Submitted by Pater Tenebrarum via Acting-Man.com,

A Useful Leading Indicator?

We often see charts comparing the S&P 500 to the growth in the Federal Reserve’s balance sheet, or more specifically, to assets held by the Fed. There is undeniably a close correlation between the two, but it has struck us as not very useful as a “timing device”, or an early warning device if you will.

Recently we have come across a video of a presentation by Bob Murphy, in which he uses a slightly different comparison that might prove more useful in this respect. Instead of merely looking at Fed assets, he uses the total monetary base. Here is a chart comparing the monetary base to the S&P 500 Index since 2009:

The monetary base (red line) vs. the S&P 500 (blue line) – as can be seen, sometimes one or the other series leads, but in recent years the monetary base has been a leading indicator. It probably lagged the market in 2010/11 due to the fact that traders at the time bought stocks in anticipation of more monetary pumping – whereas nowadays the market appears to be reacting with a slight lag to changes in base money.

Below is a chart that shows consolidated assets held by the Federal Reserve system for comparison. Since the Fed is currently reinvesting funds from MBS and treasuries that mature, its total asset base is basically flat-lining since the end of QE3. Obviously, all that can be gleaned from this fact is that the central bank is currently not actively pumping up the money supply. Currently money supply growth is therefore largely the result of commercial bank credit growth.

Assets held by the Federal Reserve – flat-lining since the end of QE3. Interesting, but not useful as a short term leading indicator of the stock market – click to enlarge.

A Different Regime

The post 2008 monetary regime differs from the previous state of affairs due to the vast growth in central bank balance sheets and the associated growth in bank reserves. This has created a technical problem for central banks if they want to tighten monetary policy, as the Fed is planning to do.

In times past the Fed would either add or withdraw liquidity from the system by means of asset purchases, resp. sales, both of the temporary and occasionally the permanent variety (i.e., via repos and coupon passes), so as to keep the effective Fed Funds rate on target. It can no longer do this if it wants to keep the stock of assets it holds unchanged. Since selling off enough assets to return to the previous regime would collapse the money supply, it isn’t going to happen.

The Fed is primarily keeping control over the FF rate target by paying interest on bank reserves. This keeps the currently almost non-existent interbank lending market in catatonia, since there is no point in lending out excess reserves for less than one can get safely from the Fed. However, ever larger short term reverse repo operations are undertaken as well (we have previously discussed the vast surge in these transactions at year-end).

These reverse repos usually swell near month-end and especially near the end of a quarter. This seems to serve various purposes. Among these is apparently the desire to relieve collateral shortages/ delivery fails (which have increased due to QE removing a great many securities from the marketplace), but the Fed is presumably also employing these reverse repos as another way of exerting control over short term interest rates.

While the amount of assets held by the Fed doesn’t change on account of such operations (since the assets are only lent out, but continue to belong to the Fed), it seems the effect is reflected in monetary base statistics. This is illustrated by the chart below, which compares outstanding reverse repos to the monetary base. Spikes in reverse repos align quite closely with short term declines in the monetary base, even if the correlation is not perfect (as these are not the only factors influencing the base).

The monetary base vs. Fed reverse repos outstanding.

Demand for Stocks Declines Around Quarter-End

One thing is clear: during the brief time periods when large reverse repo operations are undertaken, liquidity in the system temporarily decreases. The lead-lag relationship between the monetary base and the S&P 500 shown in the first chart seems to suggest that this does have an impact on the stock market.

How big an influence it really represents is however not certain, as there is another important reason why the demand for stocks tends to decline around the end of the quarter. As has recently been discussed at Bloomberg,  earnings season begins at the time as well, which forces companies to suspend stock buybacks for a few weeks.

Given the enormous size of buybacks in recent years (another new record high will likely be achieved this quarter), it is probably no surprise that the period during which buybacks are suspended also aligns closely with market weakness of late. Here is a chart derived from a Goldman Sachs research report illustrating this point:

Stocks have been especially weak last quarter around the peak of the earnings season.

