Whether we are talking about individual stocks, the stock market, or the economy, when you’re wrong just admit it and then move on. The goal is to make money, not to be right 100% of the time so you can stroke your ego.
AM TV and Peter Schiff predicted that the Federal Reserve could not stop their monthly QE injections into the economy. Even though the Fed kept cutting the monthly injection all the way down to zero, alternative media outlets AM TV and Peter Schiff kept saying the Fed wouldn’t stop the monthly infusions because they couldn’t as the patient (the economy) would die. Peter Schiff then went on to say that the Fed was not going to hike rates in December 2015 but instead actually cut rates. The Fed increased rates a quarter point right on schedule. For all of 2016, Peter Schiff has been saying that the Fed isn’t going to hike rates again but instead reverse course and lower rates. In December of 2016, the Fed will likely increase rates another quarter point.
Most alternative media outfits think they have to be crazed perma-bears to get viewers. Maybe they do. Rather than AM TV and Peter Schiff admitting they were wrong about the Federal Reserve, they double down on their wrong predictions and do another “interview” together, check it out.
There are some really good points in this interview, don’t get me wrong. However, to be a successful traders and investor, you can never be a perma-bear. You can never be a perma-bull. You have to adapt and respond to market conditions. That adaptation means you have to be willing to admit when you’re wrong and then to just move on.
As traders, we track the monthly Employment Situation report closely. The market often does a short-term move on the first Friday of every month when the Employment Situation report for the previous month is released. Do you understand what the Employment report is showing? I bet many traders do not. As traders, we have to know a bit of macroeconomics, so we don’t make the wrong decisions with our money. Let’s briefly look at what the Employment Situation report shows.
There are different types of unemployment. When we talk about unemployment, most traders default to what is called cyclical or demand deficient unemployment.
Cyclical unemployment exists when individuals lose their jobs as a result of a downturn in aggregate demand (AD). If the decline in aggregate demand is persistent, and the unemployment long-term, it is called either demand deficient, general, or Keynesian unemployment. Demand deficient unemployment is caused by a lack of aggregate demand, with insufficient demand to generate full employment. Demand deficient unemployment shifts the AD curve left (inward) from AD to AD1.
GDP contracts from Y to Y1 and wages fall from P to P1. If wages “stick” at P rather than fall to the new equilibrium wage of P1 following a shift of demand, the result will be a much greater unemployment equal to Y – Y2.
Frictional unemployment is not caused by a reduction in aggregate demand. Frictional unemployment is due to people being in the process of moving from one job to another. The time, energy and monetary cost of searching for a new job is called friction. Friction is an unavoidable aspect of the job search process. Friction is a natural part of seeking new employment, but friction is typically short-term.
When most traders get the monthly Employment Situation report data of something like 150K jobs created in October, they don’t realize that those are net changes. What actually happened is that there are around 5 million new hires during the month, and 4.85 million new separations (quits or layoffs). The number you hear about each month is the net number or the difference between new hires and new separations. The net number is misleading. The net number hides the vast amount of job change which is happening.
Every month millions of people quit their jobs to get a new job. Some go back to school for more training and some retire. Other people start new jobs after graduating or finding new opportunities. This all leads to frictional unemployment and it’s a healthy part of a dynamic economy.
The less volatile sticky CPI confirms the uptrend.
ObamaCare has exploded the cost of medical care higher.
Medical care commodities, which are prescription and non-prescription medications, have exploded higher.
Inflation is finally trending higher which is what the Federal Reserve has been trying to engineer for years through monetary policy. The WSJ writes…
Fed Chairwoman Janet Yellen herself said last week that letting the economy run hot for a while might have some benefits… None of this is enough to take a rate increase at the Fed’s December meeting off the table. But it does mean that, even as prices pick up, further rate increases will be slow to come. Investors accustomed to inflation running below the Fed’s target may be in for some retraining.
Folks, this is another reason why we need to start getting more bullish on the stock market as we head into November and the start of the best six months of the year. Remember, a big part of the bearish scenario was a slowing US economy pressured downward by deflation as a result of Saudi Arabia destroying our shale oil industry. Lots of good jobs were lost and replaced by lower paying service sector ones as a massive wave of disinflation hit our economy. The latest inflation numbers suggest that the worst is behind us as the price of oil is in a slow fade upward, and more oil rigs are brought back online as evidenced by the upward trend on the weekly Baker Huges rig count.
