Two-Speed Housing Market

A good friend of mine faithfully forwards each issue of The Kiplinger Lettter which I have studied for many decades now.  I like this newsletter because it is clear, concise, and non-partisan.

The current issue is unusually interesting.  Even though the average price of homes is expected to drop another 2% nationally this year, home prices have already been on the rise for a year in 38 states.  There are five states that are pulling down the national average.  Those states are Arizona, California, Florida, Michigan, and Nevada.

The common denominator for those five states is that they all use "judicial review" before a home can be foreclosed.  As a result, there is a huge over-hang of properties to be foreclosed and to be dumped on the market.  This depresses the market and prevents the free market from operating to clear the over-hang.

That is another "green shoot" of good news for the home market!  It is time to tell your kids to go buy their own home and to get out of your home!

Of course, I just received my annual notice from the City Assessor that my home lost almost 9% of its value last year.  Since this decreases my real estate taxes, I was privately told by a City Councilman that an increase in tax rates is coming soon.  Does that mean the tax rate will go down next year when my home starts increasing in value again?

Getting Past Losing

One of our basic values is that the lazy should not be rewarded with the earnings of people who work.

However, we have a poor, elderly relative, who is married to a husband who will not work.  When her health finally failed a year or so ago and could no longer work, we thought her husband would finally be forced to get a job.  We were wrong!  We wanted to help financially, but only if he was willing to do his share . . . by finally taking a job.  He never did, of course.

One of the most important lessons for every investment manager is NEVER, NEVER fall in love with a stock, because, sooner or late, it WILL break your heart!  That is one of the very few guarantees in the investing world.  Unfortunately, we had fallen in love with our value -- not to reward the lazy.  So, we started looking for ways to help her without concurrently helping him.

Finally, when we learned she had not enjoyed hot water for two months (during the wintertime, no less) we knew it was time to sacrifice that value or suspend it in this case.  The pain of NOT helping her exceeded any joy from adhering to one of our basic values . . . a difficult trade indeed.  When we learned she had no hot water, we knew we had lost.  He won!  What's really important anyway?

Since then, we have wondered why it is so difficult to admit defeat and move on.  Maybe, it is a mere macho win/loss issue.  But, nations are just as guilty.

Was the war in Iraq worth it?  Is the war in Afghanistan worth it?  Any intellectual discussion of those questions is prevented at this time by the emotions on both sides, but it is still the same question:  When will you know you have lost, and it is time to move on?

What has to happen before we accept the fact that the war on drugs is a futile effort, costing thousands of lives and billions of taxpayer dollars?  Even evangelist Pat Robertson thinks marijuana should be legalized.  What has to happen before we admit defeat and move on?

Shouldn't we ask those questions before we go to war and become irreversibly committed?  How do we get past failure?  There is nothing shameful about failure.  Remember:  the definition of a fool is somebody who keeps doing the same thing over and over again but expecting a different result.

When an old lady cannot take a hot bath during the winter, it is clear that some value must be sacrificed or at least suspended.

When we have lost thousands of our American boys, our entire national budget surplus (remember, we had it 13 years ago), and borrowed almost a trillion dollars from China, it is clear some value must be sacrificed or suspended.

When the Chinese won't loan us any more money to build prisons for our young people who use drugs, it is clear some value must be sacrificed or suspended.

Maybe, we should have one day every month when we admit both to ourselves and to the world . . . "OK, that didn't work.  Now, we'll do something different!"

Imagine a world less hesitant to admit defeat.  It would certainly be a less macho world, indeed . . . and more financially sound as well!

Wall Street's Dirty Little Secret

On Wednesday, a disgruntled employee wrote an open letter of resignation to the legendary Goldman Sachs which appeared on the Op-Ed page in the New York Times.  Since then, Wall Street has been obsessed with it.

Goldman Sachs has a long, storied history as an investment firm on Wall Street.  They were always considered "the smartest guys in the room."  They were feared by other firms.

However, the disgruntled employee claims Goldman Sachs has lost its moral compass, that the pursuit of profit is the ONLY thing that matters, that clients are mere "muppets" to be fleeced and fooled, and that this became the corporate culture during the reign of the current CEO, Lloyd Blankfein.

Do I believe this?  Absolutely!

While I have long been critical of the firm and frequently referenced its reputation as a Vampire Squid on the face of mankind, I do have respect for their research.  But, I have never trusted them.

It would be a mistake to assume, however, that Goldman Sachs was the only ethically-challenged investment firm.  When I started in banking decades ago, my annual bonus reflected whether the boss liked me or not.  Then, some management consultants read some Ayn Rand books and argued that people are motivated by money.  (In fairness to Ayn, she never said people are motivated "solely" by money.)  With that intellectual basis, compensation plans were changed.  It had the desired effect, changing the service culture of banks into a sales culture.  It also changed banks from being customer-centric to becoming self-centric.  And, it was painful to watch.

