Mercenary Trader SIR 38

June 7th, 2014

MACRO VIEW: Shock And Blah

Stock prices are likely to be among the prices that are
relatively vulnerable to purely social movements because
there is no accepted theory by which to understand the
worth of stock investors have no model or at best a very
incomplete model of behavior of prices, dividends, or
earnings of speculative assets.
~ Professor Robert J. Shiller
All things are subject to interpretation. Whichever
interpretation prevails at a given time is a function of power
and not truth.
~ Friedrich Nietzsche
Mario Draghi and the ECB (European Central Bank) were on
tap to deliver shock and awe this past week. They came
through with shock and blah instead. The much hailed
mechanism of negative interest rates on deposits never
before seen for a major central bank was essentially a
cosmetic exercise: A mere ten basis points, done mostly for
show. The ECBs additional measures, including a halftrillion-dollar lending facility aimed at struggling businesses,
will not be enough to turn around a sluggish euro zone.
There is, in fact, open question as to whether monetary
policy of any variety, even QE, will help at this point.

Two other ECB key rates were cut, though not below zero.
The main refinancing rate dropped 0.1 percentage points, to
0.15%, and the marginal lending facility rate dropped 35
basis points, to 0.4%. (Try to contain your excitement!)
These little numbers may sound inconsequential: Trimming
a tenth of a percentage point here, roughly a third of a
percentage point there, for rates already near zero. And
instinct is correct in this particular case: Such moves truly are
inconsequential mostly cosmetic, except in terms of social
signal. Making the main deposit rate negative, to the tune of
a tenth of a percent, was a headline generator. As the Sober
Look blog points out, euro area excess reserves have already
fallen to rock bottom levels. This move would have made
more sense 18 months ago, when reserves were far higher.

In spite of the above, it is interpretation that matters. Equity

bulls chose to view the ECB announcement with triplestrength rose-colored glasses, taking the major indices to
new highs. This was done against an extremely low volume
backdrop, with no opposition to speak of. When you can
take em higher, why not do so?
We have no problem riding Soros-style false trends. If a
move based on flawed interpretation has legs, i.e.
evidence of sustaining itself, we are more than willing to
jump on. If a potentially sustainable price move launches
itself from a base of consolidation, or some other reasonable
point of entry, we are also game.
But late-cycle moves in the teeth of rapidly deteriorating
fundamentals, with bad seasonals, mounting risk factors,
and dubious price action to boot all on top of a wildly
optimistic interpretation that could (and likely will) reverse
course without warning are tailor made to be avoided.
First lets look at what occurred. On Thursday, Draghi and
the ECB announced negative rates of -0.10% on deposits,
the first major central bank to take such a step. (A handful
of central banks have done it, but they were small.) This
means the interest on excess reserves funds parked with
the ECB above and beyond regulatory requirements is now
a fee rather than a payment, of one-tenth of one percent.
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Draghi also announced the ECB is working on the creation

of an Asset-Backed Securities market, and then unveiled the
other big-bazooka element of the plan: A Targeted LongTerm Refinancing Operation, or TLTRO. The TLTRO is a 4year, 400-billion-euro operation (approx $545 billion) aimed
at getting banks to lend to small businesses. This money will
supposedly be available, via the banks expected to borrow
and relend it, for struggling companies across the eurozone.
The question is exactly why banks would want to lend the
400B and who exactly would want to borrow it. In the
periphery countries, the unemployment problem has
reached Great Depression levels. The trouble is lack of jobs
and lack of demand, not need of credit. These are precisely
the conditions in which providing more liquidity (money to
borrow) is akin to pushing on a string. The experience of
the United States with post-crisis stimulus was that shovel
ready projects were nothing but. Here it is quite similar.
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June 7th, 2014

Japan has failed to weaken its currency over the years. With
each passing day, Europe becomes more like Japan: This is
exactly what George Soros warned in predicting Europe
could face 25 years of Japan-style stagnation. In its bid to
avoid the Japanification of Europe, the ECB faces at least two
serious problems: First, the refusal of Germany to allow
anything that resembles serious change; and second, the
failure of monetary policy prescriptions for structural illness.

