Friday, May 30, 2014

Is Good Bad ?

There has never been a time when Wall Street was NOT "climbing a wall of worry."  Today, there is considerable angst, because interest rates are TOO low.  There are lots of interest rates but the benchmark that everybody watches is the rate on U.S. Treasury bonds that have a ten year maturity.  Those rates began the year at 3% and actually touched 2.4% yesterday before bouncing up slightly.  The vast majority of analysts have been predicting higher interest rates.  What's going on?

Classical or Austrian School economists argue that interest rates are nothing more than the price of borrowing and is dependent on the supply of loanable funds and the demand to borrow those funds.  If people want to borrow more dollars than are available to be loaned, then the price of money (interest rates) will rise.  If the supply of money to be loaned exceeds the demand to borrow that money, then the price of money will drop.  Therefore, this unexpected drop in interest rates tells us that the demand for loanable funds has decreased, and yesterday's downward revision to first quarter GDP supports that argument.  Growing businesses borrow money.  If GDP is decreasing, interest rates should fall.  (Second quarter GDP is expected to be much stronger, more like 3%.)

Quantitative easing is nothing more than buying Treasury bonds by the Fed.  If the Fed buys $10 billion less each month, then the demand for Treasury bonds decreases, which should drive up the interest rate that Treasury needs to pay in order to sell their bonds.  Four months into reduced quantitative easing, interest rates have gone the wrong way.

Overlaying this belief is the reality that people sometimes become afraid.  When Russia invades Ukraine, as I still expect to happen, the benchmark interest rate will fall.  Why?  Because people will sell stocks and move their cash into something risk-free, such as U.S. Treasury bonds.  So, has geo-political risk increased this year, causing interest rates to decrease.

Of course, there is a conspiracy theory.(There is ALWAYS a conspiracy theory.)  There is one account in Belgium that appears to be buying Treasuries at the same rate as quantitative easing is reduced.  Because that means purchases of tens of billions of dollars every month, the mystery owner must be a central bank like the ECB or even the IMF.  The obvious explanation is that there is an "understanding" or conspiracy among central bankers.  As an trader at TD Ameritrade points out, this is probably just bonds being transferred to Belgium from accounts outside of Belgium.

While I believe conspiracy theories are generally crutches of a lame mind, there may be some truth to this one.  It is not uncommon for there to be a "market--maker" for securities.  They keep the price of a particular security from swinging too violently.  If a large order to sell stock in ABC comes in, it could drive down the price of ABC  unreasonably.  Therefore, the market-maker buys enough ABC for his own portfolio to minimize the downward pressure.  Conversely, if a large order to buy ABC comes in, he will sell enough ABC from his own portfolio to control upward pressure on the price of the stock.  Since the dollar is the only reserve currency, violent swings could easily disrupt the world economy.  I would not be surprised if such an "understanding" exists but doubt it is anything new.

As the ECB has made clear, the euro is currently too expensive compared to the dollar.  If you cannot make the euro less expensive, you can certainly make the dollar more expensive by buying a lot of dollar-denominated debt.  BOOM - mystery solved?

Of course, one could spend a lifetime "looking at a gift horse in the mouth."  For every month that rates stay this low, homeowners stuck with adjustable rate mortgages get a break.  Interest expense on corporate income statements is reduced, which drives up profit.  More importantly, U.S. taxpayers save money on their $17 TRILLION debt burden.  Remember rates dropped from 3% to 2.4% -- NOT from 12% to 6%, which would be much more important.

Thursday, May 29, 2014

Birthday Wish

Is there anybody who does not love the Irish?  Here is an old Irish blessing that I received today:

                              May the road rise to meet you,
                              May the wind be always at your back,
                              May the sun shine warmly on your face,
                              May the rains fall gently on your fields,
                              And until we meet again,
                              May God hold you in the palm of His hands.

Despite my love for golf, I have never been to Ireland.  I think I need to fix that . . .

