Issue 89 - May 31, 2013


Strong Hands

Equity markets around the world have posted strong returns for the first few months of 2013. This has come despite slowing corporate earnings growth and a daily chorus of skeptics who warn of everything from collapsing equity prices to collapsing bond prices. In addition, there are daily bombards by well meaning pundits speaking out of both sides of their mouths to the possibilities of an imminent inflation explosion and an imminent deflationary spiral. Five years after the beginning of this financial episode, there still does not exist a consensus on what represents our most vexing concern.

An appreciable gulf has now appeared between actual market performance and economic perception provided by traditional indicators. This is not to say that today’s market levels represent a straight forward classic bubble. There is simply an extraordinary amount of dissent around what constitutes fair value in markets today. There is a large school of thought that believes that current market performance is purely a function of extraordinary Federal Reserve policy. The worry follows that at such time when the committee begins to wind down their open market purchases or reduce accommodation, the markets will suffer badly. We saw a sample of this on May 21st, which represented a repeat performance of the January 19th meeting notes release. The mere discussion of slowing purchases by non voting members led to a substantial sell off. Certainly changes in a highly accommodative policy to something less benevolent will give the market a reason to re-evaluate what it is paying for earnings. However, the market is going to pay something for these earnings. Are we paying too much at this time? Maybe. But there are a number of factors currently at work that traditional models may not be fully incorporating and it is worth considering how the potentially changing nature of a number of basic assumptions might influence overall valuations.

#1 The New Federal Funds

In the olden days of pre 2008, The Federal Reserve ran a balance sheet of something along the lines of $800 billion. They were able to influence their benchmark rate through daily open market operations of either adding (overnight repos) or draining (coupon passes) reserves through the primary dealer network. The network acted along the lines of a sump pump and was more than capable of managing the flow volume. However, as the Federal Reserve dramatically increased the size of its balance sheet through the variety of it Quantitative Easing programs, the old sump pump of daily open market operations has become entirely swamped and is no longer effective. In comments to congress this past week, it appears that what the Fed has in mind going forward is to use Quantitative Easing programs as a tool to both drain and add reserves as deemed needed. This would represent a major change in policy and has significant market implications.

The market had been assuming that when the Federal Reserve would begin to reduce or “taper” purchases, whenever that might be, that this would be a one way trend. It would be well telegraphed and anticipated. This is the “Greenspan” way. For those who think that market performance is strictly a function of QE, this has been a terrifying and paralyzing thought. But consider the possibility that the Federal Reserve might “taper” for a time and then resume their purchases again should the economy show weakness. Quantitative Easing becomes the new Fed Funds tool and can flow in either direction at the committee’s discretion. Market participants can not simply line up on the sell side of the trade as they did in the past, but would have to stay invested since the policy is more variable. We have long thought that it would be years not quarters for the Federal Reserve to work through this current chapter. Remember that the Fed does not act in a global vacuum. Japan has recently been far more aggressive than the US in their Quantitative Easing programs and the Euro Zone has yet to really embark on what they might have in store. This QE flexibility would represent a powerful new tool for the Fed that would be available to them for however long it might take them to ultimately and gracefully wind down their extraordinary balance sheet.

#2 Income as a Commodity

One of the biggest challenges of these past few years has been the search for satisfactory income. With the benchmark rate set at zero, and policy attempting to drive rates even lower, savers and fixed income investors have been hard pressed to maintain income particularly from traditional sources. Rick Reider of Blackrock has posited that income, rather than gold, is “the most precious commodity in the marketplace today”. Demographics have contributed mightily to this phenomenon and that trend is unlikely to abate even as rates begin to rise. It is certainly reasonable to believe that the demand for income along with declining supply will keep a practical cap on rates. This is important. For all the bond bears out there, it is far more likely to see modestly higher rates in the future than anything like a return to the much higher rates we saw in the previous two decades.

#3 New Buyers, Fewer Markets, New Terms

Consider the residential real estate markets today. We have a very different dynamic than what we saw in the run up to 2007. Residential purchases are dominated by cash buyers. Gone are the days of unserviceable mortgage products and the resulting hyper-levered market. Down payments and strong credit scores are the hallmarks of today’s leveraged buyers. Meanwhile, numerous funds were raised and have been deployed to purchase single family properties. These “Strong Hands” have been absorbing inventory virtually as fast as it comes on to the market. This combination of strong credits and cash buyers serves to create market resilience as these new holders will be far less vulnerable to liquidity driven sales in any future financial stress.

If we widen our view to consider international markets, we see extraordinary prices being paid for properties in locales such as New York, London, Miami, and Singapore. The common denominator in all of these markets is the desire of the buyers to be in a city where they can count on the “Rule of Law”. It may seem slightly hysterical to think that certain parts of the world would look to confiscate wealth, but recent events have shown this to be a slippery slope. From the proposed 75% French income tax to the seizing of Cypriot deposits, individuals, particularly outside the US are looking to protect their wealth in countries with a history of strong property rights.

