You can’t expect the Fed to spell out what it’s going to do. Why? Because it doesn’t know. - Stanley Fischer
It’s been a busy week. Which do you want first, the Good News, or the Bad News?
The US stock market made an all-time high, then backed off hard. New York’s own Joe Torre was named to the Baseball Hall of Fame. In Washington, five warring regulatory agencies reconciled for an hour to sign off on the Volcker Rule. In Butner, North Carolina, Bernie Madoff observed the fifth anniversary of the day he turned himself in to the feds, while in Ottawa, Canada’s national postal service announced the end of home mail delivery because of budgetary constraints. From Jerusalem came word that former Israeli central banker Stanley Fischer is the likely candidate to be Fed vice-chairman under Janet Yellen, and from Vatican City comes the announcement that Pope Francis has been named Time Magazine’s Person of the Year, narrowly beating Edward Snowden and Miley Cyrus. No puff of white smoke was released.
Stanley Fischer’s resume includes years as chief economist at the World Bank, and his time as a professor at MIT where he mentored European central banker Mario Draghi, as well as our very own Ben Bernanke. Lest you think this makes him unsuited to oversee US monetary policy, we offer a few items from his years as Israel’s central banker.
At the Bank of Israel, Fischer created a policy committee whose purpose was to act as a brake on the power of the chairman. Fischer, who was born in Zambia, won praise from his colleagues by taking the trouble to learn Hebrew, despite the fact that all his colleagues at the bank were comfortable in English – and despite the fact that he was the boss. His stewardship of the Israeli economy included policies requiring Israeli home buyers to make 25%-30% down payments in cash. No exceptions. Fischer may not exactly duplicate these successes here – his English is probably good enough to get by in Washington, but we suspect he will have a tough time going head to head with Mel Watt on the subject of mandatory down payments for homebuyers.
Thanks to the new radioactive Congress, Mel Watt has been put in charge of the Federal Housing Finance Agency, the body that oversees Fannie Mae and Freddie Mac. Watt replaces acting director Edward DeMarco who doggedly refused to implement reductions in mortgage principal for borrowers who are underwater on their mortgages. Observers expect Watt to move forward with a program of underwater principal reduction for GSE borrowers (loans held at Fannie and Freddie). Current stepped-up restrictions on loan servicing have already made it difficult to foreclose on delinquent borrowers. New rules coming into effect in January will add to these restrictions, raising the question: Is there still such a thing as a Secured Loan?
Aside from its impact on real estate market pricing, there’s a risk that mortgage principal reduction could become a Last Straw, convincing investors that it’s dangerous to do business with the federal government. Yellen and Fischer could be boxed into a corner and be forced to actuallyincrease the Fed’s buying in order to absorb panic selling of mortgage-backed securities that are suddenly seen as riskier than the mortgage-backed issues the Fed is currently buying. In short, turbulence in the housing market could return to center stage as a major factor in the markets next year. Shades of 2007?
As far as the Volcker Rule is concerned, there will be legal challenges. But the immediate challenge is that the regulatory agencies charged with implementing it are barely equipped to keep their bathrooms stocked with toilet paper, much less to launch a major industry surveillance initiative.
The SEC and CFTC are cash starved, and Congress does not appear disposed to help (Financial Times, 11 December, “Cash-Strapped Regulators Face Heavy Volcker Workload”). The CFTC is in such dire straits they may have to furlough employees for two weeks in 2014. They have already said they may have to outsource, or completely forego certain key inspections. The SEC is better off financially, but only just. It remains to be seen how much clout Chairman White will wield with Congress.
The one agency that appears to be sufficiently funded to take on the additional burden of Volcker Rule inspections is the Office of the Controller of the Currency. You will recall that the OCC was the agency that performed multiple routine audits of HSBC’s Mexican accounts but failed to detect the bank laundering nearly a billion dollars of Mexican drug cartel money. And as overseer of America’s banking industry, the OCC didn’t bother to dig down and figure out what JPMorgan’s “London Whale” was really doing. No wonder they have so much money; they never do anything.
