The Paradox of Thrift . . . huh?

The good news is that consumers are now saving 6.4% of their after-tax income. The bad news is that consumers are saving 6.4% of their after-tax income!

Because most Americans have too much debt, it is good to see them saving more. It is good for them as individuals. However, consumer spending makes up about 67% of our GDP or national income. If they save more and spend less, our national income decreases. While increased saving is generally good for individuals, it is not good for the overall economy. Economists have long referred to this as the Paradox of Thrift.

Over the long-term, increased saving is generally good for the economy but not in the short-term.

Consumers in some nations, like China and Japan, save too much, depressing their national incomes. Their leaders are asking their people to spend more and save less. That is a luxury we do not have . . . darn it!

Is It Party-Time Yet ??

For July, the markets were up about 7%. Yesterday, on the first trading day of the month, the markets were up another 2%. While that is always pleasant, longtime readers will recall I expect we should trade in a band between 1050 and 1150 on the S&P for most of the year, but with real bullish momentum at year-end. The S&P is now 1125, approaching the upper limit of the trading band. I don't expect this strength to hold. The consumer is still moribund. This morning, even consumer staple giant, Proctor & Gamble, reported disappointing revenue numbers. The one mistake market strategists like myself keep making is forgetting that it takes awhile to de-leverage or reduce debt, which is required for consumers to become aggressive buyers again. There will be no double-dip recession. Unfortunately, there will be no quick recovery either. It is a long, sloppy recovery. So, put the party hats and balloons back in the closet . . . darn it!

Same Conclusion for Different Reasons

Readers know I have been avoiding financial stocks all year. However, when great portfolio managers, like Bruce Berkowitz of the Fairholme Fund, argue just that financial stocks are great buys, one naturally has to wonder.

The International Monetary just issued a report that our financial system indeed remains very vulnerable to another crisis (1) because our regulatory structure is still too cumbersome, despite the new Financial Regulation bill, and (2) because the commercial real estate exposure of regional banks will be worse than expected.

My argument is that our financial system is vulnerable to another crisis because the explosive nature of derivatives has not been been contained, even by the new FinReg bill, which was a big disappointment.

If I am right, the crisis will produce a short but severe market reaction. If the IMF is right, it will be less severe but longer. But, for the sake of everybody, I hope Bruce Berkowitz is right!

The Persistence of Deflation

Tom Brokaw is the famed longtime anchor of NBC News and serious chronicler of generations. His recent study of the Baby Boomers found the belief common to most Boomers was that "things" would always get better, an undying sense of optimism.

As a Boomer myself, I plead guilty!

That's why it is so important to closely examine the bad news. We have seen deflation for the last three months, which is not good. My favorite economic cycle predictor, i.e., ECRI, thinks a serious downturn is coming, perhaps as serious as last year. In other words, they think a "double-dip" is possible. One of my favorite economic indicators is the Baltic Dry Index, which is a rough measure of international trade. It has turned very ugly. http://www.investmenttools.com/futures/bdi_baltic_dry_index.htm

Despite my Boomer optimism, I have to say the evidence is grim. Nonetheless, unless we have a financial "heart attack" which would come through the banking system, I still see the market trading in a relatively wide range of, say, almost a thousand points until later in the year. There is a great sense of unease about the markets today for several good reasons. But, the most important reason is the volatility, which occurs within that thousand point range. Volatility almost always increases when trading volumes are low, and trading volumes are almost always low during the summer time.

Deflation is more problematic. Ben Bernanke is often called "Helicopter Ben", resulting from a speech he gave a few years ago, quiping that deflation could always be cured by taking enough money up in a helicopter and raining dollars onto the economy. The classic Monetarist definition of inflation is too many dollars chasing too few goods. Raining dollars on the economy should cure deflation. That has not happened. Take a look at http://www.bullandbearwise.com/MoneySupplyChgChart.asp

If the economy softens this year, I'm not worried, because it will pass. If the market takes a swoon, I'm not particularly worried, because it too will pass. But, if deflation persists, I'll be very concerned . . . unlike a Boomer!

Business Cycles, News Cycles & Other Knowns

An old Wall Street axiom is that the four most dangerous words are "This Time is Different".

