LRG Capital Report by Larry Goldfarb

A Moral Hazard

Almost one year to the day after President Obama was sworn into office as an agent of change, voters in Massachusetts sent a clear signal to Washington that the current status quo was not working.  The surprise vote out of Massachusetts late last month has completely changed the investment and political climate.  The American middle class understands that most of the elected officials in Washington are not working for them, but rather working for their lobbyist groups and major corporate donors.  The first shot was fired last week in what will turn out to be one of the most important policy making years since FDR in the 1930’s.  The people have spoken and they have made it clear that the current status quo of bailing out the big guys while the everyday man struggles to keep his job and pay the bills is not working and must be changed.  President Obama, who has turned into one of the best poll watchers since President Clinton, heard the message loud and clear and immediately called a press conference to explain how his administration is going to get tough on the banks.  Front and center at the press conference was former Federal Reserve Chairman Paul Volcker who is famously known for breaking the back of inflation in the early 1980’s.  Mr. Volcker reemerged on the campaign trail last year as part of Obama’s economics team, but was missing in action this year while Federal Reserve Chairman Bernanke and Treasury Secretary Geithner were busy giving sweetheart deals to the banks.  While the rhetoric in Obama’s speech last week was promising that he would enact tougher rules on the banking sector going forward, we can only hope that the President follows through.  All this comes at a time where the financial markets are enjoying hearty gains with the S&P 500 up over 60% from its March lows.  However for all the gains we have seen in the markets over the past 6 months the economy, while stabilized, is still losing jobs and showing little to no real economic growth after you take away the massive amounts of stimulus and incentives.  Make no mistake about it, the economic recovery we have seen the past year was bought by the Federal Reserve with taxpayer money.  Banks are still not lending, and rightfully so as the economy is weak and creditworthy borrowers are harder to find, while the consumer is still working on deleveraging his personal balance sheet by paying off or defaulting on debts.  If the economy and jobs do not start picking up soon we will see continued budget shortfalls on the federal, state, and local levels as municipalities struggle with significantly lower tax receipts from previous years.  We have begun to see major fights between city and union leaders regarding job and pension benefit cuts and we expect this debate to get heated throughout the year.  The most likely result of further budget shortfalls will be even higher unemployment.  Unfortunately, with time running out, and the market seemingly only going higher, everyone from banks, to pension funds to the individual investor are rushing back into the markets with borrowed money, forgetting the lessons of the past year and again putting the economy at risk of another major collapse.

The most notable and ironic investor to return to the markets after the financial crisis of last year is none other than the bailed out banks.  Wall Street is again marketing derivatives last seen before the credit markets froze in 2007.  Bank of America and Morgan Stanley for example are encouraging clients to buy swaps that pay higher yields for speculating on the extent of losses in corporate defaults.  These are the same instruments that according the President’s own economic advisors took the system to the brink of disaster last year.  As Wall Street recommends more complex trades, investors are also augmenting bets with borrowed money.  Some banks are offering as much as 10-1 leverage on securities backed by prime jumbo home loans for example.  While 10-1 leverage is substantially less than the 30-1 that was used during the lead up to the financial crisis, what we now know is that if the securities purchased on borrowed money begin to lose value, the holder stands to lose most or all of the investment quickly.  And with problems persisting in the residential real estate market, many of these securities seem particularly vulnerable at this time.  But if you are a bailed out bank, investment risks don’t pertain to you because you believe that the Federal Government will once again be there to pick up the pieces.  These are exactly the kinds of financial risks that we hope Obama will address as soon as possible as we cannot afford to have another meltdown like we saw last year.  

Not to be outdone, the individual investor is also back in the markets.  The New York Stock Exchange’s most recent disclosure of margin debt indicates a surge in trading in margin accounts where total debt shot up to $231 billion as of December, up $58 billion from February or 30%, and also an increase of 4.5% from November.  In other words, speculation is now rampant, and to make things worse, those speculators are once again leveraging themselves.  And we all know what happens when levered speculative bets turn out not quite as expected.  For those who may be confused, Dow Jones provides a useful primer of how a margin call feedback loop tends to play out and make things ugly, fast:

A potential pitfall for those trading "on margin" is a sharp decline in stock prices, which can expose investors to margin calls, requiring them to post additional collateral lest their brokers sell their securities to cover the debt. A wave of margin calls can worsen selling pressure on stocks and was seen as partly to blame for the market's woes in the fall and winter of 2008-09.

It’s nice to see that the United States casino is up and running again after almost taking our entire financial system and way of life into the abyss last year.  But not to worry, like the bailed out banker, the individual investor knows that if anything goes wrong Mr. Bernanke will be there to simply print our way back to prosperity. 

And if everyone else is gunning for higher returns, pension fund managers have to keep up so some have decided to leverage their portfolios.  The strategy calls for leveraging or borrowing against a pension funds’ safest assets, like government or other high grade bonds.  The State of Wisconsin for example, which manages $78 billion became among the first to adopt the strategy. The fund will borrow an amount equivalent to 4% of assets this year and as much as 20% of its assets over the next three years.  The timing of this decision to leverage a bond portfolio couldn’t have come at a worse time as many economists are forecasting a pickup in inflation and an increase in interest rates as the economy recovers.  This scenario of higher inflation and interest rates, which we agree with, would cause bond prices to fall, which would only be magnified if leverage was employed. Of course, nothing is certain with the markets and if we do end up in a deflationary environment a bond portfolio would do quite well.  However, the idea that pension funds would add to their risk exposure less than a year after one of the worst financial crashes since the Great Depression should ring an alarm that there is still more pain to come as the excesses have yet to be worked out of the system.

As we have stated here many times before, the idea of fixing a problem of too much debt with even more debt is ludicrous and doomed to fail.  We still do not know the extent of the toxic securities being held at banks (and the Fed itself for that matter), but as more companies, states and entire countries (Greece, Dubai, Spain) default on debts we will soon find out.  Bernanke may have bought the financial sector and himself another couple of years by flooding the system with massive amounts of dollars.   We only hope that investors and individuals alike do not grow complacent and begin to take on excessive risks again as the last crisis fades from memory.  The truth that no one in government is willing to admit is that if economies at home and abroad do not start growing again soon, we are very likely to be right back in the same kind of financial panic we saw last year. 

LRG Capital Report: 2010 Forecast

It’s hard to believe that it has already been a year since we published our last year end outlook and forecast for the financial markets and economy. Our forecast last year for continued volatility and higher commodity prices in 2009 came not only from a disastrous 2008, but also from the premise that the Federal Reserve and government would work with (or should we say for) Wall Street in an attempt to shore up the nations insolvent mega banks. 2009 has proved to be one of the most volatile and destructive years for Main Street and Wall Street since the Great Depression. The repercussions from the fiscal and monetary policies we have undertaken as a nation this year will be felt for some time. We believe that historians will have to rewrite the history books a few times over as the nation and world slip in and out of recession and the effectiveness and side effects of the policies initiated this year are realized. One thing we can say without a doubt is that despite the recent rise in equity markets, the general global economy is still weak and vulnerable to outside shocks such as we have seen with recent developments coming out of Dubai. As we closed out 2008, asset prices were at such depressed levels that making a directional call, on oil for example, which was trading at $35 a barrel at the time, made sense not only for technical and fundamental reasons, but also because of the amount of liquidity that global central banks were pumping into the system. As asset prices have recovered this year, we believe 2010 will prove to be much more of a stock pickers market as traders and investors will have to pay much more attention to the news coming out of central banks with respect to interest rates and timing of liquidity withdrawals from the system.  With this, our final entry to the LRG Capital Report for 2009, rather than trying to predict where we think the markets will end the year, we will attempt to identify various scenarios and trouble spots that investors and businesspeople alike should consider as 2010 unfolds.

