Crisis Investing

An investor takes a longer term view. He looks at those sectors and nations where growth looks most promising and then positions his portfolio to benefit from that growth.

A trader takes a short term view, sometimes in minutes. If war breaks out between the two Koreas, you can expect both the U.S. dollar and gold to rise together, which happens very seldom. You will see the Kospi stock exchange tank. All world markets will swoon for some period. A trader would be buying gold and dollars this morning and shorting the market indexes for Asia.

Of course, if there is no war, his gold and dollar investments will quickly lose value. More importantly, he could get wiped out by his short positions, where loss can be unlimited, if those Asian stock markets rally. His investment is based on some events happening and the fear that surrounds them. He is not interested in economics. This is not investing. This is called gambling.

End Times ??

I was only thirteen years old in 1960, when establishment Republican Henry Cabot Lodge was the running mate of Richard Nixon in the presidential campaign, that they lost to John Kennedy. I recall Lodge being criticised by the John Birch Society and some religious groups as being supportive of a one-world government, which they believed was described in the Bible as the last step before the End Times.

Another establishment Republican, David Rockefeller, finally established the organization that Lodge favored, called The Trilateral Commission in 1973 to coordinate economic policies between the U.S., Europe, and Japan. It still exists today and does almost nothing except make each country more sensitive to the impact of its own economic policies on its two most important trading partners.

Recently, my mother asked me to read "The Coming Economic Armageddon" by Dr. David Jeremiah. Although it never mentioned the Trilateral Commission, I was reminded of it throughout the book. It begins with the classic (but true) argument from Austrian economics that we are living beyond our means, proceeding to the Bible's prediction of a one-world-government. It cites the current effort to improve international regulation of major banks as ominous. However, I reject the argument that globalization will cause the End Times.

Despite this ham-fisted effort to blend Austrian economics with Biblical prophecy, Dr. Jeremiah does an excellent job of discussing three very important subjects that seems to give laryngitis to elected politicians:

First, "we spend more on national defense than China, Japan, Russia, Europe, and several other nations combined."

Second, "the average federal worker's pay is now $71,206, much higher than the average private worker's pay of $40,331."

Third, he discusses at some length that politicians like to talk about the relatively minor problems with our annual budget, instead of talking about the much more serious problems with our over-promised long-term commitments to Social Security and Medicare.

While I cannot recommend this book to others, I did appreciate the trip down Memory Lane, especially with Henry Cabot Lodge, one of my all-time favorite politicians.

Should I Be Worried?

I've been predicting a slow but steady recovery for the economy. Of course, the stock market is only loosely related to the economy. The market has improved this year more than the economy has.

But, expectations for the stock market next year are awfully high. The S&P closed yesterday at 1244. Goldman Sachs predicts it will close at 1450 at the end of next year. That's up 16.5%. J.P.Morgan predicts it will close at 1425. Barclay's predicts 1420, while Bank of America predicts 1400.

The highest prediction is Deutsche Bank at 1550, up 24.6% from now.

If they are correct, we should substantially increase our allocation to stocks. (If they are not correct, what's new?)

I am bullish for next year but not that bullish. Probably in the early Spring, the market will get too far ahead of the economy and stall again, like it did this summer. Then, I expect it will recover and continue upwards . . . but not to 1550.

Historically, the third year of a presidential administration is the best year for the stock market . . . I hope so!

A Patriot's Lament

Last night, I watched The History Channel. (Yes, economists do watch The History Channel but only because there is no Economics Channel.) The show was about the Third Reich and showed the suffering of ordinary people. Not to be disrespectful, but it also showed their inconvenience. They had shortages of consumer goods and electricity. They even had tax increases.

It reminded me of an evening a year or two ago, when one of my dearest friends and "forever clients" was sitting on my couch, lamenting the fact there was so little she could do for our warriors in Afghanistan and Iraq. A patriot, she wanted to suffer at least some inconvenience in their behalf. Instead, the President told her to go to Disney World and then gave her two tax cuts. While the President's instinct was to protect the status quo, he ignored the nobility of her emotion.

I think of her comments often. We are still a great people, and we deserve better government than we have. This lady would have taken a tax increase, a Social Security decrease, a Medicare decrease or whatever for her country.

Unlike Glen Beck, I have not given up on Americans. We are still a great people and will rise to meet the occassion. When austerity comes to America, there will, of course, be some riots, like the ones we're seeing in Greece and Ireland now, but we will handle it better than our politicians think. Bring it on!

Drumroll, please . . .

Yesterday, the stock market reached the highest point in over two years.

