A Sugar High

On and off for the last three years, the stock market has been increasingly ignoring the fundamentals of earnings, earnings per share, sales growth, market share, etc.  Investors have become far too focused on a possible, catastrophic European collapse.

Last year, we viewed the European problem (with the exception of Greece) primarily as a banking problem. Last December, the European Central Bank (ECB) launched its Long-Term-Refinancing-Operation (LTRO) which essentially provided interest-free 3-year loans to banks.  For awhile, it looked like the crisis was averted, because European leaders "would surely" devise a long-term resolution within those three years.  The market reacted strongly, and we enjoyed a nice bull run during the first quarter, as Euro-fatigue subsided.

Then, it became more clear that Europe also has a government debt problem, not a mere banking problem.  As usual, the market over-reacted, and the bears took over The Street during the second quarter, as Euro-fatigue increased again.

Last Thursday, Mario Draghi, who is head of the ECB, practically guaranteed he would "save" the Euro and dared the world markets to test him.  The Dow promptly rallied over 200 points.  The next day, there was several rumors that the ECB now had a strategic alliance with the two other large rescue funds (the EFSF and the ESF) to stop any bond vigilantes from successfully attacking the bonds of any European nation.  The Dow promptly rallied another 200 points, as Euro-fatigue suddenly dropped.

So, are we in for another bull run like we enjoyed in the first quarter or another bear attack like we suffered in the second quarter?

We'll enjoy a short bull run . . . until the market remembers that a central bank like the ECB can save banks with monetary policy, but it cannot save a nation, since it does not control fiscal policy.  Until the individual governments of Europe surrender enough control over their budgets (both spending and taxing), there can be no long-term solution to Europe.  This is tantamount to surrendering their sovereignty to the barely-existent central government of Europe.  While they wouldn't do that for Hitler . . . they may now be forced to surrender . . . by the bond vigilantes.  Instead of "your money or your life," Europeans will hear "your sovereignty or economic collapse."

Enjoy the bull run for awhile, but remember -- it is like a "sugar high" which pumps you up right now . . . before letting you down later.

Horse-Trading

Republicans and Democrats agree the budget deficit is a huge problem that must be resolved.  However, with obedience to the right wing extremists, the Republicans will not agree to any tax increases.  Likewise, with obedience to the left wing extremists, the Democrats will not agree to cut any entitlements, like Medicare and  Social Security.

Since the representative democracy we love seems to be failing us, maybe the solution is to embrace the opportunity known as the Fiscal Cliff.

Without exception, every economist predicts that "going over the Fiscal Cliff" will be bad for the economy.  The worst prediction I have seen is a 5% recession, meaning GDP would shrink 5%, which is severe.  (Assume for comparison that the 2008-9 recession was 6.4%)  Because this new recession would not be result from a financial crisis, it would probably be short-lived, certainly shorter than the last one.  It is also safe to assume unemployment would quickly jump to 10% or more.

So, here's the deal:  If I tell you we can drastically cut the deficit and eventually return to a budget surplus, like we enjoyed in 2000, are you willing to accept a short, severe recession now?

And, if you accept this deal, are you not repudiating representative democracy?

The most optimistic scenario I've heard is that Congress will just "kick the can down the road" another year, which is dangerous.  Indeed, just this morning on CNBC, my beloved professor from Wharton, Jeremy Siegel, predicted the Dow would immediately jump a thousand points if the "can" got kicked into new year.

All I know is that the world will be a better place when Washington gets out-of-the-way of Capitalism . . .

Resting on THEIR Holiday !

At one point in my life, I had to fly to Europe for business almost every month.  It was particularly annoying when I had to do business during the months of July and August, because the Europeans were maniacal about "going on Holiday."  Business would just stop!  Nothing was more important than Holiday!

So far in July, the U.S. stock market has done well, because the maniacal Europeans are off enjoying their Holiday.  As a result, we're getting very little bad news from there.  The only ongoing news from Europe are bond yields from the 24/7/365 bond market.  The U.S. stock market dipped Friday on news that the interest rate paid on new bonds issued  by Spain crossed the critical 7% level, which it has done before.

I suspect our stock market will continue to rise gently through next month, but with sudden scary dips.  One might be this Wednesday, when the European Central Bank (ECB) will stop using Greek bonds as collateral.  It seems the Greeks have not been cutting entitlements and raising taxes as they promised.  This assures us of more drama in the near future.

In the meantime . . . enjoy THEIR Holiday !