There are a good many people who have been unemployed for four years, sitting on the beach somewhere sipping drinks with tiny umbrellas, who made millions selling the toxic sub-prime mortgage-backed-securities.  All they did was work their incentive plans.  Its not their fault they helped send the American economy into the worst recession since the Great Depression.  They put "lipstick on the pig" and put the pigs into client portfolios.

The moment of truth for me came when I was told to put "structured products," which I refer to as neutron-CDs, into client portfolios.  I soon learned there was another operating model, where putting the client first was not mere lip-service, like it is with ALL investment houses, but is actually a legal requirement, enforced by the courts, i.e., a Registered Investment Advisor or RIA.  That legal responsibility is called a fiduciary responsibility, where my highest obligation is the best interests of the client.  Stockbrokers do not have that responsibility.

I'm proud to be an RIA and don't understand why anybody does business with stockbrokers at investment firms like Goldman Sachs.

Your Weekend Errand

From the late 1970's to the mid 1990's, home prices moved within a fairly narrow range.  Then, they spiked up dangerously.  Today, as indicated by this graph, home prices have returned to the bottom of that range.

With interest rates starting to tick up, that should send potential home buyers back into the market, making this the bottom of the market.  I know there are far too many months of supply on the market now, but the number of months of supply will drop quickly once demand increases even a small amount.

We have survived a stock market crash and a real estate crash simultaneously.  The stock market is recovering nicely.  Now, it is time for the real estate market to recover as well.

Now, if only the labor market would improve . . . at a faster pace . . .

A Guilty Victim

Last Friday, the Department of Labor released the all-important monthly Jobs Report.  Generally, it was better-than-expected, with 227 thousand jobs being created.  (This morning, High Frequency Economic,whom I respect, predicted over 300 thousands being created monthly by late Spring?)  Our U.S. unemployment rate did not drop, remaining at 8.3% of the workforce, because so many previously-discouraged people had re-joined the workforce to look for a job.  Otherwise, it would have dropped.

That afternoon, I read an economic report on Greece.  You know, that is the guilty country who led Europe in the current abyss with its high social safety net and no way to fund it, except for borrowing.  They were flatly irresponsible!

However, they are now facing 21% unemployment, and it is rising rapidly.  During the Great Depression, the U.S. unemployment rate was 25% for only a few months.  Greece will clearly exceed the U.S. rate.  Among young people, the unemployment rate is a volatile 51%.  (Keep it mind, that is the age group most likely to take to the streets and do something stupid.)  Their GDP fell a staggering 7.5% in the last quarter and is still dropping.  As I have written several times, if you have friends or relatives living there, send them a one-way plane ticket.

But, immigration is another problem for them.  Currently, Greece belongs to a pact of European nations that allow free movement between countries.  Unfortunately, Greece is the "Texas" of the European Union with a long, porous border between it and Turkey.  France, which is being over-run with Muslim immigrants, has threatened to withdraw from the pact if Greece does not stop the flow of Muslims into Europe.  With what resources?  Maybe, the unemployed could stand linked arm-in-arm on the Turkish border?

There is a price to be paid for being irresponsible!  Unfortunately, it is not paid by those who can afford it.  The average person gladly received the benefit of a lavish social safety net but must now suffer the collective aftershock.

The first step for Greece was to embrace austerity, which they are finally beginning now.  The second step is to promote growth, which means to liberalize business restrictions, which they must also start immediately.  When  the Greeks emerge from this long prison sentence to Hell, they will be a far better nation.  Guilty or not, I wish them well!

A Head Problem and a Heart Problem

Suppose, God forbid, that the stock market drops 50%.  Suppose unemployment rises from 8.3% to 13%.  Suppose home prices drop another 21% from already depressed levels.  And, suppose this all happens by the end of next year . . .

The Fed just announced another round of stress tests for major U.S. banks.  Generally, the results were surprisingly good, with only four banks failing to maintain adequate capital under such dire conditions.  The Dow rose a hundred points on this news.

Intellectually, this test doesn't give me the confidence that it gives to Wall Street.  The Fed did not attempt to identify and isolate which banks are vulnerable to a derivatives blow-up.  Maybe, it is just too difficult to measure that risk, but it is analogous to a doctor doing an annual physical on a patient and forgetting to check his heart.

