Monday Morning Musings

The weight of uncertainty is crushing.  The stock market abhors uncertainty.  I'm surprised it is not at least a  thousand points lower.  It seems spring-loaded to go up, but I don't see that happening anytime soon.  The weight of uncertainty is just too heavy.

The Supreme Court will rule this week on one-sixth of the economy.  That ruling is likely to increase uncertainty even more.

Spain this morning effectively asked for a bailout by asking all its banks to be bailed-out.  Unfortunately, Spain is too big to bailout.  So, what's next?  More uncertainty.

There will be yet another European Summit this week.  Greece wants a two-year deferral to austerity, which is unconscionable and is probably motivated by internal politics.  Failure to make real headway this week will weigh very heavily on the market.

There is an uncertain Federal election in a few months, costing almost $2 billion.  And, all that money is likely to be wasted, if there is a European collapse.  If there is, our economy slides into another recession, and the incumbent loses, no matter how much money politicians spend.  Europe could easily determine the U.S. vote.

By the way, the market is not sanguine about the Fiscal Cliff at year-end, when the Bush income tax cuts and Obama payroll tax cuts expire, and Federal spending is severely cut.  Non-partisan think-tanks have estimated our GDP will be depressed at least 1.0-1.4%, which is huge . . . and unnecessary.

Just to add more drama, there is likely to be another debt ceiling debacle this year, adding the weight of embarrassment to the weight of uncertainty.

There is nothing new about uncertainty.  Business deals with it routinely.  However, the level of uncertainty must be near an all-time high, at least during my lifetime.

At 5 AM, futures indicated the Dow would lose about 80 points at the open.  Both Asia and Europe were down overnight.  We might be saying that frequently . . . for awhile . . . for months . . .

Chubby Checker Was Better

On Wednesday, the Fed left the world markets with a lollipop instead of a box of chocolates.  The market was hoping for another round of quantitative easing.  This is a way of injecting money into the market, because the Fed then buys either Treasury bonds or mortgage bonds.  These bonds were already in the market.

Think about "supply and demand."  When demand increases, the price will normally increase.  In the case of bonds, when prices increase, that means the yield goes down.  For example, if a bond sells for a $1,000 and pays a 2% interest rate, the bond owner receives $20.00 in interest annually.  However, if that bond rises in price to $1,010, the annual interest income remains the same, which means the yield has dropped to 1.98%.  ($20/$1,010)

When the Fed says they will buy more bonds, the demand for bonds goes up, which means the yield goes down.  Lower interest rates are expected to help the economy (although it may cause commodity prices to rise).

What the Fed announced on Wednesday was that they would continue "Operation Twist" until year-end, which is a watered-down version of quantitative easing.  Normally, bonds that mature early pay lower interest rates than bonds that tie up your money for a long time.    If you graph the relationship between interest rates and bond maturities, it is called the "yield curve" and would look something like this:

Now, under "Operation Twist,"  the Fed sells short-term maturities and buys long-term maturities.  That increases supply of short-term bonds, driving down their price, and driving up their yield.  That also increases demand for long-term bonds, driving up their price and driving down their yield.  The end result is raising short-term rates while lowering long-term rates.  In other words, the yield curve becomes flatter.

This encourages people to buy homes and businesses to refinance their short-term debt into long-term debt, making them even stronger.  But, is it effective?  Yes, businesses are aggressively refinancing their short-term debt into cheap long-term debt.  No, because mortgages are so hard to qualify for, regardless of the interest rate.

There is a certain irony in all this to economists, who were taught that a flat yield curve is a strong indicator of an impending recession.  Now, the nation's economists are intentionally causing the yield curve to flatten.

Bottom Line:  Operation Twist is a lollipop, better than nothing, but not as good as a box of chocolates . . . or quantitative easing.

From the Devil's Lips ??

Readers know the only thing I like about Goldman Sachs is their research.  Here is a recap of their latest research analysis, which was released today:

1.  While GDP growth was 1.9% in the first quarter, it will drop to only 1.6% this quarter and average 2.0% the rest of the year.  They stated  that "fiscal policy remains the biggest source of uncertainty in the outlook."  (This investor agrees.)

2.  They don't expect the miserable job market to improve much, despite a decreasing unemployment rate.  "The reasoning is that the high level of long-term unemployment may lead to lower labor force participation rates as workers lose skills, develop a stigma in the eyes of employers, or simply become discouraged."  (This has awful long-term implications for millions of people but may give some "bragging rights" to the incumbent president if that unemployment rate falls just prior to the November election, but I doubt it falls enough to make a difference before November.)

3.  Despite massive balance sheet expansion by the Fed, they don't believe inflation is a major concern, and that the Fed still has room to maintain loose monetary policy.  (This investor thinks there is a real risk to printing so much money.  Unless the Fed does an unbelievably good job of withdrawing money as the growth rate increases, I don't see how you avoid inflation.  And, when it comes, it will come quickly.)

4.  Europe will "muddle through," and Greece stays in the Euro zone.  (This investor badly wants to believe this but thinks there will be a great deal of nerve-wracking drama before it happens.  It will make cash feel good.)

