Are Households Really Deleveraging? (excerpt)

The Fed’s flow of funds data provide some support for the notion that financial firms and households have been deleveraging. Of course, the full story is that mortgage borrowers, on balance, stopped borrowing during the current economic expansion. They stopped doing so for all sorts of reasons. Mortgage credit has become harder to obtain, and terms have been tightened. Until the past two years, falling home prices curbed buyers’ enthusiasm. When prices rebounded, as institutional investors piled into the housing market, affordability became an issue again, especially given the ongoing credit crunch in the mortgage market.

One of the big drags on home sales has been a dearth of first-time buyers because many people who might otherwise be buying their first homes have graduated from college with onerous student loans. These are included in nonrevolving consumer credit along with auto loans. This category rose to a record $2.3 trillion during April, with student loans accounting for roughly half of this total.

Large student debt burdens disqualify many young adults from getting mortgage loans, especially if they’ve been delinquent in their payments. Many of the individual loan balances are equivalent to the amount of down payment for the houses they might have bought but for their student debt burdens. That helps to explain the drop in the homeownership rate of adults under 35 years old from a record high of 43.6% during Q2-2004 to 36.2% during Q1-2014.

Today's Morning Briefing: Deleveraging Reality & Myth. (1) The long goodbye. (2) A 50% expansion. (3) The balance-sheet-recession theory. (4) Warsh and Druckenmiller weigh in. (5) Sympathy for the ideology, not its logic. (6) The deleveraging hypothesis also has some holes. (7) Financial sector has deleveraged and de-securitized. (8) Have households really deleveraged? It’s a complicated story. (9) Student debt depressing students and housing. (10) No shortage of nonfinancial business debt. (11) Leviathan lives on debt. (More for subscribers.)

Oil & Commodity Prices (excerpt)

The clear and present threat to the bull market is the current geopolitical crisis in the Middle East, specifically in Iraq. ISIS militants continue to extend their advance in the country. On Tuesday, Iraqi security forces fought fierce battles with the al Qaeda-linked group as both sides attempted to gain control of the country's largest oil refinery, which produces 300,000 bpd. The price of a barrel of Brent crude oil has risen from this year’s low of $104 to $114 on Wednesday.

Yesterday, I highlighted one of our charts, which shows the price of a barrel of Brent crude oil versus the CRB raw industrials spot price index. I observed: “When both indicators are rising together, that tends to signal that the global economy is growing. When they are both falling, the global economy is weakening. The ideal scenario is when oil prices are falling while the CRB is rising. A red flag goes up when rapidly rising oil prices depress industrial commodity prices, as may be happening now.” The CRB index is down 2.3% from its recent peak on May 12.

I average the two series to derive our YRI Global Growth Barometer. It isn’t sending a distress signal yet as the price of oil has increased more than the CRB index has dropped. In the past, it correctly signaled the global downturns and slowdowns during 2008, mid-2010, 2011, and early 2012. It has been relatively flat since then at a high level, confirming that the global economy is growing though at a lackluster pace.

Today's Morning Briefing: Early Warning Indicators. (1) There’s always something to worry about. (2) Clear and present danger is currently in Iraq. (3) Watching oil prices and commodity prices for hints of more trouble. (4) No distress signal yet. (5) A good sign: S&P 500 Energy stocks outperforming. (6) S&P 500 remains resilient, along with Transportation stocks. (7) Global oil demand at another record high, but growth is slow. (8) Crude oil demand falling in Europe and Japan, flattening in China, rising in India and Latin America, (9) Non-OPEC output at record high led by North American producers. (10) Can we manage without Iraq? (More for subscribers.)

Earnings Expectations Plummeting In Europe (excerpt)

Analysts’ consensus earnings expectations for the EMU continued to plummet through the week of June 19. The estimates for 2014 and 2015 are down 7.0% and 5.0% ytd. Forward earnings has been flat-lining for over a year and remains well below the 2007 record high and the last cyclical peak in early 2011. Forward earnings has been flat to down for all the major core and peripheral countries of the EMU since 2011.

The rebound in the EMU MSCI stock price index since the summer of 2011 has been all attributable to an 87% increase in the forward P/E from 7.6 to 14.2. The forward P/Es are especially elevated for the Eurozone’s peripheral countries. Here’s the latest forward P/E derby: Greece (32.4), Ireland (19.2), Portugal (19.1), Belgium (16.8), Finland (16.5), Spain (15.6), Netherlands (14.6), Italy (14.5), France (14.1), Germany (13.0), and Austria (11.6).

It’s the same story for the United Kingdom: Earnings estimates have been falling sharply for 2014 and 2015. Yet the UK MSCI stock index is back at its previous two cyclical peaks. The rally since the summer of 2011 was all led by a 68% increase in the forward P/E from 8.1 to 13.6.