Emotionally, it makes me sad that SunTrust was one of only four banks who flunked the test.  Having retired from there and accepting a pension check from them every month, I would like to be proud of them and my past association with them.  But, by the time of my retirement, I felt the bank wasn't as good as the many good and decent people who worked for them.  Now, I know I was right!

Still, I'm sad . . .

Basketball, Options, and the Fed

We were in Atlanta this weekend for an interesting conference, attended by investment strategists, whose idea of athletic prowess would be to draw macro-economic graphs upside-down on drink napkins during a polite barroom discussion on economic policy.

Ironically, we were surrounded by thousands of enthusiastic basketball fans attending the NCAA Tournament whose idea of physical prowess was certainly who could spill the most beer on their college basketball jersey.

Our conference focused on the latest techniques in trading options, i.e., puts, calls, etc.  I don't normally utilize options in my practice, except for "covered calls" to generate some additional income for clients with an income objective.  (I never use "naked calls" which can theoretically create unlimited losses for a client.)  However, there is one new strategy called the "Vertical Index Call Spread" that may be worthwhile for my clients, which I will be studying more.

I was more surprised by hallway conversations during breaks and lunches, which ignored options, focusing instead on the Fed and quantitative easing or QE3.  (I wondered if my profession was evolving from Fed-watching to Fed-stalking.)  More likely, the obsession reflected the fact that the Fed is meeting today (Tuesday).  Their report will be issued at 2:15 this afternoon and will likely dominate trading in the stock markets all day.

I don't expect anything important from the Fed today, as their next forecast will not be until April.  They won't make a big change in front of their own forecast.  Apparently, the stock market disagrees, as Dow futures are now up about 50 points.  If too disappointed by the Fed's lack of action today, traders may lighten up their equity exposure this afternoon, pushing down the stock market before the close.

Most traders (short-term market players) are hoping the Fed will announce more quantitative easing.  You'll recall this is the practice of the Fed buying  more bonds issued by the U.S. Treasury, lowering interest rates and injecting more liquidity into the market.  This invariably pumps up both the economy and the market over the short-term.

On the other hand, most investors (long-term market players) are less enthusiastic about QE, because they believe QE will only increase inflation down the road, especially with commodities like gold, oil, and foodstuffs, like soybeans and corn.

Of course, to all those howling basketball fans, I guess long-term only means the game goes into over-time?  The only inflation they're worried about involves ticket prices and beer.  Frankly, they're a lot more fun than investment nerds!

3:00 PM EST Today

That is when the deadline expires for owners of Greek government debt to either accept or reject a complicated offer to basically write off 53.5% of the face value of the bonds they hold.  (In other words, if I owe you $1 thousand, I will repay you only $465 instead.)

Over half of the bondholders have already announced their agreement.  However, we need 90% acceptance to clearly avoid a default which activates the credit default swaps.

One small advantage to today's action is that we finally get to see WHO actually owns the bonds.  You would expect that would be public information, but you would be wrong.  I fully expect a good number of hedge funds are holding the bonds and voting against the offer, hoping to force a better deal.

More importantly, this will be a good test of the credit default swap markets.  You'll recall the credit default swaps are like insurance.  If I buy a bond and am worried the borrower might not be able to repay, I can buy "insurance" that will pay me if the borrower cannot.  That is called a credit default swap.

After the Lehman collapse in 2008, payment on the swaps was chaotic, to be polite.  The credit markets quickly froze up because nobody knew who was liable to pay the swap or "insurance" claim.  Many commentators have worried that a default by Greece would affect the markets like the default by Lehman.

That will not happen!  As noted in this blog several months ago, those swaps "insuring" Greek bonds are now 90% collateralized.  That means we know who will have to pay the swaps, making the bondholders whole.  The credit markets will not freeze up this time . . . whew!

Still the next bailout for Greece will be closed on March 20th, and there will be a problem at the last minute, with commentators fretting the sky is falling.  The stock market will briefly drop sharply, but don't worry about it!!  This is expected and this too shall pass . . .

The Weight of News

Yesterday, the stock market was ugly, the worst loss since last November, but the question is whether it reflected the U.S. economy or simply the sheer weight of news.  For example, so far this week, we've learned that:

China's growth rate has dropped to "only" 7.5%, ignoring their announcement that they plan to target future growth among consumers instead of of export.

All of Greece's lenders have not yet agreed in writing to the new bailout deal and the deadline is this Thursday, but did anybody expect this deal would close without drama?

Brazil announced their GDP growth rate had dropped to 2.5%, ignoring their comments that there were some temporary weather-related factors contributing to this temporary drop.

Home foreclosures in January surged 28% as the wave of foreclosures delayed by the "robo-signing" crisis began to hit courthouses across the country.

