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November 30, 2009

Thanksgiving Surprises: GDP to Dubai to "Fragile"

Well Happy Thanksgiving - now that the holiday in the US is over and we're getting back to realities it's time to consider what little surprises were brought to us. One of course is the downward revision of US GDP numbers from 3.5% to 2.8%, a whopper of a surprise, though in our preferred YoY approach it was a drop from -2.3% to -2.5% "growth". Among other real surprises was the announcement from Dubai that the government was going to seek to re-structure the debt on some very grandiose real estate projects. There's a great deal of confusion and x-connections making things harder to de-cipher, not least of which is because Dubai is one of the UAE members and not the major one. So what debt gets supported or not by which government is up in the air. Nonetheless the threat of sovereign defaults shook up markets around the world.

Market Situation

We think people should be paying careful attention to Dubai and related tremors but not for the reasons you think, or are being commonly discussed. It being the tailend of the holiday we're going to throw out one chart on the Markets that we've looked at over the last couple of weeks, in some form, but not all the others we typically wrap around it to cover more ground.

Part of the reason is that the fundamental finding remains exactly the sames as it has (we almost ought to let the readers draw it out) but a) we're still in the downtrend, b) the bear rally hasn't touched the upper bounds and in fact keeps failing there and c) we're right at the 50% resistance line on the Fib limits.

What we think is really important is the re-iteration and re-confirmation of the logic chain from the last posting, the notion of fragile markets exposed to surprises and a policy-driven recovery. It's also critically important that you take all those points together as a set - as most investors haven't been. What Dubai was was a wake-up call about the fragile underpinnings that they were getting over-complacent about and the major risks and flaws that still have to be carefully worked thru to keep the wheels on the wagon and keep them turning. Back in Mar07 when the Shanghai Exchange dropped 8% with no warning we talked about the Shanghai Surprise in this post -Tender is the Market. And tried to argue that, based on economic fundamentals, the market was tender, i.e. fragile and tipsy and therefore prone to surprises and upsets. Now the next show to really drop was Bear-Stearns almost a year later but... surely you take the point? :)!

Continued....

 

Fragile Under-pinnings

Speaking of which what 'bout those GDP numbers, eh? The top part of this chart is the YoY changes in GDP and Consumption running back to 1950. We won't go back into our previous discussions where we took it apart in some detail. We will stand by our argument that we won Stalingrad but are now facing the bigger battle for Kursk, i.e. we arrested the downturn but have yet to start creating jobs. And have a lot of downside risks.

Which leads us to the second chart - call it the before and after picture comparing the Initial and Revised Q309 GDP estimates. Judging from the bar chart it'd be hard to see what the big differences had been but the red line highlights the differences by major element. The only two areas where the revised estimates are higher than the initial is in Gov't spending for both Federal and State & Local. Other than that there was a pretty across the board revision across Consumption, Capex and Housing. The relatively nasty surprise was in Net Exports - we didn't sell as much as we thought we would and we bought more than anticipated. Oops.

Myth-busting

Perhaps the two biggest dangers floating around, which we see on a very widespread basis in the news and among the talking heads, as well as in our network, is complacency about the strength and reliability of the recovery. That combines with a perverse lack of awareness of how fragile and policy-dependent the so-called recovery is. But the real myths that need to be debunked are with regard to debt and deficits. Please don't get us wrong - excess and unfunded spending is, in the long run, a poor ideas. In the short-run in our circumstances is a vital and critically important lifesaver.

Yet for partisan political reasons and/or ideological ones everybody from the politicians in Washington to the CNBC guest opinonators is wringing their hands. It might help you to remember that we were pulling out of the Great Depression, until similar handwringing pulled the plug on government spending and sent us back into Depression.

It may also help to take a careful look at this composite chart, drawn from several NYT pieces and re-combined into a new set. Despite all the hand-wringing what we're really talking about is returning to the debt levels of the '80 and '90s and the interest services charges and rates of the same period. In fact it's fair to say after the worst economic crisis in living memory how scary to find we're returning to the destructiveness of Bush I deficit and payment rates! The bottom chart highlights another key aspect of this - which is all the borrowers who drove up total US debt during the last three decades have all been driven from the credit markets. Put that another way - we have a major demand shortfall in which business and consumer's are unable to pick up  the slack and will be hurting for some time. What's picking up the spending slack is the government and what's replacing private debt, or some of it, is government borrowing.

BUT, the most important two pieces for you to put together, is nobody's acknowledging these circumstances and the economic weakness. In fact just the opposite. Which means a fragile market and recovery is very exposed to mythology and delusions. But then, what else is new.

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Markets & Investment News

A rally that needs more “E” Though conventional wisdom assumes that P/E ratios continue to grow throughout a bull market, that’s not always the case. In fact, it’s rarely the case. On average, the market’s P/E tends to peak a little more than a year into a bull market, according to analysis by Ned Davis Research, an investment consulting firm in Venice, Fla. “And the lion’s share of that P/E expansion takes place in the first six months,” said Ed Clissold, senior global analyst at Ned Davis.  Indeed, Ned Davis researchers found that price-to-earnings ratios shot up 28 percent, on average, in the first 15 months of bull markets since 1929. But four-fifths of that expansion took place within the first six months. Sam Stovall, chief investment strategist at S.& P., analyzed bull markets back to 1942 and found that in 9 of the last 11, the S.& P. 500’s P/E ratio grew within the first year by an average of 29 percent. In the second year of those run-ups, though, the market’s P/E ratio actually fell — by 6 percent, on average. What’s more, in bull markets that survived into a third year, the P/E continued to slip. In many cases, that’s because corporate profits expand so fast that their growth outpaces rising share prices. In other words, as the “E” in the P/E ratio grows faster than the “P,” the multiple contracts even as stocks gain ground. As for the current decline in corporate profits, the best that can be said is that the rate of contraction has slowed. At the start of October, Wall Street analysts were bracing for a 24.8 percent decline in S.& P. 500 profits in the third quarter, versus the same period a year ago. Today, the consensus estimate is for a much more modest fall, of 13.7 percent. WHEN will the earnings outlook turn around? For a while now, analysts have been predicting that corporate profits will start growing in 2010.

The next bubble? Here’s a logical and surprising place to look Everyone is warning about bubbles. These warnings have all been unconvincing to me because they imagine that the next bubble will look like the last one. Until today. Gillian Tett in the November 23 Financial Times has come up with the first description of a bubble that I’ve seen that is both convincing to me in its mechanism and in its unexpectedness. The bubble she describes is still inflating and isn’t about to break tomorrow, but it is worth taking very seriously if you’re building a portfolio with a time frame of five years or longer. Warnings are a dime a dozen these days. The weakness in all these warnings about a new bubble is that when they get around to describing the next bubble it sounds an awful lot like the last bubble. We’ll see an unsustainable increase in real estate prices, for instance, or commodity stocks will rocket and then burn, or banks will use cheap money to rebuild risky derivative portfolios. But if past bubbles should have taught investors anything it is that the next disaster never duplicates the last disaster. That’s because we put rules—official and ad hoc—in place after each disaster to prevent a replay. This is where Tett’s piece comes in. First, she posits a completely unanticipated location for the bubble: In the markets for what’s called sovereign debt. Sovereign debt is made up of the bonds and such that countries sell to finance their budget deficits. And second, Tett posits a mechanism for the bubble to keep inflating and then bursting. No one wants to say, Hey, these sovereign bonds really aren’t risk free. The banks certainly don’t want to say it, because recognition of the risk in these bonds would drive down their prices.

 

The Dubai Collection

Everyone agrees that the dollar will keep falling; the dispute is over how long Unemployment. Consumer spending. New home sales. End of the year profit-taking. End of the year portfolio window dressing. All those drive the stock market day to day. But none pack the wallop that the rising and falling (mostly falling recently) price of the U.S. dollar does. When the dollar falls these days, usually, stocks rise. When the dollar climbs, usually, stocks fall. Until we can see clear evidence that the U.S. economy is in a sustained economic recovery—or not—I don’t see anything as important to investors as the direction of the dollar. So what’s the most likely trend on the dollar? Down, say most of the dollar forecasters recently surveyed by Bloomberg. Although they disagree on how far into 2010 that downward trend will stretch. By the end of 2010, the Bloomberg survey projects, the European Central Bank will have increased its benchmark overnight lending rate to 1.5% while the Federal Reserve will be at 1%. If that’s correct, the dollar will stay weak against the euro into 2011, if I follow Henderson’s logic correctly.

Our steroidally challenged economy The global economy reminds me of a marathon runner who runs too hard and hurts himself. But now he has another race to run.  So he’s injected with some serious, industrial-quality steroids, and away he goes.  As the steroids kick in, his pace accelerates, as if the injury never happened.  He’s up and running, so he must be ok; this is the impression we get, judging from his speed and his progress.  What we don’t see is what is behind this athlete’s terrific performance – the steroids.  Our economy suffered severe injuries last year, and to keep it going massive amounts of steroids were and are being injected – they’re what economists call stimulus (or government intervention). Let me demonstrate what is priced into cyclical stocks by looking at Caterpillar (CAT) – your typical American blue chip industrial, cyclical stock – one that in theory should prosper during global economic recovery.   Third-quarter sales were down 44% from last year. China was its brightest spot as sales there dropped (only) 26%.  The stock is around $60, more than double its low in March and not far from $85, its all-time high, reached in 2008 when global growth was its oyster.  The company expects to earn around $2 this year (excluding recurring nonrecurring charges) and expects sales to grow in teens next year from this year’s base.  But even if CAT were to earn $3 next year, investors are not paying for next year’s earnings, as they’d paying 20 times next year’s earnings. This cyclical stock is not worth that; investors are paying for what happens beyond 2010.  If I owned CAT, the question I’d want to know the answer to is, what’s next after 2010?  Stimulus creates an appearance of stability and growth, but a lot of it is teetering on a very weak foundation of government intervention.  Investors must distinguish between what is real and what is not; in this environment, investment success will not only depend on what stocks you own but also on the ones you don’t – stock selection is important.

Investors are finally seeing the nonsense in the efficient market theory inancial Analyst Institute, which has been teaching efficient markets theory for decades, has admitted that most of its members have lost the faith. Two thirds say they no longer believe market prices reflect all available information and three quarters disagree that investors as a whole behave "rationally". What's amazing is that it has taken so long for the penny to drop. It has seemingly required investors to lose their collective senses twice in a decade (dotcom bubble, housing boom) for people to realise that the crowd is mad as often as it is wise. Markets have always been prone to bouts of "irrational exuberance". The price of tulips in 17th century Amsterdam, that of South Sea Company stock in 18th century London and of Florida real estate in the 1920s are just highlights of the procession of booms and busts down the ages that has taught every subsequent generation that markets often get it wrong. They do so for two reasons. They get it wrong because they reflect human behaviour in all its fearful, greedy irrationality. And they get it wrong because they reflect a world that is inherently unpredictable. So, increasingly few people still believe that markets are wholly efficient and that is a good thing. It means fewer people will believe, as governments and regulators did, that the prices of loss-making internet stocks in 1999 and Miami condominiums in 2006 were in any way not a disaster waiting to happen. It might mean that fewer people are tempted by passive investments which promise an answer to the awkward fact that most active fund managers do not beat the market but can only do so by guaranteeing that you will hold all the market's very worst stocks as well as its good ones. However, there is one problem with dismissing out of hand the efficient markets theory. It is that markets are not so inefficient that anyone can safely bet against them. Assuming that you know more than the market is a dangerous game to play when most of the time most of the information is accurately factored in. The answer is not to give up trying to beat the market but it argues for finding someone who, because of their skill, knowledge or intuition, is good at spotting the £20 notes on the pavement – and sticking with them. 

How to escape the next lost decade A lost decade. 1999 to 2009 sure qualifies for many investors in stocks. A lost decade to come? I can’t tell you what stocks or stock markets will perform best over the next ten years. But I can tell you that many U.S. investors are still sitting in portfolios that increase the odds that the next ten years will be as unrewarding as the last ten. The last ten years have been really, really painful for investors in U.S. stocks. It you had invested in the U.S. Standard & Poor’s 500 stock index in October 1999 by October 31, 2009 you would be looking at an average annual compounded return of a negative 0.95%. Lock your money up in stocks for 10 years and lose 1% a year. It’s not supposed to work that way. And, of course, it didn’t have to. Investors can’t go back in time and re-do the their under-exposure to overseas stocks in general and emerging markets stocks in particular, but sure can try not to make the same mistake in the next ten years that they made in the last ten. All the evidence, though, is that U.S. investors are about to do it to themselves again. The U.S. share of the global stock market is falling as other countries built larger economies and deeper capital markets. In 2004, U.S. capital markets accounted for 53% of the value of all shares in the world that were free to trade, according to Standard & Poor’s. (Many shares in markets such as China and India are locked up under government control and aren’t free to trade.) By 2007 that percentage was down to 44% and by 2008 it had fallen to 41%. Asset allocation by U.S. investors hasn’t kept pace with that change. Depending on what group of investors you measure U.S. investors have somewhere between 2% and 20% of their equity portfolios in overseas stocks. Among 401(K) investors, about 12% of their stock portfolios are in foreign stocks. If you simply look at the makeup of world equity markets, U.S. investors are massively over-weighted U.S. stocks and massively underweighted foreign stocks. That might not be so devastating to the portfolios of U.S. investors if the U.S. economy was projected to outperform the economies of the rest of the world. But it’s not. The Organization for Economic Cooperation and Development (OECD) projects that the U.S. economy will grow by 2.5% in 2010 and 2.8% in 2011. China, in comparison, will grow by a projected 10.2% in 2010 and 9.3% in 2011. For India, forecasts read 7.3% growth in 2010 and 7.6% growth in 2011. Brazil 4.8% growth in 2010 and 4.5% growth in 2011.

Economic News & Information

The world still can learn from Keynesian economics Great crises have a way of reminding us that acting as though we know perfectly well what the future holds almost always leads to disaster. That's especially true in economics, which tends to underscore the murkiness of the real world by dealing out surprises one after another -- booms, crashes, bubbles, you name it. It's fitting, therefore, that the recent economic meltdown has begun to restore that great apostle of uncertainty, John Maynard Keynes, to his rightful position of influence in economic thought. "Keynes asked why financial markets are inherently unstable," Robert Skidelsky told me the other day. "His answer was that we don't know what the future will bring. He talked about the inherent precariousness of knowledge, that when we estimate the future we're only disguising our ignorance." If that sounds obvious, keep in mind that the financial disaster of recent times was born in the hubris that the financial markets are nearly flawless machines for assessing risk and that government regulation would make them inefficient. The hallmark of Keynes' thought was the recognition that the efficient-market theory -- the notion that the market synthesizes all that is known and that needs to be known about current conditions and that it therefore can be left to regulate itself -- is flawed. "If you have a self-regulating market," Skidelsky explains, "you don't have crashes like this. You don't have great contractions."
Keynesian economics and its implicit warning that the free market has inherent limitations and therefore demands regulation remained in vogue from World War II until the mid-1970s, followed by its nearly complete abandonment by British Prime Minister Margaret Thatcher and President Ronald Reagan in the 1980s. Many of the problems that developed since then derived from the assumption that risk can be predicted, measured and accurately priced.

Housing and Credit

Seeing the Glass as Mostly Empty THE American economy is in its worst shape in a quarter-century. At least that appears to be the belief of the consumers questioned by the Conference Board for its consumer confidence survey, for which preliminary November results were announced this week. Over all, the index shows that confidence is significantly better than it was early this year, when stock markets had crumbled and the credit crisis was at its worst. That increase comes from a rise in consumer expectations. But as can be seen in the accompanying charts, the present-conditions index fell in November to 20, the lowest level for that index since early 1983. The index is based on a scale in which the average opinions of 1985 are equal to 100. Why the glum opinion, at a time when many economists say they think the recession that began in December 2007 ended sometime last summer or fall? The primary reason is unemployment. The index of present conditions is based on answers to two questions, one on jobs and one on business conditions. Business conditions are considered poor; only 8.1 percent of respondents deemed them good and 45.7 percent said they were bad. The rest said business conditions were normal. But those figures are not quite as bad as they were last winter. On jobs, however, the relentless rise in the unemployment rate, to 10.2 percent in October, has left nearly half the population, 49.8 percent, saying jobs are hard to get, while only 3.2 percent say they think jobs are plentiful. Not since late 1982 have people been that negative on jobs. Consumer Confidence Graphic

Policy and Consequences

The illusion of improving global imbalances They are blamed for the global crisis directly (Paulson 2008) or indirectly (Calvo 2009), G20 leaders are committed to ending them, and commentators have generated an ocean of html painting them as one of the world’s greatest banes. “They” are global imbalances – large trade surpluses and large trade deficits. Good news then – global imbalances have been shrinking at a fabulous rate (Figure 1). The figure – which includes China, Germany, the US and all the other usual suspects in the global-imbalances saga – shows that trade gaps have closed remarkably quickly since late 2008. The IMF and World Bank both forecast substantial improvements for 2009 and into 2010 (IMF 2009 and World Bank 2009a). The World Bank, for instance, predicts that China’s surplus in 2010 will be half its 2008 value. This rapid improvement seems odd given how little reform has occurred. The renminbi has not appreciated against the dollar and Chinese consumption has not boomed; the dollar has depreciated modestly against European currencies and the US savings rate has risen gently, but neither seems large enough to account for the massive shifts already observed, to say nothing of the World Bank predictions for future improvements. We argue here that these global imbalance improvements are mostly illusory – the transitory side effect of the greatest trade collapse the world has ever seen. Before making the argument, we lay out the basic facts.

The Dogbert theory of the debt When I was on This Week yesterday, George Will tried his hand at the debt scare thing, saying that we’re in terrible shape because by 2019 the interest on the debt will be SEVEN HUNDRED BILLION DOLLARS. (That should be read in the voice of Dr. Evil). I get that a lot — people who talk about the big numbers which are supposed to imply that things are terrible, impossible, we’re doomed, etc. The point, of course, is that everything about the United States is big. So you have to interpret numbers accordingly. As the graphic above shows — it’s taken from an article that managed to maintain a grim tone while reporting numbers that actually weren’t all that grim — what we’re talking about is a debt-service burden roughly comparable to that under the first President Bush. How many of the people now warning about the impossible burden of currently projected debt were issuing similar warnings back in 1992? Not many, I’d guess. And bear in mind my point about causes of deficits: the deficits of the Reagan-Bush years were essentially gratuitous, the result of a desire to cut taxes while increasing military spending, rather than a response to a temporary emergency. So that debt burden should have been more worrying than what we’re facing now. But people still seem to think that repeating those big numbers is enough to make their point.

Fed Officials Watch Asset Prices for Signs of ‘Excessive Risk’  Federal Reserve policy makers said for the first time that their decision to cut interest rates to zero may be fueling undue financial-market speculation even as they called the dollar’s decline “orderly.”  The Federal Open Market Committee said its policy of keeping rates low might cause “excessive risk-taking” or an “unanchoring of inflation expectations,” according to minutes of its Nov. 3-4 meeting released yesterday. Central bankers also said further dollar depreciation that might “put significant upward pressure on inflation would bear close watching.” The dollar weakened as investors wagered the central bank will tolerate further declines in a currency that has slid more than 6 percent against the yen in three months. Policy makers are wary of fueling a third asset-price bubble in about a decade as they hold the benchmark interest rate near a record low to revive growth, economists said. “Financial markets have been doing much better than people might have expected,” said Marvin Goodfriend, a former policy adviser at the Richmond Fed who is now a professor at Carnegie Mellon University in Pittsburgh. “The Fed is saying to markets, ‘Don’t overdo it.’”

Repairing China’s financial system The stock market had a bad day today, with the SSE Composite down 3.62%, mainly on rumors that banks will be seeking to raise equity capital next year in response to their loan surge this year.  On Tuesday Bloomberg reported that the five largest banks were supposed to have submitted plans to regulators for raising money, after unprecedented lending eroded their capital. I would argue that a more compelling reason to raise capital is the almost-certain surge in NPLs over the next three or four years.  In fact I am pretty surprised that these rumors caught the market by surprise.  Every time that banks have engineered a policy-induced surge in lending, they have followed up with a surge in NPLs, and it would be pretty extraordinary if this time were any different.  A refusal to raise capital levels would have been very imprudent, and it is pretty clear that the PBoC and the CBRC are already worried about the impacts of the credit expansion on the banking system.

Business

Wall Street’s Spin Game A few years ago, Wall Street would have cared less for such artifice — it was enough that the Masters of the Universe were wildly successful; their success spoke for itself. But politics and the bottom line have energized the relationship between these New York institutions of money and spin, as banks see the need to calm the rage directed toward them and confront a public relations problem that has seemed in recent weeks to be spiraling out of control. Just last week, Goldman announced that it would spend $500 million to help thousands of small businesses recover from the recession. At the same time, Mr. Blankfein acknowledged that Goldman had made mistakes. “We participated in things that were clearly wrong and we have reasons to regret and apologize for,” he said. But is that enough? And, if it isn’t, what will be? Examples of the public’s anger at Wall Street are legion. Last month, a couple of thousand protesters marched on the American Bankers Association’s annual conference in Chicago brandishing cut-outs of bank C.E.O.s. As the Chicago demonstration made clear, the image problems aren’t confined to Goldman and could have a cost. Wall Street banks are under regulatory pressure, and come election time, if unemployment is still above 10 percent and Wall Street is still paying itself big bonuses, lawmakers’ wrath might force broader pay curbs, tougher restrictions on what banks can do, or even a break up of the biggest banks. They are already losing business because of their toxic reputations. One recent Goldman deal, for instance, to buy cheap assets from Fannie Mae, the hobbled mortgage lender, was blocked by the Treasury because it couldn’t be seen to be helping Wall Street benefit once again from the crisis. Critics say the negative media chatter is dragging on their share price.

`Screaming Hot' TVs, $5 Toys Abound as Walmart, Kohl's Push for Shoppers Wal-Mart Stores Inc., Kohl’s Corp. and Toys ‘R’ Us Inc. are competing for customers with discounts and extended Black Friday hours as cost-conscious shoppers say they plan to spend less on gifts than they did last year. Kohl’s, the fourth-largest U.S. department-store chain, will open at 4 a.m. on Nov. 27 and offer more than 300 early- bird specials, including $34.99 cashmere sweaters. Toys ‘R’ Us is offering almost 50 percent more of such deals than last year. Walmart is staying open all of tonight so shoppers can grab $3 pajamas and $15 Miley Cyrus jeans when they go on sale at 5 a.m. Chains are also contending for home-electronics shoppers. Walmart’s Web site is offering home delivery of flat-panel televisions and other electronics for 97 cents. Best Buy Co., the world’s largest electronics chain, is discounting flat-panel TVs, cameras and laptops. “We have been more aggressive than ever before in our marketing and in our pricing,” Toys ‘R’ Us Inc. Chairman and Chief Executive Officer Jerry Storch said in a telephone interview yesterday. The Wayne, New Jersey-based chain is opening at midnight tonight, five hours earlier than last year, offering 220 doorbusters compared with 150 in 2008, and has distributed a 28- page national Black Friday circular. It promised to have thousands of the Zhu Zhu Pets robot hamsters that sold out in recent months, and will be handing out 64-crayon Crayola boxes as gifts with purchases.

Posted by dblwyo at 01:32 PM | | Comments (0)

November 21, 2009

Markets in a Policy-Driven Economy: Turbulence, Data and Idiocies

Our next planned post was a deep dive on some key business challenges and how well positioned the general distribution of businesses were for the new normal. A structural assessment as a follow-up to the earnings and outlook assessment. Instead we're going to take a "quick" pass at the Markets and the Economy. Partly because the Markets were so much fun this week and there was such a slew of important economic data but also because business performance the Econ/Mkt situation are NOT independent; as we keep harping "performance is everything". On the other side in this turbulent environment where all the old patterns are semi-broken the last string of posts on taking apart various stories that are being told ties directly - one damm thing linked to another as they say. In fact that might be an alternative title for this post but an even better one would be the new paradigm emerges. All of a sudden, evolving and emerging over the last month, the new meme has metastasized to explain it all - RiskOn/RiskOff, DollarUp/MarketsDown, ZIRP/QE for ever, or at least until jobs start recovering if they ever do. In fact the quickie summary we thre out seems to cover it extremely well:

Weak Recovery => Poor Job Creation =>

Sustained Low Rates => Dropping Dollar =>

Carry-driven Rally Across All Asset Classes =>

Poor Fundamentals + Rising Risks = Fragile Running Rally

 We think that captures the new consensus pretty well except for the last line, which is our own little contribution thought we've been talking about the others for a while now. But it's the most important and carries the most fraught implications. As John Mauldin put it in his latest newsletter (Where the Wild Things Are). Ask yourself this - assume it all makes sense and the markets will keep running - what's your expected return? What's a fair value? And what's your risk?

Continued....

 

Poking at the Markets

We'll start by inverting our usual order and begin with the markets using the market composite chart we tried a couple of posts ago because it puts all the relevant "new meme" information on one dashboard to see. Now sadly for us we'll have to leave you to decode the real details because each panel deserves its own post. For example the lower left panel looks at rates and Gold and uses the 10YR:3Mo ratio as a indicator for the Yield Curve, which apparently spiked thru the roof. But not because there was a sudden collapse in the credit markets as there was last Fall. Instead the 10Yr (TNX) is still dropping (so much for inflation) and the 3Mo (IRX) headed toward zero even faster. Voila' Spike!

Taking the SPX as THE general asset proxy, and amazing how well the upper left chart is holding steady, notice that the downtrend has converged exactly with the 50% retracement level on the Fibonacci chart. Which turns out to be exactly where the markets ran out of steam Th. and Fr. We REPEAT - what happens when the fragile underpinnings of this market unravel? Can you make it to the exit fast enough? Can all those folks with computers and biga-bucks (a punnish play on big and billion)? In case you're interested this is exactly the catastrophe dynamics that led to the Asian crisis over ten years ago. Check out sandpile catastrophes sometime.

So How 'bout that Economy?

One of the triggers for crossing that Rubicon would be surprises in the economic data - which the markets shrugged of earlier in the week (actually for the last several months) but suddenly paid attention to at the end of the week. Anyway there was lots of economic data that came out this week, none of it good and all of it important. Housing being the most but our buddy CalculatedRisk covers that better than anybody and you'll find links to his analysis in the readings; plus links and excerpts to two really superb pieces telling you what it all means for the "big picture". AT least skim the excerpts, please.

People got a little excited when MtM retail sales didn't do well enough. When you look at it by month and quarter on a YoY basis it clearly got better. In the sense that it's not at death's door. On the other hand retail sales ex-Autos is still down -5% YoY. On the whole sales data seems to be bumping along the bottom, though it's no longer cliff-diving.

The other set of data folks got excited about was Industrial Production and Capacity Utilization. Which was worse in both cases than expected, but again on a MtM basis. And again the YoY data was both slightly better but also still pretty abysmal if not headed for the Abyss. One thing we will point out, though you have to squint a bit, the monthly data shows that both dropped on a YoY basis. Which raises fears of the "recovery" stalling. Oops, not good news at all, is it?

Leading Indicators: What the Components Really Said

The other thing that came out was the Conference Board's Leading Indicators. Fortunately Northern Trust and another blogging buddy (Jake at EconPic) dug into the details. Now the LI include market components and lots of monetary variables, which immediately makes us suspicious. Both the ECRI's LEI and the Conference Board's LI sets have decades of history. BUT none of the history was part of a financial markets crisis nor as aberrational as this one where monetary indicators and market data are so subject to mood swings and policy changes. In other words you almost have to consider throwing them out because the underlying relationships are in question.

We think this composite set makes those points perfectly. The long-term YoY changes compared to GDP would be unambiguously good news. On that basis we're clearly crossing a turning point. On the other hand when you look at the MtM changes by component two things stand out. One, the total change and trend is down, and the non-monetary/market components performed poorly. When you net out the Yield Spread (HINT: see first charts set) and what do you get? We'll settle for OUCH!

The Policy and Pundit-Driven Economy

In the readings you'll find collections covering a lot of bases. We'll particularly draw your attention to the sections on "Re-balancing the World" which discuss trade, exchange rates and China's challenges. Since we've taken real deep divers on that before we'll save some space and not do it again. Another point we've made in the running posts on de-constructing the new shibboleths was that most of the explanations concocted by the pundits haven't held up. Which everyone implicitly admits with the sudden emergence of the new consensus. There's a lot of pontificating by authority figures that's on questionable ground. We'll also mention a post by Paul Krugman in which he shared his pitch from a recent talk at the Rijksbank in Sweden. Very good charts.

He also posted this little YouTube post - taken with think from Woody Allen's "Bananas". Any hint that we might be suggesting that much of the punditocracies pronouncements make as much sense as wearing your underwear on the outside to the authorities can check it is well-founded. Just in case you don't want to learn Swedish, change your underwear every 1/2 hour and be sixteen but would like to have a pretty good grounding on the policy vs. economy situation try this:The Sine Qua Non: Economy, Stimulus and Outlook.

Otherwise may we suggest you prepare to salute el Maximo Jefe,with your portfolio de-maximized!

Partisan Gamesmanship (Update):

Speaking of political unsinn and the dangers thereof a short excerpt pointing to a short daily commentary by a Northern Trust economist has been added to the readings. Frankly we found it stunning because it calls out two very conservative Rep. Congressmen who published a WSJ oped piece repeating the old ideological shibboleths. Not so much technically - though it's good to seem someone of this stature speaking up instead of just ourselves. You have to stop and think about the context. NT manages money for the wealthy, has one of the best and most respected economics groups in the world who's track record is impeccable and such folks never comment on politics. NEVER. To add more fat to the fire we found it thru a bloggining buddy (Prier du Pleiss of Investment Postcards) who runs money in South Africa. The bottomline here is that partisan gamesmanship set us very badly for the crisis, almost collapsed the emergency rescue efforts last Fall thru sheer idiocy, has hampered recovery efforts all along the way and thretens the recovery. And all based on provably wrong ideas, analysis, data and constructs - and we do mean PROVABLY. To throw oxygenated high-octane gas on the fire Stan Collander of Capital Gains and Games takes the same non compos mentas to task for their manipulation of deficit fears, following an earlier piece by Bruce Bartlett (the economic staffer to Jack Kemp who was the principal architect of Reagan's reforms) on Republican deficit hypocrasies. Take it for what it's worth but these people are competent, informed, sophisticated, experienced, non-partisan and scared. Our take is that we're crossing a cusp point where this kind of self-serving politics is dangerous.

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Updates

Partisan Bickering is not the Solution for Fostering Economic Growth The main theme of the opinion piece by Representatives Hensarling and Ryan from Texas and Wisconsin, respectively, in today’s Wall Street Journal (Jeb Hensarling and Paul Ryan: Why No One Expects a Strong Recovery - WSJ.com) is poor economic policy choices of the current administration. To make their case they focus on the Reagan administration’s successful economic policies. The success/failure of economic policy choices can be measured by various metrics. It is well known that the federal budget deficit as a percentage of GDP during the Reagan years has been the largest in the entire post-war period ending 2008 (see chart 1). Therefore, from a fiscal perspective, the perceived success of economic policies of the 1981-1988 period is not a resounding success. Therefore, economic history paints a very different picture from the opinion piece of representatives Hensarling and Ryan. Should political leaders be engaged in partisan rhetoric or in a serious discussion of how to make policy choices that will foster sustained economic growth?

Paul Krugman Protests Too Much Me Thinks Two excellent posts from Paul Krugman today and yesterday about why for substantive and technical reasons the federal deficit and debt aren't the threats to the economy some say they are.  I agree; substantively there is little to complain about.  The fiscal policy in place over the past year has been a success by any objective measure. But the next to last word in that last sentence -- "objective" is the key.  No matter how much we might wish it to be otherwise, this is anything but an objective discussion. The federal budget deficit and debt are political rather than technical issues and that means dealing with fact isn't likely to change many minds.

Video Clips

Economic News & Information

Employment, Data & Outlook

Accumulated Musings Although the forecast on an annual basis has changed little from last month, we have raised our GDP growth estimates meaningfully for the fourth quarter of this year and the first quarter of 2010. We have provided a table showing the changes in the forecast. You will notice that the sectors accounting for the bulk of the increases in projected real GDP growth are business and residential investment. Business equipment spending is rebounding faster than we expected, but by no means are we projecting a capital spending boom. The same holds true for residential investment expenditures. But we believe that the rebound in housing will be quite modest after the third quarter’s 23.3% annualized surge. But what does this have to do with what I started out talking about – the alleged dollar carry trade? My hypothesis is that investors, rather than borrowing dollars, are selling U.S. Treasury securities that they already owned, selling them ultimately to capital-concerned/constrained banks, and are then investing the proceeds in higher-yielding foreign government securities. This would result in a weaker dollar, but does not entail any net new credit creation as banks are reducing their holdings of non-Treasury debt by more than they are increasing their holdings of Treasury/Agency debt. The upshot? Worries about a new credit bubble from a dollar carry trade are much ado about nothing. Why is gold glittering in terms of the dollar and other major currencies? Because investors cannot get an inflation-adjusted positive return on their short-term investments. This certainly is true in dollar terms, as shown in Chart 5. But it might come as surprise to some that it also is true in Euro terms as the three-month EURIBOR interest rate is the same as the three-month annualized euro-zone CPI inflation rate (see Chart 6). When global investors are unable to get an “honest” return on their short-term investments in major currency markets, they historically have turned to gold. If ever there were a nattering nabob of negativism, it would have to be the editorial board of The Wall Street Journal. It just cannot bring itself to admit that the fiscal stimulus program has stimulated some aggregate demand and some aggregate production.

The Worst is yet to Come: Unemployed Americans Should Hunker Down for More Job Losses Think the worst is over? Wrong. Conditions in the U.S. labor markets are awful and worsening. While the official unemployment rate is already 10.2% and another 200,000 jobs were lost in October, when you include discouraged workers and partially employed workers the figure is a whopping 17.5%. While losing 200,000 jobs per month is better than the 700,000 jobs lost in January, current job losses still average more than the per month rate of 150,000 during the last recession. Also, remember: The last recession ended in November 2001, but job losses continued for more than a year and half until June of 2003; ditto for the 1990-91 recession. So we can expect that job losses will continue until the end of 2010 at the earliest. In other words, if you are unemployed and looking for work and just waiting for the economy to turn the corner, you had better hunker down. All the economic numbers suggest this will take a while. The jobs just are not coming back. There's really just one hope for our leaders to turn things around: a bold prescription that increases the fiscal stimulus with another round of labor-intensive, shovel-ready infrastructure projects, helps fiscally strapped state and local governments and provides a temporary tax credit to the private sector to hire more workers. Helping the unemployed just by extending unemployment benefits is necessary not sufficient; it leads to persistent unemployment rather than job creation. The long-term picture for workers and families is even worse than current job loss numbers alone would suggest. Now as a way of sharing the pain, many firms are telling their workers to cut hours, take furloughs and accept lower wages. Specifically, that fall in hours worked is equivalent to another 3 million full time jobs lost on top of the 7.5 million jobs formally lost.

