LRG Capital Report

Asset Stripping and Hyperinflation- Is the US Heading Down the Same Path as Belarus?

With so much attention being given to the economic problems of Portugal, Ireland, Greece and Spain, the media has overlooked one of the most important economic stories of the past month. The greatly overlooked story comes out of Belarus. Belarus is a former Soviet Nation which borders on Russia, Ukraine, Poland, Lithuania and Latvia. Recently, the economy of Belarus has completely imploded. On May 24th, The National Bank of Belarus devalued the Belarusian Ruble by 56%. Overnight, Belarusians who held the national currency saw prices for everything from food to diapers soar higher. The average monthly wage in Belarus was 1.6 million Rubles in April. In dollar terms, Belarusians saw their real wage fall from $507 to $325 in one day. The situation is so dire that the government had to step in and freeze prices for fish, tea, coffee, cheese and a number of fruits and vegetables, some of which already had doubled over the past two months. The situation could quickly descend into chaos as citizens sweep store shelves for toasters, canned goods or even Dollars or Euros- basically anything that will not lose value as quickly against the national currency. In the capital of Minsk, people have been hoarding basic staples such as sugar and salt.

To most Americans, the situation in Belarus seems like a distant event that is happening in a third world country. The message we have been trying to convey on this blog over the past two years is that not only is a Belarus-type hyperinflationary crisis possible in the United States, but it is becoming more and more likely with every passing day unless we stop pretending and face up to our financial realities.

From Scleroderma to “Just Say No to Quantitative Easing”

One of the non-profits I tirelessly support is the Scleroderma Research Foundation (SRF) (www.sfcure.org). Scleroderma is a chronic debilitating disease that affects many people, about 1 in 1,000 Americans, and women are 4 times more likely to develop the disease than men.  My family has been personally touched by this incurable disease and as a longtime supporter I would like to announce an upcoming fundraiser being held by the Scleroderma Research Foundation.  Cool Comedy- Hot Cuisine is an annual event for SRF and this year it is being held in San Francisco on Wednesday May 4, 2011. The event is hosted by Bob Saget and features appearances by Bill Bellamy and Dana Carvey with musical guest Counting Crows.  I hope that you will consider supporting this amazing organization and attend the event on May 4th. Additional information for donating or purchasing tables can be found here: http://www.srfcure.org/get-involved/store?page=shop.browse&category_id=8&vmcchk=1. Hope to see you there! Now we’ll move on to “Just Say No to Quantitative Easing.”

Federal Reserve Chairman Ben Bernanke has begun holding quarterly news conferences to answer questions about the Federal Reserve’s policy decisions.  This represents a significant shift in strategy for the Fed which will give it a chance to defend its current monetary policy given the harsh criticism over the past couple of years.  While the introduction of regular press briefings and a more transparent Fed is a positive development, many traders believe that the Fed Chairman is getting the markets ready for another round of Quantitative Easing.  In fact, almost 30% of the respondents to a poll conducted by UBS a few weeks ago said they anticipate a third round of QE, and we are also in that camp.  Given that the Chairman has, on more than one occasion, taken credit for the post-2008 bull market, we simply do not believe that Bernanke will allow the markets to truly correct on their own.   In our opinion, as soon as we get the first sign of a bear market, which incidentally has happened almost every four years like clockwork, Bernanke will be forced to intervene as he will have a tough time explaining why the stock market is falling with continuing weakness in real estate and the labor markets given we are two rounds into Quantitative Easing.   As we have learned over the past decade, the Fed’s only answer to combat economic weakness is to devalue the dollar by essentially printing more greenbacks.  In our opinion, another round of Quantitative Easing will be a disaster for the dollar, causing even higher inflation in an economy that is already having problems digesting higher prices.  

The main reasons why we have come to this conclusion are below:

1) First, if you take away the temporary gains in the stock market, there is no evidence that any of the QE’s have helped the economy.  QE1 and 2 certainly haven’t helped the housing market, as evidenced by the Case- Schiller Housing Model which clearly shows that the housing market is double dipping:

http://www.ritholtz.com/blog/wp-content/uploads/2011/04/Case-shiller-indices.png

2) And, jobs are still hard to come by.  This “recovery” has been the weakest in terms of jobs since the 2001-2005 recovery, which was also accompanied by a massive dollar decline in the dollar.

http://static.seekingalpha.com/uploads/2011/2/6/saupload_us_employment_declines_jan11.png

3) Since the start of the millennium, Federal Reserve and Treasury officials have always echoed their support a “strong dollar policy” while in reality the dollar lost over half its value since that time.   Please see the recent comments from Treasury Secretary Geithner:

"Our policy has been and will always be, as long as I will be in office, that a strong dollar is in the interest of the country," Geithner said at a New York conference organized by the Council of Foreign Relations.