Actually, you should also enjoy YOUR vacation -- whenever you take it!

At Long Last . . .

The last boom was powered by residential real estate.  The last bust then followed the value of residential real estate as it fell . . . and fell . . . and fell for a long six years.  Last month, the chief economist of the National Association of Realtors announced that residential real estate had found its bottom and would start recovering, which would eliminate a huge drag on the economy.  I looked at his research and found nothing I could disagree with.  Now, take a look at this chart:

This chart shows home prices over the last 42 years.  Note that the recent collapse in home prices took us all the back to the level of home prices in 1985.  Also, note how sharp the recovery is -- 20% of the loss in home values has been recovered in the last five months!

Record low home mortgage rates have certainly helped.  Minimal new home construction also helped.  But, most of all, the mere passage of time helped.  It was the longest and most painful collapse in modern history. Free markets may be painful . . . but they do work!

If I had any children who were renting and stable enough for home ownership, I would put them in my car and  drive them to see a realtor today.

Learning From Six-Year-Olds

Recently, I had dinner with a six-year-old boy and his parents.  Watching his attitude toward desserts, I saw the problem with Supply-Side economics . . . please stay with me on this!

Supply-Side economics is a relatively new belief that the economy will grow if the highest marginal tax rates are decreased.  It started with the realization that there is a point (the Laffer point) when the level of taxation becomes oppressive and begins to crush the economy.  Any increase in the tax rate after reaching that point will actually result in decreased revenue received by the government.  Nobody argues with that.  The question is where is that point?  How will we know if we are there?

The theory was developed by Arthur Laffer in the 1970s.  I had lunch with him in Dallas back in 1979 and immediately understood the need for a decrease in the highest marginal tax rate, i.e., cutting taxes for the "rich."  When Reagan took office in 1981, he also announced his acceptance of Supply-Side economics and set in motion his famous tax cuts, which I fully supported.  As projected, the economy improved nicely, and government receipts went up.

At that time, there was no quantitative method to determine if we had actually reached that turning point, that Laffer point, where taxes were about to become crushing.  I just felt it!  I knew it in my bones.

My dinner with the six-year-old was as instructive as my lunch with Laffer.  As soon as the boy spied his dessert sitting there, he asked his mother if he could eat it immediately.  As mothers have said for generations, he couldn't have his dessert until he ate his dinner.  As kids have promised for generations, he promised he would still eat his healthy dinner after eating his unhealthy dessert.  Of course, the mother finally relented -- to shut the kid up, so the grown-ups could talk.  And, you guessed it -- when dinner was served, the boy was not hungry and didn't eat his healthy dinner.

That's the problem with Supply-Side economists, they want to cut taxes first but then don't cut entitlements later. They instead argue the nation can afford the existing entitlements later, AFTER the economy grows.  However, history shows us the level of entitlements just increases even more when the economy improves.  The flaw in this perfectly good economic theory (like others) is the lack of discipline in politics.

Today, there is still no quantitative method to determine if we have reached that turning point, that Laffer point, where taxes are becoming crushing.  I just feel it is NOT!  I know it in my bones.

Just as kids have to eat their dinner before eating their dessert, we have to cut our entitlements before cutting our taxes.  We don't need to decrease Medicare and Social Security much for current recipients, but we have to start weaning off future generations . . . like the six-year-old boy who must learn to eat his broccoli and, unfortunately, pay for our excessive entitlements.

Of course, it is not fair to the boy, but the alternative of doing nothing now will only make it worse for him later.  Without a decrease in benefits to future generations, no amount of growth caused by tax cuts now will save the boy.  At least, we should apologize to him . . . for spending HIS inheritance and eating HIS dessert! 

Dimon + Diamond = Carbon Under Pressure . . . ?

Nobody knows why Friday the 13th is considered unlucky.  There is no written mention of it in Western literature before 1869.  Italians find Friday the 17th to be unlucky.  Greece and some parts of Spain suspect Tuesday the 13th is unlucky.  And, on Wall Street, it is still called Black Friday by the superstitious.

Hopefully, the CEO Jamie Dimon won't feel unlucky today when he announces the second quarter earnings of gigantic JP Morgan.  One of the strongest opponents of financial regulation, he was embarrassed with last month's disclosure they lost $2 billion selling credit default swaps.  Now, we find out they actually lost $4.4 billion instead.  I do believe they were engaged in "gambling" with taxpayer dollars instead of "hedging" their loan portfolio.