The above chart, also via Sober Look, illustrates a far deeper
problem for the eurozone. Even as the periphery countries
are struggling, and badly in need of more flexible monetary
policy, Germany is experiencing a speculative real estate
boom. Concrete gold is now a popular term in German real
estate circles, to describe physical buildings and other
property investments. This is another reason why Germany
is so opposed to truly bold monetary measures to help
struggling Spain, Italy, France and so on such could lead
speculative forces in the German economy to go supernova.
Trying to run a single uniform monetary policy for seventeen
(now eighteen) different countries, some of them worlds
apart, is like cooking a multi-course meal with one dial for all
the burners on the stove. Some pots may require a lot more
heat; other pots, close to boiling over, may require far less.
But with only one burner setting, there is only a least bad
solution that is ok for some and terrible for others.

While equity markets celebrated, the real verdict on the ECB

announcement came from the euro itself. The euro dropped
swiftly and heavily at first, but then recouped all losses to
close stronger on the day. As we have written before in
these pages, the strength of the euro is a bug, not a feature.
One key aim was weakening the euro via sufficient show of
looseness, that a less expensive currency might help out
eurozone exporters. But the ECB failed in this aim, much as
Mercenary Trader 2014 All Rights Reserved

The market value of a major currency is relative, meaning it

compares against the value of other major currencies. This
is one reason the euro remains strong: Other major players
want their currencies to be cheaper, and have acted to make
them so. A cheaper currency can boost your economy by
increasing the pace of exports. It is only a problem if inflation
comes alongside, or growth gets out of hand, or the cost of
external debt rises overmuch as the currency falls. The US
and China are not experiencing any of these ills. As such,
deliberate policies to weaken the dollar and the yuan have
helped their respective economies. In a currency war, the
country with the strongest currency is the loser, not the
winner, from the perspective of losing out on potential
growth against a sluggish economic backdrop. Inflation
paranoid Germany has been content to assign the eurozone
to loser status because their isolated view of things is just
fine, thank you very much (note property prices again).
In Thursdays press conference, while not exactly firing a
bazooka, Mario Draghi promised more to come from the
ECB, stating flatly that we are not done. But even if so,
what good will come of future action? There is hope and
belief that, if things get bad enough, the ECB can overcome
Germanys horror and start buying government bonds
outright. But government debt is not the problem, with
Spanish and Italian ten-year yields barely above those of the
United States (France and Germany well below). At some
point it must be realized that monetary policy alone cannot
fix an economy you need fiscal policy, e.g. changes at the
political level, to address the real problem. In the great body
of economic history, there is no evidence that central banks
can create jobs. They can help put out fires by providing
liquidity in a financial crisis, and they can make lending
conditions looser or tighter to help move things along. But
actual job creation? That is another kettle of fish entirely.
In the experience of the United States, one could make a
logical argument that the resilience of corporate America is
what turned the country around post-crisis. The Federal
Reserve alleviated crisis conditions by directing a tidal wave
of liquidity at the problem and taking bad assets off bank
balance sheets. Companies then did the heavy lifting of
renewed profit creation through deep restructuring and
cost-cutting the kind of stuff European businesses cant do.
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Mercenary Trader SIR 38

June 7th, 2014

The following implications are bearish, not bullish, for risk

assets, and havent yet been priced in to markets at all:
Europe and the United States are on divergent paths.
The ECB will face increasing desperation and loosening
Even as the Federal Reserve heads down a tightening path.
China is also on a devaluation path to fight local slowdown.
More China currency war pressure = bad news for Europe.
Tightening of Fed policy always causes global fallout.

