The enemy of knowledge is not ignorance, it’s the illusion of knowledge (Stephen Hawking)

It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so (Mark Twain)

Invest with smart knowledge and objective odds

NEW$ & VIEW$ (11 AUGUST 2014)

Earnings season recap. More debate on economic slack.

U.S. Productivity Rises at 2.5% Pace in Second Quarter

Nonfarm labor productivity, or output per hour worked, advanced at a 2.5% seasonally adjusted annual rate from April through June, the Labor Department said Friday. The gain failed to offset the 4.5% decline in the first three months of the year, the largest quarterly drop since 1981.

From a year earlier, productivity advanced 1.2%. That is only slightly ahead of the 1% average rate recorded in 2012 and 2013, and well off the better than 3% gains in the first year of the recovery. The pace of productivity gains the past two years have coincided with annual economic growth of a little better than 2%. Meanwhile, unit labor costs, a gauge of inflationary pressures, rose at a 0.6% annual rate in the second quarter following a 11.8% leap in the first quarter. From a year earlier, unit labor costs are up 1.9%, essentially in line with other inflation measures.

One bright spot in Friday’s report came in manufacturing. Productivity in the sector rose at a 3.6% pace during the second quarter and is up 2.1% from a year earlier. Both gains easily outpace the broader business sector. Meanwhile, unit labor costs in manufacturing have largely been contained, up 0.8% from a year earlier.

Comp. data have been quirky and noisy lately. Taking a 4Q moving average, one finds that comp. per hour was up 2.1% Y/Y in Q2.

Decline in ‘Slack’ Helps Fed Gauge Recovery

All are signs of an economy still healing from a deep downturn that created lots of economic slack: the gap between the resources we have and those we are using.

By many measures, such slack has narrowed considerably, but not completely, even five years after the recovery began. Conditions aren’t quite back to what was normal before the 2008 financial crisis.

Job Market Tilts Toward Workers as U.S. Enters Virtuous Cycle The balance of power in the job market is shifting slowly toward employees from employers.

(…) Americans who have been hunting for employment for more than six months are finding they’re having better luck landing a job, while people who had given up looking are returning to the labor force to resume their search.

Companies, meanwhile, are beefing up their in-house recruiting teams and increasingly using complicated computer algorithms to scour the Web for prospective job candidates. (…)

Employers in general have been “pretty stubborn” about increasing wages, said Jeffrey Joerres, executive chairman of ManpowerGroup (MAN), a Milwaukee-based staffing company with $20.3 billion in revenue last year. That may be about to change as the pool of available candidates shrinks.

“You can see a little anxiety among employers,” he said. “I can feel the inflection point is coming.”

Michael Durney, chief executive officer of Dice Holdings Inc. (DHX), agrees.

“I think you’re going to start to see wage inflation,” said Durney, whose company provides specialized websites that match employers with potential employees in industries such as technology and financial services. (…)

Businesses also are more inclined to hold onto staff. Conversions — giving full-time jobs to the temporary employees Manpower provides — are at a three-year high, according to Joerres. (…)

Express Employment had almost 90,000 job orders from employers in June, up from 62,000 a year earlier, Funk said.

More noise for Mrs. Yellen…

The WallStreetExaminer blog supports the doves as it deciphers the non-seasonally adjusted numbers to check on wage pressures:

Employment Cost Increases By SectorThe year over year gain in actual employment costs for all civilian workers was, are you ready for this–2%! That, indeed, is the highest it has been since 2011, when it spent the 2nd through 4th quarters rising at rates of 2-2.25%. Last year it never got above 1.9%. It’s a breakout! Or maybe not quite. This number is still within the same range of growth rates that it has been since the second quarter of 2010.

The gain, such as it was, was driven by gains of more than 2% in 6 major employment sectors. On the other hand, 4 broad sectors rose by less than 2%, and they can’t seem to get out of their own way. 3 of them have been wallowing below 2% since early 2011 and all 4 have been since early 2012.  Here’s a breakdown of the actual, not seasonally adjusted annual rate of gain by major sector.

Here’s how it looks on a graph.

Employment Costs By Sector- Click to enlarge

Before you get all outraged about government workers leading the increases, note that they got screwed in 2011 and 2012, falling below private sector workers for more than a year. The current surge looks like catch-up for that time when they were not getting raises. At about 16% of the workforce the government sector may be big enough that had it not been for this apparently compensatory increase, the total aggregate number for all employees may not have made it to a new 2 year high.