All traders are watching this earnings season closely to see if the falling earnings streak is over. That’s the confirmation data point that is needed. In an inflationary environment, businesses are raising prices to keep up with the growing demand from a strengthening consumer. Traders want confirmation that the inflation we are now seeing is signaling a bottom in the earnings recession we have been in since Q1 of 2015.
Looking at the aggregate supply (AS), aggregate demand (AD) model, we can see where the US economy is currently at in the economic cycle. It is critical that traders and investors understand where we are at in the business cycle so as to be in on the right side of the trade. Timing Bull/Bear cycles and sector rotation is a critical skill for traders.
Stage 1: The economy is at full employment, Q1 where AS1 (aggregate supply) intersects AD1 (aggregate demand) at a price of P1.
Stage 2: The Great Recession hit causing a demand shock, shifting the aggregate demand back to AD2. Consumers reduce their spending and businesses reduce their investment. The new equilibrium is a recessionary output of Q2 at a price of P1. And the result is a recessionary gap equal to Q1 minus Q2.
The Great Recession had a wicked negative feedback loop or multiplier effect.
In the graph above, phase one is an aggregate demand shock, which leads to $100 billion in unsold goods from a reduction in aggregate demand. In phase two, this leads to a cutback in employment and wages. While in phase three, this leads to a reduction in income. Now assuming a marginal propensity to consume of 0.75, we see a reduction in consumption of $75 billion in phase four. This triggers a cutback in sales and further cutbacks in employment, and the process continues to go around in a negative feedback loop.
Stage 3: Wages, prices, and interest rates fall, as a result of the recession. This causes aggregate demand (AD) to move downward, along the aggregate demand (AD) curve.
At the same time, the supply curve (AS) shifts out to AS2, as firms hire more workers, and expand output. Together, these price and wage adjustments drive the economy back to full employment at Q1 and close the recessionary gap, but at a new and lower price of P2.
We are currently at Stage 3 where the trouble is that aggregate demand (AD) is not increasing at a fast enough pace.
Increases in government regulation, taxes, and ObamaCare on businesses, shifts the AS curve inward and thus reduces AD.
The Federal Reserve’s goal of QE was to increase AD.
The figure above shows how an expansion of the supply of money causes a rightward shift of the aggregate demand curve from AD to AD prime. Note that in the range of this shift; the aggregate supply curve is relatively flat. This Keynesian range reflects the presence of unemployed resources and recessionary forces. In this region, we get a very small increase in the price level from the Federal Reserve’s expansionary monetary policy and a large increase in real GDP as equilibrium moves from E to E prime. This is exactly what we saw with the larger increases in GDP in 2010 through 2012.
The Fed decided to expand the economy even further and tried to push the aggregate demand out even more to E double prime. This is well past the economies level of potential output or potential GDP. Here, the slope of the aggregate supply curve turns steeply upward. In this fully employed economy, the higher money stock would be chasing the same amount of output so that the major impact of the Fed’s expansionary policy would be to significantly raise the price level, with little increase in real GDP and this is where we are currently at in the economy.
The next stage is that the Federal Reserve wants to see the price level (CPI, PPI) rise which would indicate the time to raise interest rates. We are starting to see the CPI and PPI move higher. I think this is largely from the recent rise in the price of oil. The move higher in the CPI and PPI would have happened a year ago if it were not for the crash in the price of oil which caused disinflation. The process of the Fed raising interest rates is as follows.
The Fed reduces reserves R, through open market operations which causes the money supply M to contract, and interest rates I, to rise. In the GDP formula (GDP = C + I + G + (Exports – Imports), this interest rate rise, not only reduces investment I, but it also reduces consumption expenditure C and net exports. The cumulative effects of a fall in I, C and exports are to push aggregate expenditures or aggregate demand down in doing so real GDP and inflation likewise go down, thereby achieving the desired policy goal.