Preceeding the last recession, it was widely believed this time was different because the new risk management techniques provided by derivatives, such as collateralized debt obligations, prevented any financial "blow-out". In fact, some argued that recessions were no longer possible, and that we were entering The Great Moderation instead of The Great Recession.

Prior to that recession, it was widely believed that the tech bubble of the late 1990s was also different because the increased productivity from technology would make everything more profitable, which justified the high share prices, relative to earnings per share.

I just finished reading This Time is Different by Professor Reinhart of the University of Maryland and Professor Rogoff of Harvard. In it, there is almost 800 years of data about financial crises in 66 different countries. It should not be surprising that they found very little is different before any of those crises. This is a great book but not a gentle read for the non-economist.

Frankly, it reminds me of the "Minsky Moment", named after the late Hyman Minsky, which essentially says debt will increase and increase, until it reaches that moment it can no longer increase and then collapses suddenly, causing a financial crises.

The investment implications of this today is to remember tomorrow that the four most dangerous words on Wall Street will always be the same . . . This Time is Different . . .

Financial Re-Regulation . . . FAQ

Q. Is it over?
A. The bill has passed and will become law. However, any bill this important will require many months and years of regulatory implementation. As always, the “devil will be in the details”.

Q. Is this a disaster for banking U.S. system?
A. No, but it will require some change and increase compliance costs.

Q. Will the costs be passed along to the consumer?
A. Most of it, but probably not all.

Q. Will banks begin charging for checking accounts, etc?
A. Probably, that’s the price to the consumer for reducing the risks of “too big to fail” banks.

Q. Has the problem of “too big to fail” or taxpayer bailouts really been eliminated?
A. No, but it is unlikely any future bailouts will be paid entirely by taxpayers. The regulators will also be able to move faster.

Q. Will it preclude another financial crash?
A. Nothing can guarantee that, but this will provide better tools to deal with it, when it does happen.

Q. Are there any important lessons for bankers?
A. Yes, short term incentive plans have the potential to destroy our economy.

Q. Are you glad it passed?
A. Yes, because we can finally start reducing the uncertainty. Something had to be done soon.

Q. What do you like best about the bill?
A. It creates a new function of examining systemic risk, which has never existed. It will be interesting to see what they do.

Q. What do you like least about the bill?
A. It doesn’t deal with the problem of Fannie & Freddie. Solving that problem would have delayed the rest of the bill, which needed to get done now.

Q. Don’t you think there are already enough regulations?
A. Absolutely, we are already over-regulated but, more importantly, we are very under-punished. Convictions are too rare and way too light to be worrisome to somebody on the verge of making millions.

Pat . . . pat . . . pat . . .

That’s the sound of me patting myself on the back. Tuesday, the Fed changed their position, saying the economy was weaker than they earlier expected and that it could take 5-6 years for the economy to fully recover. Long time readers know I have been expecting a Nike Swoosh type of recovery, not V-shaped, nor W-shaped, but a long, hard slog back to recovery, primarily because it takes a long time to de-leverage. Glad to see the Fed with their acres of economists finally caught up! OK, I apologize and promise not to gloat anymore. But, it did make my whole day . . .

Guns versus Butter...Not Really

Recently, there has been considerable debate within the economic community about the cost of the wars in Iraq and Afghanistan. Some argue the cost should only include the money appropriated by Congress, which is a little over $1 trillion. (See http://www.costofwar.com/)

Others argue you should include the continuing cost of veterans’ care over their lifetimes or the wages a fallen soldier would have earned in his lifetime or interest on the money borrowed and other derivative costs. I’ve seen estimates from $3 trillion to $6 trillion. It is interesting to arbitrarily accept the lowest estimate of $3 trillion and compare it to the funds appropriated by Congress for the 2008 TARP ($700 billion) and the 2009 Stimulus Package ($787 billion)

That makes the wars twice as costly as TARP and Stimulus combined. To be fair, there are many other costs associated with the Great Recession, adding trillions to that as well, but I’ve seen no research on that yet. What makes this interesting is these war costs came just before the cost of huge deficit spending required by Keynesian economics to re-start the economy. This will become known as the “Keynesian Endpoint”, which means it doesn’t work past this point. We were already so deep in debt from the wars that the needed deficit spending is more than we can afford.