Today's Morning Briefing: Global Earnings Derby. (1) US MSCI continues to outperform. (2) Forward earnings still rising to record highs in US. (3) Emerging markets have the best revenues profile. (4) Eurozone earnings expectations freefalling for 2014 and 2015. (5) Same goes for UK. (6) Europe isn’t cheap anymore. (7) Japan’s “third arrow” sparks P/E-led rally. (8) EM forward earnings still flat-lining. (9) Industrial commodity prices diverging from oil price. (10) Flash PMIs are mixed. (11) US economy is upbeat. (12) Abe shows his third arrow. (More for subscribers.)

Stock Buybacks Charge Up the Bull (excerpt)

The bull market in the S&P 500 since March 2009 has been marked by corporations buying back their shares and paying out dividends. From Q1-2009 through Q1-2014, S&P 500 companies repurchased $1.9 trillion of their shares and paid out $1.3 trillion in dividends. During the first quarter of this year, buybacks totaled $637 billion at an annual rate, nearly matching the previous record high during Q3-2007.

As I have often observed in the past, corporations have an incentive to borrow in the bond market and use the proceeds to buy back shares when their earnings yield exceeds the corporate bond yield. That’s been the case since 2004 thanks to the Fed’s easy monetary policies under both Alan Greenspan and Ben Bernanke, and now Janet Yellen.

Buybacks are a form of financial engineering since they boost earnings per share whether a company’s fundamentals are improving or not. They’ve certainly contributed to the bull market’s great run in an economic environment that has been widely described as “subpar.”

When the next recession hits, corporate cash flow will decline and investors are likely to be less willing to buy corporate bonds. As a result, buybacks will dry up as they did during 2008, exacerbating the eventual bear market in stocks.

Today's Morning Briefing: Zaitech. (1) A brief history of Zaitech. (2) Japan as a role model. (3) Bigger than ever. (4) History tends to repeat itself. (5) Buybacks are a form of financial engineering. (6) Bond funds are “shadow banks.” (7) Laing warns that ETFs are weapons of mass financial destruction. (8) Eurozone’s bond bubble. (9) JGBs at 0.6%. (10) China has excesses galore. (11) Reaching for yield in emerging markets. (12) No exit from NZIRP? (13) Janet Yellen and Bette Davis. (More for subscribers.)

The Fairy Godmother of the Bull Market (excerpt)

The Fairy Godmother of the Bull market did it again last week. Whenever Janet Yellen speaks publicly about monetary policy and the economy, stock prices tend to rise. On Wednesday, the S&P 500 climbed 0.8% to yet another new record high in response to her press conference that day. It rose 0.3% on Thursday and Friday to 1962.87. It would have to gain just 2.6% to reach my yearend target of 2014, which I am thinking about raising. However, a melt-up followed by a meltdown back to 2014 by the end of this year remains a distinct possibility.

Yellen’s pronouncements have tended to be bullish for stocks since she first took office as vice chair of the Board of Governors in October 2010. Now we can look forward to her quarterly press conferences as Fed chair, the position she assumed in February of this year. Of course, Fed policy has been ultra-easy since the start of the bull market, and stocks have also tended to rise after most FOMC meetings.

The stock market’s bulls were charged up last week by both the FOMC’s statement and Yellen’s spin on monetary policy. Consider the following:

(1) Unanimous. The latest statement was almost identical to the previous one on April 30. (See the WSJ’s Fed Statement Tracker.) Once again, the FOMC reaffirmed its NZIRP, or near-zero interest-rate policy:

The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.

Remarkably, the vote for the current policy stance was unanimous. No one dissented in favor of language suggesting that interest rates might have to be raised sooner given the ongoing improvement in the economy and the labor markets, as well as the recent rebound in inflation.

(2) Noisy inflation. Even more remarkable, when asked in her press conference about the recent inflation rebound, Yellen blew it off as noise. In her prepared remarks, she didn’t even acknowledge the recent broad-based upturn in inflation:

Inflation has continued to run below the Committee’s 2 percent objective, and the Committee remains mindful that inflation running persistently below its objective could pose risks to economic performance.

Last week, I noted that the core CPI, on an annualized three-month basis, rose from 1.4% during February to 1.8% during March to 2.2% during April to 2.8% during May. I expected some mention of this new inflation risk in the FOMC statement and Yellen’s press conference. Instead, it was like it never happened.

Indeed, Yellen’s response to the first question by CNBC’s Steve Liesman about the possibility that inflation might be on the verge of exceeding the FOMC’s 2016 target was bizarre:

So, I think recent readings on, for example, the CPI index have been a bit on the high side, but I think it's--the data that we're seeing is noisy. I think it's important to remember that broadly speaking, inflation is evolving in line with the committee's expectations. The committee has expected a gradual return in inflation toward its 2 percent objective. And I think the recent evidence we have seen, abstracting from the noise, suggests that we are moving back gradually over time toward our 2 percent objective and I see things roughly in line with where we expected inflation to be.