"We will never embrace a strategy to weaken the dollar”

But, is there anything “strong” about this chart of the USD?

http://www.shtfplan.com/wp-content/uploads/2010/11/dollar_index_since2002.gif

4) And finally, on the subject of inflation, the Fed believes it can withdraw stimulus just in time so that inflation doesn’t get out of hand but for many, inflation is already here and is getting worse.  Wal-Mart CEO Bill Simon was recently quoted that “we’re seeing cost increases starting to come through at a rapid rate”.  And he continued by saying that US consumers face “serious inflation” in the months ahead for clothing, food, and other products. 

The Fed on the other hand has blamed strong demand in emerging economies to droughts in Russia in its attempt to explain why the price of pretty much everything we use is increasing.

The truth, however, can be seen in the chart below which clearly shows the correlation between the dollar and commodities.  When the dollar loses value commodity prices, which are priced in dollars, go higher and vice versa.   

http://www.google.com/imgres?imgurl=http://www.eidolonspeak.com/wordpress/wp-content/uploads/2011/02/fig1-crb-dxy-25yr.png&imgrefurl=http://www.eidolonspeak.com/%3Fp%3D213&usg=__8xJ4_Xb26OVeTStCz9pmMAeqISY=&h=411&w=700&sz=58&hl=en&start=140&zoom=1&tbnid=oa5zeHDIIsGB3M:&tbnh=128&tbnw=218&ei=C665TbvsC8vciAKPqaAj&prev=/search%3Fq%3Dus%2Bdollar%2Bvs%2Bcommodities%26um%3D1%26hl%3Den%26sa%3DN%26biw%3D1280%26bih%3D832%26tbm%3Disch0%2C4731&um=1&itbs=1&iact=rc&dur=600&page=8&ndsp=20&ved=1t:429,r:2,s:140&tx=105&ty=88&biw=1280&bih=832

At the end of the day, the only question that really matters, is why is our monetary policy over the past decade has resulted in such a decline in the dollar when it is clear that the official government policy is to promote a strong currency?  The answer may or may not be that easy to come up with, but the bottom line is that if the Fed and Treasury are trying to keep the dollar from falling, they either haven’t been successful at achieving their goals, or they aren’t telling the truth.  

As we have written many times before, if we really want to fix our economy we need the Fed to stop manipulating markets.  Our economy is not fully recovering because the Fed is not letting capital flow to where the demand truly is.  By injecting liquidity into one sector of the economy, in this case the financial industry, the Fed is effectively taking it away from another, hampering innovation and productivity.  People have become complacent now that the stock market is temporarily higher, which is a direct result of the Fed’s monetary policy.  However, as we have seen many times before, markets tend to overcorrect to the downside as soon as the Fed exits a market.  In this case, it will be very interesting to see just who, if anyone, is going to step up and buy Treasury bonds after the Fed stops doing so in June.

 

 

From the SEC to the Economy and War

As you all know, I recently settled with the SEC with regard to their complaint against me on the use of cash in one of the “side pockets” in one of the BayStar hedge funds that we manage. The settlement was in the best interest of my family, my business, my partners and my friends. In so doing I did not admit nor deny guilt and paid the SEC a fine. I want to thank so many of you who supported me during a very difficult time. As well, to those of you who disagreed and let it be known, I appreciate very much your right to do so. If anyone has further interest in reading the terms of the settlement, the agreement is a public document and can be found on the SEC website.

With the SEC settlement now behind me, I’ve had time to re-examine my prior writings on this blog and stand by my positions as firm as ever. As always I welcome your comments.

The latest readings on US consumer confidence show some of the lowest levels in 3 years or since the onset of the banking crisis. Even more disturbing, the Expectations Component of the index had its fifth largest drop in history last month which is no surprise given the recent rise in food and gasoline prices.  One topic we have written about time and time again in this blog is that throughout history, when governments have had their back against the wall due to a poor fiscal situation, or poor approval ratings etc, they commonly have turned to war as a method of distracting the population with a common threat. Wars also serve a very critical dual purpose of creating nationalistic support for the military and most importantly, political leaders.  Some people may ask what Libya has to do with finance?  Well, besides the fact that employers aren’t going to hire as many new workers and people are going to spend and invest much less in the face of all of this uncertainty, as the consumer index shows, there are deeper social and moral issues in play here that risk seriously weakening our entire economy. 