The European Commission forecast a recession in Europe this year, forgetting they are already in one and ignoring their forecast of a recovery in the second half of this year.

The list goes on, but the point is that all this news is heavy and weighs down the market.  Of course, the heaviest news is always the first Friday of each month (yes, this Friday) when the Department of Labor releases its monthly "Jobs Report."  Wall Street is whispering some very large numbers, which means expectations are high that a good number of jobs were created last month.  If that is not the case, then the news will suddenly become much more heavy.  Stay tuned . . .

Does It Matter If You Vote Today?

Since today is the Republican primary and since I sit here with an "I Voted" sticker on my shirt,  it might be well to see which party has produced better results for Wall Street, which is predominantly Republican.

If you invested $1,000 in the S&P 500 when Kennedy took office and kept it invested only during Democratic administrations, you would have $10,920 today.

On the other hand, if you invested the same amount when Nixon took office and kept it invested only during Republican administrations, you would have a mere $2,087 today.

ADVANTAGE:  Democrats

The annualized returns during the 23 years Democratic administrations was 11% compared to only 2.7% during the 28 years of Republican administrations.

ADVANTAGE:  Democrats

However, if you remove the Democrat with the best investment record (Clinton) AND the Republican with the worst investment record (Bush II), the Democrats still win with $3,539 compared to $3,296 for Republicans, a much closer comparison . . . but still . . .

ADVANTAGE:  Democrats

Of course, facts are not nearly as important as "spin" anymore.  So, the Republican spin is that every Republican President since World War II has faced a recession in his first term, inherited from previous Democratic administrations.  (Nine of the last eleven recessions have started during Republican administrations.)

The Democratic spin is that this is proof that the Keynesian-stimulus approach works to the benefit of the economy and Wall Street.

My thought is that the Democrats are right to apply Keynesian-stimulus during recessions but derelict in not reducing the debt during good years (except for Clinton).  Additionally, Republicans are right that tax cuts will strengthen the economy, but not as much as the current level of debt weakens the economy.  

A Vertical Marathon

Years ago, when I lived in Dallas, I enjoyed participating in their annual Vertical Marathon, which was a race up the stairwell of the tallest building there -- all 72 floors.  Two participants at a time were permitted to start together, followed by another pair of participants two minutes later.  (Your time spent climbing was measured when you reached the top floor, based on when you started.)

I also noticed there were two types of participants, i.e., hares and tortoises.  The hares would quickly bound up  five or six flights of stairs and then stop to catch their breath.  We tortoises would plod up those five or six floors breathing deeply but slowly, stepping around the hares, whose ego then required them to bound up another five floors before stopping again.

The tortoises are like the overall economy, moving up steadily and quietly.  The hares are like the stock market, bounding up a thousand points and then resting.  The hares spent January bounding up.  February was spent resting.  In the meantime, the economy is steadily improving.  Yesterday's ISM report showed the service sector is expanding even faster than expected.

Also, while a sweaty climber in a stairwell might feel chest pains, the stock market is feeling a sudden rush of headlines out of Europe.  March 20th is the deadline for closing the Greek bailout.  I suspect there will be much posturing and apocalyptic warnings until then.  So, expect more chest pains and keep some 81 mg aspirins handy.

Of course, there is always the possibility an earthquake could damage the building, such as an Israeli attack on Iran, but it will not level the building.  So, just keep climbing . . .

Some Not-So-Final Thoughts

Alcoholics cannot begin to help themselves until they admit they have a problem.  In that vein, we need to repeat:  The American health care system in general and Medicare & Medicaid in particular are going to destroy this country!  There!  We said it!

We've all seen the statistics many times, maybe so many times that we're numb to facts, but the 800-pound gorilla in the room is still pronounced as "d-e-a-t-h  p-a-n-e-l-s."

Suppose I have prostate cancer, and there is a new drug that costs $90 thousand and will probably extend my life for 90 days.  Assuming the quality of my life is something other than miserable, why shouldn't I take the drug and enjoy my family another 90 days . . . since it doesn't really cost me anything?

And, since it doesn't cost my family anything to keep me around, why shouldn't they let Medicare spend the $90 thousand of taxpayer money for another 90 days with the old man?

Now, if you change the cost-sharing formula to, say, 50%, my family might or might not spend $45 thousand for another 90 days with the old man.  But, that is an option poor people would not have, and a "death panel" doesn't want to tell the poor family that another 90 days with their old man is not worth $90 thousand to the taxpayers.

Maybe, the decision should be made by China, since we borrow 40% of every dollar spent.  If you were China, would you loan the U.S. $36 thousand to keep me alive for 90 days?  That's not exactly an infrastructure investment.