(3) Unemployment spin. In her prepared remarks, Yellen acknowledged that the labor market is improving, but accentuated the negatives rather than the positives:

The unemployment rate, at 6.3 percent, is four-tenths lower than at the time of our March meeting, and the broader U-6 measure--which includes marginally attached workers and those working part time but preferring full-time work--has fallen by a similar amount. Even given these declines, however, unemployment remains elevated, and a broader assessment of indicators suggests that underutilization in the labor market remains significant.

During the Q&A, Yellen added:

That said, many of my colleagues and I would see a portion of the decline in the unemployment rate as perhaps not representing a diminution of slack in the labor market. We have seen labor force participation rate decline.

She also noted that wage inflation is running around 2%, which is too low in her opinion. It’s barely keeping up with inflation and should be rising faster to reflect productivity. She is rooting for this to happen, and isn’t inclined to tighten monetary policy if and when it does.

(4) No thresholds. The Fed’s experiment with tying monetary policy to a specific threshold for two key indicators started at the December 11-12, 2012 meeting of the FOMC, when an unemployment rate of 6.5% was specified as the “threshold” for discussing raising interest rates as long as the inflation rate wasn’t still below 2%. The unemployment threshold was dropped at the March 18-19, 2014 meeting, the first one with Yellen as chair.

At her latest press conference, Yellen said that the FOMC has reverted to a fuzzier data-dependent approach:

In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This broad assessment will not hinge on any one or two indicators, but will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.

(5) No bubbles yet. Yellen said she sees some signs of speculative excesses, and she is monitoring the low pace of volatility in financial markets, a sign of complacency. However, so far, she doesn’t see a need for monetary policy to respond to these developments, thereby contributing to the markets’ complacency!

Here is what she had to say about volatility:

The FOMC has no target for what the right level of volatility should be. But to the extent that low levels of volatility may induce risk-taking behavior that for example entails excessive buildup in leverage or maturity extension, things that can pose risks to financial stability later on, that is a concern to me and to the committee.

More specifically, she believes that the level of risk-taking remains “moderate”:

Trends in leverage lending in the underwriting standards there, diminished risk spreads in lower-grade corporate bonds, high-yield bonds have certainly caught our attention. There is some evidence of reach for yield behavior. That's one of the reasons I mentioned that this environment of low volatility is very much on my radar screen and would be a concern to me if it prompted an increase in leverage or other kinds of risk-taking behavior that could unwind in a sharp way and provoke a sharp, for example, jump in interest rates. …But broadly speaking, if the question is: To what extent is monetary policy at this time being driven by financial stability concerns? I would say that--well, I would never take off the table that monetary policy should--could in some circumstances respond. I don't see them shaping monetary policy in an important way right now. I don't see a broad-based increase in leverage, rapid increase in credit growth or maturity transformation, the kinds of broad trends that would suggest to me that the level of financial stability risks has risen above a moderate level.

(6) Complacent valuations. With regards to stock market valuations, she remains relatively complacent:

So I don't have a sense--the committee doesn't try to gauge what is the right level of equity prices. But we do certainly monitor a number of different metrics that give us a feeling for where valuations are relative to things like earnings or dividends, and look at where these metrics stand in comparison with previous history to get a sense of whether or not we're moving to valuation levels that are outside of historical norms, and I still don't see that. I still don't see that for equity prices broadly.

(7) Uber dove. Fed policy remains data dependent. However, Yellen is likely to describe the data as “noisy,” and therefore irrelevant if the numbers don’t support her ultra-liberal assessment of the disappointing performance of the economy and her preference for maintaining ultra-easy monetary policy until all ex-cons are gainfully employed. I wish I was kidding.

In her 3/31 speech in Chicago, she briefly described the struggle of three workers in the Windy City--Dorine Poole, Jermaine Brownlee, and Vicki Lira--in the labor market. On April Fools’ Day, Jon Hilsenrath reported in the WSJ:

One person cited as an example of the hurdles faced by the long-term unemployed had a two-decade-old theft conviction. Another mentioned as an example of someone whose wages have dropped since the recession had a past drug conviction.

Hilsenrath also noted that a Fed spokeswoman said Yellen knew of the people's criminal backgrounds and that they were “very forthright” about it in conversations with the chairwoman before the speech!

During last week’s Q&A, Yellen confirmed that she remains one of the FOMC’s most dovish members when she said, “inflation continues to run well below our objective, and we're still some ways away from maximum employment and for the moment, I don't see any tradeoff whatsoever in achieving our two objectives. They both call for the same policy, namely a highly accommodative monetary policy.”

Thank you, Madam Fairy Godmother! Fairy tales can come true, especially for us bulls.

Today's Morning Briefing: Inflation Is Just “Noise.” (1) Bull is high on Yellen’s fairy dust. (2) When Yellen talks, investors listen and buy stocks. (3) FOMC statement reaffirms NZIRP. (4) In Yellen’s world, inflation isn’t heating up. (5) Liesman asks a good question. (6) Fed’s doves still see too much slack in labor market. (7) From thresholds to noisy data. (8) Fed has no target for volatility, while risk-taking remains “moderate.” (9) Fed is the source of markets’ complacency. (10) Uber dove wants more jobs for ex-cons. (11) Upbeat US economic indicators. (12) US MSCI still a global outperformer. (13) Fragile-5 morph into Fab-5. (More for subscribers.)

