Market & Economy: Hussman and Schiller

 John Hussman always publishes a weekly market and economy commentary on Monday.  In this commentary he is commenting on Fed policy, the current economy and state of U.S. financial institutions, market valuation in which he estimates the ten year S&P 500 total return is down to 5.1%, and changed his market climate to hard negative and he notes there seems to be less willingness to lend to corporations.  It is not a very pretty picture.  Read it here.
 
Robert Schiller, in an interview, discussed the economic malaise effecting investing and the general economy, cites current market volatility as unhealthy and possibly indicative of a potential equity downturn but definitely fragile.  He still finds equities expensive, that housing will remain under pressure, and tells why he likes TIPS. Watch it here.

These are two viewpoints.  Like all information, it should be read critically, which means that you do not have to agree with everything or every detail to gain value and knowledge.  Information is most valuable when it can be compared and evaluated through comparison and content for relevance.

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Is Buffett Feasting on Bank of America?

A reader has asked me to comment and explain Warren Buffett's purchase of Bank of America preferred shares in the amount of $5 billion.

Bank of America has a need to raise about $100 billion and has approximately $50 billion in overvaluation of its second loans as well as other mortgage and mortgage related legal exposure.  Like Yves Smith at naked capitalism, I have no love for Bank of America, because it is too big, systemically dangerous, and needs to shed the risks of combined commercial banking and investment banking activities.  I have asserted, that since the global financial crisis, U. S. banks have been allowed legally to present public accounting statements which, if presented by any other U. S. business entity, would be considered fraudulent.  It has recently been selling business segment, such as its Canadian credit card business, and other assets to raise money.

I have indicated when discussing European banks, and it holds true for all banks globally and in the U.S., that the recent market downturn has reduced bank stock prices and bank equity, which puts pressure on them to raise money to maintain Tier I and Basel III liquidity ratios.  Bank of America's stock has declined steadily from 1/14/2011 at $15.25 to $6.42 on 8/23 and then rose to $7.76 on 8/26 with the Buffett deal.


If you compare the Goldman Sachs deal Buffet made with this Bank of America deal, you will find it is not as good as the Goldman Sachs deal.  Both were for $5 billion in preferred shares, but the Goldman dividend was 10% while Bank of America is paying 6% (8% accumulation if it suspends dividend payments); Bank of America is callable at a 5% premium while the Goldman Sachs shares were redeemable at a 10% premium; with Goldman Buffet received $5 billion in common share warrants with a strike of $115 and exercisable over five years while Bank of America gave Buffett 700,000,000 warrants for common shares with a exercise price of $7142857 ($5 billion) for a seven year period.  Some sources have characterized this as a $3 billion gift to Buffett from Bank of America, but the correctly calculated amount of the gift is $1.435 billion with the total value of the assets received at $6.45 billion.  Buffett extracted a substantial "fee" from Bank of America. Warren Buffett got a 22.5% discount on total value.

Bank of America preference share class x (Tier 1 equity) had a 7% coupon and was trading at $21 with a $25 par value on the day of this deal for an 8.3% yield.  Buffett's Bank of America preferred shares are Tier 2 debt/loss reserves and should have had a market yield of 9%; he is getting 6%.  At the time of the deal Bank of America shares were $6.88 and his exercise on the warrants were higher at $7.14 rounded.  Linus Wilson, a finance professor, has calculated the market value of the warrants to be $3.17 billion and would be dilutive, of course, of common shares outstanding if exercised.

Since Bank of America needs to raise $100 billion or more, if this deal brings the Buffett imprimatur to Bank of America, it could able to lower financing costs.  If their financing costs would be70 basis points lower, it would save $1.4 billion.

With Goldman Sachs, Buffett took the deal on the fixed side and with Bank of America he is taking it on the equity side.  Does this make Bank of America an attractive stock?  There are hedge funds and mutual funds betting that Bank of America will never be allowed to fail and they are presently losing money.  If eurozone banks develop serious liquidity problems and eurozone austerity dries up the European economy with global ramifications as the U.S. economy continues to slow down with continuing high unemployment, because U.S. political leaders refuse to provide fiscal policy to stimulate aggregate demand, then the global, and that includes the United States, economy is going to contract and stay contracted for a significant period of time.  If that serious economic decline begins to manifest itself, one of the early signs will be bank liquidity stress.