Source: A special thanks to Dr. Peter Navarro, Professor, Paul Merage School of Business, University of California for which this article would not be possible. Go here to find out more about my favorite economics professor.
Falling profit margins typically precede a recession. Last week, the Bureau of Economic Analysis released the latest profit margin numbers that clearly point to an oncoming recession.
Notice how the last two recessions (shaded areas) came within six months of a -20% change from a year ago (red line). The only thing that is different this business cycle is the record low-interest rate. In other words, low-interest rates are what is propping up the economy right now. Not exactly a revelation but something you should watch carefully. If the Federal Reserve hikes rates too soon, we could go into a recession quickly.
Democrats do not want Yellen to raise interest rates before the election. Barney Frank recently told the Fed board not to risk destabilizing markets and perhaps the broader economy before the Presidential Election. The Federal Reserve is supposed to be independent and politically neutral in their rate hike decisions.
Why are Democrats so afraid? Hillary Clinton and Democrats are bragging about how much Obama improved the U.S. economy and how strong it is now. Are Democrats so scared of a little quarter point rate hike because they know how hollow the “Obama recovery” really is?
The U.S. government is pulling out all the stops on the idea that consumers are strengthening, and that GDP will surge higher in the second half of 2016.
Below is the latest Real Personal Consumption Expenditures released on Monday.
Personal income also continues to grow…
Growing real personal consumption and income has led to an upward revision in Q3 GDP…
If the economy is going to strengthen by so much in Q3, why hasn’t the Fed raised interest rates? A whopping six years after the Great Recession supposedly ended, why are rates still at emergency low levels?
Traders have been lied to for so many years by the U.S. government, the Federal Reserve, and Wall Street, nobody knows what to believe anymore. For example, every year Wall Street analysts and the Federal Reserve do a rain dance in the mainstream media to the tune that the economy will strengthen in the second half of the year. It has not happened.
We have five consecutive quarters of falling earnings. How can the economy be strengthening when sales and hence earnings are falling for most S&P 500 companies?
There is so much dishonesty going on about the fundamentals of the U.S. economy that I prefer to weight my analysis more on technicals. Fundamentals are what the “smart money” is saying. Technicals are what the “smart money” is doing.
The real GDP per capita shows just how rocky and unstable the U.S. economy continues to be since the Great Recession.
Most stock traders know what real GDP per capita is, but let’s quickly review for anyone who doesn’t.
GDP is the market value of all finished goods and services, produced within a country in a year. There is nominal GDP and real GDP. Nominal GDP is a mirage because it’s calculated based on the dollar amount of finished goods and services. Inflation, the difference between a loaf of bread at $0.25 in 1970 and $2 in 2016, skews GDP. According to GDP or nominal GDP, if the entire economy consisted of that one loaf of bread, then GDP grew by eight times or 800% between 1970 and 2016. That’s not right because the same one loaf of bread was produced and sold so the GDP should show zero growth.
Real GDP attempts to remove the inflation mirage by using a fixed set of prices, such as the prices from 2009, to calculate GDP.
The other skewing factor of GDP is population. There are a lot more people today than in 1950. To remove the skewing effects of the population from GDP, we can divide GDP per person or per capita.
Below is a chart of real GDP per capita.
The grey areas on the chart above mark past recessions. Notice that whenever the percentage change from a year ago (Y axis) falls below zero, there is a recession. Real GDP per capita declines during recessions. Now let’s zoom in on the chart above so you can better see the terrifying reality of the economic recovery after the Great Recession.
The shocking truth is that the U.S. economy has almost gone into a recession twice since the Great Recession. In Q3 2011, the percentage change year over year (PCYOY) of real GDP per capita dropped to 0.419% narrowly avoiding a recession. In Q2 2013, the PCYOY fell to 0.306% just narrowly avoiding a recession once again. We are currently on a move down that began in Q1 2015 with declining earnings of S&P 500 companies. Whether the zero line holds, this time, remains to be seen.
The mainstream media and the Federal Reserve have woven a tale of economic improvement since the Great Recession that is completely absent of the fact that the U.S. economy has almost gone into a recession twice since the recovery began. Worse, the GDP has been contracting since the beginning of 2015, and we are currently heading for another test of the zero line. Perhaps the mainstream media and Federal Reserve think that the public doesn’t need to be spooked by this reality. However, as amateur stock traders and investors, we need to know just how unstable the economy is.