Oil & the Markets (excerpt)

The price of a barrel of Brent crude rose to $114 yesterday from a recent low of $104 on April 2. Rising oil prices can be a sign of global economic strength. Or else they can be caused by geopolitical crises that threaten to disrupt, or actually do disrupt, the supply of oil. In the latter scenario, rising oil prices can also cause a recession. Which way are the markets leaning right now? Consider the following:

(1) Industrial commodities. The current increase in the price of oil is obviously related to the turmoil in Iraq, and concerns that ISIS will disrupt the country’s oil production. As a result, the CRB raw industrials commodity spot price index has been falling recently. The price of gold hasn’t budged much, suggesting that the risks of higher inflation attributable to the recent rise in oil prices are offset by the risks of a recession.

(2) Stock prices. The S&P 500 was highly correlated with crude oil prices from 2008-2012. Since then, the two have decoupled, with stocks rising to new record highs since March 28, 2013, while the oil price has been moving sideways in a volatile range. The recent rise in oil prices hasn’t disturbed the S&P 500, which was back at a record high yesterday.

The S&P 500 Transportation index has also held up very well. It is down only 0.6% from its record high on June 9. Needless to say, the S&P 500 Energy sector has been boosted by the turmoil in Iraq. It is up 4.2% so far this month, and 10.9% ytd, the second best-performing sector of the S&P 500.

(3) The dollar. The trade-weighted dollar tends to be weak when oil prices are rising. Oil exporters may be diversifying some of their revenues into other currencies. In addition, if rising oil prices signal strong global economic growth, then investors may be seeking more opportunities outside of the US. Despite the recent increase in oil prices, the dollar has actually firmed a bit. This may indicate a mini flight to safety, especially since global economic growth remains subpar and vulnerable to an oil shock.

(4) Emerging markets. Rising oil prices should be bad news for emerging economies. However, the Emerging Markets MSCI has tended to be positively correlated with the price of Brent crude oil more often than not. That’s because when emerging economies are strong (weak), they tend to drive the price of oil up (down). The recent rise in oil prices hasn’t slowed the recent advance in the EM MSCI.

Today's Morning Briefing: The Plots Thicken. (1) Investors love Obama. (2) President’s critics say he is MIA. (3) Crises bring out the golfer in our President. (4) Disastrous consequences? (5) So why are stock prices up so much? (6) Are investors isolationists? (7) Why get in the middle of the Middle East’s Hatfields and McCoys? (8) So far, markets aren’t indicating that Iraqi turmoil will cause a recession. (9) Is the dot plot more information than we need from the Fed? (10) Focus on S&P 500 Energy sector, recently upgraded to market weight. (More for subscribers.)

Inflation Is Beating Expectations (excerpt)

Beating expectations recently has been the CPI inflation rate in the US. On a y/y basis, it rose to 2.1% during May, up from a recent low of 1.0% during October 2013. The core CPI inflation rate edged up to 2.0% from a recent low of 1.6% during February. That’s not much, but there was lots of buzz about it yesterday. Reflationists are starting to say, “we told you so.” Optimistic economists are saying that this confirms that economic growth is picking up since there is more pricing power. Pessimistic economists are warning that if price inflation continues to outpace wage inflation, eroding real incomes could depress the economy.

Where do I stand? I am in the middle, predicting that economic growth will stay moderate and that inflation will remain modest (or vice-versa). Admittedly, the core CPI inflation rate, on an annualized three-month basis, has been rising rapidly recently, from 1.4% in February to 1.8% in March to 2.2% in April to 2.8% in May.

Looking at the various components of the CPI shows that the recent flare-up in the core inflation rate has been relatively widespread. So there may be something to the reflation story, but we aren’t convinced just yet. In any event, we are feeling more comfortable with our 2.5%-3.0% range for the 10-year Treasury yield than we did on May 28 when the yield fell to the most recent low of 2.4%.

Meanwhile, the global inflation picture is mixed, but remains mostly subdued:

(1) OECD & G7. The core CPI inflation rate in the advanced economies of the OECD jumped to 2.0% y/y during April. It was just 1.4% a year ago. The same rate for the G7 major industrial economies also jumped to 1.8% from 1.2% a year ago.

(2) Eurozone. Of course, the Eurozone countries are in the OECD composite. Germany, France, and Italy are in the G7. Yet the region’s headline CPI inflation rate was only 0.5% in May. The core CPI inflation rate was only 0.7%.

(3) Emerging economies. The IMF tracks CPI headline inflation rates for both advanced and emerging economies. The former remained very low at 1.5% during April, while the latter edged up to 5.5% in March from 5.3% in February, with both rates the lowest since 2009.