5.  They have become bullish on commodities, such as oil, gas, copper, aluminum and gold, because prices have gotten so low.  (This investor agrees that commodities are cheap but are cyclical, which means they will increase in value faster than GDP growth rates . . . when GDP growth rates start increasing.)

6.  Because central banks around the world have such a low likelihood of rate increases in the foreseeable future, they are buying long-term bonds.  (This investor is not doing this, because the stampede out of bonds when the first bank increases rates the first time will be dramatic; crushing the value of those bonds.)

7.  They believe the Fiscal Cliff of December 31st this year will be extended past December 31st of next year.  But, they didn't say when that highly-important decision will be made.  (This investor thinks that kicking-the-can-down-the-road one more time is likely in order to protect the politicians, while hurting business.  Everything has a cost . . . including uncertainty.)

Often, I ask myself if I'm too "Pollyanna" or sanguine or calm about bad market conditions.  However, when I read that the legendary Goldman Sachs is more "Pollyanna" than I am, I feel even more confident!

Begging For Sugar

Have you ever watched a kid's face when asking him if he wants to go to the candy store?  His eyes get big, and his enthusiasm increases.  He even smiles.

That's the reason the stock market has been rising lately.  While there has been no good news out of Europe, the flow of bad news has slowed.  Also, the economic data on jobs over the last two weeks has been disappointing, and investors know the Fed has two equal mandates:  low inflation and low unemployment.  Since inflation data remains tame, the Fed is free to stimulate the economy.

The Fed was meeting yesterday and again this morning.  An announcement will be released during lunch today.  The stock market is as excited as the kid heading to the candy store.  It is expecting something, maybe QE3 or a continuation of "Operation Twist" or Bernanke will show his creativity again.  If the Fed doesn't give the stock market the expected candy this afternoon, I expect it will sell off.  It will pout like a kid.

The stock market is so primed to go up that it is grasping for good news . . . or a sugar hit.  

Today's Battle

Congratulations to the voters of Greece!   Yesterday, they voted to accept severe austerity, thus preventing a bearish attack on stock markets worldwide.  Of course, their only alternative to severe austerity was a severe depression . . . a terrible choice between the Devil and the Deep Blue Sea!

Still. the world is celebrating, not because the war to end the European financial crisis is over, but because we lived to fight another day.  Predictably, the Asian markets were up strongly.  Europe also opened strongly but then weakened as Spanish bond rates rose, reminding us that today is just another day to worry about the European financial crisis.  At least, Greece didn't kill the world stock markets today -- before we got a chance to worry or to fight!

Our headline-driven market will now turn its attention to the G-20 meeting in Mexico.  In an ideal world of unlimited funds, the G-20 governments would simply bailout Europe.  In the real world, the G-20 governments will urge Europe to bail itself out . . . SOON!

Our headline-driven market will be more focused on the regularly scheduled Federal Reserve meeting this week.  The market seems pretty evenly-split as to  whether the Fed will do "something" in the face of generally weakening economic data.  I don't expect a market drop if the Fed does nothing but do expect a market jump if it does.

Next week, there is yet another European summit to deal with their crisis.  Many European leaders complain they feel like they have a gun to their heads . . . GOOD!

Now, if that isn't enough headlines to drive the stock market, don't forget the U.S. Supreme Court is expected to release its decision on ObamaCare this month, and June is running out.  I've enjoyed watching market analysts try to predict how the market will react, but that is Mission Impossible until we know what the Supreme Courts actually rules on.  If the insurance mandate merely comes from the state government instead of the Federal government, I suspect the market will react positively.  If the whole bill is declared unconstitutional, I expect the market will react negatively in confusion about the future of one-sixth of our economy.  Who knows . . . nobody knows!

A headline-driven stock market is not as predictable as one driven by economics or corporate earnings -- nor as much fun!  Another problem with a headline-driven market is that newspapers are published every day . . . darn it!

A Medium Tension Weekend

This Sunday, the slow-motion train wreck known as Greece makes a momentous decision.  They will go to the polls to elect either a pro-bailout party or an anti-bailout party.  The pro-bailout party or New Democracy will continue the ongoing severe austerity program.  Assuming they win, Europe will continue the bailout program.  The anti-bailout party or Syriza will ask for a two-year window before resuming the austerity program.  Assuming they win, Europe will suspend the bailout program.  As much as the Greeks are suffering now, it will then get much worse.  The polling surveys say the election is too close to call.

A year ago, this would have been a high tension weekend.  Since then, the world has had a chance to prepare for the worst.  I have never seen so much cooperation among central banks around the world, to get in front of a problem and announce they will provide all the liquidity needed.

That is one reason the market has been up nicely this week.  Another reason is the increasing awareness that Europe is finally trying to get ahead of the problem.  There is hope that next week's G-20 meeting in Mexico will produce commitments from around the world to help Germany bailout southern Europe.  The following  week, we will see another European summit, and there is increasing hope of meaningful progress this time.