Housing Starts and the Unemployment Rate This is an update to an earlier post. As I've noted for some time, housing leads the economy and is the best leading indicator for the economy - both into and out of recessions. Update: Employment tends to be a coincident indicator into recessions, and used to be coincident coming out of recessions. Employment has lagged the economy after the previous two recessions (and appears to be lagging again). Employment lags housing, and the following graph shows the relationship between starts and unemployment. You can see both the correlation and the lag. The lag is usually about 12 to 18 months, with peak correlation at a lag of 16 months for single unit starts. The 2001 recession was a business investment led recession, and the pattern didn't hold. This suggests unemployment might peak in Spring 2010. Professor Fisher argued that unemployment will rise to about 10.4% and then fall rapidly. He is now projecting unemployment will decline to 8% by the end of 2010. He is basing the rapid decline in unemployment on a "V shaped" housing recovery similar to previous recessions. I disagree with that point. In most earlier recessions, the slumps were caused by the Fed raising interest rates to fight inflation. When the Fed cut rates, housing bounced back sharply (V shaped). Although this recession was led by a housing bust - and that makes it look similar to some previous periods - this recession was not engineered by the Fed raising rates, rather it was the busting of the credit and housing bubbles, and all the related problems that led the economy into recession. Since there is still far too much existing home inventory, a sharp bounce back in housing starts is unlikely, so I think Fisher's forecast for a rapid decline in unemployment is also unlikely.

Housing Leads the Economy, Existing Home Sales are Irrelevant  After reading some of the commentary regarding the housing starts report this morning, it might be useful to reiterate these three points:·  Residential investment is the best leading indicator for the economy. ·  Residential investment will not recover rapidly because of the large overhang of existing vacant housing units. ·  Existing home sales are largely irrelevant for the economy. Residential investment is reported quarterly by the Bureau of Economic Analysis (BEA) as part of the GDP report. We can also use monthly housing starts and new home sales as indicators of residential investment. I've written extensively about how residential investment is an excellent leading indicator for the economy (also see Dr. Leamer's paper: Housing and the Business Cycle) This morning several commentators suggested that housing starts were depressed in October because of the expiration of the tax credit (new home buyers had to close by Nov 30th to get the tax credit), and also because of the weather. Probably. But the key point is that housing starts will not increase rapidly because of the large overhang of existing vacant housing units (see 2nd graph here). And that suggests that the economy will not recover quickly either. Another key point is that existing home sales are largely irrelevant for the economy. This is an important point to remember next week when the NAR announces that existing home sales surged to 5.8 million units or so in October (seasonally adjusted annual rate). Some reporters and analysts will jump on the existing home sales report as evidence of a housing recovery. Others will point to it as showing that the first-time home buyer tax credit is helping the economy. Both points are wrong. The only contribution from existing home sales to the economy are some commissions and fees. That is good news for real estate agents and mortgage brokers, but not for the overall economy. The good news is the level of inventory for new and existing homes is declining. The bad news is the inventory of rental units is at record levels - as is the combined inventory of vacant single family homes and rental units. Residential investment will not increase significantly until this overhang is reduced. The key to reducing the overall inventory is new household formation (encouraging renters to become owners accomplishes nothing in reducing the overall housing inventory). And the key to new household formation is jobs. And usually the best leading indicator for jobs is residential investment. Somewhat of a circular trap. And that suggests the recovery will be sluggish and unemployment will stay high for some time.

Retail Sales Increase in October On a monthly basis, retail sales increased 1.4% from September to October (seasonally adjusted), and sales are off 1.7% from October 2008. Excluding auto sales and parts, retail sales rose 0.2% in October. The increase in October was mostly a rebound from the decline in September. This graph shows retail sales since 1992. This is monthly retail sales, seasonally adjusted (total and ex-gasoline).This shows that retail sales fell off a cliff in late 2008, and appear to have bottomed, but at a much lower level.The red line shows retail sales ex-gasoline and shows there has been little increase in final demand. The second graph shows the year-over-year change in retail sales since 1993.Real retail sales declined by 1.7% on a YoY basis. The year-over-year comparisons are much easier now since retail sales collapsed in October 2008. Retail sales bottomed in December 2008. It appears retail sales have bottomed, but there has been little pickup in final demand.

More on Industrial Production It is too early to tell, but those expecting a "V" shaped recovery would expect industrial production to be tracking at or above the "severe recessions" line (since this was the worst recession since the Depression).

Recovery in developed economies gathering pace Economic recovery in the world's developed countries will accelerate next year due to "substantial improvements" in financial markets but is likely to remain fragile, the Organization for Economic Cooperation and Development said Thursday, as it doubled its growth forecast for 2010. The Paris-based watchdog's chief economist, Jorgen Elmeskov, told a news conference that the recovery has been mostly driven by government stimulus measures and interest rate cuts. Those benefited financial markets, whose recovery is "considerably faster and stronger" than anticipated in the June economic outlook, he said. Still, the recovery will remain modest next year, with the U.S. and Japan outpacing Europe, the OECD report said. Elmeskov warned banks not to use the "fat margins" they have accrued thanks to government policies designed to keep money flowing to the real economy to line their own pockets. He said the margins "are the result of both weak competition in the sector and public policy interventions." "It is important that these fat margins do not just end up as higher bonuses, dividends or buybacks." The U.S. economy has been boosted by stimulus measures, improving financial conditions, demand from the fast-growing non-OECD economies of Asia -- especially China -- and the stabilization of the housing market, the OECD said. It predicted unemployment will start to ease after peaking in the first half of 2010. The OECD predicts the U.S. economy will expand at a rate of 2.5 percent in 2010, up from a June forecast of 0.9 percent. It also expects a smaller contraction this year: a 2.5 percent fall in output compared with an interim September forecast of a 2.8 percent drop.In Europe, the economies of the 16 countries sharing the euro are now expected to grow by 0.9 percent next year compared to a June forecast of zero growth. However, the OECD predicts a greater contraction of 4 percent this year, more than the 3.9 percent it calculated in September.Unemployment is not set to peak before the end of 2010 or the beginning of 2011, and is likely to sap the strength of recovery, the OECD said. Japan's economy will grow by 1.8 percent next year compared with the June forecast of 0.7 percent. The OECD reduced prediction for a contraction this year to 5.3 percent compared to a 5.6 percent rate seen in September.Elmeskov said central banks should keep interest rates low and should beware of the dangers of deflation, while governments should work on plans to reduce debt levels as the economy recovers.

Re-Balancing the World

Stronger Yuan Needed for Global Rebalancing: IMF Chief A stronger Chinese yuan is part of the reforms that Beijing needs to implement to increase domestic consumption and help ease global imbalances, the head of the International Monetary Fund said on Monday. IMF Managing Director Dominique Strauss-Kahn said the countries at the heart of global imbalances needed to take various measures to ease them. In the case of China, that means an increasing emphasis on domestic demand, especially private consumption, Strauss-Kahn said in remarks prepared for a financial conference in Beijing. "A stronger currency is part of the package of necessary reforms," he said. "Allowing the renminbi (yuan) and other Asian currencies to rise would help increase the purchasing power of households, raise the labour share of income, and provide the right incentives to reorient investment."

World Out of Balance China is the great exception. Despite huge trade surpluses and the desire of many investors to buy into this fast-growing economy — forces that should have strengthened the renminbi, China’s currency — Chinese authorities have kept that currency persistently weak. They’ve done this mainly by trading renminbi for dollars, which they have accumulated in vast quantities. And in recent months China has carried out what amounts to a beggar-thy-neighbor devaluation, keeping the yuan-dollar exchange rate fixed even as the dollar has fallen sharply against other major currencies. This has given Chinese exporters a growing competitive advantage over their rivals, especially producers in other developing countries. What makes China’s currency policy especially problematic is the depressed state of the world economy. Cheap money and fiscal stimulus seem to have averted a second Great Depression. But policy makers haven’t been able to generate enough spending, public or private, to make progress against mass unemployment. And China’s weak-currency policy exacerbates the problem, in effect siphoning much-needed demand away from the rest of the world into the pockets of artificially competitive Chinese exporters. But why do I say that this problem is about to get much worse? Because for the past year the true scale of the China problem has been masked by temporary factors. Looking forward, we can expect to see both China’s trade surplus and America’s trade deficit surge.

The Great Wallop The Chimerican era is drawing to a close. Given the bursting of the debt and housing bubbles, Americans will have to kick their addiction to cheap money and easy credit. The Chinese authorities understand that heavily indebted American consumers cannot be relied on to return as buyers of Chinese goods on the scale of the period up to 2007. And they dislike their exposure to the American currency in the form of dollar-denominated reserve assets of close to $2 trillion. The Chinese authorities are “long” the dollar like no foreign power in history, and that makes them very nervous. Yet there is a strong temptation for both halves of Chimerica to keep this lopsided partnership going. The reality, however, is that an end to Chimerica is in the American interest for at least three reasons. First, adjusting the exchange rates between the currencies would help reorient the American economy — primarily by making American exports more competitive in China, the world’s fastest-growing economy. Second, an end to Chimerica would lessen the potentially dangerous reliance of American economic policy on measures to stimulate domestic purchasing. American fiscal policy is clearly on an unsustainable path, and the Federal Reserve’s negligible interest rates and the printing of dollars are artificially inflating equity prices. Finally, renminbi revaluation would reduce the risk of potentially serious international friction over trade. The authorities in Beijing must be made to see that any book losses on its reserve assets resulting from changes in the exchange rate will be a modest price to pay for the advantages they reaped from the Chimerica model: the transformation from third-world poverty to superpower status in less than 15 years. In any case, these losses would be more than compensated for by the increase in the dollar value of China’s huge stock of renminbi assets. It is also in China’s interest to kick its currency-intervention habit. A heavily undervalued renminbi is the key financial distortion in the world economy today. If it persists for much longer, China risks losing the very foundation of its economic success: an open global trading regime.

China’s Sprint for the Gold Over the past decade, even as China’s exports have soared, the nation has begun transforming itself from a global font of low-priced goods fueled by cheap labor into a much more diverse and complex economic power. Along with that, it has developed huge disparities of wealth. “There are a lot of billionaires, but there’s also a lot of poverty in China,” says C. Fred Bergsten, director of the Peterson Institute for International Economics in Washington. “It’s a very bipolar society. People have to recognize that both elements are there.” Per capita income, for example, is still small — about $3,200, which is less than 10 percent that of the United States and slightly more than that of Iraq — and many farmers earn less than a dollar a day. Yet China is also home to the fastest-growing number of billionaires. China doesn’t just dominate trade; it scours the globe for resources; doles out multibillion-dollar loans to other developing nations; and holds stakes in Wall Street giants like Morgan Stanley and the Blackstone Group. A nation that sold about 600,000 cars in 2000 is now poised to eclipse the United States and is on course to sell nearly 15 million vehicles in 2009. No country has ever accumulated larger foreign exchange reserves ($2.2 trillion). No country has more Web surfers (338 million).

Lecturing each other on trade Away from music, my meetings in NY and DC were fairly different from the meetings I had in February.  This time around I got the impression that far more people in the US (although still a minority) understand how risky the Chinese recovery has been and how trade tensions are likely to result as a consequence of the stimulus.  In fact I have the sinking feeling that over the next two or three years I am going to find myself spending an awful amount of time thinking or writing about trade disputes between China and the rest of the world. Regular readers know that for me the key source of China’s high savings and trade surplus is the large excess of the growth rate in national income over household income, caused in large part, I believe, by policies that systematically transfer income from the household sector to investment, SOEs and large producers.  Until these policies are reversed I do not think it is meaningful to talk about China’s rebalancing. In that light I read earlier this week a fascinating and perhaps important article by Hung Ho-Fung in the current issue of the New Left Review, in which he argues that China’s development model has left it dangerously vulnerable to changes in US demand, and that these polices include repression especially of rural income. As an aside, this lopsided debate within China between the domestic constituencies (more stimulus) and the internationalists (more rebalancing) reminds me, as I have often said, of the debate over the passage of Smoot-Hawley, which most Americans with knowledge and experience in international economics and finance, including President Hoover, thought at the time a dreadful mistake. 

Policy & Key Factors: Rates, Trade, Debt and Inflation

It’s the stupidity economy OK, maybe a more polite way to say it is this: bad ideas are acting as serious constraints on policy.We’re in a liquidity trap, with interest rates up against the zero bound. This means that conventional monetary policy isn’t sufficient. What should we do? The first-best answer — that is, the answer that economic models, like my old Japan’s trap analysis, suggest would be optimal — would be to credibly commit to higher inflation, so as to reduce real interest rates. But the key thing to recognize about this answer is that it’s all about expectations — the central bank only has traction over expected inflation to the extent that it can convince people that it will deliver that inflation after the liquidity trap is over. So to make this policy work you have to (i) convince current policymakers that it’s the right answer (ii) Make that argument persuasive enough that it will guide the actions of future policymakers (iii) Convince investors, consumers, and firms that you have in fact achieved (i) and (ii). In reality, we haven’t even gotten anywhere near (i): the conventional wisdom is still that any rise in expected inflation above 2 percent is a bad thing, when it’s actually good. So some readers have asked why I’m not making the same arguments for America now that I was making for Japan a decade ago. The answer is that I don’t think I’ll get anywhere, at least not until or unless the slump goes on for a long time. OK, so what’s next? The second-best answer would be a really big fiscal expansion, sufficient to mostly close the output gap. The economic case for doing that is really clear. But Washington is caught up in deficit phobia, and there doesn’t seem to be any chance of getting a big enough push. That’s why, at this point, I’m turning to what I understand perfectly well to be a third-best solution: subsidizing jobs and promoting work-sharing. Call it constrained optimization, where the constraint comes from the power of bad ideas.

Gold prices are a dead giveaway  When can we be sure that economic recovery is in the bag? The world economy seems to be in a much better place today than it was at the beginning of the year. Policymakers haven't repeated the mistakes made during the Great Depression. The banking system seems to be in better shape, thanks in part to a large taxpayer bailout. Asset markets have recovered, suggesting that the earlier collapse in animal spirits may be over. And economists are revising upwards their forecasts for economic activity, concluding that the worst must now be behind us. For all these reasons, investors are increasingly focused on so-called "exit strategies". How and when should economic life-support policies be removed? After all, interest rates in the developed world are at their lowest levels ever, the gentle hum of the monetary printing press can still just about be heard and budget deficits are huge. Are these policies still necessary, or is it time to expect the world economy to stand up on its own two feet? It's easy to be seduced by what I might cheekily call "straight-line economics" – the idea that when the worst appears to be over, the best is just around the corner. Straight-line economics assumes that strong economic growth is a "normal" state of affairs, interrupted only occasionally by pesky recessions. Sometimes, however, economies end up in a different place, based on the physics of bungee jumping. The economy falls off a cliff. Activity drops a long way. Then there's a rebound. For a while, the rebound looks very good and it's easy enough for economists to stick to their straight-line thinking. But the economy never returns to normal; instead it is left dangling by a thread. The straight line simply doesn't apply. If we've learnt anything over the last two or three years, it's that straight-line thinking is pretty hopeless. For the economics profession, it's been a bruising experience. At the beginning of 2007, some economists recognised downside risks, but the consensus view was that, if there was to be an economic slowdown, it would be a so-called "soft landing". For the forecasting community, it was one of the biggest errors ever made.

How long will interest rates stay low? Pay attention to what the Fed does and not just what it says And if somehow the mark does guess correctly, the dealer and his crew always find an excuse not to pay off. Right now the U.S. Federal Reserve is running its own version of the game. The talk by Ben Bernanke and Co. is all about how rates will stay near the current 0% to 0.25% range for “an extended period.” That’s kept asset prices rising. Which is critical to the Fed’s plan to restoring the health of the financial system.  If banks need to raise more capital, and they do, it sure helps if they’ve got a relatively liquid and climbing stock market to sell their offerings into. In Three Card Monte you have to watch what the dealer does and not listen to the patter. In the Fed’s case while its chairman, vice-chairman, and every governor who can command a podium somewhere are talking up the “extended period” promise, the bank is acting to reduce liquidity now. The goal is to get the financial system back to something like normal. Yes, the Fed keeps talking about low interest rates for an extended period. But its actions show that the Federal Reserve is getting ready for the day when the economy and the financial system are ready to return to normal. My best guess sometime in the second half of 2010. The bank’s definition of “normal,” investors should remember, doesn’t include interest rates at 0%.

Fed's Lacker: Fed Can't be "paralyzed by patches of lingering weakness" First, I think we could see further declines in inflation in 2010; even the possibility of core PCI deflation. I don't think the risk of further declines has "diminished substantially". Second, I think Q3 GDP will be revised down based on subsequent data (like the trade report), and GDP growth will be lower than Lacker expects in early 2010. I think Lacker is overly optimistic on the economy. Also - historically the Fed hasn't raised rates until well after unemployment peaks, and I doubt they will raise rates until late in 2010 at the earliest (and probably later). In the early '90s, the Fed waited more than a 1 1/2 years after the unemployment rate peaked before raising rates. The unemployment rate had fallen from 7.8% to 6.6% before the Fed raised rates. Following the peak unemployment rate in 2003 of 6.3%, the Fed waited a year to raise rates. The unemployment rate had fallen to 5.6% in June 2004 before the Fed raised rates.

Summers, the Chinese and the Deficit Lawrence Summers, the top White House economic adviser, made a point recently that I have not seen anywhere else. Speaking at the New York Economic Club a few weeks ago, he said: … even with the dramatic action of the Treasury and the Federal Reserve, the total level of borrowing in our economy is actually lower than in normal times, not higher. Accordingly, the volume of securities that have to be absorbed by market participants is lower, not greater, than normal.To translate: Even with the big recent increase in government debt, the total amount of debt generated by the United States economy has not been growing especially fast. That’s because the amount of debt being taken on by households and companies has been falling, as they have cut their spending during the recession. Thus the amount of American debt that investors (“market participants”) must buy has not been growing very fast, despite the government’s spending of billions and billions of dollars in response to the financial crisis. You can see why Mr. Summers would be making this point. The implication seems to be that the oft-heard concerns about foreign investors — those in China, above all — potentially losing their appetite for American debt may be overblown. After all, those foreigners don’t buy only government debt. They buy all kinds of American debt, public and private. According to the Federal Reserve’s Flow of Funds data, total nonfinancial debt grew 6 percent in 2008 and has been growing at annual rate of less than 5 percent this year. It grew at least 8.1 percent every year from 2003 to 2007. So does this mean we should stop worrying about the budget deficit? No, certainly not. The deficit is deeply worrisome, and it will need to be one of the Obama administration’s priorities in the next couple of years. Investors are forward-looking, and they surely realize that private borrowing will revive sometime soon. Government borrowing is projected to remain high for a long time, in large part because of the retirement of the baby boomers and escalating health costs. At some point, lenders may well get nervous and interest rates could rise. But the fact is that rates have remained extremely low even as government borrowing has soared in the last year. The slowing of private borrowing helps explain that mystery.

To Rise, Inflation Faces an Uphill Climb Inflation numbers might soon start to look scarier, but any inflation flare-up should be short-lived, and might even sow the seeds of its own demise. The Bureau of Labor Statistics releases its producer- and consumer-price indexes for October. October PPI, due Tuesday morning, is expected to edge higher from September on rising food and energy prices.Economists estimate consumer prices, due on Wednesday morning, also rose from September. "Core" CPI, which strips out food and energy prices, was up 1.5% last month from a year earlier, according to economists' forecasts, well below the 2% the Federal Reserve generally considers a tolerable inflation rate. Those figures won't set off inflation alarms. But coming numbers could mark the start of more-notable upward pressure on year-over-year inflation growth, warns David Ader, head of government-bond strategy at CRT Capital. The reason: For the next few months, inflation will be measured against the worst depths of the recession, when prices fell across the board. A weak labor market can keep inflation in check, even if commodity prices rise. Petroleum-related costs account for just 2.3% of U.S. production costs, according to an analysis by Capital Economics. Employee compensation, on the other hand, accounts for 30.3% of production costs.  In fact, if rising commodity prices lead to more corporate cost cutting, then that will put more downward pressure on inflation. To the extent that already-cash-strapped consumers, facing 10% unemployment, cut back on other items to pay for higher food and energy prices, that also will hurt demand, and prices, for everything else. In other words, don't look for today's inflation pressures to last.

Velocity of US money supply at long last edging up Despite ballooning Fed reserves to bail out banks, money supply as measured by the growth in money supply with a zero maturity (notes and coins, check accounts, savings deposits and money-market accounts collectively) continues to slow. The slowing growth is contra to what normally happens when the Fed lowers the Federal funds rate. In real terms the growth rate is also slowing. The slowing in MZM growth is a consequence of US banks’ tight lending standards. The trend is likely to continue until the banks relax these standards. Velocity of MZM is at long last picking up after it started falling in the first quarter of 2007 - six quarters before economic growth slumped. The increase in MZM velocity effectively points to increased economic activity. Further increases in this velocity are essential for sustained economic growth. Bottoms in consumer sentiment and MZM growth coincide, emphasizing the importance of improved consumer sentiment to get the economy going.

Markets & Finance News

Currency, Rate and Trade Wars

China’s Liu Says U.S. Rates Cause Dollar Speculation The decline of the dollar and decisions in the U.S. not to raise interest rates have caused “huge” speculation in foreign exchange trading and seriously affected global asset prices, said Liu Mingkang, chairman of the China Banking Regulatory Commission. “The continuous depreciation in the dollar, and the U.S. government’s indication, that in order to resume growth and maintain public confidence, it basically won’t raise interest rates for the coming 12 to 18 months, has led to massive dollar arbitrage speculation,” he told reporters in Beijing today at the International Finance Forum. Liu said this has “seriously affected global asset prices, fuelled speculation in stock and property markets, and created new, real and insurmountable risks to the recovery of the global economy, especially emerging-market economies.”

Bernanke Expresses Worry About Weak Dollar The chairman of the Federal Reserve, Ben S. Bernanke, warned on Monday that high unemployment and a continued reluctance of banks to make loans are likely to slow the economic recovery for the next year. And in a departure from the usual practice of Fed chairmen, Mr. Bernanke expressed concern about the recent fall in the value of the dollar — a concern that could put the central bank under new pressure to push up interest rates. Taken together, the Fed chairman’s comments highlighted the difficulties that policy makers face as they try to pull the United States out of its worst downturn since the 1930s. But he warned that banks are still very reluctant to lend money, especially to small businesses that normally generate most of the new jobs. Though Fed policy makers have begun to debate the need to start raising interest rates, Mr. Bernanke made it clear that high unemployment will trump concerns about inflation and that such a move was unlikely anytime soon. The steep drop in lending stems in part from a new frugality among consumers, which has caused the total volume of household debt to drop for the first time in almost 60 years. But Mr. Bernanke said restrictive lending by banks had had a major impact on small businesses and was likely to slow the recovery and keep unemployment rate — now 10.2 percent — high for some time. The Fed chairman said this recovery, like the previous two, are likely to seem like jobless recoveries, in part because companies have become more reluctant than to rebuild their workforces and have found new ways to increase the productivity of their existing workers.

An undervalued Chinese currency is bad for the world but could be profitable for you But if you’re an individual investor looking to put money to work, the dollar-renminbi peg is a gift. And you’d better put it to work for you now because it ain’t going to be here forever. The world’s emerging markets appeal to you—these economies look set to grow faster than the United States, Europe, and Japan for a decade or more—but these stocks have had a huge run. Forget getting in through the back door either: The commodity-dominated markets of countries like Australia and Canada have run away from you too. Heaven forbid that you sold something and want to put the money back to work, or, even worse, that you’re coming late to the game and have cash on the sidelines that you want to invest. You ready for the final straw? The currencies of many of these countries are hugely stronger against the dollar than they were at the beginning of 2009. Not only are emerging market and commodity economy stocks more expensive in their own currencies than they were when this rally started on March 9, but theyre extra, super-duper expensive to any investor who needs to buy them with U.S. dollars. Not for the Chinese renminbi and the U.S. dollar, though. Back in July 2008 when China re-pegged its currency to the dollar it traded at 6.8 to 6.85 renminbi to the dollar. Today it trades at 6.8 to 6.85 renminbi to the dollar. Here are five ways that you could make the current dollar-renminbi peg your friend and put the future appreciation of the Chinese currency to work for you.

Markets

Stocks Overvalued, Recession Will Return: Meredith Whitney Stocks are overvalued and the US economy is likely to fall back into a recession next year, well-known analyst Meredith Whitney told CNBC. "I haven't been this bearish in a year," she said in a live interview. "I look at the board and every single stock from Tiffany to Bank of America to Caterpillar is up. But there is no fundamental rooting as to why these names are up—particularly in the consumer space." In a wide-ranging interview, Whitney, CEO of the Meredith Whitney Advisory Group, also said: # She was disappointed that Fed Chairman Ben Bernanke didn't spell out how the Federal Reserve planned to exit "the biggest Fed program to date, which is the mortgage-backed purchase program." In a speech earlier Thursday, Bernanke said the central bank was watching the dollar's decline but is likely to keep interest rates low. # The US consumer was going through the biggest credit contraction ever—even bigger than that during the Great Depression. "That credit contraction is accelerating," she said. "There's nowhere to hide at this point." # The banking sector is not adequately capitalized and will need to raise more capital in the coming year. # The residential real estate market is likely to worsen and remains a much bigger threat than the commercial property market. The government's mortgage modification program won't result in any major improvement in homeowners' ability to stay above water, she added. "I don't know what's going on in the market right now because it makes no sense to me," she said. "The scariest thing about the Fed's program is that the money on the sidelines isn't going to support that asset class," she added. "So the trillion dollars of Fannie (Mae), Freddie (Mac) and mortgage-backed securities that the Fed is holding—there's no substitute buyer there."

You may not like the fundamentals but this rally is headed higher The test is over. And the stock market rally has passed. On November 16, the Standard & Poor’s 500 and the NASDAQ 100 both joined the Dow Jones Industrials in setting new recovery highs. In other words all three indexes have busted out of the trading range of 1025 to 1098 on the S&P 500 that had threatened to keep stocks locked up in a narrow band for more than a month after that October low. On November 16, the Standard & Poor’s 500 closed at 1109, well above the 1098 high set on October 19. The Dow Jones Industrials closed at 10407. The Dow Industrial Average hasn’t been that high since October 2008. The NASDAQ 100 closed at 2198, a level that index hasn’t seen since November 2007. On November 12 I wrote that the market would either break above 1098 on the S&P, signaling that we were headed for a new recovery high and that the rally was alive and well or fail the test and sink back toward the lows at 1025. When the market is in a rally each high will be higher than the one before and each low will be at a higher level too. So the action of the last few days says that this rally still has a way to run. How far? As far as I’ve written repeatedly lately as the flood of global liquidity, borrowed dollars flowing into commodities, and a falling U.S. dollar can take it. Through the end of the year certainly and probably deep into the first half of 2010. The only things that could derail the rally at this point are an interest rate increase from the Federal Reserve that drove up the price of the U.S. dollar, believable promises from developed economy central banks that they are going to remove stimulus funds from the economy, or convincing evidence that the global economy—or at least a handful of the economies that count such as China, the United States, India and Germany—were growing much, much more slowly than anyone had projected. Any of those three events is possible. But each of them would take time to develop into a convincing argument for selling. I think this rally continues to have legs. It is worth investing in or staying invested in. But don’t forget that this rally hangs on two assumptions. First, that the global economic recovery has gained enough momentum that it will be sustainable in 2010. No back sliding into a double-dip recession. And second, that none of the world’s significant central banks is going to start tightening money supply until way into 2010 at the earliest.Neither of those is guaranteed.

XLF Triangle Here is a 60-minute chart of the XLF showing a symmetrical triangle outlined in blue (click to enlarge): The purple line gives the height of the triangle. The green line is the same height as the purple line and shows the 100% extension for a breakout. The red line shows the target for breakdown. So, the XLF is geared to either test the October 14th top, or the November 2nd bottom.So, as The Fly says: To the FAZ-mobile! Or the FAS-mobile. Or SKF/UYG if you prefer. I suppose that the CPI report Wednesday morning could call the direction. A little pop in inflation might make traders think that the Fed will tighten sooner, and that might be bad news for the banks. If the number is in-line, then take a look at market breadth after the open; strong breadth would give the edge to an upside breakout. Also, the swing down Tuesday morning did not reach the lower triangle line (blue arrow on chart), and that may be a bullish implication signifying impatient dip buyers. The BKX banking index has the same triangle, however, it was able to break above the upper line during the last half hour of trading today. And both the XLF and BKX have moved above all the important moving-averages on the 15-minute chart.

When bad news doesn’t take stocks down, the rally is still in charge Stocks are hanging tough in the face of some heavy duty bad news. For the last two days, November 17 and 18 the Standard & Poor’s 500 has refused to drop below 1100. That’s often a sign that stocks are ready to move higher when the bad news flow stops. How bad has the news been? Heavy duty bad. On November 18, for example, investors got early morning news that housing starts had collapsed in October. Starts fell by 10.2% to 529,000 from 592,000 in September. That was a huge negative surprise. Wall Street had be3en expecting that starts would inch ahead to 600,000 for the month. And a huge disappointment to investors who had convinced themselves that the economy was on the mend after starts climbed to 593,000 in July. Starts stayed at about that level in August and September. With the economy returning to growth in the third quarter—and at a very healthy 3.5% annual rate too—there seemed to be solid evidence that housing, the sickest sector of the economy, was headed to the recovery room. The recent numbers threw that all into doubt. The pattern the day before was similar. Bad news on weaker than expected U.S. manufacturing activity couldn’t even keep stocks down for the day. On November 17 the S&P 500 actually climbed by 1.02 points. Not much. But any gain in the face of bad news is an indicator of how strongly the stock market is being pushed up by cash flows.In fact it helps to understand this market in terms of a battle between economic news and fears, on the one hand, and cash flows into U.S. equities (and commodities and overseas financial markets). Right now cash flows are strong enough to outweigh some pretty negative economic news. It won’t always be this way. But right now cash trumps news. The trend is still up.

6 REASONS RICHARD RUSSELL WANTS TO OWN GOLD There are a number of items favoring higher gold now. (1) Interest rates are at zero, which means the “opportunity cost” of owning gold now is highly favorable. You sacrifice no yield in owning gold vs. Treasury bills. T-bills pay you nothing, so you might as well have your money in gold. (2) The Bernanke Fed will evidently stop at nothing in its all-out attempt to “jump start” the wobbly US economy. This means spending and building debt at a never-seen-before rate. This will result in inflation. (3) The world’s central banks are now seeking to protect themselves from a falling dollar by buying gold. After years of selling gold,ironically, the central banks are now buying gold.

The quant bubble Keep dancing if you will, but I continue to sit out the melt-up in stocks and the bubble in other asset classes. When investors/traders are arguably overinfluenced by prices (not fundamentals) that dominate the markets, and are all on a similar side, it has the potential to lead to a treacherous and slippery slope, as it did in 2007-08. Remember, it is some of the same momentum-based quant funds that sold in March 2009 that have been buying over the past few months. I have seen many bubbles in my 30-plus years in the investment business. There is a giant bubble in quant funds, and their outsized influence in buying stocks, bonds and commodities might soon be approaching the height its of popularity.

Investment Strategies

When Common Sense Says It's Time to Sell Just a year ago, as conversations inevitably turned to the plunging stock market, I felt like the odd man out. Most people doing the talking were boasting that they had bailed out, cut their losses, moved into cash, hunkered down. And then I'd say I was buying. Most people looked at me like I was crazy. The deeper the market fell and the longer the correction persisted, the more isolated I felt. So I stopped talking about it, just nodding when the subject arose. Now, with the market continuing to set new highs for the year, most recently on Monday, I'm again feeling isolated. That's because I've been following the Common Sense system, which calls for selling after large gains like the one we just experienced. So while everyone else is celebrating their gains, I'm thinking about what to sell. Don't get me wrong. I'm as delighted as everyone else by the market's rise, since overall, I'm always long on stocks. But I'm not buying when the market hits new highs. Instead, I'm locking in some gains, raising cash for the day when a correction arrives. Over the years I've been doing this, I've come to understand why this doesn't make me all that popular with certain kinds of investors. Many people equate a decision to sell with a prediction the market is going down. Who am I to damp the festive atmosphere of a big rally? But I don't try to predict short- or even medium-term moves in the market. All I'm trying to do is sell higher, buy lower, and thereby outperform a strict buy-and-hold approach. So far it has been working. Earlier this year I was exhorting people to buy, as I did myself. As luck would have it, I bought on March 9, which turned out to be the bottom.

  • Wall Street's Alphabet Soup Has Wall Street's alphabet soup given you investing indigestion? No other institution—with the possible exceptions of the government or the military—spews out acronyms and initials quite as prolifically. I call these products of financial engineering "WACronyms," because they tend to sound innocent when, in fact, many of them are full of wacky complications and incomprehensible risks.

Société Générale tells clients how to prepare for potential “global collapse” In a report entitled "Worst-case debt scenario", the bank's asset team said state rescue packages over the last year have merely transferred private liabilities onto sagging sovereign shoulders, creating a fresh set of problems. Overall debt is still far too high in almost all rich economies as a share of GDP (350pc in the US), whether public or private. It must be reduced by the hard slog of "deleveraging", for years. "As yet, nobody can say with any certainty whether we have in fact escaped the prospect of a global economic collapse," said the 68-page report, headed by asset chief Daniel Fermon. It is an exploration of the dangers, not a forecast. Under the French bank's "Bear Case" scenario (the gloomiest of three possible outcomes), the dollar would slide further and global equities would retest the March lows. Property prices would tumble again. Oil would fall back to $50 in 2010. Governments have already shot their fiscal bolts. Even without fresh spending, public debt would explode within two years to 105pc of GDP in the UK, 125pc in the US and the eurozone, and 270pc in Japan. Worldwide state debt would reach $45 trillion, up two-and-a-half times in a decade. (UK figures look low because debt started from a low base. Mr Ferman said the UK would converge with Europe at 130pc of GDP by 2015 under the bear case). The underlying debt burden is greater than it was after the Second World War, when nominal levels looked similar. Ageing populations will make it harder to erode debt through growth. "High public debt looks entirely unsustainable in the long run. We have almost reached a point of no return for government debt," it said. Inflating debt away might be seen by some governments as a lesser of evils. If so, gold would go "up, and up, and up" as the only safe haven from fiat paper money. Private debt is also crippling. Even if the US savings rate stabilises at 7pc, and all of it is used to pay down debt, it will still take nine years for households to reduce debt/income ratios to the safe levels of the 1980s.

Nervous? Afraid to stay in but scared to get out? Join the club (and read my three strategies for coping) Feeling twitchy?Your portfolio is probably full of stocks trading at 52-week highs. And I’ll bet you’ve thought about selling. And you would do that–except that the stock market keeps going up (well except for the last couple of days), cash pays close to nothing, and it’s hard to find a stock to buy that’s not already trading at its 52-week high. I think you’ve got three choices at this point in this stock market. [ …] I think there are problems with each of these three strategies. But I do think that if you take a dash of this and mix it with a pinch of that, you can come up with a strategy that limits risk and gives you decent upside exposure. Let me lay out that hybrid strategy for you and suggest a few stocks suited to playing mix and match. First, build a cash management plan—and put it into effect. Second, momentum is real and it can be your friend if you let it. Over and over during this rally I’ve heard from investors who have said, The stock market is ahead of the fundamentals of the economy or “This rally is built on nothing but the world’s central banks flooding the financial markets with liquidity.”