Does that mean the party is over? No, of course not!

Does that mean we will get back to our 2007 market high? Yes, but not in 2011.

Does that mean we face smooth sailing? Absolutely not! December and January are usually the two best months of the year for the market. We've been in a rally mode since July. It is time for the market to take a break and consolidate soon. February would be a logical time.

What about the market experiencing a double-dip? That is always possible. Market corrections normally occur because of cyclical factors, which I don't expect anytime soon. Sometimes, they are a result of an event, such as a financial collapss, which are sudden, like heart attacks. That scares me a lot and is the reason I hold so few bank stocks.

We're definitely in a recovery mode but remain subject to financial heart attacks.

Manana Economics

I love that expression . . . manana economics. It covers those areas of economics that can be dealt with tomorrow, i.e., where kicking the can down the road is a good idea.

Fareed Zakaria is a native of India with a Ph.D. from Harvard and writes a column for Newsweek, as well as being a CNN contributor. He coined the term referring to the inability of the U.S. to deal with its deficit problem, pointing out the new $900 billion tax cut extension only adds to the problem.

He also referred to the inability of the U.S. to tackle unpleasant and painful subjects as a disease of modern democracy.

Some drug addicts need an intervention by loved ones to deal with their addiction problems. Will loved ones provide the intervention that the U.S. needs or will it be bond vigilantes?

How time flies . . . it was only a week ago that the presidential deficit commission made their recommendations . . . seems like ancient history now?

Yesterday, for the first time, the bond rating agency of Moody's even put us on warning that we must deal with the problem. If we lose our AAA rating, the cost of borrowing will increase, making it even harder to manage the burden of our huge debt . . . tick . . . tick . . . tick . . .

A Grain of Salt

The Wall Street Journal just released their latest survey of economists. Generally, they are more optimistic!

The economy grew at 2.5% in the third quarter. Estimates for the fourth quarter were raised from 2.4% to 2.6% and 3.0% for the first half of 2011.

Also, they reduced the odds of a double-dip recession from 22% to only 15%, another good sign.

This survey was conducted prior to the tax deal. Presumably, the extension of existing tax cuts was "baked into" their thinking, but not the payroll tax reduction nor unemployment stimulus. A new survey would likely be more optimistic.

Things are certainly getting better . . . slowly!

Tax Cut Deal

Yesterday, the Senate took the first step in creating certainty about our tax burden next year. A believer in Supply-Side economics will be delighted because there are tax cuts. A believer in Keynesian economics will be relieved we didn't increase taxes during a recession. A believer in Austrian economics will be horrified that we made the deficit crisis worse.

I don't recall who said this but I've never forgotten the idea that "all great thinkers are mere followers of some dead economist." (Of course, the creator of supply-side economics, Arthur Laffer, is still very much alive.)

Putting aside all the pretty theories, the reality is that there will be a day within the next few years when the market will no longer buy U.S. bonds, unless the rate is very high and maybe not even then. We can argue the fine points of many economic theories, in addition to the Big Three. But, the bond vigilantes are not economists.

Half Full or Half Empty

When the Fed announced QE2, they expected interest rates would fall. At first, everything went as expected. Now, those rates have started to rise. Ten-year Treasury bonds now pay 3.36%, which is a six-month high.

One reason for interest rates to rise is that the Fed is causing it intentionally, which is not the case. Another reason is that the economy is improving, which makes it more expensive to sell bonds, and there has certainly been a great deal of good economic news recently. Yet another reason for rates to rise is that bondbuyers see inflation ahead, which I think is more likely.

In other ways, the rising interest rates may be sending a bullish signal or a bearish signal to the market.

Because long-term rates are moving up faster than short-term rates, I suspect the market will continue to rise slowly for some extended period, before encountering the obvious signs of inflation.

Attack of the Vigilantes

We've often mentioned the bond vigilantes who could cause unimaginable trouble for the U.S. and greatly increase the burden of paying interest on our huge national debt.

Today, our Treasury Department auctioned off $21 billion in 10-year bonds. Fewer bidders wanted the bonds. The bid-to-cover ratio was 2.92 compared to a recent average of 3.12. And, those bidders are demanding we pay a higher rate of interest, now 3.34% up from 3% a few weeks ago.

It could get a lot worse!

We've been running huge deficits for 8 years. We've spent hundreds of billions on stimulus. Yesterday, we learned the President and the Republicans added to the deficit by extending the tax cut. Today, a senior official at the Chinese Central Bank said Europe was a better credit risk than the U.S. We have no plan to deal with the growing deficit. Is it any wonder that bond buyers are worried about inflation and demanding higher rates to take risk of inflation and credit?