Despite the rising optimism, this is not a time for investment bravery.  The stock market is normally whip-sawed by corporate earnings and economic reports, making it somewhat predictable.  Today, the stock market is badly whip-sawed by political headlines, which are far too unpredictable.  Remember:   It is better to miss some of the upside than to catch most of the downside.

So, enjoy this balmy summer weekend.  You've survived high tension weekends before, and this is not!

A Mere 1.2 Decades

It was only twelve years ago -- that most investment advisors still believed that bonds, especially U.S. Treasury bonds, were a safe investment.

It was only twelve years ago -- that the U.S. had a balanced budget (ignoring some off-balance sheet entitlements).  The Berlin wall had recently fallen.  America clearly dominated the world.  Investment advisors expected the supply of U.S. Treasury bonds available for investment would soon start decreasing, as our budget surpluses grew.  What safe investment would take its place in client portfolios?

In those twelve years -- we dug a huge hole.  We enjoyed two large tax cuts, without offsetting spending cuts.  We borrowed enough money from the Chinese to fight two wars, ignoring the thousands of dead Americans and tens of thousands of wounded Americans.  Oh, we also created another huge entitlement program to provide prescription drugs to seniors, without cutting any other spending or raising revenue to pay for it, adding almost a trillion dollars to our national debt since then.  And, there was a terrible financial crisis, increasing our annual deficits to over a trillion dollars per year.

Yesterday, I read a political column about how the trademark optimism of America, especially the sunny-Ronald-Reagan-America, is drowning in pessimism.  Even Jeb Bush, whom I respect, believes America is "in decline."

It was only twelve years ago -- that we dominated the world, and now we're in decline already??  I strongly believe America can return to greatness within a mere twelve years!  But first, we have to stop the bleeding.  Neither the Republicans nor the Democrats are going to get what they want, and it is inconceivable to me that the November election will change that.  At what point will the radicals understand that?  At what point will Republicans and Democrats look in the mirror and see Don Quixote?

Our best hope is the Simpson-Bowles compromise -- yes, I used the word "compromise" -- it is not a four letter word, regardless of whatever Grover Norquist preaches.

Our national debt is now $15.8 trillion and growing another trillion dollars each year.  Do the arithmetic yourself and figure out our national debt in twelve years.  Now, tell me you're not pessimistic or even scared.

The Simpson-Bowles compromise is not perfect.  After all, it is man-made.  But, it will help stop the bleeding now, and we can make it "perfect" later.

It won't fix this country immediately, but we will be a far better nation in a mere twelve years.  I'll bet we even recover our sunny-Ronald-Reagan-optimism again!

Europe Finds A Clue ?

There were two important news reports out of Europe this weekend.  The first one is a report that Merkel is holding serious discussions about a genuine fiscal union, whereby no nation would be permitted to run a budget deficit without consent of a panel of European finance ministers, plus consent of a new pan-European finance minister for all of Europe.  This is news because it suggests Germany would then back the new Eurobonds, which would be guaranteed by all nations of Europe.  It is very interesting but not very important, because the profligate nations like Greece and Portugal would be surrendering their budget sovereignty theoretically to Europe as a whole but practically to the same nation that produced Hitler.  (While I agree it is unfair to state it so rudely, I believe such rude and unfair thoughts are commonplace in Europe.)

The second important news report is that the finance ministers of Europe have agreed to a bailout of the Spanish banks, not the Spanish government but the Spanish banks.  This is news because the funding arrangement makes it easier to help profligate nations like Spain without violating existing agreements.  While it is also interesting and much more important than Merkel's discussions about a pan-European finance minister, it is not the most important thing that happened this weekend.

The most important thing was that, for the first time, Europe did something proactive instead of reactive.  Instead of waiting for the bond vigilantes to attack Spain, which they will do after the Greek election next Sunday, Europe has prepared the Spanish banks ahead of time!!

It was estimated that the Spanish banking system needed 50 billion euros, and the finance ministers agreed to put in 100 billion euros ($125 billion).  They finally learned why Hank Paulson, Bush's Treasury Secretary, asked for a bazooka instead of a BB gun to defend our banking system during our own financial crisis.

While it is still too early to read futures for Monday morning, I expect a happy, bullish market reaction.
In addition to this good news from Spain, inflation dropped in China, making it more likely they will introduce another stimulus.

So . . . Happy Monday!  Enjoy the giddiness of the bull whenever you can, but don't forget the real solution to the European financial crisis is what exactly Merkel has proposed . . . which few nations can accept.  

Humans Being Human

Last Friday, the Dow dropped 275 points, and the world was ending.

Today, it was up 286 points, and the world just yawned.

Situation normal . . . 

The Face of the Cavalry

Yesterday, I was asked what the likely outcome of the European debt crisis would look like.  Will the Cavalry save us?  And, how will we recognize the Cavalry when they arrive?

Reporters chase politicians . . . because that's what reporters do.  Politicians think about politics . . . because that's what politicians do.  It is not surprising that the current perception of the crisis is a struggle between Germany to exercise greater control over the individual governments of Europe versus the other nations who don't want to surrender their sovereignty to Germany.  This is a political conundrum that cannot be solved on a timely basis.  As George Soros has pointed out -- Europe only has three months left to resolve this problem.  Unfortunately, Europe cannot make any kind of decision right now.

