Category Archives: Economy and Meltdown

Guest Post: Q3 GDP – The Devil Is In The Details

Submitted by Lance Roberts of Street Talk Live,

The good news this morning is that the 2nd estimate of the third quarter (3Q) GDP was revised up from 2.0% initially to 2.7%.  This is up sharply from the 2Q print of 1.3%.  As usual we will dig down into the numbers and look at the changes in the data but it is important to note that, as pointed out by Zero Hedge, Hurricane Sandy had NO EFFECT on the 3Q number as that event did not occur until the end of the 1st month of 4Q.  The first chart below shows the gross change in the main components used for the calculation of GDP from Q2 to Q3.



The jump of $89.6 billion in 3Q was driven by a $33.4 billion increase in Personal Consumption (C), a $30.9 billion rise in Private Investment (I), $4.4 billion in Net Exports (X-M) and $21.3 billion in Government Spending (G).   The next chart shows the percentage contribution to GDP that each of these primary components made towards the overall economy.



What is important to note is the large share, more than 70%, that the consumer makes up of the domestic economy.  The purchase of services currently comprises more than 45% of consumption expenditures.  The reason I make this point is that service related consumption has a very low multiplier effect in the economy versus manufacturing and production.  The rest of the economy was driven by a 14.15% contribution of private businesses expending capital (notice that housing construction is a very small 2.72% contribution as I discussed yesterday), a negative 2.95% drag from net exports (exports less imports), and a 18.34% contribution from government spending which was primarily state and local.



While this data is interesting it really doesn’t tell us much.  The immediate response by the media was that this report on economic growth was a clear sign that a recession was nowhere in sight.  This complacency is somewhat dangerous because the economy is not currently growing at a rate strong enough to achieve the “escape velocity” needed to maintain sustained organic growth.  While the economy is not currently in a recession there are two very important things to remember:  1) The NBER doesn’t look solely at GDP in determining recessions and expansions but rather the trends of employment, production, retail sales and incomes, and 2) it is not historically uncommon for GDP to tick up just prior to a recession – particularly when the bumps come from inventory accumulation.  The table shows the annual rate of GDP growth the quarter before the start of an official recession.  Sustainability of current growth is the real concern as we go into 2013.

It is already estimated the Q4 growth in the economy will again contract back towards the Q2 levels of 1.3% as consumer spending continues to retrench.  The chart below shows the trends of the PCE component of GDP.



The decline in the strength of consumption is of obvious concern when considering the weight that it carries within the economy.  The data trends contradict some of the recent analysis from mainstream economists that have stated that “healthier household finances are driving gains in confidence and spending.”  While consumer confidence may have improved recently it is much less of a reflection on improved household finances but a testament to the psychological impact of the media on consumer psychology.  While spending on goods, and durable goods, picked up in the most recent quarter it was not enough to offset the declines in services which, as shown above, is a large component of overall PCE.  Furthermore, the surge in inventories, which is most likely unwanted given the weakness in consumer spending, was 90% of the Gross Private Investment component.  The balance of the increase in GDP in 3Q came from government spending which has virtually a zero multiplier effect in the economy.

There was an anomaly though in the government spending component of the 3Q GDP.  Of the .67% contribution to the 2.67% annualized economic growth rate – the entirety came from a massive surge in defense related spending.  There are two issues with this: 1) in the previous three quarters defense spending was a drag on economic growth yet in the month just prior to the election defense spending has a massive $20.9 billion increase; and 2) manufacturers in the various regions should have seen increases in new orders and backlogs which hasn’t been the case.  



One explanation for the surge is that the government was spending dollars ahead of the fiscal cliff recognizing the future defense spending will be drastically cut.  Considering that defense spending was a huge contributor to the current quarter growth – it doesn’t bode well for economic growth in the future.

As we discussed recently in regards to housing the increase in residential investment did provide a bump to 3Q GDP – however, it is a relatively small impact to overall economic growth today versus where it was historically.  