This is not a market for individual investors to be in individual stocks.  Even mutual funds with high financial exposure should be evaluated for the risk of their investments and role within a given portfolio.  This is a time for a well diversified mutual fund portfolio individually consistent with age, assets, risk tolerance, income needs, and affordable quality of life.  All of the big banks are facing headwinds.

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Uncertainty and European Bank Risks

The stress of the global financial crisis continue to haunt European banks as the economy continues to slow and bond vigilantes target sovereign debt of countries (such as the countries of the eurozone) who do not have their own fiat money.  The emergency lending facilities of the ECB have become more important for many European banks. On last Monday, banks deposited 128.7 billion euro with the ECB and borrowed 555 million euro overnight from the ECB Marginal Lending Facility, which was up from 90 million the prior day.  As Greek default becomes more inevitable and other eurozone countries struggle with sovereign debt financing, the interbank lending market has shown increasing stress as the skepticism about bank liquidity throughout Europe grows.  On Tuesday, European banks borrowed 2.82 billion euro overnight from the ECB, despite the stigma attached to the Marginal Lending Facility.

As the result of increasingly perceived risk by investors, European banks will pay more for the $100 billion of cash they need to raise by the end of the year.  Banks are hoarding cash, depositing it with the ECB, rather than lend it to other banks as political leaders squabble and preach deficit reduction which will only slow the economy faster.  Credit Agricol, with significant Greek exposure, posted profits which beat forecasts and felt compelled to complain about unjustified market irrationality and volatility.  A Bundesbank board member stressed in public comments that recent dollar money market tensions were far from the 2008 crisis levels and European banks are not facing a funding crisis as the result of U.S. money market funds becoming more selective to whom they lend.  The Bundesbank board member emphasized the liquidity available through repos and the ECB's readiness to mitigate problems with the swap agreement with the Fed. On Thursday, the Greek central bank (Bank of Greece) announced it had activated an Emergency Liquidity Assistance program to insure liquidity funding and all small, medium, and large Greek banks, except the National Bank of Greece, have indicated they will participate.  A Fitch survey of U.S. money funds showed a 9% decreased exposure to Europe last month and significant caution with respect to Italy and Spain.  Bankers have estimated that Italy lost $40 billion worth of money market funding in July.  While these figures are miniscule compared to the 8000 billion euro funding of the 91 eurozone banks, it does show the true state and reliance of eurozone banks on short term funding with some 58% of that funding needing to rolled over in two years and 47% in less than one year, but the official line is that there is nothing really wrong with the eurozone banks.

Today, Christine Lagarde of the International Monetary Fund, in a speech at Jackson Hole, said that European banks may need urgent forced capital injections to stem the eurozone's sovereign and financial crisis as they must be strong enough, in her words, to withstand the risks of sovereigns and weak growth.  She indicated that while private funding should be the priority, public funding, perhaps through the EFSF, should be ready.  She emphasized the IMF's change from immediate fiscal tightening to fiscal programs which allow spending to continue now while economies stay weak and reduce deficits over the long term.  This speech occurred at the same time as the second and third largest Greek banks announced an all share merger to be followed with a 500 million euro capital injection.

This IMF changed emphasis which acknowledges the need for public spending to feed growth during periods of declining aggregate demand is a refreshing change from the 1997 austerity mistake the IMF imposed on Japan which stifled growth.  Eurozone banks will remain key indicators in a global economy which is slowing down and economic contraction which eurozone austerity has accelerated.

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Radio Appearance Discussing Global Economy

On Saturday, August 20th, I was a guest on Saturday Session with Bishop on WMAY and streaming live to discuss the global economy.  The conversation focused more on China and the United States and briefly touched on Europe, which is a larger and more looming problem, due to time constraints.  I am providing a MP3 link to the interview appearance.  It is all about growth globally and jobs in the United States and several eurozone countries.