As some pundits have observed, Europe is reaching the limits of democracy; where the weight of democracy makes it too difficult or too slow to solve problems.

So, is Europe doomed to a future with savages running up and down the Champs d'Elysees in Paris?  No!  The Cavalry will arrive.  The crisis will be resolved . . . but not by the politicians.

Except for TARP, the politicians in this country were less than useless in braking our economic fall.  Bernanke at the Fed did more to help end our financial crisis than all 535 members of Congress.  The same will happen in Europe.  There will not be a "big sloppy kiss" among the European leaders.  Instead, there will be a rather mundane announcement that the bankers and their regulators are working together differently.  It will subtly transfer some control over banks from individual nations to the ECB or some new "cooperative."  An example would be an announcement from the ECB that it would begin allocating bond portfolio holdings among the various banks across Europe.  This would allow the ECB to prevent banks from buying bonds issued by profligate member-nations.  It might be backed by an announcement that the IMF, the European Stability Mechanism (ESM), and the European Financial Stability Fund (EFSF) would make capital injections into each cooperating bank.

The solution will not look exactly like this, but it will be equally confusing!  The face of the Cavalry will be bureaucratic and boring . . . which means the bull will return over weeks, not days.  There will be ample time to reduce cash when this happens.

Just be thankful the Cavalry is coming . . .

"Currency Wars"

Last year, I read a book called Currency Wars:  The Making of the Next Global Crisis by James Rickards.  It was interesting -- because it changed my historical perspective of the last century from two World Wars to two Currency Wars instead.  But, in the end, I felt this book was just another ambush from a "gold bug."

Technically, a currency war occurs when one country intentionally devalues their own currency, because that helps their export industries.  It is a common method to boost economic growth and import inflation, both of which help decrease the burden of debt.  This is usually done by "printing money" or increasing the money supply greatly.  However, it hurts other nations because their exports fall and imports increase, reducing their trade balance and increasing their unemployment.  Currency wars really irritate trading partners.  It is a serious thing and often leads to shooting wars!

So, I kept thinking about the possibility of another global currency crisis and decided to read this book again.  Getting past the "ambush theme" this time, I noted that Rickards concludes there are only three possible outcomes, i.e., "paper, gold, or chaos."

If we do nothing, Rickards argues that another currency war is inevitable, as developed nations must deal with their national debt and devalue their currencies.  Doing nothing is a recipe for chaos.

He argues convincingly that a new world-wide currency, based on a basket of currencies (including the dollar, Euro, Yen, and Yuan) would preclude major currency wars in the short-run.  I believe that!  Then, he goes further by arguing that the new paper currency should be backed by gold, which would reduce the power of politicians.  Since politicians would have to vote to reduce their own power, I've never thought this was a realistic scenario and never took it seriously.

One step at a time . . . let's see the debate on a new world currency first.  It will hurt our American pride to see the dollar de-throned as the sole reserve currency in the world now . . . but it will help everybody in the long-run, including us.

The Fog of Battle

Some wars never end.  One battle just follows another.  That is the world of the investor, who is in a never-ending battle to manage risk and protect his or her portfolio.  Like all battles, there is fog everywhere, which makes it difficult to see reality.  There is the sudden eruption of loud things requiring immediate attention . . . but sometimes not.  There is always the threat of an incoming surprise mortar round from unexpected sources.   There are things that smell really, really bad.  And, there is the grinding fear of an ambush . . . or being out-flanked . . . or even over-powered.  It is easy to get "trigger-happy" and just start shooting.  In your gut, the urge to vomit and/or panic just waits for the right over-whelming moment of surprise.

Currently, investors are fighting the battle of Europe, which has already lasted two years.  Investors are tired and battle-weary.  They live in fear of each new headline out of Europe.  They are always listening for a rumor, any rumor, true or not.  They get ambushed by legal and political arrangements they are unfamiliar with.  They live minute-to-minute, waiting for an incoming round of destruction.  When they get ambushed by a surprisingly poor U.S. jobs report, for example, they get "trigger happy" and start selling.  The urge to vomit and/or panic starts to rise.

But, the odds of winning any battle are greatly improved by having a battle plan beforehand.  You know the first objective is to live to fight another day, while still taking the bridge or the town or holding a ridge.  You have been briefed on the enemy and their techniques.  You have planned for them.  You know to expect changes on the battlefield.  You adjust for them on-the-spot but stick with the battle plan.

For investors, you know your objective is to protect your portfolio for the long-run.  You know there will be changes that you must adjust for -- by increasing cash or reducing exposure to some sector of the economy or whatever -- but you stick with your battle plan . . . even when the urge to vomit and/or panic suddenly hits you!

One Knee Just Buckled

The all-important monthly Jobs Report was released this morning, and it was terrible.  While economists were expecting 155 thousand jobs were created in May, we learned it was only 69 thousand instead.  The unemployment rate rose from 8.1% to 8.2%.

