Barnes Investment Advisory Inc. Wealth in Balance®

"Tough Choices"? Puhleeze

2011-04-11T09:36:00.018-07:00

In the end the shutdown drama was but a farce.

After overseeing an unconscionable 27% increase in spending over the past three years, our elected politicians (both parties, both houses and the White House) are positively triumphant about their impressive ability to forge an agreement that prevents a shutdown of "nonessential" government services.

Yawn.

It can be no wonder that the standing ovation for which it appeared the politicians were so fervently expectant was not forthcoming. The budget cuts to which they eventually agreed totaled $38 billion.

That sounds like a meaningful amount of money.

Until you consider the entire budget totals $3.8 TRILLION.

Said another way, our leaders nearly trampled each other racing to add $800 billion to the budget but then turned a mere $38 billion reduction into a celebrity death match.

Maybe Cafe Hayek said it best (hat tip to follower Panna): Suppose that in a mere three years your family’s spending – spending, mind you, not income – jumps from $80,000 to $101,600. You’re now understandably worried about the debt you’re piling up as a result of this 27 percent hike in spending.

So mom and dad, with much drama and angst and finger-pointing about each other’s irresponsibility and insensitivity, stage marathon sessions of dinner-table talks to solve the problem. They finally agree to reduce the family’s annual spending from $101,600 to $100,584.

For this 1 percent cut in their spending, mom and dad congratulate each other. And to emphasize that this spending cut shows that they are responsible stewards of the family’s assets, they approvingly quote Sen. Harry Reid, who was party to similar negotiations that concluded last night on Capitol Hill – negotiations in which Congress agreed to cut 1 percent from a budget that rose 27 percent in just the past three years. Said Sen. Reid: “Both sides have had to make tough choices. But tough choices is what this job’s all about.”

What a joke.
For another (but no less critical) view of the "comic book budget squabble", see Clive Crook's column in today's Financial Times.

What A Joke
Don Boudreaux
Cafe Hayek
April 9, 2011

A Debt Disaster Behind a Comic Book Squabble
Clive Crook
The Financial Times
Monday, April 11, 2011

The Fed and The Long Run

2011-04-04T16:17:00.015-07:00

I used to hurry a lot, I used to worry a lot
I used to stay out till the break of day
Oh, that didn't get it,
It was high time I quit it
I just couldn't carry on that way - The Long Run by The Eagles (1979)

Kansas City Federal Reserve President Thomas Hoenig gave a speech last week at the London School of Economics. What we heard as we read the speech was that Hoenig believes the Fed is focused too much on the short term effects of its policies and insufficiently on the longer-run unintended consequences. One quote stands out: "A Swiss central banker once advised me that the duty of a central banker is to take care of the long run so the short run can take care of itself."

Thomas Hoenig is a voting member of the Federal Reserve's Open Market Committee. As such, he has been something of a lone voice in the wilderness lately by speaking - and voting - against the Fed's unusually accomodative interest rate stance as well as the second round of 'quantitative easing.' He has repeatedly shared his reasoning which we summarize as follows: Emergency measures taken during the credit crisis were necessary but continuing the emergency measures after the credit crisis passed invites adverse unintended consequences in the long run.

In fact, Hoenig takes a few moments during his speech to point out that it was the long-run unintended consequences of the Fed's overly-accomodative interest rate policy beginning in 2003 that fueled the massive credit expansion and housing boom. From his speech (which is well-worth reading): "The crisis has sometimes been described as a “perfect storm” of unfortunate events that somehow came together and systematically undermined the financial system. Such events included, for example, weak supervision and a misguided national housing policy. While these factors certainly contributed to the severity of the crisis, monetary policy cannot escape its role as a primary contributing factor."

Moreover, in giving another example of long-run unintended consequences, Hoenig lays the recent rapid increase in commodity prices (and we would add to that the resulting unrest in the Middle East/North Africa) at the feet of the Fed's current overly accomodative policies.

The good news is the "long run" is not here yet. The Fed still has time to remove what Hoenig calls "highly accomodative" policies and replace them with merely "accomodative" policies.

As the Eagles sang
Well, we're scared, but we ain't shakin'
Kinda bent, but we ain't breakin'
in the long run

Also see: Hoenig Blames Fed for Rising Prices
Vivien Lou Chen
Bloomberg
March 30, 2011

Japan's Nuclear Emergency

2011-03-16T13:44:00.002-07:00

As the weekend passed and the news of Japan's nuclear emergency continued to worsen, it was difficult not to become completely despondent. In an effort to help assuage those kind of feelings, we wanted to share a very good but very short piece on the topic published Monday by Roubini Global Economics (a source we hold in high regard).

A couple of ironies pointed out by the author, RGE analyst Mikka Pineda:
1) This year marks the 25th anniversary of the Chernobyl nuclear disaster.
2) Fukushima's 40-year-old reactors were due for decommissioning at the end of this month.

We took some consolation in RGE's opinion that Fukushima will likely be a level 5 event on the International Nuclear and Radiological Event Scale (INES). The scale runs from 0 to 7 with Three Mile Island at five and Chernobyl history's only seven.

In understanding the levels of radiation being talked about, we found the EPA's publication Radiation Risks and Realities to be helpful.

What's Up With Inflation?

2011-03-04T16:27:00.012-07:00

Well, it's not up.

We have had several conversations with clients recently about inflation - or, more specifically, the lack thereof.

Those conversations often have a conspiratorial undertone suggestive of an effort on the part of government officials to hide the true rate of inflation. The implication appears to be that 'they' don't want 'us' to know how bad inflation is getting.

First, let's recount the latest statistics. Two weeks ago we received the latest inflation data. The headline numbers seemed a bit worrisome because they were stronger than recent averages, suggesting that inflationary pressures are on the rise. For most of 2010, reported monthly inflation rates have been around 0.2%. December and January were, however, both 0.4%.

Upon further inspection it is clear that spikes in energy (+2.1%) and food at home (+0.7%) were the outliers that caused the bump in the headline CPI rate. Confirming this is the "core" CPI rate which was up a mere 0.17% in January after a 0.1% reading in December.

We know - "how can you ignore food and energy?!" We are not ignoring them. But, by the same token, we can not ignore rent, hotels, autos, home prices and medical care services, all of which are either in disinflation (falling rates of inflation) our outright deflation (falling prices). Moreover, there is a reason analysts look at both the headline and "core" rates of inflation. Food and energy are notoriously volatile. Spikes in food and/or energy prices have signaled something like 360 of the past two bouts of inflation. (we kid)

Let's talk pricing power. In the latest business outlook survey by the Philadelphia Fed, 60% of respondents said they have held or will hold their price increases to 2% or lower. No sign of pricing power (inflation) there.

Let's talk personal income. Organized labor is famously losing its clout. While layoffs have moderated and payrolls are growing (modestly) again, wage growth has again come to a standstill. February's report (released today) showed no change from January in either hourly wages or the number of hours worked. In fact, unit labor costs have declined for the past six quarters. Without wages rebounding, it is highly unlikely that energy or food price increases will last more than a few months or maybe quarters.

Let's be clear - we respect the risk of inflation and have indeed placed hedges in client portfolios in the event of a sudden return of inflation. However, such positions are currently sized only to be "starter" positions to which we will add as we believe the outlook favors doing so.

The Fed is, in fact, actively seeking inflation. But despite pushing the funds rate from 4.5% to 0%, expanding its balance sheet by more than $1.5 TRILLION, boosting US money supply (M2) by $1.2 trillion, US government debt exploding $4.8 trillion higher, and billions of dollars of direct investment into the nation's largest banks, AIG, GM and Chrysler. . . this is where we find ourselves.

Barely eking out positive inflation numbers.

Good News! China No Longer Largest Holder of Treasury Debt

2011-02-02T15:29:00.012-07:00

Bad news: the US Federal Reserve is.

Despite not even reaching the halfway mark of its latest round of bond-buying, the Financial Times is reporting that the Federal Reserve has surpassed China as the world's largest holder of US Treasury securities. (link below)
Based on weekly data released on Thursday, the New York Fed's holdings of Treasuries in its System Open Market Account, known as SOMA, total $1.108bn, made up of bills, notes, bonds and Treasury Inflation Protected securities, or TIPS.
According to the most recent US Treasury data on foreign holders of US government paper, China holds $896 bn while Japan owns $877bn.

The article quotes TD Securities strategist Richard Gilhooly: By June [the Fed] will have accumulated some $1,600bn Treasury securities, likely to be in the vicinity of China and Japan's combined holdings."

We wish we could feel some sense of pride about this #1 ranking. Unfortunately, what would make us proud continues to get kicked down the road: namely a return to policies that focus incentives on competition instead of consumption. In fact (since we mentioned it), we wholeheartedly embrace and support the President's State of the Union reference to "out-innovate, out-educate and out-build" other nations.

Yet we hasten to point out that we can not do this so long as government policies are obsessed with incenting citizens to out-consume the rest of the world.

Fed Passes China in Treasury Holdings
Michael Mackenzie
Financial Times
February 2, 2011

PS - Don't you find it silly that UK journalism still refuses to acknowledge the existence of the number "trillion"? They continue to insist on referring to a trillion as $1,000bn. Sheesh.

Do Credit Ratings Matter Any More?

2011-01-28T16:04:00.014-07:00

After completely whiffing on the sub-prime mortgage crisis (among other gaffes), it appears to us that the credit rating agencies have been so discredited as to be rendered irrelevant. Two news items of the past week caused us to stop and ponder.

If a ratings agency issues a report, does anyone listen?

Yesterday, Standard & Poor's cut Japan's sovereign debt rating for the first time in nearly a decade, bringing it down even with China's.

That cut's gotta hurt.

From S&P: In our opinion, the Democratic Party of Japan-led government lacks a coherent strategy to address these negative aspects of the country’s debt dynamics.

More on this from the Financial Times here: S&P Downgrades Japan on Debt Worries

The other story was Moody's announcing it was amending its credit analysis metrics for states when assessing relative debt burdens. Instead of comparing states' debt burdens and pension liabilities separately, Moody's will heretofore compare those figures on a combined basis.

The report is available only to subscribers but the announcement can be read here: Moody's Report Dimensions the Pension and Debt Liabilities of US States

From the announcement: Of the 50 states, those with the highest debt and pension funding needs include Connecticut, Hawaii, Massachusetts, and Illinois.

As a resident of the state, I am relieved to see that Arizona is not among the four highest debtors. In fact, upon reviewing the report, we find that Arizona, California and New York are not among 15 states with the highest liabilities compared to the four metrics* Moody's uses in their analysis.

If not outright "good" news, that's at least some not so bad news for a change.

*The four metrics of states' combined debt/liability burden are percentage of personal income, percentage of GDP, percentage of revenue and per capita.

The Unintended Consequences of Quantitative Easing

2010-12-31T10:33:00.023-07:00

Since the US Federal Reserve initiated a second round of quantitative easing (QE2) - supplemented by the recent extension of the Bush tax cuts - we have observed an increase in investors' appetite for risk but little in the way of fundamental improvements that would suggest a further rebound in the economy and/or employment. We believe this has led to an overly optimistic assumption as to the strength of the US economy. Hoisington Investment Management Company published an interim report on 12/9/10 that we neglected to spotlight until now.

Among their observations in the short note was the following: Many consider QE policy to be on a successful path because the psychology of its orchestration has boosted the stock market, thereby creating a wealth effect. However, QE has also set in motion unintended consequences. The same factors that have boosted equities have also lifted commodity prices and mortgage rates, both of which are damaging to economic activity.
The Fed's actions have served to increase bank reserves but, unfortunately, these reserves are largely left on deposit with the Fed because a) financial institutions' capital continues to erode due to loan delinquencies/defaults, and b) consumer debt ratios remain at or near record levels.

Other observations from Hoisington (although the very short note is worthy of a full read): The economy has been expanding for 17 months, yet both the labor force participation rate and the employment to population ratio stand at new cyclical lows and beneath the cyclical lows of the prior expansion. This is an unprecedented development.
The November employment to population ratio was 58.2%, its lowest reading since 1984. In fact, another 478,000 full-time jobs were lost in November. The tax compromise reached on December sixth between President Obama and the Republican leadership is in many respects like QE2. It plays to psychology but does little to improve fundamental economic conditions.
As we noted in an earlier reference to the Permanent Income Hypothesis, the kind of temporary income boosts that are contained in the Obama compromise are generally not spent. Consumers tend to save temporary income gains and tend to spend only those they interpret as permanent. Moreover, there is a substantial economic drag on the very near horizon: When the state legislatures return to work in January, they face combined deficits in the vicinity of $280 billion. At this stage, most of the quick fixes and rainy day funds have already been exhausted. Deficits of this magnitude mean that cuts in spending and higher taxes are likely outcomes.
The very bright folks at Hoisington conclude that long-term US Treasury bonds remain attractive. The 30 year bond yield is currently well above 4% yet inflation is less than 1%, resulting in roughly a 3% real yield. The real yield has averaged about 2% over the last 140 years, suggesting value at these levels.
We tend to agree.

Are We - Or Are We Not - Japan?

2010-12-13T14:56:00.014-07:00

When the US Federal Reserve announced the first round of Quantitative Easing about 21 months ago, we pointed out that the Fed was choosing the same path Japan chose. In a 3/18/09 note titled "It Is Official, We Are Japan" we argued that the Fed would likely be successful in holding down interest rates and that one of the possible unintended (or intended?) consequences would be a decline in the value of the US dollar.

Gary Shilling writes a column in the latest issue of Forbes that "We're Turning Japanese: Deal With It". (Forbes 12/20/10) The column is essentially a digest of his newest book in which he continues to espouse his belief that his self-titled "bond rally of a lifetime" is still intact as 30-year yields head for 3% (currently 4.45%).

The shellacking given to bond investors over the past three months has shaken the confidence of many. It would be disingenuous of us to say it has not raised a doubt or two in our minds. But that's the funny thing about investing - generally speaking, the lower the price of an asset, the greater the forward returns. Thus, our outlook for long-term bonds is today more positive than it was three months ago as they reached their most recent peak in prices.

No less a bond investor than Bill Gross is apparently in agreement. Bloomberg reported this week that Mr. Gross invested $17mm of his own money into five different bond funds.

Yeah, that's the same Bill Gross who was telling everyone last month that the end of the bond bull market might be nigh. If you thought Mr. Gross was telling you to sell all your bonds, well. . . not so much.

We continue to believe there is a reasonable level of risk that we are Japan.

Bond Bull Market: Reports of its Death are Greatly Exaggerated

2010-11-30T20:48:00.014-07:00

A client or two mentioned Russ Wiles' column in Sunday's Arizona Republic entitled "Bonds Not Looking So Attractive". In it, Russ (a good friend of ours and an experienced investment columnist) cites several market observers who point out (to varying degrees) the obvious reality that the bull market in bonds is rather long in the tooth.

Of those observers, PIMCo's Bill Gross is one we hold in the highest regard. Mr. Gross recently turned the attention of his monthly missive on that bond bull market and warned that the end may very well be nigh. We have no qualms with Mr. Gross' view (who are we to disagree with the greatest bond manager in the history of the world?). The sticking point is just how nigh is "nigh"? We highly recommend reading Mr. Gross' column.

It is, however, the unnamed portfolio managers at Ariel Investments in Chicago with whom we take issue. More to the point, it is their proclamation that "we have reached bubble territory in bonds" that we find misguided.

Three quick points to challenge this silly bubble talk:
1) How can we be in a bubble when the worst outcome an investor can possibly experience is a positive 4.3% annualized return (yield to maturity on the 30-year treasury bond)?

2) How can we be in a bubble when the overwhelming majority of investors are betting AGAINST bonds? (The Chicago Board of Trade reports that the net speculative short position in long treasuries has grown to 13,048 contracts, each of which represents $100,000 of face value.)

3) The definitive refutation of bond bubble talk comes from the brilliant folks at Hoisington Investment Management, the guys who have gotten the bond market right for the past thirty years. In their latest Quarterly Review and Outlook, Van Hoisington and Dr. Lacy Hunt write A bubble, however, refers to an asset with a price that is substantially beyond the asset’s fundamental or intrinsic value.
Let's cut to the chase: . . . investors are still able to purchase long-term Treasury securities at prices which do not yet reflect their positive long-run potential.
In other words, it is a stretch to describe the current bond market as a "bubble".

As wrong as we believe the Ariel folks may be about a "bubble", we concede Mr. Gross may be right that the bull market in bonds is about over. With Japan's experience fresh in our minds (along with virtually every other recorded financial crisis*), we do not yet agree.

*The work of Carmen S. Reinhart and Kenneth S. Rogoff have been invaluable in the evolution of our investment strategy over the past two years. To paraphrase their early work - the aftermath of financial crises share three characteristics:
First, asset market collapses are deep and prolonged.
Second, the aftermath of banking crises is associated with profound declines in output and employment.
Third, the real value of government debt tends to explode.

This Time is Different: A Panoramic View of Eight Centuries of Financial Crises
Carmen M. Reinhart and Kenneth S. Rogoff
April 16, 2008

The Aftermath of Financial Crises
Carmen M. Reinhart and Kenneth S. Rogoff
December 19, 2008

The Only Thing Deflating is the Fed’s Credibility

2010-11-16T17:34:00.007-07:00

Finally, the definitive answer to "What is quantitative easing?"!

I'll take "The last refuge of failed economic empires and banana republics" for $200, Alex.

Someone named Omid Malekan created a ~7 minute video that offers a hilarious (maybe nervously-hilarious), if overstated, take on quantitative easing. In an Xtranormal cartoon, two "Pawz" characters discuss the recent action by the Federal Reserve.

Xtranormal is a software site that makes the production of an animated movie simple. You type text, Xtranormal converts it into an animated movie.

Classic exchange:
Pawz #2 - "So has the Fed ever been right about anything?"
Pawz #1 - "Let me see if I can think of anything."
Loooooong pause. . .
Pawz #1 - "No. Nothing."

See it here:

The Deed Is Done

2010-11-09T06:31:00.008-07:00

No, not the election. The "deed" of which we speak is the Federal Reserve stating last Wednesday its intention to expand its balance sheet from $2.3 trillion to over $3 trillion. How do they do that? Well, think about the game Monopoly. Let's say a game is in progress in which there are a lot of properties owned but very little cash in any of the players' hands. Let's further say Ben Bernanke is serving as banker for this particular game. Mr. Bernanke would go to Kinko's and copy as many $500 bills as he wanted and then return to the game and use those $500 bills to buy anything and everything on the board.

Sidebar: You know how many $500 bills it would take to total $3 trillion? Yeah, six million. You'd need several days at Kinko's and a truck convoy to bring them back to the game!

Anyway, those assets would return to being held by the bank and the players would suddenly be flush with cash. The players would then have the ability (and - being flush with cash - likely the desire) to buy whatever their little hearts desire. If Monopoly were truly a 'free market' game, the plethora of cash would likely result in prices increasing substantially.

Inflation!

Would that the real world were so simple.

The reality is that no one knows if this experiment will be successful. The Fed's indicated objective is to lower borrowing costs and ignite a wealth effect by forcing investors out of low-interest-earning 'safe' assets and into more risky assets such as stocks. If successful, investors will feel more wealthy due to the rebounding value of their investments and will increase spending. The lower cost of borrowing will also (allegedly) encourage more spending and investing.

We doubt any net benefit will come of this second round of quantitative easing. Borrowing rates are already ridiculously low. Corporations continue to be reluctant to expand and hire despite massive reductions in their cost of borrowing. Consumers continue to deleverage rather than spend despite massive reductions in loan rates.

As for the so-called "wealth effect", Milton Friedman had an answer for that. In his 1957 book A Theory of the Consumption Function (no really - it's a riveting read!), Friedman advocated the "Permanent Income Hypothesis" which stated that consumers would regulate their consumption based on their long-term income expectations. (i.e. NOT current income) Having experienced a couple of nasty stock market crashes in the last decade, we would suggest stock market gains as something OTHER than "permanent" for most investors. From our perch, these expensive efforts to blow another bubble in the stock market will do little to help the economy short term and, unfortunately, set us up for the next ugly crash.

We sincerely hope we are wrong. But the reality is that if the first round of QE ($1.7 trillion) didn't jump-start the economy, why would anyone believe another $600 billion will? Moreover, consider Japan. They have been trying to restart growth through quantitative easing for years. . . to no avail. While Japanese government debt has increased exponentially over the past couple of decades, consumer debt in Japan peaked in 1995 and has been declining ever since. Appears we are on the same path. You know what happened in Japan.

The best reading we came across regarding the Fed's actions appeared in the Financial Times last Thursday and the NY Times last Friday. Links are below.

Finally, Gluskin Sheff Chief Economist and Strategist, David Rosenberg pointed out some scary facts regarding Japan's experiment with quantitative easing. In his November 5 observations he noted that "The day the Bank of Japan launched the program on March 19, 2001, the Nikkei surged 7.5% from 12,190 to 13,103. It went on to make a fresh high on May 7 at 14,529 (just under two months after the announcement) - rallying another 11%."
He goes on to point out that "Three months later, as it became painfully obvious that the real economy was not responding well to the shock therapy, the Nikkei Index slid 16% to just over 12,000. Moreover, the day before 9/11 it had already tumbled all the way down to 10,050 (down 27% from the nearby post-announcement high and 14% lower than the day of the announcement itself!)."
As Mr. Rosenberg concluded:

"Forewarned is forearmed."

Bernanke Pushes on a Very Long String
Financial Times editorial
November 4, 2010

Bernanke Fearing Fate of Japan, Not Greece
Sewell Chan
New York Times
November 5, 2010

Best Small Companies in America

2010-11-02T09:40:00.010-07:00

Forbes is out this week with their annual list of The Best Small Companies In America. It's always nice to see one or two of our own investments on the list but this year we scored three and one was among the 20 picked by Forbes' 'experts' as the most attractive for investment.

To be included in the list of 100 a company had to be publicly traded for at least a year with annual revenue between $5 million and $1 billion and a stock price of at least $5/share. For more on how the rankings were devised, please see the link to the article.

At number 14 on the list and picked as one of the anointed 20 by Chris Faber is Strayer Education.

Of Strayer, Mr. Faber says: Strayer has suffered by proxy thanks to government's war on for-profit schools that use contract recruiters paid based on the number of students they bring in. The government aims to withdraw funding for loans to students of for-profit schools if those schools cannot demonstrate that graduates can earn enough to pay the loans back. Strayer does not employ recruiters or compensate admissions people by head count; its graduates earn approximately $60,000 per year, well above the industry average; and its student loan default rate is much lower than the government claims because of a draconian definition of "default." When calmer heads prevail, the shares, down 43% since August, will bounce back--strong. Target price: $240.
At number 21 is TransDigm Group, the aerospace and defense company. TransDigm's components are used in 63,000 commercial and military aircraft and its five-year earnings per share growth is 61%/year. From Forbes: TransDigm recently stretched its balance sheet to buy McKechnie Aerospace from private equity firm JLL Partners for $1.3 billion. The deal will add perhaps $300 million in revenue next year and bring total debt to $3 billion. Fitch Ratings has put the company on watch for a possible downgrade.
Finally at #63 is Ansys, the simulation software company. Ansys' research and development consumes 15% of sales and accounts for nearly 1/3 of the company's 1,600 employees. No single customer accounted for more than 10% of revenue between 2007 and 2009. Ansys acquired Ansoft for $832 million in 2008 to get into the chip-design market. From Forbes: Headquartered in Canonsburg, PA, Ansys makes software that crunches simulations on how materials and components will break during use. Buyers include Ferrari and luxury yacht maker Delta Marine. The company uses a global network of resellers and also maintains its own sales offices in the US, Europe and Asia.

Forbes
November 8, 2010 edition

This is a Big Week

2010-10-30T07:37:00.020-07:00

And it's not because of the World Series. Heck, after two Giant blow-outs, that outcome hardly appears to be in question.

It's not because of Halloween, either. (Although Wednesday may bring a treat or a trick.)

No, we have two other events on our minds.

First up is the election. For the first time in our lifetimes there is a meaningful chance that voters will finally repudiate Keynesian economics and put an end to any further mismanagement of the US economy by such ideologues.

At its essence, this is not a Republican/Democrat issue although it has evolved as such in this election. The reality is that Republicans are every bit as culpable (if not more so) than Democrats in applying the 'Fatal Conceit' of Keynesianism.