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Does High Frequency Trading Stoke Volatility?

There is a lot of speculation in the financial media and among individual citizen traders about whether high frequency trading is responsible for market volatility because it ignores fundamental analysis for data trends.  Obviously, high frequency trading could increase trading volume and accelerate market trend through volume.  While the sheer volume and speed can effect prices and there has been speculation that a high frequency trader could, and maybe has from time to time, driven an equity or futures price up on sells and buys to itself, the real question is the fairness of access.  All high frequency traders have direct access to the market through broker-dealers making trades in nanoseconds, causing the question to be raised whether they have the proper structure to insure proper margins and other technical regulatory safeguards.  Since a single high frequency trader could send a million or more messages a day to a market with few trades, the cost to the stock exchanges for adequate data networks is very expensive.  Individual traders do not have direct access to the market and must meet all regulatory conditions as do broker-dealers who have direct access to the market.  The bottom line question is, consequently, one of fairness.  Do individual traders get speedy market execution and a fair market price? 

The Review of Futures Market has a special issue (Volume 19)of which the first article reviews the research literature and methodologies on high frequency trading and the last article is on the effect of high frequency trading in the futures market.  The first study finds high frequency trading is a natural evolution of the trading process, add "quality" to the market through added liquidity, lower trading prices, and reducing bid-ask spreads at the cost of shifting profits, however small on individual trades, through trading volume, only pose a modest manipulative threat because they typically do not hold positions overnight, and only present a problem when they withdraw liquidity from the market causing system breakdown or cascading.  The study suggests the need to design electronic trading systems and to slow or interrupt trading and/or change the trading mechanism.  The last study finds that high frequency trading increases liquidity in the futures market.

Individual investors would be wise to not spending time researching and fretting about the effect of high frequency trading on equity prices and concentrate on the technical and fundamental information of the equity and the market.  You never fight the market and individual investors need a very profound analytical and economic reason to be in individual stocks during a market correction.  Consequently, individual investors would be wise to pay attention to not just price movement of the equity and the market, but the volumes.  This market is not only in correction but it has been testing March lows for the last two weeks with temporary reflexive rallies of short duration.  A week ago last Monday, Monday the 15th, was the fourth market day in successively lower trading volume (down 16.6% that day) even though it went up 213.88 on the DOW.  The next day was down in price but up only 6.1% in volume.  The next day was up marginally on 14.6% down volume.  Thursday of that week it went down 419.63 on up volume of 63.5%.  Monday of this week (22nd) the DOW was up only 37.00 on down volume of 20.4%.  On Tuesday it was up 322.11 on only 1.7% up volume.  On Wednesday, the DOW was up 143.95 but on down volume of 8.5%.  All of these days of trading have been volatile.  The likelihood that today would be a down price day with up volume would have been a reasonable bet and, in fact, that is what is occurring at this time.  By watching price, volume, and economic news, which means knowing what economic reports are coming out on what days not just event news, the individual investor should have some reasonable trend indication which will serve them well as they stay out of individual stocks during any correction and research stocks to buy when the market trends up for more than a short reflexive rally. 

Pay attention to technical and fundamental information on both the equities you are researching and the market itself.  You can control your buy and sell decisions and learn from them.  You cannot make yourself a better trader by researching the effects of high frequency trading.

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Gold is Correcting

When Gold hit a record $1917 an ounce this week, which was up 16% from earlier this month, trend profit taking set in creating a market correction and gold has been dropping.  The Shanghai Gold Exchange on Tuesday raised gold margins by 26% and the CME in the United States on Thursday raised gold margins 22%, both of which undoubtedly created margin calls and more selling.  Professional traders have learned and practice profit harvesting in which they reduce positions to capture and lock in gains over 20%, depending on the market and position, and definitely when they have substantial gains, such as 100%.  Even private investors who have gold at $400 or $800 basis should have been reducing their positions to no less than their original investment to lock in profits.  Gold is a crisis hedge and has been going up accordingly.  With the continuing crisis in the eurozone and the determination of eurozone leaders to pursue austerity which will only increase and magnify the problems slowing growth in Europe and globally, gold will stop its downward moves on economic news perceived negatively and start back up.  What one wants to avoid is the historically documented reversals of gold from highs to prior lows such as $400 and $800.