Given that the US consumer accounts for almost 2/3rds of the GDP, the biggest question for 2010 is the consumer’s attitude and spending habits in the face of a 10% unemployment rate.  We simply do not see a true economic recovery happening until a) the unemployment rate drops substantially, and/ or b) the huge amounts of debt hanging over the consumer is paid back or destroyed through defaults or bankruptcy.  The sooner either of these happen, the better off we will be in the long run.  While recent economic readings have begun to show positive signs, with the unemployment rate actually dropping to 10.1% last month, we will have to wait and see if this is the start of a new trend.  We will get more clues of the state of the consumer early on in 2010 when retailers report their results on the 2009 holiday season.  Early indications, however, point to a consumer that is still dealing with the crash of home values.  Survey results released after the Thanksgiving weekend showed that cash was king for holiday shoppers, with only 26% of those who shopped over the weekend saying that they used credit cards for their purchases.  A total of 39% of those who shopped said they used cash, while the remaining shoppers used debit cards.  When consumers shun credit cards it is a bad sign for retailers because people who buy gifts with a credit card tend to spend anywhere from 20 to 40% more on gifts than those who pay with other methods.  With credit card companies increasing rates, continued job losses, boomers heading into retirement scared half to death about a lack of savings and banks reducing credit limits in response to rising defaults, it’s no wonder that consumer attitudes towards debt, borrowing and banks has changed.  This change in attitudes is key and something that we don’t feel Mr. Bernanke understands yet.  The Fed can print money until they run out of trees, but until the economy begins to show some life, people are simply not going to borrow and spend money they do not have.  This huge shift in consumer attitudes regarding credit will contribute to the delay of economic recovery next year and beyond.     

The next area where we expect to see major disruptions in 2010 is the municipal bond market.  Unfortunately, major states including California, New Jersey, Florida and Oregon, and major cities like New York are facing major fiscal deficits due to bloated pension obligations and have done little so far to ease their respective burdens aside from borrowing more money.  2009 saw investors buying municipal bonds for their attractive yields given their tax exempt status but the risk is clearly not worth the reward.  Policymakers need to be cautious that their response to this crisis does not exacerbate the next one as simply borrowing more money to paper over short term issues will only make things worse down the road.  And politicians are beginning to take notice as their constituents are voting with their pocketbooks.  In New Jersey for example, long time incumbent Democratic Governor Jon Corzine was defeated by Republican challenger Christopher Christie who has consistently said that he is opposed to borrowing more money via bond sales as voters understand that the only way to pay for more borrowing and spending by their respective municipalities would be through higher taxes.  Given that there is no realistic way for many municipalities to pay back their debt, we believe that the municipal bond market itself is in a bubble. Ever since the City of Vallejo declared bankruptcy late last year, rumors, some justified and some nonsensical, of other cities and counties that may follow a similar path have been surfacing. If and when cities, municipalities, and counties begin to declare bankruptcy, (which we are expecting) municipal bond yields are going to soar across the board making it that much more difficult for other struggling counties to refinance their debt.  The challenge for municipalities in 2010 will be to figure out how to reduce their employee and pension obligations without disrupting city services such as police and sanitary services and this will not be a small task.   The deficiencies cannot be put on the backs of taxpayers.  While bankruptcy may be the best option for some cities and counties, much of the burden will have to be met by the unions who will have to agree to major concessions.

Late last month, the first shot was fired in the sovereign debt market with Dubai telling its creditors that it will default on over $80 billion worth of obligations.  Global equity markets quickly sold off on the news and the markets have traded sideways since the announcement.  The dollar benefited from the news as investors moved back into safe assets such as US Treasuries.  In the case of Dubai, construction and real estate accounted for as much as 25% of the economy creating a massive real estate bubble- think California, Florida etc.  The major lesson to take away from Dubai’s default is that market participants know the potential for a serious correction is quite real.  Investors and media hypesters alike will begin to realize that calls for Dubai’s neighbors to step in and bail the country out will fall on deaf ears.  While Abu Dhabi has recently said that it would bailout Dubai to the tune of $10 billion, this is only a drop in the bucket to the nearly $80 billion worth of debt that Dubai has asked to restructure.  There is a simple reason why this problem will not be fixed by a simple cash infusion: the real estate assets purchased by Dubai are now only worth a fraction of what was paid for them during the boom years.  For example, the W Hotel in Manhattan, which Dubai paid $282 million for in 2006, was recently sold at auction for $2 million. 

As was the case with the sub-prime debt market in the United States, the credit agencies have proved to be extremely slow in downgrading sovereign debt credit ratings.  With Dubai, the credit agencies only began to downgrade the nation’s debt AFTER its announcement to restructure payments.  The slow response of the credit agencies means that investors will have to do their own homework and pay close attention to credit spreads around the globe.  Leading up to Dubai’s default, sovereign credit CDS began to widen dramatically forecasting the event.  Looking ahead for 2010 and beyond, it is obvious that we will see more sovereign debt defaults as countries fail to meet their obligations.  A few countries whose debt we are paying close attention to in respects to defaults are the ones that have been described with the acronym PIGS- Portugal, Ireland, Greece and Spain.  Additionally, we feel that Eastern Europe requires a careful watch and especially Ukraine, which saw a 15.9% drop in 3rd quarter GDP and is already relying on a $16.4 billion loan from the International Monetary Fund to avoid bankruptcy. 

Readers of this blog know that we believe that we are in the midst of a secular bear market.  The next decade is likely to produce less than average growth as we work through the bad choices we’ve made both individually and as a nation.  With a 10% unemployment rate (the unofficial rate, including those who have given up looking for a job or who are underemployed, is actually closer to 17%) that in the Fed’s own words will remain elevated for some time, we simply cannot avoid the fact that we are facing major structural problems and will have to make difficult choices in the coming years.  As noted above, the entire developed world has huge pension, medical and other obligations that will be nearly impossible to meet, short of a miracle.  It’s clear now that the consumer is not going to borrow and spend (and rightfully so) the way they have over the past 15 years.  Everyone understands that we are in a serious downturn and need to know the truth rather than have our politicians lie to us daily about promoting a strong dollar policy or economic readings that stretch the truth (to say the least).  Politically, President Obama must distance himself from the failed Bush economic policies and team, or he risks losing the majority Democrats now hold in Congress and his own re- election in 2012.  Federal Reserve Chairman Bernanke and Treasury Secretary Geithner have failed and need to go.  President Obama will no longer be able to blame President Bush for the country’s economic problems as his term moves into its second year.  People are fed up with what is seemingly a two tiered system of the haves and have nots and are simply going to vote whichever party is in power out of office out with a pure protest vote.  President Obama ran on a platform of change, but within weeks of his Presidency we began to see the same cast of failed characters reemerge and reappointed, and in some cases promoted.  We hope that in 2010 we begin to see some real changes from our political leaders that mirror and support the change in consumer attitudes towards debt and credit.  It’s time for Washington to work for the people again and not just the bankers who would like us all to become more indebted.  Now is the time for our elected officials to become realists and stop putting us into deeper into debt which is only kicking our problems further down the road.  The sooner we face up to our problems the better we will be in the long run.  It is likely there will be more short term pain, but we will be better off for it.  In spite of these problems we are optimists at heart and understand that nothing under the sun is new.  The world has gone through periods like this before and we will get through it this time. 

Happy Holidays from LRG Capital Group.

