3 Things Worth Thinking About

July 24, 2014

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I spent a good deal of time yesterday going through a point-counterpoint analysis of the current bull market. However, there are a few things that have been sitting on my desk that I wanted to make some comments on, and given we are now winding up the week, this is a good day address them.

1) SEC Votes To Put “Gates” On Money Market Funds

Zerohedge posted a very important article yesterday that deserves some serious consideration by all investors. To wit:

“Moments ago the gates arrived, when following a close 3-2 vote (with republican commissioner Piwowar and democrat Stein dissenting), the SEC adopted new rules designed to curb the risk of investor runs on money market funds, capping the end of a years-long heated debate between regulators and the industry dating to the financial crisis according to Reuters.

Among the changes, funds will have to switch to a floating share price instead of the current $1/share (hence the term breaking the buck). But the key part: “The SEC’s rule will require prime money market funds to move from a stable $1 per share net asset value, to a floating NAV. It also will let fund boards lower redemption ‘gates’ and fees in times of market stress.”

There are a couple of important questions that we should be asking ourselves with regards to this move.

What do they know that we don’t?
1. “Gates” are used to cease outflows of capital from an investment pool in order to prevent disorderly liquidations that create an uncontrollable crash in asset prices. While we are being told that the current “bull market” is structurally sound and will last for years, the SEC is quietly preparing for a “crash” environment. It is much like the stewardess telling passengers to remain calm while the pilots are putting on parachutes.
2. Given the fact that the Federal Reserve is preparing to withdraw their accommodative support from the financial markets which, as discussed recently, has always led to either a major financial event, recession or both; is the SEC acting now due to more serious concerns?
Will “gates” actually work? Kara Stein, one of the objectors to the ruling, stated the obvious:
1. “Redemption gates are the “wrong tool to address risk.”
2. Fear incentives will result in “greater chance of fire sales in times of stress and spread panic to other parts of the financial system while denying investors and issuers access to capital”
3. “Money market funds are only one part of wholesale funding markets that need to be strengthened”
4. In the event the gate imposed increases, investors have a “strong incentive to redeem ahead of others”
5. While a gate may be good for one fund, “it can be very damaging to the financial system as a whole”
6. When the gate for a fund is used, it doesn’t mean the “impact on wholesale funding markets will be prevented”

Kara Stein is absolutely correct. When a major correction in the market begins, any money market fund that puts up a gate will spur a “run” by investors to liquidate other money market funds in anticipation that a “gate” may be imposed on them. This panic selling will, of course, create the exact panic that the SEC is trying to avoid.

Pay attention to this issue. It is likely much more important than most realize.

2) Brace For A Weak Q2-GDP Report

Currently, the majority of economists are expecting a 3.3% annualized increase in the first estimate of the second quarter’s gross domestic product report. The problem is that there is much evidence to suggest that there may be disappointment in the next report.

Despite surging manufacturing surveys (which are sentiment based), the real drivers of economic growth are not rebounding from the “exceptionally” cold winter as strongly as was previously expected. The most recent reports on consumer spending show some pickup but have been weak, net trade due to a plunge in exports as international economies continue to struggle. While there has been some pickup in exports as of late the overall trend remains muted. Inventories will also likely contribute to weakness in the report as consumer demand continues to fail to materialize. This consumer weakness is shown in the chart below of monthly retail “control purchases.” (Note: Control purchases = Retails sales – automobiles – gasoline – building materials – food.)

3) Something Funny With Retail Sales

Speaking of retail sales, there is an anomaly that is occurring with the “seasonal adjustments” in the data. The chart below shows the “seasonal adjustments” to the June data going back to 1992. As you will notice, only in 2013 and 2014, have the seasonal adjustments contributed to the total retail sales number.

Here is the interesting part of the story. In June, the non-seasonally adjusted level of retail sales was $438.47 billion. That level represents a 5.59% decline from the reported May numbers. However, once the number were adjusted for “seasonality,” retail sales showed an increase of 0.25%.

While I do agree that some adjustment does need to be made for very volatile data series, it seems odd that the Census Bureau, which compiles and reports the data, would make such a drastic swing from historical tendencies. The chart below shows the annual change in the seasonally adjusted retail sales data as compared to the annual change in the 12-month average of the non-seasonally adjusted data. (I used a simple 12-month average to smooth data in place of the Census Bureau’s methodology)

As you can see, while the seasonally adjusted data shows a sharp uptick in sales since February of this year, the simple 12-month average of the non-seasonally adjusted data isn’t confirming it. (Note: there is an extremely high correlation between both data sets)

The non-seasonally adjusted data is confirming statements made by major retailers such as Wal-Mart and the Container Store that retail sales have not picked up as strongly as expected following the winter cold spell.

As I have discussed many times previously, the annual hopes by economists for a return to stronger economic continue to be elusive. Last fall economists were expecting growth of 3.3% in 2014. It now looks like we will see a sixth year of sub-2% growth. This is hardly enough to create the kind of real employment necessary to create stronger organic economic growth in the future.

[Note: Yes, employment has shown increases in every month over the last 52 months. However, those exiting the labor force have exceeded those becoming employed in 49 of those months. Hardly something to cheer about.]

With the Federal Reserve discussing “exuberance” in the “high yield” markets, as they continue to extract liquidity support and prepare to raise interest rates, it does lead to some concern that market risk may be elevated more than most are thinking. As I stated yesterday:

“I am currently long the markets in my models and intend on staying that way for the time being. However, the difference is that I am paying attention to the rising risks in the market and am not ignoring the fact that another major correction in the market, or potentially even a crash, will eventually occur. Even the famed John Bogle of Vanguard stated that investors should prepare for at least two declines of 25-30 percent, maybe even 50 percent, in the coming decade.

While the “buy the dip” mentality is deeply embedded in the current market, it will be understanding the difference between a “dip” and a full blown “correction” that will eventually separate winners from losers. As Seth Klarman of Baupost Capital recently stated:

“Can we say when it will end? No. Can we say that it will end? Yes. And when it ends and the trend reverses, here is what we can say for sure. Few will be ready. Few will be prepared..”