Recent Inside Business Column

To read my latest column for Inside Business, click here http://www.insidebiz.com/news/second-quarter-2010-greece-love

The End is Near......Not

Earlier this month, a market analyst named Robert Prechter predicted the Dow would fall about 90% over the next six years, from about 10,000 to only 1,000. He is better known as one of the few surviving apostles of the “Elliott Wave Theory”, first developed by Ralph Nelson Elliott in 1939 but popularized by Prechter in a 1978book titled The Elliott Wave Principle. He’s been writing a monthly newsletter (at $19/month) on this ever since.

Quoting now from the widely respected Dictionary of Finance and Investment Terms, the theory holds that all human activities, including stock market movements, can be predicted by identifying a repetitive pattern of building up and tearing down, represented graphically as eight waves, five in the direction of the main trend, followed by three corrective waves. A 5-3 moves completes a cycle, althought cycles and the underlying waves vary in duration. Some practitioners believe the most recent “supercycle” began in 1932 and ended with Black Monday in 1987, indicating a 55 supercyle.

OK, that’s a mouthful but hold on!

There are numerous other “long-wave theorists”, such as my favorite, Nicholai Kondratieff, a brilliant Russian economist who served as Deputy Minister of Food in the early 1920’s at the tender age of only 25. He also saw a “supercyle” of 48-54 years. He saw this as an advantage for capitalistic systems, since the purging and destruction that occurred during the down-cycle only insured the “surival of the fittest”. Because he believed this made capitalism better in the long run, he was stripped of his office and finally died in a Soviet prison.

And, there are other long-wave theories. But, a few observations are appropriate. First, Elliott Wave theory says “all human activities” are governed by these cycles, even love and marriage. (I struggle with that one.) Second, Prechter’s cycle is out of sync, since it has only been 33 years since the last bottom. Third, some people need to feel a sense of pre-determinism, that all things are foretold, and will find Prechter’s prediction comforting, despite over-whelming evidence of what physicists can “randomness”. Fourth, a University of Michigan study found that 54% of people were more likely to believe an extreme forecast than a moderate one, in the believe the prognosticator wouldn’t make such an outrageous prediction unless it was certain. Lastly, I’m sure Prechter will sell more newsletters (at $19/month) now!

My belief remains that we are in recovery, with predictable hiccups along the way but still in a recovery. It is not a V-shaped recovery, like the stock market made. It is not a W-shaped recovery, because things will not be as bad as last year, either in the economy or in the market. I expect a recovery in the economy to look more like the Nike Swoosh, with a rolling bottom and a long, slow climb back to full recovery. The good news is that, once the economy recovers as much as the market already has, we can expect a return of the bull, a return of positive returns. While nobody knows when that will be, I’m confident it will be.

When Economists Divorce . . .

We were watching a debate on TV between a Tea Party economist and a more traditional Republican one. They were feuding over whether or not the Austrian economics of the Tea Party was better than the Supply-side economics of the Republican Party. Renee remarked they sounded less like economists debating and more like a husband and wife bickering over a divorce.

Austrian economics is the “tough love” school of economics, emphasizing the importance of a balanced budget over all other things. Supply-side economics is the “growth” school of economics, emphasizing the importance of lowering taxes over all other things.

Unlike religion, which provides guidance for most all situations on most all days, economics is not religion. It is more like situational ethics.

When the economy is dead, Keynesian economics (read: massive deficits) is appropriate. To repair the government, Austrian economics is appropriate. To rev up a stalling economy, Supply-side economics is appropriate.

Instead of debating which view of economics is “right”, the debate should have been which school is appropriate for right now. Last year, we needed Keynesian economics and got it. This year, we need Austrian economics and hope we get it, which means both tax increases and spending cuts, especially in entitlement programs like Social Security, Medicare, and Medicaid. Once we have healed the government, the tax increases will be stalling the economy, and it will then be time to implement Supply-side economics.

So, who “won” the debate between the two economists? Like divorce, they both lost . . . because they accepted their economic beliefs as religious beliefs, forgetting they are just situational ethics.

Deja Vu....?.

The scientific term for the stock market during May was . . . lousy. The S&P was down 8.2%, the worst month of May since 1940, when it dropped over 20%. Of course, it was reminiscent of September in 2008, following the collapse of Lehman, there are differences. The U.S. economy is now rebounding nicely. Take a look at this chart on S&P profits:
It shows the most dramatic fall in profits, followed by the most dramatic rise in profits. While some of this is certainly the result of the Stimulus bill, it nonetheless shows real strength in the U.S. economy.