To understand the issue, we highly recommend any comparative study available regarding John M. Keynes and F. A. Hayek. In a nutshell, their theories boil down to the difference between steering markets (Keynes) and setting them free (Hayek). For our money, the hands down best overview is provided in the outstanding Keynes vs. Hayek rap video (embedded below).

The second item on this week's agenda is the next regularly-scheduled meeting of the US Federal Reserve's Open Market Committee (FOMC). The meeting commences Tuesday but, this one being a two-day meeting, a policy announcement from the FOMC will not be released until Wednesday. Given the extreme weakness of recent economic data, the outcome (similar to a Giant World Series victory) no longer appears to be in question. Another round of quantitative easing is expected, although the magnitude of such a procedure has recently come under question.

A few weeks ago, in the wake of shockingly weak economic data and speeches from Fed Governors that something must be done, it was assumed quantitative easing of 'shock and awe' proportions would be unleashed. The result was one of the greater dollar declines in recent memory. More recently, thoughtful reconsideration of the possible Federal Reserve response has tempered expectations. This has brought a pause to the extreme weakness in the US dollar.

One excellent example of the rethinking of the proper role for the Fed is running in the weekend FT this morning. Michael Mackenzie writes that "some notable investors are not cheering" the Fed's likely next move.

Our view pretty much matches that of Bill Gross and Jeremy Grantham as described in the article.

Mackenzie on Grantham's view: Except this time, the animal spirits are being offset by many consumers, investors and companies trying to work themselves out from crushing debts accumulated during the mortgage and credit boom of the past decade.
Gross: “We are in a ‘liquidity trap’, where [low] interest rates or trillions in asset purchases may not stimulate borrowing or lending because consumer demand is just not there.”

We are resigned to the likelihood that the Fed moves forward with a second round of quantitative easing. However, we are hopeful that US fiscal policy begins a shift to the more rational. Make no mistake, the process of deleveraging will run its course. The question is how much further debt will be piled up by the federal government in a futile effort to avoid that process?"The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design."
FA Hayek

It's a big week.

Asset Purchases Like "Ponzi Scheme"
Michael Mackenzie
Financial Times
October 30, 2010

What's All This Talk About QE II?

2010-10-12T14:17:00.021-07:00

We know that is not the QE II in the picture. It is an artist's rendering of the Titanic. However, we decided it captured more appropriately our view of QE II (the monetary tactic, not the ship) than one of the beautiful pictures of the majestic Cunard ocean liner.

In the US, the first round of QE (Quantitative Easing) was initiated when the crisis was in its early days. It involves the central bank creating money out of nothing and then using that money to buy financial assets. In theory (i.e. hopefully) this will increase bank reserves and facilitate the lending that will put the economy back on a growth track. It is an aggressive treatment for an ailing economy and is therefore generally not risked unless more traditional monetary policy (low interest rates) has failed.

PIMCo's Chief Executive and Co-Chief Investment Officer, Mohamed El-Erian wrote on the Financial Times' comment page last Friday (10/8/10) about the coordinated action that averted a global depression. It was a short, 9-paragraph column that we highly recommend. Here is the first paragraph:
When the financial crisis erupted, policymakers around the world gathered in Washington for the International Monetary Fund’s annual meeting, and responded impressively. They won the war against global depression by showing an unusual and much-needed common purpose. Now those returning to meet at the IMF in Washington this weekend, and especially policymakers from industrial countries, need to do much more to secure the peace.
Well, the IMF had their meeting this past weekend. Unfortunately, nothing meaningful was done and the current non-cooperative environment hardly seems likely to change.

At present, we can not imagine a less cooperative policy environment. The developed countries (the US, Japan, the UK, etc) are competing to see who can devalue their currency the fastest. It is a game in which there will only be losers.

Quantitative easing strikes us as the wrong tool for what ails us. US banks are holding more than $1 trillion in excess reserves. Additional reserves are unlikely to have much (if any) impact. US corporations have more cash on their balance sheets than any time we can remember (i.e. dating back to the early '80s). Pushing more cash into the system strikes us as unlikely to make much difference. US consumers are hunkered down, paying down and/or not taking on any new debt and limiting spending to essentials. A further 1% decline in long-term interest rates seems unlikely to motivate many to change their behavior.

It is said that when all one has is a hammer, everything looks like a nail. With the Fed Funds rate at zero, the Fed's only remaining tool is quantitative easing. So that is the tool of choice, the likelihood of success be damned.

Our view is it will not help much (if at all). Moreover, the long-term costs and unintended consequences of such tactics will likely be substantial. Consumers and businesses do not need more dollars shoved at them to get out of this quagmire. We need rational monetary and fiscal policies that are well communicated. We need to know how to plan. With substantial new taxes and regulations coming at us, many of which are certain but of unknown magnitude, we have anything but an environment of rational monetary and fiscal policies much less any clear communication of what policies will be implemented in the near future.

If you don't believe us, listen to Bill Dunkelberg, Chief Economist of the National Federation of Independent Business: “Members of Congress fled with no action on important issues such as extending current tax rates, leaving the cloud of uncertainty larger and darker,” said Dunkelberg. “In response, consumer sentiment fell and owner optimism remained anchored solidly in recession territory. Owners won’t make spending commitments when sales prospects remain weak and decisions such as tax rates and labor costs remain so uncertain.”
The next meeting of the Federal Reserve's Open Market Committee is November 3. Election day is November 2. It might well the day before the Fed's meeting that has the greatest impact.

The Recession is Dead! Long Live the Recession!

2010-09-24T16:50:00.012-07:00

As has been well-reported elsewhere (everywhere?), the National Bureau of Economic Research's (NBER) Business Cycle Dating Committee climbed out of its burrow this past Monday and saw its shadow. Thus it was determined that a trough in business activity occurred in the U.S. economy in June 2009 and that trough therefore marks the end of the recession that began in December 2007.

Interestingly, Warren Buffett was interviewed on CNBC yesterday (Thursday) morning, noting that by his own common sense definition, the US economy is still in recession. To quote Mr. Buffett from the interview

"I think we're in a recession until real per capita GDP gets back to where it was before."

From our perspective, it hardly matters whether we or anyone else thinks we are or are not still in recession. What matters is that we understand this was not your standard-issue post-war recession. This was a systemic financial crisis that has inflicted substantial and lasting damage to asset values, employment and economic activity. The research is clear in suggesting that a return to 'normal' rates of growth in each of those (asset values, employment and economic activity) will require years, not months.

Moreover, in stemming the pain of this systemic financial crisis we have incurred a substantial increase in real government debt that adds further challenges to the eventual recovery that was not a factor in recoveries from all other post-war recessions.

Until those factors begin to improve materially, the question of whether we are actually in a recession or not will be moot. Any 'recovery' we experience is doomed to be tepid and most fragile.

You can read the NBER press release and CNBC interview, respectively, by clicking the above links. If you would prefer to watch the interview, we will do our best to embed it below.

Cisco to Congress: "Please fix the tax code"

2010-09-17T15:48:00.006-07:00

This past Tuesday (9/14), Cisco Systems held its 2010 Financial Analyst Conference at company headquarters in San Jose, CA. The morning keynote presentation was also webcast live with a copy of the materials archived on the Scribd website.

It was yet again another impressive performance from CEO John Chambers and friends. During the presentation, management reiterated its long-term growth rate of 12-17%. However, we thought the company's discussion of the possibility of paying a 1-2% dividend to shareholders among the more notable points during the presentation. (see page 41 of the Scribd document linked above)

The dividend itself is not that big of a deal, in our view. Many of the larger technology companies have initiated a dividend in recent years, including Microsoft and Intel. It was the company's comments in discussing the dividend that caught our attention. In particular, Chambers said that initiation of a dividend would depend on action (or lack thereof) of dividend tax legislation as well as policy action (again, or lack thereof) on repatriation of foreign profits. (Nearly $30 billion of Cisco's $40 billion cash war chest is outside the US.)

We can only assume that the company will decide on a lower dividend rate if the advantageous tax rate on dividends (part of the Jobs and Growth Tax Relief Reconciliation Act of 2003) is not retained.

We understand Cisco's position. The US has employed double-taxation of dividends for far too long. Think of it this way: Let's assume you are a shareholder of Cisco. For every dollar the company pays you in dividends, it must presently earn about $1.27. This is because Cisco pays income taxes of about 21% (last three year's average) on its net income.

But it doesn't stop there. After making $1.27 and sending $0.27 to the US Treasury, Cisco sends you your $1.00. Unfortunately, that $1.00 gets taxed yet again. Yes, that $1.00 shows up on your income tax return and is hit with federal, state and local taxes. Under the 2003 tax act, you could qualify for the advantageous tax rate of 15% on that dividend. After federal taxes (we'll ignore state and local for now, in an attempt to keep this simple), you have $0.85 left to spend.

Maybe you think that's not too bad. We don't agree. A combined tax rate of about 35% is plenty in our view. Moreover, having that dollar taxed twice is insane. But we digress.

Now let's compare what will happen if nothing is done to prevent dividend taxes from increasing on 1/1/11. Back to our example. . . For every dollar the company pays you in dividends, it must presently earn about $1.27. No change here to Cisco's ~21% tax rate.

But here's where it gets uglier. After making $1.27 and sending $0.27 to the US Treasury, Cisco sends you your $1.00. That $1.00 still shows up on your income tax return and is hit with federal, state and local taxes. But now you will pay tax on it at your ordinary income tax rate. Let's say your taxable income (2010 married/joint) is above $137,300 but less than $209,250. You now pay at a rate of 28% (again, ignoring state and local taxes) and have a measly $0.72 left out of that original $1.27.

If we didn't like double taxation at the rate of 35%, you know how we feel about nearly 45%.

Think about Cisco's (and every other corporation's) choices here. They can use the money to buy back their stock. That same dollar that ends up being a $0.72 after-tax dividend to shareholders can instead be used to buy back $1.00 worth of stock. That might provide a bigger boost to shareholders' net worth than a $0.72 net dividend.

Or that $1.00 can be added to the company's huge $40 billion cash reserve and eventually used to fund growth opportunities such as new products/services or the acquisition of other companies.

Our view is that extending the lower tax rate on dividends is the minimum congress should achieve before 12/31/10. Completely eliminating the ludicrous double-taxation of corporate dividends (either by making dividends deductible to payers or tax-free to payees) is the more rational long-term solution.

This idiotic practice has been allowed to continue for far too long.

What If We Aren't Japan?

2010-09-14T10:48:00.015-07:00

Two recent publications take issue with our declaration that we are Japan.

First, we should clarify our position. Our original blog post declaring that "we are Japan" (dated 3/18/2009 - nearly 18 months ago) implied what we meant, which can be paraphrased by the Mark Twain quote that "History doesn't repeat itself, but it does rhyme." To be more specific, while we acknowledge that there are a multitude of meaningful differences between the Japan experience that began in the late-'80s and our present condition, we believe there are many similarities. Among the most notable:
<> We have suffered a systemic financial crisis.
<> It has inflicted substantial and lasting damage to asset prices, employment and the economy.
<> A return to growth in asset prices, employment and the economy will take years, not months.

What we were not (and are most assuredly are not) suggesting is that the US is identical to 1990 Japan.

With that disclaimer, we submit for your consideration the two publications. First is a research piece published by Credit Suisse on August 19, 2010 and entitled The US is not Japan. Unfortunately, due to legal and/or regulatory issues, we are not at liberty to republish or share the publication and have been unable to find a copy of it at the Credit Suisse website to which to point you.

However, we can offer an overview/summary. Indeed there are meaningful differences between the US today and Japan in 1990. Among the more persuading differences were the fact that US policymakers have been much more proactive, that US banks are not in as poor shape as their Japanese counterparts were, and that Japan's demographics were much worse than are ours.

In its ability to convince the reader that the US is in a much different position than Japan was in 1990 the paper is most effective. Our read, however, is that the paper falls far short of convincing us that the US will avoid a multi-year period of weak economic performance, a massive increase in government debt, and strong deflationary pressures.

The second publication appeared as a "Last Word" guest column in this past Monday's FT. It was authored by Edward Chancellor, a member of the asset allocation team at the global investment firm Grantham, Mayo, Van Otterloo & Co.

Mr. Chancellor writes that "the only rational explanation for the extremely low yields on Treasuries" is that "the US economy is doomed to a combination of lacklustre growth and a declining price level in years ahead."

His arguments are compelling. In particular, a referenced essay from the latest Bank for International Settlements Quarterly Review entitled Debt Reduction after Crises points out that Japan's deflationary experience is the exception rather than the rule in the history of banking crises.

A competent investment strategist should continuously check his/her outlook against the reasonable outlooks of those who may not agree. In doing so, we readily confess that we may be wrong. There may indeed be a recovery already underway that lifts our economy out of this quagmire and results in more favorable economic activity and therefore higher bond yields. That is one of the primary reasons we build diversified portfolios - one can never be sufficiently certain of an investment outcome to go 'all in'. Moreover, one must consider both the probability of being right and the magnitude of being wrong. For example, one could have a 99% probability weighting on an outcome but, if the impact of that 1% adverse outcome is sufficiently negative, it must be respected.

At this moment we see little evidence of a recovery, either in the concurrent data or in the economic history books that have examined financial crises. In doing so, we continue to point to Hoisington Investment Management's excellent Quarterly Review and Outlook as some of the best work in this area.

While we continue to maintain select exposure to equities that would benefit from an outcome less dire than we expect, we also continue to hold substantial exposure to those assets that would most benefit from the sluggish (if not deflationary) environment we believe is most likely in the months and years ahead.

Taxing "The Rich"

2010-09-10T16:38:00.012-07:00

That inflammatory title ought to be enough to get some juices flowing, eh?

Before the food fight starts, let us state that we are strong believers in everyone paying their fair share of the tax bill. As we think more and more about this topic, which is especially divisive now, two famous quotes come to mind:

The first (intended to lighten things up) is from Arthur Godfrey, who said

I'm proud to be paying taxes to the U.S. The only thing is - I could be just as proud for half the money.

and the second (intended to remind us to listen to both sides) from the Irish author St. John Ervine, who said Every man....should periodically be compelled to listen to opinions which are infuriating to him. To hear nothing but what is pleasing to one is to make a pillow of the mind.

With that out of the way, let's talk about the so-called 'Bush Tax Cuts' and what to do about them.

The 'Bush Tax Cuts' is a colloquialism that refers to the Economic Growth and Tax Relief Reconciliation Act of 2001 (aka EGTRRA). This significant tax legislation made a number of changes to the US Tax Code, some of the most notable of which were across the board reductions in the tax rates for each bracket and a lower tax rate for "qualified" stock dividends and long-term capital gains.

However, in order to get the legislation passed in the Senate (look up the Byrd Rule if you want to know why), the provisions of EGTRRA were designed to "sunset" (revert to the world as it was in 2000) on January 1, 2011.

So here we are staring down 1/1/11 and knowing that if nothing is done, tax rates will go up for all taxpayers across the board. Given that the economy remains fragile, would that be a good idea?

We believe it is a bad idea. The studies we have seen (the serious stuff, not the arguments filled with hyperbole and partisanship) suggest the actual dollars involved will not have a meaningful effect in either direction - i.e. if the lower rates are extended for a few years or not. But our view is that the uncertainty of tax and fiscal policy that is plaguing our federal government right now is a major factor in the reduced levels of investment and consumption we are seeing.

Someone - preferably the President - needs to step forward and provide that leadership, articulate the vision and champion the cause.

Unfortunately, all we are getting in this election year is a bunch of polarizing rhetoric (on both sides). The risk in that is that nothing gets done and the economy continues to languish. The ranks of the unemployed remain bloated.

We deserve better.

So anyway, from our perspective extending the tax cuts for a couple of years makes tremendous sense. But it should be accompanied by more clarity with respect to how we chart a course out of the heavily-indebted, deficit-spending status in which we find ourselves.

For some perspective on the issue, we highly recommend a couple of articles from sources we respect - namely the Washington Post and the New York Times.

In the Post, you will find straight talk about the so-called 'Bush Tax Cuts' that cuts through the hype and demonization being spewed on both sides in this election year.

In the Times, you will find an opinion piece penned by contributing columnist Peter Orszag. The significance of this one is that Orszag was the 37th director of the White House Office of Management and Budget, just leaving office about six weeks ago. His views on extending the lower tax rates are in direct contrast with those of his former boss, President Obama.

Five Myths About the Bush Tax Cuts
William G. Gale
The Washington Post
August 1, 2010

One Nation, Two Deficits
Peter Orszag
New York Times
September 6, 2010

Labor Pains

2010-09-06T12:07:00.013-07:00

This being Labor Day, it seems the right day to review the status of the US labor market.

Last Friday's employment report was expected to be yet another in a long line of lousy reports. Analysts' consensus expectation was that there would be a paltry increase of 44,000 jobs during the month. Financial markets cheered when the release hit the news wires early in the morning that there were actually 67,000 jobs added in August. From our perspective, this employment report was mixed, at best. Consider that the entire gain in jobs came from part-time positions. Moreover, the broad "U6" unemployment rate rose to a four-month high of 16.7% (16.5% in July).

Our point is not that the employment report was abysmal, it was not. But in the context of the other recent economic data, there is nothing here that offers any "new" hope. In fact, when one considers that the April gain in payrolls was +247,000, the July (+107,000) and August numbers (+67,000) suggest a disturbing trend.

Nothing we have seen in the economic data of the last couple of years suggests any change to our view that We Are Japan. We are trapped in a deleveraging process while policymakers are in denial, scrambling to incent us to leverage up.

Let's oversimplify this for the sake of understanding. For purposes of illustration, let's say the 'natural' rate of US GDP growth (i.e. the rate that would be present absent any unusual distortions) is 4% per year. Roughly thirty years ago, we discovered the magic of leverage and began using it extensively for more and more 'stuff' - i.e. houses, cars, summer homes, furnishings, vacations, etc. In doing so, we were able to create another 2% per year of GDP "growth" through the use of debt that became progressively easier to acquire (lower and lower standards) and service (lower rates and easier terms). Thus, GDP growth ramped up to 6% per year.

But at some point, the ponzi finance collapses on itself. The last available borrower has reached his/her limit. Now, it would be really nice if we could all then just be comfortable with all that 'stuff' we bought and the rate of GDP growth can merely slip back to its more normal 4% per year from that debt-accelerated 6%.

If only it were that painless. We set ourselves up for production that feeds a 6% growth monster. If that growth is not there, capacity has to be shed. Jobs will be lost. Mortgages and car payments stop being made. Home values based on an ever-increasing supply of easy money don't just stop going up, they begin to fall precipitously. As they do, more and more mortgage payments stop getting made and the negative feedback loop accelerates. Until that excess leverage has been repudiated, the "new" normal rate of GDP growth is 1% or 2% per year, not 4%.

Unlike a normal recession, a deleveraging process takes years. Many years. You don't get rid of that excess debt in a few months. Japan is 20+ years into their process, and counting.

What can we do about it?

By now you know our advice with regard to your personal finances: basically minimize non-essential expenses and pay off your debt. But we also need our policymakers to stop with the quick fixes aimed at restarting spending. The deleveraging process will not be denied and the "solutions" implemented so far have done nothing more than bring forward spending that would have happened anyway, delaying the process.

What we can do about that is elect strong leaders who will make the tough (read: "unpopular") choices that will lay the foundation for the resumption of growth. The way to do that is to vote mindfully. Vote for candidates or incumbents who understand the difference between a recession and a deleveraging process (the latter also known as a "depression").

We would suggest the following for policymakers and those who are candidates:

Regulatory Reform - the current round of so-called "financial reform" is a joke because it a) did not even mention the two biggest financial black holes - Fannie and Freddie; and b) it allowed naked credit default swaps to continue.

Entitlement Reform - the Social Security system is bankrupt, whether anyone wants to admit it or not. It is time to increase the retirement age to 70 and look for additional measures that will restore confidence in this 'safety net'.

Fiscal Reform - Since no one can make the tough choices, implement an across-the-board spending cut followed by several years of a freeze. Oh, and did we mention stop flushing money down the toilet trying to incent folks to spend? No more cash for clunkers, appliances, NOTHING. All it does is suck forward a few months of spending and then we are right back where we were.

Tax Reform - Tax policy should encourage long-term, productive investment. Incentives should be provided to develop targeted industries such as alternative energy and biomedical technology. Additionally, a meaningful portion of the Bush tax cuts should be allowed to live on and unless you want to handicap a good portion of our country's growth engine (small businesses), the income limit for those tax cuts is a lot higher than $250,000.

This November, ignore the hyperbole of the campaign machines and vote intelligently. This is not a "left-wing/right-wing", Democrat/Republican", nor "liberal/conservative" issue.

Elect strong leaders who will put this country back on the path to economic recovery.

Fed Waters Desert With Eyedropper - On Watch For Green Shoots!

2010-08-11T10:14:00.011-07:00

The Federal Open Market Committee (FOMC) announced at the conclusion of its meeting yesterday that it would stop reducing the size of its balance sheet. Recall that the Fed had created dollars out of thin air to purchase $1.3 trillion worth of mortgage-backed securities (MBS). This was an attempt to prime the economic pump (so to speak) by injecting $1.3 trillion into the economy.

Stepping back to see the big picture, the Fed embarked on a strategy two years ago to inject cash into the economy by purchasing various securities. Indeed, from September 2008 to the present, holdings on the Fed's balance sheet have increased from about $0.9 trillion to $2.3 trillion today. That additional $1.4 trillion went to the sellers of those securities.

But the bulk of that increase occurred in October and November of 2008, when the Fed purchased MBS, increasing its balance sheet holdings from $0.9 trillion on 9/10/08 to $2.2 trillion on 11/12/08. (source: the always excellent Cleveland Fed website) Since then, the Fed has not added any further money to the economy (purchased securities) and, in fact, has actually drained a modest amount of cash from the economy by not reinvesting the principal and interest payments it has received each month on those MBS.

Since completing its purchase of $1.3 trillion of MBS, speculation has ensued as to exactly what would be the Fed's 'exit strategy' with respect to those MBS. Would they turn around and sell them back into the marketplace once the economy showed it could ride without the training wheels? Would it simply allow the MBS position to slowly amortize down to zero?

So, back to the Fed's announcement yesterday. Basically, the FOMC is telling us that the economy remains too weak to allow the Fed to sell any of those securities. (Talk about your blinding glimpse of the obvious!) In fact, the economy is so weak that the FOMC does not want to allow its balance sheet to shrink any further (i.e. no further cash is to be drained from the economy.) Effective immediately, all payments received on the Fed's MBS positions will be reinvested in Treasury bonds of the two- to ten-year maturities.

Now, it is hard to know precisely how much cash flow we are talking about. But suffice it to say that the number itself is not significant enough to be much more than a rounding error in the money supply data.

So why are global equity markets selling off and global bond markets rallying? While it is always problematic to try to explain why investors do what they do, this very well could be investors taking the FOMC announcement as confirmation that this economic emperor is indeed threadbare.

We have been telling you for some time that we are Japan and that the near-term risks are deflationary, not inflationary. (See our post from March of 2009, linked below.) As the deflation camp has grown over the past few months, our contrarian 'spidey senses' have begun buzzing and we are growing more cautious about investment themes related to deflation. Treasury bonds have rallied significantly (rates declined). Asset prices have been weak.

We have gone on long enough in this post, but will have more to say about deflation in a subsequent message. For now, just know that we continue to believe we are in a global de-leveraging process that has deflationary side effects. Having said that, the time to load up on those Treasury bonds was several months ago. This might be a good time to pause and wait for the next buying opportunity.

If we know anything about the manic-depressive nature of most investors, it will come.

And, to repeat from our June 25, 2010 message:
The time-honored recommendations for investors during the rare deflationary periods are:
1) Minimize non-essential spending;
2) Pay down debt aggressively;
3) Increase savings; and
4) Buy long-term government bonds.

Formerly on our blog:
It Is Official: We Are Japan
March 18, 2009

The Debate On Bonds
April 14, 2010

FOMC: Extending the "Extended Period" for "Exceptionally Low" Rates
June 25, 2010

Cura te Ipsum (Government, Heal Thyself!)

2010-07-19T16:18:00.013-07:00

(Cura te Ipsum is a Latin proverb found in Luke 4:23, the moral of which is generally accepted to be counsel to attend to one's own defects, rather than criticizing defects in others.)