And speaking of regulators doing nothing, the fifth anniversary of the Bernie Madoff story is a reminder that America’s regulators – with the apparent exception of Ms. White at the SEC – continue to be incapable of sustaining the integrity of our markets. The collective regulatory failure to catch Madoff in the act – SEC, FINRA, the various exchanges, brokers and fund managers where Madoff executed transactions (or didn’t) and managed assets (or didn’t) – is the financial regulatory equivalent of the intelligence failure in the run-up to 9/11. From where we sit, it doesn’t look any better today. Oh well… at least we got Congress to pass another 1000 pages of legislation…
Pope Francis incurred the wrath of the Right – Rush Limbaugh called him a “communist” – with his apostolic exhortation Evangelii Gaudium, the “Joy of the Gospels,” a document that opens with the words “The great danger in today’s world, pervaded as it is by consumerism, is the desolation and anguish born of a complacent yet covetous heart, the feverish pursuit of frivolous pleasures, and a blunted conscience.” Admonishing the faithful to turn their attention to the poor, Pope Francis blasts today’s “idolatry of money and the dictatorship of an impersonal economy” as a reincarnation of the Golden Calf. “One cause of this situation is found in our relationship with money,” he writes, “since we calmly accept its dominion over ourselves and our societies. The current financial crisis can make us overlook the fact that it originated in a profound human crisis: the denial of the primacy of the human person!”
Who does this guy think he is, Jesus Christ’s personal representative?
Meanwhile, the stock market has turned very suddenly and very decidedly bearish. You might have missed it if you are following market technicians looking at 200 day moving averages, but Hedgeye’s macro work uses its own unique toolkit. This week Hedgeye CEO Keith McCullough appears on Hedgeye TV explaining his warning to “Beware This Big New Market Risk Signal.”
The mechanics of the stock market tell a story – one that you can read, once you figure out the grammar. In this case, says McCullough, they’re practically screaming. Keith developed his market models over nearly a decade as a hedge fund portfolio manager. He uses a simple three-component snapshot to derive a near-term market signal. The model looks at Price, Volume, and Volatility. When Price and Volume are rising, and Volatility falling, that’s an ideal near-term bullish set-up. It means more participants are entering the market, and are confidently adding money, happily paying higher and higher prices. It signals building confidence in the immediate term which, simply put, means you will be able to find someone else to sell your stock to when it goes up.
The obverse of that coin is declining prices, increasing volume, andincreasing volatility, signaling that investors are agitated, nervous, and possibly on the verge of panic. Says McCullough, this is precisely the signal the markets are flashing now, and it’s a new one. If you have followed our Macro work you know that we have been in favor of buying this bubble. Now, says McCullough, it is signaling that it may be ready to pop.
Prices are declining, meaning more selling coming into the market. Volume is declining, signaling a mismatch between the need to sell and the appetite to buy. And volatility is rising, indicting uncertainty. Sellers want to wait until they get their price. Rising volatility gets people upset, and people who are upset make less rational decisions. You don’t want to be the last person trying to sell your stock when volatility hits a critical point.
This negative near-term signal flashed on our screens this week, the first meaningful bearish signal we’ve had in a long time. Investors sitting on profits should consider taking them, while traders looking to ride the momentum of this bubble shouldn’t be surprised if trades go against them in a big way. In a market atmosphere characterized by gloom and uncertainty, a spike in volatility could trigger a rush for the exits. Imagine a crowded dance club. Imagine four hundred people in a space designed to hold no more than 250. Imagine a single exit door just wide enough for two people to pass through. Imagine a fire. Imagine you’re at the back of the room.
Happy Friday the Thirteenth.
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Editor's note: The piece was written by Managing Director Moshe Silver in this weekend's Investing Ideas. Hedgeye's Investing Ideas is for the savvy, longer-term investor looking for excellent long-only opportunities. With your subscription, you'll know immediately when one of our award-winning analysts uncovers a new idea or changes a current one. Additionally, every Saturday morning, you'll receive our newsletter with stock updates, Trend Levels and all the important investing information of the week. Click here to subscribe.