It doesn’t take a financial genius to understand that a nation cannot run deficits year after year without eventually running into trouble.  Three years into this economic depression  we are still wasting valuable time and energy trying to find out just who could have caused our money problems as a nation.  Just last month, the Washington Times ran a story that read “Financial Terrorism Suspected in 2008 Economic Crash”.  The article was written by a respected journalist in Washington, Bill Gertz.  The basic premise behind the article is that a Pentagon Contractor Report suggested that financial subversions carried out by unknown parties, such as terrorists or hostile nations, contributed to the 2008 economic crash by covertly using vulnerabilities in the US financial system.  The article continued by naming suspects including Middle Eastern states, Islamic terrorists, hostile members of the Chinese military or government or organized crime groups in Russia, Venezuela, or Iran.   

Unfortunately, as we all know, terrorists are not the cause of our economic problems.  Regardless of who is to blame, the damage is done and we have now spent another three years and trillions of dollars trying to repair the insolvent US banking system which is still not functioning properly and if anything is only causing a drag on domestic growth.  As we have repeated many times before on this blog- if we want to fix our economy we need the Fed to stop printing money and manipulating financial markets.  Finally getting a financial reform and regulation bill passed may also help fix our economy- but don’t hold your breath.     

Today, in this country, while states like Wisconsin, Ohio and Michigan are fighting to protect low and middle income wages of teachers, firemen, police and nurses, basically the backbone of this country, against draconian budget cuts, there is apparently more than enough money for another war. In just the first night of attacks, 112 cruise missiles were launched at Libya. Each one costs approximately $1 million so there was $112 million of destruction in one night with some analysts estimating that the war could eventually top $1 billion.  We have written about the wage disparity in this country on many occasions and it has only gotten worse after the 2008 banking crisis. Asking the workers of this country to take the majority of the cutbacks now, after giving Wall Street a $700 billion bailout, and only a few months after extending tax cuts for the rich, is flat out immoral and a slap in the face to any hard working American.  The dissatisfaction is only exacerbated when we have companies who are notorious for outsourcing American jobs are rewarded instead of punished. For example GE reported billions of dollars in profits and received extensive tax benefits at the end of the year.  On an individual level, we have all seen the data by now:  The median take home pay of full time workers is virtually unchanged on an inflation adjusted basis since 1973, and 58% of real income growth has gone to the top 1% of Americans since 1976. 

Whether or not you agree with them, the protestors in Madison, Wisconsin said that the protestors in Cairo inspired them to take over the Capitol Building.  Thankfully the protests in Madison ended peacefully, and again whether or not you agree with what happened is not the point.  The point is that our economic problems are leaving an entire generation of young, working class people and families behind and the longer it takes to fix, the worse it’s going to get for our society and country in the long term. We write this blog every month because we don’t want to see what happened in Cairo happen here. Our economic system is in dire need of a makeover as soon as possible before the situation gets truly out of hand.

This eerily prescient quote by one of our country’s Founding Fathers sums up where we are heading unless things begins to change soon:

"I see in the near future a crisis approaching that unnerves me and causes me to tremble for the safety of my country. . . . corporations have been enthroned and an era of corruption in high places will follow, and the money power of the country will endeavor to prolong its reign by working upon the prejudices of the people until all wealth is aggregated in a few hands and the Republic is destroyed."
U.S. President Abraham Lincoln, Nov. 21, 1864

Walk Like An Egyptian

"Walk like an Egyptian"
The Bangles
All the old paintings on the tombs
They do the sand dance don't you know
If they move too quick (oh whey oh)
They're falling down like a domino

 

Readers of this blog know that we have been warning for years now about the unintended consequences of the Federal Reserve’s monetary policy in response to the financial crisis of 2008.  Specifically, we have shown the link between money printing by the Federal Reserve and increased commodity costs, especially agriculture. 

On December 17th, 2010, 26 year old Mohamed Bouazizi, a fruit and vegetable vendor in Tunisia who had his cart confiscated by police set himself on fire to protest against rising food costs, job shortages and low wages.  As news of Mohamed’s death spread, riots began to erupt all over Tunisia. 