A Perma-Bull To The End

A perma-bear is someone who always thinks the glass is half-empty and that the stock market is going down.  A perma-bull is someone who always thinks the glass is half-full and that the stock market is going up.  My favorite professor from Wharton, Dr. Jeremy Siegel, is a perma-bull.  (However, his 2013 forecast was THE most accurate forecast last year, not second or third, but THE most accurate.)

His latest weekly commentary ends with an amusing line.  He notes the stock market has been largely range-bound but drifting slowly, very slowly upwards, despite the fact there has been "very little economic news."  The Fed has not provided any definitive deadlines to eliminate quantitative easing.  Retail sales have been dull, even disappointing.  Even the geo-political news like the Ukraine has been sanguine.  It's boring!

He discusses the strange performance of the VIX or "fear index."  It falls when Wall Street feels optimism and rises when it feels pessimism.  It is now very low, suggesting the market has become complacent, "suggesting that the market is near its peak."  He shows a surprising bit of bearishness in that statement.  He could just as easily say the low VIX is predictive of another upward move.

Then, he returns to character by concluding "There are just no surprising developments that are moving the market.  History has suggested that this does not last long, but one should remember that [cue the perma-bull now] any upside surprise is as likely as a downward one."

I love this guy!

Monday, May 26, 2014

Losing National Treasures . . . Every Day

It is pretty well-known that one active-duty service member commits suicide almost every day.  It is less well known that 22 veterans commit suicide every day.  It is believed that half kill themselves so their families can receive the insurance money.  Veterans are extremely vulnerable to high-pressure, commission-driven salesmen.  Frankly, they have no financial education and are easily preyed upon!

At our convention of the National Association of Personal Financial Planning in Salt Lake City a few weeks ago, I learned of a new program to assign a disabled veteran to volunteer planners for free financial planning.  Of course, I signed up and anxiously look forward to helping some fellow veteran . . . before it is too late!

I'll keep you posted . . .

A Walking GPS ?

My wife assures me that it is true, i.e., men are overly reluctant to stop the car and ask for directions.  Huh?

But, a new study by Genworth points out that women are overly reluctant to ask for financial advice.  61% of men want financial advice, whereas only 34% of women do.  The other big difference is 48% of women say the biggest roadblock to asking for advice is the complexity of financial products, whereas only 39% of men said that.  Maybe, that reflects less financial education was provided to women early in life?  Maybe, since most serious financial advisors are male, it reflects the fact that some women just hate asking men for advice on anything?  Or . . . ??  I don't know!

Fortunately, technology has come to the aid of lost male drivers in the form of GPS.  Technology has also come to the aid of women, as the internet has a huge amount of information.  Unfortunately, learning financial planning from the internet is like drinking from a fire hose - it is way too much information.  The GPS for financial planning is still a serious financial advisor.

Saturday, May 24, 2014

Memorializing the VA

Since the press focus this Memorial Day weekend is on the troubles in the Veterans Administration system of healthcare, I thought I would add my observations.

I was discharged from the Army in 1970.  The following year, the VA determined I was 20% disabled due to my injuries and started paying me $61 monthly.  While that amount has increased over the decades since then to $258 monthly, I find that, due to inflation, it still buys me approximately the same number of six-packs of 12-oz cans of pain relief as it did in 1971.

However, I have noticed two distinct trends.  First, it has clearly become more difficult to get an appointment, especially since the second Iraq War.  Twice, my doctor was out sick himself (PTSD, I suspect), and it took 4-5 months to re-schedule each appointment.  Despite increased funding, too many people have entered the system.  Providing battlefield care alone does not even begin to pay the cost of war.  (Economists have estimated the true cost of the wars in Iraq and Afghanistan at THREE TRILLION DOLLARS.)

