MarketView for January 30

 

 

Summary

 

The major equity indexes closed out the trading day on Monday with some mild negative numbers, the result once again of a seemingly never ending oscillation of on-again, off-again, Greek debt talks. Nonetheless, an afternoon rally cut losses in a sign of the underlying resilience the market has shown early in the year.

 

Major indexes had fallen more than 1 percent as negotiations between the Greek government and private bondholders over the restructuring of 200 billion euros of debt failed to reach an agreement before the start of a summit of European leaders.

 

However, by the afternoon those losses were cut sharply. Optimism that the our domestic financial markets can shrug off Europe's troubles has resulted in some nice equity gains in 2012, with the S&P 500 up 4.7 percent this month.

 

Financial shares were hurt the most by developments in Europe. The largest drag on the S&P 500 was Bank of America, which ended the day down 3 percent to close at $7.06.

 

Material, technology and telecoms stocks led the turnaround after the close of European markets. Yet, volume was low at just 6.2 billion shares changing hands on the three major equity exchanges. The 200-day moving average for volume is 7.8 billion shares.

 

Even though the euro zone crisis drags on, the S&P 500 was on track for its best month since October, helped by stronger domestic economic data and a easing of conditions in Europe's financial system following backing from global central banks.

 

From a technical analysis point of view, the fact that the S&P 500 held above the psychologically important 1,300 level after crossing it for the first time in six months earlier in January carries substantial weight.

 

Germany sought to tone down reports it was pushing for Greece to give up control over its budget policy to European institutions. Greece was unlikely to accept that scenario, presenting yet another obstacle to a second bailout package for Athens.

 

Apple’s shares helped cap losses on the Nasdaq after Morgan Stanley said the company could add China Telecom and China Mobile as distributors over the next year. Apple rose 1.3 percent to $453.01.

 

Swiss engineering group ABB agreed to buy Thomas & Betts for $3.9 billion in cash, sending shares of the company up 23.1 percent to $71.31.

 

Consumer spending was flat in December as households added to savings after the largest rise in income in nine months. Although the data pointed to a slow start for spending in 2012, there is cautious optimism that an improving labor market will support demand.

 

Is Freddie Mac Betting Against Homeowners?

 

NPR and ProPublica released an explosive report Monday that found government-owned mortgage giant Freddie Mac betting against the very homeowners it is supposed to help. According to the news article, the investment division of Freddie Mac (or as Henry calls it, Freddie's "gambling desk") placed billions of dollars of bets against homeowners who were trying to refinance their mortgages at lower rates.

 

According to NPR/ProPublica's review of public documents, Freddie Mac invested in securities called "inverse floaters," which receive all the interest payments from  specified mortgage-backed securities. "If lots of people 'pre-pay' their old loans and refinance into new, cheaper ones, then Freddie Mac starts to lose money," ProPublica's Jesse Eisinger and NPR's Chris Arnold explain. "If people can't refinance, then Freddie wins because it continues to receive that flow of older, higher interest payments."

 

Although Freddie Mac's bets are legal, they're highly offensive. Rightly or not, many Americans blame Freddie Mac and Fannie Mae -- which was not mentioned in the NPR/ProPublica report -- for the housing boom and subsequent bust. Nearly all Americans would agree the company's should not be focused on generating profits, now that they are officially wards of the state and are using taxpayer dollars to make these bets, as Aaron and Henry discuss in the accompanying video.

 

Freddie Mac plays a significant role in determining mortgage rates and is one of the "gatekeepers" with the power to decide whether a homeowner can refinance at a lower rate. If homeowners can reduce their mortgage payments, then Freddie Mac loses money. Hence the conflict of interest and the concern Freddie has been turning down refi requests in order to benefit its proprietary trades.

 

Freddie Mac and Fannie Mae are technically wards of the U.S. government after Washington stepped in to shore up the balance sheets of the troubled mortgage lenders in 2008 at the height of the housing market collapse.

 

According to the report, Washington spent $169 billion on Freddie and Fannie and any risky bets Freddie makes will technically affect all taxpayers. Freddie Mac has asserted its investment arm, the division that places bets against homeowners via complex mortgage securities, is "walled off" from the mortgage-lending unit and other Freddie Mac personnel.

 

The government mortgage buyers guarantee more than half of all the $10.3 trillion in outstanding U.S. home loans, as reported by the Wall Street Journal.

 

Many economists and policymakers say the number of foreclosures will drop if Americans are able to refinance their high-interest rates. For the week ending Jan. 26, the rate on the 30-year-fixed mortgage averaged 3.98 percent. President Obama reiterated his administration's commitment to helping homeowners in last week's State of the Union.