The bond vigilantes may get here before we expected. If so, sitting in cash would make me comfortable.

Reducing Uncertainty

Last night, the President announced a bi-partisan deal to extend the tax cuts for another two years, which reduced uncertainty. This morning, the Dow futures are up 81 points at this hour. You'll recall the inverse relationship between uncertainty and the markets.

It should be a good day for the markets! It is probably not significant enough to say it should be a good week, so let's enjoy the day. Of course, uncertainty will start to rise again before the two year extension comes up for renewal, and we'll have to re-invent the wheel.

Since there is now some faint hope that bi-partisanship may actually be possible, I do hope they will tackle the more thorny deficit problem, where every ox will be gored, including Social Security and Medicare.

Nonetheless . . . Good Start!

Partisanship

Normally, I am careful to avoid any discussion of politics, finding it seldom helpful. Both parties spin shamelessly. So, it may have been surprising to see me quoted twice in The Virginian-Pilot last Friday, referring to comments I made to a Senate hearing on redistricting.

Redistricting is as exciting as watching paint dry but terribly important. Because the borders of voting districts had been gerry-mandered years ago to limit the black vote, it was necessary to correct that wrong. But, in doing so, we have produced "safe" districts, i.e., districts that are safely Republican or safely Democratic, districts where incumbents oftentimes don't even face a challenger.

I summarized a book called "The Tipping Point" which pointed out how a single small change can produce a very large change. My point to the Senators was that the tipping point was the design of safe districts, because it eliminated moderate politicians. Safe Republican districts will not produce a moderate Republican, as they must pander to their base. Likewise, safe Democratic districts will not produce a moderate Democrat for the same reason.

I described this as "the politicians picking their voters instead of the voters picking their politicians".

I also likened the current situation to "an alcoholic who cannot be helped until he admits he has a problem. I suspect legislators will not be able to to fix this problem until they articulate it themselves and admit they have a problem. It is called partisanship."

The Schizophrenic Economist

It has been fascinating, if saddening, to observe the political spinning around expiration of the Bush and Obama tax cuts this month. (Don't forget a third of Obama's $787 billion Stimulus bill was also a tax cut.)

My inner-Keynesian economist is afraid consumer demand will decrease if they are paying more in taxes, so the tax cut should be extended. My inner-Austrian economist is afraid of the mounting deficit and a possible attack by the bond vigilantes, so the tax cut should NOT be extended. My inner-Suppy-Side economist knows there is NEVER a good time to raise taxes, so the tax cut should certainly be extended FOREVER.

Maybe, we shouldn't be so harsh on politicians when economists cannot even agree on an economic problem.

I was wrong . . . I hope!

When was the last time you heard the word "deficit" used so often? I'll bet I heard it or read it more often last week than the last two years combined. That's a good thing!

When President Obama first appointed the Deficit Commission, I was disappointed the Republican Party did not support that effort and felt it would therefore just be another waste of time, like the 1987 Social Security Commission chaired by Alan Greenspan.

Like an alcoholic cannot be helped until they admit they have a problem, America has actually started to talk seriously about the problem of our deficit and the tradeoffs of each solution. That's a good thing!

I tend to think of our political system as too impotent to do more than talk, but maybe the beauty of our "system" is that we can deal with tough problems . . . but not until we are on the edge of the abyss. That's a bad thing!

There are tides . . . and there are tides

Recently, I blogged that market reflects tidal changes in certainty and uncertainty. The market goes down when uncertainty goes up and vice versa. Increasing certainty is good for the market.

An old and dear friend sent me a Shakespearean quote from his play Julius Caesar saying

There is a tide in the affairs of men, which, taken at the flood, leads on to fortune;

The context was that Brutus and Cassius were debating whether to continue attacking with exhausted troops or to rest for awhile. Brutus argued above that it was time to strike, even with tired soldiers.

From an investing perspective, it may suggest taking larger individual postions when the level of confidence is higher. However, from a geo-political perspective, it suggests China should not be reluctant to exert its economic influence. It is still pre-mature to exert military influence, but that day is coming.

Hopefully, the Chinese do not read Shakespeare!

Awful . . . but fishy

Today's Jobs Report was awful! Economists were expecting 144 thousand jobs were created and were stunned when they learned only 39 thousand were created. Given the steady flow of relatively good economic data over the past few months, this is a surprise . . . a fishy surprise.

Data for last month's Jobs Report was increased from 151 thousand to 172 thousand. So, we created 172 thousand jobs last month, had a month of good data, but only produced 39 thousand this month . . . something is wrong.