OK, we said in our previous post that we would not say anything further about Fannie and Freddie escaping mention in the financial services reform legislation. . . but we can't stop ourselves. We are outraged. Omitting the GSEs entirely from this "reform" is unconscionable. Just look at this article that appeared in the July 14 issue of the Wall Street Journal: Signs of Risky Lending Emerges in US.

From the story:
Fannie Mae, seized by the U.S. government in 2008 to avert the mortgage company's failure, launched an initiative in January that allows some first-time home buyers to get a loan with a down payment of as little as $1,000.

Securities firm Morgan Stanley Smith Barney, a brokerage operation jointly owned by Morgan Stanley and Citigroup Inc., is offering some clients home-equity credit lines of as much as $2.5 million.

Nearly 8% of loans for new cars in the latest quarter went to borrowers with the lowest range of credit scores, up from 6.2% in 2009's fourth quarter, according to J.D. Power & Associates and Fair Isaac Corp.

Yes, indeedy. It has been confirmed: we have learned nothing.

Signs of Risky Lending Emerge
By Ruth Simon and Jessica Silver-Greenberg
Wall Street Journal
July 14, 2010

Financial Reform: Don't You Feel Safer Already?!

2010-07-16T16:44:00.014-07:00

As has been well-reported everywhere, Congress has approved the so-called "omnibus financial services reform bill" and sent it to President Obama, who intends to sign it into law next Wednesday (July 21).

Much of the post-approval media attention has been focused on the new Consumer Financial Protection Bureau (CFPB) that will be created inside the Federal Reserve, but given complete independence from the central bank. We must confess our skepticism. The regulators have been unable to protect consumers up to this point. Why will the CFPB be any less a failure? We fear the only success the CFPB will have might be in operating free of any constraints and creating onerous reporting standards.

Next up is the systemic risk regulation in the form of the Financial Stability Oversight Council (FSOC). Chaired by the Treasury Secretary, this is a body charged with identifying systemically significant companies and monitoring markets for bubbles. While we applaud the attempt to facilitate orderly wind downs of the next Lehmans and Bears, why create another regulatory body? We already have the FDIC, a regulator that already knows how to take down a financial institution in a manner that protects depositors (and taxpayers) while appropriately holding bond and stockholders financially accountable.

Other features getting attention include requirements that derivatives be executed through central clearing houses (eliminating counterparty risk) and the "Volcker rule", which bans banks from proprietary trading. That one still sounds more complicated to us than is practical, but we'll see.

Two things are ominously missing:
1) No mention of the Government Sponsored Entities that were (in our view) at the root of the entire financial crisis. How one can hope to truly fix what went wrong without addressing these financial black holes is not fathomable. But we already ranted on that (see link below) so will let it go.
2) Media coverage of the change in regulation of hedge funds that is part of this legislation. Never thought we'd see the day.

First, hedge funds gained their moniker from the fact that the original funds were set up to "hedge" risks and returns such that they provided (or attempted to do so, anyway) much more return per unit of risk than had been available via traditional investment strategies. Today, very few funds called "hedge funds" actually hedge. A more accurate name would be "leveraged funds" since what most hedge funds do today is simply leverage up an investment strategy to juice the returns. The downside of such an approach is that risks are not only not hedged, they are actually magnified.

But we digress. Under this new legislation, heretofore unregulated hedge funds will now be regulated. They must register with the SEC like the rest of us investment advisers. In addition, they will a) be required to report their holdings to the SEC every quarter, and b) be required to report their short sales to the SEC on a weekly basis.

Our view is that those two reports alone may have a significant impact on the hedgies' investment strategies. Most importantly, we are encouraged that the SEC may now actually have some teeth when it comes to flushing some of the 'bad apples' out of the investment business. In particular, we think these weekly reports (which will not be available to the public, btw) will help the SEC address the problem of naked short selling. In our view, this could very well end up being one of the few unequivocal positives to come out of this legislation.

Previously on our blog:
Financial Services Reform
May 4, 2010

FOMC: Extending the "Extended Period" for "Exceptionally Low" Rates?

2010-06-25T13:02:00.025-07:00

Wednesday afternoon, the US Federal Open Market Committee concluded their latest meeting with their usual press release. While the Committee held the target for its federal funds rate at 0 to 1/4 percent (where it has been since the financial crisis started), there were some modest changes to how the current economic environment is described.

We have compared this release with how the committee described conditions after the last meeting (April). While the general tone is similar, there are a number of modest differences and we highlight below those we found the most significant.

April 28:

". . . economic activity has continued to strengthen and that the labor market is beginning to improve."

June 23:

". . . the economic recovery is proceeding and that the labor market is improving gradually."

Note that the recovery is no longer strengthening and the labor market improvement has been downgraded to "gradually".

April 28: "Growth in household spending has picked up recently. . . "
June 23: "Household spending is increasing. . . "
In other words, the rate of increase in household spending is no longer accelerating.

April 28: "Housing starts have edged up but remain at a depressed level."
June 23: "Housing starts remain at a depressed level."
So much for the hoped-for improvement ("edged up") in housing back in April.

April 28: ". . . financial market conditions remain supportive of economic growth."
June 23:

"Financial conditions have become less supportive of economic growth. . . "

The clearest downgrade of the economic outlook in this FOMC release.

Finally, while the Committee noted that ". . . inflation is likely to be subdued for some time." back in April, this week's release contained an additional acknowledgment that "Prices of energy and other commodities have declined somewhat in recent months, and underlying inflation has trended lower." Maybe not outright deflation yet, but clearly disinflation.

Unchanged in the latest release was the long-standing admission that we are likely to see "exceptionally low levels of the federal funds rate for an extended period."

The reader may be excused for dismissing any one of these subtle changes in wording as immaterial. However, we believe when they are viewed in the context of the entire mosaic, the picture of a deflationary environment emerges. The time-honored recommendations for investors during the rare deflationary periods are:
1) Minimize non-essential spending;
2) Pay down debt aggressively;
3) Increase savings; and
4) Buy long-term government bonds.

Previously on our blog:
The Path Back To Normalcy
June 18, 2010

The Debate on Bonds
April 14, 2010

The Path Back to Normalcy

2010-06-18T14:27:00.009-07:00

During the financial crisis of the past 36 months, the US Federal Reserve has taken extraordinary steps in an attempt to lean against the dislocations - if not outright panic - in the financial markets. In the event, it appears we have avoided a complete seizing of financial markets as well as a negative economic outcome approaching (or exceeding) that of the so-called "Great Depression" of the 1930s.

The question then becomes how the Fed exits from these extraordinary actions. Glenn D. Rudebusch, senior vice-president and associate director of research of the Federal Reserve Bank of San Francisco published a paper earlier this week outlining his view of what the Fed's exit strategy might look like.

Rudebusch makes several interesting points, but it was his conclusion that caught our eye:

Many predict that the economy will take years to return to full employment and that inflation will remain very low. If so, it seems likely that the Fed’s exit from the current accommodative stance of monetary policy will take a significant period of time.

In other words, we are unlikely to see an increase in the Fed Funds rate (current target: 0 - 0.25%) anytime soon, the demands of some Federal Reserve Governors notwithstanding.

Our view remains the same. We remain mired in a deleveraging process that begets a deflationary environment. Thus, we continue to find income-oriented investment strategies attractive and believe they will remain so until the Fed begins to raise rates. We continue to evaluate the evidence as it is presented but currently believe higher rates are not a threat until early- to mid-2012.

The Fed's Exit Strategy for Monetary Policy
Federal Reserve Board of San Francisco Economic Letter
Glenn D. Rudebusch
June 14, 2010

That Pesky Arizona Immigration Law

2010-05-10T16:29:00.006-07:00

You may or may not support the new immigration law recently passed in Arizona but, as the old saying goes, you are entitled to your own opinion but not your own facts. As we listen to the talk-show-style shouting matches (apparently intelligent and civil debate is no longer an option in our society) and comedy routines/monologue jokes about it, we are struck by the number of folks opining who are apparently not familiar with the actual legislation.

Please, if you have any interest in condemning or supporting the legislation, read the bill first. It can be found here.

We also found comments made by Kris Kobach to be of interest. Kris W. Kobach is a professor at the Univ of Missouri – Kansas City School of Law. He has degrees from Harvard, Yale and Oxford. He was Attorney General Ashcroft’s chief adviser on immigration and border security from 2001 – 2003. He helped draft Arizona’s new immigration law and was a guest last Thursday on the Arizona Republic’s live talk website here.

A few excerpts we thought were of note:

Identifying a few reasons the national reaction to this bill has been surprising, he noted:

First, numerous national figures (including President Obama) significantly mischaracterized SB 1070 in their criticism of it. It is clear that much of the hyperventilating reaction to the bill came from people who did not bother to actually read it.

In answering a question about whether the new law allows law-enforcement officers to pursue suspicion of illegal status independently or only as a follow-up on some other offense:

Section 2 of the law stipulates that a law enforcement officer must first make a "lawful stop, detention, or arrest … in the enforcement of any other law or ordinance of a county, city or town or this state." If the officer, during the enforcement of that other offense, develops reasonable suspicion that the person is an alien who is unlawfully present in the United States, then the officer must contact ICE if practicable to verify the alien's immigration status. Many city, county, and state law enforcement officers already did this before SB 1070 was enacted. Opponents of the law evidently think law enforcement officers in the state should turn a blind eye to such violations of federal law that they come across during their routine duties.

. . . and finally:

The biggest misperception about SB 1070 is the claim that it somehow encourages racial profiling. The people making this claim either haven't read the bill or they are willfully misrepresenting it. SB 1070 expressly prohibits racial profiling. In four different places, the law provides that "a law enforcement official … may not consider race, color or national origin in the enforcement of this section …." Race may not be considered in making any stops or determining immigration status. So if race were considered in any particular case, in violation of the law, the prosecution would not hold up in court. In addition, all normal Fourth Amendment protections against racial profiling will continue to apply. Most state and federal statutes do not include such special protection in the text of the statute; SB 1070 goes to extraordinary lengths to protect against racial profiling.

Financial Services Reform

2010-05-04T14:55:00.010-07:00

Our clients know that we have remained concerned about the fundamental investment backdrop despite a huge rebound in global stock markets. That concern stems from the fact that, despite some massive (and massively expensive) band aids applied to avert a complete melt-down and depression, the core issues that caused the crisis in the first place have not been addressed.

As Congress prepares to 'reform' the financial services industry we are shocked - shocked - to find that they continue to ignore the elephant standing at ground zero. That would be the government-sponsored enterprises (GSEs) they created to facilitate reliable and affordable capital for the purchase of a home.

Robert Wilmers, chairman and CEO of M&T Bank Corporation, wrote an opinion column that appears in the Wall Street Journal this morning. It captures the essence of what was wrong with those enterprises and suggests what we believe is an appropriate level of urgency for enacting such reforms. For example:
a) We, the taxpayers, are already on the hook for $8.1 trillion of debt that is not even being carried as part of the entirety of the government's admitted debt (which is a stunning $7.8 trillion as it is).
b) We, the taxpayers, have already poured $126 billion into Fannie Mae and Freddie Mac just to keep them alive. Compare that to the $70 billion given to AIG or the $77 billion that was sucked down by GM and Chrysler, combined. And they (Fan and Fred) are still on the take.
c) We, the taxpayers, provided $23 billion in subsidies to Fan and Fred in 2003 of which only a fraction ($13 billion) was passed on to homeowners. Wilmers notes that this was during a period in which former Fannie Mae CEO Franklin Raines was averaging about $18 million per year in compensation and Freddie and Fannie were averaging about $25 million per year in lobbying expenses.

The entire (short) column is worth your time.

Some related comments were presented yesterday by Annaly Capital Management Chairman, CEO and President Michael Farrell during the company's conference call (the video for which can be found here). Farrell provides some excellent history of the GSEs along with principled guidelines for reforming the sector.

Also short and also worth your time.

What About Fan and Fred Reform?
Robert G. Wilmers
Wall Street Journal
May 4, 2010

It's a Wonderful Wrap
Michael J. Farrell
Annaly Capital Management, Inc.
May 3, 2010

Consumer Spending Rises as Evictions Slow

2010-04-22T14:31:00.009-07:00

Interesting article in the Financial Times yesterday about which there could be many conversations. At the moment, we want to focus on one aspect that may not be quite so obvious.

There can be no doubt that there has been a modest recovery in US economic activity, much of which has been supported by two items we believe may not be sustainable: government transfer payments and business inventories being rebuilt.

The US Government has stepped up spending in what we believe is a misguided attempt to support the US economy. Such activities have been shown to provide no more than a transitory immediate benefit to the economy with a meaningful negative effect, longer-term. (See our previous commentary and, in particular, the quarterly review and outlook from Hoisington Investment Management Company linked therein.)

Businesses exhibited a rational response to the crisis/recession, deferring the replacement of goods sold until inventories were run down to bare-minimum levels. The 'restocking' that has ensued has provided a boost to economic growth, the lasting impact of which will depend on a continued rebound in final consumer demand.

Therein lies the rub. Consumers have indeed increased spending recently, but we remain skeptical that such levels are sustainable. Employment has stopped getting worse but has not yet improved meaningfully. Wages are not increasing but taxes are.

And then there is the issue raised in the FT article.

"As many as 6m people continue to live in their homes even though they are seriously delinquent or in some stage of foreclosure, according to Moody's Economy.com."

and

"Delinquent borrowers can expect to live in their homes for about 14 months before getting evicted, nearly double the length of time it took banks to foreclose before the housing crisis began, Mr. Jadlos said."

What happens to consumer spending when these 6 million people have to start making rent or mortgage payments again?

We remain skeptical of the sustainability of the recent modest rebound in consumer spending.

Foreclosure backlog provides relief for homeowners
Suzanne Kapner
Financial Times
April 21, 2010

Previously on our blog:
The Debate On Bonds
April 14, 2010

The Debate on Bonds

2010-04-14T14:52:00.012-07:00

Our clients know that we have a very small position in long-term Treasury bonds - a position we fully intend to be "large". But before we can increase the position, however, we need to develop some conviction on the benefits of doing so.

Long-term Treasury bonds are generally regarded as among the most sensitive assets when it comes to changes in inflation and interest rates. The price of those bonds will reflect the inverse of changes in rates and will do so dramatically. Thus, if inflation and interest rates increase significantly over the next few years, the price of these long-term Treasuries will likely decrease significantly.

A consensus seems to have developed lately among market pundits that this outcome is assured. In fact, no less a publication than the New York Times recently pronounced to its readers that "Interest Rates Have Nowhere to Go but Up."

Jim Grant, Editor of Grant's Interest Rate Observer, is another who believes rates are headed higher. Gluskin-Sheff Chief Economist and Strategist, David Rosenberg, is one of the 'lower rates' lone wolves crying in the wilderness. At the recent Grant's Spring Conference, these two engaged in the 'Great Debate' "Resolved: Treasuries are for Losers". FT columnist John Dizard was the moderator, a self-confessed sympathiser with Grant. We highly recommend a video of the debate which can be accessed for free from the Grant's website.

We will not spoil the ending (run time is 49 minutes). But we will point out that Mr. Grant's strongest points (in our view) included the massive debt piled up by our federal government that does not even include the enormous 'off-balance-sheet' obligations like Medicare, Social Security and Fannie & Freddie and their kin. During his allotted time, Mr. Rosenberg made his own strong points, not least of which are the powerful deflationary forces that are at work in our economy.

But for us, the definitive argument in favor of Treasuries comes from the adroit minds at Hoisington Investment Management. Van Hoisington and Dr. Lacy Hunt have been extolling the virtues of long-term Treasury bonds for many years. And they have been right. Their First Quarter 2010 Quarterly Review and Outlook was published today and there is no change to their outlook. Debt levels are excessive. Monetary and fiscal policies are contractionary. Inflation will continue to moderate, driving long-term Treasury rates lower (prices higher).

Our conviction is growing.

Healthcare Reform: A Big (expletive deleted) Deal

2010-03-23T18:33:00.022-07:00

It is indeed a big deal, but maybe for some reasons Vice President Biden does not presently have in mind. More on that below, but first - is it us, or did President Obama look rather annoyed by the Vice President dropping the F-bomb? (If you missed it, a short video can be seen here.)

While we are providing links, let's point you to the Kaiser Family Foundation website, an excellent resource for health care reform. There you can find a comparison tool that allows you to view detailed, up-to-date, side-by-side summaries of the various health care reform proposals. You will also find an issue brief explaining the key elements of the Congressional Budget Office's estimates of the bills.

(In analyzing these bills, we relied heavily on the resources of the Kaiser Family Foundation. Their work has been invaluable, but any errors in our conclusions are all ours.)

This 'big deal' does some big things - mostly in the area of making health insurance available for many who previously could not acquire and/or could not afford it. It does some other commendable things too, like eliminate that 'doughnut hole' in Medicare coverage of prescriptions and removing many limits to other coverage.

But the one key thing this bill does not do is address cost containment. Originally, the health care reform effort was framed as an economic issue. Remember the line about "bending the cost curve" on health care inflation? This bill does nothing to address that issue. In fact, our view is that health care inflation may worsen. The problem is that the 'third party payer' nature of health care is at the core of rising health care costs.

For years, we have used the fictitious concept of "grocery insurance" in explaining to clients and friends what is wrong with health care insurance. If you imagine that you are provided or otherwise acquire coverage for purchasing groceries that worked in the same manner as health care, we would shortly see grocery inflation soar out of control.

As it is, we shoppers who pay for our groceries ourselves are keenly aware of the cost of various food alternatives available to us and we spend a commendable amount of time analyzing the cost/benefit trade offs of our choices. We are careful in spending our hard-earned dollars at the grocery store.

But turn grocery shopping into a 'third party payer' system and the motivation to comparison shop would be lost. Instead of carefully comparing the animal protein options at the butcher counter, most would simply buy the best cut of meat they can. Instead of looking for the bargains in the wine section, just grab that $50 Cabernet and the $80 imported champagne. It doesn't matter, the grocery store is going to bill your insurance company!

Why do you think Veterinarians have pushed so hard to get pet insurance more widely accepted? When the consumer is not questioning costs nor the necessity of procedures, prices rise rapidly. The National Center for Policy Analysis has written two (at least) papers on the issue. The first, entitled The Market for Medical Care: Why You Don’t Know the Price; Why You Don’t Know about Quality; And What Can Be Done about It, points out that it is only the 'third-party payer' corners of health care that are experiencing high inflation. From the paper: Long before a patient enters a doctor’s office, third-party bureaucracies have determined which medical services they will pay for, which ones they will not and how much they will pay. The result is a highly artificial market which departs in many ways from how other markets function.
Compare that to medical procedures not normally covered by insurance (again, from the paper): In health care markets where third-party payers do not negotiate prices or pay the bills, the behavior of providers is radically different. In the market for cosmetic surgery, for example, patients are offered package prices covering all aspects of care — physician fees, ancillary services, facility costs and so forth. Not only is there price competition, but the real price of cosmetic surgery has actually declined over the past 15 years — despite a six-fold increase in demand and enormous technological change. Similarly, the price of conventional LASIK vision correction surgery (for which patients pay with their own money) has fallen dramatically, even as procedures become more technically advanced.
Because this bill does nothing to address this fundamental problem, we see no reason for optimism regarding health care costs and, in fact, expect the problem to get worse. As a result, doubts about the soundness of US Treasuries are growing.

Last month, Berkshire Hathaway sold two-year notes that yielded less than Treasuries of a similar maturity - an "exceedingly rare" event according to former Lehman Brothers chief fixed-income strategist Jack Malvey. That was about the same time Fed Chairman Bernanke warned Congress that the US could soon face its own Greek tragedy. "It's not something that is 10 years away. It affects the markets currently," he told the House Financial Services Committee. "It is possible that bond markets will become worried about the sustainability [of yearly deficits over $1 trillion], and we may find ourselves facing higher interest rates even today."
It would be a relief to see Congress address the huge and rapidly growing federal deficit with the same tenacity it applied to the health care bill.

Reading China's Currency Tea Leaves

2010-03-08T19:33:00.007-07:00

For decades, China and the US have enjoyed a symbiotic relationship. China produced cheap consumer goods that US consumers purchased with US dollars. Rather than convert those dollars back into Chinese renminbi, it has been China's policy to use those dollars to purchase US treasury securities. In this way, the value of the dollar would be supported and the renminbi left at a lower relative value. The policy served both parties well - China's merchandise remained cheap due to the cheap currency and the US had a willing lender to facilitate such profligate spending.

No more. The 'new frugality' that is the result of the financial crisis is that China's exports to the US have cratered and the support of the dollar relative to the renminbi evaporated. China's political leaders have repeatedly voiced their commitment to continuing the 'weak renminbi' (strong dollar) currency policy despite a growing legion of those calling for the renminbi to be allowed to float to a level more reflective of current conditions.

In a story that may be nothing and seems to have been lost in the weekend news anyway, we may have the first acknowledgment of an emerging new policy. The Financial Times quotes Zhou Xiaochuan, governor of the People's Bank of China, describing the longstanding currency policy as a "special measure" to confront the financial crisis and that "These kinds of policies sooner or later will be withdrawn."

Mr. Zhou's comments were not necessarily supported by other officials. This may be a mistake of reading more into the comments than is there, but we sense otherwise. Besides, China can only hold its currency down for so long. Like a beach ball held underwater, at some point it becomes impossible to continue to hold it below its natural level and it will float to the surface. It could do so in an explosive move, but our view is that it will do so gradually, over a period of many years.

Protest from its officials notwithstanding, China can not long maintain its pre-crisis currency policy in the wake of a massive change in its partner's currency policy (the US moving to near-zero interest rates and Quantitative Easing). Holding the renminbi artificially lower than the dollar is essentially importing US monetary policy - and therefore inflation. China has attempted to limit the damage by slowing bank lending and raising interest rates and reserve requirements. Ultimately, however, renminbi appreciation vis-a-vis the dollar is inevitable.

As mentioned in previous comments about China's currency, we continue to review the long-term investment beneficiaries of what we believe will be an enormous factor. We continue to hold meaningful exposure to gold, commodities and foreign currencies while also building a position in Chinese and other companies doing business in China.

We are also bumping our worries about inflation up a notch, acknowledging that we could experience higher prices for many goods despite continuing weak demand here in the US.

Hopes fade of rapid removal of peg to US dollar
Geoff Dyer and Jamil Anderlini
Financial Times
March 9, 2010

Formerly on our blog:
China: Treasuries Out, Commodities In
May 21, 2009

It Is Official: We Are Japan
March 18, 2009

The Schizophrenic Stock Market

2010-02-25T15:52:00.023-07:00

If you have been watching the day-to-day movement in global stock markets this month, it is evident that there is a lot of uncertainty, if not complete confusion, in the current outlook. For example, tracking the FTSE All-World index, we saw the market:
+3.6% the first three days of February
-5.0% the next four days
+2.2% the next day
-0.5% the next day
+1.3% the next day
-0.6% the next day
+3.0% the next three days
-0.2% the next day
+0.1% the next day
-1.8% the next day
+0.9% yesterday

Even today, the FTSE was down as much as -2.1% before rallying back to close -0.2%. Talk about a choppy, directionless market. What gives?

From our perspective, it appears there is a growing confusion as to the outlook for the global economy in general and therefore interest rates and corporate profits.

The trend in the economic releases over the past six to nine months has been positive. We have stepped back from the abyss even if we have not exactly seen a strong rebound yet unfold. But there are pockets of strength. For example, China, where economic strength is sufficient to trigger efforts to rein in inflationary growth by curtailing bank lending. That is encouraging in the sense that economic growth is strong. But it has also resulted in bumping global interest rates up a bit.

On the other hand, Russia has been actively cutting rates and using the bully pulpit in an effort to stimulate growth.

Then there is the Euro zone and the PIGS (Portugal, Italy, Greece and Spain). The policymakers have repeatedly reassured us through official statements that the worst of the litter (Greece) will be supported, although the details of any such "support" have yet to be shared.

Even stateside there has been a string of conflicting economic reports. Earlier this month we saw relative strength in the ISM Index, pending home sales and the ADP Employment Report. Then came some less encouraging reports. Even the official arbiter of when recessions begin and end - the National Bureau of Economic Research (NBER) - is seeing conflicting signals. . . or so says William Hester, CFA.