Today's Morning Briefing: The Beat Goes On. (1) Forward earnings flying into the wild blue yonder. (2) Forward earnings is a great leading indicator except when it isn’t. (3) How mature is this expansion? (4) A striking difference. (5) Bears are going crazy over record-high profit margin. (6) Industry analysts doing it again. (7) Is inflation heating up in US? (8) Inflation is chilling in Eurozone. (More for subscribers.)

The UK Is Hot (excerpt)

The UK economy has been very strong of late, certainly much more so than the Eurozone’s economy. The pound has increased 9.8% relative to the euro since July 31, 2013. Almost a year ago when Mark Carney became the governor of the Bank of England (BOE), he suggested that the bank’s official interest rate would remain at 0.5% until 2016. Last week on Thursday, he changed his tune, thereby raising questions about the credibility of so-called “forward guidance” provided by central banks. He said that the first interest-rate hike “could happen sooner than markets currently expect.” Of course, by saying so, he changed expectations, with many BOE watchers now thinking that a rate hike will occur before the end of this year.

Carney’s main concern is that house prices are soaring. Carney said that this is “the greatest risk to the domestic economy." Chancellor of the Exchequer George Osborne agreed with this assessment in a speech at the same black-tie banquet for bankers and business leaders. He said that the BOE will have the authority to use “macroprudential policies” by limiting how much home buyers can borrow relative to their incomes and how much they can borrow as a proportion of a property's value.

Last Wednesday, the IMF launched “Global Housing Watch” in an effort to curb complacency among regulators and policymakers about housing bubbles. The IMF warned that the UK, Australia, Canada, and France have overheated housing markets. The US isn't currently on this watch list.

Carney is also concerned that labor markets are tightening, which could lead to higher wage and price inflation. So far, there isn’t much evidence of this happening. Average weekly earnings (including bonuses) was up just 0.7% y/y in April, while the CPI was up 1.8%. Nevertheless, the economy is hot, as evidenced by April’s 6.9% y/y increase in the volume of retail sales and the 4.4% rise in manufacturing output.

Today's Morning Briefing: Talking About Hiking Rates. (1) Talking the talk. (2) Less slack in UK and US? (3) BOE’s Carney changes forward guidance. (4) Macroprudential policies coming to UK housing market. (5) IMF says housing overheating in UK, Australia, Canada, and France. (6) Wage inflation remains low in UK. (7) Two camps on first rate hike at Fed. (8) Kuroda says BOJ doing enough, and Abe needs to do more. (9) Bank of Canada not doing much about housing bubble. (10) Stocks up, forward earnings down in UK. (11) Forward earnings looking toppy in Japan. (12) Weak loonie boosting forward earnings in Canada. (More for subscribers.)

Eurozone Recovery Remains Lackluster (excerpt)

The Eurozone’s PMIs and leading economic indicators continue to show a solid economic recovery in the region. The latter may be misleading because they’ve been boosted by rapidly rising stock prices, which have been fueled by the ECB’s ultra-easy monetary policies.

So far, such easing hasn’t provided all that much lift to the Eurozone’s industrial production. It did rise 0.8% during April, but that’s after it fell 0.4% the month before. On a y/y basis, it is up only 1.4%. The recovery is considerably stronger in Spain (4.3%), and slightly stronger in Germany (1.8) and Italy (1.6), but much weaker in France (-2.0).

Today's Morning Briefing: Something to Worry About? (1) Geopolitical crises that spike oil prices tend to lead recessions. (2) A serious threat to the bull or yet another relief rally? (3) Caliph al-Baghdadi is bad and meaner than a junk yard dog. (4) The end of complacency? (5) A dangerous situation in Iraq. (6) Oil prices didn’t spike on Libyan and Iranian output cuts. (7) Feuding Caliphates: ISIS vs. Iran. (8) Will Fed taper tapering if oil prices spike? (9) Upgrading S&P 500 Energy to market weight. (10) Happy indicators for S&P 500 revenues. (11) Q2 real GDP is looking up according to latest retail sales and inventories data. (12) Eurozone’s recovery remains lackluster. (More for subscribers.)

Whatever-It-Takes In Action (excerpt)

Last Thursday, the ECB lowered its official interest rate by 10bps to 0.15%. The rate paid on bank reserves was lowered to minus 0.1%. There isn’t much firepower in these lame actions. In addition, the ECB announced that cheap loans, possibly worth up to €400 billion, would be made available to banks under a program of “targeted long-term refinancing operations.” This TLTRO is aimed at providing more credit to small businesses. The 6/9 FT notes that it will take some time for this program to “provide an economic stimulus to those parts of the eurozone most at risk of falling into a dangerous deflationary spiral.” I agree.

Of course, the ECB also hoped that its new policy package would lower the foreign exchange value of the euro. So far, it hasn’t done much. The euro is down from a recent high of $1.39 to $1.35 currently. On July 26, 2012, ECB President Mario Draghi pledged to do whatever it takes to defend the euro. He succeeded all too well because now he is struggling to weaken it.