More troublesome is the recent disclosure that Barclay's and other big banks were colluding to set the price of money by fixing the London Interbank Offered Rate or LIBOR.  Bob Diamond was the CEO of Barclay's  and was forced to resign.  The implications of this "price-fixing" are larger that it first appears.  We'll be hearing about it for a long time.  By the way, Diamond was also one of leading opponents of financial regulation.

Together, Dimon and Diamond have been called the "carbon brothers," hardened by their opposition to financial regulation, which is like the tide.  It went out during the Bush administration and is coming back in during the Obama administration.

It is a characteristic of nations run by lawyers that we address problems with more regulation, rather than more punishment.  Admittedly, it is difficult to prove a financial malfeasance case, but that means those who are convicted should receive real punishment, i.e., Bernie Madoff style punishment.  Would Dimon and Diamond have run their banks differently if they faced hard-time in prison rather than merely losing their jobs?  Would the carbon brothers have run their banks differently if they were paid only in bank stock that vested over a ten-year period, instead of getting millions in cash now?

It may be Friday the 13th, but the futures market predicts the Dow will gain about 40 points when it opens.  Jamie Dimon will be glad when the day is over.  Without a job, Bob Diamond will probably just be busy spending his millions.

The carbon brothers are right -- we don't need more financial regulation!  But, if we justify the over-payment of bankers by calling it an incentive, then maybe we need to create a disincentive as well?   America would be a better place . . . maybe even lucky . . . everyday!

The View From The Wells

I just read the latest outlook from Wells Fargo, and here are the salient points:

1.  During the second half of this year, U.S. growth is expected to remain unchanged, at about 1.7%.
2.  Global growth is expected to be 3.0%, if Europe doesn't "blow up."
3.  While they think Europe will instead "muddle through," it remains the biggest risk.
4.  Led by lower oil prices, inflation risks have weakened and remain moderate.
5.  European growth will improve from a negative 0.3% this year to a positive 1.0%, a big change!
6.  Growth in Japan will decrease from 2.4% this year to only 1.2% next year, another big change!
7.  Russia continues to slow from 4.3% last year, to 3.4% this year, and 3.0% next year.
8.  Mexico's growth of 4.8% this year is expected to slow to 4.4% next year.

My first thought is that I wish I could be as sanguine about the ability of Europe to "muddle through."  While there is likely at least a 51%  probability it will, the consequences of a "blow up" are huge.  It is a potential cost that is disproportionate to the probability of it happening.

Second, while the immigration debate continues in this country, it seems less relevant today.  The number of illegals coming from Mexico has now reversed.  Many of those already here are returning to Mexico, whose economy is growing twice as much as ours.  In addition, the birth rate in Mexico has plummeted; thanks to the now-legalized family-planning clinics.  Indeed, we now have more Asians entering the U.S. than Mexicans.

Lastly, I remember the years of the Cold War when we breathlessly compared our GDP growth with Russia, as if it settled some argument about either communism or capitalism.  That argument is over:  Capitalism won!  But, who is more capitalistic?  The U.S. or China?

What Really Matters . . .

One day, the bulls will be running down Wall Street.  The next day, the bears will steal money from everybody on The Street.  For those of us who are both fascinated and absorbed by such things, it is often hard to see any other things in life.

This weekend, we had to help some relatives, who had been without power for eight days.  One cousin who also had no power -- didn't need any help from us and was busy helping others.  She has always been an inspiration to me, as she faithfully maintains a sunny disposition -- despite having a severely autistic son.

She probably doesn't know a bull on Wall Street from a cow on Main Street.  But, she knows what is really important.  She never complains about the unfairness of having such a badly disabled child.  She never expresses resentment about losing control of her own life, just so she can take care of him.  She never discusses her fear of what happens to him long-term.  She has that existential ability to laugh off her troubles.  She is such a role model to me!

The next day the Dow drops 200 points . . . I shall think of her!

Jobs, Jobs, and (less) Jobs ?

On Monday morning, a survey of economists indicated that the June Jobs Reports issued this morning would show 80 thousand jobs were created last month.  However, on Thursday morning, the ADP report said 176 thousand jobs were created, which was better than expected.  As a result of the ADP report, this morning's survey of economists showed their prediction had increased from 80 thousand to 100 thousand.  Many prominent labor economists were predicting at least 125 thousand jobs.