Dow futures indicate the market will drop about 200 points at the open.  Interest rates on Treasury bonds are sinking to historic lows as investors look for a "safe harbor."  I expect to see QE3 soon.

All Spring, the U.S. economic data has been getting stronger.  Then, worries about Europe began to weigh on our stock market, if not our economy.  Now, we know the economy is being weighted down as well.

For the third straight year, the market and the economy are both taking a dive during the summer.  Hopefully, it will be the third straight year that both recover at year-end, and I'm confident they will.

Winston Churchill once complained that America can always be counted on to do the right thing, but only after exhausting all other possibilities.  I think that is true of all democracies, which includes Europe, who is taking forever to exhaust all other possibilities.

In the meantime, America needs a knee-brace to support the weight of Europe . . . or a decisive election in November!

The Skinny on Shiny Metal

Historically, gold has been the asset to own during a financial crisis or inflation.  Since there is a crisis in Europe, the price of gold should be increasing.  The huge increases in money supply should eventually increase the value of gold.  Instead, it has been crushed!  Why?

As the crisis in Europe has mounted, European investors have been liquidating their gold holdings to pay for other things.  This increases the supply of gold and drives down the market price.

Also, as fear has increased in Europe, investors don't want to own government bonds in Euros.  They want the safety of dollars.  So, they're selling Euro-denominated bonds, which increases the supply of those bonds, which decreases the price, and drives up the borrowing costs of European governments.

What are they buying?  They're buying U.S. Treasuries instead, regardless of whatever the ratings agencies think.  As demand for our dollar-denominated bonds increases, they bid up the price, which drives down our borrowing costs.  The interest cost on our 10-year bonds dropped below 1.6% today, a historical low.

However, you cannot buy U.S. Treasury bonds with Euros.  You need dollars.  So they sell their Euros.  This increases the supply of Euros, which drives down the price.  When they bid to buy dollars, they drive up the price of the dollar, which has appreciated greatly this year.

What does that have to do with gold?  When the dollar appreciates, the value of gold depreciates in terms of dollars.  When the Euro depreciates, as it has, the value of gold appreciates in terms of Euro.  The Europeans think gold has been a great investment this year, because it takes a lot more Euros to buy gold today than it did a few months ago.

What is going to happen?  "Reversion to the mean" is a term explaining that all things will eventually return to normal.  While I have lots of disagreement with that argument, I'm confident the world will eventually return to normal.  Europe will not fall into the ocean.  They will eventually sell dollars to buy Euros again, which will drive up gold to us.  More importantly, the money supply has never increased so rapidly without producing inflation.  I expect that relationship to return to normal as well.  When either or both of those things happen, gold will appreciate or go up in value.

When will that happen?  Nobody is smart enough to know that, but I do have respect for the Commodity King, Jim Rogers, who predicted gold will bottom out around $1,450 per ounce.  If he's right, we can expect another drop of about $110 per ounce.

Tired of Being Europe's Tail

The U.S. stock market is extremely sensitive to the monthly Jobs Report, which will be released tomorrow morning. In addition, the giant payroll company, ADP, always releases their estimate of private sector job growth the day before, which gives the market some expectation about the Jobs Report, along with the usual weekly unemployment claims that comes out every Thursday.

This morning, ADP disappointed the market by estimating there were only 133 thousand jobs produced in May.  (This ignores changes in government jobs, which has usually been negative since 2009.  It is hard to believe there are still 600 thousand fewer government jobs now than in 2008.)  This suggests tomorrow's all-important Jobs Report will only be around 120 thousand.  The bad news is that the market is expecting 155 thousand tomorrow.  Normally, that would suggest a strong sell-off.

Then, the weekly unemployment claims came in higher than expected, more bad news.

Then, first quarter GDP growth disappointed at only 1.9%, but the market was expecting 2.2%.  The miss was  largely because government spending was reduced more than expected.

That's a lot of bad news in only an hour.  But, it is interesting to me that the futures fell by only 20 points.  I would have expected a much bigger drop.  This suggests less sensitivity to the U.S. economy and more sensitivity to something else.

It is not news that the U.S. stock market has become the tail wagged by Europe, but that is the wrong lesson to learn.  There are normal declines in the economy and abnormal declines.  A decline in the stock market from a garden-variety  recession is normal.  A decline from a financial crisis is abnormal . . . and terrifying.

The lesson is that normal economics are always over-whelmed by a financial crisis.  They are very different problems.   A financial system is the lubricant for the economy.  Without it, the economy quickly grinds to a halt.  Of course, the stock market knows this and will continue to over-react to European headlines -- or even European rumors -- darn it!

A Thank You Note

One of the most defining characteristics of existentialists is a certain contempt or ridicule for death, considering the disadvantages of death being over-rated and the advantages of death being under-rated.  For example, the disadvantage of death is missing life, which is over-rated . . . while the end of suffering is under-rated.  That fairly describes my belief . . . 364 days each year.