He also succeeded in stabilizing the banks. His 2012 pledge gave the banks the confidence to load up on sovereign bonds, especially those of the peripheral Eurozone countries. As a result, bond yields plunged, with the Spanish 10-year yield now equal to the 10-year US Treasury yield. Unfortunately, while the banks have been loading up on bonds, they’ve reduced their loan portfolios. That’s because they are subjected to regular stress tests that make government bonds more attractive than loans.

Today's Morning Briefing: Credibility Issue. (1) The first lesson in investment school. (2) Another record for stocks. (3) Bazookas turning into Pea Shooters? (4) ECB’s latest package isn’t “whatever-it-takes.” (5) Euro remains strong. (6) PBOC using rifle rather than shotgun. (7) Is deflation moderating in China? (8) BOJ’s QQE may be losing its effectiveness. So pensions will buy shares. (9) Is the Fed on the right or wrong side of inflation? (10) Feldstein’s warning. (11) Four reasons why stocks fell yesterday, and why they matter. (More for subscribers.)

S&P 500 Is Fundamentally Sound (excerpt)

Since 2000, the S&P 500 has been highly correlated with our Fundamental Stock Market Indicator. Our FSMI is the average of Bloomberg’s Consumer Comfort Index and our Boom-Bust Barometer, which is the CRB raw industrials spot price index divided by initial unemployment claims, on a four-week moving average basis. It isn’t a leading indicator of the S&P 500. Rather, it’s meant to show whether the underlying economic fundamentals are consistent with the level and direction of stock prices. The FSMI rose to a record high at the end of May.

By the way, our FSMI is highly correlated with the ECRI Weekly Leading Index. The difference is that our indicator is open-source and consists of just three nonfinancial variables. The ECRI’s recipe is a secret, though it probably includes some financial-market variables like the S&P 500 and the high-yield corporate bond spread.

Today's Morning Briefing: Fundamentally Sound.(1) The bears’ favorite chart. (2) Investment strategists shouldn’t be preachers. (3) Lesson #1: Don’t fight the Fed. (4) Will the day of reckoning be when QE is terminated? (5) Is terminating the same as tightening? (6) S&P 500 is one of 10 leading indicators. (7) Our FSMI rises to record high. (8) S&P 500 rebound since Feb. 3 led by cyclicals. (9) Small business owners more optimistic and aiming to hire additional workers. (More for subscribers.)

Global Economy Is Muddling Along (excerpt)

The recent rebound in the CRB raw industrials spot price index seems to be running out of steam in recent days. That’s consistent with our view that the global economy is growing, but at a slow pace. Interestingly, the Citigroup Economic Surprise Index for the US is also showing signs of flagging after its recent run-up. Let’s review some of the latest indicators out of China, Japan, and the Eurozone:

(1) China: The People’s Bank of China (PBOC) announced on Monday that it would like to strengthen the “weak links” in China’s economy, which is clearly slowing faster than officials expected. The PBOC cut the reserve requirement ratio by 50bps for banks that have sizeable loans to the farming sector and small- and medium-sized firms. It would also apply to financial firms that disburse consumer or auto loans. This targeted approach is deemed necessary to avoid increasing credit supply for all businesses, which would probably stoke speculation or wasteful investment.

The slowdown in China’s economy is evident in merchandise imports, which fell 1.6% y/y during May. Exports are still growing, but at a relatively slow pace of 7.0%.

(2) Japan: Japan’s real GDP rose sharply during Q1 by 6.7% (saar). Leading the way were nonresidential investment (34.2%), exports (26.3), and household consumption (9.4). The jury is out on how much of this strength was attributable to spending in advance of the April 1 sales tax hike. In any event, real GDP is likely to fall during Q2. Consumer confidence remains depressed, below where it was just before Abenomics was introduced, though it edged up during May.

(3) Eurozone: While the Eurozone’s recovery has been weak, the region’s latest data show that it is still recovering despite some of the uncertainties caused by the Ukraine crisis. The volume of retail sales (excluding motor vehicles) rose 2.4% y/y during April. That’s not much, but it’s the best pace since May 2007.

German factory orders rebounded during April by 3.1% m/m following the 2.8% decline the previous month. The gain was led by a 9.9% jump in orders to the Eurozone, which had dropped by the same amount during March. Industrial production excluding construction rose 0.4% m/m during April. However, it is up only 1.7% y/y.

Today's Morning Briefing: Too Much Love? (1) Bullishness too high and volatility too low. (2) Same old reasons for staying bullish. (3) Earnings are earning their keep. (4) King Kong vs. the Bull. (5) Bulls don’t die of broken hearts. Recessions kill them. (6) Three risks to the bull market: reflation, melt-up, and oil spike. (7) Commodity price index confirming slow global growth. (8) PBOC gives some relief to selected banks. (9) Chinese imports are weak. (10) Will Japan’s Q1 lift be temporary? (11) Eurozone recovery muddles along. (More for subscribers.)