In addition, the unemployment rate jumped to 9.8%. It is normal for the unemployment rate to increase when the job market turns around, as people begin flooding back into the market and start looking again. So, why did so many people start looking again, since we were producing fewer jobs.

I expect next month's report will show a substantial upward revision to the 39 thousand this month.

In the meantime, this report increases the likelihood that the Fed will continue its quantitative easing program, that Congress will extend the Bush & Obama tax cuts, and that unemployment benefits will be extended.

Like A Colossus

It was no secret that small, unassuming, professorial Ben Bernanke straddles the U.S. like a colossus. I have long felt that his "out-of-the-box" thinking and long study of The Great Depression made him extraordinarily effective as head of our Fed during the dark days of the Global Financial Crisis. I think he did a great job!

But, who knew he was also straddling the world? We learned yesterday that the Fed made $3.3 trillion in short term liquidity loans during the crisis, almost all of which have been repaid in full. While most of that went to U.S. firms, a surprising amount assisted foreign firms. (Because the report is 2,100 pages long, describing all transactions in all programs, the total is not yet available.)

In addition, there is now a rumor that the Fed will contribute to the European bailout fund, so it could handle a bailout of bigger nations, like Spain or Italy, probably preserving the European Union. The power of a "reserve currency" is greater than reasonable, but not unlimited.

Like a colossus . . .

The Miyagi Market

Back in 1984, there was a popular movie called "The Karate Kid". Mr. Miyagi was the mentor, teaching karate to a kid. Because karate moves are complicated, he simplified one move by telling the kid "Wax on, wax off".

The stock market has become "Risk on, risk off". Yesterday was obviously "risk on", as investors flooded into the market, taking risk. All day, good economic news rolled out, and investors continued taking risk, driving the Dow up 249 points.

The ISM Index came in better than expected. The ADP report on jobs was much better than expected. The Fed issued its Beige Book showing 10 out of 12 regions of the country are growing economically. Even the automakers reported good sales increases. Cyber-mondays sales were up 16% over last year, which is a good indicator that the consumer is getting healthier, finally! And, there was a strong rumor that the European Union would start a quantitative easing program like the U.S. With all that bullish data, it is not surprising that taking risk was more attractive to investors.

Not so surprisingly, all asset classes rose, which shouldn't happen under Modern Portfolio Theory.

For someone who studies the market daily, it is amusing to see it reduced to a simple rule-of-thumb like "risk on, risk off". Even Mr. Miyagi would be amused!

Thinking About Friday

The first Friday of each month is the most important Friday to the market, because that is the day that the monthly "Jobs Report" is issued. The current forecast is an increase in jobs of about 144,000 and the unemployment rate holding at 9.6%.

Creating that many jobs is certainly much better than losing 700,000 jobs a month, like we were doing just two years ago. We're going in the right direction but way too slowly.

This morning, we learned that productivity is still growing strongly, at 2.3%, while employment costs were down 0.1%. That means business is still getting more and more work out of the existing workers, who are grateful for the job and not complaining or asking for raises.

As I've said many times already, the bottom of this recession is not V-shaped, suggesting a sharp rebound. It is not U-shaped, suggesting we'll bump along the bottom before enjoying a sharp recovery. It is not W-shaped, suggesting we'll slip back into recovery. Instead, it is shaped like the Nike Swoosh, suggesting a long, slow recovery.

That also means unemployment will remain high a very long time. While painful, compare our 9.6% with Spain (20.6%), Ireland (14.0%), Greece (12.2%), or Portugal (11.1%). Frankly, that's a painful comparison, because those nations are teetering on the brink of financial ruin.

Recent forecasts of our Jobs Report have been overly pessimistic. Let's hope we do better than 144,000 this Friday! Go Team, Go!

Credit Default Swaps . . . Not So Boring

If I own a bond issued by AT&T, there is a possibility AT&T will not repay the bond at maturity. If I get worried about that, then I can buy insurance to protect me from that possibility of AT&T defaulting. Essentially, it guarantees I'll get repaid. The risk of the bond issuer defaulting is transferred or swapped to another company, often an insurance company. Of course, I have to pay for this insurance by paying a fee to the new company. They're not going to take on that risk for nothing.

Say, a year later, I'm no longer worried about AT&T being able to repay the loan. But, I still have this insurance or credit default swap that I purchased earlier. To recover some of the money I spent, I can sell it to someone who is still worried about AT&T. They may pay me more or less than I paid. It is a market driven price. If more investors have become worried about AT&T, then I will probably be able to sell it for more than I paid, making a profit. Some firms make a very good living just trading in Credit Default Swaps.