Actions Speak Louder Than Words

With global equity markets continuing their parabolic climb, central bankers have slowly begun to signal that they are considering ways to reverse the unprecedented liquidity that has been pumped into the financial system over the past year.  Adding up the direct cash injections, loans, assumptions of debt, commitments, guarantees, and other obligations, the total comes to a mere $11.6 trillion dollars!  To put $11.6 trillion into context, lets add up some major US expenses, adjusting for inflation:  take the Marshall Plan ($115.3 billion), the Louisiana Purchase ($217 billion), the Race to the Moon ($256 billion), the S and L Crisis ($256 billion), the Korean War ($454 billion), the New Deal ($500 billion), the Invasion of Iraq ($597 billion), the Vietnam War ($698 billion), all of NASA since ($851 billion) and World War II ($3.6 trillion).  All of the above totals $7.52 trillion.  The bailouts have been the greatest commitment of capital the US has ever engaged in.   To be fair, the Federal Reserve considers much of the $11.6 trillion a form of secured loans, but because the Fed refuses to identify the collateral backing its loans, no one really knows the quality of the assets on its balance sheet.  What we know for sure is that the policies that the Fed has embarked on, most notably quantitative easing (where the Fed buys government bonds, agency debts and  mortgage backed securities) which began in earnest in spring 2009 has fundamentally deteriorated the central bank’s balance sheet.   Not by coincidence, this also happens to be around the time when the stock market bottomed and began its current rally.  In an effort to save the troubled banking system, banks’ balance sheets have improved, but the central bank’s balance sheet deterioration has turned it into the very type of “bad bank” that it was trying to rescue. 

Minutes from the last Federal Reserve meeting stated that quantitative easing will continue at least until the end of the year.  According to the latest report, the Federal Reserve has an additional $500 billion of mortgage backed debt it intends to buy out of the proposed total $1.2 trillion.  With such a large buyer artificially propping up the mortgage market, it’s no surprise that house prices have bounced back and construction activity is up this past month.  However, this is not a true housing market recovery, but rather one that is propped up by easy money.  Therefore, at some point, when the money is withdrawn, the housing market is likely to fall back, putting stress on the banking system again.  As an example of what can happen after government subsidies and spending programs end, look no further than your local car dealership.  After a strong summer season due to the Cash for Clunkers program, September auto sales fell by a staggering 35% compared to the previous month as the program expired. 

Although the Federal Reserve and Treasury continue to publicly state that they support a strong dollar policy, market participants understand that actions speak louder than words and have pushed the dollar to its lowest level in 14 months.  But the dollars loss is the commodity markets gain with gold for example, now sitting at multi-year highs of $1060 an ounce.  Whether or not the move in gold will be sustained is anyone’s guess, but the market is signaling that the current state of affairs, with central bankers printing money simultaneously and with no end in sight, is creating inflation.  In his latest speech, Mr. Bernanke said that the Federal Reserve will be prepared to tighten monetary policy when the outlook for the economy “has improved sufficiently”.  He continued by saying that “as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation down the road”.  Other central banks have also began to signal that interest rates may have to be increased to stem the possibility of inflation, with the Australian Central Bank raising its benchmark lending rate by .25% to 3.25%. 

Interest rate increases outside of the US will continue to cause further pressure on the dollar.  We are nearing the crossroad where US policy makers will have to start thinking about either raising interest rates or withdrawing liquidity in an attempt to stem inflation.  With oil back over $75 and rising, any further increases will surely put pressure on an already weak consumer.  In addition, we are also starting to see positive numbers from real operating companies like Intel for example, although much of the growth is coming from international markets due to the weaker dollar.  While we are hopeful that Chairman Bernanke can withdraw liquidity without hurting the economy, it will be a very difficult task as the two worst depressions in US history were caused by liquidity shortages.  The first depression in 1837, when the Second Bank of the United States removed its primary instrument, Second Bank bills from the system.  And, of course the Great Depression (1930-1932), which was sparked in part to the closure of the Bank of the United States, a major New York retail bank, which caused a withdrawal of deposits from the banking system and a cascade of bank failures.  The next 3 to 6 months should tell us how the Federal Reserve is going to begin the process of withdrawing liquidity.  One solution would be to raise interest rates sharply (perhaps to 2%, or more if inflation takes off) while maintaining high liquidity.  If there is enough liquidity in the system, the higher rates should serve to deflate the various bubbles, and force the government to rein in the budget deficit, but not hamper the recovery in the real economy as banks will be able to raise rates and small business’ will have access to loans.  At this point, liquidity can be gradually removed from the market, as both the governments financing needs and the potential bubble is removed from the market (which was itself draining liquidity).  The other option the Federal Reserve has is to keep interest rates at historic lows, and try to withdraw liquidity as the economy improves.  In our opinion, if the Fed decides to take this course (withdrawing liquidity while keeping interest rates at 0%), the chances of hyperinflation increases dramatically as keeping rates at 0% will most certainly fuel a bubble in commodities as the dollar comes under pressure in response to interest rate increases outside of the US.  Even worse, if liquidity is withdrawn too quickly, the risks of a hyperinflationary depression will rise as the economy suffers from a lack of liquidity and prices continue to rise due to continued pressure on the dollar.  If this were the case, all bets are off and we would expect the market to quickly break the lows it set last March.  Thus, as policy makers begin to form their plans to withdraw liquidity from the system, it will be important to figure out which course they decide to take, and of course actions speak louder than words. 

With the latest economic readings on housing and construction coming in below expectations, we believe that the market has priced in a much stronger recovery than what the economy can support.  It is our opinion, that as the stimulus and government support is withdrawn, we will begin to see the market realize that the economy, while stabilized, is still very weak.  As readings on the economy continue to show signs of weakness, we believe that we will see the market trade down and possibly very rapidly.

Buffet Turns Cautious: Why We Should Listen

Global equity markets have run up too fast, leading us to believe that the recent rise in share prices is nothing more than a bear market rally.  At best, we believe that the market will move sideways for years as households struggle with a weak job market, credit card debt, and increasing payments on mortgages.  In a recent interview, Warren Buffett, who made some impressive moves in 2008 during the height of the financial crisis, said that “we are not out of problems yet.” He added,” we have to get the sputtering economy back so it’s functioning as it should be”.  We agree with Mr. Buffett’s assessment of the economy and believe that the odds that the markets will break the lows which were set in March of this year are increased due to reckless government spending and a banking system which is unwilling and unable to lend (rightfully so, since the economy is still very weak).  Stock markets and equities in general can disconnect from reality for months and sometimes years, as the NASDAQ did in 2000. While a 50% rise in the S & P 500, for example, is impressive we believe that it is way too early to proclaim that the recession is over and a recovery is underway, especially with consumers slowly losing access to credit.  If the first quarter of this year was marked by companies cutting payroll and expenses at a rate not seen in over 30 years, then the second quarter can be characterized by consumers finally starting to feel better about their economic prospects and very cautiously heading back out to spend.  The consumer who is not mired in debt is now able to purchase everything from homes, to cars, to clothes at deep discounts adding to the GDP.  While recent economic data does paint a picture of a shallow recovery, the massive amounts of debt and leverage that the majority of consumers took on over the past 10 years will take years to pay down.  Additionally, as the unemployment rate remains elevated, the odds that the consumer retrenches are even higher than they were a year ago, increasing the probability of a double dip recession as consumer spending accounts for almost 2/3 of US GDP.  Additionally emerging markets such as China are down over 20% (the official mark that brings them back into bear market territory) so any hope of a commodity-lead recovery (inflation) have been put on hold.

The current market, economy and government response have been very similar to what happened in late 2001 and early 2002 after the NASDAQ bubble implosion.  In an attempt to revive the economy, Federal Reserve Chairman Alan Greenspan lowered rates to historic lows and the Bush administration encouraged Americans to “shop till we dropped.”  The auto industry took its cue from the government and began to offer 0% financing rates on cars.  Consumers were quick to take advantage of the cheap rates pushing auto sales to an impressive 65% annual rate.  The brief spike in sales pushed GDP higher to an annual rate of 3.5% making most economists and market analysts believe that the recession was over and strong recovery was underway.  The similarities between then and now are evident in both the markets rise and the government’s attempt to kick start the economy.  The only difference between the two periods is that we can substitute the 0% auto financing programs offered in 2001 for the recent “Cash for Clunkers” program.   Today we hear media and analysts alike proclaiming that the stock market’s rise and improving economic numbers are forecasting a strong recovery.  While we are hopeful that this will be the case, the lessons from 2001/2002 tell us otherwise.  The S & P 500 topped out in late 2001 and subsequently fell 34%, through the lows it set a year earlier. 