Another notable factor is that the 5 sectors that rose less than 1.75% comprise more than half of all US workers. The majority of US workers are experiencing compensation increases that do not even keep up with CPI, which we know, in addition, to be understated. (…)

Among the stronger sectors, Construction AND Extraction showed a gain of 2.1%. The problem there is that all of the gain is due to Extraction. Extraction means mining, and oil and gas production. Extraction is booming, while construction–not so much. In June, the BLS reported a year to year to year increase of 4.64% in average weekly earnings for mining and oil and gas extraction workers. But construction workers got virtually nothing, showing a gain of 0.24%. According to BLS data, there are approximately 850,000 employees in mining and oil and gas extraction. There are more than 6 million construction employees. How the BLS averaged those two together to come up with a 2.1% overall increase is beyond my ability to comprehend. I am the simple one.

So when you break these numbers down, recognizing the catching up of government workers which is probably temporary, and the likely overweighting of gains in mining and oil and gas extraction, that leaves just 4 sectors barely above a 2% increase.

One is Transport workers. They account for less than 3% of the US workforce. Their year to year increase is still below the peak levels of the past two years. The current uptick does not yet indicate that they’ve turned the corner.

Likewise those in another sector gaining more than 2%, Sales, saw an increase that remains well below the peaks of the past 2 years. Finally, managers and professionals and office and administrative workers have been flatlining at a 2% rate of increase for 2 years. There’s no breakout there either.

Looking at the 4 weaker sectors comprising the majority of US workers, the idea of a turn there is ludicrous.

Overall, private sector workers and those in education are not keeping pace with inflation, and the recent gains for non-education government workers could prove transitory. Considering the trends of the actual data in all of these major sectors, there’s no breakout here. The corner has not been turned. (…)

Good analysis. However, don’t forget that wages are a very lagging indicator. I side with David Rosenberg’s analysis which finds that

50 million American workers are in industries that are already at full employment. That is 35% of the workforce. A year ago, that number was zero. And 35% of the private workforce is also now in the process of enjoying accelerating wage growth. What is holding back the aggregate data are two sectors facing relentless downward pressure -construction and financial services.

But we have reached a critical mass where a rising share of the labour force is beginning up against a supply wall -wage growth for a significant and rising minority, enough to spin the dial on national income and spending is on the mend.

OECD Indicators Point to Slowdown in Germany

(…) But the outlook for Germany appears to be weakening, with the country’s leading indicator falling again during June in what the OECD said was a sign of “growth losing momentum.” After a strong first quarter, many economists estimate that the German economy contracted in the second quarter, in part because of an unusually large number of days being lost to vacation. (…)

The OECD said its leading indicators for France and Italy continue to point to stronger growth, as they have done for a number of months. However, those pickups have yet to materialize, leaving Spain as the only major euro-zone economy to enjoy a significant acceleration over recent quarters. (…)

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Sarcastic smile Where’s Italy’s recession on these charts?

Italy’s Problem Is Europe’s Problem

(…) Italy’s paralysis is all the more striking given the strengthening recovery in countries that have undertaken reforms. Spain is now the fastest growing economy in the euro zone, expanding by 0.6% in the second quarter. Citigroup expects the Greek economy to grow this year by 1.1%; Unemployment in Portugal has been falling for almost two years to 13.9% from a peak of 17.5%; Cyprus should return to growth in 2015, far sooner than predicted at the time of its financial collapse last year. (…)

That is why Italy’s stalled economy is a challenge for the European Central Bank too. For the past year, the ECB has come under growing pressure to embark on large-scale purchases of government bonds to address the euro zone’s low inflation rate. (…)

Germany adds to eurozone worries

Official data, due to be published on Thursday, are expected to show that growth in the eurozone stagnated in the second quarter. Economists polled by Reuters forecast growth of just 0.1 per cent between April and June, compared with 0.2 per cent in the first three months of the year.

German Economy Backbone Bending From Lost Russia Sales

Sad smile Leading to this chart from The Short Side Of Long:

China Loosens Monetary Conditions in Test of Credit Power

China loosened monetary conditions last quarter at the fastest pace in almost two years, a Bloomberg LP gauge showed, testing the waning effectiveness of credit in supporting economic growth.