In September of 2008, the world feared a collapse of the U.S. banking system. Today, the world fears a collapse of the European banking system. Make no mistake, this would certainly have a huge impact on us but would not kill us. I don’t foresee the dark days of 2008 coming back to haunt us.

Plus, I suspect investor sentiment is heavily influenced by two other events. First, many investors were terrified by the “flash crash” on May 6th ,when the Dow briefly dropped 9.2% for a few minutes before recovering most of that loss. On May 28th, there was an even worse “flash crash”. Of course, that was in 1962. Since that time, the market continued to improve nicely. Fear is paralyzing. Hint: Think Long Term!

Second, I think the emotional impact of the BP oil spill should not be quickly dismissed, as it is creating a general malaise over the country. The heavy drumbeat of bad news is taking a toll on us. Remember: Think Long Term!

A Historical Perspective

So, just how great was The Great Recession? Take a look at this table from Independent Strategy Group (in billions of dollars):

My father is a World War II veteran, who landed on Omaha Beach in France. It was the defining experience of his life, which he re-lives every day of his life. Yet, separating the economics from emotions, which is admittedly difficult, that event was only twice as significant as The Great Recession, as a percentage of GDP. If you add the virtually simultaneous War on Terror to the economic cost of The Great Recession, then World War II was only 19% worse than what we have recently experienced.

Complicating matters, while we entered WWII and the War on Terror with a small budget surplus, we entered the War on Terror with a huge existing national debt. We’re now in a deep hole and will need another post-WWII recovery to get out of it. Greece is a lesson for us.

So, how great was The Great Recession? You figure it out!

The Myth of a Level Playing Field

Nobody likes to think the odds are stacked against them unfairly. As long as man is either greedy or simply competitive, people will look for an advantage, fair or unfair. Newspapers routinely report on businessmen being indicted for one reason or another. No business is untouched, from developers, realtors, lenders, or even lawyers. As a result, we have learned to be careful who we do business with, but we continue to do business, knowing the crooks represent only that small portion of the business world that unfortunately gets so much media attention.

On May 6th, the stock market experienced a “flash crash”, which means it suddenly dropped precipitously before recovering. Two weeks later, we’re still trying to figure out why this happened, although it is pretty clear that it had something to do with computer routing, not any stealth attack or market manipulation. In addition, there has been much discussion since then about “high-frequency trading” and “black pools” or other sinister sounding things. So, is the stock market rigged by the smart insiders to rip off the average small investor?

Absolutely, there are smart traders who exploit any advantage to make money! There have always been people in the market like that. This is nothing new. Nonetheless, great fortunes have been made in the stock market and will continue to be made. Countless retirements are secured by the stock market.

Warren Buffett has always said he knows where the market will be in 10 years – up—but has no idea where it will be tomorrow. If you have a short-term focus, you will have many sleepless nights. But, I don’t think Warren Buffett has any trouble sleeping at night.

After the huge bull run following the March 9th low of last year, the market was already due for a correction of 10% or so. Markets do that! While it is unfortunate that our bear market correction happens to coincide with the European crisis, this too shall pass.

Last year’s bear market was due to problems in the United States. This year’s is due to problems in Europe. Who knows, maybe next year’s correction will be due to problems in Asia. All I know is that there will be another correction of some sort next year, because markets do that. Before then, markets will be up, because markets also do that.

A Day for the History Books!

What a ride! At one point this afternoon, the Dow was down almost a thousand points. The plunge was sudden, dramatic and scary. Such a price plunge could not be attributed to the fear of Greek contagion, nor the uncertainty of the national election in England and a regional election in Germany this Sunday. At this point, it looks like a trading error of massive proportions, attributable to the entirely computerized trading system we have today. We recovered from a loss of 998 to a “mere” loss of 347 within two hours.

I have cautioned many times this year that we are subject to a heart attack, which would come thru the financial system. Today, it happened and financial stocks got killed. Now, you know why I have not bought hardly any financial stocks this year, despite their nice earlier run-up.

Despite surviving today’s heart attack, we may yet have another. If Trichet of the ECB does not indicate quantitative easing soon, there could easily be another. We’ve long sold our bank stocks, and I’m still not buying any more any time soon.