I totally agree. This is a liquidity driven rally. It is based on the huge influx of cash from government stimulus programs in countries such as the United States and China. The rally in commodities, commodity stocks, and emerging economy stock markets has been funded by money borrowed in what’s called the dollar carry trade. Third, the skeptics could be wrong and fundamentals could still count. In which case you should be now buying the great fundamental companies of 2010. The argument that this is just a momentum rally based on massive flows of global liquidity is based on two things. Huge observed flows of capital. I don’t think this is subjective or debatable. A profound disbelief in an earnings recovery in 2010. This is subjective and debatable. We simply don’t have the data yet to tell us how strong individual global economies will be in 2010. And we don’t know how sustainable any economic recovery might be.But we do know that the year to year comparisons in the March and June quarters of 2010 are going to be to some terrible quarters in 2009. In other words it won’t take much for earnings to look better on a year to year basis. And we do know that some companies are coming out of this recession as lean, mean earnings machines.

Posted by dblwyo at 08:36 PM | | Comments (0)

November 19, 2009

Firestorm Flaring up: Finance Reform, Compensation Wars & Sausages (Update)

Not to rush you along too fast but we thought we'd re-visit our previous posts on regulatory reform of the Finance Industry. Understanding the state of play AND the business performance of the Industry per se are important for their own sake. In fact this post should be considered as another deep dive into the state of the industry and as a case study. It's also important for several other reasons. One of course is the question of how viable investing in the Financials is. But because the industry is the ecology of the Markets it is systemtically important and influences how the entire economy does. It also controls how well you own investment does. This is particularly important, as we've been covering in multiple posts, because the old ideologies of Efficient Markets and Asset Allocation are being fundamentally re-visited. The long and short of it is that discussing reform touches Business Performance, Markets and Investments and the Economy! We will observe however that this famous painting, "The Scream", originally done to express the anxieties of the early 20thC, pretty well captures most folks feelings about the Industry. Which means, of course, that the pressures for reform are mounting. Which we'll discuss but pay attention!

Market Performance as Indicator

Let's start with a benchmark by looking at the stock performance of the Industry and its sectors YTD. We use the XLF ETF as a proxy for the industry as a whole while SPDR ETF's for various sectors including Banks, Regional Banks, Capital Markets, Insurance and Mortgage Finance are also shown.

As you can they all moved pretty much together into, through and after the March Madness when everybody thought the world was collapsing and the Financial Sector was going to end. Thank goodness for the Stress Test - it's called Animal Spirits, as in the world's not ending. The recovery continued for everybody thru mid-May on the back of earnings surprises (told you we'd close the loops) that turned out on examination to be a lot poorer quality than you'd hope.

Then things changed. The Regionals and Mortgage guys took some big hits as the size and scope of the CRE problems became more apparant. And as the up and downs of Housing optimism waxed and waned as well, though they both climbed back in the ballpark to keep playing with tre other teams. Since then the Regionals have re-deteriorated a bit as reality starts to set in.

The other important differentials ae with the Big Banks, the Investment Houses and Insurors. Strangely enough the Banks did relatively well but the real differential performer has been the Insurance Sector. Oddly enough the Investment folks haves slightly under-performed - it looks like performance actually matters a bit and some horses run faster than others. Of course which ones are important questions.

Continued ....

Financial Reform and Reactions

For a while there with the news that bonuses were going to be paid but would be extremely large there were multiple stories per day in the business press. Given that some of those bonuses were as large or larger than those paid during the decade of the leveraged financial boom that's pretty surprising. One might even use the word outrageous - lots of folks have.

Now we've covered the elements of reform several times in multiple posts as taking repeated deep dives on the financial business as a business over the last couple of years. So many times that we've collected all the prior posts into essay collections which, taken as a whole, are a pretty complete portrait, assessment and diagnosis of the industry. Pointers to the URL addresses for those collections are in the readings. If you're in the Industry, an investor or just concerned as we all should be we strong suggest getting them and reading them. The net net is that the old business models are broke and not coming back. But the business doesn't believe that, thinks business as usual is coming back and is pushing as hard as possible against reform. AND the culture is still locked into the last three decades view of bonuses and excess compensation. It'll be interesting to see what happens.

As it happens both the House and Senate, with strong support and enouragement from the Administration, are moving huge bills forward as we speak. One of the best surveys of the consensus views of what needs to be done is one Geithner gave at a recent SIFM conference, during an interview by Charlie Rose. Rose also interviewed Dimon who was, overall, very supportive of those arguments but pushed back where his ox was being gored. Rose has changed his web site so you just go to www.charlierose.com and scroll the exclusive archives to find them.

The Case For Reform

We think the case for reform is overwhelming on several counts. But if you cast your minds back to the late '90s there was an interesting situation where Brooksley Born, of the CFTC, tried to change te rules of the game to level the playing field. She was squashed by some major players, including folks who are again in the arena, because they were all drinking they Koolaid. They have since recanted, as has almost everybody. Except Lloyd Blankfein who thinks they are still doing "God's Work" of course. We'll see how this ends up but we're going to get something, it's going to be big and a bigger change, comprehensively, than anything we've seen since the 1930's. And let's not forget the Pecora II commission that's busy beavering away in some back rooms.

It's well worth listening to the entire PBS Special on The Warning, or so we think. You can find the web page for the whole effort HERE. If you want to take a deeper dive on the political sausage-making and the state of play, as well as the big picture implications and debates may we point you to: The Beginnings of a Great Debate: People Singing, Politicians Making Sausage.

Here the People Singing

In the essay collections plus previous posts digging into the Industry, its performance as a business and its influence and impact on the overall health of the economy we go into some detail about the business case for business as usual. So let's just summarize our findings:

1) Financial Industry malfeasance almost destroyed the economy, brought on Great Depression 2.0 and might have collapsed Western Civilization.

2) The collective and cumulatively losses of the last couple of years wiped out most of the last decades's profits, even though they were all funny money in the first place. In other words the Industry almost destroyed itself. It's in their own best interests since obviously they can't be allowed to play without adult referees.

  • NB: the bonuses that the Industry started paying itself grew exponentially starting in the '80s, accelerated in the '90s and turned into a bubble in the '00s. And put compensation completely out of line. There is no evidence that those bonuses contributed positively to the health of society. In fact all the evidence is the other way.

3) Post de-regulation in the '80s we began almost three decades of wild indulgence in debt and over-consumption that loaded up the Industry, the consumer and business with leverage that we couldn't sustain.

4) That debt caused savings to drop to nothing and severely retarded investment and economic growth.

5) The lack of economic growth led to a relatively stagnant economy with poor job creation and flat to declining wages and benefits. And that, in turn, has led to an increasingly stratified society where the top 1% of earners, strangely enough somewhat concentrated in the Finance Industry, to garner all of the gains of the last three decades.

When a society, historically, spends more effort on rent-seeking and power elites focus their careers on rule manipulation then it eventually succumbs to sclerosis and dies. Just ask the farmers and peasants who harvested all the wood on Easter Island and destroyed the ecology just to keep making giant statues for the Chiefs.

 Sadly though the mood of things is pretty well captured by the song "Here the People Singing" from Les Miserables. The real problem is that the Industry had an opportunity to both fix itself AND to collaborate on re-shaping the regulatory framework in a constructive fashion. But has refused to do so. The evidence for helmet laws and adult referees to make sure the game is played according to the rules seems to be overwhelming.

 UPDATE: an interesting summary of the last "Lost Decade" and the triumph of a terrible culture and the consequences for the rest of us:Farewell to Wall St.'s decade of hubris

 

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Table-setting Pieces

Inside the Meltdown BNN gets a behind the scenes analysis of the U.S. economic meltdown with Andrew Ross Sorkin, columist, New York Times, and author, "Too Big Too Fail". Part 2

Farewell to Wall St.'s decade of hubris As 2009 winds to a close, we bid good riddance to a decade on Wall Street that we can sum up with just one word: Hubris.Hubris is defined as haughty behavior by people who are arrogant enough to think they might rank up there with the gods. It's a bad attitude that inevitably leads to a fall.It's the perfect word for a decade in which Wall Street experts and company chiefs told us they knew what was best for our money while proving they knew very little.And that's giving the benefit of the doubt to many titans of profitless dot-coms, CEOs of shell companies such as Enron and WorldCom, and the Wall Street geniuses who engineered the credit crunch. No doubt more than a few of them knew exactly what they were doing to us. A decade ago, historians debated what to call these years -- the '00s, the Oughts or the Zeros. For investors, it's been the less-than-zero decade.It kicked off at the most boisterous phase of the tech bubble, just before the Nasdaq Composite Index ($COMPX) reached a dizzying peak of 5,132 in March 2000. In 2002, the index bottomed at 1,114. Nearly a decade later, it still sits almost 3,000 points below the peak. In between the busts, investors saw a steady stream of collapses and scandals:

Goldman Says "Sorry" And The World Moves On     In recent months, Goldman Sachs made a good run at becoming The Most Hated Company In The World. How? By nearly going bust last fall, getting a cash bailout from the taxpayer, immediately denying that it ever needed any help, and then minting so much money over the next twelve months that it will pay 2009 bonuses in excess of $20 billion. A couple of weeks ago, Goldman CEO Lloyd Blankfein then compounded the problem by going on a PR offensive in which he said Goldman was doing "God's work." Goldman does provide a lot of valuable services, but it's hard to imagine in what universe they would deserve that description. First, Lloyd Blankfein thanked the government publicly for its help. And then, yesterday, he apologized for some of Goldman's actions in recent years. In addition, Goldman - with a helping hand from Warren Buffett - announced a $500 million charitable project to assist 10,00 small businesses. Americans are very forgiving. As long as public figures (and firms) express gratitude for help and contrition for perceived wrongs, Americans are happy to move on.  Americans also love winners--and Goldman is a major winner. So we--and our guest Howard Lindzon, CEO of StockTwits--expect that the Goldman hatred has passed its peak and that the world will now move on.

Oh, So That Is God's Work Today's New York Times has an encouraging article about the things that Goldman Sachs is doing to cleanse its image as a greedy and destructive force in the U.S. economy and society. Apparently Warren Buffett is teach their senior team a bit of humility, or at least how to feign it. This is all old news, but I can't stop thinking about the comparison between how the Rolling Stone described Goldman versus how CEO Blankfein did (a statement that got him in big trouble, by the way). I am really trying to avoid the temptation to engage in mindless bashing of Goldman Sachs as I have met many people from the company I admire and in many ways it is splendidly managed company.  But the thing that gnaws at me can be gleaned from the Kurt Vonnegut poem that was published in The No Asshole Rule and that I have reprinted on this blog, called Joe Heller (read it here). When people act if no matter how much money, status, goodies, and other material goods pile-up, it is never enough for them, I start to squirm. I am glad that Goldman is reaching out to help small business , offering some 3% of their 16.7 billion in bonuses to do so.  That is a start. My gut feeling is that something closer to 50% would be more appropriate --- especially for the top 100 or so people in the firm.  But I think they ought to read Vonnegut's poem, as it is a message they need to hear -- especially at a time when over 10% of the U.S. workforce is unemployed, most of whom shelled-out tax money to help save Goldman and their ilk from their own greed, arrogance, and misleading statements -- a new government report rebukes their claim that they didn't much benefit much at all from the massive AIG bailout (see this story in the Wall Street Journal). I am glad that Goldman is starting to grovel a bit and is giving a bit more back after their arrogance failed them, but I would I think they owe their fellow Americans more than a lousy 3%. I know they will be paying whopping taxes on all this money, but for me, they need to do more to help all those people who saved their ass.

Pathology of a Crisis The coroner’s report left no doubt as to the cause of death: toxic loans.That was the conclusion of a financial autopsy that federal officials performed on Haven Trust Bank, a small bank in Duluth, Ga., that collapsed last December.In what sounds like an episode of “CSI: Wall Street,” dozens of government investigators — the coroners of the financial crisis — are conducting post-mortems on failed lenders across the nation. Their findings paint a striking portrait of management missteps and regulatory lapses.At bank after bank, the examiners are discovering that state and federal regulators knew lenders were engaging in hazardous business practices but failed to act until it was too late. At Haven Trust, for instance, regulators raised alarms about lax lending standards, poor risk controls and a buildup of potentially dangerous loans to the boom-and-bust building industry. Despite the warnings — made as far back as 2002 — neither the bank’s management nor the regulators took action. Similar stories played out at small and midsize lenders from Maryland to California.What went wrong? In many instances, the financial overseers failed to act quickly and forcefully to rein in runaway banks, according to reports compiled by the inspectors general of the four major federal banking regulators. Together, they have completed 41 inquests and have 75 more in the works.Current and former banking regulators acknowledge that they should have been more vigilant.Many bank examiners acknowledge they were lulled into believing the good times for banks would last. They also concede that they were sometimes reluctant to act when troubles surfaced, for fear of unsettling the housing market and the economy.Then as now, banking lobbyists vigorously opposed attempts to rein in the banks, like the 2006 guidelines that discouraged banks from holding big commercial real estate positions.

The AIG report Big financial institutions are a small club, with a shared interest in sustaining the system. Ever since the days of JP Morgan it has been standard practice, in times of crisis, to get major players together in a room and get them to forgo short-term profit maximization on behalf of the industry interests. It happened in the Panic of 1907; it happened in the Latin American debt crisis of the 80s; it happened in the LTCM bailout, which was financed by private firms, not the feds.Also, individual banks are in a long-term relationship with the public and the government. They have an interest in preserving that relationship. The Epicurean Dealmaker offers an imaginary speech that Tim Geithner an anonymous government official could have given:

[T]hose people and institutions in this room which did not help us, which put their own narrow personal and corporate interests before the interests of this nation and its people, will be remembered as well.And let me tell you something, gentlemen, banker to banker: you do not want to be on that list. That list will be a world of pain. That list will be Death.

Indeed. Bear Stearns famously refused to participate in the rescue of LTCM — and it’s widely believed that the lingering bad feelings from that exercise in free riding had a lot to do with the firm’s demise last year.So could the feds have negotiated a haircut? Yes. It might not have been that much money, but it would have had a lot of symbolic importance. And that matters. Brad DeLong says that the loss of public trust due to the kid-gloves treatment of bankers has raised the probability of another Great Depression, because the public won’t support another round of bailouts even if it becomes desperately necessary. I agree — but I think the bigger cost is that we’ve greatly increased the chance of a Japanese-style lost decade, with I would now give roughly even odds of happening. Why? Because bank-friendly policies have squandered public trust in all government action: try talking to the general public about stimulus, and it’s all confounded in their minds with the deeply unpopular bailouts. By itself, the AIG story would be damaging enough. But it’s part of a pattern — and that pattern has ended up undermining the economy’s prospects, big time.

Comp and Reg Wars: Finance vs Society

Why big banks hate banking There have been no obituaries. No eulogies. No burial services. But this quarter marks the death of traditional banking at the big money-center banks. Yes, we've seen amazing earnings reports from the likes of Goldman Sachs (GS, news, msgs) and JPMorgan Chase (JPM, news, msgs) this quarter, but their profits came from things like trading. From everything, in fact, but what you and I -- and certainly the preceding generation -- called banking. And it's exactly those huge profits from everything but banking that have put the final nail in the big banks as banks. Goldman Sachs and JPMorgan Chase and maybe Bank of America (BAC, news, msgs) and Citigroup (C, news, msgs), too, will survive as financial institutions. But they won't be banks. The model for what these big financial institutions will be is laid out in the most recent quarterly earnings reports from Goldman Sachs and JPMorgan Chase. Goldman Sachs, for example, blew through Wall Street projections when it announced third-quarter earnings of $5.25 a share, more than a dollar above the Wall Street consensus. Revenue climbed to $12.4 billion for the quarter, more than double Goldman's $6.04 billion in revenue in the third quarter of 2008.Not bad for a recession, eh?

If Lenders Say ‘The Dog Ate Your Mortgage’ FOR decades, when troubled homeowners and banks battled over delinquent mortgages, it wasn’t a contest. Homes went into foreclosure, and lenders took control of the property. On top of that, courts rubber-stamped the array of foreclosure charges that lenders heaped onto borrowers and took banks at their word when the lenders said they owned the mortgage notes underlying troubled properties. In other words, with lenders in the driver’s seat, borrowers were run over, more often than not. Of course, errant borrowers hardly deserve sympathy from bankers or anyone else, and banks are well within their rights to try to protect their financial interests. But if our current financial crisis has taught us anything, it is that many borrowers entered into mortgage agreements without a clear understanding of the debt they were incurring. And banks often lacked a clear understanding of whether all those borrowers could really repay their loans. Even so, banks and borrowers still do battle over foreclosures on an unlevel playing field that exists in far too many courtrooms. But some judges are starting to scrutinize the rules-don’t-matter methods used by lenders and their lawyers in the recent foreclosure wave. On occasion, lenders are even getting slapped around a bit.

Reckless strategies doomed WaMu On Sept. 10, 2007, Washington Mutual CEO Kerry Killinger stood before an audience of analysts and money managers and assured them the Seattle-based thrift would come out of the housing slump stronger than ever. WaMu, Killinger told the Lehman Brothers conference, had tightened its lending standards, could access plenty of cash, and was "picking and choosing carefully" when it came to making new loans. "This frankly may be one of the best times I have ever seen for taking on new loans into our portfolio," he said. But even as he spoke, WaMu was a dead bank walking. The company had plunged headlong into the business of making exotic, high-risk home loans, selling many of them to investors but holding onto others; now defaults on those loans were rising, and big investors had lost their taste for them. Almost a year to the day after the Lehman conference, Killinger was fired. Two and a half weeks after that, federal regulators seized WaMu's banking units, effectively euthanizing a 119-year-old institution that had survived the Great Depression and the S&L crisis. After its collapse, Killinger and other leading WaMu executives repeatedly deflected responsibility, saying the company fell victim to a housing slump turned global credit crisis that they foresaw but couldn't outrun. But interviews with former WaMu executives and employees, along with government and internal company documents, reveal a far different picture, one of executives charting a reckless course that doomed the bank:

Class Claims Lender Destroyed Records Bank of America and Countrywide Home Loans destroyed mortgage documents, and "recreate" them by "insert(ing) data as they see fit," to cover up their own failure to keep records - or their fraud - according to a federal RICO class action.  "To cover up the servicing mistakes and fraud and misrepresentation in the servicing of a consumer escrow, Defendants 'recreate' letters, insert data as they see fit, and fail to produce the entire HUD complaint form. This way, a consumer is left in the dark about the fraud that occurred to them," the complaint states. Countrywide routinely responded to customers' requests for records by claiming they were "unavailable or destroyed," according to the complaint. Statutory law requires that such records be kept for 5 years, the plaintiffs say.      Mortgage servicers have a "statutory duty to send consumers an annual escrow analysis and statement, advising the consumer of their escrow, monthly payment, and how it is calculated based on taxes," the class claims.      The information is especially important with an escrow addition to a mortgage, which "throws consumers off," as principle and interest tend to fluctuate.     The class is estimated at 10,000. They claim the documents they received from the subprime lender were "incorrect or incomplete." The records allegedly were tailored to cover up misrepresentations, and to "ward off lawsuits such as the instant one."     BAC Home Loans is also named in the complaint.

Re-thinking Compensation and Culture

Who cares if 'talent' leaves? Critics warn that reining in pay makes it hard to keep talented employees. Hemmed in, institutions like AIG (AIG, Fortune 500),Bank of America (BAC, Fortune 500) and Citigroup (C, Fortune 500) could lose their best people. These firms would then perform even more abysmally, if that's possible, leaving them hard pressed to repay tens of billions of dollars of taxpayer-backed loans. Still, we say Godspeed to this "talent." After all, the traders and suits in the corner offices don't exactly have an unblemished track record. In 2008, Citigroup, BofA and Merrill Lynch (since acquired by BofA) posted a grand total of $51 billion in losses. Yet even as they were running themselves into the ground, the firms managed to pay out more than $12 billion in bonuses -- including 1,606 million-dollar-plus bonuses, according to a report from the New York attorney general's office. "Even a cursory examination of the data suggests that in these challenging economic times, compensation for bank employees has become unmoored from the banks' financial performance," the report said. Meanwhile, it's hard to imagine that defection-hit firms would have a lot of trouble finding qualified replacements in the current job market. And Goldman Sachs' (GS, Fortune 500) charm offensive notwithstanding, it looks like the official response to runaway pay is just starting. The Fed's plan to weigh big banks' compensation plans against their potential for undermining the economy could eventually put pressure on pay at all the big banks. "This could be a game changer," said Simon Johnson, an economist at MIT. "There will be a lot of pressure on them in Congress to stick it to the big firms." But maybe the best reason not to fret about talent flight is one familiar to cubicle dwellers everywhere: just because someone has a big, high-paying job doesn't mean they're good at it. Take Bank of America, for instance. The bank's longtime CEO, Ken Lewis, unexpectedly announced his retirement this month, while agreeing to give back his 2009 salary. Lewis didn't say why he was leaving, but it seems that criticism over his empire building, mishandling of the Merrill acquisition and outsize pay got to him. The Charlotte Observer reported he had grown tired of the "mud being thrown on him day by day." Another helping or two of that mud could be just what Wall Street needs.

Bank pay crackdown Washington launched its biggest offensive yet against Wall Street pay practices Thursday, taking aim at everyone from senior executives to high-flying traders of complex securities. Leading the charge was the White House, which outlined a series of drastic pay cuts for 136 top executives at the nation's biggest bailed-out companies, including AIG (AIG, Fortune 500), Citigroup (C, Fortune 500) and Bank of America (BAC, Fortune 500). Separately, the Federal Reserve proposed a review of pay practices at 28 of the nation's largest banks to make sure employees are not tempted to make the kinds of risky bets that helped sink firms such as Lehman Brothers.

Range of Firms Alter Pay Policies Companies as diverse as Polo Ralph Lauren Corp. and Sysco Corp. are adopting executive-pay plans that echo principles laid out by government regulators, potentially signaling a broad shift in compensation practices. The changes at these non-financial firms aren't a direct response to moves by Treasury pay czar Kenneth Feinberg and the Federal Reserve, which apply to banks and big recipients of government bailout funds. The recession, more than government regulation, is driving some of the moves. But companies for a while have been seeking ways to reward executives' long-term performance and limit excessive risk-taking, according to compensation consultants. "We are at the tipping point" for eliminating big annual bonuses, outsized severance agreements and other traditional pay practices, said James F. Reda, managing director of his pay consultancy in New York. Among the changes: more stock-based compensation, with longer waiting periods before it can be sold; higher performance hurdles for bonuses; and limits on perks, severance and supplemental pensions. The shifts are far from universal. Some experts say bank-pay limits are having little impact elsewhere in corporate America. "I don't see any trend in that direction," said George Paulin, chairman and chief executive of Frederic W. Cook & Co., a pay consultancy.

Why Do Bankers Make So Much Money? A tenet of economics is that in competitive markets there are no economic rents. That is, people get fairly paid for their efforts, their capital input, and for bearing risk. They are not paid any more than is necessary as an incentive for production. In trying to understand the reason for the huge pay scale within the finance industry, we can either try to justify the pay level as being a fair one in terms of the competitive market place, or ask in what ways the financial industry deviates from the competitive economic model in order to allow economic rents. No one expects competitive levels of compensation when there are deviations from a competitive market. In what ways might the banks – and here I mean the largest banks and those banks that morphed over the past year from being investment banks – fall away from the model of pure competition? One way is through creating inefficiencies to keep competitive forces at bay. Banks can do this, for example, by constructing informational asymmetries between themselves and their clients. This gets into those pages of small print that you see in various investment and loan contracts. What we might call gotcha clauses and what the banks call revenue enhancers. And it also gets into the use of complex derivatives and other “innovative products” that are hard for the clients to understand, much less price. Another way is to misprice risk and push it into other parts of the economy. The fair economic payoff increases with the amount of risk taken. If a bank takes on more risk it should get a higher expected payoff. If the bank can get paid as if it is taking on risk while actually pushing the risk onto someone else, then it will start to pull in economic rents. The use of innovative products comes up again in this context.

Record Bonuses Return to Wall Street as Big Three May Award $29.7 Billion  Goldman Sachs Group Inc., Morgan Stanley and JPMorgan Chase & Co.’s investment bank, survivors of the worst financial crisis since the Great Depression, are set to pay record bonuses this year. The firms -- the three biggest banks to exit the Troubled Asset Relief Program -- will hand out $29.7 billion in bonuses, according to analysts’ estimates. That’s up 60 percent from last year and more than the previous high of $26.8 billion in 2007. The money, split among 119,000 employees, equals $250,400 each, almost five times the $50,303 median household income in the U.S. last year, data compiled by Bloomberg show. The three will award more in stock and defer more cash payments under pressure from regulators to tie pay to long-term results, compensation experts said. They may still face public wrath over the size of bonuses after the government injected capital into all the major financial institutions following Lehman Brothers Holdings Inc.’s collapse in September 2008. “Wall Street is beginning to resemble Clark Gable as Rhett Butler in the film ‘Gone With the Wind’: ‘Quite frankly, my dear, I don’t give a damn,’” Paul Hodgson, a senior research associate on compensation at the Portland, Maine-based Corporate Library, said in an e-mail. “It doesn’t seem as if even political threat, disastrous PR, envy, rising unemployment rates and home repossessions is enough. Bonuses for employees in fixed income will likely jump the most, 40 percent to 45 percent, while employees in asset management may see no growth in their year-end bonuses, according to a report from Options Group, a New York-based executive search and compensation consultant firm. Average bonuses for employees at financial firms worldwide will rise about 35 percent to 40 percent this year, according to the annual report, which is set to be released this week. They will still remain below 2007 levels after dropping an average of 40 percent to 45 percent last year, the report said.

Regulatory Reform

Do not ignore the need for financial reform The philosophy that has helped me both in making money as a hedge fund manager and in spending it as a policy oriented philanthropist is not about money but about the complicated relationship between thinking and reality. The crash of 2008 has convinced me that it provides a valuable insight into the workings of the financial markets. The efficient market hypothesis holds that financial markets tend towards equilibrium and accurately reflect all available information about the future. Deviations from equilibrium are caused by exogenous shocks and occur in a random manner. The crash of 2008 falsified this hypothesis. I contend that financial markets always present a distorted picture of reality. Moreover, the mispricing of financial assets can affect the so-called fundamentals that the price of those assets is supposed to reflect. That is the principle of reflexivity. Instead of a tendency towards equilibrium, financial markets have a tendency to develop bubbles. Bubbles are not irrational: it pays to join the crowd, at least for a while. So regulators cannot count on the market to correct its excesses. The crash of 2008 was caused by the collapse of a super-bubble that has been growing since 1980. This was composed of smaller bubbles. Each time a financial crisis occurred the authorities intervened, took care of the failing institutions, and applied monetary and fiscal stimulus, inflating the super-bubble even further. I believe that my analysis of the super-bubble offers clues to the reform that is needed. First, since markets are bubble-prone, financial authorities must accept responsibility for preventing bubbles from growing too big. Second, to control asset bubbles it is not enough to control the money supply; you must also control credit. The best known means to do so are margin requirements and minimum capital requirements. Currently they are fixed irrespective of the market’s mood because markets are not supposed to have moods. They do, and authorities need to counteract them to prevent asset bubbles growing too large. Third, since markets are unstable, there are systemic risks in addition to the risks affecting individual market participants. Participants may ignore these systemic risks, believing they can always sell their positions, but regulators cannot ignore them because if too many participants are on the same side, positions cannot be liquidated without causing a discontinuity or a collapse. Fourth, financial markets evolve in a one-directional, non-reversible manner. Financial authorities have extended an implicit guarantee to all institutions that are too big to fail. Withdrawing that guarantee is not credible, therefore they must impose regulations to ensure this guarantee will not be invoked.

Bill in works to let US dissolve failing firms House Democrats and the Obama administration are preparing to introduce major legislation aimed at eliminating the devil's choice the government faced last fall, when officials felt forced to decide between spending billions of dollars to rescue some of the nation's most powerful financial firms or letting their failures sink the economy. The lawmakers and Treasury Department officials labored over the weekend to finish drafting legislation that would empower the government to seize troubled firms other than banks that are deemed "too big to fail." The legislation would set up the Federal Reserve to oversee the largest financial firms, and eliminate the agency that regulates thrifts. The officials said the measure could be unveiled as soon as Tuesday. The proposal comes as debate intensifies over how far the government should go in restructuring the financial system, and it follows House action last week toward creating a consumer protection agency to oversee lending practices. Republicans on the House Financial Services Committee have remained skeptical of granting the government power to wind down or bail out large, non-bank financial institutions. In July, they proposed creating a new chapter in the bankruptcy code to deal with such troubled firms, saying it would make for a smoother, fairer process. Concerns have also deepened in Congress, among Republicans and some Democrats, that the program could amount to a permanent bailout fund and reduce private market discipline by being too generous to creditors of failed firms. Despite such differences, the problem is clear to all sides: Banks got so big that federal officials could not let them fail without risking catastrophic consequences for the economy. During the crisis, the government arranged mergers that pushed troubled banks into the arms of more stable firms. Big firms got even bigger. Senior officials now worry that these financial behemoths could return to the reckless behavior that led to the crisis, reasoning that federal officials will clean up any mess. Frank has made clear that he expects the new proposals will be contentious. Last week, after his committee had voted to create the new consumer financial protection agency, he was asked whether the most difficult and divisive part of regulatory overhaul was behind him. Frank didn't hesitate. "I think the resolution authority is probably the hardest to do," he said.

Geithner urges prompt action on financial overhaul Treasury Secretary Timothy Geithner is pushing Congress to move quickly in overhauling the nation's badly flawed financial rules, which he says is essential for the health of the economy. Both the House and Senate are making progress toward revamping the current regulations, but Geithner said a rapid conclusion is needed to keep the economic recovery on track. Both the House Financial Services Committee and the Senate Banking Committee are working on their own versions of sweeping overhaul plans. But the two panels are taking sharply divergent approaches in some areas. Both proposals also face sharp opposition from major sectors in the financial industry, casting doubt on how quickly Congress will be able to reach agreement and send a finished bill to the White House. Geithner said a key principal the administration wants to see adopted is ensuring that firms not be able to escape or avoid oversight by shopping for the most lenient regulator, a situation critics say contributed to the worst financial market crisis in seven decades. "The fact that investment banks like Bear Stearns or Lehman Brothers or other large firms like AIG could escape meaningful consolidated federal supervision simply by virtue of their legal form should be considered unthinkable from now on," Geithner said. Another key principle the administration wants to see approved by Congress is to make sure the financial system as a whole is more capable of absorbing shocks and coping with failures. Geithner said this will require putting a greater focus on the quality of capital that firms are allowed to hold.

Re-Thinkings: Capitalism RIP?

Death of “Soul of Capitalism”: Bogle, Faber, Moore Jack Bogle published "The Battle for the Soul of Capitalism" four years ago. The battle's over. The sequel should be titled: "Capitalism Died a Lost Soul." Worse, we've lost "America's Soul." And, worldwide, the consequences will be catastrophic. That's why a man like Hong Kong contrarian economist Marc Faber warns in his Doom, Boom & Gloom Report: "The future will be a total disaster, with a collapse of our capitalistic system as we know it today." Has capitalism lost its soul? Guys like Bogle and Faber sense it. Read more about the soul in physicist Gary Zukav's "The Seat of the Soul," Thomas Moore's "Care of the Soul" and sacred texts. But for Wall Street and American capitalism, use your gut. You know something's very wrong: A year ago, too-greedy-to-fail banks were insolvent, in a near-death experience. Now, magically, they're back to business as usual, arrogant, pocketing outrageous bonuses while Main Street sacrifices, and unemployment and foreclosures continue rising as tight credit, inflation and skyrocketing federal debt are killing taxpayers. Yes, Wall Street has lost its moral compass. It created the mess, but now, like vultures, Wall Streeters are capitalizing on the carcass. They have lost all sense of fiduciary duty, ethical responsibility and public obligation. Here are the Top 20 reasons American capitalism has lost its soul:

Converting the Preachers  "Large swaths of economics are going to have to be rethought on the basis of what's happened." So said Larry Summers, President Obama's chief economic adviser, in an interview in the weeks after the markets crashed a year ago. Yet to a remarkable degree, economic thinking hasn't changed very much at all. Now financier George Soros is announcing a $50 million effort to speed things along. This week Soros is gathering some of the leading practitioners of the market-skeptic school, who were marginalized during the era of "free-market fundamentalism," among them Nobelists Joseph Stiglitz, George Akerlof, Michael Spence, and Sir James Mirrlees. He's also creating an "Institute for New Economic Thinking" to make research grants, convene symposiums, and establish a journal, all in an effort to take back the economics profession from the champions of free-market zealotry who have dominated it for decades, and to correct the failures of decades of market deregulation. Soros hopes matching funds will bring the total endowment up to $200 million. "Economics has failed not only to predict and explain what happened but has also failed to protect society," says Robert Johnson, a former managing director at Soros Fund Management, who will direct the new institute. "That's what the crisis revealed. The paradigm has failed. There is no guidance." It might be tempting to dismiss all this as a war of words among brainiacs. It's not. The critical issues being discussed in Washington about the future regulation and control of the financial industry—the very nature of Wall Street and the health of the economy—depend on this battle of ideas. What led to wholesale deregulation in the '90s and '00s wasn't just Wall Street lobbying money. It was also that key legislators and policymakers, among them Larry Summers, persuaded themselves that deregulation was sound economics and good policy, and that markets and Wall Street institutions could take care of themselves. Many of those views have been discredited by the crisis. But in the absence of a new paradigm of economics, confusion still reigns in Washington. With no new concept of the proper role of government and regulation in the economy, of the proper balance between the markets and their minders, the old school still dominates. Exhibit No. 1: the late Hyman Minsky, a bushy-haired dissident at the University of California, Berkeley, and Washington University who saw into the heart of financial-market mania perhaps more deeply than anyone else. Minsky's "Financial Instability Hypothesis," which he developed in the '60s, held that success in financial markets always breeds its own instability. The longer a boom lasts, the less market players consider failure a possibility; as a result, careful borrowing, lending, and investment inevitably give way to recklessness and speculative euphoria. Margins and capital cushions come to be seen as unnecessary. At a certain watershed point—sometimes called a "Minsky moment"—the foreordained collapse begins. The most speculative bets crash, loans are called in, asset values plunge, and the downward spiral feeds on itself. That's what happened over the last two years. Minsky was in effect filling in many of the intellectual blanks left by John Maynard Keynes on the critical question of how financial markets affect the "real" economy. Nonetheless, an assessment of Minsky in 1997, a year after he died, concluded that his "work has not had a major influence in the macroeconomic discussions of the last thirty years."