Mr. Hester is the Senior Financial Analyst with Hussman Funds. He recently noted the conflicting messages being generated by the major indicators followed by the NBER to determine whether the economy is expanding or contracting. The result is a recently-published paper, a link to which can be found below.

While we recommend reading the entire paper, we believe the significant points are: One of the major indicators that the group follows is consistent with an economic recovery. One is unimpressive, but not strongly at odds with a recovery. The two remaining indicators imply that the economy may still be in recession.
and With real GDP still down more than 3 percent from its peak, it would go against precedent for the group to declare the end of a recession with the mixed signals that are currently in place.
We will have more to say about setting appropriate expectations for exiting the Great Recession, but this post has already gone on long enough.

Until then, and until we have more clarity regarding the outlook, our recommendations remain the same:
1) Minimize non-essential spending;
2) Pay down debt aggressively; and
3) Be cautious in your investment exposure.

A View From The NBER Recession Indicators
William Hester, CFA
January 2010

Learning From the Past While Rooted in the Present

2010-02-08T11:23:00.006-07:00

This past weekend's Financial Times contained an excellent column from John Authers. Authers (great name for an, ummm. . . author, eh?) writes the FT's Long View column every Saturday along with serving as FT's Investment Editor and penning other columns. In his Long View columns over the past three years, he has repeatedly referenced long-term valuations in general and the "q" and P/E ratios in particular. The point has been to try to get a feel for the extent to which stock prices have deviated from their long-term norms.

In his weekend column, Authers points out that stock markets reached extreme levels of overvaluation in 1929 and 2000 and extreme levels of undervaluation in 1932 and 1982.

One of the reasons we have yet to make a 'back up the truck' kind of re commitment to stocks in our client portfolios is that neither of these measures reached the kind of extreme level of undervaluation last year that presages the 'once in a lifetime' kind of bull market for which we are all looking. Unless and until we see such undervaluation, we expect stocks to experience tepid returns over the next few years or a return to last year's stock market lows, if not lower. Until we see those extreme levels of undervaluation, we are likely to maintain our modest (hedged) exposure to common stocks.

The full column is a short and easy read. We highly recommend it.

Learn from the past but be rooted in the present
John Authers
FT Weekend
2/6/2010

GDP: Strong Headline Number

2010-01-31T16:24:00.014-07:00

Friday morning, the Bureau of Economic Analysis (BEA) provided its advance estimate of 4Q09 GDP and the headline number appeared to be a very strong one. Real (after inflation) gross domestic product (the output of goods and services produced by labor and property in the United States) increased at an annual rate of 5.7% during 4Q09.

As usual, there will be revisions to this number as the BEA continues to evaluate the data. But there can be no argument that +5.7% is not a strong number. 3Q09 GDP growth, for example, was up a more pedestrian +2.2%. After a brief morning rally (1%+), the US stock market rolled over and suffered a decline of a little over 1%.

Nine months ago, the stock market was rallying strongly on economic data that was truly bad, but 'less bad' than it had been. Now we get truly 'good' economic data and the market tanks. What gives?

Two points. First, having rallied ~70% from the March 2009 lows, the financial markets are now discounting a very vigorous recovery - if not today, then in the very near future. In order for stocks to continue to run higher we must get economic data which clearly demonstrates that the recovery is indeed vigorous and that it is already happening.

That brings us to the second point. This report left a lot to be desired in terms of the 'vigorous-ness' and 'imminence' of any economic recovery.

The +5.7% annualized rate of growth preliminarily measured for 4Q09 was goosed by a significant increase in inventories. Nearly 2/3 of the +5.7% annualized rate of growth was a result of companies adding to their inventories (as opposed to sell-through to end users).

Granted, inventories had been run down during the most worrisome phase of last year's panic and needed to be rebuilt to some extent. Moreover, even a +2.2% rate of annualized growth (estimated GDP net of the inventory build) is better than the +1.5% recorded for 3Q09. But we worry that even the ex-inventory 4Q09 GDP number may not represent a sustainable rate of economic activity.

One of the problems with using GDP to measure economic prosperity is that it measures spending. One does not build wealth by spending.

We turn, then, to methods by which we could measure earnings. The Nelson A. Rockefeller Institute of Government tracks and analyzes state fiscal conditions, tax policies, fiscal capabilities and spending trends. In its latest release (full report here), the Institute noted a -10.9% decline in state tax collections through 9/30/09. Moreover, the early read of 4Q09 data suggests the decline in tax collections continues, albeit at a slower pace. For the 38 states reporting early data, personal income tax collections fell -6.5% in the first two months of 4Q09.

While we are not eager to spit into the wind nor tug on Superman's cape, we nonetheless take issue with the conventional wisdom that the recession is over. The Rockefeller Institute data suggests that personal income continues to lag the economic statistics being reported. It will be tough to have much of a recovery unless and until the consumer sees some stabilization to his/her income. . . much less growth.

In our view, a slower less vigorous recovery is more likely than the kind to which we have become accustomed over the past 50-60 years. That's not necessarily a bad thing. We need time for consumers and corporations to rebuild their respective balance sheets. Such a period of retrenchment and rebuilding will lay a strong foundation for a sustainable recovery.

Government policies, should therefore focus on saving and investing rather than spending.

Housing

2010-01-28T08:12:00.020-07:00

The Commerce Department reported yesterday that new home sales fell to a seasonally-adjusted rate of 342,000 units in December, 7.6% below November's rate of 370,000.

Equally worrisome is news that the inventory of new homes for sale has jumped back up to 8.1 months from 7.6 months in November. As a result, it is now taking home builders almost 14 months to sell a home, on average, versus about four months back during 'the good old days'.

Most news sources called the weak sales report "unexpected" or some similar adjective suggesting surprise. From our perspective, it is surprising that folks are surprised that home sales remain tepid.

We built too many. We borrowed too much. Largely as a result of a well-intentioned but misguided federal policy of subsidization, we put more people into home ownership than can maintain ownership - particularly through a financial crisis. It takes time to rectify such imbalances. Moreover, when the government steps in to 'cushion the blow' of this crisis, the short-term pain may indeed be blunted, but at the expense of dragging out the process.

Those well-intentioned policy choices also distort efforts to measure activity (or lack thereof) in the real estate markets. The S&P/Case-Shiller Home Price Index released this past Tuesday was worse than expected but nonetheless revealed that the rate of decline in home prices continues to slow. The problem with this data is knowing how much the readings are distorted by the first-time home buyer credit and other temporary factors.

The smart folks over at Annaly recently took a shot at sorting out what is happening. In doing so, they reference the Federal Reserve's preferred measure of national home prices: the LoanPerformance National Home Price Indices. While not perfectly correlated on a month-to-month basis, the LoanPerformance data tends to match the readings of the Case-Shiller home price data over time.

As the Annaly blog post notes:

It’s clear now that there was nothing organic about the pick-up in sales activity or prices in the back half of 2009. We look forward to seeing how S&P/Case-Shiller and LoanPerformance home price indices respond to this lower level of demand when we receive December data.

We will point out the LoanPerformance December data as soon as it is released.

In the mean time, we continue to believe expectations for real estate activity - and therefore prices - should be kept modest.

Working Man Blues

2010-01-13T17:33:00.011-07:00

Last Friday, the US Bureau of Labor Statistics (BLS) released the December Employment Situation report. It was generally received by the market as mixed to positive news, largely because a) after peaking at 10.1% in October, the unemployment rate has leveled off at 10.0% for November and December; and b) the previously-released November employment data was revised from the originally-reported loss of 11,000 jobs to a gain of 4,000 jobs.

To be sure, there were worries immediately following the release of the data, the two positive data points above notwithstanding. Most significant of the concerns was the fact that analysts' consensus forecast was for a modest gain in jobs during December but the shocking reality was a loss of 85,000 jobs. After a brief scare, the stock market ultimately 'decided' that those two positive data points above outweighed the December job losses and prices ended the day higher.

After spending much time with this data and calling on some 'friends' to check our sanity, we are writing to caution that the conventional wisdom on the current 'employment situation' might have it wrong.

Dead wrong.

First, the easy one. That the surprising loss of jobs in December was canceled out by the revision to November's data is nonsense. The December loss of jobs above expectations was several orders of magnitude greater than jobs 'saved' by the November revision.

Most concerning to us is the fact that the US civilian labor force declined by 661,000 in December. What that means is that 661,000 Americans gave up on finding a job last month and are no longer considered for statistical purposes to be "unemployed". But let's be clear: they are not employed.

To put this in perspective, consider that the number of civilians leaving the labor force in November was 134,000. December's number was nearly five times that.

Further, understand that the number of American civilians considered to be in the US labor force comprises the denominator of the unemployment calculation. The numerator is comprised of the number of civilians receiving unemployment benefits. So let's have a little fun with numbers: If the number of people leaving the labor force in December had merely matched November's -134,000, the unemployment rate would have spiked to 10.3% instead of holding steady at 10.0%.

From where we sit, that pretty much eliminates any consolation we should take from December's 'steady' unemployment rate.

Moreover, we believe this development suggests the US unemployment rate will find it very difficult to drop out of the double-digits. We say this because we would expect these "discouraged" workers to begin swiftly reentering the work force as the employment picture stabilizes, likely causing the denominator in the unemployment calculation to remain stubbornly large.

Seems Bob Dylan has more and more company singing his Working Man Blues.

Gold: Protective Hedge or Bubble?

2009-12-30T16:48:00.013-07:00

John Hathaway, Senior Managing Director of Tocqueville Asset Management, penned a column entitled "A Contrarian's Dilemma" in which he discusses the two sides of our question above. His conclusion:

Gold is a bubble only for those who maintain faith in the ability of politicians and financial authorities to swim against the tide of deflation. For the rest of us, it is protection against monetary damage still to come.

Having said that, he also acknowledges that the bull market in gold is no longer in its early stages.

In the 2005 Year-End Review and Outlook for Tocqueville's gold fund, Hathaway wrote that bull markets can be measured in four stages: the beginning, the end of the beginning, the beginning of the end, and the end. In this most recent column, he notes that the second stage of the gold bull market likely ended as the price of gold crossed above $1,000, marking the beginning of the end (stage three). From the column: The first two stages took a full ten years. The latter two stages will take years but we doubt a full decade.
For our part, we have been talking about the bull market in gold as a baseball game, noting that we are probably in the fourth or fifth inning. It's not early, but it's not late.

The greatest difficulty we have had in owning gold over the past year has been the juxtaposition of our 'contrarian' nature and the popularity of owning gold. When financially-challenged stars like Ed McMahon and MC Hammer are on television pimping the services of something called Cash4Gold, our contrarian 'Spidey-antennae' start buzzing. We checked and rechecked our work and decided to stick with our position. So far, so good. Mr. Hathaway states the case eloquently: "For the contrarian, life has become more difficult even as it has become more gratifying. The commotion surrounding gold makes the contrarian strand of thought harder to detect. It is not that we don’t welcome the “Johnny come latelys” to the hard money cause. They are, for the most part, elite investment thinkers who have a history of sound decision making. However, we no longer enjoy the luxury of peace and quiet or as much time to reflect. Our periodic sanity checks, based on the makeup of the opposition, are somewhat less frequent and perhaps not as reliable. Still, we perceive that gold continues to be under owned and misunderstood by most. While it is no longer enough to observe that the metal is of interest based on universal apathy, it is safe to say that it has a long way to go before it becomes mainstream."

A Contrarian's Dilemma
Tocqueville Asset Management, LP
December 7, 2009

But The Banks Are 'On The Mend', No?

2009-12-02T14:00:00.013-07:00

In a word, "no".

We are tardy in highlighting John Hussman's latest Sunday night column, which is one of his best. First, he has important things to say about the sustainability of both the current economic pause (sorry, we just cannot yet apply the term "recovery") and the huge rebound in the prices of financial assets (but - notably - not real assets).

But before we go there, we were pleased to read the latest blog entry from the bright folks at Annaly Capital Management. They point out the nonsense that are the present US bank financial statement practices. It is a quick (and excellent) read.

Back to the Hussman column, for which you should set aside some quiet time:

Banks are contracting their loan portfolios at a record rate, according to the latest FDIC Quarterly Banking Profile. Even so, new delinquencies continue to accelerate faster than loan loss reserves. Tier 1 capital looked quite good last quarter, as one would expect from the combination of a large new issuance of bank securities, combined with an easing of accounting rules to allow “substantial discretion” with respect to credit losses. The list of problem institutions is still rising exponentially. Overall, earnings and capital ratios have enjoyed a reprieve in the past couple of quarters, but delinquencies have not, and all evidence points to an acceleration as we move into 2010.

(emphasis ours) See the full column for details.

But then Dr. Hussman (he's a Ph.D.) itemizes three policy actions we enthusiastically support:
First, the FDIC should be given regulatory authority to take non-bank financials into conservatorship the way they should have been able to do with Bear Stearns and Lehman.
Such a policy would have rightly shifted the losses from the Bear Stearns implosion onto Bear's bondholders rather than on we taxpayers, as is the fact.

Second, bank capital requirements should be altered to require a substantial portion of bank debt to be of a form that automatically converts to equity in the event of capital inadequacy.

Remember the term "CoCos". These are the the 'contingent convertible' bonds of which Dr. Hussman writes. You will probably be hearing more about them and, as in his first proposal, this one would protect taxpayers from shouldering the losses created by failed banks - again rightly shifting such losses back where they belong - on the banks' shareholders and bondholders.

Finally, Congress should be clear that government funds will be available only to protect the interests of depositors, not bondholders.

A third layer of protection for we taxpayers.

It is time to stop
a) the unilateral subsidization of bank bondholders at the expense of this country's taxpayers; and
b) the banks' charade in valuing and reserving for loan losses.

We can 'handle the truth', although the banks' stock prices may not.

It's Just a Flesh Wound!

2009-12-01T20:42:00.010-07:00

Bear with us. We will connect the famous quote from Monty Python and the Holy Grail to the US economy. . . eventually.

The National Bureau of Economic Research (NBER) is the ultimate arbiter of when a recession begins or ends in the United States. In doing so, the NBER considers a number of factors. The four most common factors cited by the NBER are employment, real personal income (excluding government transfers such as Social Security), industrial production and real sales.

Let's take a look at each of these in more detail.

Employment
The most recent weekly report (as of 11/21) showed a large decline in unemployment claims - but only because it was a seasonally-adjusted number. Let's be honest, employment stinks. Even the seasonally-adjusted weekly claims of 466,000 is a historically-high number. That anyone would point to it as an improvement betrays just how ugly employment is right now. And it is not getting appreciably better anytime soon.

Real Personal Income
If employment is weak, personal income must also be weak. Between unemployment and under-employment (part time work), personal income has taken a hit since peaking in late 2000. The decline since 2005 is particularly steep. This year, personal income has been stuck around a -2% to -4% year-over-year decline. Not pretty.

Industrial Production
The only factor out of the four that offers any hope of having bottomed, industrial production recently logged a -13% year-over-year reading in June before stabilizing over the past four months.

Real Sales
The US Bureau of Economic Analysis provides "real final sales" data within its GDP data, defined as GDP less the change in private inventories. In other words, it is US GDP adjusted for the extent to which businesses allow inventories to accumulate or run down - i.e. it is the actual amount of goods and services purchased by end users. The latest report on retail sales (aside from auto sales that have been seriously disrupted by government incentives) continues to reveal very weak demand.

So of the four data points most often cited by the NBER for recession calls, three remain VERY weak.

Tying this back to the Holy Grail, it is as if the Black Night has had three of his four limbs severed. What are you gonna do, bleed on me?
We remain unconvinced that the recession has ended and continue to recommend that you structure you spending and saving accordingly.

Dubai Debacle

2009-11-30T15:50:00.006-07:00

Interesting timing. Dubai World, investment holding company for the city-kingdom of Dubai, announced its desire to reschedule $60 billion of debt during the Thanksgiving holiday here in the US and on the eve of the Moslem four-day holiday of Eid al-Adha. Thus, Dubai could avoid all those messy questions until things settled down a bit.

As the Church Lady would say, "how conveeeenient!"

As most global markets have revealed by rebounding today, this is not a) new news, nor b) a major global financial event. For years now, Dubai has been something of a running gag in financial circles. Because of its location on the Persian Gulf, many assume Dubai is yet another one of those oil-rich Arab kingdoms.

They would be mistaken.

Dubai's revenues from oil and gas comprise less than 10% of its total revenues. Substantially less. The primary "industries" in Dubai are tourism, real estate development and finance. Dubai is home to the Palm Islands (man-made residential community islands shaped like palm trees), the world's tallest building (Burj Dubai), the world's tallest hotel (Burj Al Arab), the world's largest airport terminal (Terminal 3 at Dubai International), and the world's only indoor ski resort - in the desert!

Can you say "excess"?

Borrowing heavily to make such investments, Dubai World suddenly finds itself unable to repay principal and interest as originally scheduled. That this was a possibility (if not certainty) was well-known. But we in the Phoenix area should be familiar with how this gets handled. We are experienced in dealing with failed real estate developments. They will be restructured and we will get on with life. The world's financial system will not implode.

Not this time, anyway.

However, there are plenty of other risks out there that COULD cause serious damage. As the Financial Times points out, the Dubai Debacle should be a reminder that the world is not yet out of the woods. We believe it should also serve as a wake up call that one should not assume government bailouts for failed investments. While Dubai is a member of the United Arab Emirates, the UAE has yet to provide such an assurance.

Among the other risks we believe are not currently priced into the world's financial markets are Greece, Spain, Italy and Eastern Europe - each of which is facing serious financial difficulties much greater than Dubai World.

Positive GDP! The Recession is Over!

2009-10-31T16:38:00.018-07:00

ummm. . . maybe.

First, the news. As was widely expected, GDP growth was positive in 3Q09 for only the second time since the end of 2007. In fact, we had four quarters (yeah - fall, winter, spring and summer) of negative GDP growth before now.

The details can be found here: http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm
The "advance estimate" of 3Q09 GDP shows output growing by 3.5% quarter-over-quarter (annualized), a smidge better than the 3.2% consensus estimate. Moreover, the growth was strong across most sectors with consumption up 3.4%, gross private domestic investment up 11.5%, exports up 14.7%, imports up 16.4% and government expenditures up 2.3%.

If only this broad-based, stronger-than-expected growth looked more sustainable.

The problem is the extent to which government intervention distorted the numbers. Check out the third paragraph in the BEA release (linked above):

"Motor vehicle output added 1.66 percentage points to the third-quarter change in real GDP after adding 0.19 percentage point to the second-quarter change."

The eighth paragraph notes another distortion:

"Real residential fixed investment increased 23.4 percent, in contrast to a decrease of 23.3 percent." (in 2Q09)

Briefing.com has estimated that government subsidies, including those for 'cash for clunkers' and "first-time" home buyers - accounted for 80% of 3Q09 GDP growth.

Finally, see paragraph 11 of the BEA release (again - linked above).

"The change in real private inventories added 0.94 percentage point to the third-quarter change in real GDP after subtracting 1.42 percentage points from the second-quarter change."

The math gets a little tricky here, but bear with us. Generally, inventory REstocking (stocking products faster than they are sold) adds to GDP growth while running down your inventories (stocking products SLOWER than they are sold) subtracts from GDP growth. In 3Q09, inventories declined $130.8 billion - normally a negative GDP growth factor. But because that was nearly $30 billion less of a runoff than in 2Q09 (which was $160.2 billion) - and because GDP growth is measured quarter-to-quarter - this was a positive factor for 3Q09 GDP growth.

So maybe the economic "growth" we saw last quarter is not so sustainable. In fact, absent more of the ridiculous 'cash for clunkers' subsidies, we believe it is fairly obvious that auto sales will fall off the cliff this quarter. For a blunt discussion of such a scenario, see The Business Insider.

We believe jobs - and more specifically, real income - is the key to a sustainable economic recovery. Those are the data upon which we are focused. When the jobless rate stops increasing and real income begins to stabilize, personal consumption expenditures will begin to rebound.

According to Briefing.com, real labor income has fallen by 7.2% since peaking in 3Q07, including a 0.7% decline this past quarter. There is such a high level of competition for jobs right now that wage growth is nonexistent. In fact, wages are declining.

This brings us to the current level of stock prices. We believe the world's stock markets, on balance, are priced for a "V-shaped" recovery. Now we won't get into debating the particular letter of the alphabet that should be used to describe the recovery for which we are all hoping. It might be a "U", it might be a "W". . . it might even be an "L". But we are fairly confident it is not a "V".

Thus, we remain underweight equity exposure in our portfolios and continue to hedge the exposure we have. Even after the volatility of the past week, we believe stock prices are 10-15% above 'fair value'. To be sure, there are still some opportunities (please refer to our website comments for specifics). But those opportunities are scattered and few.

"It's the Level, Stupid"

2009-09-29T07:51:00.014-07:00

The Financial Times has initiated a series entitled The Future of Investing and today's offering, from PIMCo CEO and co-CIO Mohamed El-Erian, provides an excellent reminder of what we believe is a primary risk facing the global economy right now. Complacency has returned, calling into question the opportunity and wherewithal to continue the process of reform.

We continue to believe the risks are high that the recovery from this crisis will be protracted and so weak as to not even feel like a recovery to most. From Mr. El-Erian's column: . . . we would be all well advised to follow the admonition of Mervyn King. Last month, the governor of the Bank of England stated bluntly: "It's the level, stupid - it's not the growth rates, it's the levels that matter here." Investors have not yet accepted his insight that the absolute levels of income, debt, wealth and unemployment, not just the rates of change, are what matters, today.
El-Erian goes on to provide four examples. . .

First, consumer indebtedness is still too high relative to income expectations and credit availability, particularly in the US and the UK.
Second, some banks' balance sheets are still too geared for the comfort of regulators or their own managers.
Third, unemployment has risen well beyond expectations, and is likely to prove unusually protracted. It will take years for US unemployment to return to its natural rate, even after the natural rate shifted upwards.
Finally, public debt has grown so rapidly as to spark concerns about future debt dynamics.

The fallout from these four examples will likely include (respectively):
1) dampening of any sustainable bounce in consumer demand;
2) inhibited lending at precisely the time it is most needed;
3) delayed recovery and a possible loss of critical support for essential reforms; and
4) preempted effectiveness of future stimulus, challenged 'exit strategies', and a questionable ability for the US to cheaply fund its massive deficits.

It is a short read. . . but an important one. We highly recommend it. (free registration may be required)

Comfy old ways will not see us through
Mohamed El-Erian
Financial Times
September 29, 2009

C4C: The Gift That Keeps On Giving

2009-09-20T14:56:00.008-07:00

We just stumbled across a column by John Crudele in the 9/10/09 issue of the New York Post. Now, we don't normally consider the Post one of our primary sources for news. But as we were digging around for the consequences of the ill-advised "Cash for Clunkers" program, we came upon the Crudele column.

From the Post: But the folks at the US Bureau of Labor Statistics confirmed to me that the subsidy received by those 800,000 car buyers will be handled in the CPI next week as if the price of a car fell by $4,500.

So let me get this straight:
1) The federal government takes $4,500 from you.
2) Said $4,500 is handed to a car buyer who was likely going to buy a new car withOUT the subsidy - just maybe not for a few months.
3) Said car buyer hands said $4,500 to the car company as a partial payment for a car.
4) The federal government tells everyone that the $4,500 was a price reduction by the car companies - even though the companies received the $4,500!

On what planet does that make sense?

And what could possibly be the incentive for the government to do this?

Ummm. . . maybe they want CPI to be artificially lower so they can:
1) pay less on $500+ billion in outstanding TIPS (Treasury Inflation Protected Securities); and/or
2) pay less in CPI adjustments to Social Security and other recipients; and/or
3) report higher levels of real (net of inflation) GDP (Gross Domestic Product).

The ~500 word article is relatively short and worth a read. If you own any TIPS or receive any government benefits that could include an inflation adjustment, let your congressman know what you think of this shell game.

Cash for clunkers will reduce rate of inflation
John Crudele
New York Post
9/10/09

Things Are Finally Turning Around!

2009-08-19T09:56:00.005-07:00

That seems to be the general consensus, at least of investors in the stock market. We, on the other hand, remain cautious in our optimism.

The primary issue is that the good news from this latest round of corporate financial results is that earnings have, on balance, been better than drastically reduced expectations. Moreover, the compelling factor for such earnings has been dramatic reductions in costs (layoffs representing a major portion of such), not pricing power nor strong sales.