Bloomberg’s new China Monetary Conditions Index — a weighted average of loan growth, real interest rates and China’s real effective exchange rate — rose 6.71 points to 82.81 in the second quarter from the previous three months. That’s the biggest jump since the July-September period of 2012, with May and June’s numbers the first back-to-back readings above 80 since January 2012.

New yuan loans in July will be a record high for that month, according to a Bloomberg News survey of analysts before data due by Aug. 15, suggesting officials are keeping the credit spigot open even as debt risks mount. While consumer inflation below the government’s goal allows room for more easing, economic data will determine how far policy makers go. (…)

China Inflation Tame in July

The consumer-price index rose 2.3% on year, in line with economists’ forecasts and unchanged from the previous month, according to data released by the National Bureau of Statistic. Prices rose 0.1% from a month earlier.

The CPI rose 0.1% M/M in July.

Meanwhile, the producer-price index, which tracks the prices paid to companies at the factory gate, has been stuck in deflation for more than two years, thanks to a combination of falling prices for raw materials and excess capacity in many Chinese industries.

The index logged a 29th straight month of declines in July, falling 0.9% year-over-year. But that is still mild compared to drops of 2% or more seen earlier this year. 

CANADA: Surprisingly negative jobs report supports low-rate stance

Statistics Canada’s monthly tally of hiring and firing produced a net gain of 200 positions last month, as a 60,000 increase in part-time jobs marginally outweighed a 59,700 plunge in full-time positions.

Canada’s unemployment rate dropped to 7 per cent from 7.1 per cent, but only because more than 35,000 people gave up looking for work, according to StatsCan’s report, released Friday in Ottawa. (…)

StatsCan estimates there were 17,820,900 people working in July, only 0.7 per cent more than a year ago. The labour participation rate, which measures the percentage of the population either working or seeking work, dropped to 65.9 per cent, the lowest since October 2001. Employment in goods-producing industries has shrunk by 56,000 positions this year, reducing the headcount to its lowest since January 2012, according National Bank Financial.

Speaking of National Bank Financial, their group of fine economists again provide the more insightful stuff:

Full-time employment has been particularly weak in Canada with a cumulative loss of 4,000 jobs so far in 2014. As today’s Hot Charts show, an unprecedented divergence has recently emerged between our country and the U.S. when it comes to full-time job creation: whereas the U.S. is growing at a robust 2% clip on a
year/year basis, Canada is actually contracting. What’s behind the weakness? The goods-producing industries has seen the destruction of 92,000 jobs over the past year with more than half of those losses coming from construction – the sector that spearheaded the rebound in job creation after the last recession.

As shown, a 3.7% annual drawdown in construction headcounts is extremely rare outside recessions. Is this development a harbinger of a much bigger slowdown in Canadian economic activity? We do not think so. For one, available data still point to a marked acceleration in real GDP in the coming months. For another, we doubt that the recent pace of layoffs in the construction industry can be maintained at a time when the value of new building permits is surging (we hit a record high in June). Should the upcoming report on new home starts show a level of around 180,000-to-200,000 units in July, a rebound in construction jobs could be in
store as soon as August.image

EARNINGS WATCH

Factset:

Overall, 446 companies in the S&P 500 have reported earnings to date for the second quarter with 73% reporting actual EPS above the mean EPS estimate. This percentage is slightly above the trailing 1-year average (72%). In aggregate, companies are reporting earnings that are 4.2% above expectations, which is also above the trailing 1-year (+3.2%) average. As a result of these upside earnings surprises, the earnings growth rate for the S&P 500 has improved to 8.4% today from 4.9% on June 30 and from 6.8% on March 31.

In terms of revenues, 64% of companies have reported actual sales above estimated sales and 36% have reported actual sales below estimated sales. The percentage of companies reporting sales above estimates is well above both the 1-year (55%) average and the 4-year average (57%).

The blended revenue growth rate for Q2 2014 is 4.3%, which is above the estimated growth rate of 2.8% at the end of the quarter (June 30).

In aggregate, companies are reporting sales that are 1.7% above expectations. This surprise percentage is well above the 1-year (+0.6%) average and the 4-year (+0.6%) average.

All ten sectors are reporting higher earnings relative to a year ago. Five of the ten sectors are reporting double-digit earnings growth, led by the Telecom Services and Health Care sectors. On the other hand, the Financials sector is reporting the lowest earnings growth of all ten sectors.