Deutsche Bank may be on the verge of collapse. Last week Deutsche Bank reported Q2 2016 earnings of 20 million euros which is a 98% drop in earnings year-over-year.
In 2015, Deutsche Bank announced its first full year of loss since the 2008 recession.
Deutsche Bank’s stock is down -60% over the last year meaning that the bank is close to collapse.
Deutsche Bank’s shares now trade for two-thirds less than their tangible book value, a steeper discount than even during the depths of the financial crisis.
Beyond Germany, few stock traders care if Deutsche Bank collapses. The problem with Deutsche Bank collapsing is its enormous derivatives portfolio valued at 42 trillion euros! To put in perspective, the entire EU (all 28 member states) has an estimated GDP value of 14.3 trillion. Deutsche Bank’s 42 trillion euro derivatives portfolio is about three times the size of the entire EU!
One might think that with such a high exposure to the derivatives market, Deutsche Bank would have already collapsed. The reason Deutsche Bank has not collapsed is because of something called netting. For every derivative position Deutsche Bank holds, they hold another position in the opposite direction, so they roughly cancel each other out. At least that’s what Deutsche Bank is reporting that they are doing. Whether that is true or not remains to be seen. Why would anyone hedge their longs with shorts in a 1:1 ratio? You would never make any money from trading, and you would slowly lose on slippage. The OCC tracks netting on U.S. banks and does, in fact, show that even with netting, net current credit exposure (NCCE) has been rising rapidly since 2014.
When Deutsche Bank collapses, it is going to be the explosion heard around the world, and it will be a disaster many times greater than the collapse of Lehman Brothers in 2008.
US Derivatives Exposure
The big U.S. banks have higher exposures to derivatives than Deutsche Bank. As of June 30, 2016, below are U.S. banks with the largest derivative exposures.
Citigroup has amassed the largest stockpile of interest-rate swaps as they bet on central bank rate changes.
Five U.S. banks hold 93% of all derivatives: Citigroup, JPMorgan Chase, Goldman Sachs, Bank of America, and Morgan Stanley. The total value of these derivatives is $247 trillion (notional).
Morgan Stanley has $31 trillion in derivatives with $1.6 trillion (notional) in credit derivatives. What is scary is that Morgan Stanley is back to speculating in the same credit derivatives market that took down AIG in 2008. I don’t think Morgan Stanley necessarily wants to speculate in credit derivatives but with revenue flat the last few years, they may be getting more desperate to prop up their stock price. Morgan Stanley’s stock is down more than -25% over the last year.
Most traders in the U.S. don’t care about Morgan Stanley’s risky credit derivatives portfolio, but they should. Morgan Stanley has more than 15,770 retail brokers managing $404 billion of other people’s money (mom and pop savings, retirees, pensions, retirement accounts, etc.cause). Morgan Stanley’s risky credit derivatives position poses a huge threat to the investing community in my opinion.
Banks and Financial Firms Will Not Disclose Information Until It’s Too Late
If you are waiting for banks and financial firms to disclose risks and even how much they were bailed out from the last time they made risky credit derivative bets, don’t.
To survive the 2007-2009 Wall Street crash, Morgan Stanley received an injection of $9 billion from the Japanese bank, Mitsubishi UFJ Financial Group; a $10 billion injection from the U.S. government and over $2 trillion in secret, cumulative, below-market-rate loans from the Federal Reserve. According to data obtained by Bloomberg News following a multi-year court battle to obtain the information from the Federal Reserve, Morgan Stanley’s one-day secret outstanding loans from the Fed peaked at $107.3 billion on September 29, 2008.
The public would have never known about these secret loans shoring up Wall Street’s reckless conduct and hubris and obscene bonuses except for the court battle of Bloomberg News and legislation secured by Senator Bernie Sanders of Vermont requiring a Fed accounting.
Credit Derivatives Exposure On the Rise In the US
The Office of the Comptroller of the Currency reports some scary facts in their most recent quarterly OCC report.