Readings and References

 The Broken Finance Industry: Credit, Crisis, Collapse and Broken Business Models The credit crisis of 2007-2008 that metastasized into a collapse and nearly caused Great Depression 2.0 was largely created by broken business models based on bad practices, malfeasance, excess leverage and synthetic, structured investment products. We've all learned the hard way that the Finance Industry is more than just another industry but impacts us all. By looking back, perhaps in anger and certainly in dismay and puzzlement, we can understand more about how this all came to pass. And, as a result, more about what to expect because all of these problems remain with us. If you'd like to get a better understanding of how broke the Industry is and what the consequences are this is a place to start.

The Broken Finance Industry II: Crisis, Adaptation, Innovation and Value? The Finance Industry brought itself and us to the brink of disaster thru bad practices and poor management. But effective capital markets are vital to the health of the economy. Now we need to consider what's broke, how to fix and how govern the Industry for its own benefit and the health of society.

Facing the Firestorm: Finance Industry, Popular Anger and Re-regulation The Finance Industry appears to have returned to profitability on the back of public funds and government support programs. Its refusal to acknowledge that debt is leading to a tidal wave of initiatives for regulatory and legislative reform which will be made worse by a refusal to constructively cooperate. Society needs a productive Finance Industry and will get it either voluntarily or otherwise. The Industry's refusal to see these pressures will make things more difficult than necessary, but are unavoidable without leadership and a sense of social responsibility.

The Corporation vs Society: Performance, Social Responsibility and the Win-Win The unfettered free market was supposed to bring enduring prosperity but recent history shows that markets and participants are not self-regulating. In fact markets require an institutional framework to work, publicly responsible behavior by participants and appropriate regulatory frameworks to balance private gain with public welfare. The results are better performing markets that are sustainable.

The Chinese Goldsmith, Finance and the Next Big Fight The last several months have seen partisan fight after partisan fight in Washington, often leaving us average citizens as innocent bystanders or even collateral damage, or so it seems to many people. Now we've been focused on the Healthcare Reform fight and the debate on Afghanistan. The big fight you may be missing is the one over Finance Industry Reform. It was back-burnered because of the urgency and importance of immediate business, e.g. saving the country from economic collapse, but is moving center stage. Like many of the stakeholders in HC Reform those in Finance have been fighting to water down the bill but in this case with less justification, if possible, more smoldering anger among the public and, with this week's announcements. The Industry argues that the last two quarters of monumental bonuses are right, proper, the way they do business, indicate a return to health and good for the economy and country. The country's mood is probably captured by the cartoon collage but just in case were wondering how angry people are check out this video clip from Dylan Rattigan's Morning Meeting. The question is who's right?

Banks Hate Banks, Voters Hate Banks: Hear the People Singing! We're going to stick with Financial Reform for a while because so much has happened in the last week, and even more importantly, because it's such an important, even critical, issue. In some ways, though not all, Financial Reform is the single most important domestic policy challenge after stimulating the economy. Healthcare Reform as well as Education, Energy and Innovation are probably more important in the long-run but to get there we need to have a healthy, reliable and effective Finance Industry. Setting aside the natural anger that almost all of us feel about the last two years, which should be counter-balanced by the fact that we all rode the gravy train for the last three decades, we've concluded that the policy and business cases for not reforming Finance do NOT hold up, and in fact are completely contradicted by the facts and the economic history. But, like almost every other major policy initiative, we're now having to pay the Piper for that three decades party, before he comes to collect with claymore in hand

 

Posted by dblwyo at 01:45 PM | | Comments (0)

November 17, 2009

Reality vs Delustion Check: Earnings, Performance, Outlook (Updates)

It's time to return to our knitting, a bit, and focus on business performance. But we're going to come at by combining readings and comments on earnings and key company stories with a composite view on earnings, earnings/PE outlooks and some economic data. Having built up all this machinery digging thru PEs, Profits and the Economy it seems like a perfect opportunity to bump the financial data against the economic information and outlook. So in the readings section you'll find some very interesting stories providing an overview of the earnings story followed by another major section with specific stories on the Banking Industry, Auto Industry (the "Task Force"), WMT, Berkshire & Warren, Merck and MSFT & AAPL. Each selected not just because they a names but because they are deeply representative of key trends and issues in their industries.

Earnings Reporting and Outlook

 About 90% of the SP500 have reported and apparently 4 of 5 have beat estimates on the high side. Which is one of the best numbers in a long time. Of course it helps that YoY comps are against pretty bad numbers and that tailwind will work even more in everybody's favor next quarter. The interesting thing, especially with the energizer market running like crazy, is that heading into this season the headline mantra was something like "we believe the economy's recovering, that they'll beat, but will they grow revenue?". The answer is that they didn't. And that's after managing earnings expectations down again. And playing what's increasingly the unusual game with as-reported earnings vs. unadulterated ones.

This table is worth your time to read, parse and contemplate. It shows the Earnings, % Change and PE Actual/Estimates from several different time periods direct from S&P (Dec08, and Feb/Jun/Aug/Nov09) for two time periods, varying with the time the estimates were issued.

In Dec08 for example the estimate was for $65.73 for 2008 but it came in at $49.51. The 2009 estimate started at $81.52 for a 24% increase, then dropped to $68.88 and 19.2% by Feb09. By Jun09 the estimate was down to $55.61 for only a 12.3% increase, dropped to $54.28 in Aug09 and is now at $56.39. Seems to have converged but does that give you a huge hit of confidence?

Continued ....

Meanwhile the Nov09 estimates for 2010 are for earnings of $75.03 for a 33% growth rate with a PE of 14.57. Now that's not an outrageous PE estimate though from our earlier (many times) assessment it's pretty optimistic. But a 33% growth rate seems more than a tad optimistic based on the last thirty economic posts and the data we're seeing. In any case $75.03 X 14.57 = 1093 on the SPX! Hmmm....to say the least.

Earnings & PE History and Outlook

The next pair of charts look at Operating vs As Reported earnings and PE's historically for 1988 thru the quarter before this one and forward to 2010. Apparently this little modest recession we went thru isn't going to have any serious impact on earnings or valuations in the opinions of S&P analysts. One of the things we found fascinating was the growing gap between Operating and As Reported earnings. Now OpEarn are pre-finance and other screwing around while AsRptd are after all the maneuvers any CFO can think of are included. Nonetheless they tracked very well indeed from 1988 thru 1998, even 2000. But that gap has been growing (as the red trend lines show).

Now it looks to us as if we starting to rapidly segue from the reality to the delusion part of our title. Shall we pause a moment to let you contemplate these charts? We really urge you to think about it. At the end of the day the key to this is how's the economy going to grow - a topic on which we've waxed eloquent from time to time. Even if we say so ourselves.

Re-introducing Economic Realities

 To get a better idea of how realistic those estimates are let's retrieve a couple of charts on Profits from the National Accounts as compared to GDP and another on historic PE Ratios from S&P's own data. NB: on the latter it's interesting that S&P have just completed a major re-design and overhaul of their web site and, for the life of us, we can't find the historical data we used to generate the chart. Nonetheless give that parts of it run back to 1936 we've probably got what we need. Certainly with the National Account data running back to 1950 reliably we're in good shape.

On the top chart we'll repeat the key point - up until de-regulation Profits grew cumulatively right along with GDP. Then there began to be a major divergence with Finance profits booming thru the roof while Non-Finance profits lagged GDP until this decade.

That latter is an important telltale - the reason we had a jobless recovery is because companies were neither hiring nor investing in capital equipment. With earnings coming in strictly on the basis of cost-cutting and not revenue growth, with a very week economic outlook and an extended period of below potential growth what do you think the future will look like. The there's the Finance profits. Judging from Street behavior over the last several months they think it's business as usual (BAUie!). We think we're never going to see the new normal finance industry looking like the ond one and have realy dug into their business performance analysis to back that up.

Finally there's the historic PE data. We won't repeat ourselves but judging by the historical averages the PE's in S&P's outlook are, shall we say, a tad aggressive. Which leads to the question that sets up the whole last section of the readings selection. We'll let you take yourselves thru those, even if it's only to skim our excerpts. But you have to ask yourself where's the performance going to come from?

The reading set we found extraordinarily fascinating was Steve Ratner's article and interview after he finished up with the Auto Task Force. You know what their major finding was? That management and execution was beyond abysmal. Think about that - allegedly bad enough for the government to have to take over two major corporations (one of which - Chrysler - they thought not worth saving). But for them to find appalling bad management ... well what more can we say?

If all of our economic analysis is anywhere close to target the entire next decade is going to call for extraordinarily competent management on the part of business. Based on all this how likely are we to see the necessary performance in the new normal of the reset economy?

UPDATES: Two TechTicker clips have been added on WMT and retail that are very telling IMHO. Take a listen when you get the chance.

NB: we know the title has a mis-spelling (Delustion instead of Delusion but just wait and watch - it'll turn into a point!).

 

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Earnings Outlook vs Business Performance

Earnings likely to trend lower This morning I wanted to expand on last Wednesday's "The Earnings Season Racket," in which I questioned the business media's preoccupation with third-quarter earnings beats. My conclusion in that column was that third-quarter 2009 beats are overhyped as they are the outgrowth from lowered guidance. Underpromising and overdelivering is the oldest game in the investor relations handbook, as earnings expectations are often cagily crafted by corporate managements. In turn, many Wall Street analysts, emulating Ralph Wanger's zebras, follow that company guidance in adopting a herd mentality that morphs into a Wall Street consensus. To be sure, I am being somewhat hyperbolic. Not all Wall Street analysts are lemmings or are simply providing maintenance research. There are still (and always will be) research stars. But, in the main, a variant view from the sell-side consensus is relatively rare, as the middle of the Wanger's herd of zebras seems to provide a security blanket to most analysts. This helps to explain why on average over the past decade, over 60% of reporting companies beat consensus, with a range through thick (economic expansion) and thin (economic contraction) of between 45% and 80% beats. So amazingly, even through the very thin (recession), there has never been a single quarter in 40 quarterly periods in which under 45% of reporting companies didn't beat consensus!

Admittedly, the improving trend in recent earnings beats (from the low in fourth quarter 2008 of 54% to the current beat rate of over 75%) is important, but it could be argued that the most recent quarter's historically large earnings beat rate might have been favorably impacted by the lowered guidance and reduced expectations made during and immediately after the credit crisis. Even though the percentage beat rate is now at the highest level since third quarter 2006, which had a beat rate of 72%, the fact that over 75% of reporting companies in third quarter 2009 exceeded consensus expectations may be less impressive than has been evinced in this month's endless media celebrations.

Beating the Street is easy: Companies game the system to surpass earnings estimates More than 80 percent of major companies reporting third-quarter results this month have beaten Wall Street expectations. So is business that good? No. Are companies gaming the system? Yes. Corporate America has a habit of low-balling the earnings forecasts used by analysts to determine their estimates. That way, the bar is lower, and companies can easily jump over when the quarter's results are announced -- even if profits and revenues have fallen off a cliff. "Over the last decade, there's been a distinctive tendency for companies to underpromise and overdeliver," says Dirk van Dijk, chief equity strategist of Zacks Investment Research. "Lately companies are being even more cautious. They realize investors can very harshly punish any company that disappoints." Beating expectations generally gives share prices a quick lift, but the news can mislead investors about the real state of the business -- and just how far this economic recovery has to go. In fact, of the companies reporting third-quarter results so far, 60 percent have posted lower net income compared with a year ago.

U.S. Earnings Are Strong, But Not Sales  A record number of U.S. companies beat earnings expectations in the third quarter, but a big portion of their profits came from cost-cutting, disappointing investors who were hoping for boosts in revenue. With nearly all of the companies in the Standard & Poor's 500-stock index reporting their numbers, 80% did better than Wall Street analysts anticipated, according to Thomson Reuters. That's up from 73% last quarter, which tied the previous record. Revenue is on track to fall 10%, but that is what analysts were expecting. The worry is that without a meaningful upturn in U.S. sales, cost-cutting can only boost profits for so long. "It goes to the heart of the question about the recovery," said David Kostin, equity market strategist at Goldman Sachs. "Are we going to get some end-demand picking up that is more than just inventory rebuilding?" The good news is that companies are running so lean that should revenue pick up in coming months, operating margins would likely surge, giving a powerful boost to profits. Companies with a strong presence in emerging markets are particularly poised to benefit, because faster economic growth there could drive higher sales. With 93% of S&P 500 companies reporting, third-quarter operating profits are on pace to have fallen nearly 14% from the third quarter of 2008, just before the recession peaked. Analysts had expected profits to fall by 25%. Some 370 of S&P 500 companies beat earnings estimates, the highest since Thomson Reuters began keeping track in 1994 and well above the 61% average in that time frame. Roughly five companies beat expectations for every one that disappointed.

Are banks starving the recovery? The government and the Federal Reserve are pumping money into the economy as fast as they can, yet the supply of money in the economy has started to fall -- and that, in turn, could endanger the entire economic recovery. The Fed is buying mortgage-backed securities ($1.25 trillion) and debt from Fannie Mae and Freddie Mac ($200 billion), expanding its lending to banks by keeping interest rates close to zero and buying up U.S. Treasurys. All that, according to the textbooks, should be flooding the economy with money. And that's exactly what you're supposed to do to get the economy running again and to avoid turning the Great Recession into a rerun of the Great Depression. (And if you need a reminder about a recovery going into reverse, try my soothing story on the recession of 1937.) Despite everything the Federal Reserve has done to pump money into the economy (and don't forget the $787 billion stimulus package passed by Congress), money supply as measured by M2 actually declined in the four weeks ending Sept. 14. And that's because what's called the velocity of money, the speed with which a dollar moves through the economy, has fallen. The good news is that it's pretty clear what the problem is. The bad news is that it's not at all clear how to fix it. The problem is that the banks still aren't lending. They're sitting on a huge proportion of all the money that the Fed is pumping into the economy, and because the money they're sitting on isn't moving, that's putting the brakes on the velocity of money.

Stay lean even post-recession If ever you were entitled to start breathing easier, now would seem to be the moment. So why am I telling you not to? The end of the recession seems so close that you can almost smell it. The stock market is surging, China and India are firing on all cylinders again, and no one would be surprised if in the next quarter the U.S. economy shows signs of growth too. Yet this is exactly the wrong moment to let up on the mean and lean strategies you've adopted over the past year and a half. In fact, it's time to go further and develop a new, even tougher mindset: managing for -- yes -- the next recession. Downturns are only a small part of the economic cycle, but they are the moments when the pecking order shifts -- and when entire sectors change in ways that last for years. Think of how the landscape shifted among investment banks (Goldman Sachs stronger than ever; Lehman Brothers and Bear Stearns gone for good) and automakers (Chrysler bankrupt and bought; Toyota roaring past GM). The primary factor in determining which companies won and which lost was the way they were managed during the boom. So now that the next expansion is about to start, it's time to make sure not only that you grow and succeed, but also that you position your business to prevail in the inevitable next recession. Three imperatives:

Bankruptcy Rise Slows  The bankruptcy boom is going bust -- for now. The financial crisis created one of the worst periods in U.S. history for corporate bankruptcies, felling the likes of Circuit City Stores Inc., General Motors Corp. and CIT Group Inc., the giant lender to small businesses. Now corporate failures have slowed, as companies once on the verge of default have found a new life. These companies are now refinancing their balance sheets with new debt, pushing out maturities on existing loans or using distressed-debt exchanges to avoid a bankruptcy filing. Speculative-grade companies -- or those with "junk" credit ratings -- have issued about $123 billion in new bonds this year, compared with roughly $48 billion in all of last year, according to data provider Dealogic. That's on pace to challenge 2006's record issuance of more than $143 billion, Barclays Capital analysts said late last week. Many analysts worry the refinancing wave is just "kicking the can" down the road, without fundamentally fixing companies' deeper problems. Among weaker companies, about $1.4 trillion in bonds and loans will still come due in the next five years, said Dominic DiNapoli of FTI Consulting, a business advisory firm. At the height of the credit crisis in January, Moody's Investors Service predicted that as much as 16.4% of U.S. junk-rated companies would have defaulted in the past 12 months. Some analysts said the default rate might not peak until early 2010.

Now, Moody's expects that U.S. default rate to peak at 13.6% this month and fall to 4.4% a year from now. Despite maneuvers like these, the debt totals coming due over the next five years represent "a staggering amount of money," said Michael Imber, who does restructuring work for financial-advisory firm Grant Thornton LLP. He and other experts said many businesses will remain challenged amid 10% unemployment and still-fragile markets. "Nobody can forecast revenue right now. The consumer is still unsteady," Mr. Imber said. "There is going to be a steady stream of problems ahead of us."

Business Readings

Big banks take your money and run A river of cash has flowed into the biggest banks over the past year. But for borrowers, it has been more of a meandering stream. Deposits at the top five bank holding companies soared 29% in the year ended June 30, according to the Federal Deposit Insurance Corp. All told, the five biggest deposit-taking banks added $852 billion in core deposits over the past year -- essentially checking and savings accounts of less than $100,000. Over the same period, their loan portfolios rose by just $564 billion. Some fear the lending gap could hamper chances of an economic recovery. Federal Reserve governor Daniel Tarullo told Congress this month that commercial bank lending has declined through most of 2009, "with particularly severe consequences for small- and medium-sized businesses, which are much more dependent on banks than on the public capital markets that can be accessed by larger corporations." Of course, the slower loan growth is hardly a shocker. Loan demand naturally drops off during a recession, as consumers and businesses pay down debt and build cash reserves. The latest Fed senior loan officer opinion survey cited weaker demand for all sorts of loans -- particularly industrial loans and commercial real estate loans. Banks have also been reluctant to lend since they have been taking big hits as existing loans go sour as well. Commercial net loan charge-offs hit 2.06% in the second quarter -- their highest level since the government started tracking the data in 1988, according to the Federal Financial Institutions Examination Council. Still, evidence that the banks are sitting on cash won't sit well with the growing chorus of bailout critics. Big banks have come under fire for resisting plans to reduce the risk of another financial sector meltdown and for handing out huge pay packages at a time when jobs are disappearing.

Auto task force shocked by state of GM, Chrysler The shockingly poor financial management of General Motors and Chrysler weakened their case for a government bailout, but officials feared letting the automakers collapse would severely harm the U.S. economy, the former head of the Obama administration's auto task force says. In a first-person account posted on Fortune's Web site Wednesday, Steven Rattner said he was alarmed by the "stunningly poor management" at the Detroit companies and said GM had "perhaps the weakest finance operation any of us had ever seen in a major company." GM's board of directors was "utterly docile in the face of mounting evidence of a looming disaster" and former GM chairman and chief executive Rick Wagoner set a tone of "friendly arrogance" that permeated the company, Rattner wrote. "Certainly Rick and his team seemed to believe that virtually all of their problems could be laid at the feet of some combination of the financial crisis, oil prices, the yen-dollar exchange rate and the UAW," Rattner wrote. Rattner said the task force was divided on whether to save Chrysler. Chrysler was poorly run during its alignment with Daimler AG, and "larded up with debt, hollowed out by years of mismanagement, Chrysler under (private equity firm) Cerberus never had a chance."

A visit to Wal-Mart’s home “Control your expenses better than your competition. This is where you can always find the competitive advantage.” That was said, simply enough, by Wal-Mart (WMT) founder Sam Walton. And though today it’s widely known that Wal-Mart is the world’s most efficient retailer, a little-known fact is that for 25 years–long before Wal-Mart became America’s largest retailer–it ranked No. 1 in its industry for the lowest ratio of expenses to sales. Efficiency runs in the water here in Bentonville, Arkansas, where I’ve spent the past 36 hours. I hadn’t been to the center of the retail universe since 1996, when Wal-Mart crossed the line of $100 billion in annual sales. This past year, the company, which started in 1962, crossed the $400 billion line. And while it’s now 17 years since Sam has died, the rules he established when he opened his first five-and-dime, on Bentonville’s town square, still apply. On Monday night, when I had dinner with Wal-Mart financial services president Jane Thompson and seven other corporate officers, everybody chipped in $20 a piece for the wine. That’s because Wal-Mart’s founder refused to pay for alcohol of any kind.

How Warren Buffett manages his managers Jacques said that the best advice she’s gotten from Buffett comes in a memo that he sends to his 77 All-Stars every couple of years. Every memo includes some version of this message: We can afford to lose money–even a lot of money. We cannot afford to lose reputation–even a shred of reputation. Let’s be sure that everything we do in business can be reported on the front page of a national newspaper in an article written by an unfriendly but intelligent reporter. In many areas, including acquisitions, Berkshire’s results have benefitted from its reputation, and we don’t want to do anything that in any way can tarnish it. Berkshire is ranked by Fortune as the second-most admired company in the world. It took us 43 years to get there, but we could lose it in 43 minutes. “This is the mantra I use every day in both my personal and professional life,” Jacques said, noting three more pieces of wisdom from Buffett: “Think like an owner. Tell us bad news right away. And if you don’t know jewelery, know your jeweler.”

Merck in a post-blockbuster world When Richard Clark was named CEO and president of Merck in 2005, the drug behemoth was reeling in the wake of the Vioxx scandal, which in 2004 forced the company to withdraw the blockbuster painkiller for safety reasons. Since then, Merck has shrunk in size and faced additional challenges, such as multiple lawsuits over Vioxx and other medications, and the expiration of its blockbuster statin Zocor (for lowering cholesterol) in 2006. Under Clark, the company has sought to reorganize its research approach to embrace more acquisitions and collaborations; late this year, the company plans to merge with drug giant Schering-Plough to form the world's second largest pharma company. Clark, who's been with Merck for 37 years -- most recently as president of the Merck Manufacturing Division -- recently took time out during a health care summit at the Cleveland Clinic to give his first one-on-one interview in two years. In the excerpts that follow, he reflects on the state of his industry, the likelihood of universal health care, and the future of the Big Pharma business model. What letter grade would you give pharma right now? When it comes to intent and focus, and when it comes to a sense of better transparency, collaboration and better management, I give us a high grade. Critics say that Big Pharma companies have lost the knack to innovate like they used to. Do you agree? If so, why is this happening? I think different companies in our industry are trying different models to accomplish this. It requires an external view, a transparent view, and much more collaboration. We need a very strong, science-based, well-resourced FDA; we need health-care reform; we need intellectual property protection on a global basis; the NIH needs to be resourced correctly; we need better science in our schools. The focus on public health and the ability to make a difference in people's lives is the core of the pharmaceutical industry. What does Big Pharma do best within this ecosystem, and what does it not do so well? The heart and soul of any pharma company is basic research and intellectual capital. The second is in clinical development. Not all good science is created at Merck, we know that. Perhaps 1% of it is at our company. We're much more externally focused than we ever have been. How is the blockbuster model shifting, or is it failing? Now I see the model as a combination model. You can see novel compounds still coming out of the traditional model that will benefit a general population on a global basis. So it's not a model that needs to be totally disregarded. Having said that, we have molecular profiling technology, genomic focus, RNAi (RNA interference) -- you can certainly focus more from a gene standpoint on a disease and determine how to treat it. And that leads to a more personalized medicine or a subpopulation that you're aiming at with a particular mechanism or compound. It also allows you to eliminate or kill projects early. This is a radical shift for Big Pharma, moving from the one-drug-for-one-target model. It was very lucrative, too. Is this a true sea change? I've seen more change in Merck's laboratories in the last five years than in the previous three decades. Not only are we changing the thought process around the science to focus more on subpopulations and targeting gene analysis, but we're also bringing in scientific leaders that give us a competitive advantage, along with our acquisitions of GlycoFi, Sirna, Rosetta, and other companies. The proof is in the pudding: Will you see compounds come through the pipeline from a rapid and safety standpoint to meet the need?

Pfizer Broke Law by Promoting Drugs for Wrong Uses In Violation of Pledge ProsecutorMichael Loucks remembers clearly when lawyers for Pfizer Inc., the world’s largest drug company, looked across the table and promised it wouldn’t break the law again. It was January 2004, and the attorneys were negotiating in a conference room on the ninth floor of the federal courthouse in Boston, where Loucks was head of the health-care fraud unit of the U.S. Attorney’s Office. One of Pfizer’s units had been pushing doctors to prescribe an epilepsy drug called Neurontin for uses the Food and Drug Administration had never approved. In the agreement the lawyers eventually hammered out, the Pfizer unit, Warner-Lambert, pleaded guilty to two felony counts of marketing a drug for unapproved uses. New York-based Pfizer agreed to pay $430 million in criminal fines and civil penalties, and the company’s lawyers assured Loucks and three other prosecutors that Pfizer and its units would stop promoting drugs for unauthorized purposes.What Loucks, who’s now acting U.S. attorney in Boston, didn’t know until years later was that Pfizer managers were breaking that pledge not to practice so-called off-label marketing even before the ink was dry on their plea. On the morning of Sept. 2, 2009, another Pfizer unit, Pharmacia & Upjohn, agreed to plead guilty to the same crime. This time, Pfizer executives had been instructing more than 100 salespeople to promote Bextra, a drug approved only for the relief of arthritis and menstrual discomfort, for treatment of acute pains of all kinds.

To Rebuild Windows, Microsoft Razed Walls To build its new operating system, Microsoft Corp. needed to do more than fix the flaws of its predecessor. The company also had to address major bugs in its software development process. The three-year effort to create Windows 7, which lands on store shelves this Thursday, was marked by closer collaboration between the thousands of people working on aspects of the high-stakes product—reducing communications breakdowns that contributed to delays and defects in Windows Vista, one of the company's biggest missteps. A key problem was that the Windows team had evolved into a rigid set of silos—each responsible for specific technical features—that didn't share their plans widely. The programming code each created might work fine on its own, but cause technical problems when integrated with code created by others.

Apple earnings: How the analysts got it so wrong "Well, that was quite embarrassing!" writes "deagol," a widely read amateur analyst whose estimate of Apple's (AAPL) fourth quarter earnings fell 16% short of the record profits the company reported Monday. The irony is that deagol, who filed a long post-mortem mea culpa on his website Monday night, had less to be embarrassed about than 18 of the 19 Wall Street analysts we polled in advance of Apple's fiscal 2009 4Q earnings report. (See The Street awaits Apple's earnings.) Once again, the amateurs and independents out-performed the professionals in our quarterly Apple analyst bake-off. The color-coded spreadsheet is pasted below the fold. But first, some general comments about why everybody failed to predict that Apple's profits would grow 46% or that the company would sell a record 3 million Macs — up 17% in a quarter in which its competitors, selling cut-rate Windows boxes at razor-thin profit margins, grew an anemic 2%. (See here.) The key misses: Macs. Apple was right and Microsoft's (MSFT) Laptop Hunters ad campaign was wrong. Consumers — or at least enough of them — were shopping for user experience, not low prices or spec lists. iPods. Although Piper Jaffray's Gene Munster dismisses the iPod as "no longer an investable theme" due to cannibalization from the iPhone, iPod touch sales were up 100%, suggesting that there may be still be life in the category. iPhones. A record 7.4 million sold even though Apple couldn't build them fast enough to meet demand. We won't even talk about Jim Cramer, who told his Mad Money audience that because of this, Apple's share price was going to fall — not explode as it did in after-hours trading. ASPs. Average selling prices actually went up a bit, rather than down as you might have expected after back-to-school sales and price cuts on iPhones and MacBooks. Deagol attributes it to 15" and 17" MacBook Pros getting "crazy popular" among college students. Taxes. For reasons I can't begin to explain, Apple's effective tax rate was 25.6%, not the 30% they had guided.

Has Apple blown it? Did the company squander the competitive chance of a lifetime? I know Apple (AAPL) is an investor darling trading near an all-time high. And I know the company’s products have tremendous consumer cache. So much so that the company is able to sell its iPhones and iMacs for prices well above those charged by competitors. But it still looks to me that Apple has missed its chance. It had a limited window of opportunity when competitors such as Microsoft (MSFT) couldn’t do anything right and it didn’t turn that opening into a big enough share of the personal computer market. It was first to market with a game-changing smart phone but the company has pursued a high-end niche strategy with the iPhone that has left the door wide open for Google (GOOG) to grab for the mass market. If this is as good as it gets for Apple, the company has no one to blame, finally, but itself. The opportunity was there and Apple didn’t exploit it as ruthlessly and as relentlessly as it needed to. Here’s my basic problem with Apple’s strategy and execution: The company didn’t kick ‘em hard enough when they were down.

Posted by dblwyo at 10:04 PM | | Comments (0)

November 15, 2009

Carry Me Out to 'ol Rateginny: Markets, Dollar, Gold, Rates

Time to tag up with the current market situation, starting with two facts we think we've argued and established for months now. The economic outlook is poor for a long time and the market has run and run on sentiment. Beyond that it's fair to say everybody's been scratching their heads so hard we're all balding or worse. But there's a rapidly emerging general consensus for the short-term outlook - this is all about the dollar carry trade. Dollar up, markets down, risk off and visa versa - or as my buddy MacroMan puts it some other pool trade gets the Pink Flamingo. Now we've just spent a whole bunch of time digging thru all the complexities that are artifacts of a policy-driven environment and the whys and wherefores and have found most of the shibboleths poorly grounded in the deep realities. But plausible enough to get some attention. As long as the Employment outlook is terrible rates will stay low and dollars sitting on bank books will be loaned out to hedgies tne carry traders. Which makes this, like all turbulent and unsettled systems incredibly fragile and vulnerable to surprises. Which means the risks are mounting and mounting while the likely returns are retreating and retreating, at this likely earnings growth rates and valuations, at any rate (puns implied and intended!). Prieur du Pleiss (hattip) gets it right with this cartoon.

Main Street for Real

Now a small word of graphic design warning - we want to go whipping on thru several current situations that we've covered before so you can see them all together and recently. But we aren't going to spend a lot of time re-dissecting things so the graphics will be a tad small so click to enlarge. On the other hand there's a rather large inventory of readings and links that you might want to browse, skim and click thru and read where they catch your eye. Something for everybody and everything on the anomolies for somebody.

The composite graphic puts the points on the Wall St. vs. Main St. themes though. Even though the statisitcal economy has turned the corner you'll note that the pain on Main St. is all to real. That's since a) retail sales despite turning up is still badly down YoY, b) is about as bad as it's been AFTER turning up, since 1960, and c) Employment is still headed down despite the upturns to "not as bad as it was" for GDP and Consumption. Having spilled lots of ink we'll leave it there but it sets the stage for looking at some market stuff.

 

Updates:

We ran across a whole slew of interesting stories and commentary that will go into the next big market post but we wanted to draw your attention to them as they're a) from reputable sources, b) explore themes we've been poking at and c) tie in nicely to the storyline of this post. We'll just list them here, suggest you clickthru and skim them but please note the storyline that's been evolving, the new meme in widespread circulation is now something like this:

Weak Recovery => Poor Job Creation =>

Sustained Low Rates => Dropping Dollar =>

Carry-driven Rally Across All Asset Classes =>

Poor Fundamentals + Rising Risks = Fragile Running Rally

On that note we leave you with the following links plus the accompanying over-compressed and compacted chart. Notice that despite yesterday's huge gap up the SPX is still below the downtrend AND the downtrend and the next Fibonacci resistence level converge almost exactly. The other sub-charts are left for your decoding pleasure but bounce them against these links and the theme we just sketched.

SPX: Same 'ol, Same 'ol

Starting with a 9Mo and 3Yr SPX chart which kinda highlights the point. The short-term market is still running for the sky (why does "slipped the surly bonds of earth" come to mind? Look it up - great poem but the guy who wrote it got shot down a few weeks later). Meanwhile on the 3YR chart the downtrend still looks intact to us. What about you?

Interestingly enough the gut check that the market is "fading" or "feeling toppy" gets born out by the TRIX (a version of the MACD) slow deterioration. On the other hand the Acc/Dist indicator is still climbing. Which tells us everybody's still in this for the ride. That is they're looking to hang on to the Pink Flamingo as long as it's breathing and hand it off like a hot potato before it stops. Don't they call that the "greater fool theory"? You might also notice that the VIX has climbed back to 30, which used to be a reliable indicator of trouble before we knew what trouble really was.

All That Glitters: Dollar vs. Gold

Speaking of carry trades you might want to look at this set of SPX vs Dollar and Dollar vs Gold charts as symptomatic of all these interesting things going on. The top sub-chart is the SPX:$USD ratio matched up with them separately. Took a good look - first they went down together, then disaster struck and the went mirror image during the flight to save me. Now the mirror image thing is still going strong.

The bottom chart is the Gold:$USD Ratio matched up with Gold and $USD separately again. Fascinating for a while there that the "store of value" went down in '08 while the $ was going up. Betcha it's for roughly the same causes. Remember this all goes back to policy and the fears of inflation and a collapse in the dollar, at least in theory.

If you want a good short-term take on the outlook for Gold to bump all this against from a Trader's technical perspective we suggest you take a gander at this online presentation (make sure the volume is turned up).

Briefly these guys are expecting a possible short-term pullback which they see as a buying opportunity. We think they're a) probably right and b) better technicians with a slicker set of tools than we've got. We also think this is also dancing on a fragile crust over deep quicksand. Bottomline here, as in all these markets, this is pure trading or speculation. NOT investing.

Looking for the Secret Name and the Hidden Magic

Now in all the not-so-great fantasy and sword and sorcery novels running around since everybody decided they could be another prof. tolkien the trick is to know the magic word or the secret names of things. (BtW - tolkien's name is not capitalized deliberately as there's only one Tolkien). Similarly the search for the magic pattern that turns apparent chaos into mere turbulence where we understand what's going on and can manage it is our current magical theory. To the best of our efforts at detective work it is indeed the secret name - it's certainly gotten widespread acceptance, convergence and conviction. We're reminded of Bob Sutton's favorite phrase though - "strong opinions weakly held" and subject to evidence-based testing. We're not sure much of that is going on.

Part of that search for the secret name is this looksee at the 10YR Treasuries and Gold. Start with the bottom chart showing TNX and IRX (10Yr & 3Mo). When the ratio rises that tells us the yield curve is getting steeper. In the collapse it was back IRX went to zero. Now it's because the credit markets are anticipating a poor recovery. Notice also that that after a big crisis dip the 10Yr has climbed back up and STOPPED. If there were serious anticipation of either rapid growth and/or inflation that wouldn't be the case. It's stopping around its downtrend limit from the last couple of years. The GOLD:TNX ratio is back on a major downtrend because long-term rates are continuing down a bit and Gold is climbing on flamingo passing (btw - if the true meaning of that catchphrase keeps escaping you check out MacroMan's blog where he conceives, explains and exploits the term).

Another interesting little thing happened last week - some NYU profs published a study that found that Buy-N-Hold didn't perform as well as informed investing over the last decade. Wow, can you imagine that. Barry Ritholz over at BigPicture has some interesting perspectives but we think he gets it right. And in our nomenclature it would be a) understand the structural and fundamental characteristics of the current stage of the cycle and b) put your investments in the right asset buckets to reflect where the indicators tell us we're at and going based on c) reasonable valuations and return expectations.