According to GS analyst David Kostin, the influence of the “blackout period” is especially large at the moment, as other important groups of potential buyers are currently out of the picture:

“Corporate buybacks are the sole demand for corporate equities in this market,” David Kostin, the chief U.S. equity strategist at Goldman Sachs Group Inc., said in a Feb. 23 Bloomberg Television interview. “It’s been a very challenging market this year in terms of some of the macro rotations, concerns about China and oil, which have encouraged fund managers to reduce their exposure.”

[…]

Kostin said companies tend to enact a blackout period and restrict share repurchases in the month following the end of a calendar quarter, and come back once they’ve reported results. In a market where everyone else is selling, the ebb and flow of corporate actions have amplified volatility.”

We’re not so sure that corporate buybacks are the “sole demand for equities”, but it is probably true that buybacks or the lack thereof have more effect on short term volatility in times when other market participants are uncertain and less inclined to buy.

Conclusion

Regardless of which source ultimately proves more important, the above suggests that market liquidity tends to become more scarce around the end of the quarter at present. We have already seen this effect play out twice in row and it could well be that there will be another replay this quarter.

Considering what happened in 2010, much also depends on perceptions about upcoming Fed policy, but it seems unlikely that yesterday’s FOMC statement will do much to alter expectations. We can take the buyback blackout period as a given, which leaves us with watching the monetary base for clues.

It will be interesting to see whether the next decline in the monetary base – which should be expected to occur around quarter-end based on previous observations – will once again precipitate stock market weakness. It is definitely possible that this indicator is useful for short term trading purposes – at least for the time being.

Stay tuned for a more general look at developments in the US monetary backdrop to be posted shortly.

By Wolf Richter, WOLF STREET

Companies are still borrowing and spending billions on buying back their own shares – one of the big drivers behind the blistering stock market rally of the past few years. It worked wonderfully and without fail. But suddenly, it’s doing the opposite, and now the shares of the biggest buyback queens are getting hammered. Something broke in the gears of this financially engineered market!

During the November-January period, 378 of the S&P 500 companies bought back their own shares, according to FactSet. Total buybacks in the quarter rose 5.2% from a year ago, to $136.6 billion. Over the trailing 12 months (TTM), buybacks totaled $568.9 billion.

That’s an enormous amount of corporate cash that was dumped on the market!

The sector that blew – “blew” because that’s how it turned out – the most money on this type of financial engineering project was Information Technology, with $33.2 billion in buybacks last quarter. Four of the top 10 buyback queens were Information Technology: Apple, Microsoft, Oracle, and Visa.

Apple alone blew $6 billion in the quarter, even as its stock was tanking. Relative to its average share price over the period, it paid a 13% premium, the second highest premium paid by S&P 500 companies, after Symantec! Over the trailing 12 months, Apple blew nearly $40 billion on buybacks, and yet its stock dropped 15.5%.

This table shows the top 10 buyback queens in order of the amount spent on a TTM basis, and the mostly dismal performance of their shares over the same period.

GE didn’t quite make this list (though it bought back $3.1 billion in Q4), but it was very active in different ways, following through on its $50-billion buyback program announced in April last year. FactSet:

In addition to the repurchase program, GE completed a stock swap with the former GE Capital retail finance division, Synchrony Financial, which had an effect on shares outstanding that was equivalent to a $20.4 billion buyback. As a result, the shares outstanding for GE were reduced by 6.7% in the last twelve months.

Total buybacks are ballooning in proportion to net income, which declined over the TTM period for the first time since 2009. So buybacks as a percent of income rose from 64.9% a year ago to 68.1% at the end of the quarter. In terms of free cash flow after dividends, share buybacks have now ballooned to 101.7%. This was, as FactSet put it, “a huge jump from the year ago quarter when the ratio was 81.6%.”

The culprit? With income down over the TTM period, aggregate free cash flow has dropped 9.5% year-over-year.

FactSet’s chart shows the declining net income (green bars), the nearly flat share-buybacks (blue bars), and the rising buyback-to-income ratio (red line, right scale). Note what happened last time income began to decline (2007) and share buybacks followed in 2008: the stock market crashed.

And yet, despite the current heroic efforts to prop up their shares, companies have seen their shares get hammered.