– Insured U.S. commercial banks and savings associations reported trading revenue of $5.8 billion in the first quarter of 2016… $1.9 billion lower (24.9 percent) than a year earlier. [In my opinion, when trading revenues are down, trading divisions take on more risks in a desperate attempt to meet quotas like buying riskier credit derivatives as the data points below confirm].
– Credit exposure from derivatives increased in the first quarter of 2016. Net current credit exposure (NCCE) increased $65.1 billion, or 16.5 percent, to $460.1 billion.
– Notional derivatives increased $12.0 trillion, or 6.6 percent, to $192.9 trillion.
– Derivative contracts remained concentrated in interest rate products, which represented 76.3 percent of total derivative notional amounts.
Measuring credit exposure in derivative contracts involves identifying those contracts where a bank would lose value if the counterparty to a contract defaulted. The total of all contracts with positive value (i.e., derivative receivables) to the bank is the gross positive fair value (GPFV) and represents an initial measurement of credit exposure. The total of all contracts with negative value (i.e., derivative payables) to the bank is the gross negative fair value (GNFV) and represents a measurement of the exposure the bank poses to its counterparties.
GPFV increased by $0.8 trillion (26.6 percent) in the first quarter of 2016 to $3.8 trillion, driven by a 29.9 percent increase in receivables from interest rate and FX contracts. Because interest rate contracts make up 76.2 percent of total notional derivative contracts, changes in interest rates drive credit exposure in derivative portfolios. Declines in interest rates tend to increase exposure. This effect has increased in recent years, as the maturity profile of interest rate derivatives has increased, making credit exposure more sensitive to changes in longer-term rates.
Credit risk exposure increased a whopping 26.6% in Q1 2016. Much of that increased credit risk exposure is coming from bets on Federal Reserve rate hikes. If interest rates go up, credit risk exposure in derivative positions goes down. If interest rates go down, credit risk exposure goes up. In other words, most of the bets in the derivatives market are on interest rates rising. Better hope Janet Yellen doesn’t have to lower interest rates!
Credit Default Swaps Dwarf All Other Forms of Derivatives
Credit default swaps dwarf any other form of credit derivative trading.
The notional amount for the 54 insured U.S. commercial banks and savings associations that sold credit protection (i.e., assumed credit risk) was $3.6 trillion, up $206.4 billion (6.0 percent) from the fourth quarter of 2015. The notional amount for the 50 banks that purchased credit protection (i.e., hedged credit risk) was $3.8 trillion, $224.9 billion higher (6.3 percent) than in
the fourth quarter of 2015.
It is interesting that many people are reporting having received a letter from their credit card company informing them that their interest rate is going up from 19.9% to 25% in August 2016. Some people have even reported receiving credit limit increase letters too. How kind of these bankers to go long credit default swaps while raising your credit limit and interest rate to insane levels at the same time.
Folks derivatives are dark financial products that cause excessive risk taking that ultimately leads to disaster. I have little doubt that the next global financial crisis will, at its core, once again involve speculative derivatives betting.
The yield curve continues to flatten at an alarming rate. The spread between the two years and the 30-year bond is the lowest since 2008.
In a note to clients, Deutsche Bank writes…
Since the UK referendum the US yield curve has flattened to new post-crisis lows… This relentless flattening of the curve is worrisome… the probability of a recession within the next 12 months has jumped to 60 percent, the highest it’s been since August 2008.
U.S. residential construction growth is grinding to a halt.
Even auto sales, which have been a bright spot for the U.S. economy for several years, are rapidly slowing.
Payroll growth has also dropped like a rock, and we await this Friday’s non-farm payrolls report update.
Do not panic folks. Deutsche Bank is saying that the odds of a recession are about the same as a coin-flip, 12 months from now.
The yield curve is still healthy.
Once the yield curve goes flat or even inverted, we usually have 3 to 6 months before a recession. The flat or inverted yield curve signal will give us plenty of time to react.
While the stock market could crash at any time between now and the end of October, a stock market crashing from a recession is an entirely different matter. Do not confuse a stock market crash with an economic downturn. A stock market crash could happen at any time and will come like a thief in the night. We will have plenty of time to react to a flat or inverted yield curve before the next economic recession.