MarketView for October 25

 

 

Summary 

 

Although share prices ended the day well off their intraday highs,  prices nonetheless were still at a five-and-a-half month peak on Monday as a falling dollar, partly driven by expectations of further stimulus by the Federal Reserve, sent funds moving into riskier assets. The benchmark S&P 500 index ended at its highest point since May 3.  

 

Meanwhile, the dollar continued to move lower after a weekend meeting of the Group of 20 countries stopped short of setting targets to reduce trade imbalances. Furthermore, Wall Street is still betting heavily that the Fed will stimulate growth by effectively printing money to buy assets, which in turn has weakened the dollar, and thereby sent commodity prices higher.

 

Equities and the dollar have formed an inverse relationship, so as the dollar drops, equities often gain ground. Since September 1, the S&P is up 13 percent while the dollar index, which measures its value against a basket of major currencies, is down 7.4 percent.

 

The S&P materials sector, which is particularly sensitive to the weak dollar, gained 1.7 percent and was the index's best performing group. Freeport-McMoRan Copper and Gold ended the day up 2.2 percent to close at $96.07.

 

In a research report, Goldman Sachs said the Federal Open Market Committee is almost certain to announce renewed monetary easing at its November 2-3 meeting. Goldman analysts calculated the Fed may have to buy up to $4 trillion in assets to achieve desired growth and inflation targets.

 

After the closing bell, Texas Instruments saw its share price fall 0.4 percent to $28.86, while Amgen fewll 0.6 percent to $57.60 after releasing quarterly results.

 

During the session, Office Depot and Lorillard rallied as a result of stronger-than-expected earnings. Office Depot also said that its embattled chief executive would be stepping down, sending the stock up 3.5 percent to $4.79. Lorillard advanced 1.3 percent to $85.14.

 

Fed May Need $4 Trillion

 

Economists at Goldman Sachs estimate the Federal Reserve may need to buy a staggering $4 trillion worth of assets such as Treasury securities to get the economy rolling again.

 

The Goldman economists, Jan Hatzius and Sven Jari Stehn, don't expect the Federal Reserve to go nearly that far when it resumes its asset-purchasing quantitative easing policy. Citing many officials' unease with the prospect of adding significantly to the Fed's already bloated balance sheet, Goldman expects the Fed to end up buying around $2 trillion worth of assets over the next few years.

 

But even the lower Goldman estimate at least doubles the size of the purchases most observers have been saying they expect the Fed to target when it unveils so-called QE2 at its meeting next week.

 

"The key strategic question is not the size of the first step, but how far Fed officials will ultimately need to move in order to achieve their dual mandate of low inflation and maximum sustainable employment," Hatzius and Stehn write.

 

Hatzius and Stehn say that with unemployment near 10% and inflation falling, there is no reason to believe the widely anticipated, modest second round of quantitative easing will pull the economy out of its funk. Economists have been bandying about figures between $500 billion and $1 trillion, though some suspect the Fed will stop short of using numbers even that large and simply announce a plan to buy $80 billion to $100 billion worth of Treasurys till conditions improve.

 

The Fed has been complaining in recent weeks that inflation is falling too low, in a development that threatens to raise real borrowing costs for households and businesses, further slowing an already anemic recovery. Meanwhile, Fed chief Ben Bernanke said in a speech this month that joblessness "is clearly too high relative to estimates of its sustainable rate."

 

Those comments point to a building consensus at the Fed for another round of monetary stimulus in a bid to boost demand for goods and services. At the same time, commodity prices have surged over the past three months and interest rates have plunged, leading some observers to question whether the market has already priced in next week's announcement -- and raising fears that an all-in approach such as the one described in Goldman's $4 trillion scenario could lead to a destabilizing surge in goods prices.

 

But for now, the burning question is why all the stimulus the Fed has provided over the past few years has eased financial conditions without aiding the actual economy. The Goldman economists answer that while the Fed's current policy is "very easy," that's not nearly loose enough.

 

"Instead, policy should be massively easy to facilitate growth and job creation, fill in the output gap, and ultimately raise inflation to a mandate-consistent level," they say.

 

The Goldman economists acknowledge the risks the Fed faces in doing new asset purchases, such as rising friction with critics in Congress and fears that the massively expanded monetary base will make it impossible to avoid a large dose of inflation down the road.

 

But skeptics of the Fed's firepower, and by now there are many, say the bigger problem is that the benefits of QE will simply be siphoned off by unfair traders such as China. They say the answer to our economic morass thus must come from the White House and Congress rather than from the Federal Reserve. "China's yuan policy and trade barriers make the Fed nearly irrelevant," writes University of Maryland business professor Peter Morici.

 

Et Tu Mr. Buffett

 

The SEC questioned Berkshire Hathaway, the company run by Warren Buffett, in the second quarter on why it was not writing down large losses on shares in Kraft and US Bancorp. In an April letter, the SEC asked Berkshire why it was not recording write-downs on shares with $1.86 billion in unrealized losses, all of which had been in that position for at least a year. Given the duration of those losses, the SEC said they appeared to be more than temporary and as such should have been written down.