At this point in time, 80 companies in the index have issued EPS guidance for the third quarter. Of these 80 companies, 56 have issued negative EPS guidance and 24 have issued positive EPS guidance. Thus, the percentage of companies issuing negative EPS guidance to date for the third quarter is 70% (56 out of 80). This percentage is above than the 5-year average of 64%.

But well below the 6-quarter average of 79%.

Analysts expect earnings growth for the S&P 500 for the second half of 2014 to be in the same range as the 8.4% growth currently being reported for Q2 2014. For Q3 2014 and Q4 2014, analysts are predicting earnings growth rates of 7.1% and 9.9%.

Note that the estimated growth rate from Q3 was cut from 9.0% on June 30 to 7.1%, in spite of these facts:

  • Q2 actual EPS growth of +8.4% is 4.2% above expectations and shared across all sectors with 5 of the 10 sectors recording double digit growth in Q2.
  • Q2 actual revenue growth of +4.3% is 1.7% above expectations.
  • Margins keep growing. Q2 margins at 10.2% leapt above the previous 5Q highs.

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S&P’s database of 452 company reports shows a 66% beat rate and a 21% miss rate, the former being in line with recent years while the latter is much lower than the 24.7% average of the past 8 quarters. Interestingly, only 3 of the 10 sectors meaningfully better the average beat. Excluding Health Care (82%), IT (73%) and Materials (70%), the beat rate drops to 61%.

Q2 EPS are expected to come in at $29.56, up from the suspicious $29.18 last week and +12.1% Y/Y. Revenues are up 5.8% Y/Y, a marked acceleration from Q1’s +3.4% and Q4’13’s +0.5%.

S&P also says that margins rose nicely form 9.5% in Q2’13 to 10.1% this year, another record.

Trailing 12-month EPS should total $112.05 after Q2, up a significant 12.9% Y/Y. Q3 and Q4 estimates receded a little to $30.21 (+12.2% Y/Y) and $32.38 (+14.6%) respectively.

In all, this will end up as a pretty good earnings season. The bears have little meat to feed on as revenues have accelerated, margins keep rising and guidance is not deteriorating. At 1932, the S&P 500 Index is selling at 17.2x trailing EPS, a clear premium on the average (and median) of 13.7x since 1927, 1953 and 1983. Only if you are using data since 1993 (18.5) can you affirm that equities are cheap. At your own risk however!

The more dependable Rule of 20 P/E is at 19.2, a mere 4% below the “20” fair value (2020 on the S&P 500 Index).

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The latest Investors Intelligence survey revealed that bulls fell sharply to 50.5% from 55.6% a week ago. It noted that the latest reading is almost out of the caution territory and represents a decline over 12 points from the multi-year high of 62.6% in mid-June. It added that the spread between the bulls and bears contracted to 33.4% from 39.4% in the last survey and nearly low enough to shift to a neutral.

I will come back to that shortly. 

A 1.4-acre property in Lake Tahoe sold on Thursday for $1.6 million in bitcoins, joining a handful of other real-estate transactions that used the virtual currency.

NEW$ & VIEW$ (21 JULY 2014)

Hot smile RECESSION WATCH

Today, we get both the best and the worst recession indicators, courtesy of Doug Short. First, the best:

Conference Board Leading Economic Index: Fifth Monthly Increase

The index rose 0.3 percent in June to 102.2 percent. May was revised upward from 101.4 to 1.07 percent (2004 = 100). The positive contributions from the financial and new orders components more than offset declines in building permits and the labor market indicators. In the first half of this year, the leading economic index increased 2.7 percent (about a 5.5 percent annual rate), slower than the growth of 3.5 percent (about a 7.2 percent annual rate) during the second half of 2013. In addition, the strengths among the leading indicators continue to be more widespread than the weaknesses.

Click to View

Click to View

The worst:

The ECRI Indicator

Doug Short is one of the few bloggers to keep following the ECRI:

Here is a chart of ECRI’s data that illustrates why the company’s published proprietary indicator has lost credibility as a recession indicator. It’s the smoothed year-over-year percent change since 2000 of their weekly leading index. I’ve highlighted the 2011 date of ECRI’s original recession call and the hypothetical July 2012 business cycle peak, which the company previously claimed was the start of a recession. I’ve update the chart to include the “epicenter” (Achuthan’s terminology) of the hypothetical recession.

