Thain Train

In a WSJ article this morning John Thain was fairly confident that the offer on the table will be accepted by Eurnoext in December:

"Our deal has to look economically attractive at the time they vote -- and it will"

I'm not sure how he can make this type of a guarantee when NYSE stock has been as volatile as it has been since the deal was announced in June, but let's assume for the time being that he is correct and the price of NYSE shares holds up, at least until December.

Keep that in mind while reading the following paragraph from the article:

The NYSE and Euronext plan to combine technology platforms, but not the markets they operate. European officials prefer this because it keeps U.S. regulations out of Europe. Mr. Thain said the exchanges aren't contemplating merging operations, but he did say convergence of regulation across borders would be desirable, particularly if changes are made to the U.S. Sarbanes-Oxley law.

A couple questions for Mr. Thain - Tell me again what will be combined? So the current NYSE price will hold up, but you're not merging operations? What IS merging other than the human resources and I.T. departments?

The recent NYSE appreciation seems a little steep for some new computers and a snazzy marketing campaign...I don't see how this deal can justify the recent NYSE share appreciation when the efficiencies you would expect from the deal are hampered by the details of the deal itself. The deal sounds great in principle, but I think the new shares are in for a bumpy ride. Especially when you consider that since the deal was announced, NYSE shares have outperformed Euronext shares on the back of this week's gains:


Volatility in the NYSE, as measured by a 5-day moving average of hi-low spread, is at its highest level since the merger was announced, while Euronext has logged steadier gains with less volatility.

The timing of Mr. Thain's announcement (on the heels of a 3.7% price jump in a single day) is just a little suspect - is it out of the question to think that an exchange such as the NYSE could call in a few favors to boost its share price? Conspiracy theories aside, the current valuation of the NYSE is high no matter how you look at it compared with the additional profitability and value added to the NYSE by this deal.

Yesterday

Here's yesterday's chart with the S&P 500 added, and the FF Rate/2-YR spread flipped around to represent the amount that 2-year treasuries yield over the target FF rate:


As noted yesterday, the only other time on this chart when the 2-year yield was below the FF rate and above the 10-year yield was in 2000.

Stock and Bond markets as predictors

The WSJ ran an article this morning re: the strong rallies we're seeing in stocks and bonds, and the competing views of the future these rallies imply. Either growth will remain strong and inflation under control and stocks have it right, or growth will disappoint to the point where rate cuts will be needed to stimulate the economy and inflation will be a peripheral concern. I have posted on this topic previously, and I still tend to side with the bond bulls.

A couple things - first, the Fed's stated focus on inflation is at this time a bit overblown and behind the times given the data, and I think the only reason they have not altered their statement to reflect any downside growth risk is that BB must still live up to the Fed's history as a staunch inflation fighter. His not wanting to include downside growth risks along with inflation risks has single-handedly brought the markets to near all-time highs, and by the time growth slows to the point of revising the Fed statement, it will come as a HUGE surprise to the stock market. Expect this to happen early next year.

Second, here is a chart showing that if history is any guide the FF rate will be in for some hefty adjustments next year. The only other time since 1990 the yield curve was inverted (measured here by 10-yr/2-yr spread) AND the 2-yr yield was below the target FF rate was in 2000...

Obviously the past is not necessarily indicative of the future, but I think the Fed has to ease at some point next year. The likelihood that they hit it dead-on with 5.25% is next to none, and another rate increase would absolutely rattle the markets at this point - it's a little shaky as it is. I think the Fed is pigeonholed into keeping rates steady for the remainder of this year to preserve its inflation-fighting cred, but as soon as BB thinks he can get away with it, the Fed will cut.

Who Determines Rates on Bonds of Varying Maturity

Pondering yesterday's post on Accrued Interest re: implied rate odds and the yield curve got me thinking about the relationship between the fed funds rate and bond yields at its most basic levels. There is an enormous amount of complexity and variety that now goes in to analyzing this relationship, and I wanted to shy away from that at the moment. I thought it would be interesting to take a look at what length of maturity the Fed likes to trade in.

Wish I had some more up-to-date numbers, but this graph will have to do to illustrate the point. Using data from an older FRB document covering the years 1975-1997 it looks at the average maturity of bond portfolios held by the Fed and by the market:


Prior to 1980 the Fed had a longer maturity portfolio than the market, however the 80's saw a rapid turnaround with the market having portfolios of bonds with twice the maturity by 1991 and sustained this trend through 1997. The Fed during this period essentially dealt with 3-year bonds or less. The Fed apparently decided that it would only attempt to influence rates on the short end at let the market make up its mind regarding longer maturities. You can see that anything beyond 5 years is simply the market placing bets amongst itself and taking cues from the Fed on the short end.

So High

Oil at $60 and the Dow finishes at 11613.19 - 4th best all time, and only 29.46 points off the year's high of 11642.65. How quickly things change. A few weeks ago oil was still around $73 and the market was hitting severe headwinds, up one day and down the next.