Recall the above chart of US corporate profits after tax. In

the 2008 financial crisis, corporate profits fell off a cliff but
then roared back, thanks to huge efficiency gains born of
mass layoffs and major restructurings. These radical
adjustments were available to US companies because of
flexible labor laws the exact sort of flexibility Europe lacks!
The Federal Reserve was highly active these past five years,
but again one can argue QE was akin to magic pixie dust,
or Dumbos magic feather: It kept confidence up without
providing real changes at the economic level. The actual
business of business had to do that.
As such, the ECBs attempt to provide shock and awe is not
just too little, too late by some estimates. It is poor mimicry
of a program that might have been smoke and mirrors in the
first place (absent the real driver of corporate resilience).
There is very little reason to get excited about 1) a negative
interest rate that is merely a headline; 2) cuts to key rates
that amount to mere trifles; 3) a half-trillion-dollar lending
facility that is pushing on a string (liquidity is not the
problem here); and 4) promises of more to come when
even full-blown eurozone QE is not likely to help much at all.
Nor have we yet mentioned (again) the most important
guideline of all: Dont Fight the Fed is fast en route to
becoming a headwind, not a tailwind, for markets on the
whole. It is becoming more clear that, even as Europe heads
for years of stagnation, the US economy is healing, which will
hasten the Federal Reserve down a tightening path.
Consider the following (via the Financial Times):
The number of Americans in work has surpassed the prerecession peak, recording four straight months of growth
above 200,000 for the first time in 14 years, as the worlds
largest economy bounces back
And this via Bloomberg:
Fewer Americans applied for unemployment benefits over
the past month than at any time in seven years, a sign of a
healthier labor market thats helping brighten consumer
sentiment

Mercenary Trader 2014 All Rights Reserved

The news from Europe is largely bad and will stay bad. The
news from the United States is getting better, at least on the
economic front. May 2014 saw the fastest pace for US auto
sales in seven years (despite a flood of recalls). Consumer
confidence is at twelve-month highs and rising. All of this
hastens the day when the Federal Reserve switches from
easing to tightening and the broad market, as a forward
discounting mechanism, will at some point anticipate this.
In the short run, though, long-only money managers have
gone on record saying very stupid things to justify bidding
stocks up. Mario Draghi is taking a sledgehammer to the
disinflationary environment in the eurozone, writes fund
manager Chad Morganlander of Stifel Nicolaus & Co. (which
runs $160B). His actions are well beyond expectations. To
which we say, really? A sledgehammer made of silly putty
perhaps. We have already shown how the ECBs actions are
largely cosmetic. The overly strong euro (which hurts
recovery prospects) provided a thumbs down verdict on ECB
efficacy (closing higher on the day of the announcement, not
lower). And strong doubt remains as to whether Europes
problems can be solved by monetary policy in the first place.
The world is overbought, observes Bespoke Investment
Group. By Bespokes estimates, the indices of more than 22
of 30 countries are now overbought, with a handful at
extreme levels. To make matters worse, US corporate
profits (again see impressive chart, top left column) are now
in meaningful decline after a long extended run. Via Barrons:
Until the first quarter, GDP and S&P 500 profit numbers
tracked each other closely. But now the S&P data show a 6%
year-over-year gain, while the GDP profit series (after taxes,
inventory adjustments, and capital-consumer adjustments)
shows a 7% decline from the level a year earlier the
second-worst showing, after the 2008 plunge, in 20 years
The sharp rebound in US corporate profits, which began in
2009, long preceded (and likely enabled) the slow healing of
the US economy. But now the Fed is closer to a true turning
point, with real US economy improvements bolstering such,
even as corporate profits show definitive sign of peaking out.
It is a very, VERY dangerous time to be unhedged bullish.
Those who remain so should check their risk controls.

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Mercenary Trader SIR 38

June 7th, 2014

SPOTLIGHT: Lights Out

Q. When is a safe haven not a safe haven?

A. When it becomes an overvalued, overbought and overcrowded trade, with increasingly sketchy dynamics and a
serious deterioration of the long-term fundamental outlook.
We lead this weeks spotlight not with a joke or riddle per
se, but a basic description of whats happening in utilities (as
demonstrated by XLU, chart above).
Utility stocks have been a go-to safe haven trade from the
depths of the financial crisis onward, thanks to their safeand-steady characteristics. Utility companies have a built-in
customer base: Everyone needs heating, lighting and air
conditioning. They have steady revenues: Most people and
businesses pay their bills like clockwork. They have
predictable revenue streams: Its not rocket science to
estimate future payments. And they benefit from low
interest rates: High debt loads, meant to cover
infrastructure costs, are easier serviced when rates are low.
Add dividend yields to this mix of safety and predictability,
and its no wonder many portfolio managers see utilities as
a proxy for cash (when they have to park their funds
somewhere in the market, while remaining fully invested).
But just as there are no such thing as bad investments only
bad prices even the best investment is a bad one if you pay
too much for it. Particularly if you pay through the nose even
as broad market conditions are turning, with many of your
fellow investors prone to stampeding (as the herd is known
to do now and then). With valuations for utilities far above
historical norms, stampede potential now exists. A rising
interest rate threat, onerous regulations, solar inroads, and
crowded trade dynamics are all now in play
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The valuation case alone should give pause. Above we have