The commercial side has also seen a resurgence through the combination of a modestly improving economy, but also the willingness from investors to accept far lower cap (return) rates than history would otherwise suggest. In part these lower returns are a function of the quest for income, but it also a function of the depreciation offset that is so valuable especially in high income tax locales such as New York that currently justifies ever higher prices.

#4 Changing Demand for Leverage

Jim Bianco, who is one of our favorite reads, has given the US economy a grade of a “Gentleman’s C”. It is not terrible, but as he says, if your child came home with this report card you would not be happy. While it is hard to know precisely what percentage of pre-2008 GDP was attributable to unsustainable leverage, we do know that credit is far more limited and used with far more discretion at this point. Despite the massive efforts of the Federal Reserve to inject some $3 Trillion into the system, there is no massive demand for cheap credit. Even improving economics have not unleashed the dogs of demand. A very interesting piece by Andy Kessler in the May 22nd edition of the Wall Street Journal titled, “The Fed Squeezes the Shadow – Banking System”, speaks to yet another factor impacting credit creation; the lack of US Treasury collateral available for Repurchase Agreements. Now understanding the mechanics of the “Repo” market certainly qualifies under the heading of “Inside Baseball”, but that does not diminish its relative importance. With the Federal Reserve owning $1.8 Trillion of US Treasuries which are sitting on their balance sheet and out of circulation, there is a real collateral shortage of qualifying Treasuries. Institutions can borrow and lever up against Treasuries very efficiently. That $1.8 Trillion of Fed owned Treasuries equals approximately $5 Trillion of credit that is NOT in the system currently. Any wonder why the High Yield Market is so historically expensive? These Treasury securities are not coming back into the market any time soon, so the palliative effect of their Repo potential will remain sidelined. Just as the previous three points have long and lasting implications; less gearing in the system will also impact the accuracy of traditional models.

Measuring Our Multi Speed World with a 12 Inch Ruler

Recently, the term Multi Speed World has entered our lexicon to define a number of different economic phenomenons. Christine Legarde of the IMF and Mohamed El-Erian of Pimco cited as Multi Speed the differential in growth rates of the US versus that of the EU and Japan and the emerging world. Better understanding the levers of our 21st economy would dramatically improve our ability to address imbalances. So let’s take this line of thinking one step further. If we can see that there are differences in speed say between the economies of the US and the EU, shouldn’t we also expect to see differences within the US? Our economy is not by any means a monolithic enterprise. We do however, measure it as if it were. We have an archaic and inaccurate data mining system to measure the most dynamic economy in the world. What does a “non farm” payroll number which will be revised three times tell us exactly? Not much. Our economic data readings have become so meaningless that they are almost all received with the headline, “unexpected” regardless of direction. Better economic data could certainly result in better considered and targeted “therapies”. In the mean time, we are left to the tools we do have at hand. In this regard, the best of the lot by far is the information gleaned from individual companies.

Audited corporate financials are far more instructive than any current government sponsored data set. Corporate quarterly reports paint a picture by industry, geography, and demographics. They tell us a story. Think about the breadth and depth of data that Home Depot, Wal-Mart, and Google possess on the US economy. We know for example that Costco carries vastly different inventory between Kirkland and Southcenter a mere 20 miles apart, reflecting the different needs of their communities. That is the level of data precision that the 21st century demands and should be available.

The many changes we are experiencing in areas such as income demand, the nature of ownership, and leverage are not entirely a function of the current Federal Reserve Policy and are likely to persist beyond the current interest rate policy. These new trends are also not well represented in the current set of traditional and uniform economic measurements whereas they are far more likely to present themselves in the information we receive from corporate entities. There is a story being told by this economy. It may just not be the story being told by the antiquated measurements.

There are many other factors impacting this market than those we focused on in this note. For example, the dramatically changing nature of our energy needs and resources that we have touched upon in the past is a massive tailwind at our economic back. Overall economic improvement will not be even or geographically uniform. However, the sum total of current trends are likely leading to an interest rate policy that will be close to the what we are currently experiencing. With a stable rate backdrop and improving fundamentals, quality companies will remain in demand.

Best Wishes,

Jen & Patsy


In this Edition

  • Strong Hands
  • #1 The New Federal Funds
  • #2 Income as a Commodity
  • #3 New Buyers, Fewer Markets, New Terms
  • #4 Changing Demands for Leverage
  • Measuring Our Multi Speed World with a 12 Inch Ruler

Huntington Steele

925 4th Avenue
Suite 3700
Seattle, WA 98104



Past Issues

88 - 03.27.13
European Union?/ Global Arbitrage/ 1940s Fed

87 - 03.08.13
Pulling & Pushing/ Deus ex Machina/ Perfect as the Enemy

86 - 01.04.13
The Fiscal Alps/ The Paradox & the Rub/ Next up - Zero Rates Forever/ 2013: Promises & Plausibility/ On a Positive Note

85 - 12.13.12
Giving Sausage a Bad Name/ Drowning in a River 2 Feet Deep/ Scarcity in US Treasuries