Shall we spell that out? Now is the time for all good investors to not depend on faith, hope and charity but to understand this is a trader and speculator's market. If you're willing and able to play that and want to run with the bulls a while longer feel free. But start looking for the exists. And if you're comfortable with the chances of getting gored or don't have insurance start moving toward safety.

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Current Markets

Words from the (investment) wise for the week that was (November 2 – 8, 2009) The Federal Open Market Committee (FOMC) maintained its extraordinarily accommodative monetary policy following its meeting on Wednesday. The communiqué had no surprises and said that the committee expected to keep the fed funds rate target in the 0-0.25% range “for an extended period”. As expected, the European Central Bank (ECB) and the Bank of England (BoE) also kept interest rates unchanged at 1% and 0.5% respectively.“A hesitant economic recovery, tame inflation and severe credit headwinds suggest that monetary policy will need to stay very easy for at least another year. Liquidity trends will not be a constraint on higher prices for risk assets for a while,” said BCA Research.The jump in the unemployment rate to a 26-year high of 10.2% in October - an increase of 0.4 of a percentage point - reminded pundits of the challenges in the labor market and broader economy. While investors’ hopes of an economic recovery might have got ahead of reality, the cartoonists continually reminded us of worrisome issues … The past week’s performance of the major asset classes is summarized by the chart below. Gold bullion was the star of the week, especially subsequent to the purchase by India’s central bank of 200 metric tons of gold from the International Monetary Fund. The price jumped by 4.7%, recording an all-time high of just over $1,100, with platinum (+1.7%) and silver (+6.6%) also handsomely higher. Referring to the surge in the gold price, the quote du jour this week comes from long-timer Richard Russell, author of the Dow Theory Letters. He said: “An integral part of our prosperity since World War II has to do with the dollar as a reserve currency. As the world’s reserve currency, we could print our ‘wealth’ and the world would accept it. That ‘free lunch’ is now in the process of changing. Moving on to government bonds for a moment, the ten-year US Treasury Notes yield has risen by 33 basis points since the October low as financial markets adopted a more upbeat outlook on the economy, while also grappling with concerns about massive issuance and inflationary pressures. As highlighted in a post a few days ago, the chart below shows monthly data for the ten-year Treasury Note yield since 1998 and conveys an important message when considering the two momentum-type oscillators at the bottom (ROC and MACD). The ROC has just reversed course (crossing the zero line) for the first time since a buy signal was given at the beginning of 2007 and now indicates a primary sell signal. The MACD provided a similar indication six months ago.

Stocks, Commodities Soar, Dollar Falls on G-20 Stimulus; Gold Sets Record Stocks and commodities rallied and the dollar plunged after the Group of 20 nations agreed to maintain measures to boost economic growth and remained silent on the U.S. currency’s weakness. Gold advanced to a record. The MSCI World Index of equities in 23 developed countries increased 0.9 percent at 12:05 p.m. in London and futures on the Standard & Poor’s 500 Index climbed 0.9 percent. Russia’s Micex Index added 3.7 percent. Gold gained as much as 1.3 percent to $1,109.50 an ounce and crude oil jumped 2 percent. The dollar weakened against all 16 major currencies tracked by Bloomberg. Policy makers from the U.S., U.K., Japan and 17 nations said on Nov. 7 that it’s too early to withdraw spending intended to revive growth. European Central Bank President Jean-Claude Trichet said before the G-20 meeting that “excessive volatility” in currency markets is damaging and a strong dollar is important for global economic stability. “Markets don’t need to be worried that these governments and central banks are suddenly going to take away all the stimulus measures,” Stuart Bennett, a senior currency strategist at Calyon in London, said in an interview on Bloomberg Television. “Risk appetite should remain supported into the end of the year.” Equities extended gains after Germany’s Economy Ministry said industrial output rose 2.7 percent in September, beating the median estimate of 1 percent in a Bloomberg survey of 37 economists.

Risk Trade Makes a Comeback  After Group-of-20 finance ministers gave a de facto green light to dollar sellers and vowed to maintain stimulus programs, markets on Monday piled aggressively back into riskier assets. The news from the G-20 meeting pushed U.S. stock averages to new highs for the year, and gave even more fuel to gold and other commodity prices. It also translated into a stronger euro against the dollar and even bolstered U.S. Treasurys, which tend not to benefit as much from improved risk appetites.The Dow Jones Industrial Average climbed for a fourth straight day, to end up 203.52 points, or 2%, at 10226.94, its highest finish since Oct. 3, 2008. The blue-chip measure has risen 4.7% over its recent winning streak. The S&P 500 was up 2.2% at 1093.08, ending just below its Oct. 19 high for the year of 1097.91. Both benchmarks appeared to have overcome the indecisive, back-and-forth moves of the previous three weeks, during which the DJIA lost luster after it broke above the psychologically significant 10000-mark on Oct. 14.In currency markets, the euro was off its highs for the day late in New York trading, changing hands at $1.4990 from $1.4844 late Friday, according to EBS via CQG. That's off from an intraday peak of $1.5021. The dollar was virtually unchanged against the yen, however, at ¥89.99, compared with ¥89.96 on Friday, although it did drop to a low of ¥89.70 earlier in the day. Ahead of the weekend's meeting of G-20 finance ministers and central bank chiefs in St. Andrews, Scotland, there was some fear, albeit small, that they would express concern about a nine-month-long appreciation in non-dollar currencies. But not only did the G-20 delegates make no mention of foreign exchange, they gave strong support to the stimulus policies that have done much to reflate global markets, restore risk appetites and drive the dollar's decline.

For Stock Investors, Bad Economy Isn't Bad First the bad news: The economy is weak. And now the good news: The economy is weak. Oddly, the same problem that worries many investors over the longer term is what encourages some for the short term: a soft economy. The reason is that an ailing economy requires the Federal Reserve to keep its short-term interest-rate targets near zero and continue pumping billions of dollars into the financial system. That is great for stocks because much of that money eventually finds its way into financial markets, and because cheap money keeps financing costs low and pushes corporate profits higher. Economists at Morgan Stanley measure the amount of cash circulating in the global economy as a percentage of total economic activity. Large money injections by the world's central banks have pushed that gauge to its highest level by far since Morgan Stanley began tracking it 30 years ago. So while the basic economic motors such as sales, employment and credit remain on life support, the continued expansion of cheap money means that a basic pillar of the stock market remains in place. Some investors worry that, one day, all the intervention may lead to unsustainable deficits or new bubbles in junk bonds, developing-country stocks or commodities. But that is a problem for later. "First, we enjoy our dinner. Later come the after-dinner speeches," says David Kotok, president of money-management firm Cumberland Advisors in Vineland, N.J. "We have a period ahead of us of low interest rates. Markets love that." He is heavily invested in stocks and says the market can keep rising at least into spring or summer of next year. He believes corporate cost-cutting could continue to lead to higher-than-expected profits even on modest sales improvement. Plenty of investors see things differently. Some are deeply pessimistic, believing that huge government deficits and borrowing will end the market recovery soon and lead to severe inflation or, if the stimulus is withdrawn too quickly, deflation. Others are optimistic, believing that the economy and stock market are entering a long-term recovery that will confound doubters. A surprising number are caught in between, worried about what comes later but trying to profit for now.

Investor Outlook: Befuzzlements Galore

Stock Rally Just Getting Started in History of Period Preceding Rate Rises Stocks around the world are falling at the fastest rate since the worst of the credit crisis on concern central banks will start raising rates, a signal that triggered the biggest rallies over the past three decades. Benchmark indexes from New York to Tokyo to Frankfurt have lost an average of 4.4 percent since Oct. 19 on speculation policy makers will curtail stimulus measures before the global economy revives. History shows stocks have climbed 92 percent of the time in the six months before government borrowing costs began the biggest increases, data compiled by Bloomberg show. Federated Investors Inc., Renaissance Financial Corp. and Citigroup Inc. say investors may miss out on more gains after $12 trillion in spending by governments worldwide pushed the MSCI World Index up 65 percent since March. Shares rise before central banks push up interest rates because markets anticipate economic expansion first, says Linda Duessel, Federated’s Pittsburgh-based equity strategist. U.S. Federal Reserve Chairman Ben S. Bernanke may start to increase borrowing costs in June, according to Fed funds futures prices compiled by Bloomberg. Traders assign a 54 percent chance of an increase to at least 0.5 percent at the end of the Federal Open Market Committee’s meeting on June 23, when the American economy is forecast to be in its fourth straight quarter of expansion, according to estimates compiled by Bloomberg. “You absolutely want to front-run the Fed,” said Douglas Ciocca, who helps oversee $1.7 billion as the managing director at Renaissance in Leawood, Kansas, and recommended corporate bonds in November 2008 before they rallied 30 percent, according to Merrill Lynch & Co. indexes. “If I’m an investor and I see that there’s a small progression toward stimulus extraction, it says to me that the economy is being re-established on a much firmer footing, and that’s very positive.”

Investors Hope It's a 1983 Flashback but...  It's beginning to look a bit like 1983: Stocks are soaring, unemployment is above 10% and the sci-fi TV miniseries "V" is back. Stock investors can only hope for a repeat of that year, which continued the first leg of an 18-year bull market. So far, stocks have behaved much as in the early 1980s. The Standard & Poor's 500-stock index soared 69% between August 1982 and October 1983. Since March 9, it has jumped 58%. Both eras had deep recessions, and fast snapbacks usually follow such recessions. Unfortunately, other similarities are scarce. The market is not nearly as cheap now as it was then. When the 1980s bull market began, the S&P 500 was priced at less than 7 times trailing earnings. Even after a 69% rally, that multiple was just 10 times earnings. The latest rally began with the market at a P/E of 13. The ratio has bloated to nearly 19, compared with its long-term average of 16. In April 1983, when unemployment was last at 10.2%, it was on its way down. Now it looks like unemployment could rise for months. And when the 1980s rally began, the Federal Reserve's key policy interest rate was 11%, meaning it could simply slash rates to get things moving again. Today, the fed-funds target rate is nearly zero. U.S. consumers in 1983 hadn't yet embarked on a 20-year debt binge. Household debt was 62% of disposable income, a level that had endured since the 1960s. That percentage now stands at 122%, even with debt growth stalled for the past two years. The outlook for regulation and taxes is likely different now than in 1983. The market has proven it can endure higher taxes and more regulation, but they make Wall Street squirm.

5 early investing ideas for 2010 The easy money in this bull market has been made, but if you're waiting for a downturn, you're missing out. Here's how to play the key sectors. Stocks have been sailing swiftly this year, but many investors missed the boat by clinging to defensive positions set in the depths of the downturn. Rather than spending it regretting lost opportunity, though, now is the time to make sure your portfolio is ready for 2010. That will likely mean putting money in places that already have enjoyed tremendous returns. Sure, many experts caution that the global economy is anemic at best and that top-performing markets have come too far, too fast. Maybe these sprinters are due for a breather, but you can't ignore them. "Don't be afraid of a weak recovery; that's not going to be a shock to anyone," said Alec Young, an equity market strategist at Standard & Poor's. "Don't be afraid of a weak consumer. Things that everyone's talking about don't move markets." Here are five places to consider putting your money now to set you up for a happy new year:

New crisis ahead? 5 things to watch Thanks to confusion, shortsightedness and anger, global markets are on course to be wiped out by a third -- if we're lucky, renowned bear Bob Janjuah says. If not, expect markets to fall by half. First, Janjuah believes that individuals get it. He says they know they borrowed too much and are reacting by borrowing and spending less, and saving more. This is expected to be a multiyear trend in the face of employment and wage fears, volatility in the economy and confusing messages from policymakers. Janjuah believes the financial sector is largely confused at this point. On one hand, bankers and asset managers fear deep regulation and compensation restrictions, as well as demands to cut their balance sheets under threat of being broken up, taxed to death and vilified. But on the other hand, they are being allowed to use supercheap money provided by central bankers to bid up other financial assets. Moreover, banks are being told that they must cut balance-sheet risk while at the same time lend vigorously to the public, which is a contradiction. From there, the great bear sees three to five years of government, corporate and individual balance-sheet repair in which U.S. and British gross-domestic-product growth limps forward at around 1% a year -- "a long period of repair and refueling." And just for good measure, Janjuah calls this the "least worst outcome" because he thinks it would be more catastrophic if governments responded with more policy measures that further prolonged the inevitable. For those who need to be in stocks, he recommends sticking to "hard-currency, strong balance-sheet" countries such as Australia.

Market ignorance is bliss I do believe with some certainty that the market’s vulnerability to disappointment and/or exogenous events has been elevated and that many apparent warning signs - for instance, a 17.5% underemployment rate, weak consumer and small business (National Federation of Independent Business) sentiment, the unrelenting increase in the price of gold, a steadily declining U.S. dollar, the specter of cost-push inflation from higher commodity prices and so forth - are too comfortably being ignored or are being rationalized away in a tide of rising world stock prices. I now see a far less attractive risk/reward ratio than at any time in 2009 - maybe longer.

Key Assets and Risks

Dark vision - the coming collapse of the municipal bond market This paper is directed to traditional municipal bondholders, those who hold bonds primarily to receive tax-exempt, steady income. That investor generally holds municipal bonds expecting little change in the prices of these securities. That investor welcomes capital gains, but that is a secondary objective. Such investors do not own municipal bonds as speculative securities. They do not get paid enough to do so. They buy municipal bonds for the income, not for appreciation. Today, no matter what one’s reason for owning municipal bonds, there are speculative investments.

Are ETFs Causing an Emerging-Markets Bubble? U.S. investors have pumped roughly $26 billion into emerging-markets funds so far this year. Of that, $15 billion came in through exchange-traded funds -- portfolios that hold every stock in a market benchmark with utterly no regard to price. Several hedge-fund managers and other active stockpickers have told me that this "mindless money" is distorting valuations and pumping up a potentially monstrous bubble. At first blush, it is hard to imagine that they are wrong. As money pours into the ETFs, they must mechanically match their holdings to those in the emerging-market indexes. That forced buying drives up stock prices, attracting still more new money into the ETFs, spiraling stock prices even higher. Mr. Sauter adds that several markets, such as Brazil and Peru, are up roughly 100% in 2009. "Either something has changed quite dramatically," he deadpans, "or pricing has been dislocated from reality. And it's probably a little bit of the latter." Before you panic and bail out of your emerging-market fund, however, you should know that there is a little more to this story than a bubble that so far has refused to pop. ETFs mightn't be the culprit here. And, surprisingly, they may soon be letting some of the air out of the bubble in a controlled release. Vinicius Silva, an analyst at Morgan Stanley, calculates that emerging markets are trading at 12.9 times their expected earnings over the next year. Since 1993, that average has been 12.8 times earnings. Emerging markets as a whole are neither a bubble or a bargain. So what does all this mean for investors? ETFs probably haven't caused a bubble, and they might even help a bit to prevent one from forming. But many will remain superconcentrated bets on very risky markets. If you invest in an ETF with most of its assets in a few stocks and think you have made a diversified bet, the real bubble is the one between your own ears.

A Villain in China's Growth Story?  The bull case for global financial markets hinges partly on belief in a bulletproof Chinese economy. But China is vulnerable to the same Kryptonite that has hurt countless other economies: credit. Fresh evidence of China's strength is expected this week, when the government is due to release data on trade, retail sales, industrial production, consumer and producer-price inflation, money supply and fixed-asset investment. Economists expect the inflation and trade measures to fall from a year ago; they expect other measures to rise by fat double digits. China has supplied most of the world's economic growth in the past three years, according to the International Monetary Fund. While the U.S. and other developed nations are expected to expand sluggishly for years to come, China's economy is widely expected to keep rising at this year's 8% growth rate or better. Most of China's growth this year has been unsustainable, driven by stimulus. China's money supply has risen 29% in the past year. At the government's behest, banks have increased their lending by nearly $1.4 trillion, or 32%, during that time. That flood of borrowed cash has been channeled into new infrastructure and production capacity. These investments will account for up to half of China's gross domestic product this year, according to some estimates. A key question is whether China needs all of this investment. Analysts at the London hedge fund Pivot Capital Management say that China already has enough idle steel-production capacity, for example, to match the steel output of Japan and South Korea combined. Meanwhile, the ratio of investment to GDP is rising, suggesting China's investment is less and less efficient, says Edward Chancellor at Boston asset-management firm GMO. The combination of soaring investment and dwindling returns was seen in Japan in its asset bubbles in the 1980s and in the "Asian Tigers" just before their crises in the late 1990s, he says. These data are hard to measure and subject to much debate. China's economy may turn out to be strong enough to merit all of this investment. But any hiccup in growth raises the risk that these investments become bad debts.

Emerging Shift in Power for the Government-Bond Market The bull market in government bonds is dead. Long live the bull market in government bonds. Of course, it will look rather different. Yields on U.S., U.K., German and Japanese debt have recently risen and are likely to continue to do so. But international bonds sold by emerging-market governments in Eastern Europe and Latin America should continue to rally, pushing yields lower. This could be the start of a shift in relative power in the bond markets. The tensions in developed bond markets are becoming clear as extraordinary stimulus measures start to wane: Yield curves have steepened sharply, and there is greater credit discrimination. The spread between 10-year U.K. gilts and German Bunds, for instance, has widened to more than half a percentage point recently, from around 0.3 point. Demand for short-dated bonds has remained strong, based on a commitment from policy makers to refrain from rate hikes, but investors have increasingly been buying protection against higher long-end yields. Fears have risen over the appetite for 2010's supply avalanche. Contrast that with emerging-market borrowers, who have been tapping the market as risk appetite has built. The spread on J.P. Morgan's EMBI Global index of dollar-denominated debt has fallen to 3.3 percentage points over Treasurys from more than eight points. Even those hit hard by the global financial crisis, such as Lithuania, Hungary and Croatia, have seen good demand for international bond sales. Others are testing the waters: Russian officials visited London to gauge appetite for as much as $17.8 billion of planned bond issues next year that would mark the country's first international sales in a decade. Credit risk -- historically the main driver of emerging-market bonds -- is improving. While investors fret about whether the U.S. and U.K. can hang on to triple-A status, upgrades have been dished out for borrowers such as Brazil and Turkey. Emerging economies are set to bounce back faster from the crisis, helped in some cases by resilient banking sectors. That is supporting government revenues and their ability to service international debt. Emerging-market consumption is also resurgent, recently surpassing U.S. consumption, according to J.P. Morgan. And supply-and-demand is not a millstone around their necks. Barclays Capital forecasts gross emerging sovereign supply of $77 billion in 2010. By contrast, last week alone the U.S. Treasury sold $123 billion of debt. The result is that yields on developed- and emerging-market government bonds are likely increasingly to converge, even though there will be volatility along the way. That would reflect the likely rebalancing of the global economy in favor of emerging markets -- and reward investors who are willing to rethink risk.

Gold - a six thousand year-old bubble Gold is unlike any other commodity.  It is costly to extract from the earth and to refine to a reasonable degree of purity.  It is costly to store.  It has no remaining uses as a producer good - equivalent or superior alternatives exist for all its industrial uses.  It may have some value as a consumer good - somewhat surprisingly people like to attach it to their earlobes or nostrils or to hang it around their necks. Since gold is a fiat commodity currency, its value will be determined largely by its attractiveness relative to other fiat currencies - the fiat paper currencies issued by central banks. Such a time is what we are going through now.  Many systemically important central banks have expanded their base money stocks and balance sheets massively. Although in most of the overdeveloped world (except the UK), deflation is the immediate threat, there is a medium and long-term threat of much higher inflation in all countries with enlarged central bank balance sheets and the prospect of large future fiscal deficits.  The great advantage to investors of gold is that, although it is not intrinsically valuable, it is very costly to increase its stock.  The tap can be opened at the drop of a hat for fiat paper and electronic currency.  The tap produces never more than a trickle in the case of gold. So when fiscal incontinence threatens price stability in some of the main industrial countries (especially the US and the UK) because the central banks in these countries may be forced to monetise both the stock and large new net flows of public debt, the one fiat money whose quantity cannot be varied at will by a monetary authority will do well.  We see that with gold today.  We also see that, to a lesser degree, in the strength of the euro.  The ECB is by far the most independent of the leading central banks.  They also have a heavily asymmetric de-facto interpretation of price stability: inflation is unacceptable, deflation is OK. So until the risk of serious inflation is removed from the medium-term outlook for the US, the UK and other fiat currencies, gold will be a relatively attractive store of value despite the cost of storing it. In a world with multiple fiat moneys, the zero value of money equilibrium lurks for each of the fiat currencies, including gold.  Admittedly, as regards gold, so far so good.  Gold has positive value.  It has had positive value for nigh-on 6000 years.  That must make it the longest-lasting bubble in human history.I don’t want to argue with a 6000-year old bubble.  It may well be good for another 6000 years.  Its value may go from $1,100 per fine ounce to $1,500 or $5,000 for all I know.  But I would not invest more than a sliver of my wealth into something without intrinsic value, something whose positive value is based on nothing more than a set of self-confirming beliefs.

 Oops for Buy N Hold

NYU: Market Timing Bests Buy & Hold Here’s something that oughta give the marketing wizards at traditional Wall Street firms a heart attack: Timing beats buy and hold, according to a study by  finance professors at the New York University Stern School of Business. I doubt its pure timing — my best guess is, the fund managers involved more likely used aggressive risk management tools and capital preservation strategies. To the unknowing, these look like timing but are not. The profs found that fund managers who invest based on macroeconomic trends — and are willing to adjust their portfolios as those trends change — are the managers most likely to add value for investors. How you define “macroeconomic trend changes” and the basis of portfolio adjustments is a key factor — one that is not delineated all that clearly:

“By analyzing data from January 1980 through December 2005, the study identified the top 25% of actively managed equity mutual funds based on their ability to select stocks during expansionary economic periods. The report noted that this same group showed proficiency at market timing during recessions as well.

This group outperformed other funds in both risk-adjusted terms and after expenses, according to the study.”

Cash has beaten stocks for the past 10 years; Even worse, Bonds have beaten Stocks since 1966. To me, this suggests that an active asset allocation program (rather than pure market timing) is the way to go for most high net worth investors. Despite the weak stock performance, expect massive pushback on this from the long-only, fully-invested, fee-based actors on the street. Already, we see critiques from Morningstar. Russel Kinnel, the director of mutual fund research, carped that “the 1980s were littered with funds that blew up because managers tried to follow macroeconomic trends.” The Street will this line of thought tooth and nail, but given the horrific performance if the LOFIFB firms, they have their work cut out for them . . .

1. “Superior Information” is a misnomer. In 2005, there were lots of people discussing Housing, Derivatives, Credit. What often occurs at key turning points is that widely understood — but heavily doubted — information about the market gets ignored.

I prefer to call this Variant Perception; To take advantage of it, you need some methodology/model (call it a belief system if you like) that you have enough confidence in you can rely on it in order to buck the crowd

2. Think about this in terms of Capital Preservation strategies versus pure market timing. The potential losses (i.e. 2008) versus the modest costs/taxes of a major negative event are vastly asymmetrical;

3. In terms of pure Timing, the secret isn’t finding superior dope; rather, it is understanding what to do with existing information at key turning points. Various timing metrics will reach extremes, and trading off of that information requires a rare skill set.

The greatest trade ever In a span of just three years, hedge-fund manager John Paulson went from practically unknown to practically unparalleled. After a series of smart bets against the housing market made Paulson's hedge fund billions of dollars—including days where it made more than $1 billion—he earned a place alongside George Soros and Warren Buffett as an oracle of investing. In his new book, The Greatest Trade Ever, Gregory Zuckerman, a reporter at The Wall Street Journal, examines how the unlikely team of Paulson and assistant Paolo Pellegrini—as well as a few other investors—bucked conventional wisdom and saw through the housing hype. Who is John Paulson, and why is he worthy of an entire book? John Paulson spent a career on Wall Street underappreciated as an investor, in relative obscurity. Only on Wall Street can you be worth about $100 million and still be in relative obscurity. He had slowly built up his hedge fund, and by 2005 or so he started getting nervous about this whole housing market and tried to think, maybe I should bet against it. And he wound up making the greatest trade in financial history. In 2007 alone he made $15 billion for his firm—by way of comparison, George Soros made a billion dollars betting against the British pound [in 1992]—and in the next, in 2008, he transformed the trade into more of a bet against financial firms and made another $5 billion. And yet he wasn't a mortgage expert, or a real estate expert, and didn't have much background in the derivatives he used to make the bets, like credit-default swaps (CDS).

Additional Readings

Posted by dblwyo at 06:40 PM | | Comments (0)

November 13, 2009

The Policy-driven Economy: Turbulence, Outlook, Recovery?

In the last post we took a special dive on the current Employment situation and the strategic and structural outlook while also spending some time talking about seeing things as they really are, instead of how ideological distortions would have. We're going to continue that with a look at the overall economic situation, as we really think it is, and look back on some key policy issues. One critical point is that normally policy evolves slowly but in this sustained crisis it's been changing very rapidly, which means deep structural factors are gyrating on the same pace as high-frequency economic or market data. That the G-20 announced continued support for stimulus and monetary easing led to the market rally early in the week. But it also highlighted how weak and challenged things remain. Make absolutely no mistake about it - all that's keeping the wheels on the wagon right now is public spending.

Current Economic Situation

We've liked to use military metaphors around here and in particular the timeline of major Eastern Front battles, comparing last Fall's near-collapse to the Battle of Moscow and the months from Jan. to recently to the Stalingrad campaign. The really good news, in two pieces, is that we have avoided Depression 2.0, something that the policy makers are now publicly admitting was, as the Iron Duke said, "a near run thing, a damn near-run thing." Almost as good is that we judge Stalingrad to have been won.

As you can see both GDP and Consumption on a YoY% basis turned up and we definitely got a jump on a QtQ basis. But the bottom chart also defines the next major campaign - to start growing jobs again. Continuing the metaphor we'll compare the problem of job growth to the Kursk Campaign, where the Russians had a chance to attack (or more properly counter-attack for the first time) by careful intelligence and planning. Our problem right now is that the economy is a long way from self-sustaining, organic growth - hence the need for stimulus and eased monetary policy. And, by way of collateral damage, the continuing crunch in the credit markets which will continue to hamper the recovery for a long time. BtW - Kursk was fought in 1943, as we recall.


The Business Cycle and Outlook

To put that in a framework that should help you picture what's going on and where we're at let's use this composite graphic of the business cycle. We've used the parts before so we'll be short but the UL shows the feedback loop from Consumer demand to Business to Capex + Employment and back to the Consumers that link everything together. Notice the special decision loops where assets, rates & confidences enter the "credit market" decision function. Interestingly enough the mainstream profession is engaged in a great debate about how to include these factors in its models. The UR illustrates how that cycle plays out over time and, lo, the concept chart maps rather nicely the real data.

In the LL we guesstimate where we're at. The last post on Employment links into that argument - on a GDP basis we're about at the bottom. But the reason we have to "you are here" pointers is that Unemployment will keep growing and it'll be a jobless/jobloss recovery, with Unemployment returning to 5% by 2014 at best. There are all sorts of implications for Hiring and Investment demand from weak consumer demand plus the long-term de-leveraging of balance sheets. Which explains why in the LR corner we left the Int'l Economy shaded red. While the headline is that China and Asis have done very well you have to compare that to what they need to keep the hordes employed along with the structural shift from US consumers no longer holding up the world economy. We're going to get weak growth eventually from organic, internal sources. They're facing a world where the major driver of growth is going away. Think about.

Growth Outlook vs Potential: the Long-term Gap

This was already a weak economy headed into a major recession that then turned into a near-catastrophe when the credit markets collapsed last Fall. As Reinhardt and Rogoff keep reminding us when you combine a major cyclic downturn with a major credit market collapse you get long-lasting damage. That takes a long time to repair. When it happens simultaneously in every economy in the world things are even more interesting.

The IMF looked back over a bunch of these crisis and tried to extrapolate the forward impacts. When we talk about Potential GDP we're talking about when the natural limit on Employment is reached, about 4.5-5.0%, and all resources available are reasonably fully employed. The IMF's best guess is that we'll never recover from the deep loses we've suffered, at least not for years. In this chart the gap continues for eight years and actually grows. Since our long-term growth forecast is for 2.5% and we need a period of 4-5% to make up the ground on employment they have a real case. Come full circle back to China and the rapidly emerging economies and their export-driven growth models. What can we say but OOPS!

Policy vs Politics vs Outlook

Which brings us full cycle back to our opening point about the criticality of policy stimulus and the fundamental dangers of slowing or halting stimulus too soon. And what we need to do about it. If we win Kursk and get jobs growing again then we end up with an U-shaped recovery. If we get a better than expected acceleration (remember the feedback loops) we get back to closing that long-term potential gap, but on the best available evidence from all corners it peaks out to a long-run 2.5% rate. Which is not a healthy economy. Speaking of the doldrums.

To get anything better than that we need to re-based the economy, which means addressing fundamental drags on efficiency and performance like Energy, Healthcare, Education and Innovation. Without substantial long-term improvements in those factors the outlook stays "yellow" for a long-time to come. Did you know for example that the last joint discussions between the US and China on economic issues had a major focus on Healthcare Reform? Now stop and wonder why the Chinese care whether or not we succeed in controlling health costs, improving wages and consumer demand and getting our economy back on a higher growth path.

Right now our biggest danger is ourselves. With more political posturing against public spending the risks of stopping it too soon are high and will result in an aborted recovery. Ironically a lot of investors as well as voters, not understanding how this all works, and making their decisions based on ideology are seeing things thru the "Veil of Maya". And may end up shooting off all our feet in the service of ideological purity. If you believe any of this you can understand why we're looking forward to a volatile, unstable and hard to predict policy-driven environment for a long time to come. Now we covered a bunch of this in some detail in earlier posts (More De-mythologizing: a Little Markets, Some Economics, Lots of Policy, Between Stalingrad and Kursk: Real Economy, Policy and Outlook) and the readings embedded there. Econbrowser takes another shot in this recent discussion of why the political analysts just don't get it:Politico Does Economic Analysis....

So if you don't believe us we'd strongly urge you to double check there. After disagreeing with the available evidence let us know so we can stock up on guns, ammo, gold, food and water.

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Strategic/Structural Employment

The Recession’s Over, but Not the Layoffs But just as climate change has altered how we contemplate the seasons, some economists argue that the business cycle no longer operates as it once did, failing to replenish the jobs it destroys, and leaving our economy vulnerable to a potentially long-term shortage of work. The tools we use to assess the business cycle date back to the 1920s, when the economy looked much different. Manufacturing jobs have declined sharply as a percentage of overall employment, while services have emerged as the primary economic engine. Automation and globalization have supplied thrifty corporate managers with myriad ways to boost production without hiring. But the latest reassessment of the business cycle now has a couple of decades of data to consider. After recession gave way to expansion in March 1991, it took a year before hiring resumed in earnest — a so-called jobless recovery. After the following recession ended in March 2001, two years passed before jobs grew. Many economists assume that the third straight jobless recovery has already begun, as nervous businesses — worried about the lingering bite of the financial crisis and weak prospects — continue to hold back on hiring. This is not how things are supposed to go, not according to our traditional view of the business cycle.

Employment: No Recovery Till 2013? An important question is whether this new relationship between unemployment and output observed in the last two recessions will also be present in this recession. All indications are that it will. The most recent employment report shows the unemployment rate rising past 10 percent even though it appears output may have already turned the corner, while new claims for unemployment insurance are still over 500,000, a number that indicates the economy is still losing jobs overall. In fact, I am worried that the peak in unemployment could lag even further behind the recovery than it did in the last two recessions. It’s not just the lag between the turning points in output and employment that leads to a pessimistic outlook for labor numbers. Once unemployment does peak, output still needs to return to its normal growth level before we see a return to full employment. The San Francisco Fed doesn’t expect a return to normal growth until the middle of 2012, and this means that unemployment likely won’t fully recover until somewhere in 2013. The reason for the slow recovery is partly due to the depth of the recession — the deeper the hole, the longer it takes to crawl out of it — but it’s also because of the large amount of structural change that the economy must go through before it can recover.

Economic Outlook: Risks & Opportunities?

Economic Outlook: Possible Upside Surprises, Downside Risks As I've noted several times, my general outlook is for GDP growth to be decent in Q4 (similar to Q3) and for sluggish and choppy GDP growth in 2010. I've been asked to list some possible upside surprises, and downside risks, to this forecast. Possible Upside Surprises: Consumer spending. One of the key reasons I think growth will be sluggish in 2010 is because I expect the personal saving rate to increase as households rebuild their balance sheets and reduce their debt burden. Exports. Perhaps we are seeing a shift from a U.S. consumption driven world economy, to a more balanced global economy. An increase in consumption in other countries, combined with the weaker dollar should lead to more U.S. exports. And if China revalued that might lead to a boom in U.S. exports. Residential Investment. Those expecting a "V-shaped" or immaculate recovery - with unemployment falling sharply in 2010 - are expecting single family housing starts to rebound quickly to a rate significantly above 1 million units per year. That won't happen.

Possible Downside Risks: Housing Market. Probably the key downside risk to the economy is further declines in house prices and a large second wave of foreclosures. The government is doing everything possible to support house prices - by reducing supply with the modification programs, foreclosure moratoriums, and servicer backlogs - and boosting demand with the homebuyer tax credit and loose lending standards (especially with FHA insured loans).  I expect another wave of foreclosures in early 2010, and the impact of the housing tax credit to wane, and eventually lower house prices especially in higher priced bubble areas (although I think we've seen the bottom in many other areas). My expectation is prices will fall in real terms for several years. But if prices fall further than I expect that could have a serious impact on banks (more losses) and consumer confidence (less spending). Consumer Spending and Exports. The flip side to consumer spending is that households might increase their saving rate faster than I expect. And with exports, if the global recovery falters, exports would probably decline.  Unemployment and Wage Deflation If the unemployment rate keeps rising (say to 11% or higher), and CPI goes negative - this could lead to falling wages and even more downward pressure on consumer spending. And deflationary expectations might lead to consumers putting off certain expenditures. Small businesses. I think there is a strong possibility that small businesses will not be able to obtain financing and increase hiring - partly because many of the banks impacted by the commercial real estate disaster also loan to small businesses.

World markets get G-20 boost World stock markets rose Monday after the Group of 20 leading rich and developing countries agreed to maintain their stimulus measures in the wake of weak U.S. employment figures. At a meeting in Scotland, the countries' finance ministers pledged to "continue to provide support for the economy until the recovery is assured" after U.S. jobs figures Friday showed unemployment at a 26-year high of 10.2 percent. "Asset markets have taken comfort from the continued coordinated pro-growth plans of the G-20, with equity markets remaining supported," said Hans Redeker, an analyst at BNP Paribas. Though stocks have managed to garner some gains after the G-20 meeting, the dollar has continued to fall as the finance ministers steered clear of any attempt to talk up the U.S. currency. Comments from the International Monetary Fund that the dollar was still "on the strong side" in terms of its trade-weighted basis helped fan the dollar selling Monday, particularly against the euro. While the dollar may be weak against the euro, it is considered to be overvalued against the Chinese yuan. BNP Paribas' Redeker said the market took the IMF's comments as a "green light to continue with the broader dollar bearish trade."