A month ago when it was still debatable as to which direction oil prices were headed I posted my thoughts on the Dow testing its 2006 highs. Here we are, and I still believe that this rally is setting itself up for a sizable drop off. The run-up in oil prices didn't dent profit growth, I doubt the slump in prices will have the reverse effect. Sans oil not much has fundamentally changed about the economy since a month ago (even the National Federation for the Blind saw the housing slump coming) - so what gives?

If you predict that it will rain tomorrow and you act on that prediction by purchasing a raincoat, when it rains the next day do you buy another one or are you content with the position you took prior to your prediction? Supposedly the market priced all of this in months ago, right? Housing slowdown, commodity slowdown, oil relief...it goes on and on - so why the rally now? When everything goes as scripted it might just be time to worry.

Keeping One Eye on the Road

Driving a car is an activity where the range of potential distractions necessitates you keep an eye on the road at all times. Whether you're passing a 5 car pile-up or have a screaming child in the backseat, other drivers on the road and passengers in your car count on you to sidestep those distractions and pay just enough attention to the road to arrive at your destination safely. You depend on the other driver as much as you do yourself to remain in one piece.

Much like driving a car, both the market and the Fed must not only be aware of where the other is, but they must also keep an eye on the road - the objective economic environment (outside of the FF rate, bond yields, and equity prices). Earlier today I thought I saw two drivers staring at each other, and not minding the road ahead of them - TickerSense mentioned that (at least) one Fed governor believes in the predictive powers of the yield curve. Now I know that the bond market is fixated on the Fed, but if the Fed were to be staring back with the same focus the situation would be a little uncomfortable.

With the Fed looking at the yield curve, the yield curve being derived from FF rate expectations - who exactly would be doing the driving? This is not to say the Fed should not look at bond yields or consider their impact, but if the almighty Fed believes the bond market can predict future economic conditions then why have the Fed meetings and all their black-box calculations enter into the decision at all? Why not just peg the FF rate to the 10 year? Probably because it would be a disaster. Probably because what makes the system work is that the Fed and the bond market represent two distinct interpretations of the same objective economic conditions that are both necessary. That the conclusions are often the same is not important, often they are not, and what is important is that there remains two separate methodologies for processing data and formulating ideas about the state of future economic affairs. Hopefully the two don't stare directly at each other and they keep at least one eye focused on the road.

Bush's Oil

Hilarious chart from Ticker Sense this morning showing Bush's approval ratings charted against the price of gas at the pump:

(TickerSense 9/19/06)

But we're still in Iraq for the cheap oil, right? At least according to all the protestors I pass every Friday on my way home from work we are. Give it a rest. Please. I hate to say it, but the Grassy Knoll seems like a fresh topic worth entertaining at this point.

On the global scene, here is a chart showing the number of inflammatory statements directed towards Israel by the Iranian president along with his approval rating:

US back in Vogue

Here is the performance of various assets over the past week from the WSJ:


It appears investors' appetite for risk is up slightly looking at the growth of small cap and tech stocks last week, but still wary of emerging markets - more money has moved into US and Euro Large Caps than the EMs. The search for higher returns re-focused investors on US markets, and I think we'll see more shuffling between US large/small/mid caps and among US sectors before we see any significant branching out to global stocks again.

NYSE/Euronext Merger Mania

For anyone as interested in this merger as I am, at the bottom of this site there is a table that allows you to get an idea of where the current Euronext share price is at versus where it should be/what it's worth. It's below all the posts but above the "under construction" segment at the VERY bottom.

As a side note, the current interest in NYSE and Euronext stock is very high when you consider that the estimated market cap from NYSE in the June disclosure is $20 billion - more than a billion UNDER what investors currently have sitting in these exchanges. I don't think NYSE anticipated their estimate to be under what it is really worth. Especially when you consider the market cap was around $18 billion one month ago. It's no wonder companies doing the buying in mergers historically tend to underperform. And I don't think that says anything about the buying companies necessarily, just seems to be the nature of the beast.

South African Gold

While I have previously commented on the potential for growth in South African markets related to hosting the World Cup, the country has caught my attention again for a different reason. While the gold selloff from its May peak has been downright nasty, things in the Johannesburg Stock Exchange (as measured by the EZA ETF) have been far worse. Gold prices and risk aversion in the form of emerging market selloffs have been a double-whammy for South Africa, however when I see EZA and the price of gold (GLD ETF) I can't help but think there has been some over-selling here. The first half of the year saw gold and the JSE move fairly closely together, parting ways after the May/June selloff:


Notice that after the two separated, from July through the present they are highly correlated directionally, they are just at very different levels relative to where they began the year.

Warranted or unwarranted?

What we can infer from the above chart is the relative expectations the market has regarding non-precious metals sectors in the South African market. If the JSE were composed entirely of precious metals/gold stocks the two lines above would overlap almost entirely. The deviation can be thought of as the returns on the remainder of the companies that make up the JSE, and I don't see how the outlook for the remainder of the market can be THAT awful, despite the riskiness of the market.