Click to View
As for the disconnect between the stock market and the mid-2012 recession start date, Achuthan has repeatedly pointed out that the market can rise during recessions. (…) The next chart gives us a visualization of the S&P 500 during the nine recessions since the S&P 500 was initiated in 1957. I’ve included a dotted line to show how the index has performed since ERIC’s original July 2012 recession start date (now adjusted forward by three months).

Click to View

Yes, the market can rise during recessions. It just generally doesn’t.

INFLATION WATCH: TRANSPORTATION COSTS

Truckload linehaul rates paid by North American shippers in June were 5.2% higher than in June of last year. As demand continues to increase while capacity exits the marketplace, this year’s procurement events and contract negotiations have not, in general, been ending favorably for shippers.

Cass truckload cost index June 2014

Although intermodal costs seem to have peaked for this year and have been falling over the last couple of months, they remain considerably high compared to the last several years. On average for 2014, intermodal costs have been up 2.1% year-over-year, with the difference greater in the last three months, partially due to rising diesel costs. For the most part though, it’s supply and demand. The AAR has reported that U.S. intermodal volumes are up significantly over last year: 9% in April, 8% in May, and 7% in June. (Cass)

Cass Intermodal Index June 2014

In all, intermodal rates are up 3.8% Y/Y in June.

More Firms Are Handing Out Pay Raises, NABE Survey Finds The share of U.S. firms that report giving pay raises has nearly tripled since last fall, though official data haven’t shown any broad acceleration in wage growth.

Some 43% of the NABE members who responded to the survey said wages and salaries at their firms have risen in the past three months. No respondents said wages had fallen, and 57% said wages were unchanged in the second quarter.

In the October 2013 survey, just 16% of economists said their companies had given raises in the prior quarter. That number has risen steadily since to 23% in January, 35% in April and 43% now.

Raises were spotty by sector, with just 11% of goods-producing firms and 35% of service firms reporting wage hikes. Some 59% of finance, insurance and real estate firms reported a rise in wages, as did 50% of transportation, utility, information and communications companies. (…)

In the NABE survey, 35% of respondents said they expected wages at their firms to rise in the third quarter versus 65% who expected no change.

Some 25% of economists said their firm has raised prices in the last three months, up from 20% in April and January. Fewer, 21%, said they expect prices to rise in the next three months.

Yellen Wage Gauges Blurred by Boomer-Millennial Workforce Shift

As today’s middle-aged Americans grow older, they are leaving their prime working years behind, trading big salaries for part-time gigs or retirement, just as an even larger group of young people come into thelabor force at entry-level salaries. The seismic shift may be one reason behind the sub-par wage growth that Yellen says still shows “significant slack” in the job market. (…)

China’s First Mortgage Debt Since Crisis Shows Li Concern China will revive mortgage-backed debt sales this week after a six-year hiatus, as the government extends help to homebuyers in a flagging property market.

Postal Savings Bank of China Co., which has 39,000 branches in the country, plans to sell 6.8 billion yuan ($1.1 billion) of the notes backed by residential mortgages tomorrow, according to a July 15 statement on the website of Chinabond. The last such security in the nation was sold by China Construction Bank Co. in 2007, Bloomberg-compiled data show.

Premier Li Keqiang is seeking to avert a collapse of the real-estate market after data last week showed new home prices dropped in a record number of cities in the world’s second-largest economy. The central bank in May called on the nation’s biggest lenders to accelerate the granting of mortgages to first-home buyers, and cities including Nanning, Hohhot and Jinan eased property restrictions. (…)

EARNINGS WATCH
Earnings and Revenue Beat Rates

Last earnings season, the earnings beat rate hit its lowest level of the current bull market with a reading below 60%.  So far this season, 64.2% of companies have beaten estimates.  Keep in mind that only 10% of companies have reported so far this season, so it’s still very early.

The top-line revenue beat rate is a bit weaker than the earnings beat rate, coming in at 57% so far this season.  This is slightly better than the final reading of 56% that was registered last season.

  • Factset focuses on S&P 500 companies as of last Friday:

imageAs of today, 74 companies in the S&P 500 have reported actual earnings and sales numbers for the second quarter. Of these 74 companies, 73.0% have reported sales above estimates and 30.0% have reported sales below estimates. Thus, the percentage of companies reporting sales above estimates to date for Q2 2014 is running well above both the trailing 1-year trailing  (55.3%) and 4- year averages (57.2%). The current record for the highest percentage for a quarter is 71.5%, set in Q2 2011.