Or, maybe the decision should be made by my grandson, since he is the one who will have to repay the Chinese?

To the cold, unblinking eyes of economists and accountants, the facts are harsh and demand an answer, which unfortunately can only come from our political class, useless as they are.  Democrats have taken an already complicated health care system and made it even more so.  By default, Republicans defend the indefensible current system, when they offer only philosophical bromides which are dead-on-arrival, such as the Ryan Plan.

However, during my recent tour through the world of intensive care, I witnessed an army of decent, hard-working people dedicated to saving lives and improving the quality of those lives.  I appreciate and salute those folks and the work they do.  It is a cruel irony that they seem so removed from the process of making decisions about the future of health care.  I would much prefer that they make the decision about my final days, instead of my family or, even worse, elected politicians.

Getting Snarky . . .

Today, it was announced that Google (whose corporate motto is "Do no evil") is being investigated in Europe concerning the legality of Google's new privacy policy.

Good . . . it couldn't happen to a better thug!

Carrying the Water for Politicians

The European Central Bank announced their second round of Long-Term Re-financing Operations" or LTRO this morning.  It was bigger than the first round, and over 800 banks signed up.  The European markets rallied on this news.

But, what is it?  Consider that the interest cost of government bonds in Europe has increased significantly, which starves their national budgets and spending plans.  Getting those costs down is a substitute for raising taxes or cutting entitlements, which politicians lack the courage to do.

Also, consider that the ECB told European banks a year ago to raise additional capital, so they would be strong enough to absorb expected losses.  Unfortunately, the banks found very few investors willing to inject additional capital and therefore failed to raise the capital as instructed by the ECB.

Today's LTRO announcement allows the ECB to make an additional $700 billion in loans to banks at a rate of only 1%.  Those banks must give collateral for the loans.  So, they buy government bonds as collateral for the ECB loan.  As the demand for government bonds is then increased, the price goes up, which drives down the interest rate, allowing the governments to sell bonds at lower interest rates.

Now, if the bank borrows at 1% from the ECB and buys a bond paying 4%, then the bank is making 3% pure  profit, which adds to their capital.  (3% on $700 billion each year will buy a lot of coffee at Starbucks!)  Thus, the ECB is making it easier for banks to fulfill the requirement to increase their capital.

Lastly, this LTRO program restored short-run confidence and stabilized the financial crisis in Europe, which was a spectacular success.  It is just another example of monetary policy being forced to compensate for the failure of fiscal policy (read democratically elected politicians).

The Confident Weakling

Yesterday, we learned that consumer confidence has risen to a one-year high, improving from 61.5 to 70.8 in the last month alone.  It is interesting that their confidence has risen at the same time as gasoline prices have risen.  This is unusual.  Their confidence in the improving labor market is greater than their anxiety about rising gas prices.  (I suspect the lack of scary headlines from Europe also contributed to their improved confidence.)

But, does it really matter?  Historically, consumer spending is 65-70% of our GDP.  Increased spending by consumers flows from their increased confidence.  Unfortunately, the U.S. consumer is still so deeply in debt (which they are working hard to reduce) that they cannot significantly increase their spending to match their increased confidence.  That is a major reason this recovery continues to be painfully slow.

The danger is that consumers may start spending before reducing their debts more.  This may be great in the short-run but bad for the country in the long-run.  (Encouraging the weak minded to spend must be a sin somewhere?)

Also, my 2012 forecast was that the market would improve by the second half, as uncertainty declines over Europe, China, and the presidential election.  To my relief, uncertainty over both Europe and China is declining.  However, to my surprise, economists are already debating whether uncertainty over the election has started to decline, because the average investor is assuming President Obama will be elected.  Most economists agree the market will go up, regardless of who is elected, but expect it will rise more if Romney is elected.  One can only wonder if this is also good in the short run but bad in the long run . . . or not?

Anyway, I'm tired of being a weakling . . . see you at the gym!

A Survey of Economists . . . zzzzzzzzzzz

As a long-time member of the National Association of Business Economics, I pay close attention to their forecasting survey.  Here is the bottom line on the latest survey, which was just released this morning:

• The NABE Outlook Panel of 45 forecasters continues to predict moderate real GDP growth through 2012. Economists expect the economy to grow 2.4 percent in 2012, with GDP growth slightly stronger in the second half of the year than in the first.
• Employment growth brightens. Panelists increased their anticipated average monthly job change to 170,000 in 2012, which would result in an average annual unemployment rate of 8.3 percent. NABE forecasters expect stronger job growth in 2013 with the unemployment rate falling an additional half percentage point to 7.8 percent.
• Consumer spending to remain subdued. Even with higher employment forecasts, real consumer spending is forecast to increase only 2.1 percent this year and 2.3 percent in 2013. This rate remains below the historical norm of 2.8 percent and is consistent with a positive but below-trend recovery. Light vehicle sales are anticipated to grow at a solid pace of 14 million units this year and 14.6 million units in 2013, up from 12.7 million units in 2011.
• Housing starts are expected to increase 19 percent in 2012. The economists surveyed expect housing starts to reach 700,000 units in 2012, up from 610,000 in 2011 and an upward revision from the November forecast. The forecast for 2013 shows continued improvement, with housing starts reaching 850,000 units. Correspondingly, real residential investment is forecast to increase 6.6 percent in 2012, slightly higher than the 4.3 percent predicted in November, and then strengthen further, rising 10 percent in 2013. The projection for home prices in 2012 was lowered slightly from a projected increase in the FHFA index of 0.9 percent (Q4/Q4) in the November survey to home prices remaining unchanged in the February survey. In 2013 home prices are expected to increase slightly more than 2 percent.
• Panelists continue to forecast strong business spending growth. The outlook for spending on real nonresidential equipment and software in 2012 was marginally revised upward to 8.1 percent, and panelists forecast a lower but still solid 7.3 percent in 2013. The projection for real spending on nonresidential structures for 2012 was lowered slightly from that in the November survey, to 4.2 percent, but in 2013 the growth rate is expected to pick up to 5.1 percent. Industrial production is expected to increase moderately at 3.5 percent in 2012 and at 3.3 percent in 2013.  

I have argued for many months that this recovery is sustainable but relatively weak.  That is because it is a de-leveraging recovery.  It takes time to work off debt.  This also explains why consumer spending will remain subdued and that average unemployment for 2013 is expected to still be a high 7.8%.  

I was also not surprised that there is agreement on the continued strong growth in business spending, as business was never as highly-leveraged as the consumer.

But, I am surprised by the optimistic outlook for housing and plan to study this more.  Hopefully, I'm wrong, and they're right!

For Whom the Bell Tolls

In the final scene of Ernest Hemingway's 1940 classic, the American Robert Jordan lies wounded.  He awaits his certain death at the hands of General Franco's soldiers, but he is determined to take as many of those soldiers with him as possible.  He never knows the outcome of the Spanish Civil War.

Mario Draghi is the new head of the European Central Bank.  In four short months, he has proven himself far more agile and creative than his longtime predecessor.  In the mold of Ben Bernanke, he deserves much credit for stabilizing the European debt crisis.

This weekend, The Wall Street Journal ran an interesting article on his views of how Europe is changing and will continue to change.  He confidently predicts greater fiscal integration, which means more centralized governance from Brussels and less from each nation's capital.  More interesting, he sees the famed European social contract of generous benefits and great job security as a dying relic.  That social contract was the envy of the world, including the U.S., for many decades.  Those dreams are dead.

As an American, I know the death of generous benefits and job security is coming to our economy as well.  In the end, we will be a stronger economy and a stronger people.  However, getting there will be painful.  The continuing demands of labor unions and government employees for generous benefits and job security will be the enemy soldiers.

The good news is that, even if we don't live long enough to see the new American social contact, I do know the outcome of this war.  We will be a stronger nation and a stronger people, less reliant on big-brother institutions.  We will have a balanced budget and enough foreign reserves to embarrass even the Chinese.

That is not uninformed boosterism or unbridled patriotism or even simplistic optimism.  It is recognition that the creative if cantankerous nation still has massive natural resources, geographical strength spanning two oceans, excellent higher-education, and a passion for competition.  Draghi sees good times ahead for Europe.  I see better times ahead for America.

I just hope it is a short war . . .

Holding My Breath . . . Nope!

Suppose you have a first cousin living in California and another one living in Texas.  You trust and respect them equally.  Both of them have an investment proposal for you.  You like each proposal equally.  Incredibly, each proposal projects the same revenue as the other.

However, one of the proposals shows higher expenses, which means lower profits for that proposal.  Do you really care if the higher expenses are due to rent, labor, or taxes?  No, you are focused on the bottom line, i.e., the profits.

But, wait . . . one of those expenses is taxes!

My point is that corporate tax is just another corporate expense.  Increasing that expense reduces profit and the value of the investment.

Yesterday, the President proposed decreasing the top marginal tax rate for corporations from 35% to 28%, which sounds great.  At 35%, our country has one of the highest stated corporate tax rates in the world.  However, the actual rate is only 12.1%.  This huge difference is due to the many, many tax breaks allocated to certain industries, but not all.  It is a Christmas tree of loopholes for businesses with the best lobbyists.