the top ten holdings of XLU, the popular utilities ETF, as
compared by trailing twelve-month price-to-earnings ratio
(P/E) for June 2010 versus June 2014. Only one, PPL, has
seen a P/E decline. The others have all recorded stunning
percentage increases, mainly based on safe haven bids.
Why would a dollars worth of utility earnings today, in 2014,
be worth so much more than it was four years ago? If
anything, one could pound the table for the opposite to be
true. Four years ago, the bottoming-out of US interest rates
(a bearish event for utilities) was a far lower likelihood than
it is today. US economic recovery prospects also bearish
for utilities, as other industries gain were far less robust
then versus now. Most importantly, today we see
developments that utilities investors, at least thus far, have
ignored: Rising threats on three fronts (environmental
regulation, competitive technology, and solar inroads) that
put the long-term stability of utility earnings in doubt.

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On June 2nd, President Obama and the EPA (Environmental

Protection Agency) announced one of the most aggressive
environmental regulation initiatives seen in decades, with
deep (and deeply unprofitable) implications for many utility
companies. It is no surprise that Senator Mitch McConnell,
the top Senate Republican and representative of a coal
state, called it a dagger in the heart of the American middle
class.
By 2030, according to the Obama administrations 645-page
rule, carbon emissions must be cut by 30% from baseline
2005 levels. The EPA estimates this will shrink electricity bills
8%, Reuters reports, by increasing energy efficiency and
reducing demand on the electricity system. Senator
McConnell, speaking out for Kentucky coal, retorts that the
impact on individuals and families and entire regions of the
country will be catastrophic, as a proud domestic industry is
decimated.

Critics of the new carbon legislation will be further angered

by the leading by example aspects of the strategy. In
taking a strong stand on carbon emissions, it is hoped that
the United States can positively influence China, where CO2
emissions are literally off the charts. For those committed
to solving the problem of global warming (and avoiding
potentially dire consequences), this makes sense. For those
instead focused on the potential harm done to the American
coal and utility industries, such do-gooder global policy,
taken at cost to US jobs and businesses, is maddening. We
have no dog in this particular fight. Nor do we hold strong
opinion on who is more correct in their prediction of future

Mercenary Trader 2014 All Rights Reserved

outcomes, Obama and the EPA or their fierce critics. We do,

however, see a crowded trade par excellence in the form
of over-bought, over-valued utilities, functioning as an overrated safe haven, with a legislative target on its back.
Coal, long the cheapest source of fuel for US power plants,
has also long been the dominant source of US electricity
production, thanks in part to US ownership of the worlds
largest coal reserves. Only the record low prices reached by
natural gas, as a result of the shale boom, have dented King
Coals hefty share of the US fuel mix.
Its instructive to note which utilities derive the most power
from coal (and thus have the biggest carbon adjustment
costs on deck). American Electric Power Company (AEP) is
particularly at risk, with 78% of its electricity production
coal-derived. Duke Energy (DUK) and Dominion Resources
(D), meanwhile, generate over 40% of their power
production from coal. The +25 P/E ratios for DUK and D,
given the circumstances, thus look all the more irrational.

There is another boogeyman for utility companies: The

increasingly compelling economics of solar. As the chart
above shows, the average cost for a US residential solar
installation has been falling rapidly. From 2007-2012, the
average annual cost decline doubled, from 5% to 10%. In the
past nine years, meanwhile, the rate of photovoltaic module
production has increased thirty-fold! These stats are related:
The more panels that get produced, the better the
economics of producing them become, thus further
lowering costs and fueling more demand. As solar power
grows less expensive to generate on the business and
residential level, utilities face increasing threat from offthe-grid electricity sources. Longer term, this paints a
picture of falling revenues coupled to static or rising costs:
The expensive grids have to be maintained and repaired,
even as net demand for grid power shrinks. The solar threat
is long-term, not immediate, but here and now perception is
what matters. It could soon be lights out for utilities.

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