Prior to 1980 housing was a major contributor to the overall growth of the economy along with automobile manufacturing.  That is no longer the case as services have become a much larger share of overall consumption and exports are comprising almost a 14% share of GDP.  Even a doubling of residential construction from current levels will only return the contribution to the economy back to levels where it was previously seen during recessions.

Output Gap Still High

The output gap as a percentage of potential GDP did narrow this past quarter from 6.01% to 5.78%.  The output gap, which is the difference between real and potential GDP, continues to run at levels normally seen during recessions.  The problem is that it has been nearly four years since the peak of the previous recession and we are still at a very severe gap.  A quick look at history tells you that something different is occurring this time within the economy which is why continued artificial interventions have been required to keep it afloat.



This output gap also shows up when looking at GDP from a per capita standpoint.  My friend Doug Short stated in his analysis of real GDP per capita (I highly recommend you read his article) that:

“The real per-capita series gives us a better understanding of the depth and duration of GDP contractions. As we can see, since our 1960 starting point, the recession that began in December 2007 is associated with a deeper trough than previous contractions, which perhaps justifies its nickname as the Great Recession. In fact, at this point, 19 quarters beyond the 2007 GDP peak, real GDP per capita is still 1.45% off the all-time high following the deepest trough in the series.”

Gross Domestic Income

Another big concern for the 3Q GDP is the decline in Gross Domestic Income (GDI).  GDI is the total income received by all sectors of the economy including wages, profits and taxes less subsidies.  In the latest quarter the annual rate of change in GDI rose at a 1.7% annual rate which was slower than real GDP.  Since all income is derived from production (including the production of services) these two numbers should exactly equal. Furthermore, 2Q growth in real GDI was revised down to a -0.7%.  History suggests that the weakness in GDI will lead to subsequent downward revisions to GDP growth in the future as shown in the chart below.



Real Final Sales

Lastly, the annual rate of change in real final sales of domestic product continues to decelerate and currently sits at 1.88%.  Historically, when the annual rate of change of real final sales has been below 2%, the economy has been or was about to be in a recession.  



The combination of rising levels of unsold goods (inventory), slowing sales growth and declining incomes all point to weaker GDP growth in Q4 and into the early quarters of 2013.  Look for GDP growth in the 4Q to decelerate to 1.5% to 1.7%.  

While there is currently not an official recession in the U.S. economy, as of yet, the details of the current economic growth are not ones of robust strength. Furthermore, we will have to wait for revisions to the current data until next year where we will see some of these anomalies revised away.  With recent weakness in industrial production, capacity utilization rates and exports it is likely that there will be further deteroration of economic growth in the months to come.

If I am correct in my assumptions the economic underpinnings will continue to negatively impact fundamental valuations as profit margins continue to be compressed.  Furthermore, the outlook by corporate CEO’s for the next couple of quarters are not optimistic as top line sales and revenues slide.  Any impact from the “fiscal cliff” or “debt ceiling” debate, a resurgence of the Eurozone crisis or some other exogenous event could quickly impact the markets.  

While most of the media, and mainstream analysts, continue to focus on the state of the economy from one quarter to the next – the trend of the data clearly shows the need for concern.  Of course, this also why Bernanke is already considering QE4.  As I stated previously, while economic growth did pick up this quarter it is the makeup, and more importantly the sustainability, of that growth is what we need to continue to focus on.

SAC Capital – Too Much Of A Good Thing

SAC Capital – Too Much Of A Good Thing

Courtesy of The Banker

I covered the mortgage bond side of SAC Capital in the early 2000s, and I remember half-kidding, half-probing my client about Steven A Cohen’s seeming inability to miss. Back then Cohen’s SAC had put together a string of annual monster returns like no other hedge fund.[1]  Cohen’s SAC Capital was the Mark McGuire of stock trading, and we knew enough to think the home run records of 1998 looked mighty suspicious.