President Obama wants to reduce the top rate and eliminate most of the loopholes.  The end result will be that American businesses will actually pay more in taxes.  Therefore, his proposal is dead-on-arrival.

There is a perception that business does not pay its "fair share" of taxes.  My belief is that business should pay nothing in income taxes.  Businesses are neither good nor evil.  They may occasionally do something evil or bad, but that is because management is bad.  A tax on business is just an indirect tax on investors.  If you want to tax investors, then tax them directly.  Why tax an artificial entity that simply passes through income, like corporations?

So, which cousin do you invest with?  The one with the lower taxes, of course!  Capital or money flows where it is treated best, whether it is California, Texas, or Israel or China or wherever.  Taxes are just another cost of doing business.

After much thought, I've decided not to hold my breath until corporate tax expenses are eliminated . . .

The Smell of Napalm in the Morning . . .

There is an old Wall Street adage that you should buy when you hear the cannons fire and sell when they fall silent.  In other words, if and when Israel attacks Iran's nuclear reactors, stock markets around the world will fall, which is a good time to buy.  When a sustainable truce is announced, the markets will rise, which is a good time to sell.

This adage have more value for the short-term traders than it does for investors who invest for the long-term and ride through down-markets.

However, applying that adage to the new Greek settlement, traders heard cannon fire, and stock markets rose in January in anticipation of the pending Greek settlement (and other factors as well, of course).  Traders were buying lots of stocks.  Still, there was an expectation that the traders would sell-off when the deal was announced.  Instead, there was very little reaction.  In fact, the Dow even flirted with 13,000 for awhile.

What does this tell me?  Traders don't know whether to buy or sell because they don't know if this deal will work or not.  (This morning, one of the major credit rating agencies downgraded Greece, saying a default was imminent.)  Lastly, because long-term investors did not rush in to bid up the market, that tells me they also don't know if the deal will work or not.

Still, I think the all-important risk of systemic failure has been greatly reduced by the ECB's new LTRO program.  In addition, the new technocratic leader of Italy is making real progress in opening up that huge economy. And, while every nation is different, the Greek deal does provide a useful template or starting point for any future bailouts, such as Portugal.

While cautious, I remain bullish . . . for now.

A Thug By Any Other Name . . .

First, The Wall Street Journal tells me that Google is violating its own Privacy Policy and sharing information on users.  As I value my privacy and that of others, I felt violated.

Next, I cannot access my blog, which I have written for years.  I learn that I must download Google's new browser, Chrome, in order to access my own blog.  Surrendering to The Thug, I paid their extortion demand and did so, even though I was satisfied with whatever browser I had.

At this point, I do not know if this post will appear on my blog or not.  I don't know if past blog postings are still available or not.

Of course, in a theoretical world, I could have refused to pay the ransom to access my own blog and NOT download whatever Google wanted me to download.   Of course, this is the real world, where a Thug by any other name is still a Thug!

At this point, I do know that Google has also violated its own motto of "Do No Evil."

Just for the record, I have been a long-time fan of Google but am mad-as-hell right now.  First, I read in the Wall Street Journal that you ignore your own privacy policy.  Now, I cannot find my blog, which I have labored over for years.  Then, you force me to download a new browser, when I am perfectly happy with whatever I had.  I would gladly have paid a lot of money to avoid all this hassle, waste of time, and loss of privacy.

How could you do this?  Have you no decency?

Framing the Election . . . ??

Americans usually demand excellence but, being realists, accept something less.  Our political debate often looks for the best or most excellent solution to problems.  But, the politics of the possible makes us accept something less.

Readers will recall we live in a tri-polar world of economics.  We have Austrian economics, which argues that the budget should be balanced EVERY year and is often called the "tough-love" school of economics.  We have Keynesian economics, which argues that the budget should be in deficit during recessions and in surplus during economic expansions.  And, we have Supply-Side economics, which argues that expansion occurs only when the top marginal tax rate is decreased.

Each of the three schools of economics has their own predictable solutions to reducing the dangerously-high national deficit.  However, one of my favorite pundits is John Mauldin, a small guy with a large family in Dallas.  As he is largely self-taught, he often brings original thoughts to the conversation.  This is a comment in his most recent newsletter:

"Let me shock a few of my fellow Republicans and say that I think the deficit is such a deadly disease that it would be better for the country for the Democrats to be in power and forced to deal with the situation than to do nothing. I would not like their solution, and I think it would be harmful, but not as harmful as a second Depression, brought on by not dealing with the deficits and entitlement problems.