In fact, with regard to the latter (sales), we have serious reservations regarding any anticipated economic rebound. If sales do not rebound, there can hardly be an economic rebound.

This morning's Financial Times offers an interesting glimpse into the issue. The back page (p. 20) contains a headline that reads "Home Depot raises outlook as buyers are tempted back". Unmentioned, either in the headline or the full article, is that Home Depot's sales plunged -9.1%. . . and this news comes on the heels of Lowes' confession that its sales cratered -9.5%. In both companies' cases, whatever "improvement" was provided in their outlook is a result of cost cutting, not actual improvement in sales.

An economy can not cost-cut its way into a rebound.

From the article:

"Only 43 per cent of companies that have reported their earnings have beat expectations on both the top and the bottom line," said Quincy Krosby, chief market strategist at Prudential. "We need to see revenue growth in the next quarter."

Word.

Home Depot raises outlook as buyers are tempted back
by Kiran Stacey
Financial Times
Wednesday, August 19, 2009

Have We Learned Nothing?

2009-08-06T23:04:00.025-07:00

"Human beings, who are almost unique in having the ability to learn from the experience of others, are also remarkable for their apparent disinclination to do so."
Douglas Adams (author - The Hitchiker's Guide to the Galaxy)

We were going to rant about how the mainstream media is exhibiting a frustrating pattern of shallow reporting. Then, on the drive home today, we heard NPR actually scratch just a smidge below the surface on the "Cash for Clunkers" issue.

As an aside. . .
When was the last time you heard us point to NPR as a source of 'balanced reporting'?
(That is, of course, a rhetorical question.)

With that snarky comment out of the way, let's have Sherman set Mr. Peabody's WABAC Machine for 2001 and see what we find. (As another aside - didn't you just love Peabody's bow tie?!)

Anyway, here we are in late 2001. In the wake of 9/11, conspicuous consumption began to fade and, as a result, auto sales slowed. Detroit had the brilliant idea of offering 0% financing to 'restart' demand. While sales did indeed spike, within a few years that "demand" had evaporated. In other words, it was never "restarted". Instead, all that was accomplished was to suck forward a good portion of the next few years' sales.

By 2005, auto sales had again slowed. (A more thoughtful observer would say that auto sales had simply returned to their natural level.) In 2005, with financing gimmicks no longer doing the trick, Detroit resorts to "employee pricing" to 'restart' demand. Once again, sales spiked. Once again, that artificial level of sales proved unsustainable.

So we find ourselves in 2009 with sales again having returned to their new, natural level. Automakers don't like that level because it is fewer cars than they can profitably sell. They have two choices: 1) come up with another gimmick to spike sales to a higher, more profitable level, or 2) drastically 'right-size' their companies to profitably sell fewer autos.

Enter "Cash for Clunkers". (That would be door #1, Monty.) Oh, sorry. . . we neglected to include the now-conventional title of the program, as reported by the mainstream media: "Wildly-Successful Cash for Clunkers". (Sometimes referred to as the "Wildly-Popular Cash for Clunkers" program.)

Would someone please have the intellectual integrity to call this what it is? It is nothing more than the government taking $1 billion from American taxpayers to hand out to a select few Americans who happened to be considering trading in older model cars sometime in the next few months. All those lucky older-model car owners had to do was agree to commit to the trade-in during a very small window of opportunity - a few days, as it turns out.

Jeremy Anwyl is the CEO of Edmunds, Inc., one of the foremost authorities on the automotive industry. In a Wall Street Journal opinion last Monday, he wrote:

This sales frenzy was inevitable. We have crammed three to four months of normal activity into just a few days. What everyone fails to realize is that once this backlog is met, interest in the program will fade.

Still, isn't one of the goals of the program to benefit the environment? In the first of NPR's series on C4C, Dan Becker of the Safe Climate Campaign is quoted: "The problem is the auto industry hijacked this law so it doesn't get the better ones on the road," he says. "All it does is replace old clunkers with new clunkers."
Today's next story in the NPR series interviewed Allen Sanderson, an economist at the University of Chicago. Sanderson points out that the carbon 'footprint' of the new, allegedly 'greener' car can negate most (if not all) of the environmental benefits resulting from its better mileage. Moreover, the economic waste of destroying perfectly good assets (i.e. many/most of the "clunkers") is "silly". Sanderson admits that there is some environmental benefit to the clunkers program. "The question is at what cost," he says. "For $3 billion, could we do something better for the environment than what we're doing? I think absolutely. It's a very inefficient expenditure."
When did Congress' mission creep into incenting Americans to spend and borrow? With a deficit that is approaching (and will surely blow through) 13% of GDP, shouldn't there be greater priorities than burning up $3 billion to do little more than compress into a few days several months of auto purchases that would have been made anyway?

In the end, Detroit will have to retool for a lower level of auto sales. . . unless they can come up with yet another gimmick. Stay tuned for "Bride of Cash-For-Clunkers!" ("You'll laugh! You'll cry! You'll kiss $3 billion goodbye!")

I hope our children and grandchildren forgive us for wasting their money like this.

More Cash for Clunkers?
Jeremy Anwyl
The Wall Street Journal
August 3, 2009

Critics Say 'Clunkers' Program Isn't Very Green
Christopher Joyce
National Public Radio
August 3, 2009

The Shaky Economics Of 'Cash For Clunkers'
Christopher Joyce
National Public Radio
August 6, 2009

After The Storm

2009-07-15T15:30:00.023-07:00

The Financial Times' Martin Wolf has been one of the most reliable global economic commentators we follow. His last column before his summer hiatus appears on page 9 of this morning's issue (again - the pink paper in our reception area).

In today's commentary, he provides the most lucid and articulate (if a bit wonkish) view of from where we have come and where we are likely to go. In a nutshell, the world is not ending, but the path forward will be rocky and steep. It is a view that very much matches ours.

Significant points:
The financial crisis is over. When addressed powerfully, panics end. In this case, the commitment of the authorities to the rescue of a failing financial system was unprecedented. It has had the desired results.
The worst of the economic crisis is behind us, but. . . Yet we must put this news, welcome though it is, in context. The worst of the financial crisis may be behind us, but the financial system remains undercapitalised and weighed down with an as yet unknown burden of doubtful assets. It is also far from a truly “private” financial system. On the contrary, it is underpinned by massive explicit and implicit taxpayer support. The probability of mischief down the road is close to 100 per cent. But the current hope is that the road to any such mischief goes via a recovery.
The "recovery" will not feel like much of one. The capacity to produce continues to grow faster than consumption, meaning we will likely have more "excess" capacity in a year than we have now. The implication is that high-grade bonds and other income-producing assets should be favored.

The risks to inflation – or rather risks of deflation – are self-evident.

Despite an aggressive pay down of debt, household borrowing as a percent of GDP as of 3/31/09 was a mere 2% lower than 12/31/07. De-leveraging is a painful process: it has barely begun.
We will settle into a 'new normal.' Those who expect a swift return to the business-as-usual of 2006 are fantasists. A slow and difficult recovery, dominated by de-leveraging and deflationary risks, is the most likely prospect. Fiscal deficits will remain huge for years.
Some things are not only NOT fixed, they are worse. The financial sector that is emerging from the crisis is even more riddled with moral hazard than the one that went into it. Its fundamental weaknesses are not yet redressed.
Our view is that this 'new normal' will have its own opportunities for profit. They just won't be the ones to which we became accustomed over the past half-century.

As for your personal and/or business finances, we cannot emphasize it enough: A sustained environment of deflation suggests debt should be paid down aggressively (i.e. paid off) and non-essential expenses should be minimized.

After the Storm Comes a Hard Climb
Martin Wolf
Financial Times
Wednesday, July 15 2009

It Is "Silly Season" Again

2009-07-14T07:40:00.021-07:00

That would be earnings season. As is customary, Alcoa got things rolling last week when the aluminum producer revealed a quarterly loss that was not as bad as feared.

But the 'season' starts in earnest this week and the latest media darling analyst, Meredith Whitney, got things going with a bang by raising Goldman Sachs to a "buy" (from "neutral"). In a CNBC interview yesterday morning, we thought she was pretty clear in describing her upgrade as bullish on Goldman specifically but noting that the environment remains bearish for the industry. In typical fashion, the markets pretty much ignored the industry details and ran the entire financial services sector higher on the Goldman headline.

But what you should be focusing on, gentle reader, is the story that is captured very well in this morning's news analysis in the Financial Times. That story is how - unlike three months ago - a lot of good news is now priced into common stocks. Back in March/April, stocks were priced for the 'end of the world.' When first quarter earnings revealed that the end was not so nigh, stock prices rebounded strongly.

But the inconvenient truth is that earnings did not rebound, so what we got was merely an expansion in multiples - i.e. a big increase in the P/E (price to earnings ratio). Common stocks today are priced for anything but the end of the world as we know it. It is therefore unlikely that earnings will surprise in anything close to the manner in which we saw three months ago.

Moreover, the manner by which companies avoided Armageddon was, by and large, through aggressive cost cutting - not sales growth. Costs can only be cut so far. One can not grow a company by cutting costs. In this morning's FT column, Michael Mackenzie writes: In the first quarter, only 46.1 per cent of US companies beat revenue forecasts, lower than any other quarter since at least 2002, according to analysts at Bespoke Investment Group. “If top line [or revenue] results don’t improve relative to expectations, we could be in for a long summer,” say analysts at BIG.
With investors now focused on second quarter revenue growth and earnings forecasts for the balance of this year, we believe a cautious investment stance is warranted.
“The markets cannot just rely on less bad news, we need to see signs of an underlying improvement in the economy,” says Jane Caron, chief economist and strategist at Dwight Asset Management.

Weeds Start to Sprout Among the Green Shoots
Michael Mackenzie
Financial Times (page 21)
July 14, 2009

David Rosenberg on CNBC's Squawk Box

2009-07-10T08:52:00.007-07:00

We have referenced Mr. Rosenberg's work in the past, both here at our blog and in our client communication. Rosie has been among the most lucid observers of what is happening in the global economy over the past couple of years. As we began to see the mounting evidence this past winter that "this time it is different" - that this is not your normal, post-WWII recession - we began to realize that Rosie's view of where we are and where we are heading very much matches ours.

Back when he was Merrill Lynch's North American Chief Economist (up until a couple of months ago), we were unable to consistently access his writing, due to the fact that we had no business relationship with Merrill. We scavenged friends, associates and the internet for the occasional morsel. Now that he has joined Canada's Gluskin Sheff + Associates, his daily writing is offered free of charge (for now).

This past Tuesday morning he was a guest on CNBC's Squawk Box segment and the result was outstanding television. We have long been among CNBC's biggest critics for having sold out to the 'entertainment' side (as opposed to the 'information' side). We gave up watching the station years ago, relying on our more deeply-addicted friends and acquaintance to make us aware of the rare instances when the show's original promise shines through. Monday morning was just such a rare instance.

The segment is broken into three vids on the CNBC website and we have embedded them below, properly ordered. Combined run time is a smidge over 20 minutes and worth several times that.

Key points:
The "Green Shoots" were overstated.
The stock market has gotten ahead of the economy.
We need actual good news to support stocks now, not merely "less bad" news.
Inflation will not be a problem for years.

Enjoy.

It's the Debt, Stupid

2009-07-09T15:38:00.036-07:00

Annaly Capital Management (NLY) has long been one of our core holdings - largely because of the vision and leadership of Chairman, CEO and President Michael Farrell. Over the years, he has surrounded himself with a very strong team, not the least of which is Managing Director Jeremy Diamond, whom Michael poached from his friend James Grant.

Annaly posts excellent commentary to its website on a regular basis, the latest of which is no disappointment.

This month's commentary starts out with the perfect example of what is wrong with America. Six Flags is the example, debt is what is wrong. From the commentary:

The new poster child for excess leverage is the amusement park operator Six Flags Inc., which filed for Chapter 11 protection on June 13, 2009. To us, the bankruptcy is emblematic of what ails the nation. Typically, firms filing Chapter 11 line up debtor-in-possession loans to help provide working capital during the sometimes lengthy bankruptcy process. In the case of Six Flags, they don’t need it. Earnings before interest, taxes, depreciation and amortization (EBITDA) has always covered interest payments, but as the ratio of total debt to total capital ramped up from roughly 60% at the turn of the century to over 100% at the time of the filing, precious little cash remained for operating the business after servicing the debt. It borrowed for growth and ended up with the wrong capital structure for this economic downturn. In other words, Six Flags would be fine if it weren’t for the debt! Relieved of the burden of interest payments, the company estimates that it will have plenty of working capital. If only it were that easy for the U.S. consumer, state and local governments and the U.S. Treasury.

Indeed.

Annaly Capital Management Monthly Commentary
June 2009 (Released July 9, 2009)
Jeremy Diamond, Managing Director
Kevin Riordan, Director
Ryan O'Hagan, Vice President
Robert Calhoun, Vice President

Stimulus: Thank you sir! May I have another?

2009-07-06T16:54:00.011-07:00

Remember six months ago when the Obama administration said we could hold the unemployment rate to an 8% peak by passing the fiscal stimulus bill?

Since then, unemployment has been on a steady climb, presently registering 9.5% and clearly on its way to double-digits. We haven't seen double-digit unemployment since the early '80s. In fact, in my lifetime, the highest unemployment rate ever recorded was the back-to-back months of 10.8% in November and December of 1982.

As scary as these numbers are, it would be prudent to keep our wits about us. In that regard, Bruce Bartlett (Treasury Department economist in the Bush administration) reminds us on the Comment page of this morning's Financial Times (the pink paper sitting on the table in our reception area) that the Obama stimulus needs time to work.

We just have to wait for the medicine we have already taken to work. Pushing ahead with another stimulus will only make it harder to tighten fiscal policy down the road to keep inflation in check.

That kind of talk may surprise you, given that he was part of the Bush administration. But he is right. There was FAR too much optimism about how fast this stimulus would find its way through the economy. Bartlett's argument is persuasive and is our recommended reading for today.

We Do Not Need A Second Stimulus Plan
Bruce Bartlett
Financial Times
Monday, July 6, 2009

Employment (Or Lack Thereof)

2009-07-02T14:58:00.005-07:00

So much for the "green shoots".

There is no way to sugar coat it, so we will just say it: 467,000 non-farm jobs were shed in June. That's 100,000 - or 27% - more than analysts were expecting. Many of the more optimistic analysts were even hoping for a number around 300,000, which would continue the recent trend of a slowing rate of job losses. Instead, we are back to an accelerating rate of losses.

For those who look beyond the headlines (that would be us), the news was even worse. The average weekly hours worked fell from 33.1 to 33.0 in June. What that means is a lot of folks who could (should?) have been laid off simply had their hours reduced. This data point is an excellent advance warning of future hires/layoffs. When average weekly hours is climbing, one can be assured new hiring is coming. When falling. . . yeah, don't expect a rebound in employment anytime soon.

A good frank read on our (un)employment situation appeared in last weekend's New York Times. Writing in the Op-Ed section, staff writer Bob Herbert was blunt in his portrayal of our current situation as well as in his assessment of policy to address the problems. His first line says it all:

"How do you put together a consumer economy that works when the consumers are out of work?"

It is a read worthy of 10 minutes of your time this holiday weekend. (link below)

The investment implications of this outlook are as we have noted in recent posts and notes to clients: bonds and high quality, dividend-paying stocks are most attractive. The financial planning implications also remain as we have been suggesting: minimize non-essential spending and pay off loans aggressively. All loans.

No Recovery in Sight
Bob Herbert
New York Times
June 26, 2009

Out: Conspicuous Consumption, In: Spirit of Sobriety

2009-06-15T07:53:00.008-07:00

From the weekend Financial Times comes another in what we expect could be a long series on frugality replacing frivolity.

The FT offers up periodic Special Reports on various business sectors and this weekend contained the latest Watches and Jewellery issue. The cover story is entitled "A new spirit of sobriety takes hold" and it tells the story of lagging sales of consumer discretionary items like Swiss watches. For the first time in five years the annualized sales trend in Swiss watches has turned negative.

The article compares a recent successful auction of a vintage, conservative Patek Philippe against extremely weak sales of new, over sized heavy models with more complications:

Some analysts say it may even have indicated a new age of sobriety in the watch business, as buyers shift away from conspicuous consumption to conservative quality.

Despite recent struggles, there remains some optimism within the industry that sales will rebound along with the economy. Our view on that can be expressed in two points: 1) It will likely take much longer than most presently expect for the economy to rebound, and 2) just as an entire generation of consumers changed their 'evil ways' of conspicuous consumption after the "Roaring Twenties", we believe today's US consumers have been similarly shocked into austerity. Again quoting the article:

But some analysts are asking whether the shattering events of the past 18 months, with slashed bonuses, lost jobs and decimated asset prices may not prompt a new era of sobriety among watch buyers.

Yeah, and it won't be limited to watch buyers.

In navigating this difficult economic period, we are reminded of the story of the two friends hiking in the woods. When they happened upon an angry bear, one of the two knelt down and began to put on running shoes. The other man scolded his friend, saying "don't you know you can't outrun a bear?!"

To which his runner/friend replied: "I don't have to outrun the bear. I only have to outrun you."

Your financial survival today requires that you outrun 'the crowd' in your frugality. We continue to strongly recommend:
1) Minimize non-essential spending,
2) Pay down debt aggressively, and
3) Hedge your portfolio.

Watches & Jewellery
Financial Times Special Report
A new spirit of sobriety takes hold
Haig Simonian
June 13, 2009
(free registration required)

Previously on our blog:
Frugality Replaces Frivolity
June 8, 2009

Inflection Point?

2009-06-09T11:51:00.013-07:00

You probably remember from your differential calculus studies that an inflection point is a point on a curve at which the curvature changes sign. The curve changes from being positive to negative, or vice versa.

If you slept through differential calculus, just think of driving your fuel-efficient 'green' automobile on an "S" curve. The inflection point is that moment in the middle of the "S" when your steering wheel is momentarily straight. It is the moment at which you have completed the long left-hand turn but just before you have embarked on the long right-hand turn.

Well, the bond ‘bears’ have come out of hibernation.

Over the last three months, the yield on the 10-year Treasury has surged 100 basis points, from below 3% to 3.9% this morning. The catalyst for this move is apparently the new consensus view that the economy is close to rebounding and that inflation is about to roar higher.

As we have repeatedly noted here recently, we believe inflation will return and will do so with a vengeance. But that is a longer-term risk. Deflation comes first. In the near term, we believe the economy remains too fragile for rates to rise as fast and as far as they have. History tells us that the aftershocks of a credit collapse/asset deflation are long-lasting. We are likely to continue to see a very fragile economy and lingering deflationary pressures for years. We believe the recent sell-off in bonds represents a very attractive buying opportunity.

From this morning's Financial Times (linked below):

In the UK, John Wraith, head of sterling rates product development at RBC Capital Markets, says: "Expectations of a robust near-term economic recovery are getting ahead of themselves. Indebted consumers and demand-starved businesses are not ready to deal with higher interest rate costs yet."

At the same time, a serious complacency appears to have returned to the stock market. The S&P 500’s recent +40% run from ~667 to ~940 reflects this and is essentially the other side of the ‘bond bear’ coin. It is clear (in hindsight) that stocks were oversold at levels under 700. What we believe will become just as clear is that stocks are overbought at current levels. We find no justification of ~950 on the S&P as “cheap”. There are substantial economic difficulties ahead of us and there is precious little evidence that these difficulties are reflected in current stock prices. A more reasonable estimate of ‘fair value’ for the S&P is ~800. (That is about 15 times a reasonable - if not optimistic - estimate of 2010 earnings.) It strikes us as reasonable that prices can fluctuate within a range that extends 20% above and below that level. (i.e. between ~650 and ~950)

Our goal in managing client portfolios is to hold peak exposure to stocks at ‘cheap’ prices and minimal exposure at peak prices.

Finally, we should note that we are not making a 'market call'. We are not "predicting" a decline in the stock market. We are simply continuing to steer portfolios on a prudent course - staying away from the guard rails by further limiting our exposure to stocks at a time when the risk/return trade off is tilted distinctly against us. Similarly, we are taking advantage of a much more attractive risk/return trade off in bonds.

Relentless Rise of Treasury Yields Could Choke Nascent Recovery
Michael Mackenzie and David Oakley
Financial Times
June 9, 2009
http://www.ft.com/cms/s/0/9b410b7e-548d-11de-a58d-00144feabdc0.html

Frugality Replaces Frivolity

2009-06-08T15:06:00.016-07:00

This has been - and remains - a continuing theme in our current supervision of investment portfolios. The current crisis has changed consumer behavior - a change we believe will be lasting. During the Great Depression, attitudes toward spending and credit were changed for an entire generation.

We believe a similar lasting memory of this crisis has been seared into consumers' brains.

Last Friday, the latest in a stunning string of data was released by the Federal Reserve. US consumers continue to pay down consumer debt (credit cards, car loans and personal loans) at a record pace. The $15.7 billion reduction in April comes on the heels of paydowns of $16.5 billion in March and $10.9 billion in February. The March and April declines are the largest in the history of the data series that started in 1943.

As for anecdotal evidence, the weekend New York Times' The Nation section featured a story about Wal Mart's recent results and how consumer spending patterns are evident in the chain's sales. We link to it below, but found Chief Merchandising Officer John E. Fleming's comments most interesting:

“This whole idea of staying home and entertaining at home, we’re seeing that everywhere,” Mr. Fleming said, “from the ‘take and bake’ pizza to the $5 movies.” Ms. Tesija noted that “sales of popcorn poppers and microwave poppers are very strong.”

Our advice remains unchanged:
1) Minimize non-essential spending,
2) Pay down debt aggressively, and
3) Hedge your investments.

FEDERAL RESERVE statistical release G.19
Consumer Credit - April 2009
June 5, 2009
http://www.federalreserve.gov/releases/g19/Current/

The Recession, Wal-Mart Style
Stephanie Rosenbloom
June 7, 2009
The New York Times (weekend The Nation section)
http://www.nytimes.com/2009/06/07/weekinreview/07rosenbloom.html

Aren't You Glad You Don't Own GM?

2009-06-05T15:50:00.020-07:00

I have some bad news: You do.

No, we did not purchase it for you. Your Portfolio Manager-in-Chief decided your tax dollars should be used to purchase 60% of the company.

As expected by nearly everyone outside the Obama administration, GM filed for bankruptcy protection on Monday. It will be interesting to see how this plays out because this is the first time a company controlled by the US government has gone through bankruptcy.

It didn't have to end this way.

This is a company that survived the Great Depression. GM's former President, Charles Wilson, noted in his confirmation hearing for Secretary of Defense in the '50s:

"For years I thought that what was good for our country was good for General Motors, and vice versa."

No, it didn't have to end this way. Thanks to GM Chairman and CEO Rick Wagoner, the US government flushed billions down the toilet in a senseless effort to avoid the optimal outcome: an efficient, market-driven reorganization of a company that made a lot of poor business decisions. Instead, bankruptcy has merely been postponed. Worse, it has been transformed from a process that would likely result in a leaner, more profitable GM to one that will result in conflicted, dysfunctional choices that lead to a post-bankruptcy GM that is hopelessly ill-prepared to compete in a global market.

Wagoner could have gone straight to bankruptcy and not collect the government's '200 dollars' (not to mention ceding it control). To his credit, Wagoner's successor - Fritz Henderson - realized early on that bankruptcy was GM's only real hope. Unfortunately, he must now restructure GM in a manner that pleases the US government and the unions. Decisions are highly unlikely to be made purely for business purposes (i.e. market demand). Political and union agendas will now influence those decisions with what we expect will be painful and costly results.

We say costly because a successful, post-bankruptcy GM is our best hope for repayment of all those billions of ill-conceived bailouts. Unfortunately, the automobile market only looks to get more and more competitive.

David Rosenberg is the Chief Economist and Strategist at Gluskin Sheff. (Those interested can sign up to receive his excellent daily commentary at the link below.) In a recent note, he observed:

"Auto sales are still languishing at quarter-century lows and well below replacement demand levels for an unprecedented eight months in a row. J.D. Power is reporting that U.S. motor vehicle sales jumped 9% in May (their estimate) but down 36% YOY. I think they are using non-seasonally adjusted data - May is always a very strong month seasonally for auto sales, typically up 10% MoM from April. If my calculations are correct, then the tally for May on a SAAR basis would be 9.1 million units, down 2.2% sequentially from April, and that would probably mark the third decline in a row in total retail sales because the weekly surveys are showing no rebound this month in same-store chain sales despite the tax stimulus. . ."