A quick look at the current state of the housing and mortgage markets will give more insight to the overall economic health of the country.  We have known for years now that the US government’s economic data must be dissected to get the full picture.  For example, summer and fall are the seasonally strong periods for the housing market and this proved to be the case again when US existing home sales posted a gain of 7.2% in July.  A closer look at these numbers show that 31% of those sales were either distressed sales or foreclosures.  This level of foreclosure activity simply cannot be so high if housing is truly going to stabilize.  Foreclosures only soften the prices of homes, keeping buyers on the sidelines prudently waiting for the price declines to stop.  A recent analyst note predicted that as many as 48% of all US mortgages will be underwater (where the mortgage is larger than the value of the house) by 2011.  Many of these mortgages will also adjust to a higher rate over the next two years putting more pressure on the market.  As the supply of homes increases, prices will continue to drop.  Adding to the supply of homes is the so -called “shadow inventory.”  These are homes that banks have taken back after foreclosures.  In normal times, the bank will immediately put the house back on the market, but in this environment banks are holding on to the homes to not flood the market and put further pressure on prices.  It is estimated that the shadow inventory consists of as many as 700,000 homes being held by banks.  This shadow inventory will add pressure on the housing market for years to come, as banks will sell into markets that they believe are stabilizing, further increasing the supply of homes and holding prices down.

As we previously mentioned, stock markets can disconnect from the true economic fundamentals for months and years in some cases.  One of the biggest factors that can drive a market higher (or lower) is the amount of money in the system.  We already know that the Federal Reserve has instituted one of the most aggressive money printing campaigns in history and this will undoubtedly create dislocations in the economy.  The dollar for example, is continuing its race to the bottom, with the US Dollar index falling to its weakest level in 2009.  And with a push for universal healthcare, a program which would immediately be put to the test if passed as companies will rush to save on employee health care costs, the current administration is making it clear that the US will continue to borrow and spend its way through this tumultuous period.   One natural place all the excess liquidity can flood into is equities themselves causing yet another bubble.  With the latest unemployment reading coming in at a 26 year high of 9.7%, we believe that the bond market (where most of the investors are institutions and not individuals or day traders who can bid up prices) is a better gauge to forecast the overall health of the economy.  The bond and equity markets have diverged since early May, and bond yields are currently still trading at the level they were during that month.  If the economy were truly getting better, bond yields would have moved higher.  This divergence will have to be addressed sooner rather than later.  The S & P 500 was trading at around 850 in May, and for this reason, along with recent cautious outlooks from investing legends such as Mr. Buffet, we believe that at minimum, a 15% correction back to those levels over the next couple of months is warranted.  

Why Deficits Do Matter: Obamanomics and the US Dollar

With global equity markets continuing to move higher in recent weeks, media pundits and economists have now begun to proclaim an end to the “Great Recession”.  US stock indexes are now firmly in positive territory for the year with the S& P 500 up 11.9% year to date, and the Nasdaq Composite up by 27% year to date.  Although it’s tough to argue with the impressive rally we have seen in equities since the devilish low of 666 was set on the S&P 500 in early March, we are maintaining our stance that this rally has little to do with improving economic fundamentals. In our view the upward surge in stock prices is nothing more than a technical bounce off of a major low which has now turned into speculation fever and quite possibly the beginning of another asset bubble, this time in equities themselves.  Given that interest rates are currently at 0%, and the government has now resorted to giveaway programs for everything from loan modifications to used cars, it shouldn’t be a surprise to anyone that the stock market would be higher in the short term.  The nature of recessions is that they clear the system so that capital can move freely to enterprises that offer products or services that have actual demand.  Ben Bernanke was recently quoted in saying that he did not want to be the Federal Reserve Chairman that presided over the second Great Depression.  By injecting the economy with an exponential amount of monetary stimulus as compared to other previous recessions, Mr. Bernanke may have gotten his wish.  Just like his predecessor, Alan Greenspan, who held interest rates too low for too long and helped fuel the housing bubble, Mr. Bernanke may have stabilized the economy in the short term, but will leave the next Federal Reserve Chairman and the US taxpayer with a mountain of debt and liabilities that will have to be faced at some point.  With interest rates already at 0 %, the next Fed Chairman will not have the same luxury of cutting rates that his predecessors enjoyed.  This next crisis will be bigger and may prove to be the one that will finally clean out the system and allow a true recovery to begin.

Recent readings on the economy point to a mixed picture at best with businesses cutting costs wherever possible.  The US consumer, who is widely believed to be the most important piece to the global recovery, is still dealing with high debt, along with a house that is worth at least 20% less than it was last year, and a stock portfolio that is almost half of what it was last year at this time.  About 70 percent of the country’s GDP comes from consumer spending, so in order for a sustainable recovery to begin we are going to have to see that major sector of the economy do better.  Sales at U.S. retailers unexpectedly fell in July by 0.1%, the first drop in three months. Economists were expecting a rise of .8 % which just shows how far ahead some analysts’ expectations are of the actual economy.  Confidence among US consumers unexpectedly fell in August as concern over jobs and wages grew.  While economists were expecting a rise to 69.0 in the University of Michigan Sentiment Index, the number actually decreased to 63.2, the lowest level since March.  A rise of almost 50% in the S&P 500 has turned some of the most bearish analysts into bulls.  Going forward, we expect to see more misses on readings of the economy which will surprise the markets to the downside and will force analysts and economists to adjust their estimates down. 

A closer look at the S&P 500 shows just how out of sync the stock market is from the actual economy.  After a 50 percent rebound from a 12 year low in March, the index is now trading at 18.6 times earnings, which is the highest valuation since 2004.  The fundamental differences between today’s economy and 2004 couldn’t be clearer.  Back in 2004, we were in the midst of the biggest credit expansion in history, with banks lending to anyone with a pulse, which resulted in the housing bubble.  Today, the opposite holds true with banks that are hesitant to lend, and a consumer who is looking to pay down debt.  As much as we would like to see a return to prosperity, we do not see how today’s stock market could be valued at the same level as 2004.  With an unemployment rate almost double what it was in 2004, consumer demand simply isn’t there (unemployed people do not usually buy homes, cars, etc) and we think the market will figure this out very soon.  Recent earnings have had little to do with revenue and more to do with companies cutting costs. 

History shows that US investors lose the most in September as compared to any other month (a loss of 1.3% on average since 1928).  After the run-up we’ve seen in the market we think the same will hold true for this September and we caution investors to take profits and keep tight stops on positions going into the 3rd quarter.  We are sticking to our thesis that due to the massive monetary and fiscal policies that governments around the world have chosen to take, we will at some point very soon (possibly as soon as this fall) see one or more currency come under severe selling pressure.  While the US Dollar is the obvious candidate, the contrarian view tells us that it will be another major currency.  Unfortunately, we have a plethora of countries with vulnerable currencies to choose from starting with Western Europe (Spain and England come to mind) who have undertaken massive stimulus programs of their own in an attempt to fight off deflation.  All things being equal, governments can only spend what they take in through tax revenues.  During boom years, governments should spend wisely and save for a rainy day.  It is now raining and Western governments are continuing to borrow and spend without discretion and at this rate will literally spend their respective countries into poverty.   One thing is for sure: currency traders understand what is happening in regards to government spending even if equity markets haven’t gotten the idea yet.  Along those lines, although flawed, the US Dollar remains to be the world’s reserve currency, thus, we expect the dollar to move higher over the next couple of months with inflows returning to the greenback as volatility returns to the markets.  Dollar strength will reverse much of the gains we have seen in the markets which are centered on commodities, metals, and emerging markets.  Just how strong this fall’s correction will be is anyone’s guess as it is nearly impossible to predict just what will trigger the selling, but given that equity markets have risen almost 50% over the past 4 months, and these things tend to overshoot on the downside, we would caution patience when putting on any new long positions.  What will be interesting to watch for is just how traders react to some kind of currency shock.  Most traders, outside of currency traders, have never seen what a currency crisis looks like and just how it will affect their positions.  Will traders continue to hold positions after knowing that the market is up 50 % in three months with the possibility of a return to recent lows?  Will the lack of liquidity return again forcing the Fed to move even more aggressively or will they step aside this year now that the banks are “out of the woods”.  Just like last fall, we believe that there are just too many unknowns right now to make any big bets in the market and believe that holding cash for a clearer market picture going forward is the best strategy.  Fortunes have been made and lost during volatile markets such as we have seen over the past year and this time will not be any different. 