My client was one of the nicest and most straight-forward men I ever worked with, and his team of bond portfolio managers were really not the beating heart of SAC’s fund, which at its core was a high volume, stock-trading firm.

My client honorably defended his employer Cohen, marveling at his ability to stand in the middle of his trading floor in Stamford, CT and synthesize all the trading inputs and react unerringly with his ‘feel’ for the markets.

SAC was known then to produce an inordinate amount of volume on the NYSE for just one fund,[2] making Cohen’s fund the top equity client for a number of broker-dealers who earned extraordinarily high commissions on his stock trading. The implication of high volume like this, at the time, was that a top client like SAC could command top coverage from the Street.

According to the honest way of looking at things, this meant SAC might receive a phone call,[3] tip-off, or access to the Street’s best research ideas, first.

According to the dishonest way of looking at things, this meant SAC might get information that nobody else had access to, possibly – unethically – the client-flows of rival funds, or – illegally – straight-up insider information.

With yesterday’s accusation of one of SAC’s portfolio managers, we have what some believe to be the first major chink in the armor of Steven Cohen’s code of silence around his trading success.

This has got me thinking again about hedge fund cheaters and too-good-to-be-true results.

The first investing lesson of the Madoff scheme was this: If your hedge fund manager is flawless, if he never endures a down month, if he beats the competition month after month and year after year, then he’s not a genius, he’s a crook. Real investing sometimes involves losses, and sometimes involves volatility. Fake investing by contrast offers you steady, non-volatile wins every month. Until all the money’s gone.

The second investing lesson of the Madoff scandal was that investors will look the other way with their own crooked hedge fund manager, if they think it benefits them.  Investors turned out to be wrong about Madoff (he wasn’t cheating on their behalf!) but many people inside the financial community have long wondered if SAC fits in this category of acceptable cheaters.

Insider trading is a kind of ‘everybody wins’ cheating[4] that investors hope benefits them, so they are willing to not ask too many questions.

Steven A Cohen’s unrivaled success over the years brought the unwelcome attention of securities crime prosecutors long ago, as the Lance Armstrong of the hedge fund world.

As we learn more about Cohen’s proximity to insider trading, the parallels with Armstrong hold. Armstrong enforced a code of silence among his fellow riders for nearly ten years at the top of the cycling world, as who wants to be the first Judas to admit the whole operation depends on cheating? Too many people’s livelihoods depended on maintaining appearances and not asking questions.

Cheating on the kind of scale of Armstrong, or the SAC scale, however, involves so many people that eventually a few can be peeled away to talk to prosecutors. Based really on a gut feeling, and on no particular personal knowledge of the situation over the years, I wouldn’t be surprised if Steven Cohen eventually gets his 7 Tour de France titles taken away as well.


[1] With the possible exception of Jim Simonds’ Renaissance Fund, but that managed no outside money.


[2] This was ten years ago, and SAC was alleged to generate 25% of equity commissions on the NYSE.  These days, its all run by Skynet so I can’t believe any one fund could have that kind of influence.


[3] Back when, you know, people used phones.  It’s all so quaint.


[4] It’s not really ‘everybody wins,’ it’s just that winning is concentrated in the hands of a few interested parties with quantifiable benefits, while losing is diffusely shared by the entire system of unknowing, losing, participants. Kind of like tax loopholes.


See also: 

Who is Steve Cohen?

S.E.C. Weighs Suit Against SAC Capital

On The 'Uniqueness' Of 2012's Equity Performance

Credit and equity markets (should they avoid a catalcysmic year-end slump back to reality) are heading for much better results that one might have expected. As JPMorgan’s Michael Cembalest somewhat passive aggressively notes, this year looks to be a reward to those who stuck to normal investment allocations despite the macro issues in play, and despite low global economic growth.