Second, the VA is clearly an Equal Opportunity project that has now run amuck, with tragic results.  While the healthcare staff draws talent from 100% of population and does a remarkable job, there is a world of difference with the administrative staff, which draws talent from only 11% of the population.  It reminds me of the old TV commercial showing a long line of people waiting in a post office, while the two postal workers discussed their fringe benefits.  My understanding of the pending legislation is that it did contain language permitting the VA to eliminate deadwood, but that it was deleted, which is unfortunate.  An Affirmative Action job should not come with tenure.  The problem is with the administrative staff, not the healthcare staff.

Make no mistake:  I am grateful for the healthcare I receive from the Veterans Administration and often feel guilty using it, since I already have good healthcare, but I do feel a kinship to the other veterans and enjoy their company.

During all these decades, I have often praised the VA healthcare system as a model for delivering healthcare to the uninsured.  With the political windbags spinning points from the current controversy, it is easy to lose sight of the fact that millions of people STILL have no access to healthcare, even in a post-ObamaCare age.

Thank you, VA!  I hope you have a happy, healthy Memorial Day weekend too!!

Thursday, May 22, 2014


The CEO of Goldman Sachs once famously said the firm was doing "God's Work."  That may or may not be true, but I am confident the highly-respected research department of that firm would never make such a comment.

For example, here are some of their more useful comments:

1.  The first quarter was worse than expected, with the economy actually shrinking, due to weather.
2.  They expect the economy to grow at a respectable 3% the rest of the year.
3.  Core inflation will end this year at 1.7% and next year at 2.0% -- hardly worrisome.
4.  The benchmark rate on 10-year Treasuries will end the year at 3.25% and next year at 3.75%.
5.  The S&P 500 will end 2014 at 1,900, which means minimal growth for the rest of this year.
6.  The S&P 500 will end 2015 at a much better 2,100.
7.  Oil will continue a slow, steady drop in prices, ending next year at $90/barrel.
8.  Gold will end this year lower at $1,050/oz but increase to $1,200 by the end of 2015.
9.  The Euro will continue to weaken to $1.32 this year and $1.27 next year - so, vacation next year!
10.  The Yen will also continue to weaken to 110/$ this year and 115/$ next year.

My only issue with their analysis is that I do expect some upward pressure on the stock market in the fourth quarter, which is traditional in an off-year election.

While I agree completely with their prediction of the dollar strengthening against the Euro and Yen, I do worry what that will do to our exporters and hope they are hedging their currency risk.

By the way, since when did oil prices become so un-worrisome?  Those prices have not rattled the stock market in years.  Thank goodness for shale oil, I guess . . .

Thank God for Goldman Sachs doing God's work . . . well, maybe their Research Department anyway!

TSA Absurdity

Flying out of Norfolk last week, the steel shank in my shoes set up the METAL detector.  Instead of checking whether I was carrying a gun, they swabbed my hands for explosive residue.  Flying out of San Francisco yesterday, the same steel shank in the same shoes did NOT set off the metal detector.  However, I forgot to remove a comb from my back pocket, and they decided America would be safer by swabbing my right hand, but not my left one.  Huh?

And, that makes sense because . . . ???

Tuesday, May 20, 2014

Great Idea . . . Lousy Timing

I keep thinking about one particular lecture last week.  The speaker began by saying his parents told him that some things should never be discussed in mixed company, i.e., sex, religion, and politics.  Today, he is adding a fourth subject, i.e., healthcare.  That term is now too politicized.

If you say something positive about healthcare, then you are a supporter of Obamacare and therefore an "Obama-lover."  If you say something negative, then you oppose healthcare for the poor, and you are an "Obama-hater."  He wanted to emphasize that Obamacare and healthcare are two different things, related but different.

Long before anybody ever heard of President Obama, we faced a crisis in healthcare.  It consumed 12% of our  national income in 1993 but had risen to 17.5% by 2012, which means we had less money for our homes, cars, education, infrastructure and everything else.  "Bending this cost curve" was already declared essential by both sides of the aisle.