Key Secular Issues and Policy

Fed: Lending Standards Tighten, Loan Demand Weakens In the October survey, domestic banks indicated that they continued to tighten standards and terms over the past three months on all major types of loans to businesses and households. However, the net percentages of banks that tightened standards and terms for most loan categories continued to decline from the peaks reached late last year. The exceptions were prime residential mortgages and revolving home equity lines of credit, for which there were only small changes in the net fractions of banks that had tightened standards. A small net fraction of branches and agencies of foreign banks eased standards on C&I loans, whereas a significant net fraction continued to tighten standards on CRE loans. Demand for most major categories of loans at domestic banks reportedly continued to weaken, on balance, over the past three months.

TIPS and inflation expectations Treasury inflation-protected securities — bonds whose payouts are indexed to consumer prices — are really useful for economic analysis: they give an objective, market-based measure of expected inflation. But you have to be a bit careful about using them to interpret recent events, because the same financial disruptions that wreaked havoc with many assets also did some funny stuff to TIPS. Oh, and this particular story did something I’ve noticed more and more in financial reporting: when reporters are assigned to write a story about how bond markets are afraid of debt/deficits/inflation, they have a strange and telling habit of telling readers a lot of scare stories about how markets are nervous, along with something about how interest rates or spreads are at their highest level in x weeks or y months — but strangely fail ever to mention what the spreads or rates actually are. Thus I’ve read scary-sounding articles about Japanese debt that somehow never mention that Japan is currently able to borrow long-term at less than 1.5%. And in this case you’d never know from the story what the 10-year U.S. inflation rate implied by the TIPS spread is. The answer, as of Friday, was 1.98 percent. But that number sort of wouldn’t match the whole thing about bond vigilantes, I guess, so it was omitted.

The "Paradox of Deleveraging"  Deleveraging has the ability to drive down GDP as well as asset prices. Our economy is heavily dependent on consumption, which in itself is dependent on debt financing, which in itself is dependent on asset prices that serve as collateral for the financing (or in the case of banks, improve their capital requirement ratios so they can put more capital to work). This is the reason why the Fed has intervened in an attempt to re-inflate asset prices with a wide assortment of initiatives. Will it work? If the goal was to reinflate these assets back to 'fair value' following the deleveraging of 2008 than these new prices may be sustainable. The issue (in my opinion) is that the goal seems to be to reinflate asset prices (i.e. homes, financial assets, etc...) to pre-crisis "bubble" valuation levels. So far we've seen subsidized financing, tax incentives, private/public partnerships (i.e. TALF and PPIP), purchases by the Fed, etc... to make this happen. I am of the opinion that whenever these initiatives roll off, prices will once again (absent inflation), fall. Is this bad? For GDP in the short run... absolutely. But in the long run we need debt levels as a percent of GDP to rebalance. There are only two ways to do this... decrease the numerator (i.e. delever) or increase the denominator (through growth or inflation). Thus, absent atrong growth and/or perfectly timed and scaled inflation, we need to accept the inevitable pain before we pump up prices to even more unsustainable levels.

U.S., Europe Differ in Approach to Getting Back on Growth Track Policy makers around the world are sifting through the wreckage of the Great Recession. They're immediately finding gaping holes in the form of lost economic output. The question they must consider soon is whether any of that lost production is recoverable once growth resumes. And it has once again made potential growth -- defined as an economy's ability to grow without inflation -- a hot topic. For Europeans, a big dent to potential growth for at least the next couple of years, or even longer, would mean output lost during the recession is probably gone for good. European officials are already musing about a "lost decade" like Japan experienced in the 1990s. In contrast, stronger productivity in the U.S. gives it a better shot at recouping at least some of its lost output, with a helping hand from the Federal Reserve. It's more than an academic issue. Potential growth greatly affects living standards, and a few tenths of a percentage point pile up quickly in terms of incomes and national wealth.

The hit to potential comes through several channels: productivity softens; companies cut back too much on efficiency-improving investments; discouraged workers leave the labor force for good; their skills idle; and after bank crises, financial markets no longer effectively channel savings into productive investment. In a report last month, the European Commission issued its warning that an entire decade may be lost, outlining a scenario in which potential growth in Europe takes 10 years to return to precrisis rates. Under that scenario, "output lost during the crisis years is definitely lost," it said. Compared with the U.S., Europe hasn't taken a large labor-market hit -- especially its largest economy, Germany, where unemployment has actually fallen four months running. That suggests productivity is a lot lower. Economists at UBS figure productivity in Europe will shrink 1.4% this year, while it expands 2.3% in the U.S. One risk is certain: The more policy makers worry about growth being fundamentally weaker after the crisis, the more likely it is to happen. In the midst of crisis, attitudes toward potential growth don't really matter; everyone needs stimulus, no matter how fast or slow they think they can grow. But it's at turning points -- like now -- when it makes a difference. It might mean an itchier trigger finger on monetary policy in Frankfurt than in Washington. And it could make potential-growth worries a self-fulfilling prophesy in Europe.

Why some countries are stopping their stimulus The Aussies' aggressive tightening is seen as the start of the global exit from the unprecedented liquidity governments have injected into their financial systems to avert an economic depression. It's a potentially dangerous step. No one knows exactly how a withdrawal will affect the tentative global economic recovery — just as it is not clear, even now, whether interest-rate cuts and huge stimulus spending in the U.S. and elsewhere are resulting in sustainable economic growth. The world is in uncharted territory. Policymakers are acting on the fly, without much in the way of historical precedence to guide them. Investors, including those saving for retirement, are on uncertain ground as well. The global crisis and the stimulatory monetary and fiscal policies that were brought to bear against it have overturned all the verities about long-term investing. Exiting from those policies is not likely to reinstate them. How will equities, bonds, commodities, oil, gold, currencies and other investment vehicles fare in the post-crisis, post-stimulus-spending world?

Report: 10 states face looming budget disasters In Arizona, the budget has grown so gloomy that lawmakers are considering mortgaging Capitol buildings. In Michigan, state officials dealing with the nation's highest unemployment rate are slashing spending on schools and health care. Drastic financial remedies are no longer limited to California, where a historic budget crisis earlier this year grew so bad that state agencies issued IOUs to pay bills. A study released Wednesday warned that at least nine other big states are also barreling toward economic disaster, raising the likelihood of higher taxes, more government layoffs and deep cuts in services.The report by the Pew Center on the States found that Arizona, Florida, Illinois, Michigan, Nevada, New Jersey, Oregon, Rhode Island and Wisconsin are also at grave risk. Double-digit budget gaps, rising unemployment, high foreclosure rates and built-in budget constraints are the key reasons. "While California often takes the spotlight, other states are facing hardships just as daunting," said Susan Urahn, managing director of the Washington, D.C.-based center. "Decisions these states make as they try to navigate the recession will play a role in how quickly the entire nation recovers." The analysis, "Beyond California: States in Fiscal Peril," urged lawmakers and governors in those states to take quick action to head off a wider catastrophe. The 10 states account for more than one-third of the nation's population and economic output, according to the report.

Here comes the big tax squeeze The tax man cometh. Not only is it going to be individually painful in 2010, but the collective hit to consumers could be enough to stall the economic recovery as well. According to the National Conference of State Legislatures, the total budget gap for the 50 states comes to $145 billion for the fiscal year, which ends in June 2010 for many states. The Center on Budget and Policy Priorities comes up with an even higher number: $178 billion. The conference also reports that 26 of the 45 states that reported numbers expect to collect less in taxes in fiscal 2010 than in 2009. And that's even though 20 states raised taxes in 2009 to the tune of $27 billion. A slumping economy wiped out all the effects of higher tax rates. And then, of course, there's fiscal 2011, generally starting next July. The Center on Budget and Policy Priorities calculates fiscal 2011's gaps at $80 billion for the 35 states that have put together estimates. With state revenues expected to continue to deteriorate well into 2010, the final tally, the center estimates, could be $180 billion or more. The center also projects that states could still show a collective budget gap of as much as $120 billion as late as 2012. Just for some context, the worst annual budget shortfall during the 2002-05 recession years was $80 billion in 2004.

Roubini versus Rogers is right debate for 2010 Investor Jim Rogers thinks gold will double to at least $2,000 an ounce. Economist Nouriel Roubini says that’s “utter nonsense.” As these well-known market personalities duke it out, they’re doing us a favor by highlighting a critical debate: Which is the bigger threat -- inflation or deflation? Inflation, though not to the extent many fear. Then again, who really does these days? If you’re looking at economics and markets through traditional lenses, very little makes sense. Many concepts that seemed like rock-hard truths two years ago are looking shaky. Just ask John Reed, who helped engineer the merger that created Citigroup Inc. Reed last week apologized for his role in building a company that has taken $45 billion in direct U.S. aid, and said banks that big should be split up. Turns out, the 1999 repeal of the Depression-era Glass-Steagall Act separating consumer banking from those involved in capital markets was a terrible idea after all. Up has become down, and down has become up. Amid such disorientation, the risk is that policy makers will apply old ideas and relationships to new and diverse challenges. One such error would be prematurely taking away the stimulus that’s only now stabilizing growth. The risk is that policy makers go overboard looking for exit strategies. That, in a nutshell, is Roubini’s shtick and it’s hard to refute the views of the New York University professor. Yes, inflation must be contained, but so must the forces of deflation in the short run. To me, Roubini’s worries are more persuasive than Rogers’s bet on gold. That also goes for Roubini’s view that bubbles pervade rallies in emerging-market stocks. They do. Yet the global economy is turning Japanese more than those fixated on inflation may realize. In a world awash in liquidity traps, price pressures aren’t the usual threat. That’s not to say inflation won’t perk up, particularly in emerging markets. The Fed’s ultra-low rates are likely to result in inflation in China, Indonesia and Thailand before they do in the U.S. Bank lending is locked in neutral, at best, even though monetary-base growth in the U.S. has increased exponentially over the past year. Oddly, the main beneficiary of the Fed’s liquidity is emerging-market stocks. At the same time, highly indebted U.S. households will be spending even less now that unemployment is above 10 percent. Weekend news reports about the jobless rate climbing to a 26- year high were a huge consumption killer.

Recovery Looks Like `L' Without Job Growth: David Blanchflower  A year ago, we were hit by the greatest financial crisis in a century. Its scale was greater than the 1929 Crash, principally because of its more global nature. The evidence from analyses of more recent meltdowns around the world shows they have long-lasting effects. The big question is how close it is to being over. The answer seems to be: quite a long way, in both the U.S. and Europe. Banks still aren’t lending, and credit is hard to get. Deflation remains a major concern in many countries. Central bankers’ great worry is that they have no idea what to do about hyper-deflation. They are trying to create some inflation because they know what to do about that. We now seem to have entered what John Maynard Keynes called “the long dragging conditions of semi-slump,” following the acute phase of the cycle, which we experienced over the last year or so. The biggest policy error that could be made now would be to remove stimulus too early. That could result in a W-shaped or even L-shaped recovery, given that the private sector seems to be on its back. The experience of what happened in the U.S. in 1937, when the recession was assumed to be over and monetary policy was tightened too soon causing the economy to slump again, should be instructive.

Posted by dblwyo at 02:07 PM | | Comments (0)

November 10, 2009

Turbulence vs Chaos: the Buddha's Lessons on Data, Distortions & Decisions

One of the things we try and do around here is find the right data, put it thru the right filters and interpretative frameworks without torturing it to say what we want and then use to reach the conclusions and make the right decisions. Over the last five years that approach has served us very well by and large and hopefully helped those who've read this blog or seen our newsletters or other communications. Beyond that when we don't understand something we try and dig into until we find the right data, a useful explanation and even a framework for thinking about it. The last several posts have all served that "tradition" but rather than get back to our knitting we're going to take another example and then try some big picture lessons from it. The example, which is vitally important for its own sake, is the Employment Data. The important lesson is understanding the data sources and interpretations but the critical lesson is the implied one about letting your thinking be distorted by your pre-dispositions. Which we'll come back to you in a bit. Let's dive in on the Employment data.

There are three OMG look at the data ideas floating around the memosphere (meme+MSM+blogosphere) about the Employment data. Now we'll just say that in the last few years this is not the first such tempest that's blown up from conspiracy theories to mal-adjustment in inflation data to....on and on. EVERY single one of them on being checked out was somebody not looking at the data, charting it out and seeing whether or not it made sense or if they had a workable suggestion for making it better at an affordable cost. NOT a single OMG moment has held up in five years. There are three related ones floating around about the Employment data that we want to test in the process of learning something about what's really going on. One is that the Non-seasonally adjusted data shows job increases so it's not as bad, another is that the two different sources of data - the Establishment survey which talks to businesses directly and has a more limited but more accurate sample and the Household Survey which picks up freelancers, consultants, farmers and other n'er do wells like ourselves have a huge disparity and the third is because this economy "is so different this time" that you can't rely on the employment data as a lagging indicator because it's actually a leading indicator. Putting these to rest is almost as important as understanding the data per se.

Three Gotchas in the Employment Data

Let's start with looking at the Establishment employment data, both seasonally adjusted and unadjusted, and comparing it to the Household survey data and seeing what we see. As usual and always click to enlarge the chart please! The top chart shows SA and NSA Establishment vs Household Employment. The thin red line is the NSA and notice especially that a) it's very noisy constantly wiggling around the SA data and b) there's a constant gap of around 10 million jobs between the two surveys, which once you adjust for the difference in data sources, turns out over the last several decades to yield the same answer as to the state of Employment. At least according to the Fed in several repeated looks they've taken at the issue. If you get what we just said all three of the OMG shibboleths just died on the facts. We could spend the rest of this blog explaining in detail but will pass on.

The second sub-chart shows new jobs, from which we've dropped the NSA data which is SO noisy that the repeated and useless up & down spikes result in a chart too noisy to read and interpret. By and large over nearly three decades the two surveys yield exactly the identical number of new jobs, though there is a slight discrepancy on this quarterly basis in the last quarter. Which is not out of line with previous discrepancies. The third sub-chart shows YoY% changes - SA and NSA are so close that the red and blue lines overlay and turn purple. Compare that inadvertently created line with the Household survey and guess what - again the YoY changes give us just about the same answer again. Though the Household survey is nosier and therefore it tends to be harder to rely on period to period. The bottomline therefore is that YoY SA data gives us the cleanest, most reliable indicator of trends, patterns and turning points.

Continued ...

A Deeper Dive in Granularity

Lest you think we palmed a card lets go to the monthly data, which is as fine as it gets and see if we can keep those mis-interpretations properly out of the way. Lo and behold the top sub-chart comparing SA'd Employment (Establishment) and Civilian Employment (Household) seem to be dancing the same dance to the same music, beat and rhythm. You can see the discrepancy in detail that everybody's excited about on the tail of the second sub-chart where EmpSa shows about -200K jobs and CivEmp shows about -600K. Of course earlier in the year it was running the other way and has before in the last decade. Is this mere noise or some deep mal-adjustment? So far it's not out of line for noise.

Which leads us to the third sub-chart which shows monthly YoY% changes between the two. Wow - what wild divergences over a decade. Why it must be approximately zero percent, or so close as to not make much if any difference for our purposes. Just ignore the fact that for most of the last year they've laid over eac other almost exactly please.

As for the third mis-understood (the old KGB tactical term Maskirova comes to mind, or would except with them it was deliberate instead of a failure to do their due diligence) meme that this time it's different gets put to bed. Employment growth peaked around Jan06 and started slowing down almost immediately. Which we widely warned about at the time and were almost as widely ignored about.

Let's Get Serious About the Real Data

Hopefully having put the monsters, at least the imaginary ones, back in the closet it's time to take a look at the real ones with the right data. The top sub-chart compares YoY changes in real GDP, net of trade putting another little data difficulty to rest, with Employment. Notice that GDP stopped improving in Q104, leading Employment by far but also telling us how delayed the last recovery was and how weak and non-organic it was. Again something we tried to tell people at the time. There is a piece of wonderful news however for those of you who recall our comparisons to Eastern Front major battles. We've been talking about this being Stalingrad - well the good news is we won. The bad news it's time to start the intel work and planning for Kursk.

All of which is reinforced in the second sub-chart which shows four different Employment indicators: Employment, Hours, Unemployment and Private jobs. Same 'ol good news, bad news. The bottom chart comes back to that implicit bad news about organic growth, self-sustaining in other words, and jobs. It shows New Jobs, Net New Jobs and Cumulative Net New Jobs. We've discussed before the notion that it takes about 147K jobs/month (~150K), though estimates range from 120-170, to breakeven on labor force plus productivity growth. New Jobs is just that, Net New is New-450K/Qtr and Cumulative is the running total. Here's the really bad news in two parts. Because of the non-organic nature of the last recovery we entered this downturn still about 1.5 million jobs in the hole. Now we're about -12 million jobs in the hole and it'll keep getting worse. In fact Lakshman Achuthan was on PBS, despite his deserved rep as an optimist, and pointed out it would take at least four years of 5% real growth to get back to breakeven which we're not going to get.  In fact in one of those previous reality checks (Refreshing the Economic Outlook: Fundamentals to Business Outlook) we put up this chart showing the various relationships and found that to get 2.5% Employment growth we need 5% real GDP growth. At 2.5% GDP growth we get about 1.8% Employment growth. Whether anybody knows it or not that pretty well settles the V-shape vs. U-shape debate, though not in a way we'd like.

Non-organic Recovery and the Drawn-Out U

Just to drive home some other nails in the coffin we'll put up this composite borrowing from our buddies Bill over at CalculatedRisk and Jake at EconPic (we'll confess to a great deal of guilt since Jake and I started cross-talk his posts are getting longer and longer....deeply informative but we still feel like a corrupting influence). Anyway if you think you've seen Bill's chart in the UL corner in the NYT your right - they must've liked it 'cause he thought it up several months ahead of time. Here's the reinforcing lesson - take the current curve, copy it, flip it around as a mirror image in your mind and ask yourself what you get and where it crosses the zero line. We think we'll be lucky on current course and speed if it bottoms before Month30. Applying the flip transformation that tells us zero is at Month60. That's so depressing we'll let you work out the rest of it for yourselves. Consider Jakes' and my charts as repeating and reinforcing the point in different guises.

The Bodhisattvas of Reality

One of the things about the Buddhists we like and think is especially apt for our purposes is that they don't tell you that some authority somewhere has the final and ultimate answers. Instead they tell you to go and see for yourself. Though they do start and add that they've found some basic principles, some techniques for calming and clearing your mind and making sure your decisions are based on un-distorted data and analysis and they don't kid you it's easy or there are magic answers. That might be a summary description of the worst danger we face - running after simple but distorted answers beause they're easy to pretend to understand or suit our unexamined prejudices.

When the Buddhists talk about enlightenment they talk about a Buddhist Saint who has chosen to remain in the world after reaching Nirvana, which for our purposes we take as always making un-deluded decisions without being led by their emotions. They stay behind with the rest of us poor slobs to serve as examples and coaches. Well we won't go that far here but it's a comparison worth bearing in mind with the last two must-read readings. One is Janet Yellen's take on the economic outlook, which strangely enough, rather closely resembles the one you've just read thru. The other is a superb, and we mean superb, piece by Paul McCulley on explaining why it's U-shaped not V-shaped but why that's consistent with the surge in asset prices. Ahem - needless to say his much clearer and well-written explanation bears some passing resemblence to several of our recent discussions.

The graphic is Ganesha the Hindu God of Wisdom among other things, taken from another earlier post (Ganesh Filter II: Clear-seeing Algorithims for an '08 Plan) and it seems appropriate to quote from an earlier post of ours on the topic of not letting your thinking get distorted:

 Seeing thru Maya: Piercing the Veils of Delusion

The Buddhists (& the Hindus) talk about Maya the "Veil of Illusion" and suggest that we don't see the real world underneath the surface. Now for a while, and still, there was a tendency in the West to do some sort of mystical mapping between quantum physics and so forth to suggest that was what's being talked about. Or alternatively it was a mystical point and to be dismissed. In any case the critics, pro and con, took it as arm-waving philosophy.

When you dig into the propositions are much simpler, harder and useful. What they really mean is that we tend to look at the world as prisoners of a whole host of assumptions and presumptions - to see the world as we'd wish it to be instead of how it is. Hence we view the world thru a distorting veil of delusions brought about by our own bad thinking.

The recommended cure is to both learn to see the world and to learn how to think. To see the world the primary tool is to learn how one thing leads to another and that to another and so on in a cause-and-effect chain. Or if it's complex enough web of linkages and feedbacks. In other words Maya is not mystical it's talking about having a bad model and not knowing how, or choosing not to, fix it. Which is the other part of the prescription - learn how to think and make up your own mind. The Buddhists call that "Right Thinking".

Well the common thread running all throughout the four stories, or at least so it seems to me as it finally dawned, was each was the result of distorted thinking, bad models and delusions about what was really going on. Delusions all the worse for having gotten so much intellectual and emotional investment that the commitment to denial was pretty pronounced. The problem with Reality is that sooner or later the tide comes in, water doesn't run up hill, business cycles cycle, profits decline and bad due diligence and poor operating performance get their entropic rewards. 

Actually with Prof. Ben's announcement that they're going to do everything they can to prevent a recession, though it's too late to stop it and now the goal is to mitigate it before it cracks all the fault lines we've been talking about (just yesterday and for months now was it :) ), we may have a fifth good example. Watching the markets gyrate back and forth where's the surprise? And what changes about the underlying realities?

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Employment, Data & Outlook

Two PBS Newshour vidclips:

US Economy: Unemployment Rate Jumps to 26-Year High The unemployment rate in the U.S. jumped to 10.2 percent in October, the highest level since 1983, casting a pall over the prospects for a sustained recovery and risking further erosion of President Barack Obama’s popularity. Payrolls fell by 190,000 last month, more than forecast by economists, a Labor Department report showed today in Washington. The jobless rate rose from 9.8 percent in September. Factory payrolls dropped by the most in four months, and the average workweek held at a record low. Treasury two-year notes rose on bets the Federal Reserve is more likely to maintain its pledge to keep interest rates near zero. The figures prompted Obama, who signed a bill today extending jobless benefits, to promise fresh measures to help put some of the 15.7 million unemployed Americans back to work. “We will certainly have very bad payroll numbers in November and December,” said Harm Bandholz, an economist at UniCredit Global Research in New York, whose forecast for a 10.1 percent unemployment rate matched the highest among economists surveyed by Bloomberg. “We don’t foresee businesses going on a hiring spree anytime soon.” Payrolls were forecast to drop 175,000 after an initially reported 263,000 decline for September, according to the median estimate of 84 economists surveyed by Bloomberg News. The jobless rate was projected to rise to 9.9 percent.

Economists Seek to Fix a Defect in Data That Overstates the Nation’s Vigor A widening gap between data and reality is distorting the government’s picture of the country’s economic health, overstating growth and productivity in ways that could affect the political debate on issues like trade, wages and job creation. The shortcomings of the data-gathering system came through loud and clear here Friday and Saturday at a first-of-its-kind gathering of economists from academia and government determined to come up with a more accurate statistical picture. The fundamental shortcoming is in the way imports are accounted for. A carburetor bought for $50 in China as a component of an American-made car, for example, more often than not shows up in the statistics as if it were the American-made version valued at, say, $100. The failure to distinguish adequately between what is made in America and what is made abroad falsely inflates the gross domestic product, which sums up all value added within the country. American workers lose their jobs when carburetors they once made are imported instead. The federal data notices the decline in employment but fails to revalue the carburetors or even pinpoint that they are foreign-made. Because it seems as if $100 carburetors are being produced but fewer workers are needed to do so, productivity falsely rises — in the national statistics. The statistical distortions can be significant. At worst, the gross domestic product would have risen at only a 3.3 percent annual rate in the third quarter instead of the 3.5 percent actually reported, according to some experts at the conference. The same gap applies to productivity. And the spread is growing as imports do.

That may help to explain why the recovery from the 2001 recession was a jobless one for many months and why the recovery from this recession is likely to generate few jobs for many months. In addition, more detailed import data would help to explain wage inequality, by linking some low wages more accurately to particular industries exposed to import competition. On another front, many argue that labor productivity is rising faster than the pay of workers who made the greater productivity possible. That argument would be watered down if more accurate data showed that productivity had been overstated. Grappling with these blind spots, nearly all of the 80 experts at the conference, which was sponsored by the Upjohn Institute and the National Academy of Public Administration, agreed that the statistics now published tend to overstate the strength of the economy. That view was shared by those who attended from the Bureau of Economic Analysis, the Bureau of Labor Statistics and the Federal Reserve, all big players in measuring economic performance.

Memosphere Disinformation and Mis-understandings

Seasonally Adjusting Unemployment Floyd Norris points us to one of the foibles of seasonal adjustments: How SA can make things look better or worse at various times of the year. He is referring to the Non-Farm Payrolls data from Friday. Comparing non seasonal apples to apples, the data was somewhat better than usual.

The Glide Path Option The headlines said unemployment, as measured by the "establishment survey," was down by 190,000; and even though that was slightly worse than forecast, market bulls were cheered by the fact that the number was not as bad as last month's. It is an improvement that we are not falling as fast. Well, maybe. What I did not see in many of the stories I read was that the number of unemployed actually soared by 558,000, to 15.7 million, as measured by the household survey. The establishment survey polls larger businesses; the household survey actually calls individual households. Let's look at the real number in the establishment survey. If you don't seasonally adjust the number, the actual change in unemployment for October was 641,000, or about 450,000 more than the seasonally adjusted number.

Real Reality Checks: the Bodhisatvas Speak

Fed's Yellen on the Economic Outlook Lately I’ve been leaning against the view of a “V shaped” recovery. I think that growth will be decent in the second half of 2009, but growth will be sluggish in 2010. San Francisco Fed President Dr. Yellen has a similar view – from her speech this morning: The Outlook for the Economy and Real Estate;

The big issue is how strong the upturn will be. With such enormous reservoirs of slack in the form of high unemployment and idle productive capacity, we need a strong rebound to put unemployed people back to work and get underutilized factories, offices, and stores humming again. Unfortunately, my own forecast envisions a less-than-robust recovery for several reasons. As the impetus from government programs and inventories diminishes in the quarters ahead, private final demand will have to fill the breach. The danger is that demand may grow at too anemic a pace to support vigorous expansion.

The uncomfortable dance between V’ers and U’ers, …. while rich risk asset prices can certainly be viewed as a consensus expectation for a strong recovery, such lofty valuations can also be viewed as a consensus expectation about the Fed’s commitment to erring on the side of being too late, rather than too early, in starting a Fed funds tightening cycle. Indeed, one could actually be agnostic, even antagonistic, about a big-V recovery and still be favourably disposed to risk assets, in the short run. Historically, what pounds risk asset prices is either a recession or unexpected Fed tightening; or worse, both. Right now, it is hard to get wrapped around the axle about recession, since we’ve just had one, which might not even be over. Thus, as long as economic recovery appears underway, even if stoked primarily by (1) policy stimulus and (2) a turn in the inventory cycle, there is no urgent reason for investors to run from risk assets. Put differently, investors can be agnostic about (3) the strength of private demand growth until the one-off forces supporting growth exhaust themselves, as long as they don’t have fear of Fed tightening. In turn, a bull flattening bias of the Treasury curve, with longer-dated rates falling toward the near-zero Fed policy rate, can be viewed as a consensus view that the level of the output/unemployment gap plumbed during the recession is so great that disinflationary forces in goods and services prices, and perhaps even more important, wages, will be in train, even if growth surprises on the upside. Accordingly, Treasury players, like their equity brethren, need not fear the Fed, as there is no economic rationale for an early turn to a tightening process. Thus, both rich risk markets and the lofty Treasury market can be viewed as rational in their own spheres, even if they are seemingly irrational when compared to each other. The tie that binds them, that allows them to co-exist, need not be a common view regarding the prospective strength of the recovery, but rather a common view as to the Fed’s friendly intent and reaction function.

The Shadow Banking System and Hyman Minsky’s Economic Journey”

Posted by dblwyo at 06:36 PM | | Comments (0)

November 07, 2009

Turbulence Isn't Chaos: Dollar, Rates, Trade and Markets

Recently when the dollar's been up stocks have been down, and visa versa. Lying behind that turbulence is the gyrations between RiskOn/RiskOff trading based on liquidity-fueled speculation and the dollar carry trade. All this turbulence has been with us in some form for almost two years but seems to be dampening down. The two problems with a turbulent environment is that the risk and uncertainty is higher so everyone's looking for the patterns and explanations to make high-information signals out of the noisy data. Part of that filtering is the one we just applied (RiskOn/RiskOff) but there are layers behind it as well. A lot of those layers have to do with the outlook for deficits, trade flows, interest rates and exchange rates. And because we're in a policy-driven environment where deep structural changes that are normally predictable and evolve slowly are moving more like high-frequency technical information and subject to changing policy decisions. In this environment it's hard to decide whether or not turbulence is chaos - unpatterned or unpredictable - or not. Sometimes in fact it's not only hard to tell the differences but there aren't many (aerospace engineers talk about turbulent flow which is best modeled with chaos math for example but can be approximated by better behaved equations work ably enough).

What makes the chaos more likely is when to many folks substitute simple-minded ideologies based on philosophical or political preferences for the best available data, analysis and information. In other words when they worship at certain political shibboleths. We're going to attempt to keep on de-bunking yet another set of those shibboleths as part of our continuing efforts to find the patterns and develop the workable, good-enough models for our needs. This time we're going to focus on the Dollar and its relationships to Trade and Rates, while trusting you to review the prior discussions on the economy, deficits, economic policy, inflation, etc. Just to close the loop though the chart is two analysis of the same 3yr weekly SP500 chart which shows that a) all the downtrends we've been talking about are still intact and b) despite the recent rise it's both bumping against the Fib limits from the Oct07 high and churning around now on shorter timeframes of the recent bear rally. Which way it breaks is going to be a tradeoff between liquidity and reality.

Talking About Trade and Rates

To sort the chaos into patterns and make it merely turbulent we're going to try and present some machinery, admittedly conceptual, to try and explain how trade flows are linked to exchange rates and how those are linked to interest rates. The basic relationship is that Net Exports = Savings-Investment, which makes sense when you think about it but also follows from an accounting identity we've talked about before. Briefly (sorry for the shortness but...) Y=C+I+G+X-I. If Net Exports NX=X-I then Y-C-I-G = NX. But Y-C-G is savings so S-I=NX and voila'.

In the long run (at the bottom of this layer cake) you'd like for trade flows to balance out, that is we buy as much stuff abroad as we sell. That requires that we either make lots of stuff they want or don't buy as much from them as we want or they'd like to sell. NB: we've just explained the last ten years inter-dependency between China and the US. In this example Europe buys US goods but needs $ to do that while we need E to buy their stuff. When we buy too little or they sell to much we end up with fewer E than we'd like and they have a hoard of $. One way for that to balance out is for the E:$ exchange rate to adjust, in this case since they've got to many dollars by a drop in the E:$ rate, which would then work backward to reduce the demand for their goods until things are balanced out again.

Another way to re-balance is for that excess hoard of European $ to be invested in US assets, say stocks, bonds or loans. Which is exactly what's been happening between the US and China, or the $ and the Renminbi. We buy more stuff from them, they end up with too many $ so they loan us the funds which we use to buy more stuff. Simple right? In our equations NX<0 => S<I and R:$ should increase to re-balance things. Oops..that didn't work. So now the machinery runs backward, so to speak. Since R:$ is to low money keeps flowing to the US and we keep borrowing to buy things. Before you get to upset about all that let's bear in mind both sides are culpable. We kept playing grasshopper and they got to bring millions and millions of people out of poverty and keep their country from blowing up. There trade and international relations in one easy two paragraph lesson, right?

Continued ...

SPX vs Dollar

Or it could make your head hurt, like it does mine but let's make it worse by circling back to the markets vs dollar question. A while back we took a long look at the impact of exchange rates on the real returns on the stock market using the top part of this chart. It shows the inflation-adjusted vs exchange-rate adjusted SPX and up until 2003 there was no practical divergence. (Now there's a potential investing lesson!). Since then as trade imbalances have grown so has the the divergence and so has the tendency of the dollar to drive the markets inversely. The second sub-chart looks at that directly by comparing the trade-weighted exchange rate for major currencies ($TWX) to the SPX. Pre-bubble there didn't appear to be a lot of relationship but during the bubbles we start to see more...and more with the recent aberrational environment.

From the machinery you'd expect that there'd be a fairly strong relationship between business cycles and exchange rates since during a recovery demand goes up which would increase imports and increase the outflow of $. In the last sub-chart there's some relationship but it doesn't strike us as very clear-cut or stable. So what's going on?

Dollar Driving Factors

Well that's kind of complicated and involves multiple relationships all gyrating together. From the top sub-chart and our trade layer-cake machinery you'd expect one factor would be Net Exports. As NX gets more negative you'd expect the dollar to start dropping. From the top part there's clearly a relationship but it's also another one of those it depends things as well. For example during the '90s the dollar was strengthening while the trade imbalance was getting increasingly worse. Could that have been demand for US equities during the Tech Bubble? Which eventually caught up with us on both fronts (the bubble burst and the imbalances got "too big")? We think that's part of it. And from the middle sub-chart clearly there are business cycle influences, as we noted.

Another major factor though is interest rates. In fact from the bottom sub-chart that seems to be the most clear-cut driving factor, if not the dominant one. As US rates came down and started their long secular decline the dollar followed suit with its own long secular decline, interrupted from time-to-time by other factors, e.g. the Tech Bubble or the recent "Flight to Quality" during the panics last fall. In fact if you look at a shorter-term dollar chart you'll find that after a rapid runup during the flight the dollar is basically returning to that trend. You'll also find that it's flattening out around the 75 level.

Wrapping UP: Long-term Secular Implications

There's a whole bunch of shibbolethic thinking floating around driving Emerging Markets, Dollar depreciation and other asset bubbles. Briefly it's that huge and unaffordable US budget deficits will increase demand for government funding. Now some of that's true and there will be some major impacts. But, paraphrasing Mark Twain, the death of the dollar is greatly exaggerated.

1. A reserve currency must be safe, secure, large and liquid. It's going to be a long time before any other currency can match those requirements and best intermediate term candidate is the Euro. But at the end of the day that will come back to relative growth rates and the long-term prospects of the US are still much better than Europe's, or China's for that matter with the latter's long-term demographic and institutional problems as well as their need to re-structure their economy on a more domestic foundation.

2. As the US saves more it will import less and that will decrease the outflow pressures on the dollar AND increase the domestic pool of funds available for investing in US assets. That means that deficits become more financable domestically for one thing. Coupled to that is the fact that while deficits will be large as the results of previous policy decisions (90% of the deficit problem comes from Bush administration decisions and the financial crisis not new programs) they will not be historically excessive. Again that means that the demand to borrow abroad to finance deficits won't be what people are thinking. A third coupling is that as we demand less and shift to lower energy consumption a similar dynamic sets in with regard to Oil imports.

3. The world needs to re-balance trade flows which requires signifiant adjustments in domestic economies. The US is already making those adjustments and China knows and acknowledges that it needs to but will take time and have political and stability challenges in making them speedily and forcefully.