One way to visualize 2012: the red dot in the chart, which shows global GDP growth and equity market returns each year since 1970. There’s normally a connection between growth and equity returns, with the exception of the dots in the box, which are low-growth equity rallies. If we remove post-recession rallies and rallies based on significant interest-rate declines; what we are left with is the conclusion that 2012 is kind of unique: a low-growth year with double-digit global equity returns not based on a recession rebound or a bond market rally.

The only other was 1998. Of course, a huge factor this year was the European rescue. What about 2013?


Without the usual catalysts for a low-growth rally, a stronger recovery in global growth would probably be needed to generate similar equity returns. As things stand now, the pieces are in place for a modest improvement in growth in the US, China and EM Asia, but less so in Europe and Japan. At first glance, a 3% global growth rate would match up with high single-digit global equity markets returns in 2013.

A fiscal “grand bargain” in the US could result in multiple expansion which would drive returns higher. Multiples of 13.6x on the S&P 500 have room to rise before becoming overpriced (at least from a historical perspective).

How likely is this “grand bargain”? Recall the Republican Presidential debate in which some candidates pledged to eliminate or seriously constrict the Environmental Protection Agency. A proposal like this2 reflects the fact that after the Budget Control Act, there really isn’t that much non-defense discretionary spending left for politicians to fight over (by 2017, it will be at the lowest level in 50 years).

On government spending, the grand bargain is mostly about cutting entitlements, which runs counter to voter sentiment.


Source: JPMorgan

IceCap Asset Management: 'Not' Salma Hayek And The Keynesians' 3 Big Mistakes

Salma Hayek is beautiful, rich and famous. Friedrich Hayek is a deceased Austrian economist. He wasn’t very good looking, certainly not wealthy but he did become famous – but only 20 years after his death and then only within the make believe world of nerdy economists. Fortunately for the World today, if we are lucky, Friedrich Hayek may become the most famous Hayek of them all. Until then, the World remains firmly trapped in an economic hell created by Friedrich’s (and therefore Salma’s) arch enemy – John Maynard Keynes. IceCap’s Keith Dicker points out that, as most politicians and central bankers view the World in very short time frames, to truly understand the devastation wreaked by Keynesian economics, one has to take a step back and see how the financial destruction accumulated over time. It is true that these policies initially provided sugar highs for the economy – but the 3 step cycle of cutting interest rates, cutting taxes and borrowing money to create growth has finally reached its end point. If Mr. Keynes was alive today, we are confident he would be embarrassed that his lifelong work had been so severely distorted.


The war that no one heard about

Few people in the World are even vaguely familiar with perhaps the most important war over ideology ever waged. Some may say the American-Soviet cold war was the tops – yet this riff over 4 legs good, 2 legs bad had nothing on what we are about to share with you.

On one side, you had Friedrich Hayek and the Austrian School of Economics, while the other side was anchored by John Maynard Keynes and the later to be named Keynesian Economics.


It’s no coincidence

Since WWII, the Americans, Japanese, British and Europeans have spent way more money than they owned. But that was ok because the money they borrowed wouldn’t have to be repaid until some far away day in the future.

Unfortunately the future has now arrived and today, the next generations of Americans, Japanese, British and Europeans have all plunged into a deathly debt spiral.

Today it is no coincidence that the Americans, Japanese, British and Europeans have all set interest rates as close to 0% as possible.

Also today, it is no coincidence that the Americans, Japanese, British and Europeans are all printing money.

And finally, today it is also no coincidence that the Americans, Japanese, British and Europeans ignored Friedrich Hayek and instead followed the economic principles of John Maynard Keynes.

Today the entire global economic and financial system is rooted in unwavering support for John Maynard Keynes and his beliefs in deficit spending and debt-fueled growth.


Money makes the World go ‘round

Arts, science, and politics certainly makes the World go ‘round. Yet, nothing can move without money and capital. Thank goodness we have an army of academic and real-world economists tackling the dynamics of money.

Of course, when it comes down to it we should be grateful that Mr. Hayek and Mr. Keynes, both grappled with perhaps the most fascinating economics question of all time – what causes the economy to move and what should be done when it stops moving?