Companies are also beating revenue estimates by wider margins than average. In aggregate, companies are reporting actual sales that are 1.43% above expectations. This percentage is well above the trailing 1-year average (+0.58%) and 4-year average (+0.57%).

Of these 74 companies, 72% have reported actual EPS above the mean EPS estimate and 28% have reported actual EPS below the mean EPS estimate. The percentage of companies reporting EPS above the mean EPS estimate isequal to both the 1-year (72%) average and the 4-year (72%) average. At the sector level, the Materials (100%), Health Care (83%), and Financials (79%) sectors have the highest percentages of companies reporting earnings above estimates, while the Consumer Discretionary (55%) and Consumer Staples (57%) and sectors have the lowest percentages of companies reporting earnings above estimates.

Pointing up In aggregate, companies are reporting earnings that are 4.5% above expectations. This surprise percentage is above the 1-year (+3.2%) average but slightly below the 4-year (+5.1%) average.

Companies in the Materials (+7.5%), Financials (+7.5%), and Health Care (+7.0%) sectors are reporting the largest upside aggregate differences between actual earnings and estimated earnings. On the other hand, companies in the Energy (-0.6%) sector are reporting the largest downside aggregate differences between actual earnings and estimated earnings.

Thumbs up The blended earnings growth rate for the second quarter is 5.5% this week, above the growth rate of 4.5% last week. During the past week, upside earnings surprises reported by companies in the Financials and Health Care sectors were the largest contributors to the increase in the growth rate for the index.

At this point in time, 14 companies in the index have issued EPS guidance for the third quarter. Of these 14 companies, 9 have issued negative EPS guidance and 5 have issued positive EPS guidance. Thus, the percentage of companies issuing negative EPS guidance to date for the second quarter is 64% (9 out of 14). This percentage is slightly below the 5-year average of 64%.

  • S&P has 84 reports in and the beat rate is 66.7%. Importantly, S&P now sees Q2 EPS at $29.64, 1.8% higher than the $29.12 estimate one week ago. This would bring trailing 12-month EPS to $112.13, up 0.5% from last week. Q3 and Q4 estimates are also being ratcheted up. Operating margins are now estimated at 10.05%, a big jump from Q2’13’s 9.51%.

Melt-up conditions are clearly accumulating. Geopolitics are the only major impediment. Here’s the Rule of 20 Barometer using trailing earnings of $112.13 and 2.0% inflation (June CPI is out tomorrow):

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Lance Roberts rightly noted Saturday that all of the S&P 500 gains for the year have occurred since April 1st, a period that has historically been some of the weakest return months of the year.SP500-Chart-071914

But then he wrongly writes that

These gains have also come at a time when corporate profits are slowing; economic growth is weak and geopolitical tensions have been on the rise.

Profits are showing signs of accelerating: Q1’14 +6.0%, Q2e +12.4%, Q3e +14.1%, Q4e +14.7%.

Economic growth is strengthening after a strangely feeble Q1. The domestic economy is indeed accelerating looking at PMI production and new orders data, transportation stats, bank loans, employment and consumer income and core retail sales. Only a weak housing market and lagging capex prevent a real economic take off.

As to valuations, we are indeed a little stretched. Unless inflation really takes off, the economic and financial background seems supportive as is the lack of general enthusiasm towards equities. The Yellen and Draghi show is underway. The apparent central banks put should hold until investors begin to worry that these modern day Atlas are well behind the curve and are about to drop the ball.

SENTIMENT WATCH

Russ Koesterich is global chief investment strategist at BlackRock

(…) Financial market volatility is mostly driven by the credit cycle. When monetary conditions are loose – meaning credit is both available and cheap – market volatility tends to be lower. (…)

Of course, other factors have been at work as well. Since investors have been comforted in recent years by the warm blanket of central bank accommodation, they are essentially conditioned to “buy the dip”.

(…) Stocks have also been supported by a steady stream of mergers and acquisitions. (…)

Recent levels of volatility have been in the bottom 1 per cent of volatility levels going back to 1990. In other words, it looks too low even after accounting for a benign credit environment. This is particularly so given that up until last week investors were ignoring rising geopolitical risk.

Indeed, the recent escalation of violence in Iraq and Ukraine has raised the stakes. Turmoil in both regions has the potential to cause a spike in oil prices, which would be a real headwind for the global economy at a time when economic growth is fragile. (…)

To the extent a rate rise occurs earlier than investors expect, this could affect volatility. A marginal tightening in monetary policy means a less accommodative credit regime, which in the past has generally been associated with an uptick in volatility.