 

"I'm sending this Congress a plan that gives every responsible homeowner the chance to save about $3,000 a year on their mortgage, by refinancing at historically low rates," Obama said. "No more red tape. No more runaround from the banks."

 

Both companies have been in the hot seat before over payments to their CEOs and top executives. The salaries for Michael Williams and Charles Haldeman Jr., the departing CEOs of Freddie Mac and Fannie Mae, were expected to be as high as $6 million each last year although both companies reported deep financial losses.

 

 California has filed a suit against Freddie and Fannie last December, asking the firms to provide extensive rejoinders about the properties they own and foreclosed in the state. The Securities and Exchange Commission has brought civil fraud charges against former Fannie CEO Daniel Mudd and former Freddie CEO Richard Syron, stating that the mortgage giants were untruthful about their subprime exposure.

 

Longest S&P 500 Valuation Slump Since 1973

 

Valuations for U.S. equities have been stuck below the five-decade average for the longest period since Richard Nixon's presidency; an indication that investors do not trust earnings even after a three-year bull market.

 

Analysts estimate profits in the Standard & Poor's 500 Index will reach a record $104.78 this year after increasing 125 percent since the end of 2009, the fastest expansion in a quarter century, according to data compiled by Bloomberg. American companies are boosting income so much that even after stocks doubled, the S&P 500 hasn't traded above its 16.4 mean ratio for 446 days, the longest stretch since the 13 years beginning in 1973.

 

Battered by the 14 percent decline in the S&P 500 since 2000, the worst financial crisis since the Great Depression and the so-called flash crash 21 months ago, investors are staying away from stocks, even after record profits, 10 quarters of U.S. economic growth and promises by the Federal Reserve to keep interest rates near zero through 2014. Of the $37 trillion erased from global equities in the credit crisis, $24 trillion has been restored.

 

The Fed's pledge to keep interest rates low through 2014 helped send the S&P 500 up 0.07 percent to 1,316.33 last week and extended its 2012 advance to 4.7 percent, the best start to a year since 1989. At the same time, an average of 6.69 billion shares traded on U.S. exchanges in the 50 days ended Jan. 18, the fewest since at least 2008, according to data compiled by Bloomberg. Futures on the equity benchmark slipped 0.5 percent at 2:20 p.m. in Hong Kong today.

 

The S&P 500 trades for 13.7 times profits. It was last above the mean valuation since 1954 on May 13, 2010, less than a week after $862 billion was erased from U.S. equity values in 20 minutes, data compiled by Bloomberg show. The slump has surpassed the two longest periods of the last quarter century, in 2008 and 1988.

 

Profits for the 169 companies in the S&P 500 that reported earnings since Jan. 9 have risen 3.2 percent from a year earlier and beat analyst projections by 2.9 percent, the data show. Apple, Textron and 110 other companies posted higher- than-forecast earnings in the three months ending Dec. 31.

 

Companies in the S&P 500 earned $657 billion in the first nine months of 2011, including $225.2 billion between April and June, the most for any quarter in at least 12 years. That's 72 percent more than the comparable period in 2008. U.S. GDP, which grew at a slower-than-forecast 2.8 percent rate in the fourth quarter, totals about $13.4 trillion, data compiled by Bloomberg and the Commerce Department show.

 

The last two times the S&P 500 slumped below its historic average, equities rallied. The benchmark index is up 42 percent since it climbed above the five-decade mean in June 2009. It spent 14 months below the average level from August 1988 through October 1989 before quadrupling within eight years starting in October 1990, data compiled by Bloomberg show.

 

Multiples for the benchmark gauge rose as high as 13.82 this year. Should earnings match analyst forecasts and climb to $104.78 a share, the index would have to reach 1,718.39 to trade at the average ratio of 16.4, according to data compiled by Bloomberg. That's more than 30 percent above its last close.

 

Our economy has expanded by an average of 2.4 percent a quarter since 2009. While that helped push the S&P 500 up 95 percent, the index's price-earnings multiple is down 43 percent. The decline is part of a decade-long retreat in U.S. equity valuations since the S&P 500 peaked at 31.2 times earnings in December 1999.

 

Investor doubts helped send new equity sales by U.S. companies down 4 percent in 2011 as interest rates near record lows spurred companies to issue bonds instead. U.S. corporate debt sales rose 0.9 percent to $1.19 trillion, according to data compiled by Bloomberg.

 

Customers of domestic stock mutual funds have pulled out more than $146 billion since May 2010 as the S&P 500's valuation shrunk by as much as 33 percent.

 

The longest valuation slump lasted from June 1973 through January 1986, according to data compiled by Bloomberg. The start coincided with the Watergate scandal that led to Nixon's resignation and the Arab oil embargo, marking the end of a three-year bull market as shares declined 32 percent over 16 months.