The bottomlines here are that the US will be a reserve curreny for a long time, though perhaps not the only one and is likely to remain the most important. Another bottomline is that rates will adjust back up since they were abnormally low as the result of the crisis and policy interventions. But we're not likely to see any many surge in rates for a long time and they aren't likely to surge out of control. And, over time, as we get the economy growing again, control deficits and start working them down the doomsayers will find their worries not well-grounded. Which is not to say we aren't facing a decade of slow growth, employment problems and difficulties in writing down the debt. It's what always happens when you've been partying to hard for to long. The hangovers are terrible.

The bottom bottomline is that all the simple answers on investment and business strategy that you've been hearing in the headlines or from the talking heads need to be carefully examined. Will Oil and Commodity demand return to their old levels, speculation included? Unlikely though there are counter-vailing pressures. How about speculating in BRIC equities? Ditto.

More than at any time in a long time this next decade is going to require understanding how things really work from trade to rates to business performance. That's how Warren does it anyway.

 

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READINGS

Dollar up and stocks down–don’t expect that to continue I can’t tell you where stocks are headed in the short term but it does look like the days of the dollar rally are numbered. Why do I think that? The central bank of India tells me so. And if the recent relationship between the U.S. dollar and global equities holds, that means stocks are set to end their current losing streak in the not so distant future. (Recently stocks have gone up when the dollar ha gone down.) The U.S. dollar has an interest rate problem–and it looks like it’s getting worse. The U.S. Federal Reserve has set its target for short-term interest rates near 0%. That makes sense if you’re a central bank desperately trying to get your national economy going. But a 0% interest rate doesn’t help you currency much. Investors can earn more in bonds denominated in Australian dollars or Brazilian reals. Traders can borrow dollars in what’s called the carry trade and then buy assets, again denominated in currencies other than the dollar,  that promise better returns. The desire to sell dollars and hold other currencies gets even stronger when the interest rate differential between the U.S. and other countries is increasing. And that’s exactly what’s happening right now.

Dollar: History, Outlook and Assessments

Growth optimism hits US dollar The dollar hit its lowest level for 14 months on a trade-weighted basis on Thursday as optimism over the prospects for global growth stemmed haven demand. Improving US retail sales figures and a stronger-than-expected fall in weekly jobless claims in the US added to the buoyant sentiment triggered by forecast-beating third-quarter earnings from Alcoa. The dollar index, which tracks its progress against a basket of six leading currencies, fell as much as 1 per cent to a low of 75.767. Late in New York, the dollar was down 0.2 per cent at Y88.45 against the yen and 0.6 per cent lower at SFr1.0262 against the Swiss franc. The dollar also dropped 0.9 per cent to $1.4810 against the euro after comments from Jean Claude Trichet, president of the European Central Bank, weighed on the single currency. At the press conference following the ECB’s policy meeting, at which it kept its main lending rate at 1 per cent, Mr Trichet repeated the mantra that “excessive volatility and disorderly movement in exchange rates” had negative implications for economic and monetary stability.

Dollar Reaches Breaking Point as Banks Shift Reserves Central banks flush with record reserves are increasingly snubbing dollars in favor of euros and yen, further pressuring the greenback after its biggest two- quarter rout in almost two decades. Policy makers boosted foreign currency holdings by $413 billion last quarter, the most since at least 2003, to $7.3 trillion, according to data compiled by Bloomberg. Nations reporting currency breakdowns put 63 percent of the new cash into euros and yen in April, May and June, the latest Barclays Capital data show. That’s the highest percentage in any quarter with more than an $80 billion increase. World leaders are acting on threats to dump the dollar while the Obama administration shows a willingness to tolerate a weaker currency in an effort to boost exports and the economy as long as it doesn’t drive away the nation’s creditors. The diversification signals that the currency won’t rebound anytime soon after losing 10.3 percent on a trade-weighted basis the past six months, the biggest drop since 1991. The economies of both Japan and Europe depend on exports that get more expensive whenever the greenback slumps. European Central Bank President Jean-Claude Trichet said in Venice on Oct. 8 that U.S. policy makers’ preference for a strong dollar is “extremely important in the present circumstances.”  “Major reserve-currency issuing countries should take into account and balance the implications of their monetary policies for both their own economies and the world economy with a view to upholding stability of international financial markets,” China President Hu Jintao told the Group of 20 leaders in Pittsburgh on Sept. 25, according to an English translation of his prepared remarks. China is America’s largest creditor. “The world is currently flush with the U.S. dollar, which is available at no cost,” Kind said. “If there’s a turnaround in U.S. monetary policy, there will be a change of perception about the dollar as a reserve currency. The diversification has more to do with reduction of concentration risks rather than a dim view of the U.S. or its currency.”  The median forecast in a Bloomberg survey of 54 economists is for the Fed to lift its target rate for overnight loans between banks to 1.25 percent by the end of 2010. The European Central Bank will boost its benchmark a half percentage point to 1.5 percent, a separate poll shows.  America’s economy will grow 2.4 percent in 2010, compared with 0.95 percent in the euro-zone, and 1 percent in Japan, median predictions show. Japan is seen keeping its rate at 0.1 percent through 2010. Central bank diversification is helping push the relative worth of the euro and the yen above what differences in interest rates, cost of living and other data indicate they should be. The euro is 16 percent more expensive than its fair value of $1.22, according to economic models used by Credit Suisse Group AG. Morgan Stanley says the yen is 10 percent overvalued.

Currencies: The diminishing dollar This dollar declinism is overblown. It exaggerates the scale of the slide and misunderstands its cause. Much of the recent weakness simply reverses the earlier safe-haven flight to dollars, a sign of investors’ optimism about riskier assets rather than their fears about America’s currency. On a trade-weighted basis the dollar today is close to where it was before Lehman failed. Yields on Treasuries have not risen and spreads on riskier dollar assets continue to shrink. If investors were growing leerier of dollars, the opposite should have occurred. Furthermore, a weaker dollar is what you would expect, given the relative cyclical weakness of America’s economy. Thanks to the hangover from its financial crisis, America’s recovery will be slower than that of other economies, especially emerging ones. That suggests America’s monetary policy will stay looser for longer, pushing the dollar down. A weaker dollar should also assist global economic rebalancing by helping to reorient America’s economy towards exports. So in general, it should help rather than hinder the global recovery.

Foreign demand rises for long-term US assets Foreign demand for long-term U.S. financial assets rose in August even though China trimmed its holdings of Treasury securities. Foreigners purchased $28.6 billion more in assets than they sold in August, according to Treasury data released Friday. That followed a net increase of $15.3 billion in July, and $90.2 billion in June. The Treasury Department is auctioning record amounts of debt to cover a deficit estimated to have hit $1.41 trillion for the budget year that ended in September. Some economists worry that if overseas buyers don't keep buying U.S. debt, interest rates could rise. Inflation eats away at the purchasing power of a currency. China trimmed its holdings by $3.4 billion to $797.1 billion in August, but still remained the largest foreign holder of Treasury securities. Japan, the second largest foreign holder, boosted its Treasury securities to $731 billion, from $724.5 billion in July. The federal budget deficit for 2009, which will be officially released later Friday, is expected to more than triple last year's record imbalance. The Congressional Budget Office projects that under President Barack Obama's spending plans, the red ink will total $9.1 trillion over the next decade. The 2009 deficit ballooned as the government spent massive amounts to stabilize the financial system and jump-start the economy. In addition, revenues plunged as millions of Americans lost their jobs and recession-battered companies paid less in corporate income taxes. China's foreign holdings of Treasury securities are a direct result of the huge trade deficits the U.S. runs with China. The Chinese take the dollars Americans pay for Chinese products and invest them in Treasury securities and other dollar-denominated assets.

Wolfgang Munchau: The case for a weaker dollar Imagine a world with a small current account deficit in the US, a somewhat larger deficit in the eurozone and a not too excessive Asian surplus. In such a world, economic commentators would no longer bang on about global imbalances and would have to find a different subject. In the long run, such a world would require significant reform of the international monetary system. In the short term, a fall in the dollar’s exchange rate would help get us there. And I note with some satisfaction that it is happening. A lower dollar is desirable because it would help America achieve the right kind of recovery. The US economy is severely constrained by household and financial sector deleveraging and possibly by a permanent fall in potential growth. In the absence of another housing bubble and consumer boom, an export-led recovery is the best growth strategy the US could employ. The surplus countries will never adopt policies to get rid of their surpluses. The exchange rate will have to do the job for them. Last week’s announcement of a surprise fall in German exports during August tells me that the hopes of another export-led recovery, as in 2006, are unrealistic. I expect a much reduced current account surplus for Germany in the next few years and, for the eurozone, a sizeable, probably not excessive, current account deficit. The sensible goal of a more balanced world economy is entirely consistent with a weaker dollar and a stronger euro. Exchange rates cannot solve the problem of global imbalances. They did not in the past. Reform of the global monetary system is necessary for sustained balance. Several proposals are floating around for how this could be achieved, for example the creation of special reserve baskets or the use of the International Monetary Fund’s special drawing rights. I expect we will see neither but are moving towards a dual system in which the dollar and the euro act as the world’s de facto reserve currencies.

Policymakers' strong buck myth stops here Be careful what you wish for. True or false? Policymakers here in the United States tell us that they are in favor of a strong dollar. After all, a muscular buck is in everyone's best interest, so they say. Well, Virginia, if you believe these statements, I have a bridge I would like to sell you. Policymakers are actually happy that the dollar is falling, although they will never admit it. You see, a weak dollar at this point in our business cycle is good for what ails us. And if they thought they could get away with it -- in other words, not trigger a round of competitive devaluations -- policymakers would push the dollar down even further. Now before you accuse me of trying to grow this country by debasing its currency while ignoring the risk that foreign investors might lose faith in our currency and not buy U.S. debt, let me remind you that I don't make the rules, I just play the game. And the game is this: a weak dollar helps exports while curbing imports. Besides reducing our trade deficit, a weak dollar gets people to buy less -- especially from other countries. This has got to be good news for such industries as autos, whose firms have seen many of their customers abandon their products for cars made abroad. It is also tidings of comfort and joy for their many suppliers. More good news comes from the fact that about half of American companies' earnings are generated abroad. The stronger other currencies are, the more dollars they translate into when they are totted up back home. A weak dollar also reduces the need for U.S. firms to outsource, thus costing American jobs. Indeed, if the dollar gets weak enough, some jobs might actually be repatriated. As for the reluctance of foreigners to hold dollars and dollar-denominated instruments, let's face it: Where else are they going to put their money? Weak or not, no other currency rivals the dollar when it comes to safety and ease of moving funds in and out. Another byproduct of a weak dollar, of course, is inflation, as the cost of imports goes up giving some domestic companies cover to raise their tags. If the dollar gets weak enough long enough this could happen. But these are two big "ifs" that are unlikely to occur. You see, trees don't grow to the sky, people don't live forever, and no item's price goes one way indefinitely. Recall the dot-com, tech, stock and housing bubbles, to name some recent examples -- not to mention such oldies as Tulipmania, the South Sea bubble, etc. As they teach in Eco 101, the value of the dollar (or any other currency, for that matter) is determined by supply and demand. Today, world financial markets are swimming in dollars because the Federal Reserve created tons of them to forestall deflation after last year's panic. But lately, the central bank has been making noises about taking some of these dollars back, once it thinks that the economy has regained its sea legs. Does this suggest that the beleaguered buck is more likely to be stronger rather than weaker a year from now? You betcha. As dollars become less plentiful, their value will rise as will foreign investors' willingness to hold them. The threat of inflation will diminish as well. But a stronger dollar will in time reverse all the good things I noted above. It's hard to imagine today, but the dollar could even get too strong -- as happened in the mid 1980s. Remember 1985's Plaza Agreement to drive down the dollar?

The Dollar in Doubt? As I've noted on previous occasions [0] [1], Jeff Frankel and I [pdf] have outlined the conditions under which the dollar could lose primary reserve currency status to the Euro. In short, calamitously bad policies that induce rapid currency depreciation, or high inflation, would do the trick. Our results, last updated in early 2008 [pdf], might seem somewhat out of date given all the turmoil that has occurred in the meantime. But it's important to realize that it's the relative performance (US versus euro area) that matters, and I see no greater reason to believe that the conditions are in place for a drastic "reversal of fortune" than before. So, if one looks at the breathless commentary about the euro's share rising to new highs, well, that's true, insofar as one looks at known euro reserves and known allocations. The picture looks a lot less clear when one tries to think about total reserves, a large share of which is of unknown (well, unreported) composition. As always, a little perspective is helpful. In thinking about the prospects for the dollar, I think it's useful to break the forces affecting it into separate pieces. In particular, reserve currency status is not directly linked to the dollar's value, although they are of course related. The dollar could lose value without losing primary reserve currency status, and could gain reserve share without gaining value. In addition, in thinking about the other forces that can affect the dollar in the absence of tectonic shifts in the dollars international currency role, one can identify a number of factors:

  • Portfolio balance effects (dollar asset supply versus demand).
  • Cyclical factors (demand for credit, relative price movements, interest rates).
  • Safe haven factors
  • Structural factors (composition of demand, trend output).

The Dollar Dilemma Legions of pundits have argued that the dollar's status as an international currency has been damaged by the great credit crisis of 2007-9 -- and not a few have argued that the injury may prove fatal. The crisis certainly has not made the United States more attractive as a supplier of high-quality financial assets. It would be no surprise if the dysfunctionality of U.S. financial markets diminished the appetite of central banks for U.S. debt securities. The only problem is that, for all the talk about change, the dollar's importance to the world has not diminished. In the foreign exchange market, the dollar actually strengthened following the outbreak of the crisis. When investors fled to safety, they fled to U.S. Treasury bills. In the face of spreading illiquidity, U.S. and foreign investors alike sought refuge in the most liquid market, the market for U.S. government debt securities. Since then, the dollar exchange rate has fluctuated, but there has been no dollar crash. And there is no evidence of a massive loss of confidence. By process of elimination, it is clear that the dollar will remain the principal form of international reserves well into the future. It will not be as dominant as in the past, for the same reasons that the United States will not be as dominant economically as it once was. In the short run, the euro will gain market share, especially in and around Europe. In the longer run, the renminbi's role will also grow, especially in Asia. But for as far as one can see clearly into the future, the dollar will remain first among equals. This state of affairs -- with several national currencies sharing, albeit unequally, the status of reserve currency -- would not be unprecedented. The emergence of a reserve system based on multiple currencies should not be viewed as alarming. Such an arrangement functioned smoothly before World War I: the different reserve units coexisted peaceably, each in effect with its own constituency.

The rumours of the dollar’s death are much exaggerated It is the season of dollar panic. These panic-mongers are varied: gold bugs, fiscal hawks and many others agree that the dollar, the dominant currency since the first world war, is on its death bed. Hyperinflationary collapse is in store. Does this make sense? No. All the same, the dollar-based global monetary system is defective. It would be good to start building alternative arrangements. We should start with what is not happening. In the recent panic, the children ran to their mother even though her mistakes did so much to cause the crisis. The dollar’s value rose. As confidence has returned, this has reversed. The dollar jumped 20 per cent between July 2008 and March of this year. Since then it has lost much of its gains. Thus, the dollar’s fall is a symptom of success, not of failure. Can we find deeper signs that the world is abandoning the US currency? One beloved indicator is the price of gold, which has risen four-fold since the early 2000s (see chart). But its price is a dubious indicator of inflation risks: its previous peak was in January 1980, just before inflation was crushed. Higher prices of gold reflect fear, not fact. This fear is not widely shared. The US government can borrow at 4.2 per cent over 30 years and 3.4 per cent over 10 years. During the crisis, the inflation expectations implied by the gap in yields between conventional and inflation-protected securities collapsed. These have since recovered – yet another sign of policy success. But they are still below where they were before the crisis. The immediate danger, given excess capacity, in the US and the world, is deflation, not inflation. The dollar’s correction is not just natural; it is helpful. It will lower the risk of deflation in the US and facilitate the correction of the global “imbalances” that helped cause the crisis. I agree with a forthcoming article by Fred Bergsten of the Peterson Institute for International Economics that “huge inflows of foreign capital to the US facilitated the over-leveraging and underpricing of risk”.* Even those who are sceptical of this agree that the US needs export-led growth. Finally, what can replace the dollar? Unless and until China removes exchange controls and develops deep and liquid financial markets – probably a generation away – the euro is the dollar’s only serious competitor. At present, 65 per cent of the world’s reserves are in dollars and 25 per cent in euros. Yes, there could be some shift. But it is likely to be slow. The eurozone also has high fiscal deficits and debts. The dollar will exist 30 years from now; the euro’s fate is less certain. This view may be too complacent. The danger of a collapse of the dollar is small and of its replacement by another currency still smaller. But a global monetary system that rests on the currency of a single country is problematic, for both issuer and users. The risks are also growing, particularly since the emergence of “Bretton Woods II” – the practice of managing exchange rates against the dollar.

Dollar hegemony for another century Let me stick my neck out. The dollar will still be the world’s dominant reserve currency in 2030, sharing a degree of leadership in uneasy condominium with the Chinese yuan. It will then regain much of its hegemonic status as the 21st century unfolds. It may indeed end the century even stronger than it was at the start. The aging crisis in Asia — and indeed the outright demographic implosion in Japan and China, not to mention China’s water crisis — will soon be obvious to everybody. Talk of Oriental supremacy will start to sound overblown at first, and then preposterous. Japan is about to go bankrupt. It is on the cusp of a fiscal crisis that will change perceptions of Asia dramatically. The fact that Asian central banks are accumulating $600bn or more a year in reserves by running huge trade surpluses is proof enough that their (mostly rigged) currencies are undervalued by 30pc to 40pc against the West. To that extent, I agree entirely with HSBC currency guru David Bloom that this is untenable. If these countries continue to resist currency appreciation they will overheat and succumb to asset bubbles — if they haven’t already in China. Where I am less sure is that this will necessarily be resolved by a falling dollar. The evidence so far is that Asia will put off the day of adjustment as long as possible because they are addicted to mercantilist export strategies — and export oligarchs control the political systems (bar Japan). In which case they will lose competitive edge the old-fashioned way, by wage inflation for year after year until the world comes back into alignment. If so, the dollar will not fall at all. It may rise. Professor Becker said a collapsing birth rate is extremely hard to reverse, and the cultural effects are insidious. Old societies are status quo. They are slow to embrace new technologies. Young minds are the source of hi-tech invention. The EU is fully aware of the danger. “What is at risk in the medium to long run is nothing less than the sustainability of the society Europe has built and the viability of its civilisation,” said an EU report (initially suppressed) by former Dutch premier Wim Kok as long ago as 2004. Nothing has been done since despite endless warnings from the Commission. China’s work force will peak in absolute terms in six years, and then go into sharp decline. I have no idea how people square this with claims that China will soon replace the US as world hegemon. The stark reality is that China will hit a Japanese-style demographic crunch before it becomes rich. Sheer size will give it weight. But mastery?

Misguided monetary mentalities One lesson from the Great Depression is that you should never underestimate the destructive power of bad ideas. And some of the bad ideas that helped cause the Depression have, alas, proved all too durable: in modified form, they continue to influence economic debate today. What ideas am I talking about? The economic historian Peter Temin has argued that a key cause of the Depression was what he calls the “gold-standard mentality.” By this he means not just belief in the sacred importance of maintaining the gold value of one’s currency, but a set of associated attitudes: obsessive fear of inflation even in the face of deflation; opposition to easy credit, even when the economy desperately needs it, on the grounds that it would be somehow corrupting; assertions that even if the government can create jobs it shouldn’t, because this would only be an “artificial” recovery. In the early 1930s this mentality led governments to raise interest rates and slash spending, despite mass unemployment, in an attempt to defend their gold reserves. And even when countries went off gold, the prevailing mentality made them reluctant to cut rates and create jobs.

But we’re past all that now. Or are we? America isn’t about to go back on the gold standard. But a modern version of the gold standard mentality is nonetheless exerting a growing influence on our economic discourse. And this new version of a bad old idea could undermine our chances for full recovery. Consider first the current uproar over the declining international value of the dollar. The truth is that the falling dollar is good news. For one thing, it’s mainly the result of rising confidence: the dollar rose at the height of the financial crisis as panicked investors sought safe haven in America, and it’s falling again now that the fear is subsiding. And a lower dollar is good for U.S. exporters, helping us make the transition away from huge trade deficits to a more sustainable international position. What’s even more extraordinary, however, is the idea that raising rates would make sense any time soon. After all, the unemployment rate is a horrifying 9.8 percent and still rising, while inflation is running well below the Fed’s long-term target. This suggests that the Fed should be in no hurry to tighten — in fact, standard policy rules of thumb suggest that interest rates should be left on hold for the next two years or more, or until the unemployment rate has fallen to around 7 percent.

Death cometh for the greenback, For the past eight years, the dollar has increasingly become less revered. Its value has been volatile. As the rest of the world saw the United States struggling with a failing war and soaring budget deficits, many who had large dollar holdings began to reduce those reserves (or increase them less than they otherwise would have). All this put downward pressure on the dollar. And thus began the first signs of a vicious circle. The strength of the dollar is becoming riskier and riskier. The growing U.S. deficit and the ballooning of the Federal Reserve’s balance sheets leave many worried that in their wake will come inflation, undermining the long-term attractiveness of the U.S. currency. In this article, I try to explain why the dollar is in trouble, but ask—should we care? What are the consequences? I will suggest that, for the most part, and for most Americans, it is probably a good thing. But the adjustment to a lower value of the dollar will not necessarily come easily. One of the consequences—already under way—is the fraying of the dollar-reserve system. I argue that a move to a global reserve system would be good for the United States, and good for the world. America’s debt-to-GDP ratio is slated to increase from 40.8 percent in 2008 to 70 percent or more by 2019, and if interest rates return to more normal levels of say 5 to 6 percent from their current range of 0.0 to 0.25 percent, it will mean the cost of paying interest on the debt will eat up a substantial fraction of tax revenue (20 percent or more)—unless taxes are raised. The costs of funding programs for the aging baby boomers will only put further strains on the budget. Granted, deficits by themselves need not present a problem. Deficits are of course only one side of a country’s balance sheet. On the other side are assets. If a company borrows money to make high-return investments, no one is worried—so long as those investments do in fact yield returns.Our soaring deficit is not a concern if the money is spent on education, technology, infrastructure—all investments that historically have yielded very high returns, far higher than the interest rate the government has to pay—because then the returns to our society are far greater than the costs. But, if the money is spent on wars in Afghanistan or Iraq, poorly designed bailouts for banks or tax cuts for upper-income Americans, then there will be no asset corresponding to the increased liabilities, and then there is cause for concern. This seems to be the road we have been heading down for the last eight years and, disappointingly, are to too-large an extent continuing to travel. And with it there will be strong incentives to reduce the burden of the debt through inflation because inflation reduces the real value of what is owed. It means the government will pay back its debt with dollars that are worth less than they are today. THE CURRENT system is unstable, leads to a weakened global economy and is unfair. It works to the disadvantage of developing countries, but also to the disadvantage of the United States. It is a system that produces only losers. Developing countries have been putting aside hundreds of billions of dollars in low-yielding reserves instead of undertaking potentially high-yielding investments.

Rates, Monetary Policy and Trade

Treasuries Rise on Speculation Fed Won't Raise Rates Until Late Next Year  Treasuries rose for the first time in three days on speculation the dollar’s decline will spur demand from foreign investors as the Federal Reserve keeps interest rates at a record low through late 2010. Today’s rally follows the biggest weekly decline in Treasuries in two months and comes as the dollar slid to the weakest level against the euro since before the bankruptcy of Lehman Brothers Holdings Inc. Fed Vice Chairman Donald Kohn said very low interest rates will be warranted for “quite some time.”  “A decline in the dollar makes Treasuries cheaper,” said Michael Pond, an interest-rate strategist in New York at Barclays Plc, one of 18 primary dealers that trade with the Fed. “That could encourage some buying. If that trend is expected to continue, then foreign investors should expect a decline in the value of their foreign holdings.”

There Is No Divine Right To A Trade Surplus Another day, another dollar (going down forever.) The reflation trade is on, so on, baby, kick-started by Don Kohn's suggestion last night that the output gap is wider than the Grand Canyon and another wave of better than expected earnings, led by Intel after last night's close. JP Morgan announces at noon London today, kicking off a busy week of kleptocrats' banks' earnings. But while equities are performing strongly, the real story of the day thus far has once again been the dollar. Not only has EUR/USD made a new high for the year above 1.49, but now even oil has broken out, suggesting that a sinking dollar lifts all boats. While the dollar is traditionally weak in Q4 as FX reserve managers top up their non-US$ holdings (a trend that should be in full effect this year as Voldy and co. scoop up zillions in fresh reserves via intervention), it's hard to shake the feeling that the Obama administration is secretly delighted with the demise of the buck. To date, there have been no meaningful adverse effects of a dollar decline- Treasury auctions are still going swimmingly, and oil prices have been in a range for the past several months. Sure, they've had to field the odd angry phone call from the Europeans, but that's pretty small potatoes to date. Still...it's not hard to see a scenario where the Eurogroup (and potentially the ECB) start hammering more forcefully on the Americans about dollar weakness and the Chinese about euro strength. Yet while Macro Man has considerable sympathy for the view that China needs to quit taking the piss when it comes to its and others' currencies, he finds it less easy to swallow the Europeans' viewpoint vis-a-vis the dollar. A few charts will explain why. So what lessons are we to draw from all this? Looking at the assembled charts above, it seems pretty clear that (quelle surprise!) further rebalancing is required in the US. A weaker dollar would appear to be part of that equation; certainly the anecdotal evidence here in the UK (another persistent deficit country with a toilet paper currency) is that sterling weakness has curtailed the amount of foreign-made goods available for purchase. Unfortunately, the (admittedly unscientific) contrast between Japan and Switzerland sends the message that protecting your patch is the right thing to do, while letting the global rebalancing chips fall where they may is an act of supreme folly. It's a message that China and Europe appear to have learned all too well. Looming protectionism has been a flashing dot on Macro Man's radar for sometime; the apotheosis of the DGDF trend is likely to bring it into sharper focus. With the global recovery still on shaky footing, it seems likely that dollar weakness is going to force everyone (including the Americans) to try and protect their patch, whether they "should" be running a positive trade balance or not. Unfortunately, there is no divine right to a trade surplus. Seventeenth and eighteenth century European monarchs once thought that they, too, had a divine right- in their case to rule as they saw fit. That worked fine.....until it didn't. (Just ask Charles I or Louis XVI!!). One can only hope that the denouement to the current "divine right" thinking is a bit less bloody....

Reviewing the recession: Was monetary policy to blame? In a recent speech given at the University of South Alabama, Federal Reserve Bank of Atlanta President Dennis Lockhart added his voice to what is now the general consensus: "I agree with all who are declaring that a technical recovery is under way." There is still much work to be done, of course, not least the continuing examination of just what led to the recession and how a repeat performance can be avoided. One theme of this examination appeared in last week's Financial Times:

"It is certainly true that the most recent bubble, its bursting and the Fed's actions in the aftermath have inspired existing critics and recruited new ones. The first charge is that interest rates under Alan Greenspan, [current Fed Chairman Ben] Bernanke's predecessor, were kept too low for too long, contributing to a bubble of easy credit."

Here is an exercise that that I find intriguing. Suppose we try to estimate, as closely as we can, the actual interest rate decisions of the Federal Open Market Committee (FOMC) over the period spanning the beginning of Greenspan's tenure to the present. It turns out that by using an approach based not only on measures of inflation and actual output relative to potential but also on the lagged fed funds rate, you can actually get pretty darn close to statistically describing what the FOMC did: Which leads me to my main point on the chart above: If you are of the opinion that interest rate policy was good through the late 1980s and 1990s, then there seems to be a good case the FOMC was just sticking with "proven" success as it set interest rates through the dawning of the new millennium. There is, of course, the possibility that the pattern of the funds rate depicted in the chart above was incomplete all along in the sense that whatever variables are explicit and implicit in the estimated rule, they did not include information to which the FOMC should have responded. In calmer times, the story would go, not including potentially pertinent information was not much of a problem. Eventually the missing-data chickens could come home to roost. The prime omitted variable suspect would, of course, be some sort of asset prices. Scratch any gathering of macroeconomists these days and out will bleed a steady stream directed at incorporating credit and financial market activity into thinking about the aggregate economy. Thus far, one of the lessons from models in which financial intermediation is taken seriously is that interest rate spreads or stock prices or other asset prices do become part of the policy rate recipe. Your response might well be something along the lines of "duh." You are entitled to that opinion, and I won't push back too hard. But it is yet far from clear that the financial crisis can be explained by a misstep in the setting of the federal funds rate caused by the failure to make whatever adjustments might have been indicated by the inclusion of pertinent financial variables in implicit rate-setting rules of thumb. Furthermore, early versions of research I have seen that combines capital regulation policy and interest rate policy suggest that the macroeconomic consequences of getting the former wrong may be much greater than the consequences of getting the latter wrong. To me, that conclusion has the ring of truth.

Bernanke Calls for Trade-Gap Action Large U.S. trade deficits with developing countries, though smaller than they were two years ago, remain a threat to the global economy, Federal Reserve chief Ben Bernanke said Monday in a speech that called on policy makers in the U.S. and Asia to address the issue. Mr. Bernanke's comments -- in which he urged Asian leaders to build better pension systems and to increase government spending, and the Obama administration to address the U.S. budget deficit -- reflect a growing consensus among world leaders on the need to rebalance global economic growth so it depends less on U.S. consumers. The U.S. shipped dollars overseas to buy foreign-made goods and services. Many emerging-market central banks, wary of letting their currencies appreciate against the dollar and hurting their own export-led growth, recycled those dollars by purchasing U.S. Treasury bonds and other debt. Speaking at a Federal Reserve Bank of San Francisco conference on Asia, Mr. Bernanke said the U.S. financial system was "overwhelmed" by the inflow of capital. "We must avoid ever-increasing and unsustainable imbalances in trade and capital flows," he said.

Posted by dblwyo at 11:50 AM | | Comments (0)

November 05, 2009

Cuspiness, Collisions & Conundrums: Market Carry, Employment & Euphorillusions

An amusingly alliterative title, don't you think? With just that touch of the common with the hattip to what's his name the comedian..John Stewart was it? :) An alternative might be it's still not any different but the delusions are rampant. We also find ourselves in the familiar position of having to much to add to let it go with just an update, especially since the mythologies and delusions continue to run rampant. Specifically we're in a trading market being pushed along by speculative momentum and sentiment and based on the US Fed interest rates funding an all market carry trade. That's one major delusion. A deeper one is that, despite all the claims to the contrary, most of these folks think that it really was going to be a V-recovery and it's dawning on them that's not true, though they haven't adjusted their positions. The third is that the number of ungrounded and ideological shibboleths driving investment and trading decisions is monumental, including mis-understandings of rate outlooks, employment, debt and deficits, inflation and the dollar.

Our next major scheduled post was going to be on the dollar and further de-mythologizing in fact. Instead we're going with the flow and putting up our fourth major post on the markets, three in a row in fact, to try and keep trying to correct some of the euphorillusions. Actually this whole set of market discussions are really one long giant post that fits into our series on de-mythologizing so we start the readings off with the complete inventory of Market and Mythologies history and will hope to get back on track sometime in the future. The net result of substituting ideology for analysis is two colliding mis-understandings that are on major tipping points. The first is the obvious carry trade and asset bubbles. The second is employment and the implications for rate policy. We won't re-visit all the mythologies but will concentrate on two: Rates vs Employment and the Bubble(s), but we'll also spend a little time looking at Emerging Markets and Illusions.

Rates, Employment and Inflation

 The first thing to understand about Fed rates is that they don't raise rates until employment is growing again. That's one of the primary purposes in life, a strategic goal and explains why Greenspan's Fed left rates so low for so long (Employment didn't begin a "recovery" until '03 btw). The other thing to understand is the other key factor is Inflation. Now we've discussed both of those repeatedly and some of those discussions are listed in the readings for your review. As it happens almost all of the standard thinking has got it wrong - which means almost all of the headlines and investment decisions floating around are ill-founded, to say the least and being very polite. Employment is going to be very weak for a very long time (it takes 5%+ real GDP growth to start making a dent and we're going to have 2.5%). Inflation is likewise not a danger for the foreseeable future because banks poor position means that all that excess liquidity is going to stay on their books and not in the economy - technically that's called money velocity and it's a measure of how fast the supply of money turnsovers in the economy (cf. the readings). What ties it all together is a modified Taylor Rule that links Employment and Inflation to rates. A version that works very well is:

Rates = 2.07+1.28*Inflation-1.95*Excess Unemployment.

With low inflation and high unemployment the Fed should be setting rates at -5.6% and keeping them there for well into 2011 or beyond. That may lead to future problems but it also means that the only thing keeping the wheels on the wagon is stimulus spending plus quantitative easing where the Fed buys various debt instruments to try and lower rates directly. That means that fuel could be added to the carry trade fire for a while and that the dollar could continue under pressure. It also means that all the surge in asset prices is policy-driven, not based on fundamentals and all the talk you hear about Gold, Emerging Markets, et.al. is based on very shaky foundations.

Continued ...

 Bubbles to the Left, Right & All Around

Let's take another look at that question of widespread and endemic bubbles. There a a couple of things to notice here. First, that we are indeed riding into the valley of the Six Hundred Again and, second, that lots of folks have noticed. Though we think the first to really point to the problem are, not surprisingly, Roubini and Simon Johnson. But this week both the IMF and the World Bank issued major warnings.

Aside from Gold another really bad example is Emerging Markets, which have just roared ahead. But it's not the only one as the graphs of South Korean and Australian home prices show. Can you believe it? That might bring us full circle back to China and the now multiple stories about liquidity injections showing up in stock prices, real estate, and mis-placed investment in infrastructure investment (a point we won't dig into since we've been hammerring away at it so many times before, largely courtsey of Michael Pettis. NB: the world appears to have picked up on Michael's warnings and his themes are now widely written about and accepted but he's still the original and the deepest IOHO.). Here's you homework assignment - actually two, and they ARE for extra-credit. What asset class do you think is NOT part of all this? What happens when realities set in? Which they will sooner or later.

EM as Representative Futures

Lest you think we're picking on Emerging Markets too much rather than treating them as representative let's take a sideways segue and look at the Strategic Outlook. Emerging Markets crossed a cusp point at least five years ago where they've moved onto entirely new footings with regards to stability, security and safety and returns. Many have noticed that recently but have still not adjusted their investment strategies. A state of affairs we think is well-captured in this graphic.

In our reading the top chart shows both the double-bubble in EM stocks, which anticipated the inflow of investment funds surge, and the continuation of that surge after investors discovered the cusp point crossing. BUT...the bottom half perfectly well proves the other point - allocations to EM stocks relfect the old realities not the new ones. Which calls for major re-structurings of portfolios and investment strategies. The question is when and based on what information?