       

Those Supposed “Green Shoots” Are Looking Awfully Brown

With earnings season now fully underway, bulls and bears alike have been treated to a range bound equity market over the past few weeks with a low end of the range at 875 on the S and P 500 and resistance in the 950 area.  After trading down for almost a month, equity markets across the globe cheered as Goldman Sachs and Intel beat analyst estimates.  Major indexes now sit firmly within their ranges as summer trading continues with low to moderate volume.  Market volatility, as measured by the VIX index, is now at or near one year lows, giving some traders and economists hope that the worst is finally behind us.   For the contrarian trader however, a low reading on the VIX is a warning signal that caution should be warranted in the next weeks or months as market participants have become complacent.  Whether or not this proves to be the case this time is yet to be seen.  Since the beginning of the equity rally in early March, the media and some perma- bull analysts have proclaimed that we were witnessing “green shoots” of economic growth in the US and global economies and that a recovery should be expected by early 2010.  We would caution investors that trying to figure out a trend in equities during low volume summer trading is a fool’s game especially in a market that has just come off of a major bottom.   What we do know for sure is that the Federal Government will now essentially provide a backstop for the equity markets and will add a second stimulus package if markets begin to fall again.  This was especially true over the past few weeks as the market traded down and major players in the Obama Administration (as echoed by the media) began making the case for another shot of fake confetti stimulus dollars to boost the economy.  Where this money is going to come from is anyone’s guess but apparently it is available.  As we have stated here before, the US is probably going to have to get used to a slower rate of economic growth for the next 5-10 years, mainly due to the actions taken by the Federal Reserve and Congress.  In our opinion, the “green shoots” that people are proclaiming are little more than a replenishment of inventory after the consumer pretty much stopped spending last fall due to the financial crisis, and we are at least a year away before we start seeing any sort of real growth in the economy. 

With the number of foreclosures still rising and unemployment not improving, the consumer is still in very bad shape.  Industry reports are now showing that as many as one in eight American are now delinquent on their mortgage payment or already in foreclosure.  And with as many 3/4 of payment option adjustable rate mortgages due to adjust higher in 2010 and 2011 these charges will hit banks’ balance sheets at precisely the time the consumer will need financing available.  Nationwide housing prices are down 32% and most likely will continue to soften further in the coming months as markets tend to overshoot to the downside especially after bubbles of the magnitude we had in housing.  While housing sales have started to pickup, most of those sales have been at deep discounts or foreclosed properties.  Due to the long period of overbuilding, housing inventories are approximately 2 million higher than normal.  These numbers will have to improve before we see growth return to the economy and this will take some time.  (Please see my previous post for our current real estate market outlook)

And with another wave of foreclosures set to next year, we should also expect to see more credit card charge offs at the major banks.  JP Morgan and Bank of America have already stated that they are preparing for further credit defaults.  JP Morgan alone lost $433 million in the second quarter on credit card loans that have defaulted.  Analysts are particularly concerned that early stage delinquencies, or loans that are overdue 30 to 59 days at JP Morgan.  Similarly, Bank of America, said that June charge offs were as high as 13.86 percent.  As bankruptcies continue to rise in the US due to a weak labor market and rising foreclosures, we should expect similar numbers from the other major credit card issuers.  Whether or not the banks have set aside enough capital to absorb these losses is yet to be seen, but we all know now that the Federal Reserve and Treasury will do whatever it takes to save the major banks from collapse.  Hopefully we have finally seen a line drawn in the sand in regards to bailouts for failed institutions with the Treasury’s decision to not give capital to CIT, which is unfortunately one of the nation’s biggest lenders to small businesses.  The ripple effect from this decision, and if and when CIT finally declares bankruptcy, will be felt temporarily but like the GM and Chrysler bankruptcies, there will similarly be buyers to pick up the pieces from the failed company.  Every stimulus package, bailout, and credit program changes the nature of the marketplace.  For example, by denying CIT access to the same credit programs that were given to the major US Banks, lenders in a similar position to CIT’s, and more importantly their investors, now understand that they should not expect to have access to the same credit facilities available to them.  Perhaps if CIT would have had enough exposure to Goldman Sachs, or enough ex CIT employees were now working at the Treasury, we would have seen a different decision handed out to the lender.  By denying access to CIT, the Treasury closed the door to an entire business model, (in this case lenders to small and medium size business) and depending on the individual companies’ current financial position, the Treasury may have just made things far worse for an entire industry.  We should expect to see more failures of companies that are in a similar position to CIT’s, where the liquidity needed to refinance its debt has simply dried up.

One of the biggest challenges that the US economy faces now is that it doesn’t let itself slide into an extended period of slow growth and rising prices.  Unfortunately, with the government intervening in almost every aspect of our economy now, it seems like a reasonable probability that we are going to enter into such a scenario.  Another problem with government intervention, (besides the fact that eventually one entity or person will be left out as with the case of CIT), is that at some point someone is going to have to take away the punch bowl.  The Federal Reserve has pumped $1 trillion into the banking system over the past year through bond purchases and emergency loans.  As of now, we still haven’t heard when or how they are going to take away this excess liquidity.  With unemployment expected to stay high for an extended period of time, the Fed risks damaging the economy further if they take away the liquidity too soon.  On the other hand if they don’t act soon enough the Fed risks losing control of interest rates which will pretty much negate all the programs and central planning they have done so far.  If history is any guide, unfortunately the Fed will not be able to walk this tight rope as there are simply too many variables to try to control.  Whether the end result will be years of slow growth or an extreme case of inflation is yet to be seen.  While the Fed may have been able to save some of the banks for now, the economy as a whole is still in bad shape. 

Is It Time To Get Back Into Real Estate?

Over the past decade or so, long term investors who have followed the herd, whether it was in high flying internet stocks, or more recently buying homes as an investment in hopes of turning a quick profit have been burned.  The massive amounts of liquidity and cheap rates initiated or overseen by the Federal Reserve fueled not one, but two bubbles, the likes of which have not been seen in generations.  Prudent asset managers were forced to compete with speculators boasting of impressive, yet short term returns.  As we all know now, the dramatic rise and fall of the residential real estate market threatened to take down not only the US financial system, but the global economy as a whole.  We will leave the question of whether or not the government’s response to this crisis was appropriate for another day.  The reality is that the government chose a course of action which includes massive amounts of printing and borrowing of money in an attempt to ease the stress on banks.

In simple terms, an investor can allocate resources to five different asset classes.  These include stocks, bonds, commodities, real estate, and currencies.  As the turmoil in the residential real estate market begins to subside, and the economy as a whole begins to digest the various stimulus packages provided by the government, investors should adjust their portfolios accordingly to benefit from and guard against oncoming inflation.  Despite the negativity surrounding the real estate market in general, we believe that attractive opportunities can be found in certain regional commercial real estate markets for the medium to long term investor.

The ability of real estate to provide a hedge against inflation is one of the primary arguments for including the asset class in a diversified portfolio.  Research on the question of the inflation hedging ability of real estate generally shows that when markets are experiencing equilibrium, the lack of rental space alternatives provides negotiating power for the landlord.  By contrast, during periods of high vacancy rates, the negotiating power transfers to the tenant who will have options available to move and/or lower rental expenses.  Thus, it is important that the investor consider what kind of companies and industries inhabit a given region and will be positioned well for turnaround growth.  For example, since the current downturn has centered on the financial community, major money center metropolitan areas such as New York City will most likely not benefit greatly from inflation unless a new industry quickly emerges to fill the void left by the financial companies who are forced to cut costs and downsize.  It is our view that regions which are not heavily concentrated in finance should only see a temporary weakening of rental demand as the economy works its way through the recession and recovers more quickly.  With a long term view in mind, we believe that the 2009 inflation rate will remain moderate at best while beginning to pick up steam in the latter half of 2010 at which point the Federal Reserve will have a tough decision to make around raising interest rates.  We do not believe that the Fed will be able to raise interest rates in 2010, even with higher inflation, due to fear of damaging the recovery and causing a double dip recession or worse.  Therefore, the next 12-18 month period should provide an excellent window to find value in select commercial real estate markets.