As FactSet’s chart below shows, over the past 12 months, the S&P 500 total return index, which included dividends, rose 1.3% (green line). But the total return of SPDR S&P 500 Buyback ETF, which tracks the 100 companies in the S&P 500 with the highest buyback ratio, dropped 7.6% (blue line):

Clearly, financial engineering is kaput! Buybacks no longer function reliably in inflating stock prices. The opposite seems to be happening. Perhaps investors are finally starting to see through these shenanigans, and perhaps they’re now beginning to fret about all the debt these companies take on in order to fund buybacks!

When companies borrow billions to then blow that moolah on buying their own shares that then promptly decline in value, it doesn’t create a loss on the income statement. Instead, those billions quietly go up in smoke. What’s left behind? Fewer shares outstanding, piles of additional debt, mauled cash balances, and much higher financial risk.

But once companies see that share buybacks are becoming toxic as their shares decline despite buybacks, they curtail them. And last time this happened – in 2008 – it pulled the rug out from under the already teetering markets.

The bull market from early 2009 into May 2015 looks just like every bubble in history, and there’s one sign after the next that we did indeed peak last May. The dominant pattern in the stock market is the “rounded top” pattern. Read…  This Chart Shows the First Big Crash Is Likely Just Ahead

Submitted by Lance Roberts via RealInvestmentAdvice.com,

In this past weekend’s newsletter, I stated

“While my “emotions” are currently screaming to start increasing equity allocations at this juncture, there are several reasons why my discipline is keeping me from doing so currently:

1. The market is GROSSLY overbought in the short-term and will have either a mild corrective process or consolidation to allow for an increase in equity exposure.
2. Negative trends are still in place which suggests the current rally, while significant, remains within the context of a reflexive rally.
3. Volume is declining on the rally suggesting a lack of conviction.
4. This rally looks very similar to the rally last October except the fundamentals are substantially weaker.

While I have maintained a cautious stance in portfolio allocations since May of last year, I have reiterated many times that interventions by Central Banks could change the shorter-term dynamic of the markets from bearish back to bullish. These past few weeks have seen exactly that occur.

The question that we must primarily answer is whether enough “technical repair” has been completed to warrant an increase in equity exposure in portfolios. As stated above, the “risk” that the current “bear market” rally is nearer completion outweighs the possibility currently the markets are changing back to a “bull market.” Therefore, it is more prudent, for long-term investors, to remain cautious for now.

Only 4% From All-Time Highs

Yesterday, while I was at the gym I looked up to see a “talking head” on CNBC stating the markets are only 4% off of their all-time highs. He was making the case, of course, that the “bull market was back” and the recent sell-off was a “buy the dip” opportunity. But is that really the case? Of course, we will never know for certain until we have the clarity of hindsight. However, since we can’t invest with hindsight we must make some assumptions, or should I say “guesses” about what will happen in the weeks and months ahead.

He is correct. The markets are just off of their all-time closing highs as of yesterday’s close as shown below.

However, this is only part of the story as the current action in the market is still reminiscent of “broadening market tops” we have witnessed in the past. A quick review of 2000 and 2007 show some important similarities to the current market environment.

In 2000, as the market began its long and drawn out topping process, the market plunged by 11.2% in early 2000.The market then rallied back to within just 0.5% of setting new all-time highs before the “dot.com”crash set in.

We can see the same “topping process” again in 2007. In August of that year, the market dropped almost 8% and then subsequently rallied to a new “all-time high” leading the bulls to chastise the “bears” for missing out on a “buy-the-dip” opportunity.

The market then dove again, another 7.8% decline, followed by a new rally to within just 4% of all-time highs. The airwaves were filled with chatter the “bull market” remained intact as “green shoots” and a “Goldilocks economy” were evident.

Nothing was further from the truth.

Let’s look at the current market environment once again.

As shown above, the current market environment remains very similar to those previous market topping processes. The 8.7% in late summer rallied back to being just shy of setting all-time highs. The “bulls” were lured back into calming waters just as the next wave crashed upon them sending markets down 11.3% to closing lows.

Yes…the markets are once again just 3.7% off of their closing highs. The rally from the lows has been extremely sharp and has once again lured the “bulls” back into the water. Could this be when the markets break out to new “all-time” highs and re-establish the underlying bullish trend? Possibly. Or, could this be another rally within an ongoing topping process that leads to sharper losses in the future?

