things look so bad, so maybe you could buy some time and trade out of a lot of the losses? Just throwing that out there.
Anyway, Javier Martin-Artajo and Julien Grout of JPM’s London trading office are being called out for allegedly “fraudulently” mismarking the desk’s huge positions to mask the huge losses ($6.2 billion) they would eventually take.
A lot of talk will be wasted over who was responsible, who knew, how did the book of trades get priced, how were numbers manipulated, by who, for how long, and on and on and on. It’s going to be a good show. But it’s a sideshow.
The only question worth asking is: Why in God’s name would we ever let get banks get so big that they can and have to make such giant bets to make money for their bonus pools?
The marking thing is a problem. It didn’t just happen here in this instance. It happens all the time. It is why banks trade derivatives. Because they can. Because they can manipulate prices to their advantage, which is how they get around capital ratios and measures like those that are supposed to tell us about how safe a banks is.
Oh, it gets better.
On Monday I’m going to tell you how what happened at JPM is happening all over the place and why we all should be scared when the banks say, as Morgan Stanley, for one, just said, they have a 99.9% certainty they know how much they can lose on any given day.
Newsflash! That’s what they all said back in 2008. Only all their value at risk (VaR) models blew up in their faces.
You don’t think that’s still happening? Boy, have I got news for you!
The escalator taking Big Bank stocks higher may have finally reached the “top floor.”
That means now’s a good time to take a look at how they got to where they are and where their stocks might go from here.
Also, if you own these stocks or are thinking about buying any of them because they’ve had a nice run up, you’re going to need a strategy going forward. I’ll give you an easy one.
What’s been easy for the Big Banks – so far – is the greased path the Fed’s laid out before them. But, with the prospect of less rather than more grease on the wheels ahead, the path looks a lot more slippery.
Just talk of the Fed potentially “tapering” their bond purchases knocked the breath out of the bond market. Interest rates are still low, by every historical measure, so no one’s spitting into the wind just yet. Still, the 10-year Treasury note’s yield rose from 1.63% on May 2 to 2.74% on July 5. That’s a 68% jump in nine weeks. In the bond world, that’s a huge move. Huge!
The immediate effect that upward movement in rates had was reflected in banks’ mortgage business lines.
JPMorgan Chase & Co. (NYSE:JPM) last week reported better-than-expected results, up 32% in Q2, while Wells Fargo & Co. (NYSE:WFC) reported a 20% rise in earnings per share. But they aren’t betting on their mortgage business lines adding much to net profits in the second half.
Citigroup Inc. (NYSE:C), which reported a 42% increase in Q2 profits this morning, isn’t optimistic about the mortgage side of its business either.
Analysts are all over the place when predicting second half refinancing and new-money purchase growth in the second half of the year. But in fact, growth isn’t in anyone’s forecast. The range is from down 10% to down 50%. You can drive a train through the range of those estimates. Why? Because what happens is a function of where interest rates are headed, and that’s anybody’s guess.
JPMorgan’s traditional commercial loan business, like the other Big Banks, isn’t exactly on fire. That business line was down 8% in Q2.
What’s happening with big loans to corporate clients is that they really aren’t happening. With rates so low, corporations are financing themselves in the bond market, not by borrowing from banks.
Besides deteriorating mortgage business profitability and lackluster to negative loan growth, the bright spot in earnings and profitability, from investment banking and capital markets, is increasingly going to be under the gun if the Volcker Rule is ever finalized and put into effect.
Also in Q2, JPMorgan saw a 31% increase in its investment banking earnings (to $6.5 billion). And Citigroup’s stock trading revenue produced $4.18 billion in net income.
Investment banking has to do with charging fees to corporate clients, but investment banking also includes capital markets, depending on how a bank breaks down its business lines. What a lot of investors miss is that “trading” by the banks is done on the other side of the services they perform in capital markets. In other words, banks’ “proprietary” trading, which they don’t label as that any more, is precisely that and has been pumping up their net numbers recently.
Volatility taketh away and it giveth. What was “taken away” from the mortgage business as a result of bond market volatility has largely been made up on the trading in capital markets, which thrives in a more volatile, especially predictable, environment.
Savings are coming banks’ way in the form of reduced headcounts, cutting overseas operations, and slicing expenses where possible. But there’s only so much slimming down an organization can do before it starts cutting into bone.
The Big Banks are all closer to the bone than they were in their pre-2008 fat days.