 

In response, the company insisted its accounting was right. To support its position, Berkshire on Monday publicly filed copies of a letter it sent to the SEC in May, answering questions from the regulator about its accounting treatment for those and other stock investments. The response, from Berkshire’s Chief Financial Officer Marc Hamburg indicated that the losses with more than 12 months' duration as of December 31 were concentrated in Kraft and U.S. Bancorp, shares it had acquired in 2006 and 2007.

 

Hamburg said that as of December 31, Berkshire determined both companies had enough earnings potential that their share prices would eventually exceed the original cost of the stock. It also has the "ability and intent" to hold the shares until they recovered, he said.

 

"We believe it is reasonably possible that the market prices of Kraft Foods and U.S. Bancorp will recover to our cost within the next one to two years assuming that there are no material adverse events affecting these companies or the industries in which they operate," Hamburg said.

 

Both stocks recorded double-digit percentage increases in the first quarter, he noted. They have since held on to some of those gains, with Kraft up 17.4 year-to-date and U.S. Bancorp up 5.2 percent. None of the other filings Berkshire disclosed on Monday indicate how the issue was resolved.

 

Existing Home Sales Gain Traction

 

Existing homes sales were higher than expected in September, posting a 10 percent increase. Nonetheless, they still remain at depressed levels that continue to portend a protracted recovery. The increase meant that sales hit an annual rate of 4.53 million units, the National Association of Realtors said on Monday. It was the second monthly gain and far outstripped economists' expectations for an increase to a 4.30 million-unit pace.

 

Still, the data did little to weaken the case for further monetary easing from the Federal Reserve, with sales far below the 5 million-unit pace usually associated with a healthy market.

 

Although the housing market is showing signs of having bottomed after following the heavy declines that occurred  in the aftermath of the end of a popular tax credit for home buyers earlier this year, sales activity remains subdued. Furthermore, the recovery is expected to continue to be slow given the 9.6 percent unemployment rate. A cloud of uncertainty from investigations into the processing of foreclosures by some banks looms over the sector, which was at the heart of the Great Recession.

 

Last month, foreclosed properties accounted for 23 percent of sales while short sales made up 12 percent. The combined percentage was up slightly from August. First-time buyers accounted for 32 percent of transactions in September. Concerns remain that the foreclosure investigation could slow the housing market correction as banks hold back on sales. According to the NAR, foreclosed properties constitute about 20 percent of homes on the market.

 

The industry group said a survey of its members taken two weeks ago showed buyers were becoming hesitant to snap up foreclosed properties, worried they might not be dealing with the lawful owner.

 

Sales of single-family homes and condominiums both rose, the report showed. A 1.9 percent fall in the supply of houses available for sale to 4.04 million units also offered a sign of increased stability in the market.

 

Still, the inventory -- a 10.7 months' supply -- remained high and economists believe sales will level off soon, citing a recent drop in applications for loans to buy homes. They fear the supply overhang will continue to weigh on prices.

 

Robotic Trades in the Crosshairs of Regulators

 

Computer-generated trades have run amok in markets more than once this year, and. regulators should look for ways to hold traders accountable, a top official on the Commodity Futures Trading Commission said on Monday. Bart Chilton, a commissioner with the futures regulator, said "mini-flash crashes occur all too often" following a surge in high-frequency trading.

 

Securities and futures regulators have been trying to determine ways to prevent another event like the May 6 "flash crash" when markets temporarily plunged. The CFTC on Tuesday will unveil new draft rules to clamp down on disruptive trading practices.

 

"They don't cause as much of a disruption as that of May 6, but more than once this year, runaway trades have disrupted markets. By that I mean, cost people money," Chilton said. "We should explore ways to hold those who set off runaway robotic trades accountable," he said.

 

At least one algorithm is known to have disrupted the oil markets this year. Infinium Capital Management said in August it was the company at the center of a six-month probe by CME into why a new trading program malfunctioned, racking up a million-dollar loss in about a second on February 3.

 

The regulatory agency faces tight deadlines to write regulations to implement the Wall Street reforms that Congress passed in July to increase oversight of the $615 trillion over-the-counter derivatives market. The CFTC hopes to unveil the first drafts of all proposed rules by the end of the year to allow time for public comment and revisions before its July deadline for final regulations.

 

Some measures have earlier deadlines, including speculative position limits in energy and metals markets, which must be finalized in January. Chilton questioned whether there should be position limits for financial futures.

 

"Given our experience with the Flash Crash, however, and the key role one financial futures market appears to have led in the domino decline, I'm wondering if it is appropriate to consider limits in these markets as well," Chilton said.

 

Regulators are trying to ensure that commercial end-users, who are exempt from having to clear trades and post margin, do not face higher costs for hedging with swaps. Swap dealers and major swap participants will be required to clear most swaps, and will have extra capital and margin requirements.

 

"It's clear that we need to exercise some caution when we write those definitions (for swap dealers and major swap participants) so that legitimate hedgers are not inadvertently pulled into the categories," Chilton said.

 

Hundreds of firms are lobbying the CFTC for exemptions from regulations or for favorable interpretations of the new law. "Others think we should ignore the deadlines Congress gave us and phase this stuff in over years and years. Well, sorry Charlie," said Chilton. "That's not going to happen."