We are in a secular decline in U.S. discretionary consumer spending, not a cyclical one. A cyclical decline is a short term downtrend from a primary trend. A secular decline is the primary trend.

There are still many profitable investments that can be made. The U.S. auto industry is still not among them.

From Frivolity to Frugality
Breakfast With Dave
David A. Rosenberg, Chief Economist & Strategist
May 22, 2009
Gluskin Sheff

The Frugal Future is a Present Day Reality
Breakfast With Dave
David A. Rosenberg, Chief Economist & Strategist
June 1, 2009
Gluskin Sheff
http://www.gluskinsheff.com/

Summer Vacations Put On Ice
Larry Copeland
USA Today
May 22, 2009
http://www.usatoday.com/printedition/news/20090522/travelside22_st.art.htm

Trading Down: From Decadence to Discounts
The Economist
May 28, 2009
http://www.economist.com/specialreports/displaystory.cfm?story_id=13686524

Industry Fears Americans May Quit New Car Habit
Micheline Maynard
May 30, 2009
New York Times
http://www.nytimes.com/2009/05/31/business/31car.html?_r=1

Formerly on our blog
Change We Can Believe In
April 1, 2009

Bond Market to Obama: "Drop Dead"

2009-05-31T17:58:00.014-07:00

The bond market's recent sell-off reminds us of the famous NY Daily News headline. The bond market of the past month is telling us that the US government is on the wrong fiscal path. Ed Yardeni in the Bloomberg article linked below:

“Ten trillion dollars over the next 10 years is just an indication that Washington is really out of control and that there is no fiscal discipline whatsoever.”

On May 21, Standard & Poor's warned that the UK might lose its AAA rating due to its rising level of debt and stagnant economy. This lethal combination means Britain's net government debt could approach 100% of national GDP. From the FT article below:

“A government debt burden of that level, if sustained, would in Standard & Poor’s view be incompatible with a AAA rating,” the agency said.

Naturally, all eyes shifted immediately to the US and how soon its debt might approach 100% of GDP. This past Thursday, John Taylor (professor of economics at Stanford) weighed in on the topic in a comment to the FT, also linked below:

Under President Barack Obama’s budget plan, the federal debt is exploding. To be precise, it is rising – and will continue to rise – much faster than gross domestic product, a measure of America’s ability to service it. The federal debt was equivalent to 41 per cent of GDP at the end of 2008; the Congressional Budget Office projects it will increase to 82 per cent of GDP in 10 years. With no change in policy, it could hit 100 per cent of GDP in just another five years.

What is significant in the bond market's action is how opposite it is to normal behavior. Bonds normally rally in price (yields decline) during recessions because inflation is benign. Currently, the economy is in decline and inflation is barely a positive number. PIMCo Co-Chief Investment Officer Bill Gross from the Bloomberg story below:

There’s becoming an embedded inflationary premium in the bond market that wasn’t there six months ago.

The risk we see in all of this is that the rest of the world could lose confidence in the dollar as THE reserve currency. John Taylor again on what that might look like:

Americans would have to pay $2.80 for a euro; the Japanese could buy a dollar for Y50; and gold would be $2,000 per ounce. This is not a forecast, because policy can change; rather it is an indication of how much systemic risk the government is now creating.

It is not too late. But it is time to act. Our government needs to engage in behaviors that focus in both the numerator and the denominator of the debt/GDP ratio. That means grow GDP (not merely wealth transfers disguised as "stimulus") and reduce debt.

If you only read one of the articles below, make it the Taylor comment in the FT. It is relatively short and to the point.

S&P warns UK over high debt level
Chris Giles and Dave Shellock
Financial Times
http://www.ft.com/cms/s/0/e46f01c4-45e3-11de-803f-00144feabdc0.html

Exploding debt threatens America
John Taylor
Financial Times
May 27, 2009
http://www.ft.com/cms/s/71520770-4a2c-11de-8e7e-00144feabdc0,Authorised=false.html?_i_location=http%3A%2F%2Fwww.ft.com%2Fcms%2Fs%2F0%2F71520770-4a2c-11de-8e7e-00144feabdc0.html%3Fnclick_check%3D1&_i_referer=&nclick_check=1
(free registration required)

Bond Vigilantes Confront Obama as Housing Falters
Liz Capo McCormick and Daniel Kruger
Bloomberg
May 29, 2009
http://bloomberg.com/apps/news?pid=20601087&sid=akW9GQw.X9KM&refer=home

Be Wary of Green Shoots

2009-05-24T18:23:00.009-07:00

Tomorrow's weekly issue of Barron's contains another clever article by my favorite current Barron's columnist, Randall Forsyth. His bottom line:

Hold your horses on calling a new bull market -- the bear has several years to go.

Randall usually has terrific historical observations as well as some clever turns on phrases and words. In the former category is his quoting Pentagram Fund manager Mark Turner regarding the origin of the term "green shoots":

It was originated by former British Chancellor of the Exchequer Norman Lamont, who was quoted as spotting green shoots in the British economy back in 1991.

In the latter category is his play on the "green shoots" term:

So, why the attraction of green shoots? One can only speculate that they must be in some ways intoxicating. Perhaps not the shoots exactly, or the stems or seeds, but the leaves of a certain plant. Those might be smoked or otherwise ingested to bring about a euphoric effect. From what I've read, the current crop is far more potent than the commodity available in years past. How else to explain the mind-bending notion that an economy that is declining less quickly is somehow improving?

Tacked on to the end of his column about green shoots is an interesting observation about how closely the 2002-2008 stock market has tracked the 1932-38 pattern. Citing the work of famed technical analyst Louise Yamada, Randall notes that the frustrating, roller-coaster rallies and declines of the bear market are precisely what permitted stocks to build the base from which the 1942 bull market was born. Quoting Forsyth, referencing Yamada:

But, she emphasizes, that means investors probably face years of frustration if they think a new, sustained bull market has begun. Structural bear markets typically last 13 to 16 years. Given the declines that have been suffered so far -- topped only by 1929-32 -- the structural bear has several years to go to complete the repair process.

Of course, we are drawn to Randall's column this week because it supports our own outlook. If we (and he) are right, traditional long-only investment strategies will find it a difficult environment in which to generate net positive returns the next few years. We believe commodities (with an emphasis on gold), currencies, options and a long-short approach will provide investors with more - and more sustainable - positive return opportunities.

Be Wary of Green Shoots
Randall W. Forsyth
Barron's
Monday, May 29, 2009

Previously on our blog:
Getting Worse Less Fast
May 19, 2009

"Less Bad" is the New "Good News"
May 11, 2009

Sheila Bair Keeps Saying the Right Thing

2009-05-22T16:59:00.014-07:00

Now, when will the right thing actually be done?

Appearing on Bloomberg's "Political Capital with Al Hunt" television show, FDIC Chairman Bair said of bank executives

“Management needs to be evaluated. Have they been doing a good job? Are there people who can do a better job?”

When asked if she thought some would be replaced in the next couple of months, Bair replied

“Yeah, I think there will be an evaluation process. We’re requesting it as part of the capital plan and yes.”

Unfortunately, the FDIC later issued a statement that effectively pulled the punches Ms. Bair's comments delivered.

Hey, it's a start.

Look. The banking problem is a problem of poor (fraudulent?) loan default estimates compounded by unconscionable levels of leverage. Whether these mistakes are a result of incompetence or greed (fraud) is not important. What is important is that these clowns (be they executives and/or their boards) be removed and that the financial institutions be put in the hands of competent leadership.

As for Ms. Bair, Mr. Geithner and their ilk. . . compensation is the wrong rabbit to be chasing. Leverage is where the problem was and will continue to be if not addressed. Allowing banks to leverage up 40:1 (or higher) was just stupid.

As Paul Krugman wrote last month in an Op-Ed column in the New York Times, "make banking boring again".

What made banking 'exciting' - what made it insanely profitable - is the leverage. A bank leveraged up to 40:1 ($40 of loans for every $1 of capital) is a disaster waiting to happen. It is not a matter of if there will be a problem, it is a matter of when. As my mom used to say when we kids would begin to play too rough: "some one's gonna be crying"!

The problem with these 'disaster waiting to happen' banks is that their obscene profits are privatized, but (being too big to fail) their losses are socialized. Good work, if you can find it.

Heads: you win. Tails: the taxpayers lose.

Yes, some of the ridiculous compensation given out to bank executives the past few years should be reviewed for 'clawbacks'. But going forward, regulators should focus on the amount of leverage a 'boring' bank can take on. Doing so would - by definition - limit the compensation of anyone in that organization. You just can't make enough money on a 10:1 (or lower) scale to pay those bawdy bonuses.

Well, at least not as bawdy.

Bank Chiefs Will Be Replaced in Next Few Months, Bair Predicts
by Alison Vekshin
Bloomberg.com
5/16/09
http://www.bloomberg.com/apps/news?pid=20601087&sid=ayhAHRWdbDqw&

Making Banking Boring
Paul Krugman
New York Times
4/9/09
http://www.nytimes.com/2009/04/10/opinion/10krugman.html

China: Treasuries Out, Commodities In

2009-05-21T10:29:00.006-07:00

A Bloomberg article earlier this week confirms what we have been expecting: China is moving to limit its exposure to the US dollar. (We also link below to an earlier, similarly flavored New York Times story.)

The article references a May 15 Royal Bank of Canada research note from analyst Brian Jackson:

“Increased spending on commodities represents a reallocation of China’s sovereign wealth away from the accumulation of financial assets.”

The article is an important read because of the long-term effects of China's strategy. Many believe a weaker US dollar will have a limited impact on those whose income and expenses are denominated in dollars.

The reality is that many items in each of our expenses are sensitive to currency swings. Anything produced overseas will become more expensive, particularly those products that include commodities. Additionally, with the US government on track to issue more debt at a time China is limiting its purchases, interest rates are likely to rise (bond prices decline) as the supply of US Treasury bonds increases relative to the demand for it.

We moved several months ago to defend client portfolios against just this scenario, purchasing substantial positions in commodities, foreign currencies and gold. We expect these positions will continue to increase as a percentage of client portfolios over time.

China’s Stockpiles Are New Sovereign Wealth Strategy, RBC Says
By Kevin Hamlin
May 18, 2009
Bloomberg.com

China Slows Purchases of U.S. and Other Bonds
by Keith Bradsher
April 12, 2009
The New York Times

Previously in our blog:
It Is Official: We Are Japan

Getting Worse Less Fast

2009-05-19T23:18:00.016-07:00

We have had a few recent conversations with some folks about the current state of the economy. Apparently, based largely on chatter from the mainstream media, there is a growing optimism that the economic worst is behind us.

This may be so, but we would caution investors to not bet the farm on it.

Warren Buffett had a great quote a couple of weeks ago that fits how we see the current environment. First some background: In a CNBC interview last fall, Mr. Buffet described the then-current conditions as an "economic Pearl Harbor".

In a follow-up interview on May 1, Mr. Buffett told CNBC reporter Becky Quick that we are no longer in that "economic Pearl Harbor" but that "The war isn't over, though."

In other words, the shock and devastation of Pearl Harbor was over fairly quickly. However, the struggle of war went on another 3-4 years after that. While we are hopeful that the current economic struggles end sooner than that, we believe it is prudent to be prepared for a multi-year effort.

As for the current state of the economy, we believe the title we chose for this post best describes it. Media reports and stock market advances to the contrary, things are continuing to get worse. The best we can say is that in some cases, the rate of decline is slowing.

Last Friday, Industrial Production was reported to have declined a further -0.5% in April following a downwardly revised drop of -1.7% in March. While that -0.5% decline might be a smidgen better than the expected -0.6% decline, if you add in the extra -0.2% by which March was revised lower (which you must), you end up with results worse than expected. Then again, who cares? Either way industrial production continues to decline. It is not good news no matter how you slice it.

The Census Bureau's recent release of trade data is likewise sobering. Since July 2008, US exports have declined -23.4%. Ignoring oil, imports have declined a similar -23.0%. While the decline in imports might be seen in some corners as positive (as it suggests consumers may be buying more US goods and services), the decline in exports is profoundly negative for US businesses. One of the most troubling aspects of global trade is the extent to which protectionism is rising. For example, the US recently canceled a program that allowed Mexican trucks into the US. Mexico responded by slapping tariffs on nearly 100 US goods. The Obama administration's "stimulus" package is another example as a meaningful portion of it attempts to direct spending toward US products - the inverse of a tariff on foreign products. Our view is that robust global trade is a necessary ingredient in an economic recovery.

Finally, the latest housing starts and permits data were released this morning. April starts were down -12.8% from March while permits were down -3.3%. The absolute number of starts and permits both registered their lowest levels ever. We will point out one perversely positive aspect to this ugliness. There is such a glut of homes available for purchase that the best way to clear them (aside from bulldozing) is to stop building more of them. The more new homes we build, the longer it is going to take to clear this excess inventory of homes for sale.

To be clear, economic conditions continue to be poor. Demand continues to be weak. The number of people out of work (and still looking) is now well-over 6 million. This doesn't even count the millions who are working part-time or have given up looking.

This crisis was years in the making and we believe it will require years to resolve. We continue to counsel caution with respect to spending and investing. The pertinent question continues to be "How long can you hold your breath under water?"

Warren Buffett Tells CNBC We're Past Pearl Harbor, But Economic War Isn't Over
Alex Crippen
May 1, 2009
CNBC.com

U.S. International Trade in Goods and Services Highlights
US Census Bureau
May 12, 2009
www.census.gov

Industrial Production and Capacity Utilization
US Federal Reserve
May 15, 2009
www.federalreserve.gov

NEW RESIDENTIAL CONSTRUCTION IN APRIL 2009
US Census Bureau
May 19, 2009
www.census.gov

"Less Bad" is the New "Good News"

2009-05-11T14:56:00.012-07:00

Headline from the Wall Street Journal: "Home Prices Sink Again, but Pace Is a Bit Slower"

Sounds good, huh? Well, it is good if, by "good" you mean the decline was less than the previous month. You see, January's year-over-year decline in home prices was -19%.

Gosh, by comparison that makes February's decline of -18.6% almost look like a gain, eh?

This is what passes for "green shoots" today. By some strange reckoning, "not worse" means it is better.

Of course, when you look at year-over-year prices, things can get confusing. Year-over-year comparisons are quite sensitive to things that happened a year ago. So let's just look at what happened in January of 2009 and then in February of 2009, shall we?

The Standard & Poor's/Case-Shiller index of 20 major cities declined -2.2% in January, 2009. In February 2009 it declined a further -1.9%.

Calling this evidence of "green shoots" reminds us of Congress when they tell us they "cut spending" because spending increased only 5% when they originally intended to increase it 10%.

PS - those of you owning a home in Phoenix, please be forewarned that by clicking the link to the Case-Shiller report below you will be exposing yourself to some particularly ugly numbers. Home prices in Phoenix fell -4.5% in February after a -5.5% decline in January. The one-year change in home prices is -35.2%. This brings the decline since the 2006 to more than -50%. Basically, Phoenix home prices have returned to 2002 levels.

The trend suggests we have a bit further to fall.

Home Prices Sink Again, but Pace Is a Bit Slower
Sudeep Reddy
The Wall Street Journal
April 29, 2009

Standard & Poor's/Case-Shiller Report dated 4/28/09
"The Pace of the Decline in Residential Real Estate Prices Slowed in February According to the S&P/Case-Shiller Home Prices Indices"

That's Not EXACTLY What We Had In Mind, Mr. President

2009-05-05T16:14:00.022-07:00

The strange twists and turns continue. Over the weekend, Chrysler 'decided' to file for bankruptcy protection, following the 'suggestion' of the Obama administration. Although the details of the negotiations remain sketchy, it appears that the President became frustrated when senior creditors of Chrysler balked at the trampling of their contractual rights.

A quick sidebar: when making an investment, the investor (capital provider) requires a higher return (lower price for the investment) the further down the capital structure the investment might reside. At the top of the capital structure is the most senior debt. Near the bottom are common stockholders. In the middle are junior and subordinated creditors. In terms of a claim on the assets of a company, the bankruptcy law is very clear: senior creditors receive the largest percentage of their respective claims, common shareholders the lowest (if any). Subordinated debtholders receive something in the middle. Again, the law is very clear. It is precisely for this reason that a senior creditor will accept a lower rate of return - she can be confident of protection if things don't work out as well as anticipated.

Any attempt to rewrite bankruptcy laws to fit a populist agenda is fraught with risk, the culmination of which could include global investors rethinking whether there remain any capital structure distinctions within US contract law.

As serious as that concern may be, it is not even at the top of our list. Let us return to the President's weekend announcement delivered from a poorly-considered 'bully pulpit'. From the NYT story linked below:
Bringing to bear his White House megaphone on Thursday, Mr. Obama laid out the terms of a deal that he said would save well over 35,000 jobs. And with a hint of anger, he railed against the holdout lenders, now effectively a hostile group of business partners, whom he called “speculators.”

"Speculators"? Senior creditors - by definition - are not "speculators".

More importantly, the purpose of bankruptcy is not to protect jobs. The purpose of bankruptcy is to profitably re-size a company to its market opportunity. By definition, that is usually the antithesis of saving jobs. A meaningful part of the problem at the US automakers is the number - and cost - of those jobs. Again from the NYT story:
Chrysler said its factories would go mostly idle starting Monday, and remain so for the bulk of the process. Auto workers will receive about 80 percent of their base pay during the shutdown.

If we were creditors of Chrysler (which we are not), our first question for the bankruptcy judge would be to ask why assets of the bankruptcy estate were being used to compensate people not even working for the estate.

This nation has a perfectly good social safety net that was created for the express purpose of assisting those finding themselves in the unfortunate position that these autoworkers are facing. There can be little doubt that this is a thinly-veiled purchase of union votes on behalf of this administration. We are equally confident that the cost (to taxpayers) of $1 of benefit to these 'non-workers' is astronomically higher than would be $1 of unemployment benefits.

Moreover, after already providing $3 billion to Chrysler, the Obama administration is promising another $6 billion to get the company through the bankruptcy process. This is looking less and less like a bankruptcy and more and more like a "bailout".

One final point (there are many more, but we know your time is short) on this administration's mind-numbing hypocrisy. Why is this administration eager to hand hundreds of billions of dollars to the big banks to prevent their bondholders from taking a haircut, while they have zero tolerance when Chrysler's bondholders balk at their 'buzz job'?

One word. Unions.

We understand too well the old adage that 'the perfect is the enemy of the good'. In that regard, we are willing to accept this "bankruptcy" as the most expedient step forward. If it is to survive, Chrysler desperately - and quickly - needs to 'right-size' its costs. Bankruptcy is the only way this can be done.

Our hope sufficiently dashed by the President's approach, we now shift it to the bankruptcy court. Unless new precedents are set, the rule of law will bring some sanity to this process.

Chrysler Files to Seek Bankruptcy Protection
JIM RUTENBERG and BILL VLASIC
New York Times
April 30, 2009

For an outstanding three-part series on the Chrysler bankruptcy process:
Chrysler Files Bankruptcy - Part I: Assessing The Financial Carnage
Chrysler Files Bankruptcy - Part II: Testing The Limits Of Section 363 Sales
Chrysler Bankruptcy Analysis - Part III: Will The "Absolute Priority Rule" Kill The Sale?
Steve Jakubowski, Founder
The Coleman Law Firm
The Bankruptcy Litigation Blog

We are shocked, SHOCKED to find that. . .

2009-04-28T08:32:00.013-07:00

Citigroup and Bank of America need more capital!

Gosh, what happened to BofA's "strong, positive net income" that was "welcome news in this environment", Mr. Lewis? Where is "the power of our diversified business model"?

More to the point, was it only a week ago that you were on CNBC (actually, last Monday afternoon at approximately 3pm, NY time) telling us how BofA does not expect to need more capital?

At least the truth is trying to wiggle free. We are also encouraged that FDIC Chair Sheila Bair is beginning to say the right things. From another Bloomberg story this morning:

The FDIC should be able to take over and shut bank-holding companies and other large institutions instead of just failed commercial banks, Bair said today in a speech at the Economic Club of New York. Such power would shield taxpayers from losses when government protects companies deemed “too big to fail,” a concept that should be “tossed into the dustbin,” she said.

Next stop: DO the right thing.

Citigroup, Bank of America Decline on Capital Report
Andrew MacAskill
Bloomberg
April 28, 2009

Fed Pushes Citi, BofA to Increase Capital
Dan Fitzpatrick, David Enrich & Damian Paletta
The Wall Street Journal
April 28, 2009

Previously on our blog:
Earnings? Don't Bank On It

Change We Can Believe In

Earnings? Don't Bank On It

2009-04-27T15:00:00.015-07:00

Plenty of attention has been focused on the banks over the past week or so as financial results for the first quarter of 2009 were released.

Color us skeptical. The reaction to the results could be described anywhere from 'relief that it wasn't as bad as feared' to 'enthusiasm that things are finally turning around.' We would be of the former opinion while noting that the primary reason things were not as bad as feared is the direct result of events from which the banks are unlikely to benefit again.

To wit -
JP Morgan Chase and Citigroup booked earnings as a result of their bonds falling in value. You can do that because - theoretically speaking - they could now retire that debt at a lower cost.

BofA sold its shares in China Construction Bank for a big (one-time) gain. Wonder what they'll sell next quarter?

BofA also booked a big profit by writing up the value of the Merrill Lynch assets it acquired last quarter. We can't figure out why BofA thinks they are worth more than Merrill thought they were worth. . . except that they can get away with it now because of the relaxation of the 'mark to market' rule.

But this one's our personal fave. . .
Both Goldman Sachs and Morgan Stanley benefited from a change in their reporting status that allowed them to both 'orphan' the month of December. (Both converted from investment banks to bank holding companies in September, forcing them to change from a November 30 fiscal year to a calendar year.) Morgan Stanley lost $177 million in the first quarter. . . but that ignores $1,600,000 million (i.e. $1.6 billion) of losses shoveled into the lost month of December. For its part, Goldman posted a $1.7 billion profit in the first quarter, conveniently sweeping $1 billion of losses under the December carpet.

For our part, we are looking forward to the day that we can go back to valuing banks based on how successful they are at loaning money out at rates higher than they pay to access that capital. It's a quaint notion, we know.

Until then, banks are in a different game, sucking as much cheap capital they can out of taxpayers (via the federal government handouts) and then digging deep into their accounting bag of (legal) tricks to prettify their financial statements.

Morgan Stanley Posts Loss, Hurt By Revenue Drop and Write-Downs
David Jolly
New York Times
April 22, 2009

Bank Profits Appear Out of Thin Air
Andrew Ross Sorkin
New York Times
April 20, 2009

Why Lower Rates (and other stimuli) May Not Work

2009-04-21T14:35:00.011-07:00

It strikes us as perverse that the Obama Administration believes the answer to an economic malaise that resulted from a consumption binge is to encourage Americans to consume more.

American individuals, families and businesses are - on balance - over indebted and simply have too much stuff. GM is the poster child, spending more than it makes, owing $47 billion (more than its assets), too many plants, too many employees. . . and on and on. We live in a society that has created far too much capacity - too many houses, too many cars, too many televisions, too much available credit, too many celebrities, too many reality shows. . . oh, sorry.

There are two basic ways to cure this: we can either hang on to all this 'stuff' and hope the economy grows its way into it (much like my mom bought extra large jeans, the cuffs of which would be rolled up until I grew into them), or we can destroy some capacity to 'right-size' this economy for its true growth rate.

Given the anemic condition of the economy and banks, the first option (which has been the default option thus far) will likely resemble Japan since 1990, the US in the 1930s, and Mexico after the Latin America crisis. The second option, however, would most likely turbocharge our recovery, although it would cause some short-term pain.

For our money, the best layman's explanation of government intervention was authored by renowned technical analyst Robert Prechter in the 2/20/04 issue of his newsletter The Elliot Wave Theorist.

The Ludwig von Mises Institute recently republished Prechter's article here.

We highly recommend it. Sometimes a simple analogy helps to clarify an issue.

Additional information from The Elliot Wave Theorist
http://www.elliottwave.com/

(Un)Intended Consequences: Uncertainty, Inflation & Inflexibility

2009-04-20T15:21:00.010-07:00

Axel Merk - President and CIO of Merk Investments, LLC - with another excellent column. This one talks about the significant future adverse and unintended consequences of the ongoing intervention in financial markets and the economy.