Somehow, that doesn't apply on Memorial Day.  At some point today, I will have a tear in my eye.  It may happen at a ceremony in memory of those who died for us.  It may happen when I simply look at the flag.  It will certainly happen when I remember some of my Army buddies who paid the price for my great life, and I will speak their names one more time.

A reverence for those who pay the ultimate price is not new in history.  The ancient Aztecs believed there were seven levels in Heaven, with the highest level reserved solely for women who died in childbirth and men who died in battle.  (I don't know what happened after the Vietnam War, when we somehow forgot to remember?)

To those who died, I try to remember that the only advantage of your death was to pay the cost of freedom for the rest of us.  Thank you.  I will never forget you.

From Pessimism to Fear

Last December, the editor of Inside Business called me, asking for the one thing economists fear the most . . . an economic forecast.  It was published January 15th of this year, when I predicted "2012 will be an emotional roller-coaster."  Last month, Wall Street was bullish, before turning bearish early this month.  When I watched the European markets open early this morning, I could tell the attitude had changed from pessimism to fear.

I also predicted the U.S. would not enter a recession, unless Europe pulls us into one.  I still believe that!

I predicted the European Central Bank would have to deal with their problem by mid-year.  As I write this, there is a dinner meeting with the leaders of 27 nations to resolve the European debt crisis.  While the best solution would be for the EU to issue Euro-bonds, it will not happen, and even if it did, it would take too long.  The best plausible outcome is authority to invest capital directly into banks, like the U.S. did with TARP.  We'll see . . . I just hope we see something soon!

Another prediction was that the Dow would approach 10,000 but not fall below that level.  I still believe that is possible, if the EU doesn't resolve their crisis.  If that is the case, why wouldn't I sell everything right now and buy them back at the bottom?  One, market timing is almost impossible and extremely risky.  Contrary to popular belief, the stock market is very emotional (read:  irrational).  It is always difficult for rational people to predict irrational events.  Two, the U.S. is spring-loaded for growth and could move up suddenly.  If Europe finds a way to put capital into banks tonight, the Dow could easily rise 300 points tomorrow.  

The Dow really wants to rise!

However, if you believe the leaders of the European Union are too irrational to resolve their crisis, you also probably believe the leaders of the United States are too irrational to keep our economy from going over the Fiscal Cliff at year-end;  when the Bush tax cuts and payroll tax cuts expire, plus sequestration of Federal spending begins.  Some analysts predict that will cause a 4% minimum drop in our GDP growth rate, which is only 2%.  I suspect the drop will be more than 4%.

If Europe gets its act together, if Congress gets their act together, and when we get past the Presidential election (no matter who wins), uncertainty will be vastly reduced, which will drive the stock market way up, at least a thousand points, I expect.

Greece can still generate fear, but it cannot do the damage it could have done a year ago,   The market has adjusted to the possibility of Greek default and removal from the EU.  This will not be a "Lehman" moment, when the financial dam broke in September of 2008.  If we go off the Fiscal Cliff and our GDP growth rate drops 4%, that is still less than the 6% drop we suffered in 2008-9.

My point is this -- even though fear is the predominant emotion on Wall Street right now, capitalism will still survive, and, by the way, so will the United States of America!

An Economic Forecast + $1 = $1

Every quarter, the National Association of Business Economics (NABE) conducts a random sample survey of its members.  Despite the fact that I've never been one of the 50 economists called to participate, I still enjoy reading their quarterly predictions, which were released today.

Job growth averaged 254 thousand new jobs each month from December thru February but fell to an average of 134,500 for March and April.  They predict the average for 2012 will be 200 thousand new jobs per month or 2.4 million jobs all year, which would be a fairly decent year.  Still, they don't expect the unemployment rate to drop below 8.1% before year-end but dropping to 7.6% by the end of 2013.

Their estimate of GDP remained unchanged at 2.3% this year and 2.7% next year.  Despite the flare-up in Europe, this estimate was not changed, which surprises me.

The most surprising prediction was that home prices would got UP(?) this year, by a tiny 0.5% but still UP!  The residential real estate market has been a huge drag on the economy.  Any improvement there will help the rest of the economy.

Maybe, they'll call me for the next quarterly survey, and I will probably pull the averages down.

Advice for the Tea Party

Everybody has had the sad experience of watching doctors, nurses, and ministers make a valiant but futile effort  to delay the inevitable death of a loved one.  Could we be watching the inevitable death of democracy?

Thomas Babington Macaulay was a famous British historian and Secretary of War.  Before his death in 1859, he once said:

A democracy cannot survive as a permanent form of government.  It can last only until its citizens discover that they can vote themselves largesse from the pubic treasury.  From that moment on, the majority (who vote) will vote for those candidates promising the greatest benefits from the public purse, with the result that a democracy will always collapse from loose fiscal policies.