The Long-View

While the technical backdrop has indeed improved in the short-term, the longer-term picture still remains worrisome. As shown below, two of the three major monthly sell signals have been triggered. The last will be the crossover of the short-term and long-term monthly averages. As discussed previously, due to the length of time involved in monthly moving averages, by the time this signal crosses the bear market will already be in full swing. However, what is important to note is that all the signs of previous market action during a major market topping process are present.

“If the markets fail to rise above the short-term moving average and then correct below the long-term, which has currently been acting as support, that will be the beginning of a confirmed bear market cycle.

Conversely, if the market can rally above old highs and, reverse the two lower sell signals, the bull market will be reconfirmed and equity exposure will need to be increased. Of course, at this moment, given the economic and fundamental backdrop, this is a low probability event. Note: I did not say it was IMPOSSIBLE, just IMPROBABLE.

As investors, who have no control over future outcomes, our job is to understand and play within the confines of statistical probabilities rather than making bets on possibilities. The latter is the playground of amateur gamblers who regularly supplies Las Vegas with the operating capital it needs to function.”

However, as we approach summer, the seasonal weakness of the markets will likely resurface as the reality of Central Bank interventions are digested and focus once again returns to the real driver of asset prices longer term – profits. As shown below, that is also another picture more reminiscent of past problems for the “bulls.” 

We will not know for certain until well into the future when either the “bulls” or “bears” can claim victory. Unfortunately, we don’t have the ability to invest with hindsight.

“There have been three great inventions since the beginning of time: fire, the wheel, and Central Banking.” – Will Rogers

On Saturday, we highlighted a rather disturbing statistic.

60+ day delinquencies for subprime auto ABS have now risen above crisis levels to 5.16% - levels we haven't seen since 1996.

That won’t surprise regular readers. The writing has been on the wall for quite a while. More auto loan originations are going to borrowers with shoddy credit and loan terms are looking more and more stretched by the quarter. Just ask the NY Fed. Or Experian, where even permabull Melinda Zabritski will tell you that underwriting standards are getting looser (although she likely won’t say that’s a bad thing).

While Citi and others are quick to point out that the originate to sell model isn’t prevalent in the auto loan industry, the inability for lenders to securitize subprime loans may well put the brakes on US auto sales. After all, the pool of creditworthy borrowers is finite. That means that at a certain point, incremental sales must be engineered by making ineligible borrowers eligible by resorting to looser underwriting. But that only works if you can offload that credit risk. No lender wants to be sitting on a book full of used car loans to deep subprime borrowers with sub-600 FICOs, and so, if demand for subprime auto ABS dries up, so too will credit to the subset of borrowers who are driving (no pun intended) incremental sales growth.

Here’s a look at the share of total auto loans that have been securitized:

As you can see, and as we noted last week, the share has remained range-bound for at least 15 years. But again, the question is what happens to auto sales if lenders can no longer expand the pool of eligible borrowers by relaxing their standards? That would likely occur if subprime and deep suprime start to underperform, leading investors to pull back from paper backed by loans to less creditworthy borrowers. And guess what? Deep subprime is underperforming. Massively. Here's Goldman: 

Many of the deep subprime pools are experiencing losses above the industry average. Exhibit 6, for example, shows the losses on three large 2015 vintage deep subprime deals vs. the subprime industry aggregate. The deeper subprime deals have losses over two times the industry average.

 

 

Remember, somebody owns this paper and they sure as hell won't be buying into any more deep subprime deals if the collateral pools continue to perform like that. And if investors aren't buying, then lenders can't offload their credit risk which in turn means they will simply stop lending to shoddy borrowers. Once that happens, you can kiss the US auto sales "miracle" goodbye - for good. 

If you need proof of just how important the ability to securitize truly is for subprime auto lenders, simply review the first-hand account we published last week that details what's happening "under the industry's hood," so to speak.