Looking in the TIPS Jar

TIPS are Treasury Inflation Protected Securities. They are issued by the U.S. Treasury and have the “full faith and credit” of the United States government. Of all bonds issued by the Treasury for any given maturity, TIPS pay the lowest interest rate, because they are “inflation-protected”, which means they pay extra to keep the purchasing power of the bonds roughly equal to inflation. For investors concerned with inflation, this is attractive, because the low interest they receive is AFTER inflation.

Today, the Treasury auctioned off $11 billion of 5-year TIPS. Normally, they receive bids to buy about 2.2 to 2.4 times the amount of TIPS being offered. Today, there was 3.15 times. In other words, the government could have sold 3.15 as much as they had ti sell. It was the best since October of 1997.

This is a huge difference and strongly suggests more people are getting worried about inflation. One of the biggest fears of Fed Head Ben Bernanke is an increase in inflationary expectations, because those inflationary expectations completely become a self-fulfilling prophecy, actually creating inflation and requiring Bernanke to start raising interest rates sooner than he would like.

Disco Diva on Financial Regulation

Today, I watched the President when he visited Wall Street to discuss his pending re-regulation of financial services. Some pundits called it his “closing argument”. Maybe, it was. I don’t know. However, it was certainly not the scolding many of us expected. In his campaign, he said there is no Red America nor Blue America, just America. Today, he said there is no Wall Street nor Main Street, just America, and I have to agree with that.

The nagging problem of derivatives was discussed. While the problem is bad, derivatives are certainly not evil. They serve very valuable purposes. Hopefully, the new bill will not kill them. As always, the details are in the details. If the 1300-page bill does damage to Wall Street, we have brought it upon ourselves and deserve what we get. The worst case is that we drive the “shady” derivatives offshore to another nation. If so, good riddance! With apologies to Gloria Gaynor . . . We will survive!

Enron Redux?

Years ago, I was lucky not to have been one of the many investors who lost money in the Enron debacle. About a year before their fall, Enron got into trouble with the State of California about electricity rates. It quickly became apparent that the people at Enron enjoyed a very high opinion of their own intelligence. Remembering that “pride goeth before the fall”, I got out. It is no small irony that the best-selling book about Enron was later titled “The Smartest Guys in the Room”.

Last month, I sold Goldman Sachs for largely the same reason. Intelligence becomes over-rated and dangerous when it becomes hubris. Their current legal difficulties are no surprise, and I have no plans to ever buy GS again. Maybe, it is true that justice comes in many guises. I hope so!

Beware: Danger

The most dangerous words on Wall Street are “It’s different this time”. Take a look at this chart of the long-term unemployed, which is 27 weeks or more, as a percent of the total unemployed. Almost 45% of the unemployed have been out-of-work over six months, which is the highest percentage since the government began compiling this data. It is not just a little worse! This does not include people just entering the workforce like students, nor part-timers, nor those who have given up, nor the short-term unemployed, all of whom are usually the vast majority of unemployed. Because workers have usually taken on more financial obligations than others, the financial consequences of this graph becomes even more worrisome.

But, is it different this time? Or, is it just an extreme case? I do believe that things can indeed be different, such as the opaque nature of derivatives. I think this is just an extreme case and was probably the same after the Great Depression.

And, you thought you didn’t like rap music . . . .

Long time readers will remember about a year ago I was asked to speak to the twenty brightest seniors in Virginia Beach about economics, which I was happy to do. The biggest shock to me was when one of them asked me about the difference between Keynesian economics and Austrian economics. Since I was probably a senior in college before I knew about such things, it was a pleasant surprise to hear a high school student ask the question. Hopefully, I gave a cogent answer. Unfortunately, I didn’t have the benefit of a delightful viral video, answering the question by using rap music. For a good time, click on http://www.econstories.tv/home.html.
Enjoy!!

Current Currency Thoughts

In my last column for Inside Business, I commented that the fear of the dollar losing its status as the world’s reserve currency was over-blown. This worried a number of readers. If this loss does occur, it will not happen for many years. In the meantime, we need to remember that responsibility comes along with the status of being the reserve currency. Since the Asian Contagion in the late 1990’s, when currencies could not be borrowed, the need for national reserves has been increasing about $600 billion a year and 60% of all reserves are in the dollar. We have to provide that currency.