It is well-known that doctors must practice "defensive medicine" to protect themselves from predatory lawyers.  This means they test everybody for everything, so the predatory lawyers cannot accuse them of negligence.  The dirty little secret is that doctors started doing the testing themselves, which greatly increased their profit margins.  Doctors made more money when they ordered more tests.

The trendline for the last few years has been for hospitals to buy out the medical practices of doctors and put them on a salary, instead of a "fee-for-service."  Hospitals are big enough to fend off the predatory lawyers and can also make the employee-doctors justify tests they order.  Hospitals who have done this include the Mayo Clinic and the Cleveland Clinic.  Their charges are as much as 40% cheaper than old-fashioned "fee-for-service" doctors and hospitals.  They are called "Accountable Care Organizations" or ACOs.

Making this transition from a high-cost "fee-for-service" model into an ACO model was already confusing enough.  Then, the President added 30 million people to the staggering system, under the belief that poor people deserved some healthcare as well.  It was a one-two punch -- first, we hit the system with a confusing transition and, second, we dump a lot more people into that system.

So, which is better?  Should we have added the poor to our healthcare system years ago?  Or, should we tell them to wait even longer?  

Friday, May 16, 2014

A Hint From Heloise

She always asked the rhetorical question of, when you drop a piece of toast, why does it land with jelly-side down, making the floor more difficult to clean up?  Why cannot toast land jelly-side up?

The same is true with market data.  Yesterday, the benchmark interest rate on 10-year Treasuries dropped below 2.5%, the lowest in over six months.  Most Americans would find it comforting that our government can borrow so cheaply.  If rates were higher, our budget deficit would be higher, and the need to increase taxes would be greater.

Traders read that information differently.  It used to be that geopolitical troubles would cause the price of gold to increase.  Now, gold prices are considered too volatile to park money during geopolitical troubles.  So, people buy ultra-safe U.S. Treasuries.

During economic troubles or bear markets, it used to be that investors would sell stocks and remain in cash.  Now, having recently experienced banking troubles, money market accounts are not considered safe enough, above the FDIC insurance.  Why not buy Treasuries which has the same government guarantee as FDIC?

Yesterday, with interest rates dropping,which means that people are buying Treasuries, bidding up the price.  This takes on special importance among those who believe the bond market is much "smarter" than the stock market.  The bond market was saying traders should sell stocks and buy safe Treasuries.

What actually happened was a tsunami of cash from Europe, bidding up the price of Treasuries, which drives down interest rates.  As low as interest rates are in the U.S., they are lower in Europe.  Why hold your money in Europe when you can get a higher return in the U.S.?  One reason is that the dollar may change value against the euro.

You'll recall that ECB Head Draghi announced additional monetary measures to strengthen the European economy and drive down the price of the euro.  So, you can sell your euros before they lose any more value, buy dollars (which are getting stronger against the euro) and use those dollars to buy U.S. Treasuries, earning more than your European holdings and with a stronger guarantee.  When you later sell the Treasuries, the dollars will buy even more euros when you repatriate the cash.  It was a smart move by European investors, which also helped the U.S.

So, the toast was really landing jelly-side up, but the traders insisted it was jelly-side down.  They were wrong!  Why do some people always insist that any news is bad news?  Why do they assume the toast landed jelly-side down before even looking?  Oh, because Heloise told them!

Thursday, May 15, 2014

Too Clean or Too Wholesome?

I have been to South America once, Asia three times, and Europe at least twenty times, but the cleanest city I've ever seen is Salt Lake City.  It is almost scary-clean.  Even though it has undergone substantial redevelopment since I was here two years ago, the construction sites are even clean, which is hard to comprehend.  There is virtually no litter!

It is a city that has not experienced as much diversity as other cities, and enjoys low unemployment.  Also, with a relatively low crime rate, I feel totally safe even after dark.  In fact, the only person I saw jay-walking was that guy in the mirror this morning.  It is like the movie "Pleasantville" grows up to become a city!

Still, there is a crushing wholesomeness to it all.  The "Stepford Wives" movie was not filmed here but could have been.  Fashions are very modern and often racy, but you cannot buy a beer unless you buy some food to accompany it.