For now, we'll close with one last chart from Goldman which shows what happens when a pair of trillion dollar bubbles collide head-on with Americans' inability to free themselves from the shackles of debt:

Submitted by Eric Peters via EricPetersAutos.com,

Termites start low and work their way up. By the time you notice them, it’s often already too late to save the place. All you can do is rebuild, start over.

This analogy may be useful in terms of understanding what’s going on in the car business… on the lower end of that business. And what that could portend for the rest of the business – ostensibly “doing gangbusters,” according to mainstream media accounts.

You know … like the housing market was “doing gangbusters” a few years back.

Until, of course, it wasn’t.

Well, check this:

The number of “subprime” car loans being sold is increasing – and so is the number of delinquencieson those loans. They are up to 5.16 percent, the highest level in 20 years.

Consider what this means.

First, a growing number of people cannot get traditional loans for new cars. They lack the verifiable income to qualify – or their credit scores suck. But financial flimflam outfits are loaning them money – often, at exorbitant interest – nonetheless.

Sound familiar?

It does to Comptroller of the Currency Thomas Curry, who recently said “… what’s happening in the auto loan market reminds me of what happened in mortgage-backed securities in the run-up to the (housing) crisis.”

Second – and not surprisingly – these loans are being defaulted on in growing numbers. Apparently, people who can’t swing a mainline loan at 3 or 4 percent interest are having trouble keeping up with loans that have interest rates twice as high.

Who’d a thunk it?

Now, are talking about $25 billion in subprime auto loans. Will Uncle step in – once again – and bail out the shysters issuing these loans with more of our money?

Of course he will.

Spending other people’s money is not only what Uncle does best – it’s all that Uncle does. He hasn’t got a penny of money that’s not been taken from others first. Why not be generous? There’s always more where that came from.

But this rant is not primarily about Uncle and his bottomless generosity with other people’s money.

It’s about what the bubbling trouble in the subprime auto loan mark says – canary in the coal mine-wise – about the health of the car industry generally.

Consider:

If – as the numbers suggest – more and more people are having trouble getting conventional car loans, either they are uncreditworthy or cars are too expensive for them (relative to income).

This latter thing is the canary in the coal mine.

A few weeks ago, I wrote about the average price paid for a new car last year – about $32,000 – a record high. And about the corollary to this: The ever-increasing duration of new cars loans. They are now on average six years long – and seven year loans are becoming pretty common. In order to spread out payments (now averaging almost $500 a month) that have become simply too much to manage for most people.

All these things are canaries in the coal mine.

And the canary’s looking woozy.

Even a slight upticking of interest rates will send him toppling off his perch, to land lifeless on the newspaper below. The private banking cartel that manipulates the American economy for its benefit – you know, the “Federal” (like “Federal” Express) Reserve  – has been threatening to raise the cost of money (interest) for some time now. The only thing holding it back has been flaccid spending, a general reluctance on the part of the public to buy stuff with money they haven’t got.

Which includes cars.

There was a time – within living memory – when you didn’t have to hock yourself to a six or seven year loan to be able to drive home a new car car.

Many people paid cash.

Today, almost 90 percent of all new car “sales” are financed.

And more than 55 percent of used car “sales” are financed, too.

The Fed has been attempting to “stimulate” (false) demand by tempting people with low-cost money (i.e., low interest rates) and that is probably the main thing propping up demand for new cars – much in the same way that artificial demand for homes was confected by the very same Fed.

Especially given that Uncle succeeded in executing a kind of mechanical genocide of good (and affordable) used cars via the odious “cash for clunkers” program several years back.

There are not many serviceable used cars available as a result – and the ones that are cost a pretty penny.

Hence the need to finance them.

But the high cost of used cars plus low-cost (even “free”) money in the form of interest-free (or interest so low it pretty much tracks with inflation) loans on new cars makes it very tempting to sign up for a new car loan… even one that’s six or seven years long (about the same time as the typical indenture contract during the early colonial era, if you’re interested in a historical parallel).

But when, inevitably, the cost of money goes up – as it must if the private banking cartel is going to resume its profiteering – it will have the same effect on the car business as the same thing had on the housing /real-estate business.

Better grab hold of something.

The spreading evidence of a new round of subprime rot is just the beginning.

And it won’t be confined to just this one thing, either.