This discussion began with comments by the Chinese finance minister who suggested the dollar could lose its status. He never suggested the Yuan could take its place, for good reason. It is not freely convertible, and its capital markets are rudimentary. Most importantly, they have demonstrated they will manipulate their currency to help their exports. Likewise, the Euro is not a good candidate either, because they have no central Treasury. Don’t forget, there could never be a two-currency reserve system, as that is inherently unstable.

For now, the dollar remains the loser in the ugly currency contest, i.e., it is not as ugly as the others. Besides, America has many problems more worrisome than this.

Not Market Timing, Cycle Timing.........

The National Association of Business Economics is an organization of “working” economists, as opposed to “theoretical or academic” economists, and I have been a member for years. This week, we held our annual policy conference in Washington, and it was fascinating as always.

If asked what was most interesting to me, it is that the developed nations actually got their act together at the beginning of this global recession and implemented a synchronized set of responses together. That alone semi-renews what little faith that traditional institutions work effectively any longer. But, now comes the hard part: How to implement a non-synchronized set of exit strategies?

Because different nations suffered different degrees of damage, each needs a different exit strategy from all the government stimulus. Indeed, major commodity exporters, such as Australia, have already begun withdrawing stimulus. When nations running large surpluses, like China, begin exhibiting inflation, their exit strategies will have to be implemented more quickly. Failure to coordinate our exit strategies could push us back towards a “double-dip” or at best, delay the recovery. The U.S. and England were arguably damaged the most, primarily because finance is a larger share of GDP than anywhere else in the world. They will also be the last to implement their exit strategies, which is convenient because it will require “tough love”, which our politicians are loathe to do and maybe incapable of doing.

Credit Where Credit is Due.....and Needed

Most people know that individual home mortgages are put into bundles, which is funded by bond purchases to repay the mortgage originators. This greatly expanded the amount of money available for home mortgages by allowing bond buyers to provide it, a lot of it. Less well known is that the same is done for auto loans, student loans, and equipment loans. When the market collapsed last year, no bond buyers were putting money into anything, for obvious reasons. To get this market for consumer loans functioning again, the Fed made non-recourse loans to bond buyers if they would buy this consumer debt. Effectively, the Fed put $100 billion into consumer loans to kick-start the market. The program was called TALF or Term Asset-backed securities Loan Facility, one of an alphabet variety of surprisingly innovative programs.

The good news is that the program quietly ended last week, as the market for bonds collateralized with consumer debt was functioning normally again. Not only did the taxpayer get all their money back, they even made a profit. I hate to say it but . . . Kudos to Ben Bernanke and the Fed!

Recovery Postponed...due to weather delay?

While few economists disagree, the most important monthly economic statistic released each month for investment strategists is the “Jobs Report”, which is released the first Friday of each month. Today, the Labor Department announced the unemployment rate remained unchanged at 9.7%. The good news is that we only lost 36 thousand jobs last month, compared with a loss of 26 thousand in January. The reason this is good is because that we were expecting a loss of 50 thousand jobs, primarily due to the terrible weather last month. Clearly, there had to be some impact but it is not measurable. As a result of this pleasant surprise, futures jumped from 29 to 65 immediately, indicating a strong open for the market today.

The sad news is that the rate of under-employment increased from 16.7% to 16.8%. If we stopped losing jobs, the rate stays like that. To restore full employment within five years, we need to see over 200 thousand job created each month. It will be a long, hard slog, and this weather delay didn’t help.

Return to the Future . . . I hope not!

Today, the Commerce Department reported that consumer spending in January increased for the fourth straight month and increased by more than expected. They also announced that the December increase was greater than earlier reported. Unfortunately, spending increased five times as fast as personal income increased, which only increased about one-fourth of what was expected. Hopefully, we are not returning to our old habits. The US savings rate got as low as 1.2% in early 2008 before rising to 5.1% last Spring and declining since then.

At the same time, our economy is still losing jobs, albeit at a slower rate. Obviously, those who feel secure in their jobs are really ramping up their spending. The question is whether the 17 million people who are either unemployed or under-employed will ever feel that secure again? While we have experienced numerous recessions, this was the Great Recession. If the spending psyche of 17 million workers is damaged, it will be a drag on our consumption-based economy. Just maybe, that is a good thing.