Utah is one of the reddest states in America, but the newspapers are reporting a growing anger toward Congress and the Republican Party over both climate change and immigration reform.  Change is coming to Pleasantville.  Maybe, it will become acceptable some day NOT to be a Stepford Wife?

Punishing a Good Deed With Bad Debt

Back when dinosaurs roamed the beach where I live, young financial planners were taught that debt is bad. That's it -- debt is bad, period.  If you had to get a mortgage that was understandable, but it was still bad and should be paid off as soon as possible.

By the turn of this century, everybody had a mortgage, and there was almost an infinite variety of mortgages. Software programmers became wealthy designing new and improved software for new and "improved" mortgage types.  Eventually, mortgage consultants became a successful career alternative.

Proving that "no good deed goes unpunished," in 1965 Congress enabled loans to students attending college. Obviously, the intent was to create more college graduates -- a noble objective, indeed.  Each year, it became easier to borrow more and more to attend a wider variety of schools.  Often called "failure factories," private, for-profit colleges became widespread, encouraging students to borrow all the money they needed to pay high tuition expenses.   Over 30 million people have some kind of college debt, totaling over a trillion dollars.  With high debt payments, young borrowers cannot qualify for home mortgages.  It is estimated that 50 thousand homes are not sold each year, because of student debt burdens, hurting the critical homebuilding industry.  It has become a huge problem and is getting worse!

I attended a class on this yesterday and was startled to realize that there are so many different types of student loans and at least nine types of complicated debt workout plans for troubled borrowers, mostly regulated by the government.  Software programmers are beginning to fill the void.  There is now another type of debt so complicated that specialists are required and another good career opportunity for some people.

Congress rushed in with various programs to help deal with the mortgage crisis.  If they don't plan now to defuse this pending student loan time-bomb, it will only get worse.

Do you think Congress can make more timely decisions than dinosaurs?

Wednesday, May 14, 2014

A Sage Old Pro

This morning, I enjoyed listening to an older Registered Investment Advisor.  He pointed out that all NAPFA-Registered Financial Advisors get into the business because they want to do good things for our clients.  And, because the demand for objective, experienced financial advice is strong and growing, he pointed out that most of us are doing well by doing good.  But, it is important that we are also happy doing well by doing good things for our clients.

He pointed out that the dominant determinant of investment outcomes is not investment performance but investor behavior.  In 1952, the S&P 500 was 24.  Today, it is quietly approaching 1,900.  So, how is it possible that anybody could have lost money during that time?  By panicking during their first bear market!

Keeping our clients from panicking is Job One for us.  As he said, we are the only thing between our client and the abyss.  We deserve to be happy by doing well when doing good for our clients.

His advice to be happy was not to waste our time and talents on people who don't appreciate our time and talents.  Fire those clients who complain constantly and don't appreciate you.

Now, can we do that for spouses too?  Oh, we can?  But, then we're no longer doing well . . .

Gyrating Traders

Early Wednesday, the futures market indicated an up day for the market.  Then, the Producer Price Index was released, showing a troubling surge in inflation.  In fact, it was the highest reading in 16 months, with food prices leading the surge.

To a trader, this implied that the worries about deflation were over, which means the Fed will no longer have to "prime the pump" quite so much.  A less accommodative Fed means less quantitative easing and higher interest rates.  With increased uncertainty, traders reduced their exposure to it by selling stocks.

To an economist, this is irrational.  Remember the formula:  GDP = MV, where M is the money supply and V is the velocity of money.  The huge increase in M over the last few years has not driven up GDP above productivity growth because V has decreased.  We will not fear inflation until V increases, which will be preceded by increases in the consumer confidence index and consumer credit outstanding.  Stay focused on that and ignore the gyrations of traders.