84 - 09.19.12
Plus Ça Change/ Fantasia meets the Euro Zone/ Cue the Federal Reserve/ Shifting Transmission/ Bottom's Up

83 - 08.21.12
Summer Time Slows but the Lawyers are busy/ Whatever it Takes/ Heavy Weight Fight

82 - 06.29.12
Half Time 2012/ 19 Euro Summits - A Tiger by the Tail/ The Crystal Ball

81 - 06.11.12
Next Chapter/ Election Lessons/ A Gentleman's C/ Opportunities

80 - 05.10.12
Choices/ Texas Hedge/ Outcomes

79 - 04.09.12
13,000 x 1,400/ Lessons Learned/ It's Not Insider Trading When Congress Does It/ Crystal Ball

78 - 03.21.12
Goldman's Casablanca Moment/ Mr. Macy meet Mr. Gimbel/ The Fiduciary Standard - The Gold Standard

77 - 03.05.12
Punxsutawney Greece/ Foaming the Runway/ "The Euro Crisis is Behind Us/ Healing Hoopla/ What Price Income?

76 - 01.09.12
2012 - The Continuum/ Europe - Working in the Injury Time/ "Risk On - Risk Off"/ The Road Ahead

75 - 12.05.11
The Problem/ What Could Go Wrong/ Compound Interest/ Germany or Bust/ The Cavalry/ Stress Tests/ Next Chapters/ MF Global

74 - 09.29.11
Broken Transmission/ Chickens and Eggs/ Where to?

73 - 08.29.11
The Confluence/ The ECB/ US Economy - Distinction without a Difference/ A Different Kind of Exit/ Gold as a Thermos/ Where to Now?

72 - 06.28.11
Sovereign, Central, Commercial/ Why we call them "Banksters"/ "Extended Period" just got a lot longer/ Forward.

71 - 05.24.11
The Question is... How Many Years?/ "Unexpected" Housing Weakness/ P.I.G.S. Can't Fly/ Stages.

70 - 04.11.11
Inflation for thee, but not for me/ On the Other Hand .

69 - 04.05.11
Implications - A Bevy & A Wedge/ Implications - Quantitative Easing 2.0/ Implications - Rules Rules Rules/ Catching Up with the Can.

68 - 03.03.11
What Ever Happened to Housing?/ Where Do Loans Come From?/
Where Do Loans Go?/ The Last Straw/ The Path Forward/ Equity/ Clearing Mechanism/ Restart Your Securitization Engines.

67 - 01.10.11
Curiosity of the Federal Reserve/ Complacency & Fragility

66 - 11.12.10
Phew/ Taxes and Employment/ Quantitative Easing Returns/ Incentives & Unintended Consequences/ Dear Mr. President

65 - 09.28.10
Progress in the Absence of Milestones/ Changing Nature/ Correlations & Valuations/ Synthetic Securities

64 - 08.18.10
A Tricky Diagnosis/ Traditional Treatment/ Bad Medicine/ New Age Medicine/ Homeowners/ The Banks/ Pension Plans/ Bull Flattening

63 - 06.17.10
Hip & Groovy/ The Trouble with Zombies

62 - 05.24.10
Next Sequel/ 2012

61 - 05.04.10
Intensity/ Principles versus Rules

60 - 04.01.10
Grand Isle to Lincoln
/ Mile Post 312/ Mile Post 353/ Mile Post 399/ P.I.G.S. are a Problem

59 - 02.17.10
Surprise, Surprise, Surprise/ P.I.G.S. Matter/ Leverage vs. Debt/ Going Forward



More Past Issues
can be found in our

Newsletter Archive


Market Highlights

6/29/12 3/30/12 12/30/11 12/31/10 12/31/09 12/31/08 12/31/07
14,560 13,104 12,880 13,212 12,218 11,578 10,428
S&P 500 US


1,564 1,426 1,362 1,408 1,258 1,258 1,115
Nasdaq US
3,252 3,020 2,935 3,092 2,605 2,653 2,269
EAFE Int'l Equity
1,678 1,604 1,423 1,553 1,413 1,658 1,581
5 Yr Treasury 1.02 .82 .74 .75 1.07 .85 2.02 2.71
5 Yr AAA Muni .94 .88 .9 .86 1.03 .94 1.75
10 Yr Treasury
1.98 1.81 1.73 2.28 1.96 3.38 3.92
10 Yr AAA Muni
2.13 1.99 2.05 2.24 2.08 3.44 3.26
30 Yr Treasury 3.27 3.13 2.94 2.78 3.33 2.914 4.325
30 Yr AAA Muni 3.30 3.21 3.16 3.56 3.72 3.82 4.9
EUR Currency 1.30 1.29 1.32 1.26 1.33 1.29 1.34
JPY Currency 101.38 94.28 86.10 79.49 82.08 77.36 81.32
If you would prefer not to receive future newsletters, or if you've changed your email address, please click here or send mail to