Lastly, there’s the take-back of loan losses. As the economy has improved, or not slipped, and corporate earnings and balance sheets keep defaults at near record lows, and of course with the Fed buying mortgage bonds and Treasuries to float everyone’s boat, banks have been reclaiming the loan loss provisions they set aside for bad times and repatriating them back into their “plus” columns. That’s a good sign, if it isn’t a mistake.
The bottom line is that the Big Banks have seen their stock prices rise handsomely, but the rally in them is about to start showing some age lines.
So here’s an easy strategy you can put into place.
If you own these stocks, it would be a good time to maybe buy some cheap puts or maybe raise your stop-loss levels to lock in some of those nice gains, should the group slip.
If you’re a momentum player and think the economy is improving and banks will be beneficiaries, go ahead, take the ride. But be mindful that they are at the top of their range here and prone to a sell-off on bad economic news, rising rates, or a faltering housing market. So use tight stops and don’t get too greedy.
Me personally, I don’t own any Big Banks stocks here, and I’m going to wait for some corrective action in them before I recommend jumping in with both feet.
What’s causing the market selloff? And I mean all the markets. Because they’re all selling off.
And what should you do about it? I mean, how can you make money? Because you can.
First of all, the good news is the storm is only just beginning to brew at this point.
The bad news is it could be a perfect storm.
Most importantly, correlation is back – with a vengeance. All asset classes are being whacked today. Rising bond yields (lower bond prices) are leading the way down. Stocks are following bonds. Commodities are following stocks. Precious metals are following commodities, real estate and mortgage securities are following each other down.
It’s a global rout. It’s a sharp reminder, in case anyone forgot what happened in 2008, that interconnectedness, or correlation of asset classes, makes things worse when they are bad.
The reasoning is simple…
Institutions are diversified, investors are diversified, and everyone’s ultimately diversified in the same asset classes.
Because there are only so many asset classes and because exchange traded funds (ETFs) now make diversifying simple, when someone yells fire in the theater where everyone is watching the same movie, everyone heads for the same exit doors.
As prices fall and margin calls get sent out, investors have to sell stocks and institutions like mutual funds have to sell to prepare for redemptions. Diversified investors start selling what’s going down. And everything is going down, so that’s what’s happening.
The Fed precipitated it by talking taper. They didn’t say they were putting their foot on the brakes, just that they were taking it off the accelerator.
But the world is now looking for what the Fed says it sees, which is better growth in the U.S., which is why they say they are going to start to taper. The problem is no one but the Fed sees that better growth.
China is freaking everyone out. Their banks have lent like sailors on leave (of their senses, that is). And the Chinese monetary authorities came out and said, hey, the banks here have to figure out their own problems, let this be a lesson to them. And that’s crazy because everyone expects the Chinese government to back their banks.
Between the taper talk and China’s banks being in trouble, it’s a short hop around the globe to see that other countries, like commodity producers, are wondering who they are going to sell their products to if China is in trouble.
And if China – and the other emerging markets that have been the only real engine of growth globally – is in trouble, it’s a short hop back to the developed world to see that they are over leveraged, sitting on huge deficits, and suffering economic slippage.
That’s the storm brewing.
If it gets out of control, which will be obvious if global banks start getting hit hard, the brew could be deadly.
If you haven’t put stops down on your investments, you should. Don’t be worried about getting back in if this storm passes. There’ll be plenty of time for that. But there won’t be enough time in the day to sell your positions if prices fall off a cliff.
If you don’t have any hedges on, put some on now. It’s not too late.
If you want to make a ton of money in the event that what’s brewing turns into a hurricane, then put on some smart short-styled positions.
Here’s the caveat. This overhead storm is only brewing, it might calm down. So when you put on your hedges or outright short stuff, make sure you also have stops on those positions to get out of them if this all passes and the sun shines through the clouds.
Now, here are some things you might want to consider:
Short the biggest, most liquid exchange-traded funds (ETFs) that are proxies for various asset classes, or buy puts on them. ETFs are what you buy when you want to diversify, so if all asset classes are headed lower, you’ll want to get out of the stuff you own that’s falling and short them.
I would be shorting or buying puts on China, Europe, the euro, the Australian dollar, industrial commodities, steel, copper, high-yield bonds, municipal bonds, and the Nasdaq.