Some have characterized this correction in gold prices to panic selling, because it was overbought, and to fears the FED will not satisfy the market with comments on Friday from the Jackson Hole economic discussion meeting, which is reaching for causation since the FED has little it could announce from such an academic exercise.  With the margins being raised, we are seeing the same market correction silver saw in May.  It was time then to sell silver and it is time now to sell gold and harvest profits.
Dennis Gartman of the Gartman Letter was one of the professional trading advisors who began cutting their gold holdings on Tuesday when gold got "frothy" at $1910. On the same day, Nouriel Roubini was sending messages that gold was in a hyperbolic bubble, which implies a possible correction, although he also acknowledged, as I stated above, that uncertainty is rising and gold should consequently continue upward after a correction.  It does not appear that any gold correction will burst the bubble given the uncertainty in Europe and slowing global growth which will make the economies of Europe worse faster, but it will briefly reduce the size of the bubble as the professional and smart traders lock up their profits.



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European Bank Liquidity

Starting last week we started seeing questions surfacing regarding the liquidity needs of European banks as a result of the volatile swings in the stock markets (if bank stock equity goes down they face the need to raise more capital) and potential opening market attacks on French banks (which I find hard to believe resulted from misinterpretation of a fictional series in a French newspaper). On August 10th, ECB overnight lending facility use jumped $5.75 billion dollars (4.058 billion euro), although it could have been from timing issues as banks awaited the arrival of ECB six month funds.  It was noted last week that the LIBOR-OIS (bank credit risk) spread with EURUSD basis swaps was widening but differently than it did in 2008.  The LIBOR-OIS was due to a rise in the LIBOR which would indicate the gap is being driven by liquidity measures, but the EURUSD basis swap was increasing on the short end implying near term caution rather than systemic risk.  Short term wholesale funding problems are magnified when access to long term funding in senior unsecured debt markets become more independently difficult for banks.  Nomura  noted the net stable funding ratio shows CASA, SocGen, Bankia, UniCredit, Commerzbank, and Intesa with the lowest ratios, but no European banks have reserve problems and, as of last week, no European bank had gone to the ECB for USD liquidity.  In relation to the short term liquidity functions last week, it also appeared that the peripheral eurozone countries were having a collateral crunch as well as a credit crunch.

Yves Smith at naked capitalism noted this week that mid-tier banks are finding it harder to get funding in interbank markets, that five year CDS of eurobanks are trading wider than they did in 2008m U.S> money market funds have cut back on exposure to European banks, eurobanks are have a harder time borrowing euro from the ECB to swap for US dollars, and the eurozone is not prepared for any large scale recapitalization of banks program.

On Wednesday of this week, one European bank borrowed $500 million, which was an unusually large amount for one bank, from the ECB in US dollar liquidity for the first time since February.  This would indicate it was probably a larger European bank under temporary stress.

Today, the Wall Street Journal wrote that the New York FED is meeting with the U.S. offices of large European banks to gauge their vulnerability to to escalating financial conditions and potential funding difficulties as U.S. branches of foreign banks became net borrowers of dollars from their overseas affiliates for the first time in a decade.  The New York FED President, Dudley, was quick to publicly state this was just a standard FED review.

On this Wednesday, excess liquidity in money markets actually rose 167 billion euro as Euribor lending rates went down.

This has led to a renewed discussion, involving nerves, noise and funding fears, of what level of funding stress European banks may or may not be facing.  While there are indications of stress in the wider markets, the spread on the three month Euribor rate and the overnight  index swap OIS rates has widen but nowhere near the post-Lehman 2008 peak.  What is interesting is the spike is from a drop in the OIS rate not the Euribor, which implies banks think the swap rates will drop and liquidity improve.  This would indicate the situation is not one of extreme stress, but an evolving situation which requires watching.

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