Most analysts agree that technology companies, which spent the last 8 years cutting costs and raising cash due to the bubble burst of 2001, may be one of the strongest sectors to emerge from the current recession.  In addition to tech, well diversified regional economies with access to the global supply chain, including and especially commodity transportation and the global trade network, should stand to benefit from some of the strongest growth as the economy begins to improve.  Finally, regional economies with a high concentration of small business entrepreneurs and professional services should also perform well in a growth scenario.   We are beginning to see parallels between the commercial real estate market today and the values seen after the recession of the early 1990’s.  With interest rates at a 40-year low, massive fiscal spending by the federal government, and unemployment rates now beginning to stabilize we believe the time is right to invest in commercial real estate in well-positioned markets.  However, as value investors, we know that sometimes good prices can turn into outstanding prices with a little patience.  There is no substitute for doing the research and diligence necessary for making a good investment.  That definitely holds true in this market. 

Earlier this month, Paulson and Co., a hedge fund which made billions by correctly anticipating a crumbling housing market, said that it would buy $100 million in stock of commercial real estate services firm, CB Richard Ellis Group.  Additionally, the hedge fund company is in the early stages of raising “a couple of hundred million dollars” for a fund focused on a medium- term property recovery.  The smart money has always known to enter the marketplace when fear is at its highest.  By including commercial with residential real estate, the financial media and misinformed analysts and investors have created an artificially high risk premium for commercial properties.  The big difference that many people aren’t recognizing between commercial and residential real estate is that the hype and annual median price increases seen on the residential side were not seen in commercial real estate.  After almost two years now of monthly declines seen on the residential side, and some overheated markets such as Florida and Nevada falling as much as 40% from their peaks, we believe the downturn in housing has finally begun to stabilize.  And with major commercial operators such as General Growth Properties declaring bankruptcy, the supply of quality properties at good prices are plentiful.  Commercial property investors should not expect a straight ride up, but we do think most of the risk of investing in commercial property is already in the price.  And there are good reasons to believe that today’s opportunity to invest at decent yields won’t last forever.   

If You Think Things are Getting Better, Think Again

With the market continuing to move higher in recent weeks, the onus lies squarely on the bulls now to produce evidence of an economic rebound in the coming months.  The powerful rally in global equities has forced the staunchest bears to take notice of, at the very least, rising asset prices and a thawing out of credit conditions.  Throughout this rally, the major theme we have heard from the bulls is that “the pace of the decline is slowing”.  But does a slower rate of decline necessarily warrant a near 40% move off the bottom for the S&P 500, one of the biggest moves in the history of the index?  Are we really starting to see “green shoots” in the economy like the media says and the government would like us to believe?  Unfortunately, due to the massive government intervention in the markets, asset prices may be improving, but the global and domestic economy are still very weak, and don’t look like they can improve anytime soon.  With the astronomical amount of money the Federal Reserve has thrown at the economy, it’s no surprise that asset prices have been moving higher in recent months.  The total amount spent by the government, in addition to all of the loan guarantees, 0% interest rates, and treasury purchases is in now the range of 5 to 6 trillion dollars   To put this into perspective, less than 8 years ago our entire national debt was 3 trillion dollars.  It is my strong view now, that sooner (rather than later) the markets, most likely the currency or bond market or a combination of both, will force the Treasury and Federal Reserve back into the same precarious position of making the tough choice they should have made almost a year and trillions of dollars ago, which was to just let the market work this mess out on its own, so the country and world can truly begin the process of rebuilding.  The unintended consequences of the actions the government has chosen to embark on are just now starting to show in our economy through the troubles seen at the regional banks, or the continued funding and pension crunch in the state and local governments, and of course the daily decline in the dollar that we are all getting used to now.   Not to mention the overwhelming evidence of a credit card implosion that can further derail economic recovery.  While we applaud President Obama’s new efforts on the credit card pandemic, no one wants to really open the Pandora’s Box of the staggering amount of principal credit card debt that will never be repaid.   In my opinion, while the markets may have improved, the improvement was mainly due to the money printing by the Federal Reserve and is not reflective of the real economy which is still very weak and struggling with mountains of debt at the household level.

For those who haven’t read my previous post which refers to a potential currency crisis at home and abroad, please do so.  Already at the time of this writing, Standard and Poors is warning that the United Kingdom may lose its AAA credit rating and rumors abound that the US is next.  Immediately on these rumors, yields on US Treasury debt spiked higher to prices we haven’t seen in almost 6 months.  This is in the face of Mr. Bernanke’s continued bond purchase plan in an attempt to keep rates low.  The cat is now out of the bag.  The entire world knows now that the US and UK will do whatever it takes to save already insolvent banks, including and especially devaluing the currency.  Readers of the LRG Capital Report knew the time would come where US debt would come under pressure but that day has come quicker than anyone has expected.  We are now pushing our forecast for an outright currency crisis to sometime this fall or winter as the world begins to slow its purchases of US Dollar denominated assets that are losing money due to a declining currency.  We would caution investors who believe, like our friends at the Fed and Treasury, that a devalued currency would increase exports and stoke just the right amount of inflation.  The truth is that throughout history governments have NEVER been successful at what the Fed is attempting (reinflate a bubble without causing high inflation in other areas of the economy).  In fact, now the odds are more in favor of higher prices for food and energy and interest rates.  The cross currents the market has shown recently have been extremely negative.  The normal movements we have been used to since 2001, (or about the time the dollar began its secular decline) was on days the dollar falls, stocks would move higher due to higher commodity prices and in turn more profitable energy sector.  Over the past week or so however, we have seen the dollar decline, but at the same time commodity and US stocks falling.  This has mainly been due to the rumors that the US will lose its AAA credit rating (due to excessive debt and money printing by the government) which in turn would make it more difficult for everyone, government and private sector included, to borrow at favorable terms.  I want to personally congratulate Mr. Bernanke for potentially ruining the dollar, and now bonds, and thus the equity markets to save Wall Street. 

As far as the real economy is concerned, we must now wait and see just what kind of recovery we should expect.  We have been told by the Federal Reserve and Treasury that we should not expect to see jobs come back any time soon.  A recovery without jobs is like a birthday party with no cake.  The truth is that over the past year or so it has been the state and local governments that have done most of the new hiring.  Now, as Californians know all too well, some states are facing huge deficits and some face cash shortages.  After delaying state refund checks earlier this year, the Golden State is on the verge of running out of cash again as early as July.   With the resounding defeat of Props 1A and 1E, voters essentially told lawmakers that its time for them to finally take responsibility for their budget and stop the tax increases.  The idea of raising taxes or borrowing more money only to delay the inevitable is complete lunacy.  Three areas where the state needs to address its problems are the overpromises on pensions, union wages and a bloated budget.  The day of reckoning for decades of wasteful spending has arrived for California as well as other state and local governments across the US.  Until these structural problems are addressed by legislators, we are only delaying a worse outcome down the road.

Finally, the free markets seem to be working with respect to the Chrysler bankruptcy and inevitable General Motors bankruptcy.  Maybe the real green shoots are that the bankruptcies of Chrysler and GM (as they are bankrupt) are now showing what markets are supposed to do: stop rewarding failure so smart and productive industries, whatever they may be, can successfully compete on any level.  I applaud the Obama administration, along with the executives and counsel at Chrysler who are moving at warp speed to complete the Chrysler bankruptcy.  It’s hard to imagine that a company with the size and reach of Chrysler could complete a bankruptcy filing within 30 days, but they seem to be pulling it off.  Bankruptcy has always been the best course for both Chrysler and GM.  This will allow the companies to truly restructure labor contracts that don’t make sense and in GM’s case, may even allow it to possibly survive as a functional company.  Without bankruptcy, it will just be the same old, same old and we the taxpayers will be forced to continually fund the company’s shortfalls. 