As a businessman, I would rather pay higher taxes on profits than to have no profits at all. Just tell me the rules and I will figure out how to adjust. A Depression to would mean 20% unemployment (at least) and a real lost decade, with the Boomer generation trying to figure out how to deal with no money and no jobs and being old."

In other words, the choice is not between Obama and Romney or whomever.  The choice is between a Democrat who would be forced by the credit markets to deal with the deficit now or a Republican who would not be able to accomplish anything due to Democratic opposition.
 
Looking at the election this way, I could easily become either too depressed or too sober . . .

Market Timing?

January was the best month for the stock market in 25 years.  Unfortunately, a huge number of retail investors have been so shell-shocked by the 2008 collapse that they still remain on the sidelines.  This is one of the primary reasons why trading volumes on the New York Stock Exchange and others have been so low.

So, the question becomes whether it is too late for them to benefit from the current bull market?  Take a look at this chart:



In the last 111 years, there have been 13 bull markets that followed bear markets dropping at least 30%, which means there is one about every 8.5 years.  This chart shows me that this bull market is still quite young.  (More surprising to me is that the strength of this market is about average, even though the economy is growing more slowly due to de-leveraging.)

The point is that history suggests it is NOT too late to get back into the market. 

Of course, not only is past investment performance not any guarantee of the future, neither is history, darn it!

Extend and Pretend

First, a little review of Accounting 101 -- If you subtract total liabilities from total assets, you get net worth or capital.  If you sustain a loss on the sale of an asset, you decrease net income by the amount of the loss.  If you have no net income, you must decrease net worth or capital by the amount of the loss.  For banks, if you expect a loss on a loan repayment, you must decrease net income by the amount of the expected loss.  If you have no net income, you must decrease net worth or capital by that amount.  Thus, when banks are running short of capital, they don't want to recognize any loan losses, because they have no income and must decrease their net worth, making the capital shortage worse.

Years ago in Texas, I was appointed by the Governor to serve on the four-member Texas State Depository Board with the State Treasurer, State Controller, and State Banking Commissioner.  This was during the infamous "Savings and Loan Crisis."  As those financial institutions had no income, they were forced to decrease their capital or net worth every time they had an expected loss on some loan, that would not be repaid in full.  Not surprisingly, they were reluctant to admit any loan was bad loan.  They were motivated to extend any loan that came due and pretend they would eventually receive full payment, i.e., "extend & pretend."

Of course, as regulators, we were always suspicious of any financial statements, as they may not be properly recognizing loan losses.  In addition, the outside auditors checked for evidence of this accounting practice.  Eventually, the crisis passed . . . after taxpayers lost about $300 billion.

I think we are seeing the same thing again, only on a vaster scale.  The recent Long-Term Refinancing Operation (LTRO) of the ECB essentially tells European banks that no loans are due for three years and that no losses should be expected at this time.  Quietly, over the weekend, the Chinese government told their banks to rollover or renew all municipal bonds/loans for the next three years and pretend those bonds/loans contain no losses.

"Extend & Pretend" was an accounting trick used by Texas financial institutions.  Then, a central bank practiced it.  Now, a major government is doing it.

This is more than just "kicking the can down the road," because we don't want to deal with a problem now.  It is buying time during a crisis.  Monetary policy is being used to buy enough time for fiscal policy to do whatever needs to be done, i.e., decrease entitlements and increase taxes.

Fortunately, it also buys time for the bulls to run . . .

On Wealth Watching

We have spent the last four days on Jekyll Island, a lovely resort of gentility and Spanish Moss.  It was originally founded 125 years ago by the famous "Robber Barons" as a place to escape the awful New York winters.  They spent lavishly on their 5,000 square foot "cottages."  Their clubhouse even had a restaurant to rival their favorite restaurant back home, the legendary Delmonico's in lower Manhattan.  They spent their days in fine style, indeed.  The men wore suits and neckties to hunt.  The ladies wore long dresses and hose to ride bikes.  They dressed the same for the beach.

As succeeding generations customarily become more indolent, they also become less interested in gentility and Spanish Moss, preferring more "exciting" places to vacation.  Eventually, this lovely place fell into the hands of the government of Georgia, which has done an excellent job of restoring it and commercializing it.

I was pleased to watch other tourists gawk at the ostentatious cottages but in a respectful manner.  Unlike France where the homes of the rich were sacked after the French Revolution, people here merely admired the ostentation of the Robber Barons with a wry smile and a knowing look.  There was no obvious envy, merely wry amusement.  That speaks well of both America and Americans.

Of course, I heard the term "Robber Barons" one time too many and finally suggested the tour guide refer to them as "job creators" instead.  For some reason, I was promptly heckled by the other tourists.  Did I go too far and get too political?