Tuesday, May 13, 2014

Flying The Friendly (and/or Safe) Skies

One of the most disgusting experiences in my life was one night shortly before graduation from Infantry Officer Candidate School in Fort Benning, Georgia, when we were ordered to crawl across a sewage drying bed -- about 100 yards of yuck!  The object was to demonstrate we had the self-discipline to accomplish the mission -- no matter how disgusting.  To me, it was simply absurd!  After so much training and indignation, I would have crawled into the bowels of Hell to graduate from OCS and get my gold Second Lieutenant bars.

Existentialists have great difficulty tolerating absurdity.  It is easier to crawl across a sewage drying bed.

I am always reminded of that disgusting experience when dealing with TSA at airports.  They are indeed masters of absurdity, preferring rules to logic.  Yesterday, I was assigned to the pre-checked line, which means you don't have remove your shoes or laptop.  Wearing Birkenstock shoes with a steel shank, I expected the alarm to go off, which it did.  Since a METAL detector went off, you would expect them to check for a gun or other metal.  Instead of wanding my pockets for a gun, they merely wiped the palm of my hands, looking for explosive materials.  So, was it stupid or absurd?

Obsessive rule-sucking may be stupid, and it invariably produces something absurd.  Flying is easy.  Tolerating TSA is hard.  Decent people trying to follow mind-numbing rules does not make me feel safe.

Sunday, May 11, 2014

A Little Mystery

The conventional wisdom is that the stock of small companies, called small caps, increases faster than the stock of large companies, called large caps, during a bull market but falls faster during a bear market.  The obvious underlying assumption is that the stock of both large and small companies always move in the same direction.  Small caps just move more.

Did you notice that the Dow, which is all mega-big companies, just hit another all-time record high?  At the same time, the Russell, which is small cap companies, just entered official correction territory, which is down 10%.  I don't know if something is very wrong, but something is very unusual.

The most obvious interpretation is that investors are seeking greater safety by fleeing small caps and chasing large caps.  Another is that investors are simply chasing dividend income, which is more common in large caps than small caps.  Maybe, the most obvious implication is that this is a mere anomaly that is self-correcting and offers a good entry point for buying small cap stocks now.

The question is how long will this anomaly exist before it self-corrects? 

Saturday, May 10, 2014

Business News

A common question is which business news channel is best.  Like all good answers, it depends . . .

If you are a short-term trader, instead of an long-term investor, you might like the frenetic pace of CNBC.  (This is channel 25 on the Cox line-up.)  I find they are consistently reliable and good business journalists.  However, if I'm having a busy day and need to concentrate, I avoid the frenetic CNBC.

If you are a long-term investor, an economist, or a stodgy intellectual, you are more inclined to watch Bloomberg (channel 236).  It also provides much fuller coverage of international markets.

If you enjoy a dash of political nuance, try Fox Business News (channel 54).  This is the newest of the three.  It hasn't hit its stride yet.  Some is very good coverage, while some is just silly.  In time, it will level out, but it will be more like CNBC than Bloomberg.

I normally begin my day about 5AM watching Bloomberg for its coverage of the Asian markets closing and the European markets opening.  At 6AM, I switch over to CNBC for a more detailed look at the expected opening of the U.S. markets.  By noon, I've usually returned to Bloomberg for the rest of the day.

But, one problem of watching business news is that there is ALWAYS some "expert" saying that the end of the world is near and, even worse, that the markets are going to crash.,  If it makes you nervous,  it is NOT WORTH WATCHING!  It is healthier to take a walk instead!

Friday, May 9, 2014

Demographics = Destiny ?

Remembering that a small rat can become a vicious creature when cornered, there were some fascinating factoids about Russia in Thursday's Wall Street Journal.  Here are a few:

Birth Rate:  After falling each year since the collapse of the Soviet Union, it has now stabilized at 20% below the replacement rate.  However, women of Russian ethnicity are not replacing themselves, while Muslim women have an increasing fertility rate.  Russia's labor force will be smaller in 2030 than it is today.  In an echo of the post-Soviet "baby crash," the number of women entering their 20s will continue to shrink over the next decade.