Two Steps Forward, Three Steps Back

US stocks closed up for the sixth week in a row last week, marking the steepest six-week gain since 1938.  The S&P 500 had gained 29% since reaching a 12 year low of 666.79 on March 6th.  Washington has officially thrown the kitchen sink at the global economic crisis with measures that will have long term consequences that no one can really imagine at this point.  Various new measures aimed at “fixing” the banking system have included everything from yet another AIG bailout, to the Fed finally unleashing its plans to buy long term Treasury bonds to keep interest rates low, to a long awaited ruling and subsequent change to the way banks have to value assets on their balance sheets.  With all of the cheerleading going on in the media, it seems like happy days are here again.  And the change in character of the market can’t be ignored, with the momentum clearly now on the bull’s side.  For example, after an absolutely horrendous unemployment number was released showing that the unemployment rate rose from 8.1 % to 8.5 % in March with 663,000 jobs lost, the market opened down, only to be met with buyers who managed to push the market higher and finish the day up.  A month ago, we would have sold off on a jobs report number like that- but now the dip was bought.  So have we really bottomed?  Have the Fed and Treasury finally managed to get it right after getting it wrong for over two years?  Is the change in mark-to-market accounting really the “game changer” as our friends in the media have been proclaiming?  Probably the best answer to this question lies with the man in charge of the US economy, Ben Bernanke, who hinted that last month that nation can expect to see 10% unemployment “for a period”.  Indeed, I believe that the Fed’s reckless actions in an attempt to save the banks at any cost have not only made overall economic conditions worse, but have thrown the country into a recession not seen since the 1930’s.  I’m going to go out on a limb here and say that equity investors should expect more selloffs in the year ahead, and far lower lows in the overall market.  As evidenced by Bank of America’s earnings report, banks balance sheets are still littered with these toxic assets that have yet to be fully written down and are continuing to worsen due to the deteriorating economy.  Whether the market’s downturn will fully resume one month from now or one year from now is anyone’s guess, but the imbalances that have been created in the foreign exchange and debt markets will, at some point, spread to equities.

A closer look at the unemployment data shows that the job losses are now intensifying with almost two-thirds (3.3 million) of the total job losses  (5.1 million) since the recession began in December 2007 occurring in the last 5 months alone.  In addition, the job losses were large and widespread across the major industry sectors.  The service sector in particular, an area of the economy which held up relatively well in past recessions, lost 358,000 jobs as more and more business’ and consumers found it more difficult to refinance or get access to loans as failed banks continued to hoard cash in an attempt to repair their balance sheets.  The official unemployment rate is 8.5% and rising.  However, if you start counting all the people that want a job but gave up, all the people with part-time jobs that want a full- time job, and all the people whose unemployment benefits ran out, the more accurate number for the unemployment rate is closer to 15.6%.  These numbers do not point to a recovery in any way and if anything only should ring the alarm that a second wave of debt default, this time in consumer and credit card debt might just be under way.   With earnings season upon us, we can expect to see more and more companies miss estimates as we all know just from looking around that business activity has fallen off a cliff.  Additionally, we should begin to start hearing the results of Treasury Secretary Geithner’s stress test for the banks.  Keep in mind the rules for this stress test are that the banks that don’t need capital pass the test, whatever that means.  While the banks that do not pass the test, become eligible for MORE Federal Aid.  Thus the stress test is nothing more than a way for the Treasury to funnel more taxpayer money to failed banks.  Even worse, the public will not be allowed to know which banks passed and which banks failed the stress test.  Instead, we the taxpayers are just supposed to sit back while billions of dollars are absolutely wasted on programs that have not shown to be effective (unless you are an employee at Goldman Sachs, Morgan Stanley or any other bank that is an indirect recipient of federal funds).  For example, AIG’s bailout now totals in the $150 billion dollar range, of which a majority has gone to payoff side bets by counterparty banks, most notably Goldman Sachs.  What a nice spot for Goldman Sachs to be in to have all of its competitors ( Bear Stearns, Lehman Brothers, Merrill Lynch) disappear while having the backing of the US government and the money printing presses all working in your favor.  This is all truly illegal and a travesty to say the least. 

Going back to the subject of the economy, debt deflation is a long and painful process.  In the future we can expect more volatility as the economy tries to recover, only to see inflation move higher and weaken the economy further.  In the short term, while some areas of the economy begin to stabilize, the recoveries in those areas will be dampened by the effects of price increases in other areas of the economy, specifically in food and energy.  The result is a two steps forward, three steps back phenomena as any economic growth will be choked off by higher prices.  This will undoubtedly lengthen the downturn and spread its pain.  We expect inflation to really pick up four years from now after the full downward pressures from the recession have abated and we begin to see real economic growth (not the money printing we are seeing now).  Because of the rare nature of this recession, and Washington’s choice to continue with the failed policies of more debt and inflation to get us out of the crisis, the lack of job growth will most likely result in a second round of stimulus, much more federal capital for the banking system and stunning budget deficits.

In a 60 minutes interview, Mr. Bernanke said that many people have suggested that we should just let the banks fail.  The metaphor he used to explain how he is handling the Federal Reserve and how the Treasury is handling this crisis is that “when there is a fire in the neighborhood, you should do everything you can to put that fire out so that it doesn’t destroy the entire neighborhood”.  The Feds most recent action to inject capital into the system is through a method called quantitative easing in which the Fed will expand its own balance sheet (a balance sheet that is kept private) and go out in the open market and buy long term treasury bonds to keep rates interest rates down.  This action is essentially “printing money” or creating money out of thin air.  It has never worked in the past, (most notably it has failed in Japan, where a decade long stagflation has taken hold of the economy). Other examples of countries that have used quantitative easing are France and England in the 18th century.  This time around, instead of the banter coming out of the monetary authorities being “let them eat cake”, the line should be “let them have 5 year option ARMs with no down payment”.  Not surprisingly, the day the Fed announced that it would buy up to $300 billion of Treasuries, the dollar had its worst day since 1985, dropping an astonishing 4.8 % against the Euro alone.  Currencies, especially reserve currencies like the dollar should not move this quickly under any circumstances.  In reality, this was a de facto devaluation of the US dollar and a sign of more to come.  Over the past month and a half, during the almost 30% “rally” in stocks, the dollar fell over 12% against a basket of 6 other major currencies.  What the Fed and Treasury have done is nothing more than creating a mirage that will simply not last due to the disintegrating jobs picture.  Going back to Mr. Bernanke’s comments on using all available resources to put out the fire in the neighborhood, my interpretation of the situation is a bit different. By printing money, debasing the currency, and trying to inflate away debt, the Fed is hurting the poorest members of the society.  Inflation has always been known as the cruelest tax of all because it hurts those on a fixed budget the most because prices everywhere are rising.  Instead, the metaphor that I would use to describe the policies coming out of Washington are more like this:  “There is a fire going on in the neighborhood, and it is heading towards the most affluent portion of the neighborhood, so what we will do is burn down the poor people’s houses around the neighborhood to create a fire line that will prevent the fire from reaching the rich people's houses”.

The More Things Change, The More They Stay The Same: How to Swallow the Poison Pill and Survive

In my previous posts I have always used a lot of economic data to back up any points I’ve made, this post will be slightly different. I am so furious about what is happening that I’m going to speak honestly about what I think is going on and focus less on the details.