S&P 500 Nearing 2014 Target Ahead of Schedule (excerpt)

The S&P 500 closed at 1949.44 on Friday. It would have to rise by only 3.3% to reach my yearend target of 2014. What if it hits my yearend target within the next few days or weeks? Somehow, 2015 by 2015 doesn’t seem like a very compelling forecast. In fact, 2014 by the end of 2014 might still play out, but there could be a melt-up between now and then. I was hoping that the internal correction over the past two months would reduce the likelihood of an irrational exuberance scenario for the market. Now I am not so sure. Consider the following valuation metrics showing that stocks aren’t cheap:

(1) P/E and price-to-sales ratio. On Friday, the forward P/E rebounded back up to 15.5 from a recent low of 14.4 on February 3. That’s a new high for the bull market, and the highest since June 20, 2005. I also track the ratio of the S&P 500 stock price index to its forward revenues. It rose to 1.63 at the end of May, exceeding the previous cyclical peak of 1.56 during the week of July 19, 2007.

The ratio of the S&P 500’s market capitalization to its actual revenues rose to 1.64 during Q1, the highest since Q1-2002. The ratio of the market value of all domestic equities traded in the US to nominal GDP rose to 1.63 during Q1, the highest since Q3-2000.

(2) GDP P/Es. The ratio of the value of all US stocks traded in the US excluding foreign issues to after-tax profits from current production rose to 13.8 during Q1, the highest since Q4-2007.

(3) Tobin’s Q. Many years ago, Professor James Tobin of Yale (and the chairman of my PhD committee) devised his Q Ratio, which is the total market value of a firm divided by the replacement cost of building the firm from scratch. When Q exceeds 1.00, entrepreneurs have an incentive to build it because its market value will exceed its cost.

That’s obviously a very theoretical construct used to explain the capital spending cycle. Nevertheless, the Fed’s Flow of Funds database includes two series that can be used to derive a Q ratio for the overall market showing the extent to which investors are either overvaluing or undervaluing the capital stock. I adjust it so that it has equaled 1.00 on average since the start of the data in 1952. During Q1, it rose to 1.56, the highest since Q4-2000.

(4) Bear case. Any way we slice and dice it, stocks aren’t cheap. At best, they are fairly valued. Of course, the bears say that they are grossly overvalued because they are expecting a recession. In their opinion, the problem is that earnings are at a record high and so are profit margins. So these two are increasingly likely to go down rather than up.

According to the bears, P/Es based on forward earnings are underestimating the overvaluation problem because they are based on analysts’ consensus expectations for earnings that are too optimistic. That’s true if a recession is coming soon. I don’t see one coming soon, so I don’t have a problem using forward P/Es for assessing valuation. Nevertheless, there is a valuation problem, though it isn’t as extreme as the bears say it is. Of course, a melt-up would force me to reassess my position.

Today's Morning Briefing: Lake Winnipesaukee. (1) Fewer bears at Bahre’s annual retreat. (2) When will the Fed start hiking rates? (3) Will termination of QE trigger a stock selloff? (4) Bubbles everywhere? (5) 2015 by 2015? (6) What’s next: a melt-up? (7) Various valuation ratios all show stocks aren’t cheap. (8) Unemployment rate at 5.5% by January. (9) Low wage inflation should moderate Fed’s rate hikes once they start. (10) YRI Earned Income Proxy at record high again. (11) Fewer amber lights on Yellen’s dashboard. (More for subscribers.)

Misery & Stocks (excerpt)

Many years ago, economist Arthur Okun created the Misery Index. It is simply the sum of the unemployment rate and the inflation rate. It tends to peak at the start of bull markets and to trough at the start of bear markets. That cycle is mostly attributable to the similar cycle in the unemployment rate. The unemployment rate was 6.3% during April. I expect that it will fall to 5.5% by mid-2015. That should keep the bull running for another year, at least.

Of course, that scenario will also depend on inflation. I am using the core PCED inflation rate to calculate the Misery Index. It rose from a recent low of 1.1% during February to 1.4% during April. I expect it will remain subdued.

By the way, there is an inverse correlation between the Misery Index and the S&P 500 forward P/E. The drop in the Misery Index from 10.6% during September 2011 to 7.7% now certainly justifies the rebound in the P/E from about 10 to about 15 over this period.

Today's Morning Briefing: Sentimental Journey. (1) Lots of bulls. (2) Okun’s Misery Index. (3) P/E inversely correlated with misery. (4) Party on? (5) Neither boom nor bust. (6) Industrial commodity prices rising, while global export volumes falling. (7) China’s government still boosting growth, but jobs indicator remains weak. (8) Eurozone’s GDP recovery remains weak despite solid PMI readings. (9) UK benefitting from Eurozone’s woes. (10) US exports confirm global slowdown. (11) Focus on overweight-rated S&P 500 Transportation sector. (More for subscribers.)