Health Care:  For a 15-year old male in Russia, his life expectancy is three years less than a 15-year old male in Haiti.  A 15-year old female in Russia has 3 years less life expectancy than a 15-year old female in Cambodia.  Of the 48 least developed nations, Russia is only #33 in life expectancy.  Russian men have the highest rate of cardiovascular disease in the world.

Educational Weakness:  Russia's population is fifteen times greater than Austria but files for fewer patents every year.  Austria is #20, and Russia is #21.  If you look at the number of patents per college graduate, little Austria produces 35 times as many patents as mighty Russia.  In 1990, Russia had 9% of the working age college graduates in the world.  By 2030, it is expected to have only 3%.

The Journal article concluded "Russia is simply being left behind."  Clearly, there is a cancer on the body politic.  It also poses the question "If his (Putin's) dangerous new brinkmanship is a response to that bad news, then we should expect more of it in the future, possibly much more."

Now, who wants to invest in Russia??

Wednesday, May 7, 2014

You Go Girl !

I watched the new Fed Head, Janet Yellen, testify Wednesday before the joint economic committee of Congress.  She must have done a good job, as she annoyed both Republicans and Democrats.

The Republicans of the Ayd Rand/Libertarian wing think the Fed should be abolished (read:  The Creature from Jekyll Island) and kept asking questions they knew would backfire on the Fed, primarily along the lines of WHEN various steps would be taken, which she deflected handily.

The Democrats of the Left/Elizabeth Warren wing think the Fed should adhere more closely to its dual mandate of keeping both inflation and unemployment low, suggesting the Fed may have helped the short-term unemployed but did nothing for the long-term unemployed.  Yellen implied politely that monetary policy is better suited to deal with cyclical problems of normal unemployment , and that fiscal policy is better suited to deal with the structural problems of the long-term unemployed.

Amid the partisan preening, the purpose of the hearing was for Congress to hear the Fed describe the state of the economy.  Somehow, that never seems as important?  Anyway, the Fed is confident that the economy suffered a setback during the first quarter due to the unusually severe weather but is rebounding nicely in the second quarter.  She does NOT believe the stock market is over-valued or too high.  She emphasized the Fed has "both the tools and the willingness" to start shrinking its enormous holdings of government bonds.  I've no doubt she has the tools, but Fed Heads receive unrelenting criticism when they are used.  Somehow, I don't think she cares, which is a good thing .

It was amusing to watch a tiny older lady "standing" before a phalanx of Alpha-males and handling them like college freshmen.  It was amazing that she can recall so many numbers, which I envied.  But, it was re-assuring that U.S. economic policy is mostly in her hands and not in the hands of elected partisans.

A Ray of Hope

When Congress was debating or yelling at each other about the Dodd-Frank Bill, which re-regulated large chucks of the financial services industry, one argument against passage was that regulation would chase the derivatives business out of the U.S. and into Europe.  My thought was . . . that's bad??

The derivatives market is estimated at $700 TRILLION worldwide, of which over $300 TRILLION is held by U.S. banks.  In fact, 95% of U.S. derivatives are help by the five biggest banks, all of which are way too big to fail.  That really worries me!

To avoid Dodd-Frank regulations, the Big Five are setting up European subsidiaries to sell derivatives, which would not have any guaranties from the parent company in the U.S.  It is a small step but definitely an improvement!

Derivatives are not bad things, but large amounts of money rapidly moving in secrecy is.