Are you asleep yet?

You can do the same for bonds issued by the U.S. government. Fortunately, the cost of buying such insurance against a U.S. default is very cheap, because we still have a AAA rating. If I own a bond issued by the government of Portugal due in 5 years and want insurance or a CDS that I will be repaid, the current price is about $54,490 per million. For Greece, it is $95,480, indicating investors are still more worried about Greece than Portugal.

Here's the interesting part . . .

Watching the changes in these prices tell you a great deal about the expected financial stability of other countries. When the bond market turns against you, this is where it shows up first. When the cost of Credit Default Swaps start rising, somebody out there in the marketplace probably knows more about something than you do, and it is time to start digging!

Now, was that really so boring?

One More Time . . .

The most frequent question I get is "So what? Jim, your analysis is interesting, but you don't say what we should do now."

The reason is that I am not permitted to give investment advice to anybody who is not a client, as well any anybody whose investment needs are not clearly understood. That is the law!

In most cases, it's probably better that I don't anyway, because a reader might slip into trying to out-smart the market with market timing. That is a fool's mission.

The Real Money Boss . . . maybe the only one?

When the financial markets didn't behave the way he expected, President Clinton famously said "You mean to tell me that the success of the economic program and my re-election hinges on the Federal Reserve and a bunch of xxxxing bond traders?"

He was complaining about the bond market, often considered wiser and more exacting than the stock market. Watching the bond market is very important.

That's worrying me now, in light of the continuing European debt crisis. Sure, the EU has come to the rescue of Greece, and the bond market rallied. Yesterday, it came to the rescue of Ireland, and the bond market has not rallied. The bond market doesn't believe this will contain the problem. One would expect the cost of insuring Irish bonds or CDS spreads would decrease as a result of yesterday's bailout. They did but only slightly. Meanwhile, the cost for Portugal's bonds continues to increase.

Portugal will be next. That may be the last stand. After that, Spain's bonds will get hammered. As they are 20% of the GDP of the EU, that would probably be fatal to the Eurozone. Not even mighty Germany could bail them out.

Not surprising, the Euro has been dropping this morning. As investors sell the Euro, the dollar has been increasing, which is bad for our exports. Over the last year, a strengthing dollar has been strongly linked to a weakening stock markets.

Like cholera in Haiti, the fear of loss by bond traders spreads quickly. If the Eurozone comes apart, the bond traders will then focus on U.S. bonds . . . may God help us!

Politicians . . . Step Aside . . . Please!

One of my favorite bureaucrats is Sheila Bair, Chairman of the FDIC. She just wrote an excellent editorial in The Washington Post, asking "Will the Next Fiscal Crisis Start in Washington?"

That's a fair question. The fair answer is that the next one might start somewhere else but one is certainly coming out of Washington, and it will be terrible, far worse than the last one!

She lays out the clear economic facts. She cites both current deficit commissions as producing effective solutions. Both have called for entitlement cuts and tax increases.

While economists may quibble about shades of gray, politicians make decisions, and that's the problem. Half of them don't understand economics and the other half is only interested in being re-elected.

Our best hope is that the recommendations of either deficit commission are given an "up or down" vote, meaning no amendments. I don't agree with either set of recommendations 100%, but neither will anybody else. Whatever we do, if we do anything at all, will require pain. However, doing nothing requires far more pain.

The economists of the deficit commissions have almost completed their job. My Christmas Wish is that politicians would step aside, salute, and say "Yes, Sir"!

Don't count on it!

Two Steps Forward and One Step Backward

Yesterday morning, the Commerce Department looked in their rear-view mirror and raised their estimate of this year's third quarter GDP growth rate. We did better than expected.

Yesterday afternoon, the Fed looked thru their windshield and lowered their estimate of GDP growth next year, saying the economy is doing worse than they expected previously.

Conflicting economic data makes it tricky to read the market. That's why no one piece of data is ever conclusive. Just remember, we're in a long hard slog out of The Great Recession. When it is over and we look in the rear-view mirrow, we will once again swear . . . "Never Again!"

The Wall of Worry

The stock market is always trying to climb a Wall of Worry. Today, the Wall was very tall, indeed!

The day began with North Korea rattling a very loud saber. It continued with lots of unrest in Ireland about the pending, distasteful austerity package they have to swallow. It finished with conflicting economic data in the U.S, as well as the realization that our stock market has already gone up enough and needed a pullback.

As a result, the Dow dropped 142 points today. I'm surprised it was not worse.