Stocks Grinding Higher With Earnings (excerpt)

The internal correction had a more significant impact in depressing valuation multiples than did the EM crisis and the Crimean incident. That’s because the correction wasn’t triggered by any macro event, but was all about money moving out of high-P/E stocks into low-P/E stocks. As a result, the forward P/E for the S&P 600 SmallCaps dropped from 19.3 on March 18 to 17.6 on May 15. It has edged back up to 17.9.

The forward P/E correction for the S&P 400 MidCaps occurred from March 4 through May 20 as it fell from 17.7 to 16.7. It is back up to 17.0. The forward P/E of the S&P 500 declined less than the other two and over a shorter time period (just 8 days!), from 15.5 to 14.8 from April 3 to April 11. It is back up to 15.3.

While valuation multiples were undergoing this internal correction, forward earnings for all three S&P market capitalization composites continued to rise to new record highs. Indeed, the pace of the ascent in the S&P 500 and S&P 400 has actually risen in recent weeks. Annual earnings estimates for 2014 and 2015, which had been falling last year and early this year, have picked up recently.

I am heartened to see that analysts seem to be getting more upbeat about earnings. Apparently, so are investors, as the stock market continues to grind higher in the face of valuation multiples that remain relatively high. I would like to see stock prices continue to grind higher along with earnings.

Today's Morning Briefing: Grinding Higher. (1) Complacency is worrying the Fed according to Hilsenrath. (2) Anatomy of corrections and bear markets. (3) Is the internal correction over already? (4) Forward earnings continue to grind higher. (5) Analysts’ upbeat earnings feeding investors’ complacency. (6) NIPA profits dropped during Q1, but should grind higher too. (7) Cash flow moving sideways in record territory. (8) Focus on market-weight-rated S&P 500 Auto industry. (More for subscribers.)

Urge to Emerge (excerpt)

Complacency has also benefitted bond and stock markets in emerging economies. Recent weeks have seen government bond yields falling in many of them, including Brazil, India, Indonesia, Mexico, and Turkey. The EM MSCI stock price index (in US dollars) is up 12.1% from its recent low on February 5, and 2.5% ytd. It is back to its level just prior to the taper tantrum. The Fragile Five have morphed into the Fab Five since March as both their currencies and stock price indexes (in dollars) rebounded.

Our Stay Home investment theme is back on top over Go Global on a year-to-date basis. Here’s the MSCI performance derby in dollars since the end of last year: US (4.0%), EMU (3.7), All Country World (3.2), EM (2.5), All Country World ex-US (2.4), BRIC (-0.4), Japan (-4.1), and China (-4.3). The top five MSCI are all for EMs: Turkey (21.6), Indonesia (21.0), India (18.2), Israel (17.0), and Philippines (16.3). This confirms my position that while EMs should underperform this year, some of them could outperform, but you have to pick the right ones.

Today's Morning Briefing: Fretting About Complacency. (1) Nothing to fear, but nothing to fear, again. (2) Corrections are MIA. (3) Complacent indicators. (4) Dudley is nervous. (5) Minsky’s moments are mostly geopolitical for the moment. (6) Stocks love Obama’s foreign policy. (7) Bond Vigilantes, Zombies, and Vivants. (8) George, Lacker, & Plosser are trigger-happy. (9) The ECB will lead the way until Thursday. (10) Urge to emerge. (11) Stay Home outperforming Go Global again. (More for subscribers.)

Dow Theory Is Bullish (excerpt)

The bull is back on steroids, especially for transportation stocks. The S&P 500 Transportation stock price index is up 9.9% ytd to a new record high, outpacing the 4.1% increase in the S&P 500. Flying high and barreling along are Airlines (43.5%), Trucking (17.6), and Railroads (10.5). Lagging behind is Air Freight & Logistics (-0.2). This suggests that the US economy is growing at a solid pace, while the global economy is doing so more slowly.

The strength of the S&P 500 Transportation index also confirms my secular bull market thesis. This index is now 66% above its previous record high on June 5, 2008. As I noted last week, the S&P 500 is 23% above its previous record high on October 9, 2007. This is a bullish development according to Dow Theory, which posits that as the DJIT goes, so go the economy and the DJIA. The former is up 9.5% ytd, while the latter is up 0.8%.

Industry analysts recently have been raising their 2014 and 2015 earnings estimates for the S&P 500 Transportation Composite. Its forward earnings rose to a record high last week, up 16.4% y/y. Its forward P/E is up to 16.3 from a recent low of 12.0 during September 29, 2011. That’s not frothy, but it isn’t cheap either. In any event, the fundamentals remain bullish.

Today's Morning Briefing: Chugging Along. (1) Transportation stocks on steroids. (2) Confirming secular bull thesis. (3) High correlation between business inventories and transportation indicators. (4) Shipping oil by rail is a big business. (5) Another record high for the S&P 500 profit margin. (6) It has been different this time for margins, so far. (7) Industry analysts remain upbeat on margins. (8) Core inflation rebounding in US. (9) Abenomics delivers higher inflation and unintended consequences. (10) ECB struggling to do whatever it takes. (11) “Ida” (+ + +). (More for subscribers.)