In my Capital Wave Forecast and Shah Gilani’s DealBook services, we’re already in several of these positions. If we see more clouds starting to spin, we will be shorting more stuff to diversify our bets to make a lot of money on the way down, just like we did on the way up.
Want to make some money in the markets? Here’s what you need to know.
First of all…welcome to the new Abby Normal. For those of you that didn’t catch it, that’s a Mel Brooks reference. And it means this thing ain’t normal.
In fact, this thing, this Frankenstein of a market, is about to go into cardiac arrest.
Volatility is the new normal, and it’s going to be here, there, and everywhere.
The Federal Reserve, the real creator of Frankenstein, just hit the master switch to electrify the monster.
Here’s what happened…
First, they took care to build up the markets. They drove the dollar down to hike exports, and in the process got some people hired. They liquefied banks with money by buying their crappy mortgage-backed paper for good old cash…which the banks leveraged to buy more crappy mortgages to sell to the Fed. They liquefied the government’s mounting deficit problems by buying almost all of its new debt. To be precise, they didn’t buy it directly from the government. The banks bought it from the government first, then they repo’d (repurchase agreements) those bonds between each other to generate even more short-term cash, which they then used to buy more of the government’s bills, notes, and bonds, which they then sold at marked-up prices to the Fed.
Now that’s how you trade when you have a backstop!
So far so good, right? The play by the Fed was to keep interest rates at basically zero for borrowers. Not borrowers like you, but borrowers like, oh yeah…the banks.
Everyone benefited from super low rates.
Corporations borrowed cheaply to pay down more expensive debt and borrowed still more to buy back their stock to decrease their total number of shares so their earnings per share looked a lot better. Which was all part of the plan to hike stock prices.
The Fed’s idea of creating an equity asset bubble was to make the market hit new highs so people got all warm and fuzzy inside, and with that “wealth effect” making them dizzy, they reached into their empty wallets and purses to whip out their credit cards to spend, spend, spend.
Because it feels good. Don’t you feel good?
Ah, the wealth effect.
But the party had to end at some point. And yesterday was the beginning of the beginning of the end of the party.
Because the dollar was beaten down, other countries had to beat down their currencies (because they need to export too!), and now we’re about to see the residual effects of all that beating down (which, ironically, was caused by stimulus).
We’re going to see real currency wars. The first salvos have already been fired. The big guns are eventually going to come out. Welcome to massive currency volatility.
Because interest rates were so low for so long, yield-starved investors clamored for junk bonds that had some decent potential for income. Issuers fell over themselves to supply the demand, and hundreds of billions of dollars of junk has been injected into ETFs, CLOs (collateralized loan obligations), and CDOs (collateralized debt obligations). All are now all subject to massive volatility if rates rise, and if rising rates impact issuers’ ability to pay what they owe investors. Welcome to massive high-yield debt volatility.
Because banks have been so pumped up (kind of like on a cocktail of steroids and creatine) and have to deal with rising rates, they will hold off making loans to consumers because they don’t want to get caught lending long at fixed rates when their short-term borrowing costs (which is how they finance their loan books) are rising. That means mortgage money will be more expensive. Welcome to massive volatility in housing… that includes mortgages, home prices, and everything else.
Like the Federal Reserve System, for instance. It’s a central bank that was conceived in the private study of a private hunting lodge on a private island by a bunch of private bankers who didn’t want to use the word “bank” in its name to fool taxpayers who thought it was a “system” to safeguard the public… from the very bankers who conceived it.
I don’t know about you, but the feeling of safety I have is just overwhelming… NOT.
Then there’s the Fed’s Open Market Committee. That’s a committee of top plotters that meets in private to discuss what’s going on in “free” markets so they can figure out how to manipulate them.
The Open Market Committee, or the Old Boys Club (they have a woman on the committee, but she’s just a token “dove” who plays “Follow the Beard”), meets tomorrow and Wednesday to check on how their manipulations have stopped unruly free markets from sinking the banks that secretly run the Fed (you know it’s not a secret, but there are a whole lot of taxpayers who don’t).
For some time now, far too long in fact, the Open Market Committee has been buying a smallish $85 billion a month of various types of bonds to save the world and their masters.
They’re buying $45 billion a month of government bonds to save the government from having to tax taxpayers to pay for government waste. And they’re buying $40 billion a month of mortgage-backed securities (because they’re so safety-minded they’re only buying “agency-backed” mortgage bonds. Agency-backed? That means taxpayer-backed, which is why they’re supposedly safe).