Waiting for the announcement this morning, the futures market indicated the Dow would lose about 20 points at the open.  Then, the announcement was that 80 thousand jobs were created, exactly what economists were predicting on Monday.  The futures market then indicated the market would open down about 70 points -- a 50 point drop in mere minutes.

That reminds me of  the "recency bias," which means we are most heavily influenced by the most recent information, before the accuracy of that information is known.

More importantly, it is another grim reminder of how painful our economic recovery from the financial crisis has been.  Don't forget that almost 15% of our workers are either unemployed or under-employed, which includes people working part-time only because they cannot find full-time work.  That is almost one out of seven workers.  What a huge waste of money!  A day un-worked can never be recovered.  It is lost forever.

The European One - Two

From an economic perspective, the causes of the European financial crisis are twofold.  First, they give more money to their voters than they can afford to give.  Second, they over-protect workers, greatly limiting business flexibility and productivity.

Accountants can easily document the first, but how do you document the second?  How about a crystal-clear example?

The European Court of Justice just ruled that an employee who gets sick on their vacation is entitled to yet another vacation.  The Court said:  "The purpose of entitlement to paid annual leave is to enable the worker to rest and enjoy a period of relaxation and leisure."  If they get sick, the employee has been cheated.  As if the employer was somehow to blame for an employee catching cold, he must then change the vacation planning and staffing needs of his business.  The employee's twin rights to be both on vacation AND to be healthy on vacation is more important than the employer's right to manage his business.

Got that . . . ?!?!

The Predictable Pendulum

Nobody ever spit on me, but I do remember one pimply-faced kid saying "Oh, look, a baby-killer" when he so astutely observed a young, fit Jim Flinchum with short hair returning to college in 1970.  Over the next few years, there were several minor snubs, none of which mattered . . . then or now.

But, somehow a nation of 300  million people got embarrassed by their treatment of returning veterans.  Every Veterans Day and Memorial Day, the praise flows like the Mississippi.  Now, it seems to permeate every holiday.

Today is our Independence Day, when we used to marvel at the foresight of the visionaries in Philadelphia, who brought the concept of democracy into reality.  Independence Day was a day to be thankful for the nation we inherited.

Yet, somehow, it has become just another opportunity to rain more praise upon veterans one more time.  I agree veterans deserve praise, but how much is enough?  Doesn't our nation deserve as much or more praise?

Maybe, the relentless carpet-bombing of our national psyche by politicians and pundits has made us forget -- or even made us ashamed?  Maybe, the pendulum will swing back, and we will once again become embarrassed and praise our nation . . . as well as our veterans!

"Culture of Cynical Entitlement"

That is how the chairman of the British Financial Services Authority described the environment of the big banks setting interest rates.  In particular, he was talking about the current scandal involving the London Inter-Bank Offered Rate or LIBOR.  This is an important scandal because the interest rate on countless home mortgages, credit cards, and virtually all commercial loans change according to LIBOR.

At this point, it is not clear whether they pushed the rate higher than it should have been, which would hurt borrowers, or keep it lower, which would hurt lenders.  However, it is clear that the truth was not as important as manipulating their individual incentive plans to maximize their "entitlement-bonus."

If the borrower paid too little, the lender is entitled to more.  If the borrower paid too much much, the borrower is entitled to a refund.  Now, who is going to audit millions of home mortgages, credit cards, and commercial loans to figure out who owes whom how much?  Do you think banks or plaintiff attorneys will just shrug their shoulders and do nothing?  If you think the robo-signing of thousands of mortgage documents was a paperwork snafu of epic proportions, this interest-rate manipulation will easily eclipse that.  It could cost billions to clean up the paperwork!

Bob Diamond was CEO of the huge international Barclays Bank, which is at the center of the scandal.  At the urging of the British Chancellor of the Exchequer or Treasury Secretary, Diamond resigned this morning. I'm confident he will walk away with many millions of both English pounds and American dollars.  But, assuming he approved this scandalous manipulation, shouldn't the money be "clawed-back" and Diamond placed in prison, along with whomever else was involved?


But, the take-away for me is the reminder that people will chance the destruction of their company, the jobs of their co-workers, and sacrifice their own honor by intentionally confusing the lives of millions.  They just did what their incentive plan pays them to do.  There is indeed a "culture of cynical entitlement" on Wall Street!  We saw it at Bear Stearns, Lehman Brothers, and many other places.  Unfortunately, we WILL see it again.  However, we will see less of it -- IF we start demanding real punishment, instead of mere firings and a little public embarrassment.