Which leads to the really critical point. There is no substitute for actually understanding what's going on. Too many folks have substituted "invest in the BRICs" for actually digging even the slightest into the underlying realities. Now in several previous posts we've tried to apply our Vulcun methodology of evidence-based analysis instead of relying on ideological shibboleths by pointing out that Brazil appears to solidly grounded, then India, then China and way behind, Russia. On a 1-10 scale we'd rate Russia as at best a 3, China a 4-6, India a 5 and Brazil a 7 from a long-term perspective. Anticipating a burst bubble though we'd apply a systemic downgrade that would take everybody down several notches. In other words if you're interested in protecting your investments it's time to start getting out, or getting prepared to get out and re-position yourself for the anticipated future.

Warren Is a Vulcun: Lessons From the Master

One of the interesting, among many, West Wing episodes is the one in which one sub-theme is about a bunch of Chinese Christians who fled persecution and are seeking asymlum in the US. President Bartlett proposes to test their Faith by testing them for Shibboleths, a label we've often used repeatedly. A shibboleth is, as the Chinese leader says, an outward sign of an inward Faith. The catch is that one can't apply evidence and analysis on this topic but one can and must to questions of investment strategy or decision-making in general.

One of the most startling learnings for us over the last year is the extent to which people let their hindbrains entirely dominate their thinking and realy on their forebrains as engines of rationalization to justify the conclusions they've already reached. Warren Buffett is famous for his results, for his folksy wisdom and for his principles. What almost all the commentators ignore is that Warren DOES NOT make his decisions in 15 minutes of gut-level response. Instead he invests enormous time and effort, which he doesn't talk about very often, on acquiring a detailed knowledge of how things really work. The most difficult of his principles is never invest in anything where the intrinsic value is not far less than current market value, preferably by at least 25% if not more. The difficulty of course lies in determing  that value, which is where careful investigation is required. If you're not willing to Pay the Piper then go to the Dance. The other, among several key lessons, he follows is not to let ideology substitute for thinking. It's all right to have emotions and principles. It's not all right to let them dictate your decisions - they are ideals and goals.

Right now all the evidence points to almost all assets being vastly over-valued based on reasonable analysis of the best available data, the Spockian approach. What does that tell you? Especially when so many are are arriving at their conclusions based on ideology instead of analysis and converting the resulting conclusions into Shibboleths. Your hindbrain will win if you let it so it's up to you to substitute thinking and discipline. Easy to say of course and very hard to do - and not something we've found many (sadly including ourselves) are willing to do in all circumstances (cf. Cognitive Dissonance, Double-Bind).

But that way lies salvation!

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Previous Posts

Markets

Mythologies

Rates vs Recovery

Fed Keeps Rates Low, Leaves Statement Largely Unchanged  The Federal Reserve affirmed its plan to keep interest rates "exceptionally low" for a long time despite signs of economic recovery. But the Fed began to lay rhetorical groundwork for an eventual shift in its stance, suggesting that when the unemployment rate falls or if expectations of inflation turn up, it could change course. "Economic activity has continued to pick up," the Fed said in a statement following a two-day meeting. It noted that consumer spending has improved, housing activity has increased and businesses were retrenching at a slower pace. Fed officials voted unanimously to maintain their target for the key federal-funds interest rate -- at which banks lend to each other overnight -- near zero and said they expect to keep it there for an "extended period," which suggested increases are at least several months off. Central banks in smaller economies -- such as Australia, Israel and Norway -- have started raising interest rates. But the Fed made clear the U.S. economy isn't nearly strong enough to begin moving in that direction, even though the economy grew at a 3.5% rate in the third quarter and is expected to keep growing into 2010. While consumers are spending, the Fed noted they were "constrained by ongoing job losses, sluggish income growth, lower housing wealth and tight credit." Meanwhile, "businesses are still cutting back on fixed investment and staffing, though at a slower pace."

Two easy-money pieces As regular readers know, I’ve been growing increasingly concerned about the buzz saying “the recession’s over, let’s raise interest rates”. I think the ZIRP — the zero interest rate policy — needs to stay in place until unemployment has declined a long way, probably below 7 percent. And that will probably take years. A couple of recent pieces reinforce that argument. One is this recent post at Macroblog on “trimmed” inflation. The concept is this: when we’re trying to assess inflation trends, what you really want is the sluggish, “inertial” part, not the short-run fluctuations. The usual technique is to exclude traditionally volatile prices — food and energy — to get “core” inflation. An alternative, however, is to “trim” all big price changes, and look at the middle of the distribution. What you get depends on how much you trim. This suggests that disinflation is proceeding rapidly. And a falling inflation rate, possibly even deflation, means that a zero interest rate is less expansionary than it seems. I do want to beware of the ECB syndrome, switching my preferred inflation rate as needed so as always to justify the same policy, but I think there’s something there. Next up, a San Francisco Fed study that tries to capture how the Fed funds rate relates to the interest rates that matter for spending. Basically, this says that much of the Fed’s loosening has been offset by troubles in the financial system, so that actual credit hasn’t gotten much looser at all. And this in turn means that the zero-rate policy isn’t nearly as expansionary as it might seem. That doesn’t mean that the Fed funds rate has no effect; it means, rather, that you need a lower Fed funds rate to get any given effect. If credit-market troubles persist, this adds up to another reason to keep rates at zero for a long time — possibly even after a Taylor rule suggests they should finaly start going up.

The madness of the monetary hawks (wonkish) Well, let’s use the Taylor rule estimated by Glenn Rudebusch at the San Francisco Fed. (Yes, I know that John Taylor himself likes a different rule — but like Brad DeLong, I find Taylor’s argument more or less incomprehensible.) The Rudebusch version of the rule is: Target fed funds rate = 2.07 + 1.28 x inflation - 1.95 x excess unemployment where inflation is measured by the four-quarter change in the core PCE deflator, and excess unemployment is the difference between the actual unemployment rate and the CBO estimate of the NAIRU, which is currently 4.8 percent. This rule describes past Fed policy quite well. Applied to current data, the rule says that the Fed funds rate should be — drum roll — minus 5.6 percent. You can’t do that, of course, so we’re very hard up against the zero lower bound. And if you think the Taylor rule was a good guide to policy in the past, the Fed shouldn’t start to raise rates until the rule starts, you know, yielding a positive number. So when will that happen? Will it happen any time soon? Not if you believe conventional forecasts. Predictions from the Survey of Professional Forecasters, say that unemployment late next year will still be only marginally lower than it is now, and core inflation will have fallen; the implied target rate for fourth quarter 2010 is around minus 5.5, barely changed from the current situation. By late 2011 the forecast calls for modest reductions in unemployment — but I still get a target Fed funds rate well below zero.

When should the Fed raise rates? (even more wonkish)  Right now, this rule says that the Fed funds rate should be -5.6%. So we’re hard up against the zero bound. Suppose that core inflation stays at 1.6% (although in fact it’s almost sure to go lower.) Then we can back out the unemployment rate at which the target would cross zero, suggesting that tightening should begin: it’s an excess unemployment rate of 2.2, implying an actual rate of 7 percent. That’s a long way from here. If inflation drops to, say, 1 percent, the Fed shouldn’t tighten until unemployment drops to 6.25%. What would it take to get to that range of unemployment? Okun’s Law suggests that it takes 2 points of GDP growth in excess of potential to reduce unemployment by 1 point. Potential growth is probably around 2.5. So say we have 5 percent growth for the next 2 years — which would be hailed as a stunning boom. Even so, unemployment should fall only 2.5 points, to 7.3. In other words, even with a really strong recovery (which almost nobody expects), the Fed should keep rates on hold for at least two years.

Credit vs Velocity: NOT

Credit woes continue A recent Bloomberg article was titled”Pandit “near death” hoard signals lower bank profits “, and stated that Citigroup Inc. and JPMorgan Chase & Co. were hoarding cash as if another crisis were on the way. Also, a Wall Street Journal article entitled “Jittery Companies Stash Cash“ showed cash on the balance sheets of S&P 500 companies was the highest in 40 years. The chart below, courtesy of economist David Rosenberg of Gluskin Sheff & Associates, shows that credit is still contracting as banks go through the painful process of repairing their balance sheets. As indicated, bank lending has now declined for 21 weeks in a row and over this entire period a total of $216 billion (15% at an annual rate) of loans and leases has vanished. “The contraction in bank credit is broad based across all lines of business - consumer, real estate and companies - and seems to be motivated by both the bank and the borrower. This is a dead-weight drag on aggregate demand and it goes to show that the real story in Q3 was not that it was so wonderful that real GDP expanded at a 3.5% annual rate but that the number was so low in view of the massive dose of government stimulus and that the contraction in credit is ongoing and acting as a tourniquet on private sector spending activity,” said Rosenberg. Meanwhile, the US Depository Institutions Aggregate Excess Reserves continue their ascent at levels far in excess of the amount banks need to keep on deposit to meet their reserve requirements (see chart below). The level indicates that the balance sheets of banks remain under pressure, especially in view of the fact that the value of some assets is not known. A definite peak in the Excess Reserves graph should coincide with a turning point for banks getting back into the business of making loans.

Money Magazine Interview, Part 2  The current crisis and the Great Depression are the only two that took place under deflationary conditions. In the Depression, the economy fell into what economists call a liquidity trap. The money supply shrunk, banks closed, money wasn't circulating. When you're in a liquidity trap there's no question that the government has to step in with fiscal policy to drive spending in the economy upwards so that money will circulate. You have to have an activist fiscal policy. Fast-forward to the present time, and a lot of conservative economists said, "Well, we can't be having a repeat of the Great Depression because the money supply did not shrink." But what they forgot is that insofar as the money supply affects the economy, it depends not only on the amount of money but on the velocity, that is the rate at which the money turns over. DF: And people aren't spending money, banks aren't lending money. BB: Exactly. For years, spending was inflated because of the housing bubble. People tend to spend anywhere between 5 and 10 cents of each additional dollar of increase in their wealth, so if housing wealth goes up by, say, a trillion dollars, you're going to get perhaps as much as a hundred billion dollars per year of additional spending. And so the decline of many trillions of dollars in housing wealth causes the reverse effect, with people spending less. This decrease in spending reduces velocity, and a decline in velocity is identical economically to a decrease in the money supply. DF: And the deflation that results from that has been especially pernicious, discouraging people from spending money, because they know that if they wait, things will just get cheaper. BB: That's absolutely right, most particularly with the housing market. Nobody wants to be a sucker and spend $300,000 for a house today and find out you could have paid $275,000 if you'd waited a week or two. Now, the Fed tried to compensate, but spending declined too fast. And they ran into the same problem we had in the Great Depression - a liquidity trap. The stimulus package may have been oversold by the Obama administration, but the basic principle - that we needed government spending to get us out of the liquidity trap and make monetary policy effective - was absolutely correct. With the benefit of hindsight we can say that the stimulus could have been better targeted, better designed. But you know, the house was on fire, and we were spraying water on the house. And you can't worry about water damage when the house is burning down.

Arrogance, Ignorance Recurring in Economic History  PAUL SOLMAN: In a new book, "This Time Is Different," Rogoff and co-author Carmen Reinhart document the long history of financial crises. And we do mean long. If you looked at financial crises across virtually every continent for something like 800 years, is it just something in the nature of human beings that we go through these cycles? KENNETH ROGOFF: There's no doubt about it. I mean, the recurring theme is arrogance and ignorance: ignorance that this has happened before in other places, in other countries; and arrogance thinking we're special, this time is different. We have financial globalization. We're running our economy better. "They're lending us a lot of money because they love us and we're doing a good job." That's what the officials think. PAUL SOLMAN: Co-author Carmen Reinhart: CARMEN REINHART, coauthor, "This Time Is Different: Eight Centuries of Financial Folly": "Whatever rules of the game are, they just simply don't apply to us." And that is the essence of the arrogance that dominates the boom phase. And it is. The seeds of the crisis are sown during the boom. PAUL SOLMAN: They say they tried to warn a convention of economists in a paper they gave in January 2008. But you didn't say to your colleagues, look, it's time to sell, sell, sell? KENNETH ROGOFF: No. We didn't say, sell, sell, sell. But our paper said that the United States will be lucky not to have a deep financial crisis. CARMEN REINHART: You know we're not seers, but it allowed us to say, if history is any guide, we're lucky if that doesn't happen here and now. PAUL SOLMAN: Lucky, we were not, which would have come as no surprise to the data. KENNETH ROGOFF: When you have a big inflow of foreign funds -- and we had a massive one -- you're at risk. When you deregulate your markets rapidly, which we did in the states, that also very often happens that you have a deep crisis. The real killer is short-term debt, debt that has to be refinanced all the time. Well, that's what the subprime was. You had to refinance it. PAUL SOLMAN: And, so far, it turns out, the recovery, too, is typical, housing prices, for instance. KENNETH ROGOFF: They tend to collapse and stay down for a long time. PAUL SOLMAN: And the stock market? KENNETH ROGOFF: Well, believe it or not, it goes back to where it was after two to three years. PAUL SOLMAN: And unemployment? KENNETH ROGOFF: Unemployment lingers. It goes on almost five years from the beginning with unemployment rising. CARMEN REINHART: It takes a little under two years to go from peak to bottom, which is roughly where we are right now. But it takes about another two years, on average, to get back to your income level before the crisis.

Carry, Markets & Bubbles

Fears of a New Bubble as Cash Pours In Concerns are mounting that efforts by governments and central banks to stoke a recovery will create a nasty side effect: asset bubbles in real-estate, stock and currency markets, especially in Asia. The World Bank warned Tuesday that the sudden reappearance of billions of dollars in investment capital in East Asia is "raising concerns about asset price bubbles" in equity markets across Asia and in real estate in China, Hong Kong, Singapore and Vietnam. Also Tuesday, the International Monetary Fund cited "a risk" that surging Hong Kong asset prices are being driven by a flood of capital "divorced from fundamental forces of supply and demand." Behind the trend are measures such as cutting interest rates and pumping money into the financial system, which have left parts of the world awash in cash and at risk of bubbles, or run-ups in asset prices beyond what economic fundamentals suggest are reasonable. Prices are surging across a host of markets. Gold, up about 44% this year, soared to a record high Tuesday. Copper is up about 50% in the past year. In the U.S., risky assets are rising rapidly in price: The risk spreads, or interest-rate premiums, on low-rated junk bonds have narrowed to about where they were in February 2008, before Bear Stearns and Lehman Brothers fell, according to Barclays Capital. Policy makers from Beijing to London, seared by the fallout from burst housing and credit bubbles, are searching for ways to head off new ones. How to handle a bubble "is one of the big two or three unanswered questions at the end of this crisis," says Adair Turner, chairman of the U.K.'s Financial Services Authority. Bank of Korea Governor Lee Seong-tae hinted last month he would raise interest rates, if necessary, to prevent Seoul's housing market from lurching out of control."This is the beginning of another big and excessive run-up in asset prices," said Simon Johnson, a former IMF chief economist.The symptoms of a frenzy are most evident in Asia and the Pacific, where economies are recovering most quickly.

Did We Learn Anything? Carry Trade Edition  While many hedge funds make claims that they don't have any equity beta and the returns are alpha driven, as a group that is certainly not the case. That said, over the long term these funds have done exceptionally well, providing equity like returns when equity markets were up and dampening the downturn when equities sold off. The problem for hedge funds comes when the correlation among all risk assets approaches one (i.e. the EVERY strategy performing in line issue - see the reverse of the top chart from last November). When 'all assets' sold off in the Fall of 2008, leverage became an investors worst enemy as it meant forced selling to meet liquidity needs. It was only the MASSIVE injection of liquidity from the Fed that stopped the risk asset sell-off downward spiral that had the potential to take out any and all levered investors (along with hedge funds, we can throw banks, endowments, and even homeowners in the mix). My concern now is that it appears we haven't learned anything from the turmoil that happened all of 8-12 months ago. As Nouriel Roubini recently pointed out, the correlation of all risk assets has approached one as all assets have all moved in one direction... up. Why? One reason is the world's investors are turning to the US dollar for their carry trade currency of choice (if you haven't read it yet... READ IT). At a high level it goes like this... the dollar's decline is a one way bet. The issue is that at some point the dollar may not even reverse its decline, but will stabilize, increasing the "real" cost of borrowing the dollar. BUT... if the correlation of assets purchased is near one on the way up, it is sure as hell going to be that high or higher on the way down. And what happens to all these investors that are attempting to leave the same exit door at the same time? Massive re-purchasing of the dollar and massive selling of any risk asset... joy.

Turbulence, Shibboleths & Illusions

Setting free the bears, THE STOCK MARKET'S astounding run from its March lows has finally run into a real ceiling. After outpacing most, if not all, post bear-market rallies over the past century the inevitable is finally here. But is it part of another correction or something more? The urgency of the sell-off suggests the latter. That said, I don't see the danger of the market testing its March lows any time soon. Previous bouts of selling in August and September gave indications that the top was finally in, prematurely it turned out. While the underlying fundamentals didn't appear to justify such a huge rally of more than 50% from the lows, the technicals weren't negative enough to satisfy the bears. But now, both of these factors have been reversed. The rising trends in the major market indexes have been broken to the downside, and industry group after industry group is now rolling over, including banks, transportation and apparel stocks.  On the sentiment side, the widely followed Chicago Board Options Exchange volatility index -- a.k.a. the VIX -- spiked up to levels not seen since July, when financial media was rife with talk of a major reversal pattern on the charts. Back in the summer, the sudden attention paid to technicals underscored the anxiety that was growing. But the market continued to climb that proverbial "wall of worry." But with the VIX topping the 30 level Friday, many technical analysts now believe that the bears have taken control.

Chances of a deeper correction are rising: Chris Wood, Global equities have surged about 70% in six months on hopes of a rebound in the US economy. However, with valuations getting stretched, central banks raising the drumbeat on policy tightening, and fear that governments may withdraw their stimulus measures, the road ahead looks bleak for global equities. Chris Wood, Equity Strategist, CLSA, says the chances of a deeper correction in global equities are rising. Jim Walker, MD, Asianomics, too doesn't see a V-shaped recovery in global equities. "If you look at the level of activity across the world from Europe to America to Japan to Asia, it is weak. It's a very weak recovery so far and as governments withdraw stimulus over the course of the next year, it is going to get weaker still."

  • Why I think this is only a correction The last leg of this rally has been built almost solely on speculative cash flows in my opinion. Borrowing in the global dollar carry trade—where traders borrow U.S. dollars at interest rates near 0% and then use that cash to buy commodities, commodity stocks, commodity-backed currencies, and emerging market equities—has been the biggest source of that cash. Which is why I don’t think the rally that started on March 9 is over yet.
  • Have stocks moved from dip to consolidation already? And is the next move up? With the Federal Reserve set to speak on the economy and interest rates later today, November 4, and with potentially market-moving numbers on unemployment due out on November 5 and 6, it is certainly too early to say that the dip, correction, whatever, is over. The news in the next few days could certainly send investors back into worry mode and extend the losses of late October into early November. But the stock market indexes are showing signs of moving from a potential correction to consolidation.
  • Is gold the new dollar? The U.S. dollar does, indeed, seem to be in a long-term decline. Many of the countries with large currency reserves such as China are heavily over-weighted toward the dollar and are known to be looking for alternatives. The currency alternatives to the dollar have their own problems ranging from low trading volumes to fiscal deficits at home. Gold, in contrast, looks like a stable store of value for the long term.
  • Pincers Here is a weekly chart of the SPX showing the 20-week (red) and 100-week (blue) moving averages (click to enlarge): The 100-week halted the rally, while the 20-week has been supporting the rally. So, as these two pincers converge, we are getting volatile ping-pong action. This will build to a boil until prices explode out of the apex. Traders are obviously keyed into the FOMC announcement on Wednesday, and the big jobs report Friday. I would expect a breakout, one way or another, by the end of this week.
  • Turnarounds As is always the case with the yellow metal, there are a dozen stories and theories offered for its performance, and per the usual it is difficult to distinguish fact from fantasy. However, an Occam's Razor analysis might well suggest that someone is taking an (informed?) punt on either financial stability, the maintenance of globally easy liquidity conditions, or both. If the latter, in particular, one would have to posit that the dollar would come under renewed pressure after the Fed (unless punters wish to wait for payrolls).

A whole new world for emerging markets, Pension fund executives around the world are putting their faith — and assets — into emerging markets to provide more investment bang for the buck. But some consultants and money managers believe pension funds still have a long way to go and need to increase those allocations closer to 35% of total assets — or roughly the weighting of emerging markets in the global economy — from the current allocation of about 5% or less for the average fund. The financial crisis has challenged several historical assumptions generally made about investments in developing nations, including the level of volatility, liquidity constraints and ability to withstand a severe global downturn. So far, emerging markets generally have fared better than major economies in weathering the storm, helping to attract assets at a record pace.  “We're in the midst of resetting the clock on emerging markets. Going into this (financial) crisis, the assumption that many pension plans — even the most sophisticated — made was that emerging markets would do less well than developed countries coming out of it,” said Cynthia Steer, chief research strategist and head of beta research group at consulting firm Rogerscasey Inc., Darien, Conn. “A whole new construct is evolving — driven by factors such as higher (gross domestic product) growth and lower impact from the banking crisis on emerging markets. This is a presage to a re-evaluation of the risk/return relationship between developing and developed markets” by defined benefit pension fund executives, Ms. Steer said. “I think it is long overdue.”

It’s a Small World (of Illusion) After All! When Barry invited me to contribute a blog post this week, I thought it might be fun to think of the many forms of illusion we all frequently experience in our broad world of finance and economics. I’ll contribute a few of my own observations and perhaps you could add some of your own. Financial Plans: This may be unexpected coming from a CFP but financial plans, in general, are highly illusory in nature. The conventional planner gives the client exactly what the client (or what the client’s brain) wants – a neat and attractive package containing graphical displays and supporting data that illustrate the quickest monetary movement from point A to point B – in other words, unrealistic shortcuts. Most financial planning software still have default annualized returns of higher than 10%, which is simply an irresponsible assumption to make, to put it lightly. Heuristics: On the subject of illusions and brains, your brain is wired for pattern recognition, which is why the vast majority of investors are fooled by randomness. In my humble opinion, the fundamental cause of this financial crisis is heuristics. The core deadly assumption, based upon pattern recognition, made on all sides of finance preceding the crisis included the assumption that home values and personal income would continue rising in perpetuity. In summary, illusion is not just visual or optical in nature – it may be considered a distortion of reality, including the understanding (or misunderstanding) of any form of information received by the brain. Because the information available to the brain is rarely complete, it simply fills in the missing spaces, which opens the door to much opportunity for the illusionist to manipulate reality (and the potential peril for those lacking in self-knowledge and mindfulness). Without this awareness, we actually enable the illusion.

Think Like the Master

Think Like Warren Buffett 1. Think of Stocks as a Business Many investors think of stocks and the stock market in general as nothing more than little pieces of paper being traded back and forth among investors, which might help prevent investors from becoming too emotional over a given position but it doesn't necessarily allow them to make the best possible investment decisions. 6. Recognize the Psychological Aspects of Investing Very simply, this means that individuals must understand that there is a psychological mindset that the successful investor tends to have. More specifically, the successful investor will focus on probabilities and economic issues and let decisions be ruled by rational, as opposed to emotional, thinking. More than anything, investors' own emotions can be their worst enemy. 8. Wait for the Fat Pitch Hagstrom's book uses the model of legendary baseball player Ted Williams as an example of a wise investor. Williams would wait for a specific pitch (in an area of the plate where he knew he had a high probability of making contact with the ball) before swinging. It is said that this discipline enabled Williams to have a higher lifetime batting average than the average player. Buffett, in the same way, suggests that all investors act as if they owned a lifetime decision card with only 20 investment choice punches in it. The logic is that this should prevent them from making mediocre investment choices and hopefully, by extension, enhance the overall returns of their respective portfolios.

Masterclass: Buffett on Investing and Business Analysis At the end of the last post we laid down a, perhaps the, challenge for these interesting times:

"As this sorting goes on the real winners will be the firms and industries who have an effective business model or who re-invent one. Finding them will be the interesting challenge. "

So how does one go about sorting things out. Well there's our interesting little mantra of economy - industry - firm but we thought, beyond that, we'd appeal to the words of the Master. Mr. Warren Buffett himself. Now at some point you've probably seen Warren's basic principle's in some business article or heard him on Rose or someplace else. Certainly the AAII article does a superb job of translating those principles into a screening set, within the limits. We'd summarize/paraphrase them roughly as: 1) Understand the business and be absolutely confident in it as a business for the long-haul, 2) view investments as buying a piece of the business and be comfortable not trading them for 10 years, 3) look for companies with sustainable competitive advantages that protect the core value proposition and 4) pick companies with good management. Listening to Warren takes those simple-sounding principles and fleshes them out with examples and discussions that makes them meaningfully operational. Beyond that though we got several surprises that, as long we thought we'd been following Buffett, were eye-openers: 1. Understand the business - everybody's heard that he make a decision in 5-10 mins. What's new news to us is that a) he adds develop a circle of competency, say 30+ companies, you really understand and follow and b) it takes a lot of digging and research. It turns out the Warren spent a long...long time and a lot of effort learning how businesses really work, i.e. what their business models are. Since this is our central mantra we were extremely gratified to hear it.  

 

Posted by dblwyo at 02:24 PM | | Comments (0)

November 03, 2009

It's Still Different: Refreshing Policy and Market Info

We were going to add a few links with some interesting stories that came out since our last post on the Markets. Interestingly there were so many that adding a couple, or a mere few, to that post seemed in appropriate. Nonetheless if you'd consider this as at least partly an extension it might be a good idea.

The basic themes we struck, and have been striking, are:

1. We could never justify the rally on the basis of fundamentals, economic outlook or valuations and have been viewing it as a relief rally. The continued triumph of optimism over experience, otherwise euphorillusion.

2. The central fact that we think explains about everything is the world's Central Banks have been pouring liquidity into the world's banks who have largely been sitting on. In that process they've in turn made their returns, where they made them, in the last two quarters thru proprietary trading of one form or another.

3. Generally we've taken to calling this the RiskOn trade where the saving of the financial system combined with all that surge in homeless cash led to money pouring into risky assets. If you checklist your way thru all the markets and asset classes it explains about everything from China to Gold to the rise and fall of the dollar. For example when Risk is on money flows out of the US, thereby dropping the dollar, and visa versa.

4. As the recovery gets underway several Central Banks are beginning to tighten up their policies and are preparing to withdraw liquidity. That will tend to reduce the liquidity pools.

5. At the same time it is slowly and reluctantly beginning to dawn on folk that the economy is not going to see a V-Recovery. Which shows up, for example, in last Friday's debacle when consumer spending was so much worse than expected. Or, as we put it, supwise, supwise (in the immortal words of Gomer Pyle, FRB).

A Glance at the Markets

Given that the markets are all moving together we can continue to look at the SP500 as the proxy for just about everything else, suitably adjusted for differences in liquidty, risk preferences and illusions. So here's a little market snapshot we took yesterday that highlights the situation as we see it.

What we see is a technical pattern called a "fallling wedge" where the market is very shortly going to have to make up its mind about which way to break. On the last several months history having it break yet again to the upside wouldn't be a great surprise. Having it break to the downside would be merely rationale and on any number of grounds (earnings, profits, economic outlook, valuations). Barry Ritholz put up a couple of David Singer annotated charts on Head & Shoulders patterns today that are linked in the readings you ought to look at as well, though they are a bit more complicated.

Notice as well that volatility is increasing. Prior to the sandpile collapse last Fall when the VIX got to 30 it meant a major drop in the market. Now we'll see, won't we? Notice that the MACD indicator is beginning to tip over on the bottom of the weekly chart as well. Since everybody's expecting a correction it ought not to exceed 15-20%. It'll be when the real economic realities sink in next year that fundamental re-thinkings set in on valuations.

In the meantime we suggest you at least skim the readings on Central Bank policy as well as several others on the market situation and outlook.


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READINGS

Tighter policy could slam the recovery Looking toward the final two months of the year, will the same themes that have worked so far this year, keep working? To date in Hong Kong and China, property and high beta stocks have outperformed, boosted by a renewed risk appetite and massive monetary easing.The weakening greenback has also been an important driver, as the U.S. dollar debasement trade has allowed equity investors to engage the carry trade with a great deal of impunity, according to a new strategy report from Nomura.But policy tightening could soon become the dominant market theme, meaning it's time for a rethink. After recent rate hikes in Australia and Norway, tightening is back on the agenda in many countries, including China. And with the U.S. just clocking up 3.5% annualized GDP growth for the third quarter, dollar bears will have something to think about.Nomura says its time to get a little more defensive in the face of what they call a "cappuccino recovery" - one-third espresso, one-third milk and one-third froth.They argue investors face a dilemma on how to discriminate between genuine and sustainable areas of economic growth and the sharp rise in asset prices, often aided by excess liquidity.

Central banks to call tune  A round of rate decisions from across the globe this week will underscore the difference between the commodity-oriented economies that have proved insulated from the global credit crunch, and those at its core -- the United States and Great Britain.Australia is expected Tuesday to continue leading the way toward higher interest rates, but it's not clear that major central banks will be following suit any time soon.A faltering equity rally and rising volatility will put extra emphasis on this week's round of major central bank meetings, strategists said, with the U.S. Federal Reserve's policy statement Wednesday likely to serve as the linchpin.On Thursday, the Bank of England must decide whether or not to extend its massive 175 billion pound ($289 billion) quantitative easing program as it wrestles with a recession that appears set to outlast other industrialized economies. The European Central Bank, which sets monetary policy for the 16-nation region that uses the euro currency, also holds its monthly meeting Thursday.

Fed's Path to Higher Interest Rates Begins to Take Shape  An economic recovery seems to have begun, and Federal Reserve officials are thinking mostly these days about how to unwind the unprecedented stimulus they've pumped into the economy. Eventually that will mean raising interest rates.What will a Fed tightening cycle look like? When will it begin? Fed officials don't have answers to either question yet, and investors would be wrong to think they do. But the contours of what a rate-boost cycle could look like are beginning to come into focus as the Fed's next policy meeting approaches Tuesday and Wednesday.Three points emerge: First, an internal debate on tightening policy and how to communicate that to the market is only just beginning, and most officials don't believe the economy is near healthy enough yet to move toward tightening. Second, don't count on a tightening cycle to look like the last one. And third, the behavior of financial markets could take on added importance this time.In the weeks ahead, officials are likely to begin elaborating on the economic outlook and speaking more directly about how that will affect their decisions about interest rates. Fed Vice Chairman Donald Kohn took a step in that direction in a late September speech, in which he pointed to how hard it will be to fill in the blanks for investors.

Watch out, higher volatility ahead. A jumpy market can cost you a chunk of cash even if the indexes don’t plunge.What the last week or so most likely signals, in my opinion, isn’t a clear shift in market direction but an increase in the market’s volatility. Up and down moves both are going to be more exaggerated for a while even as the market as a whole doesn’t go much of anywhere.In other words we’re going to go sideways for a while. (Yes, I know “a while” isn’t terribly specific but it’s the best my crystal ball can do right now.) I still expect that this sideways period will resolve into another leg up.“Sideways” isn’t as good as up if you’re invested in stocks. It sure beats “down,” of course.But it does come with its own dangers- especially if it’s sideways with enough volatility get emotions running.The danger is that a choppy market will lead you into a frenzy of buying and sell as you try to keep up with its constantly changing moods. All this supposes, of course, that what we’re going through now is a period of scary volatility that will with a resumption of the rally that will run into 2010.

Words from the (investment) wise for the week that was (Oct 26 – Nov 1, 2009)Rewind the movie to before the stock market lows of March 9: stocks down, corporate bonds down, commodities and gold down, emerging-market currencies down, safe havens in fashion, including the US dollar and government bonds. In short, risky assets closed sharply lower over the past few days as concerns mounted over the outlook for central bank policy and the sustainability of the global economic recovery, with investors only warming momentarily to the US emerging from recession as shown by the Q3 GDP report (announced on the 80th anniversary of Black Tuesday, October 29, 1929).Cameron Brandt, senior analyst of fund tracker EPFR Global, said (via the Financial Times): “Good corporate earnings - viewed in recent weeks as fuel for a sustained recovery - are currently being regarded as ammunition for policymakers looking to close the fiscal and monetary stimulus taps.”

Jittery Companies Stash Cash Stung by the financial crisis, companies are holding more cash -- and a greater percentage of assets in cash -- than at any time in the past 40 years.In the second quarter, the 500 largest nonfinancial U.S. firms, by total assets, held about $994 billion in cash and short-term investments, or 9.8% of their assets, according a Wall Street Journal analysis of corporate filings. That is up from $846 billion, or 7.9% of assets, a year earlier.The trend appears to have continued in the third quarter, despite an improving economy. Of those 500 companies, 248 have reported third-quarter results. Their cash increased to 11.1% of assets, from 10.1% in the second quarter.The cash stockpiling has accelerated a trend that dates back about two decades. In the second quarter of 1991, the 500 largest nonfinancial companies held 3.9% of their assets in cash, according to the Journal's analysis of data from corporate filings compiled by Capital IQ, a Standard & Poor's business. That number rose steadily to 9.2% in mid-2004.Rene Stulz, a finance professor at Ohio State University's business school, says companies increased cash holdings as globalization and technological change exposed them to more risk. "Firms are riskier than they used to be, so they need a bigger security blanket," he says. They are holding more of their assets in cash than at anytime since the 1960s, when payment automation reduced the need to hold cash for daily operations, he says.Kathleen Kahle, a professor at the University of Georgia's business school, offers another reason: the growth of high-tech companies, which tend to hold lots of cash. Younger, riskier firms have more difficulty raising money when credit is tight, so they keep more cash on hand, she says. "At the same time, they have a lot of growth opportunities and want to make sure that they have the funds necessary to invest in good projects," she adds.

Up/down, buy/sell, gloom/boom: It’s not easy to be a long-term investor The stock market is fixated on the short-term, we all know that. It’s an unusual occasion when stock analysts and investors look more than a few quarters ahead. That means stock prices often tend to respond to short-term news as if it were the only news.And that means investors with a long-term view of companies and economic trends can often buy likely long-term winners while they are temporarily depressed by short-term news. This kind of long-term thinking in a short-term market is one of the best ways I know of for the average investor to beat the stock market indexes.In pursuing that kind of strategy, however, too much caution is actually a bad thing. Let me explain—and give you some examples of stocks and sectors where taking the long view will pay off.Investors who believe, firmly, in those long-term trends sold gold, oil and other commodities; bought dollars; and dumped developing economies. The iShares MSCI Brazil Index ETF (EWZ) fell even more steeply than the S&P 500, dropping 6.2% from October 19 through October 28.That’s completely understandable. After all investors have suffered through two vicious bear markets, the one that began in 2000 and the other than started in 2007, in the last ten years. And the lesson of those bear markets is sell first and ask questions later. And right now caution shouldn’t be stopping you from making the kind of long-term bets that you’ll need to earn decent returns in the decade ahead. If, as I suspect, average annual returns are going to be lower than the long term average for stocks of about 10%, then you need to some kind of strategy for beating the market if you hope to meet your financial goals. That’s exactly what the best oil company CEOs are doing right now, for example.

Posted by dblwyo at 03:50 PM | | Comments (0)