Still, all else being equal, stocks can continue to climb this year. Stocks are fully valued after a strong rally, but the lack of attractive alternatives (bonds are expensive and cash pays zero), and a slow, but steady, recovery, can support further modest gains. That said, further gains are likely to come with more volatility.

Complacency is still the biggest risk, with little bad news priced into the markets. Investors might want to consider taking steps that can help insulate them against an increase of volatility if – or when – it spikes up again.

As every student of US film clichés knows, when the hero in the movie says “It’s quiet, too quiet”, bad things are about to happen. It is impossible to predict when the next bad thing will happen, but it is unlikely our good fortune can last. Investors should consider preparing now.

(…) (The negative January Rule this year has, for that matter, also been ineffective so far.) So, all is apparently well, as we have arrived within three months of the dreaded (by bears) presidential third year. Accordingly, my recent forecast of a fully-fledged bubble, our definition of which requires at least 2250 on the S&P, remains in effect.

What is worse for us value-driven bears, a further bullish argument has struck me recently concerning the probabilities of a large increase in financial deals. Don’t tell me there are already a lot of deals. I am talking about a veritable explosion, to levels never seen before. These are my reasons. First, when compared to other deal frenzies, the real cost of debt this cycle is lower. Second, profit margins are, despite the first quarter, still at very high levels and are widely expected to stay there. Not a bad combination for a deal maker, but it is the third reason that influences my thinking most: the economy, despite its being in year six of an economic recovery, still looks in many ways like quite a young economy.

There are massive reserves of labor in the official unemployment plus room for perhaps a 2% increase in labor participation rates as discouraged workers potentially get drawn into the workforce by steady growth in the economy. There is also lots of room for a pick-up in capital spending that has been uniquely low in this recovery, and I use the word “uniquely” in its old-fashioned sense, for such a slow recovery in capital spending has never, ever occurred before. The very disappointment in the rate of recovery thus becomes a virtue for deal making. (…)

(…)  Also, individuals and institutions did feel chastened by the crash of 2009 and many are just now picking up their courage. And as they look around they see dismayingly little in the way of attractive investments or yields. So, the returns promised from deal making are likely to appear, relatively at least, exceptional. I think it is likely (better than 50/50) that all previous deal records will be broken in the next year or two. This of course will help push the market up to true bubble levels, where it will once again become very dangerous indeed. (…)

In early July, Janet Yellen made an admirably clear statement that she is sticking faithfully to the Greenspan-Bernanke policy of extreme moral hazard. She will not use interest rates to head off or curtail any asset bubbles encouraged by the extremely low rates that might appear. And history is clear: very low rates absolutely will encourage extreme speculation. (…)

  • $100B down, $200B to go!

(…) according to data compiled by Bloomberg and the Investment Company Institute, nearly $100 billion has been added to various equity funds in the past year. That is ten times more than in the previous twelve months. In the five years through 2012, as much as $300 billion was withdrawn. There is no doubt that individual investors have developed a considerable degree of confidence about the Fed’s intention plowing “plenty of plenty” back into risky assets. (Palos Management)

Investors have grappled with many obstacles this year, ranging from the withdrawal of the Federal Reserve’s postcrisis stimulus to patchy economic growth and military flare-ups in Ukraine and Israel.

Their response? Buy the dips.

The latest proof that fund managers are heeding this stock-market adage came on Friday, when the Dow Jones Industrial Average jumped 123.37 points, recovering almost all the ground it lost a day earlier after the downing of a Malaysia Airlines 3786.KU 0.00%jetliner over Ukraine and Israel’s incursion into Gaza.

The gain left the Dow just 0.2% below its most recent all-time high set Wednesday. The Dow has set 15 records this year after notching 50 last year. (…)

“Investors are learning that it’s a loser’s game to sell on the news,” said Jim Paulsen, chief investment strategist at Wells Capital Management, which oversees $350 billion. Recent events “don’t give you a sense that they’re going to turn into some wider conflict,” Mr. Paulsen said. (…)

“The dips have been relatively small and short-lived, so you have to move in pretty quickly,” he said. (…)

When you sit on the sidelines, clients demand an explanation, Mr. Armiger added.