 

The economy contracted three of the four quarters in 1974, consumer prices climbed 12.3 percent in December and unemployment reached 9 percent in May of the following year. Gross domestic product shrank 5.1 percent from the fourth quarter of 2007 to the second quarter of 2009, according to the Commerce Department.

 

The current slump is different from the one that started more than 38 years ago. Equities face less competition from fixed-income investments and inflation compared with the 1970s and 1980s. The yield on the 10-year Treasury note peaked at a record 15.84 percent on Sept. 30, 1981. The consumer price index surged during the oil crisis in 1973, rising from 2.7 percent in June of 1972 to 12.3 by the end of 1974. It peaked at 14.8 percent in March 1980.

 

Plosser Wanted A More Upbeat Report

 

Philadelphia Fed President Charles Plosser said on Monday said he would have preferred a more optimistic statement on the economy, after the central bank last week painted a grim picture of the recovery and forecast ultra-low interest rates until late 2014.

 

"I thought it was a little bit pessimistic. I would have preferred a little more optimism in the outlook," Plosser said on CNBC.

 

"It's not that we're going to take off like a sky rocket going into this year, but I do think things are looking better," he said, citing a drop in the unemployment rate to 8.5 percent, which is still historically high.

 

Plosser, a policy hawk concerned more with keeping a lid on inflation than on the labor market, said he didn't see a need to buy mortgage-backed securities at this point.

 

"I'm very concerned about policy we keep saying that we've got to do more... I worry about this accelerationist view that we have to go ever faster on the pedal of monetary policy," said Plosser, who does not have a vote on the Fed's policy-setting panel this year.

 

"I was unhappy with the calendar date in the statement. I'm still unhappy with the calendar date in the statement. I don't think that's the right way to convey policy," he said, adding he expects rates to likely rise before mid-2013, even as early as this year.

 

Dudley Says Fed Will Do Its Part

 

Much work remains to maximize employment and stabilize prices in the face of a "sluggish" economic recovery, and the Federal Reserve will do its part, New York Fed President William Dudley said.

 

According to Dudley, unemployment is likely to remain "unacceptably high" for some time and inflation is likely to be below 2 percent, the Fed's new objective, for several years. “Clearly, much work remains to achieve the Fed's dual mandate of maximum sustainable employment in the context of price stability," Dudley said.

 

The comments come two days after the Fed offered a bleak outlook for the economy and Chairman Ben Bernanke said the central bank stood ready to offer more stimulus in the form of bond purchases if inflation stays below 2 percent and if unemployment, now at 8.5 percent, remains high.

 

The speech by Dudley, who has emphasized driving down the high jobless numbers, could reassure those who see another round of Fed asset purchases - including mortgage-backed securities - as all but inevitable.

 

The Fed, which has kept interest rates near zero for more than three years, "has done and will continue to do its part in supporting the recovery - but it is not all-powerful," Dudley said.

 

"Other complementary policy actions in housing, fiscal policy and structural adjustment or rebalancing of the economy will be essential if we are to achieve the best available recovery."

 

Aside from the low rates, the Fed has also bought $2.3 trillion in long-term securities in an unprecedented drive to spur growth and revive the economy after the worst recession in decades. Yet the recovery has been slow, leading the central bank to say on Wednesday that it expects to keep rates "exceptionally low" at least through late 2014.

 

Asked about that target, which is more than one year later than the Fed's previous date, Dudley said the move does not suggest Fed policymakers are panicked. "I don't sense any panic whatsoever, speaking for myself," he said.

 

Dudley, a permanent voter on the Fed's policy-setting committee, expects "moderate" growth this year, and warned the risks are skewed to the downside in part because of Europe's debt crisis.

 

The economy continues to operate with "significant excess slack," he said, adding that inflation has retreated and may be headed down further, while he expects job growth this year to be "not that different from what we've been experiencing."

 

Still, the slow overall recovery has cast some doubt on the central bank's far-reaching strategy, with some, including congressional Republicans, warning that the massive quantitative easing efforts over the last few years could crimp the Fed's ability to tighten policy when the time comes.

 

The Fed and Bernanke in particular have been sharply criticized throughout the Republican presidential campaign.

 

The Fed's ultra-easy monetary policy stance, to nurse the recovery, got some support from data on Friday showing U.S. gross domestic product expanded at a 2.8 percent annual rate in the fourth quarter of 2011. It was a sharp acceleration from the 1.8 percent clip of the prior three months and the quickest pace since the second quarter of 2010.

 

Recent data from employment to manufacturing to consumer credit suggest the world's largest economy gained momentum going into 2012, but Bernanke said Wednesday the Fed was not yet ready to "declare that we've entered a new, stronger phase."