For example:

- Bad Businesses Saved at the Expense of Good
- Heightened Risk Aversion Bred By Uncertainty
- Inflation and Inflexibility

In particular (and related to our recent commentary), Merk is critical of the subsidies provided to failed businesses:

Incentives are sorely needed that reward responsible, efficient businesses, not policies that restrict them. In our opinion, present policies are inefficient and likely to foster a deterioration of “good” business models, a situation that may, in itself, precipitate further government spending to get the private sector functioning properly again. Intuitively, if we know the government will intervene regardless when an economy enters a downturn or recession, one would think the government would like resources to be re-allocated from inefficient market participants to more efficient ones. Indeed, efficient markets ensure that in most economic downturns strong businesses tend to strengthen their industry position while weaker, less efficient players fall to the wayside. Yet there are many situations where we see the exact opposite currently taking place.

In fact, this is precisely what the FDIC's receivership process is supposed to do. Failed banks are taken over by the FDIC, scrubbed up a bit, and turned over to successful banks to resume (successful) operations.

We would hasten to point out that this criticism also applies directly to individuals. In particular, we find it deplorable that those of us who have been responsible in our personal finances now find that our tax bills will be increasing so we can subsidize those individuals who were not so responsible.

Mr. Merk's commentary can be found here.

Axel Merk is the portfolio manager of the Merk Hard Currency Fund, which invests in a basket of hard currencies. Hard currencies are those currencies backed by "sound monetary policy". Sound monetary policy focuses on price stability.

First the Automakers, Then the Banks?

2009-04-17T16:46:00.020-07:00

A couple of weeks ago, in a post entitled "Change We Can Believe In", we noted our optimism that it appeared the Obama administration would finally handle GM properly. We closed that post stating our hope that the administration would similarly come around to the proper way to handle the insolvent banks: FDIC receivership.

We are still hoping.

In the mean time, Bloomberg is reporting today that Nobel Prize-winning economist Joseph Stiglitz agrees:

“You’re really bailing out the shareholders and the bondholders,” he said.

The article goes on to quote Stiglitz on a wide range of related topics, including the likelihood that efforts to rescue the insolvent banks will fail.

The Obama administration’s bank- rescue efforts will probably fail because the programs have been designed to help Wall Street rather than create a viable financial system, Nobel Prize-winning economist Joseph Stiglitz said.

“All the ingredients they have so far are weak, and there are several missing ingredients,” Stiglitz said in an interview yesterday. The people who designed the plans are “either in the pocket of the banks or they’re incompetent.”

That might be the most frustrating part of this whole bank 'bail-out' silliness for us - we can't tell if the policy makers are crooked or stupid. Either way, it is we taxpayers who will be left holding a very expensive bag.

The insolvent banks should be taken into receivership, shareholders wiped out, bondholders given a haircut, the bank's capitalization scrubbed up, and a 'new and improved' version of the bank spun back out to new shareholders in a very strong position to resume normal banking activities.

Unfortunately, if you are Larry Summers and have received millions of dollars of compensation from hedge funds and banks, or Tim Geithner and worked for the Federal Reserve Bank of NY*, you are at risk of being biased and/or conflicted about doing 'the right thing'. Stiglitz again:

“America has had a revolving door. People go from Wall Street to Treasury and back to Wall Street,” he said. “Even if there is no quid pro quo, that is not the issue. The issue is the mindset.”

The entire article is a worthy read.

*Six of the NY Fed's nine directors are elected by the very banks in the NY Fed's region. The Chairman and the CEO are both former Goldman Sachs partners.

"Mark To Market": What's This All About?

2009-04-16T16:37:00.025-07:00

"Lying makes a problem part of the future;
truth makes a problem part of the past."
- Rick Pitino (per Sean Covey's attribution in his book The Six Most Important Decisions You'll Ever Make, p. 277)

On March 17, the Financial Accounting Standards Board (FASB) issued for comment two significant staff positions on securities valuation. These positions were written essentially as 'ransom' paid to the U.S. House of Representatives Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises (isn't THAT a mouthful!). You see, Subcommittee members threatened to introduce legislation to alter the accounting standards unless FASB acted immediately. So FASB caved.

But it gets worse. FASB did issue the positions for comment, and they did so with an unusually short two-week comment period. That Congress pressured FASB so - and that FASB caved to such pressure - calls into question FASB's independence in setting accounting standards. The CFA Institute has been very vocal in its concern regarding this sordid chapter and we share those concerns. It has nonetheless moved forward.

So what's the deal with "mark to market" (aka "MTM")? MTM is the accounting convention that requires companies to carry assets on their balance sheet at the most recent price available in 'the market'. In other words, just like your brokerage statement. Assets are valued at the last price at which a transaction was executed.

What's wrong with that? Our answer: "nothing".

But why would a company - let's say a bank (understand that we're speaking purely hypothetically) - have a problem with MTM? Well, if that bank had some securities on its balance sheet that recently traded at distressed (low) levels, those securities would then be valued on their balance sheet at such distressed levels. That means their capital (essentially assets minus liabilities) is likely to foot to a lower number than when those assets were NOT trading at distressed levels. If their capital is insufficient to meet regulatory requirements, they must raise more - possibly by issuing more stock, which would dilute their existing shareholders.

So (to carry our hypothetical illustration just a smidge further), if that bank could instead influence some policy-setting folks (oh, I don't know. . . maybe some CONGRESSMEN?) to hold accounting standards hostage via legislative threats, maybe they could get some relief from this 'capital inadequacy'. They could then value these 'impaired' securities using a financial model that estimates the 'true' value.

(After all, who would know the true value better? These banks, who have a clear conflict of interest in where they are priced? Or those wacky financial markets comprised of millions of investors who compete ruthlessly on both sides of every trade to ensure such trades are executed at the most efficient price possible?)

If that sounds to you a lot like what actually happened, please understand it is purely coincidence.

The end result is that, despite objections from an overwhelming number of the most experienced investment professionals on the planet, FASB indeed voted on April 2, 2009 to suspend MTM accounting.

Why do we care? We care because valuing these securities at inflated prices means that our TARP dollars (our taxes) will now be used to purchase equity interests in these financial institutions at artificially-inflated prices rather than their true historic values. We care because MTM did not cause this problem and suspending MTM will not solve it. The problem was caused by poor lending practices, insufficient risk management, and pathetic governance/compensation practices. We care because financial statement transparency is always better than opacity.

We care because saying a bank is solvent when it is not does not put the problem in our past.

Summary of FASB 157
"Fair Value Measurements"

Bankers Say Rules Are The Problem
Floyd Norris
New York Times
March 13, 2009

April 2, 2009 CFA Institute Press Release regarding threats to FASB independence

Change We Can Believe In

2009-04-01T16:19:00.013-07:00

Citing unnamed sources, Bloomberg is today reporting that President Obama "believes a quick, negotiated bankruptcy is the most likely way for General Motors Corp. to restructure and become a competitive automaker".

We acknowledge that the President and his staffers continue to be quoted on the record as wanting to avoid bankruptcy. But this nugget from Bloomberg provides us with a glimmer of hope that this administration will finally handle the auto companies the way they should have been handled from the start.

You see, subsidizing (let's avoid the incendiary term "bail out") the auto companies does not help the companies. At its core, such a subsidy merely prevents the stockholders and creditors from suffering the consequences of a poor investment.

Had the government not given away $25 billion of taxpayers' hard-earned dollars to the auto industry, GM would already be several months through the bankruptcy process. That process would likely wipe out the existing shareholders and result in creditors taking a significant loss. GM would be reorganized as a smaller, leaner, more focused company with a realistic opportunity to achieve profitable growth.

Yes, some plants would be closed, product lines eliminated, and employees laid off. Yes, some of those nice benefits negotiated by the unions during good times would be eliminated.

The 'inconvenient truth' is that this company is insolvent. Everyone - stockholders, creditors, employees - must accept that truth so that GM can reorganize and survive.

The key is to direct the pain where it should be properly directed. That is what the bankruptcy process is all about - it ensures the free enterprise method of optimal capital allocation is honored.

In GM's case, there is insufficient capital to provide any return to shareholders, so the current stock is marked to $0.

As for the creditors, there is neither sufficient income from the continuing business nor sufficient capital to service the debt, much less repay it. Therefore, a small portion of the existing (most senior) debt should be rolled forward into the 'new' GM at reasonable terms with the balance of the debt converted to equity (stock) in the new company (valued at substantially less than the current face value of such debt).

That plants need to be closed and employees laid off has nothing to do with the bankruptcy process. These actions are merely the result of a company finally accepting the truth - it can not possibly sell, in a sustainably profitable manner, as many cars as it is presently structured to manufacture.

The beauty of this well-established process is that the likely cost of the social safety net for those terminated employees would be less than the 'bailout' checks cashed by GM.

Although I have been unable to source it, Winston Churchill is widely claimed to have quipped that “The Americans can always be trusted to do the right thing, once all other possibilities have been exhausted.” We cling today to a hope that this apparent automaker epiphany for the Obama Administration is real.

Now, how about we 'do the right thing' with the insolvent banks. There is a well-established procedure for doing so. . . it's called FDIC receivership.

It Is Official: We Are Japan

2009-03-18T16:35:00.021-07:00

The Federal Reserve announced today that the Open Market Committee. . . well, here - let's just quote the press release (linked above):

To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months.

So after talking about it for months, the Fed is now playing the same trump card Japan played: Quantitative Easing. Obviously, the Fed's objective is to drive rates lower. Through putting a $1,000,000,000,000 bid in the market (that's one trillion dollars), they hope to drive up the price for Treasuries, mortgage-backed securities, and government-sponsored enterprise debt (i.e. Fannie, Freddie and family). Higher prices, of course, mean lower yields. Indeed, upon release of the news, the yield on the 10-year Treasury was hammered down from 3.01% to 2.48%. According to Bloomberg, it is the biggest decline in yields since 1962.

Is *that* good? I don't know. Think about it this way. Let's say you are China and you are nervously sitting on a 1$ trillion pile of US Treasuries. You have been increasingly anxious about holding them, given the United States' deteriorating financial condition. But you also know that if you start putting such large amounts of Treasuries out for sale, you will crush the price. (i.e. the opposite of what the Fed did today) Now, well let's see. . . if we wanted to sell our Treasuries, what better time than when there is an elephant-sized bid for them?

However, if China does 'hit the bid' for Treasuries, they still have to convert those dollar proceeds back into their home currency (the yuan). That many dollars being exchanged for that many yuan would cause the dollar to collapse vs. the yuan. . . and collapse is just what the dollar did today upon the Fed's announcement. It should be no surprise then that gold ripped higher on the news. Gold is the hedge of choice against an imploding dollar or hyperinflation. The Fed's move today suggests we are about to get one or the other. . . maybe both.

Japan's experience with quantitative easing is instructive. Bond yields were indeed forced lower, as the authorities intended. We believe the US Federal Reserve will likewise be successful in holding rates down. It is the unintended consequences of such a strategy for which we are bracing.

One will surely be a weaker dollar. As noted above in our discussion of China's quandary, there is now very little chance the dollar will strengthen and any number of reasons it will weaken. We will take the other side of that dollar trade, which would include gold and many commodities. Normally, we might also be looking at several of the traditional 'hard' currencies. However, most of the world is engaging in similar behavior as the Fed, so the ability of most foreign currencies to mount a meaningful rally vis-a-vis the dollar seems limited.

China would represent the notable exception to that last statement. Although China's currency is not presently 'fully convertible' (i.e. freely converted to and from ours), we are exploring other methods by which we could obtain exposure to the yuan. Owning shares in companies that conduct most/all of their business in yuan would be one way. Another would be to own a fund that invests in yuan-denominated shares of Chinese companies. Both of these approaches obviously expose the investor to risks other than pure currency risks, so there are additional factors that must be considered.

Mr. Madoff Goes To Jail

2009-03-14T09:23:00.026-07:00

Although Bernie's behind bars, the story should not be locked up. There surely remain others out there that helped Bernie bilk billions ($50 billion, to be exact) and should be brought to justice. Additionally, Mr. Stanford's 'wannabe' Ponzi scheme ('merely' $8 billion) continues to run its course through the legal system. But investors would be wise to FINALLY learn the following lessons to avoid Madoff- and Stanford-like scams.

1) IF IT IS TOO GOOD TO BE TRUE, IT IS!
How many times do we have to be told this? There is no such thing as an investment strategy that is never out of favor - that never incurs a loss. If you encounter an investment opportunity that appears too good to be true, walk away.

2) Never Forget Lesson Number One
Ever.

3) Always Diversify
If you simply *must* invest in "the opportunity of a lifetime", limit your investment to no more than 10% of your investment portfolio. Moreover, NEVER allow that investment to grow larger than 10% of your investment poftfolio. Any investment that does grow so large should immediately be reduced to/below the 10% level. If you hire an investment advisor to diversify your portfolio for you, as many of our clients do, you *must* be able to independently verify that diversification. Mr. Madoff's clients could only accept his word (via his internally-produced "statements" and "confirms") that they were diversified. Which brings us to. . .

4) Always Utilize an Independent Custodian
Mr. Madoff was both the advisor to and the custodian of his clients' assets. There were no checks and balances, no independent custodian who reported to clients separately from Mr. Madoff's reports precisely what was in the clients' accounts. At our firm, we employ one of the largest financial service firms in the world to custody for - and report independently to - our clients. Moreover, clients can access online account status 24/7 via that independent firm's secure website to see transactions, positions and balances.

5) Understand & Verify What Your Advisor Will Be Doing
Mr. Madoff described his investment approach as a "split-strike conversion" strategy. This is a valid investment strategy that can produce reasonable results. . . but not 'too good to be true' results. The strategy generally avoids only large losses, but does incur modest losses from time to time. More importantly, even the most cursory review of an account statement from Madoff would reveal the absence of anything remotely resembling a "split-strike conversion" strategy, immediately hoisting the proverbial red flag.

All investments eventually encounter some kind of loss. It is the nature of taking on even very modest levels of risk. As noted above, the "perfect" investment (i.e. high returns with no risk) does not exist. But if you learn - and remember - the five simple lessons above, you will be able to avoid any single investment ever wiping out your entire portfolio.

US Trade Deficit Shrinks

2009-03-13T08:41:00.016-07:00

That's a good thing, no?

In a word: No.

We have heard a few 'news' reports this morning telling us that the US trade deficit narrowed to $36 billion in January (from $39.9 billion in December), the smallest trade deficit in six years. The deficit fell because our imports fell faster than our exports: -$11.5 billion and -$7.6 billion, respectively.

A couple of these reports have given us (and probably other listeners) the impression that this is a good thing and, while a balance between imports and exports might be a worthy goal, we should be very careful for what we wish. Bringing our imports and exports closer to balance via a near-total collapse in global trade is decidedly not a good thing.

Bloomberg, to its credit, gets this story right.

The narrower gap is not good news for the U.S. economy because it mainly reflected the drop in petroleum prices. The numbers used to calculate gross domestic product, which eliminate the influence of prices, showed the trade deficit widened to $44 billion, the most since October.

In other words, the single biggest reason our trade deficit contracted (i.e. that our imports fell faster than our exports) is that oil prices fell. Gross domestic product (GDP) calculations are made on a 'price-adjusted' basis, meaning the effect of price increases and decreases are adjusted out of the calculation. On that basis, our trade deficit increased.

Should this trend continue, we will see further downward revisions to first quarter US GDP estimates.

There are other worries embedded in this report. Because of its huge trade surplus with the US, China has become the largest holder of US Treasury bonds. So, even more troubling than the impact here in the US is the impact overseas. For example, China's exports fell by a record 25.7% in February. Largely because of plunging exports, China's trade surplus has understandably taken a big hit and has so far declined by a stunning 50%. While China may have already begun to reconsider its desire to continue purchasing US Treasury bonds, the country's vaporized trade surplus now calls into question its ability to continue purchasing Treasuries.

Others of our concerns include the impact of declining oil exports on oil-dependent economies like the Middle East, Russia and Venezuela and the spectre of further increases in protectionism as policy makers respond with well-intentioned but economically suicidal "Buy [insert domestic country name here]" programs.

Global trade has been a meaningful and positive contributor to global economic growth for the past quarter-century or so. Now? Not so much.

Detroit's Wrong Turn

2009-03-05T15:50:00.009-07:00

An excellent strategic overview of the state of the US auto industry was published this week by CIBC World Markets analyst Jeff Rubin. You can find a pdf version HERE.

It is another in a very long series of reports that confirm that the world has been geared up to make too much 'stuff'.

In particular, we want to highlight a few statements from the research:

Just as two million housing starts proved to be a bubble, so was the average 16 million unit auto sales of the last five years.

. . . US domestic production will likely shrink to between six and seven million units a year. At that rate, almost half of the capacity now shut in will be lost for good.

. . . by 2013 we predict that there will be 25 million fewer passenger vehicles travelling on America’s streets and highways compared with 2008.

The current state of the US Auto industry is depressing to consider. However, there is a silver lining for those considering the purchase of an automobile. With excess capacity, we believe new car prices are likely to remain cheap for an extended period. Moreover, as consumers continue to deleverage, there will be a large supply of used cars available for purchase, many of which will be fairly new leases from which people decide to just walk away. These select opportunities are likely to offer even better value than a new car purchase.

If you are thinking about buying a car, we suggest you seriously consider waiting for even lower prices/better incentives and/or look for a late-model used car.

Withdrawal Rules of Thumb

2009-03-03T12:15:00.010-07:00

This month's Journal of Financial Planning has an article that asks important questions about 'safe withdrawal rates' from investment portfolios. (It should be noted that this is an article and not "research".)

First, some background. In 1994, William P. Bengen published a study in the Journal of Financial Planning (Determining Withdrawal Rates Using Historical Data" October 1994) indicating that investors could withdraw 4% from their portfolios during retirement and have a high degree of confidence that they would not run out of money. ("An initial five-percent withdrawal rate is risky; six percent or more is 'gambling'.") The author of this month's article, Richard F. Stolz, sets out to discover if today's financial planners are applying this 'safe withdrawal' concept to their clients.

An important reminder is offered in the article by our friend Ross Levin. As investors and their advisors fret over withdrawing too much and outliving their assets, Ross reminds us to balance that concern with one for enjoying life. Ross cleverly terms this the risk of "underliving your experiences".

“People are so worried about running out of money that they don’t bring their children along on the cruise. The kids inherit a lot of money, but they don’t have the time they could have spent as a family."

Of particular interest is a discussion about whether the bear market in which we find ourselves today may render Bengen's original work obsolete. (There are a handful of quotes from Stephen, too.)

At our firm, we continue to believe that a 'safe withdrawal rate' is one that does not exceed 4-5% of the current value of one's investment portfolio.

Milton Friedman on Capitalism

2009-02-28T11:16:00.004-07:00

The late Milton Friedman was never better than when he was speaking on the virtues of individual freedom. This short clip, from a 1979 interview with Phil Donahue, strikes me as particularly 'of the moment'.
(hat tip: Bespoke Investment Group)

What Happened To My "Change"?

2009-02-11T09:20:00.006-07:00

President Obama was on ABC Nightline last night and was asked directly about nationalizing the insolvent banks. Click on the link in the previous sentence to read the transcript.

The President is describing - and defending! - a continuation of the same or similar ineffective strategies implemented by the Secretary Paulson and the Bush administration.

Where is the promised change?

The desperation in his argument is palpable. That Sweden only had five banks versus the thousands here in the US is an excuse unworthy of a man of the President's obvious (alleged?) intelligence. Besides the fact that the relative size of the two countries' financial sectors pretty much explains this difference away, there is no need to nationalize "thousands" of US banks, much less all of them. This problem manifests itself primarily in a handful of mega-banks. (Yes, I am looking at you BofA and Citigroup.)

But don't take my word for it. Nouriel Roubini, Professor of Economics at NYU's Stern School of Business and Chairman of RGE Monitor, wrote an excellent column yesterday that can be found at Ned Grace's Blog Site. In this column, he clearly spells out why nationalizing the insolvent banks is necessary, but also (compassionately) explains why it is not politically feasible at this time. But it will be and now is the time to position one's portfolio for that inevitability.

Strike Three, Mr. Secretary

2009-02-10T11:45:00.012-07:00

Treasury Secretary Timothy Geithner is not off to a good start.

Strike One
I once heard the definition of "integrity" described to me as what you do when no one is looking.

Secretary Geithner's confirmation hearings were plagued primarily by the fact that he failed to pay FICA taxes during his employment at the International Monetary Fund (2001 - 2004). Upon examination by the Internal Revenue Service, he recently coughed up the taxes for '03 and '04 but not for '01 and '02. The reason could only be that the statute of limitations had by then passed for those two earlier years. So rather than do the 'right' thing, he stiffed the Treasury (now his employer) for the money that he owed but for which Treasury could no longer legally collect.

Upon his nomination for Treasury Secretary, he decided it might be a good idea to 'come clean' on those tax obligations for 2001 and 2002.

Strike Two
In written testimony to the Senate on January 22, Secretary Geithner accused China of deliberately undervaluing its currency via "manipulation". The Secretary might want to be a little more circumspect with his accusations going forward. It is in the mutual best interests of China and the US that China's currency had been kept "cheap". It helped Chinese goods remain inexpensive so Americans could purchase more of them and it motivated China to continue purchasing US Treasury bonds, in an effort to maintain that advantageous exchange rate. Now, with China ranking as the #1 non-US holder of Treasury debt and with the US about to issue massive amounts of same, I would think we would want to stay on China's good side so as to enable further meaningful purchases of our debt.

Strike Three
Secretary Geithner's rescue plan misses the point. For a guy who actually worked in Japan during the Lost Decades, this rescue plan offers no evidence that he understands what happened. The lesson of Japan is not that Japan failed to throw sufficient money at the banks soon enough. The lesson of Japan is "Dead Banks Walking" - i.e. allowing undercapitalized, malfunctioning "zombie" banks to continue taking up space that could have been filled by healthy, well-capitalized banks.

Some brief points from the Secretary's prepared remarks:

"First, we're going to require banking institutions to go through a carefully designed comprehensive stress test."

The FDIC has supposedly already been doing this, Mr. Secretary. A great help that has been.

"Second, alongside this new Financial Stability Trust, together with the Fed, the FDIC, and the private sector, we will establish a Public-Private Investment Fund."

Great. We've seen this movie, Tim. Private equity gets most of the upside and no downside. The "government" (aka us taxpayers!) gets crumbs of the upside with ALL of the downside.

No thanks.

Look, just stop the handouts. These guys caused the problem, they should be removed. Nationalize the insolvent banks temporarily, a la Sweden.

Nationalizing the banks will be like ripping a bandaid off. So far, Geithner is borrowing from Japan's playbook and tearing it off slowly over a decade or two. The market is telling you as much this afternoon.

Get it over with Mr. Secretary.

Bernanke is "All In"

2009-01-13T15:54:00.005-07:00

When a poker player is faced with a current bet amount for which he has an insufficient remaining stake to call and he wishes to call, he bets his entire remaining stake and declares himself "all in". In his latest monthly publication, PIMCo's Paul McCulley likens Fed Chairman Ben Bernanke's response to the current crisis to that of the poker player making a final, all-or-nothing bet.

McCulley is a managing director, generalist portfolio manager and member of the investment committee at PIMCo, where he heads the company's short-term bond desk. He also authors the monthly research publication, Global Central Bank Focus (GCBF).

GCBF is always insightful, but the latest issue is particularly so. It is his annual conversation with his pet bunny, "Bun Bun". Yeah - the format sounds lame, but it is one of the best explanations we have seen to explain for the layperson what is going on in the financial markets. (Incidently, "Bun Bun" succeeded McCulley's original 'interviewer bunny', Morgan Le Fay, when the latter passed a few years ago.)

Of particular note near the end of this issue, McCulley spells out an investment strategy for one's portfolio that matches the approach we adopted for clients a couple of months ago:
I’d tilt it toward corporate bonds over corporate stocks, however, as seemingly little known in the popular press, high grade corporate bonds have, on a risk- and volatility-adjusted basis, been beaten up even more than blue chips stocks this year.

Is It Safe? III

2009-01-12T16:38:00.007-07:00

A sequel to our 11/17/08 sequel. . .