Mr. Hayek’s business cycle theory was groundbreaking to independent thinkers, yet terrifying to anyone with ambitions to become central bankers or masters of the universe.

The groundbreaking component was actually very easy to understand. In essence, the best way to influence the economy was to not influence the economy. Rather, instead of tinkering with interest rates, taxes and deficit spending, masters of the universe should instead focus on ensuring the amount of new money released into the economy was just enough to equal the natural growth rate of the economy.

Sadly, our great leaders dismissed this concept. Instead of giving us “not too much” and “not too little,” we received “way too much” and never “too little.”

Of course, the mere idea that one could not use their financial and economic acumen to control the World was clearly not acceptable to central bankers. It was even more preposterous to politicians who promised multiple chickens in multiple pots. Of course, exactly who paid for these extra chickens and extra pots was highly irrelevant.

Mr. Keynes’ view was very different in that he believed the business cycle could be influenced by a government’s use of fiscal policy which included taxes, spending and deficits.

So, instead of embracing Mr. Hayek’s theory, the masters of the universe obviously opted for Mr. Keynes’ economic theory.

Unfortunately, and through no fault of Mr. Keynes, over the years governments and their advisors have only seen a one-way street in that changes could only occur in one direction.

  • Taxes were always reduced, never increased.
  • Spending always increased, never reduced.
  • Deficits always grew, never eliminated.

If Mr. Keynes was alive today, we are confident he would be embarrassed that his lifelong work had been so severely distorted. Yet, presented with today’s economic dilemma – he would also be highly excited to begin his new and improved economic thesis.


IceCap Asset Management Limited Global Markets November 2012

Sneaky Exchanges And HFT

The debate around HFT has been morphed ever since it went mainstream.  The anger that is being heard from day-traders and other market participants is not focused on automated trading on its purest level which is strict code of statements regarding when to buy how much of what at what price given some input.  The anger is focused on the “expert-networks” that offer certain individuals access to order types that are not public information.  The anger comes from “Hide and Light” and the abilities select groups have.  That very connection is what drove Haim Bodek into a frenzy at Trading Machines and surely many others. 

Haim’s event is hard to imagine prior to what we know now about HFT, market structure, etc.  Imagine scanning lines and lines of code looking for a specific error which was causing a constant hemorrhage of money through bad trading executions.  Now imagine having a cocktail at a party and discovering through the aid of a napkin drawing exactly what type of order was causing your firm to destroy its Alpha over a consistent 6 month period.  That’s the reason we’re hammering the table, because it’s not merely about reading the information wrong, its about inside connections to the exchanges.  These connections have helped many firms skirt the REG-NMS rules and Rule 610 as exchanges cater to the HFT in an effort to garner the most fee’s possible. 

We’re hammering the table because Mom and Pop have become unwilling participants in what has become an internalized order-flow through brokerage house.  There are only so many times Retaul can be filled ona buy order at the sub-penny only to have the stop-hunt algo’s go on a tear and turn P/(L)’s red.  The whole process of trading or investing in a company has become unnecessarily complex, and it’s hurting us.  The following image comes from the TABB Group and is part of an article from Simone Foxman over at Quartz on the power struggle between exchanges and brokerages over HFT.  Readers can see just how broken down the process of matching buyers and sellers has become.


Order Flow Diagram

The dark pool issue is for another time but the article does address a critical point which is that while regulators proclaim their ability to produce transparency, we have discovered this is not the case and that furthermore our regulators are clueless as to how little they actually understand about the relationships of the pillars of our financial asset market centers.  What once was our exchanges, have become for profit and have been fragmenting the market further and further as each one of them creates their own Retail Liquidity Program (RLP) in the chase for fee’s and that ever pervasive “volume”. 

And we wonder why Mom and Pop won’t come back to the market.  Soon we’ll just have ghost exchanges.