The pressure to buy shares is strong in part because more portfolio managers are lagging behind their benchmarks than in years past, and conservative managers who hoard cash risk falling further behind, analysts said. (…)

There you go! But wait, there’s more in the same WSJ:

Little can take down U.S. stocks these days. Call it the “honey badger” market.

That’s what Andrew Wilkinson, chief market analyst at Interactive Brokers, labeled Wall Street on Friday, a play off of a YouTube video showing the fearlessness of the honey badger and how the animal will do whatever it takes to survive.

“If financial market participants acted more like that famous honey badger, fewer investors might be suffering from seller’s remorse on Friday,” Mr. Wilkinson wrote to clients on Friday. “The cobra-scoffing, honeycomb-raiding honey badger, famous for snacking no matter whether its prey bites, injects venom or stings the heck out of its attacker, just eats what it wants, when it wants, and pays little attention to the risk.”

Friday’s stock rally “appears to be a victory for couldn’t-give-a damn-what-you throw-at-me risk managers,” Mr. Wilkinson said.

Crying face Honey, I shrunk the retirement account!

There is also this new twist on “fundamentals” from JPMorgan (via Business Insider)

We accept such correction risks, but see only modest near-term downside that may anyway be quite difficult to trade, as the fundamentals behind the rally in stocks are to us largely intact. Low implied volatilities make it relatively cheap to hedge such downside, though. The fundamentals we focus on remain the lack of any return on cash and generally low market and economic volatility. Incoming economic data and surveys are raising our confidence that global and US growth is set to rebound to a 3% handle in H2, after a dismal and unexplained weak H1. The major first GDP report for Q2, China, came in just above our expectations, reducing fear on the downside. Forward looking PMIs suggest a strong Q3, even as we accept that this signal has not functioned well so far this year. Q2 earnings reports are also coming in well above expectations (see equity section below).

BTW, from FT Alphaville:

Roughly a quarter of all hedge funds tracked by Preqin have posted negative returns year to date, though the industry is up 3.2 per cent overall.

One in four is pretty bad for an industry with aspirations to asset class status, when the world has largely been calm and markets positive. Indeed, hedge fund managers are braced for their worst year since 2008.

Nearly two-thirds of hedge fund managers are anticipating full year returns of 6 per cent or less, according to Preqin, the data provider, which surveyed 150 hedge funds collectively managing $380bn of assets. Of these, 44 per cent expect a full-year return of 5 per cent or less.

(…) Michael Kastner, principal at Halyard Asset Management, says the common refrain from retail and professional investors is the complaint that they need to do something with their cash.

The amount of cash sitting on the sidelines, known as money market fund balances, stands at about $2.575tn, where it stood in 2007 before the financial crisis erupted.

In March 2009, money markets were holding nearly $4tn as investors were firmly in bunker mode. Since then that cash kitty, earning essentially nothing, has normalised, driven by the search for yield. That is an activity that flashes red on the radar screen of central bankers. (…)

Beyond valuations, there is also the issue of how investor behaviour in terms of risk taking has been altered by an extended period of low interest rates that a central bank is in no rush to change. (…)

Mr Kastner says Fed policy has driven investors into areas of the market and exuberance that typified the end of the last boom in 2007. But he worries that changes since then have exposed retail investors to greater excesses with credit derivative securities being packaged into exchange traded funds and how small investors are now able to invest in illiquid hedge fund strategies. He also contends that junk bonds and the bank debt market “is approaching bubble territory”.

The greatest reason to worry about all these developments is that when investors seek an exit, any crowding of the gate will send markets into a tailspin, as we saw in 2008 and also for tech stocks in 2000.

Having told investors that the Fed wants a stronger economy and higher inflation before policy tightens, Ms Yellen faces the prospect that asset prices will rise further and ignore her powers of persuasion to deter the reach for yield.

Only a genuine inflation scare can alter investors’ mindsets, but by then any major market reversal could well damage the economy and central bank credibility.

That assumes that investors understand how inflation can hurt the economy and investment returns. It has been nearly 20 years since core CPI has exceeded 3.0% and nearly 25 years since it reached 5.0%.

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CHART FOR THOUGHT

from BoAML via Zerohedge:

Finally,

 Michael Dell announced via Twitter that his eponymous company will start accepting bitcoin on the company’s website. For Dell, it’s a chance to reach out to a hip, tech-savvy customer base. For bitcoin, it’s one of the clearest signs yet of mainstream acceptance.

Hot smile I beg your pardon, I have been accepting bitcoins for a while now!