I don't think there is any doubt that any investment in South Africa should be thought of as long-term in nature, but I do think the outlook is more promising than the market is currently giving it credit for.

When Growth Isn't Growth

photo by Sandrine Huet

Great Long & Short column in yesterday's WSJ recounting some highlights of economic affairs since 9/11. Nothing earth-shattering, but I thought the idea of looking at trends since 9/11 in the market was noteworthy - it's always helpful no matter what you're doing to take a step back and gather some perspective.

The discussion about corporate profit growth having nowhere to go but down is spot on - 17 quarters of double-digit profit growth combined with an increased number of share buybacks and m&a activity (read: little investment in future profit-generating, productive resources) doesn't paint a bright picture for earnings growth down the road.

Profits (wages) as a share of GDP are abnormally high (low), meaning that companies can easliy absorb increases in costs (energy) without putting a lot of pressure on the overall price level. This is one reason why it feels like the inflation readings should be higher than they are, but it simply hasn't materialized to this point. As the situation unwinds, however, the opposite will not be true - if wages begin to increase their share of GDP at the expense of profits, earnings will begin to disappoint and prices will certainly rise - a double-whammy when combined with a flailing housing market.

The level of earnings/profit growth is a direct result of companies keeping a larger percentage of their profits as opposed to re-investing them - if you decide not to buy a car you'll instantly be $50,000 richer but you'll be poorer in the long-run when you lose your job for not showing up. This is the kind of mentality that the oil industry has been criticized so heavily for (they're robbing us blind and not building new refineries!), but it seems like we're giving many other companies posting monster earnings growth quarter after quarter a free-pass despite their increasing similarity to oil companies' modus operandi.

In the end I think we'll remember that productive resources and innovation drive growth (which requires spending and lower near-term profits) - not simply re-distributing money so that more of it passes through everyone's hands.

Volatility Anyone?

Volatility in the Nasdaq has taken sharp turn upwards even by historically volatile Nasdaq standards. The chart below shows the volatility indices for Nasdaq in blue and the S&P in red - the Nasdaq is around 75% of its peak during the May/June selloff, while the S&P is nowhere near its June peak:

To add some perspective about how volatile the Nasdaq is now, the relative volatility of the Nasdaq versus the S&P is now at a 2-year high:


What this means for the levels of the S&P/Nasdaq isn't clear, but there appears only one way to go for the future of the volatility spread. It would be interesting to look at periods where the volatility spread is relatively high or low and how the respective markets performed.

The Miraculous Dow

Due for a correction?

Groundhog Rally

Another run-of-the-mill rally off the back of falling oil prices, by now a very familiar sight. While not unexpected (see yesterday's post, previous posts on this site re:oil prices), I still have some issues with how many times the market has rallied this year in response to oil price slides of varying degrees. The run-up in oil prices the past few years has not hampered the growth in corporate profits, and there have been as many explanations for this as there have been oil-based rallies - the US economy operates using far less oil per unit of output than 10 years ago, we live in a service-based economy and oil price spikes are a concern for developing countries that are newly industrialized...you get the picture.

So when oil futures drop off (in a predictable manner), shouldn't the reverse be true? Why should we anticipate that a slide in the price of oil would stimulate/stabilize profit growth? Especially in the immediate future - if the effects of oil price increases operate on a lag, shouldn't the same lag delay any expected benefits from falling oil prices?

The only immediate impact of oil's price is reduced gas prices at the pump, which I don't feel will have the consumption-inducing effect the market is hoping for. I felt that $60 oil would push the market to test its highs, and at $64 and the DJ at 11500 I feel even more confident that will be the case if oil gets that low, and I just don't think it is a rally that has staying power.

In more general news, this morning's WSJ notes that global fund managers' outlook for corporate profits has fallen to lows not seen since 2001. That doesn't mean they are bearish, however, as the same segment also notes increased optimism regarding the global equity outlook. So...defensive sectors are leading the way, but triple-digit rallies come on the back of oil price news. This market is semi-schizophrenic and the tension has investors looking for love in all the wrong places.

O-I-L spells relief

The drop off in oil prices over the last few months has investors excited as the price of crude pushes 6-month lows. As I've commented in this blog before on the upcoming price decline (here and here) to be expected, this development should not surprise investors nor should it surprise anyone, really. The cyclical behavior of oil is certainly not new, and the price still hasn't fallen as far as it could based on the last two fall/winter slumps in price.
In other speculative news gold has taken an absolute beating today relative to oil. The correlation between oil and gold is well established, but it seemed as if gold had found its own support levels and wouldn't be as severely impacted by the recent drop in oil prices. I really didn't anticipate the drop in oil prices having this drastic of an effect on gold. Here is the chart over the past week, today really stands out: