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”.