Assuming that democracy can have a fatal flaw, like everything else in life, and assuming this is the fatal flaw of democracy, it begs several questions:

1.  How do we manage the risk of excessive "largesse"?  That requires admitting there is a potential problem, honestly assessing the real costs, and then paying for it -- really paying for it, without relying on some accounting trick or economic hope.
2.  How do we measure our success . . . or failure . . . in managing the risk?  The fiscal debt or structural debt?
3.  When will we admit we have failed to manage that risk?  What has to happen first?
4.  What replaces the greatest political system in history and who decides?
5.  Does democracy "self-renew"?   If so, how?
6.  Can we have a fiscal revolution without a physical revolution?

It takes endless vigilance to protect our democracy from this fatal flaw.  Fortunately, we have been blessed by effective elected officials who have protected the purse . . . and therefore our democracy.  Ronald Reagan comes to mind.

However, I know of no intransigent elected officials who have effectively protected the purse or our democracy.  Ronald Reagan again comes to mind, with his 80/20 rule -- to give up 20% in order to get 80% of what he wanted.

Watching the Tea Party trying to protect our purse and our democracy is like watching a good doctor yelling at a dying patient to stop being sick.  The doctor's intentions are honorable, but his actions are ineffective.

I hope the Tea Party gets 80% of what they want . . . and learns how to legislate effectively!

99% Agreement Is Not Good Enough?

Now, tell me one more time, why is it that Republicans and Democrats cannot work together:

http://www.youtube.com/watch?v=IWDJEc92d38&feature=player_embedded http://www.youtube.com/watch?v=IWDJEc92d38&feature=player_embedded

You may need to copy & paste this URL, but it is worth it, I promise!

Facebook Fatigue

Normally, I get up each day about 4:30AM, to see how the Asian markets are doing and to watch the opening of the European markets, switching between CNBC and Bloomberg TV.

But, not today!  Oh, I was up at the normal time, but those channels were just "un-watchable."

Today is the Initial Public Offering (IPO) for Facebook, and the media coverage is both intense and continuous.  The U.S. market is absolutely giddy over it, shrugging off the bad night in the Asia stock market and weak morning in Europe as well.  Global stock markets have collectively lost over a trillion dollars in the past month, but you wouldn't know it on Wall Street.  Facebook has changed the mood on the street, albeit temporarily.

No, I'm not buying Facebook.  To me, it is a company that shreds the privacy of its users, loathes its own advertisers/clients, and has a CEO who, to be kind, is not often called a nice guy.  Warren Buffett won't touch the stock, and neither will I.

Maybe, CNBC and Bloomberg TV need a Facebook detox program to end the non-stop coverage.  Today, I will watch the market online, while the TV is on . . . The Golf Channel.

The Proper Role of Greece?

Late Tuesday afternoon, my anxiety level with the market rose markedly.  That was when the Greek president announced that almost $900 billion of bank deposits left the country that DAY.

While not always true, a run-on-the-bank is a very strong indicator that big trouble is imminent.  Since January of 2010, total bank deposits in Greece are down a whopping 29%.  Some of that decrease is certainly that the people of Greece are consuming their savings, but the majority is people getting their cash outside of Greece.

If you are a Greek citizens and if you have your Euros in a Greek bank and if Greece is tossed out of the Euro Zone, you will no longer own Euros but will own Drachmas instead.  If you had enough Euros to cover a month's worth of living expenses before, you might now only have enough Drachmas to live a week, for example.  I've seen one computer simulation suggesting the price of gas in Greece will rise to $28 per liter, a crushing "tax" on any economy.  The Greeks are already suffering now, but it will get much worse when they are tossed out.  I feel sorry for them!  They don't even know how bad it will be.

It was a mistake for the Greek president to make that statement on Tuesday.  On Wednesday, he was careful to say no bank deposits left the country that day, but nobody believes him.  It is a good reminder to keep a finger close to the SELL button.

Of course, the greatest fear is contagion, i.e., that the same sad fate of Greece awaits Spain and Italy.  With political paralysis in Europe (as in the U.S.),  the only hope for Europe is that the European Central Bank (ECB) does for Europe what the Fed has done for America.  Central bankers around the world will be begging the ECB to issue Euro bonds (something Germany opposes strongly) and then engage in quantitative easing.  Euro bonds would backstop the bonds of Spain and Italy, reducing their borrowing costs.

Sometimes, you have to make an example of somebody.  It is time for Europe in general and the ECB in particular to make an example of Greece.  They will not accept austerity.  They will not cut their entitlement programs.  They will not increase taxes.  They will not reduce their regulatory restrictions.  Let them go, sadly let them suffer, but let them terrify the remaining Europeans into accepting greater austerity. 

JP Morgan Trade 101

Although all the details are not known yet and likely won't be known for a very long time, I have seen the basic idea of their horrible trade-gone-wild, and it simply reinforces why I've been so bearish on financial stocks.

As a large commercial bank, they have a large portfolio of loans they have made.  As the economy gets stronger, the risk of those loans defaulting decreases and, therefore, the quality of those loans increases, which increases the value of those loans, just like bonds increase in value when the quality increases.  After all, wouldn't you pay more to buy a good bond or loan than you would pay to buy a bad bond or loan?