A typical derivative is the credit default swap.  Say, you want to buy $10 million in bonds issued by the Greek government, but you worry they may not be able to repay the bonds when due.  So, I promise to repay for the Greek government if they do not.  You pay me a big fee for using my balance sheet as a source of repayment.  As a bondholder, you know the Greek government will repay you or, if not, I will.  Of course, that is expensive for you and profitable for me, to issue you a credit default swap.  But, wait a minute, I might have to pay out $10 million if the Greek government defaults.  So, I allocate part of the fee you paid me to buy a $9 million swap from another bank, and they will turn around and buy an $8 million swap from somebody else and so on.  But, what if the bank who issued the $7 million swap cannot pay?  Whoever issued the $8 million swap now has more risk than they expected.  And, I'm holding a $10 million swap and don't even know who issued the $7 million swap, much less their ability to repay.  On my balance sheet, I'm only showing the net liability of $1 million even though it is much greater.  It would be much easier to evaluate a bank's balance sheet if we knew who was holding what credit exposure.  Of course, that is one big reason banks have fought transparency.  They want to operate in secret.  (They also argue that their clients want secrecy as well.)

Once this change is implemented next year, you must buy derivatives from a European subsidiary of the Big Five.  If the credit default swap must be paid, the Big Five don't have to pay, only their subsidiaries do.    Unfortunately, this change doesn't prevent the Big Five from voluntarily backstopping their subsidiary, but that takes time.

So, if there is a derivatives blow-up, it must first overwhelm the subsidiary before spreading to the U.S.  I figure that gives us one additional day to sell stocks before the financial crisis arrives on our shore.  It is not a solution for the secrecy but it is a step in the right direction!  When it happens, I will sleep better . . .

Tuesday, May 6, 2014

Thank You, Mr. Putin

Economics is all about the allocation of scarce resources, loosely described as land, labor, and capital.  If you are trying to defeat an opponent, it takes less labor and capital to let him escape defeated than to continue spending resources to simply pound him.  Giving your opponent a face-saving exit may not be as satisfying, but it is certainly a better allocation of resources.

On March 14th, I argued that Cold War II had begun, with the Russian annexation of Crimea, but the resulting chaos developing inside the Russian economy would cause the Russian leader to look for a face-saving exit, just like it did during the early 1980s,  Now, I suspect I underestimated Putin.  Instead, he  provided the U.S. with a face-saving exit from the whole Ukraine imbroglio.

If he had sent 50 thousand troops across the Ukrainian border and simply taken the country, it would have been quick and easy.  In fact, I predicted he would do that the following week.  After all, why shouldn't he just take it?  A large portion of the nation, especially the eastern half, had a strong Russian heritage and even spoke the language.  Most of them would embrace and shelter the Russian invaders.  Besides, with the Ukraine actively aligning itself with the European Union, it would only be a matter of time before it also became a member of NATO, when all members would be obligated to defend the Ukraine against a Russian military invasion.  The window to take the Ukraine was closing for Putin.

But, the U.S. would surely be antagonized, and it ain't smart to antagonize the U.S!

Putin knew we would be very unlikely to assert our military force in a relatively remote nation, especially where we have so few economic or military interests.  However, as insurance to keep our military on the sidelines, Putin choose to arm the Ukrainians of Russian heritage and to send undercover Special Forces to start fights.  He invaded the nation by feeding internal dissatisfaction.  By doing so, he provided a cover for the U.S. to merely bluster, saving economic resources for both sides.  Ukraine will return to the Russian orbit, but the U.S. will save face.

But, Putin doesn't understand markets, and, sooner or later, Russia will pay a larger price than he ever expected from the inevitable sanctions, which is bad for everybody.

Thursday, May 1, 2014

What Goes Down Must Come Up

Yesterday, we learned that the Gross Domestic Product (GDP) for the first quarter of this year was a pathetic 0.1%.  Does that mean the economy is going over the cliff?  No!

Take a look at this chart and you will notice how volatile this number is:

The primary reason for this is obviously the awful weather we experienced, which should give some stimulus to the second quarter as deferred purchases are made.

For the last four quarters, the average GDP growth rate has been 2.3%, which is acceptable, but given the amount of fiscal drag last year (from the lack of government spending), we should expect greater growth going forward.

Janet Yellen, Chair of the Fed, stated the economy is growing nicely -- certainly much higher than 0.1%, which should be ignored.