Who are they buying all those bonds from? Go on, take a guess…
Duh… the banks!
You see, in an open market where banks can do what they want, they can get in trouble (they own a lot of MBS stuff that’s been sucking wind, which the Fed is kindly taking off their hands until it bounces back) because they are greedy you-know-whats. You wouldn’t understand unless you’ve ever been caught in quicksand. But, because it’s an open market, thank goodness, there’s an Open Market Committee to throw them a rope (too bad it never lands around their necks, but whatever).
The job of the Open Market Committee is, as you have figured out by now, to manipulate open markets for the benefit of banks.
They tell us they’re doing it to benefit the economy (which they helped to sink… don’t you just love free markets?). They tell us they are buying bonds from banks to boost their bottom lines so they can knock down the unemployment rate.
What they are doing is manipulating open markets for the benefit of banks. Got it?
But, I digress.
The Fed’s Open Market Committee meets tomorrow and Wednesday. On Wednesday afternoon at 2:00 we get to hear what they want us to hear. And at 2:30, Bernanke talks to reporters to answer questions about how well the manipulation is going.
The Dow’s up triple digits today (good thing there’s no volatility in this market) on account of the latest speculation that because the market was down triple digits on Friday, the Fed is going to look at recent volatility and come out saying something that’s supposed to calm volatile markets.
Don’t be confused… even though you’re supposed to be confused.
It will all be cleared up on Wednesday afternoon when the private deliberations of the Open Market Committee will be revealed.
There’s nothing I love better than free markets! God Bless you, Adam Smith and “The Creature From Jekyll Island.”
I don’t have one for sale, but I know some folks that are willing to sell you… well, it’s not a watch, but it’s something much, much better. They’ll sell you time. You want to buy some time?
Turns out, and who knew, you can buy time. You, yes you, can buy a few seconds for a whole bunch of money. High-frequency trading outfits and apparently tons of other “traders” and “investors” are buying this time. You can, too.
For a “Fistful of Dollars,” what you get is a few seconds head start on knowing some very important economic data points.
It’s amazing what money can buy.
Forget integrity, it’s not for sale because it’s out of stock. But if you want to buy the University of Michigan’s highly regarded and market-moving report on consumer confidence, you can get it, right alongside the “investors” like the HFT boys and girls who pay the University to get the numbers two seconds before the rest of the world sees them.
Or you can pony up next to the same crowd that buys the Institute for Supply Management’s manufacturing index numbers before the world sees them.
It’s not insider trading. It’s totally legal.
I’M NOT KIDDING.
Just yesterday, out of left field comes this revelation that for some time folks willing to pay to get market-moving data from private, non-governmental sources, sources that we all rely on, that we all thought were providing important (equal access) economic data points, have been getting that market-moving data before we all see it.
And they are making a ton of money front running all of us.
Apparently, selling access is “routine,” according to some sellers. Besides the usual creeps manipulating the markets for their own bottom lines, Thomson Reuters is also buying data points from these sources and charging their news-feed customers a fat premium to get it passed along to them.
Hey, wanna buy some time?
I’M NOT KIDDING.
Honestly, I didn’t know. I had no idea. For heaven’s sake, if I’d known, I’d have gladly paid to gain a few seconds for a few hundred million dollars. I can afford it.
The truth is, I’m glad this came out. I’ve had my eye on this Russian’s mega-yacht (the owner is building a new 1000-foot model), and with the extra time I can buy I’m going to make an offer. It might take me a few months of getting the data ahead of the tape to position myself to make those mega-millions, but that other ship won’t be ready until the Baltic Dry Index hits it support levels.
Like the old saying goes, if you can’t beat ‘em, join ‘em. And, darn it, I want to join that big yacht club. Besides, it will look great anchored off my place in the Hamptons.
I’d say more about the whole affair, but I have to go. I’m arranging a thank-you lunch and having the SEC, all of those darling folks, over to thank them for their generosity in allowing the complete bastardization of “fair and orderly” markets.
While I’m at it, maybe I’ll ask the folks at the SEC how much it costs to buy their integrity to allow this “event jumping” or “news feed trading,” as it’s called by its long-time practitioners.
Well, that’s it, I gotta go. Got a little luncheon and charity auction I’m putting on for the SEC. God bless American regulatory entrepreneurialism! That they can be bought is a beautiful thing.