Our brain trusts in Washington DC just signed an additional $789 billion stimulus package into law with members of Congress having little or no time to read it.  The bill consisted of 1419 pages of creative ways to spend your money on everything from infrastructure projects to healthcare.  The media hailed the bill’s passage as a victory for the Obama administration.  The market on the other hand, seemingly has different views.  The S&P and Dow indices have been crushed ever since the Obama administration took office. The Dow is less than half its record high and the S&P is at a 12 year low.

We hope that the Obama administration is realizing that no matter how much money they say they will spend (attained through taxes or by borrowing from other countries), or how many different “plans” they come up with, they aren’t getting any closer to the solution. It seems that Washington is not yet ready come to terms with the fact that the best and inevitable course of action would be for it to just step aside and let the market quickly and efficiently (albeit painfully) find its equilibrium.  The politicians need to remember that the governments’ job when it comes to commerce and markets is to keep the playing field fair (which they seem to be incompetent at, think Madoff, Stanford, and so on).  Continually propping up failed companies, especially without understanding the business plan or valuation is simply making things worse.  With Citibank now trading at basically zero and the recent announcement that taxpayers are taking a 36% stake in the company (a deal that no prudent businessman would make), and Bank of America not much farther behind,  how do we know that Mr. Geithner and President Obama won’t do the same with the rest of the nation's banks?  As the stock market continues to plunge day after day, we hope that a light bulb is starting to go on in Washington that the current course of action will not work. As we have said in previous posts, throwing money at the problem will not make it better and it certainly hasn’t worked so far. 

It’s now obvious that we are ever so slowly nationalization our banking system.  The unfortunate thing is that most of the responsible people in Washington understand what happened in Japan, and Switzerland, and the numerous other banking crisis throughout history, yet they still pound away at the idea that “something needs to be done” in regards to our nation's banks.  No matter how big, or how much money they plan on spending, the market has more money and power than any politician, lobbying group or central bank. A few readers have asked what is wrong with propping up failed banks, or “zombies”.  Besides the moral and social aspects of playing favorites to save a certain industry group or company over another (basically the well connected or those were able to lobby the hardest), the economic consequences are far reaching. What was previously an industry that thrived on capital raising to give an entrepreneur the chance to build a business, is now a shell of itself unable to take the risks which in some cases need to be taken to expand the economy. The one good side effect that might come out of all this is the greater scrutiny of the bailed out banks and auto companies in terms of bonuses, perks, golden parachutes and parties. What makes me nauseous is that a tabloid TV show called TMZ broke the story of Northern Trust’s lavish parties including concerts by Sheryl Crow and Earth, Wind and Fire (right after they reported on Nicky Hilton eating at IHOP) before The Wall Street Journal even got wind of the story.

In a sense, by having the government take a position in the banking industry we are institutionalizing risk aversion.  It’s a vicious cycle that could lead to years of slow growth, falling capital expenditures and little or no recovery in employment.  It’s no coincidence that the second Obama announces the new budget with another $750 billion of taxpayer money slated for bank rescue the stock market takes a nose dive.  Politicians should let go of the idea that they have the power to control the markets and allow true equilibrium to be found. Not to mention, the taxpayer money and resources that have been spent in executing these plans.  By the way, has anyone figured out what happened to that first $350 billion tranche that the Bush Administration was in charge of towards the end of last year?  Or is that ancient history? 

In addition to stifling the banking sector, another problem with the stimulus package is that, in effect, it treats healthcare as a cost problem instead of a growth industry.  The healthcare and biotech industries are a group that we follow closely at LRG Capital Group.  Stifling innovation through legislation in these industries in an attempt to reduce cost is a dangerous idea that will not only hurt the industry’s profits, but also the ability for it to provide safe and reliable healthcare.  There are many ways to cut costs in the healthcare industry, with the first being the number of people the plan intends to deliver healthcare to. This is a dangerous road to go down for this Administration and the way they are addressing the inadequacies of the industry have the potential to make things worse. Maybe we must deal with the fact that life isn’t fair and even though it would be great to provide healthcare to all right now, it would bring everything down to the lowest common denominator and everyone will lose out.

In further digging our economy into a deep hole, President Obama’s nomination of Tim Geithner was by far the worst pick for his administration.  Besides the folks at the SEC, it would be tough to find another person who could receive more blame for the lack of regulation and foresight than the President of the New York Federal Reserve at the time, Mr. Geithner.  Perhaps no one had a better view of what was going on during the boom years on Wall Street than Mr. Geithner. And to make matters worse, since his plans have gone so well in “repairing” the banking industry, President Obama has added Mr. Geithner to an inter agency task force that will help determine the fate of the auto industry.  This is the same auto industry where Toyota and Honda are able to build cars profitably in the United States, while the domestic car manufacturers struggle with legacy costs and poor management decisions that they hope to dump on the taxpayer. 

With all of the rhetoric and promise of hope and change coming out of the Obama Administration, the appointment of Mr. Geithner proves that the more things change, the more they stay the same.  With the market making new lows yet again, the Treasury Department issued a statement that Secretary Geithner is planning to release yet another plan for the banking industry.  Some are now speculating that some form of nationalization would be necessary at least temporarily.  The “Swedish Model”, would call for a temporary nationalization of the weakest banks, auctioning off assets while cleaning up the failed banks’ balance sheets.  Most importantly, we hope the plan will FINALLY set out a framework that would reveal the extent of the likely credit losses facing the banks.  In a sense, the markets failure to respond in a favorable manner to all of the previous plans that were put together since the crisis began, has forced policymakers to admit total failure of those plans, and do what should have been done a long time ago, which is to have the banks completely come clean about what they are holding on their balance sheets. Hopefully we are prepared to swallow the terrible and painful pill of reality and begin the healing process. 

Since the domestic economy and the global economy, in our view, are dangerously close to implosion, I’d like to, as my last point, draw a very grave parallel between the recession and a serious illness that, in some way or another, has probably affected each one of us: cancer. A diagnosis as serious as cancer requires a quick and forceful plan of action, working to heal the patient (the economy) not just make the symptoms (the recession) go away. There is simply no way we can play Wizard of Oz and close our eyes, click our heels and wish and forecast the problem to go away, which in many ways is what we have seen the previous and current administrations attempting to do with the recession. The only cure our government has tried thus far is to feed the recession with as much money as taxpayers can handle (or not handle?) and the cancer only seems to grow. A doctor comes up with a treatment plan with varied methods of combating the illness and similarly our president needs a list of completely different treatments for our economy. Just as most doctors would quickly check off a method that wasn’t working, Obama must dismiss the idea that more and more taxpayer money will help. It’s time to move onto the next treatment option. As everyone knows treatment of such a serious problem will be difficult and extremely painful, so we are perplexed as to why people think that finding a true end to this recession will just be a mere pin pick. Once we can accept that the treatment for this recession will really hurt, we can abandon the “easy” way out and get down to really fixing our economy. Sometimes you have to stop all growth, good and bad in order to stop the cancer from growing before the healing process can begin and the same may be true of the economy. Here’s the cure to the recession we believe in (definitely a painful one): finally writing down all the assets, wiping out equity and debt in companies that owned troubled assets, treating Americans’ addiction to over-leveraging their lifestyles and start saving instead. Swallow the horrible pill and start anew.

In closing, Obama’s most recent treatment attempt, the stimulus package, we find it looks more like a disguised Federal Budget than anything else and is basically more of the same.  This package attempts to treat the symptoms of the recession not provide a cure. The moral of the story is that the administration and Congress need to realize that people are watching what they are doing now more than ever before.  People are struggling and suffering today in ways that haven’t been seen in decades.  The end of the President’s elected term of four years may seem like a long time away from now, but if the new administration and the entire Congress for that matter want to keep their jobs, the time has come for some straight talk and solutions that we all know will take some sacrifice on all our parts.  While sound bites, speeches and promises of a reduced deficit can play well with the media, they will do little good to get us through this mess if the government isn’t ready to face the reality of the pain we all are going to experience by writing down bad assets and extinguishing equity and bad debt of falling companies. It’s the only way we will truly be able to begin recovering from years and years of folly and excess.

-Larry Goldfarb