The 3-month Libor/OIS spread fell this morning to its lowest level since the Lehman bankruptcy on 9/15/08. The spread - a measure of banks' willingness to lend to each other - crossed back below the 1.0% level to 0.98% - it was 0.99% the morning before the Lehman announcement.

So the credit markets continue to improve, providing visible proof that the Fed's aggressive actions are bearing fruit. Unfortunately, while much progress has been made, we have a ways to go. As encouraging as it is for the 3-month Libor/OIS spread to drop back to pre-Lehman bankruptcy levels, it must fall further to get back to the 0.09% average it enjoyed prior to the unfolding of the credit crisis in August of 2007.

Then again, we are well-off the high water mark of 2.69% on 10/10/08.

Bloomberg News story here.

There is evidence, nonetheless, that some limited risk-taking is re-entering the financial markets. Give a look at a chart that compares the last six months' price performance of three iShares ETFs: the 20+ year Treasury bond, investment grade corporate bond, and the high yield bond.

The picture (chart) is worth 1,000 words - but in short (~100 words?), it clearly shows that risky assets (the two corporate bond indices) were crushed in the wake of the Lehman bankruptcy but the safe asset (long-term Treasury index) was bid higher (and continues to be so). The first of the two corporate bond indices to recover was the high-grade bonds as investors continued to shun high-yield (junque) bonds through mid-December. Lately, however, investors show signs of recovering some of their risk appetite as the high yield bond index has rallied ~20%.

It nonetheless strikes us as premature for such a rally. We could be wrong, but we believe the staying power of this recession may be greater than investors currently appreciate.

This Time It IS Different

2009-01-08T07:46:00.006-07:00

This morning's Financial Times contains a solid overview of how policy makers' surge in activism has changed the investment landscape. (free registration required - but it's worth it) The column was authored by PIMCo CEO Mohamed El-Erian, who also wrote When Markets Collide: Investment Strategies for the Age of Global Economic Change (winner of the 2008 FT/Goldman Sachs busines book of the year award).

From the article:

In this new world, investors should pay particular attention to three issues.

First, the authorities are forced to make difficult choices about which markets and, more controversially, which institutions to support. By definition, these choices are not commercially driven. As a result, the notion of a level playing field for markets is giving way to the more random influence of discretionary decisions.

Second, given the speed and highly contagious nature of the crisis, the authorities do not have the luxury of a master plan that specifies ex ante the extent and sequencing of market interventions. Instead, they seek to respond quickly to severe market failures.

Third, when they intervene, the authorities must also seek to protect taxpayers. As such, they will subordinate somebody in the capital structure – the equity holders for sure. In some very exceptional cases, holders of preferred and senior securities could also be vulnerable.

The specific implications would appear to validate our recent efforts to underweight traditional equity assets and overweight fixed income assets - particularly those near the top of the capital structure (i.e. first claim on a company's assets). This has led us to draft revisions to our investment policy that we believe will provide the appropriate additional flexibility to take advantage of these opportunities.

We will be contacting clients to communicate these changes in more detail.

Time to Lighten Up

2009-01-06T14:54:00.005-07:00

After that long, boring post about the federal debt, how about something a little lighter?

I have long enjoyed Dave Barry's humor. I am a bit tardy in putting this up, but here is a link to his review of 2008.

It starts good. . .

How weird a year was it?

Here's how weird:

• O.J. actually got convicted of something.

. . . and gets even better.

But the presidential campaign is soon overshadowed by the troubled economy. The federal government is finally forced to take over Fannie Mae and Freddie Mac after they are caught selling crack at a middle school. But that is not enough, as major financial institutions, having lost hundreds of billions of dollars thanks to years of engaging in practices ranging from questionable to moronic, begin failing, which gives the federal government an idea: Why not give these institutions MORE hundreds of billions of dollars, generously provided by taxpayers?

Enjoy.

In God We Trust (all others pay cash)

2009-01-06T08:28:00.010-07:00

Q: How much debt-financed "stimulus" is too much?
A: When panicked by collapsing consumer demand, apparently that number is at least $1 trillion. Probably higher.

Q: How much federal debt is too much?
A: That number is evidently north of $8 trillion.

As outlined by Robert Samuelson in the Washington Post, policy makers can throw as much money at the economy as is necessary to get it restarted. From there, it resumes growth at a rate that allows not only for the stimulus to be removed, but for the federal debt incurred to be paid down.

That's the theory, anyway.

As Samuelson outlines, the plan could backfire. One possibility would be investors losing their appetite for US Treasury debt. The further result could be higher interest on that debt - making the problem worse instead of better - and a decline in the US dollar relative to foreign currencies. The latter outcome could push inflation higher and/or further tarnish the attractiveness of any investments denominated in the US dollar.

But our intent is not to scare you. There clearly are risks and they are (unfortunately) well-covered in the mainstream media. One viewpoint we have noticed missing in such discussions, however, is an objective review of debt levels. So here's our 'back of the envelope' take:

First of all, when folks write/talk about the federal debt, it can get confusing because there is the nominal debt figure and then there is the number that represents the federal debt net of "intra-governmental debt".

"Intra-governmental debt" is that debt owed by a government department to another (the Treasury). Our view is that it is nonsensical to include (for example) Treasury bonds owned by the Social Security Administration in total federal debt. Look at it this way: if Kathie loans me $100, our community property debt has not increased. Thus, we consider total federal debt as that number which is net of intra-government holdings.

With that accounting minutiae aside, let's look at US federal net debt in the context of history and current global conditions. Total US debt (net of intra-government holdings) as of 11/30/08 was $6.4 trillion. The latest calculations put total US GDP at $14.4 trillion. That means current US debt is about 44% of GDP.

To put that in context, note that
a) Japan has debt totaling 170% of GDP;
b) Germany has debt totaling 65% of GDP;
c) the 27 nations comprising the European Union have debt of almost 60% of GDP;
d) the core 15 EU countries have debt totaling about 2/3 of GDP.

So even if we throw another $2 trillion on the US total, that still only gets us to about 55% of GDP.

Moreover, we had a worse debt/GDP problem coming out of World War II. Debt as a percentage of GDP was 109% at the end of 1946. By 1975, the percentage had been reduced to 25%. . . although that "reduction" was due to GDP growing more rapidly than debt, rather than any "pay down" of the debt. From '46 to '75, total debt increased from $242 billion to $395 billion.

So we return to the critical point - borrowing heavily to jump start the economy is a necessary evil and even 'ok' - so long as it works. The keys are: 1) economic recovery would need to start soon (2010?), and 2) the stimulus would thereafter need to be removed and the debt reduced.

If the recovery does not come, then the similarities with Japan's "Lost Decade" scenario increase.

Through last fall, the financial markets were (in our view) pricing in a high probability that the US was facing its own 'Lost Decade'. The recent rebound in financial markets suggests that the current thinking is "notsomuch".

2009 Required Minimum Distributions

2008-12-12T15:25:00.003-07:00

The Senate yesterday approved legislation introduced and passed by the House on Wednesday that provides for a one-year suspension of "Required Minimum Distributions" (RMDs). The President is expected to sign the legislation.

Note that 2008 RMDs are not affected and must still be taken.

For those of you who rely on distributions from qualified retirement plans (QRPs) for cash flow, there will likely be little (if any) impact from this new legislation. However, for those of you taking distributions from QRPs solely to satisfy the RMD requirement, we would suggest you consider not taking a distribution in 2009.

As always, we recommend consulting your tax and investment advisors before making a decision about whether to take a distribution from a QRP in 2009.

Best. Leadership. Example. Ever.

2008-12-09T10:17:00.004-07:00

As Detroit's 'Big 2.5' beg for a handout from taxpayers, JAL's CEO shows the world a thing or two about leadership during times of crisis.

I particularly enjoyed his chosen method of transportation at the beginning of this clip.

(hat tip to Barry Ritholtz's The Big Picture)

"If You Wait For The Robins, Spring Will Be Over"

2008-11-24T14:06:00.005-07:00

We have often invoked this famous quote from Warren Buffet, which he used to drive home his point that stocks tend to rebound long before the 'news flow' turns positive. William Hester writes eloquently about this same point in his latest column posted yesterday at Hussman Funds's website.

In studying the last nine bull markets that followed a recession, Hester writes:
Earnings sometimes fell another 15 to 20 percent over a year or longer after the bull market started, and were typically flat even two years later. In 1990, earnings fell almost 20 percent over almost a 2-year period. During the same period the S&P rose more than 40 percent.

Similar outcomes were observed with unemployment data:
From November 1974 when the unemployment rate reached 6.5 percent to when it reached 9 percent six months later, the S&P rallied by more than 30 percent.

While none of this should be misconstrued as suggesting a bull market is imminent (NO one knows when the next one will start), what it clearly demonstrates is that stocks usually rebound - and substantially so - long before the economic data are uniformly optimistic. Said another way, as the next bull market gets underway, be prepared for the economic news to continue to worsen.

More On This NOT Being A Depression
Dr. Steve Hanke (Johns Hopkins Professor and Cato Institute Senior Fellow) writes in the December 2008 issue of Globe Asia:
The financial crisis of 2008 has prompted many commentators to claim that we are about to enter another Great Depression. Yes, we are entering a serious slump — one that will probably last until late 2009 or early 2010. That said, the current slump is not (and will not be) comparable to the Great Depression of 1929-1933. Before they manufacture a greater crisis, the chattering classes should stop scaring the public and check the facts.

Dr. Hanke goes on to offer a history lesson about what did (and what did not) rescue the economy from the Great Depression. (hint - it was not the "New Deal")

Not Your Grandfather's Depression

2008-11-21T15:22:00.013-07:00

Well, not yet anyway. Much has been made about how this is the worst economy/market crash/panic/whatever since the Great Depression. . . the suggestion (unintended or otherwise) being that we are entering another depression. Let's try to keep our heads and deal with facts. There is no argument that the economy has hit the wall in the past six weeks. We are likely entering a recession that could be deep and/or long. But, at least at this point, this is no depression. During the Great Depression, GDP declined by nearly one-third. Unemployment rose above 20%. Industrial production was crushed by nearly 50%. Prices fell by about one-third.

In other words, what we are presently experiencing is nothing like the Great Depression. In fact, things could get quite a bit worse and still be nothing like the Great Depression. Let's be a little more circumspect in our "depression" talk.

Unusual? Yes. Unprecedented? No.
On a related note - the media has been having an "unprecedented" party. The use of that and other similar terms (like "uncharted territory") has exploded over the last couple of months. Those who believe we truly are in "uncharted territory" or we are experiencing "unprecedented moves" in the financial markets are either too young to remember or are not students of history. While no two bear markets are identical, what we are experiencing is not unlike any of history's market panics.

John Hussman eloquently makes the case in this excellent column at his firm's website.

Stocks Are Oversold
Finally, there is a plethora of evidence that common stock valuations have gotten ridiculously cheap, so we thought we would point out a few for you to peruse during your weekend reading:

This week, the dividend yield on the S&P 500 index rose above the yield on the ten-year Treasury note. For the first time since I was a one-year old living in Texas, companies are paying you more (in current income!) to own their stock than the government is paying you to lend it your money. You get the growth opportunity for free. Randall Forsyth wrote about it in this column at Barron's online.

Barry Ritholtz runs a terrific blog entitled The Big Picture. Today, he posted a chart showing the amount of money individuals have exposed to equities relative to their historical average. What it shows is that equity allocations by individual investors is 15% below its 21-year historical mean. The three other times it has notched a reading this low correspond to the three other major lows in the stock market: 1987, 1990 and 2002.

Is It Safe?, The Sequel

2008-11-17T19:19:00.019-07:00

When we wrote the first "Is It Safe?" weblog on October 18, we were focused on the thawing of the credit markets. A quick check of current lending rates reveals that it is certainly 'safer' than it was. Unfortunately, hindsight reveals that we left out an equally important factor. Uncertainty.

When faced with uncertainty, we gather our possessions closely and look for more certainty. Originally, the uncertainty of this particular episode was largely related to the credit markets. Gradually, that has been usurped by the policy makers. What Congress would do dominated things for a few days. What the Fed would do has been a valid concern, but Bernanke and friends have done a commendable job of communicating their M.O.

Unfortunately, the lion's share of the uncertainty now derives from the Treasury. First Bear Stearns was saved in an arranged acquisition. Then Lehman was allowed to go under after similar arrangement attempts failed. Then AIG was left to fail. Then AIG was bailed out. Then a TARP was spread over "troubled assets". Then the TARP was used to cover banks. Then "troubled assets" were no longer the purpose of TARP.

You get the picture.

Who would spend any meaningful amount of money - much less invest - when we don't know what the policy makers will do next?

In defense of Secretary Paulson, no one knows for certain what should be done. The Treasury has been working virtually around the clock to come up with a coherent strategy. Hopefully one is forthcoming very soon to replace the erratic, ad hoc attempts to create liquidity.

In the mean time, here is another in our series of commentary from 'really smart people.' Today, we link you to a letter from Tweedy, Browne Company dated October 8.

Tweedy, Browne was founded by Forrest Berwind Tweedy in 1920. The firm's approach derives from the work of the late Benjamin Graham, a client of Tweedy's for many years. This relationship also led Tweedy to similar relationships with other investment legends such as Walter Schloss, Warren Buffett and Tom Knapp.

Highlights from this letter include:
> With apologies for what sounds like a cliche`, you don't make money buying at the top and selling at the bottom.
> Try to avoid projecting current conditions endlessly into the future. Things will change and likely for the better.
> We are seeing businesses with great economic fundamentals being driven down to unreasonable valuations in the stock markets around the world creating opportunities for patient, long-term capital.

The full letter can be found here.

Groping for a Bottom

2008-11-12T13:51:00.007-07:00

On October 27, the S&P 500 closed at 848.92. On November 4, it closed at 1007.75. Today, we find ourselves back at the mid-800s, with the S&P closing at 852.30. As we wrote a couple of weeks ago, bottoming is a process not an event. That process continues and our outlook is unchanged. Successful investors force themselves to do what unsuccessful investors can not - buy when the crowd is selling and sell when the crowd is buying.

On October 16, Warren Buffet's now-famous op-ed column was published in the NY Times. In it, he wrote: "Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky’s advice: 'I skate to where the puck is going to be, not to where it has been.'"

We linked you to that article because we wanted you to hear what one of the most successful investors in the history of the world thought of current market conditions. Finding ourselves in the distasteful position of again scraping against the stock market's low points, we wanted to pass along some additional thoughts from others who are among that first tier of successful investors.

First up is Wally Weitz, President of Wallace R. Weitz & Company. Weitz & Co is a mutual fund family based in Omaha, Nebraska and its President is often referred to as the "other Oracle of Omaha". In his October 12 letter to shareholders, he wrote:

"As we wrote at the beginning of this letter, we are willing to believe that the current liquidity crisis will be solved and that the recession, however painful, will end. We believe that real businesses and real people will find ways to produce and consume. We believe that certain companies are financially strong enough and well-managed enough to survive and even thrive over the next few years. From today’s price levels, we believe that patient and disciplined investors (with strong stomachs) have a very reasonable prospect of earning excellent returns over the next several years."

You can read the entire letter here:
http://www.weitzfunds.com/Literature/ShareholderLetters/Archive/WeitzFunds3Q2008Letter.pdf?title=

Guess Who's Coming To The White House

2008-11-06T15:03:00.006-07:00

Now that we know who will be in the White House for the next four years, what should we expect from the Obama Administration?

Chief financial correspondent Floyd Norris writes in the New York Times today, offering an optimistic take. It is a thought-provoking read. Norris' hope seems to rest in Candidate Obama's affection for how Ronald Reagan conducted himself as President. In particular, Senator Obama pointed to President Reagan's ability to pursuade Americans that accepting some sacrifices in the short-term could bring meaningful benefits over the long-term.

From our perspective, the Obama Administration is inheriting a mess. Given the weak economy, the massive budget deficit and the already massive level of debt, there simply is not enough money to do everything promised during the campaign. Senator Obama acknowledged as much during his speech Tuesday night, telling supporters that he knows he will disappoint some. In the NYT column, Norris writes that "The success, or failure, of his administration is likely to be determined by how well he deals with the long-term problems the nation confronts, not by how soon the current recession ends."

Hear, hear.

Our advice during this difficult period remains as it has been - worry about what you can control, not that which is beyond your control (financial markets, actions of politicians, the economy, etc.). No 'silver bullets' here, just old-fashioned fundamentals:

Spend less than you make. It is the only certain path to building and maintaining wealth. Particularly at this time and for those living off of (deflated) investments, this is a time that calls for limiting expenses to only the most necessary.

The corollary then is to increase savings and/or accelerate debt reduction. The less you owe, the more flexibility you retain for dealing with change.

Maintain balance in your investments. Concentrating your investments can be fun while you accumulate, but it is death to an 'accumulated' portfolio.

Read Norris' column here: http://www.nytimes.com/2008/11/06/business/economy/06norris.html?em

Submerging Markets

2008-10-28T10:51:00.013-07:00

Our clients know and understand that we have a strategic overweight in foreign emerging markets. We do so for two reasons:

1) Although highly volatile, emerging markets have a low correlation with more traditional asset classes like domestic large cap equity and investment grade bonds, providing a tremendous diversification benefit; and

2) We believe foreign emerging markets will provide higher returns over full market cycles than will other asset classes.

Of course, there will be sub-periods in which emerging markets underperform. We happen to be experiencing one of those right now. We nonetheless remain confident that the long-term outlook is intact.

This morning, the Financial Times published a short note that supports our view. Additionally, FT highlights the little-appreciated fact that emerging markets have outperformed since October 2002 and since 1998, despite an unprecedented decline this month. To wit:

The S&P 500 is now just 14 per cent above its October 2002 bear market low and down 17 per cent over a decade, while emerging markets still hold a gain of 86 per cent from the 2002 low and have doubled since their 1998 low.

Full article here: http://www.ft.com/cms/s/1/9b23401c-a4d4-11dd-b4f5-000077b07658,s01=1.html

Our modest overweight of foreign emerging markets is a primary reason client returns have been favorable relative to their respective benchmark over the past six and ten years. We remain confident in our strategic overweight of the asset class.

"Bottoming" Is A Process

2008-10-24T14:22:00.010-07:00

Over at Matthews Asia Funds, Director of Research Dr. Robert Horrocks recently authored an article on the investment merits of Asia. While his subject at hand is Asia's attractiveness, his points extend to the global stock market in general. I particularly identified with the following passage:

"Keeping your head whilst those around you panic is not an easy thing to do. The ability to invest in times of panic is often presented as the ability to pick the bottom of the market—the ability to not lose money. Those who dive in and are immediately shaken out by further precipitous declines invariably fail in this effort. For those who have the luxury of time, the ability to not miss the upswing is paramount. But that requires the willingness to dive in and accept that it's going to hurt. On a daily basis, we are all reading about bank failures and slowing earnings growth; it is hard to be distracted from falling prices and how much it's going to hurt if you fail to “time it right.” If you are trying to pick the very bottom of the market it is doubly difficult to ignore the swirling panic when making that split-second decision."

. . . which is why no one successfully picks the bottom. Moreover, there is rarely one split-second when the market "bottoms". As today's title states, bottoming is a process not an event. There is every indication that the process is underway. The key is to distract ourselves from the noise and focus on the truly important: accumulating shares of profitable businesses at inexpensive prices.

The decline has been traumatic and we do not know how much time will pass before we see a meaningful recovery. What we do know is that the panic and forced selling is an essential step along the path to recovery. We are gratified that our cash and bond positions have provided some cushion. We continue to execute on our strategy of rebuilding our equity exposure through the disciplined accumulation of profitable companies during this bottoming process.

The full article can be found at the Matthews Asia Funds website: http://www.matthewsfunds.com/about_asia/asia_insight.cfm

The Report of the Economy's Death is an Exaggeration

2008-10-21T14:36:00.013-07:00

Yeah, I enjoy (mis)quoting Mark Twain. Funny guy.

Regular readers of our monthly note to clients know my frustration with the mainstream media's characterization of the US economy over the past year or so. Starting with 2Q07, quarterly GDP growth has been +4.8%, +4.8%, -0.2%, +0.9%, and +2.8%. That's right, the past five quarters have averaged GDP growth of a very healthy +2.6%. Moreover, 3Q08 GDP growth (yet to be formally announced) can pretty much be 'reverse engineered' from the economic data that has already been announced. Our guesstimate is that it is roughly +1%.

Strange to see all those positive numbers, given the media's wailing and gnashing of teeth over a "recession".

Well, we may now get there. Maybe we have talked ourselves into a recession. If one becomes sufficiently fearful of a downturn in economic activity, that downturn can become self-fulfilling. Certainly we have seen a sharp slowdown in reports of the last week or two.

I, however, continue to believe it is too early to pronounce the economy dead. How the fourth quarter plays out depends largely on how much hope consumers recover. The slowdown seen in the most recent of reports is a direct result of the pure panic related to the credit crisis. I would argue that the massive liquidity global policy makers have thrown (and will continue to throw) at the problem stand a decent chance of restoring consumer confidence. If that is indeed how this plays out, 4Q GDP growth could actually be another positive number.

Brian Wesbury and Robert Stein, Chief Economist and Senior Economist respectively at First Trust Advisors, have authored an article published at the Forbes website suggesting something like that. (Tip of the hat to Dave Beck.) I may not agree with every point they make. The real point, however, is that the mainstream media is not providing a balanced picture. A "recession" is not a foregone conclusion.

http://www.forbes.com/2008/10/20/money-recession-recovery-oped-cx_bw_rs_1021wesburystein.html

Is It Safe?

2008-10-18T14:07:00.001-07:00

In the movie "Marathon Man", much pain is inflicted as Dr. Szell (Laurence Olivier) attempts to procure the correct response to that question from the unknowing Babe Levy (Dustin Hoffman). Similarly, investors have experienced much pain this year and are asking how they will know when it is "safe"?

We believe the key is interbank lending. The core problem with which the world is dealing is the lack of confidence in the credit (lending) markets - particularly among banks. This lack of confidence manifests itself through a freeze of credit markets - no one wants to lend because of the fear that the counterparty may go the way of Lehman Brothers. The best indicator of such confidence (or lack thereof) is the London Interbank Offer Rate, or LIBOR, a brief description of which can be found here: http://www.investopedia.com/terms/l/libor.asp

A chart of the one month LIBOR can be found here: http://www.bloomberg.com/apps/cbuilder?ticker1=EE0001M%3AIND. Click on the "5y" button at the top of the chart to see LIBOR over the past five years. You will note the huge increase in the rate that commenced in late 2005. To put that chart into words - banks have grown increasingly reluctant to lend to each other over the past couple of years. This fear became "panic" in the past month as the rate spiked to more than 2.5 times its normal level. The credit markets froze. The world's policy makers have since been implementing measures to thaw those markets, none of which appeared to be working until this week. The recapitalization of banks, injection of mass quantities of liquidity, and coordinated rate cuts appear to have started a trickle out of that ice block. For the first time since the crisis started we are seeing overnight rates begin to decline. This "trickle" must continue, if not accelerate, for us to exit this crisis and begin to return to whatever now passes for "normal".

LIBOR must continue to normalize for it to be "safe".

Turn Off the Television

2008-10-17T11:19:00.016-07:00

Television is for entertainment. Please remember that. Much of what passes for "news" on the economy and/or financial markets these days is little more than sensationalized facts repackaged in such a manner as to suck you into continued viewing.

Having said that, a client asked us this week where to turn for information if not the television? That is an excellent question and our motivation for creating this blog. Television is notoriously shallow, highlighting "breaking" news accompanied by little analysis and approximately zero thoughtful commentary. It is a distraction. The written word can be more thoughtful. More importantly, the reader can exercise judgment, filtering such that only the most relevant and experienced commentators have access to his/her mind. The television viewer, on the other hand, is subjected to pretty much whatever the producer wants to broadcast.

That is where this blog comes in. Our intent is to provide you, gentle reader, with relevant but brief thoughts on what we believe to be the items of import for our clients. We also plan to provide links to what we believe to be the most relevant and thoughtful material elsewhere.

We get started with a column appearing in the New York Times this morning, authored by Warren Buffett, arguably the world's most successful investor. The column is entitled "Buy American. I am." and can be found here:
http://www.nytimes.com/2008/10/17/opinion/17buffett.html?ref=opinion