The loans that banks make are carried as assets on their balance sheets.  Like any company, banks want to protect the value of those assets.  JP Morgan believed the U.S. economy was improving nicely, which means the value of their loans-made or assets would also be improving nicely.  However, what if they are wrong?

To protect themselves from the downside risk of being wrong, they hedged their bet.  To do this, they bought credit default swaps (CDS) on a popular index of commercial loans. Think of CDS as repayment insurance.  The bank paid a fee to some third-party to insure the index would not lose value.  If the economy got worse and the value of loans made went down, the value of the index would go down, which means the third-party would have to make the bank whole.  They hedged their bet.

Up to this point, it is a normal hedging procedure.  In case JP Morgan was wrong that the economy was improving nicely, they bought some protection, which is prudent.

Apparently, they bought so much of the available CDS, the value rose and prices to buy CDS rose.  They had "moved the market."  JP Morgan was finding the cost of buying the protection was increasing.  At some point, they decided to start selling CDS or protection for the easy fees.  Since they believed the economy was improving nicely, why shouldn't they accept fees for insuring against something they didn't think would happen anyway?

While there is a high probability that there are facts I don't know yet, it was at this point, when they started selling insurance, that I believe JP Morgan jumped the rails.  When the economy stumbled recently, the value of the CDS which they had sold lost billions in value, because they would have to make others whole on losses in the index.

In other words, when they stopped paying out fees to be insured and started receiving fees to insure others, I think they crossed the line of investing their own money and starting gambling with taxpayer-guaranteed-money.

JP Morgan's Stunning Announcement

After the market closed yesterday, JP Morgan announced a huge trading loss, with estimates ranging from $2 billion to $4.2 billion.  While the Wall Street bank can certainly handle the loss, it is important to note the loss occurred in their "synthetic credit portfolio" (Read:  derivatives portfolio).

The derivatives market is a vast, thinly-regulated set of largely private contracts that worries me.  The market is so lightly regulated, nobody knows just how large it is, although it must be in trillions of dollars.  I have often said it is time to sell as soon as you hear of the first derivatives blow-up, i.e., the first time a counter-party to a derivatives contract reneges.

This is NOT such a situation!  While my trigger-finger got itchy last night to hit the SELL button, it is not the correct time for a panic sell.  JP Morgan can easily handle their obligations on these derivatives.

The more important result from this announcement by JP Morgan is that passage of the Volcker Rule now seems more likely; a rule that JP Morgan has fought bitterly.  Because some banks really are too big to fail, they have the ability to take huge losses, which the taxpayers will pay.  If they make huge profits instead, the banks keep all the money.  In other words, heads I win, tails you lose.  The profits are privatized, while the losses are socialized.  That is simply unfair to taxpayers!

Maybe, JP Morgan did America a big favor ??

A Glum View From a Good Guy

Among economists, the University of Chicago has the reputation for being the home of "conservative" economics.  Famed Nobel-winning economist Milton Friedman, who was the father of the Monetarist philosophy, worked here for decades.  Yesterday, I attended a lecture by a current professor there, Austan Goolsbee, who is a Yale graduate and earned a Ph.D. from M.I.T.  He was also Chairman of the Council of Economic Advisors under President Obama.

He began with a spirited defense of the TARP program during the Bush administration and the Stimulus program during the Obama administration.  TARP was particularly successful because it re-capitalized the banks, he said.

Looking at Europe, he is concerned about their refusal to directly re-capitalize their banks.  In fairness, the ECB has instructed European banks to increase their capital base, but the banks cannot find investors.  That's why the ECB should imitate TARP, according to Goolsbee, and I think he's right.

He agreed that the U.S. recovery has been very slow, indeed.  I have long argued that is because a recovery  from a financial crisis is very different than a recovery from a normal recession, as it takes time to de-leverage.  However, he argues the slowness is due to a lack of construction, which traditionally accounts for one-third of the rate of recovery.  His argument provides economic cover for another stimulus program aimed at "shovel-ready" construction.

Far more disturbing to me was his bleak assessment of the political environment -- everywhere.  He doesn't expect a good outcome for the ongoing Greek negotiations.  More importantly, he doesn't expect a good outcome for the U.S. negotiations on the year-end fiscal cliff, when the Bush tax cuts expire, the payroll tax cut expires, and sequestration kicks in -- no matter who wins the Presidency.

Goolsbee enjoys a reputation as being a genuinely nice guy.  Having heard him three times, I am not surprised.  He recalled a humorous lunch during his government service.  It is customary for the Chairman of the Council of Economic Advisors and the Chairman of the Federal Reserve System to have lunch one day each month.  One day, Bernanke was late, apologizing that he got stuck wrapping up the Watergate report.  Confused, Goolsbee asked what was the Watergate report?  Bernanke explained that the security guard who discovered the break-in of Democratic headquarters one night in 1968 was also a security guard for the Federal Reserve Bank during the day.  Ron Paul initiated an investigation of whether the Fed was the conspirator behind the Watergate break-in.  This political vendetta against the Fed is petty and silly, but it seems emblematic of our current political culture.

My take-away is to re-think the "Taxageddon" scenario at year-end . . .