At first, the head of the military refused to put his troops onto the streets to stop the protestors.  He was quickly replaced by the President.  The Army then began to shoot the protestors in earnest and the death toll mounted.  But the riots continued, moving from outlying cities into the heart of the capital and, at that point, the military decided to replace the President.  We all know what happened next as the world watched the protestors jump borders and move into Egypt where rioters and workers had been on strike for almost a month nearly collapsing the Egyptian economy. 

The biggest Arab country with a population of 82 million was on the verge of a civil war as large sections of its economy were already shut down.  There hasn’t been train service in Egypt since railway workers declared a general strike and we have all seen the images of highways barricaded by protestors.  Basic necessities can’t get to where they need to go, so Egyptians have seen already high food prices double and triple since the riots began.  The entire power structure of the Middle East hangs in the balance and no one honestly has a clue what is going to happen next. 

Naturally, the Federal Reserve wanted to distance itself from the riots in the Middle East so it unleashed an all out media offensive regarding the issue.  For example, some Fed apologists are claiming that global warming is the main reason we are seeing food prices spike.  Make no mistake about it however, the food, energy and metal price spikes we are seeing now are directly correlated to the failed policies of the Federal Reserve and as more and more mistakes are made we are going to see more and more demonstrations and protests across the globe.  

To counter the growing view that blames the Fed for higher commodity prices, Chairman Bernanke went on the offensive by stating, “It’s entirely unfair to attribute excess demand pressure in emerging markets to US monetary policy, because emerging markets have all the tools they need to address excess demand in those countries”.  In a nutshell, Bernanke told the world that the policy coordination between Central Banks that had been in place since the 2008 crisis was now over and that the rest of the world was now on its own. 

Those of us who lived through the internet and housing bubbles know this tactic from the Fed very well.  They have become experts at inflating an economy until it picks up steam to the point of becoming overheated.  As the later stages of the investment bubble forms the Fed claims no responsibility or concern toward the asset bubble, which ultimately increases the probability for the asset bubble to break and in some cases violently. 

This time around the asset bubble we are all watching from is in the form of globalization, where some emerging market companies have seen their stock prices go up 10 fold in extreme cases.  While the Chinese, Indian, and Brazilian Central Banks have begun to tighten their monetary policy in an attempt to cool inflation in their respected countries, it is not likely to be successful if Chairman Bernanke keeps an ultra accommodative US monetary policy.  

 In his weekly column in the New York Times, Paul Krugman, an economist who perhaps is the biggest cheerleader for continued money printing by the Fed, wrote a piece claiming that global warming was THE main culprit for why we are seeing the prices of agriculture soar.  We were saddened to read his article since it meant that Mr. Krugman had not read The LRG Capital Report anytime over the past couple of years- because had he done so he would have known that agricultural commodity supplies are at the lowest point they have been in decades.. not months, or years.. but decades.  

With supplies being so tight, anytime we get any sort of weather related event, like a heat wave in Russia for example, prices shoot higher because there aren’t enough farmers to make up for the decrease in supply.  In fact, in a recent US farming report, the average age of farmers in the US is now 58 years old and getting older by the day.  If we don’t get more young people into the agricultural industry soon, in ten years the average age of a US Farmer will be 68 years old.  There simply aren’t enough farmers in the world and one big reason is because of the policies of the Federal Reserve. 

What Mr. Krugman doesn’t understand, or perhaps want to admit, is that when the Federal Reserve offers cheap credit the biggest beneficiary is the financial industry which pockets hefty commissions on the debased currency.  For most young people coming out of college the opportunity to make a quick buck on Wall Street seems a lot better and more exciting than working long days on the farm. 

So naturally, and as we have seen over the past 20 years or so in this era of cheap credit, our brightest and smartest young people end up working on Wall Street instead of manufacturing, engineering, or other industries where they are really needed.  Over time these imbalances will work themselves out, but not before Mr. Krugman and the rest of the Fed deniers watch as agricultural prices move higher than anyone could have imagined. 

Another and most obvious reason why we can and should blame the Federal Reserve for the inflation we are seeing around the globe today is because the Fed wants inflation.   Think of the $700 billion bailout, TARP I, QE I and now QE 2.  All of these programs were instituted by the Federal Reserve in an attempt to raise housing prices so that people will continue to pay their mortgage.  Additionally, the Fed certainly knows that low rates encourage higher asset prices and increased speculation and that higher asset prices have a beneficial short term impact on the economy, mainly through the Wealth Effect. 

The Wealth Effect is an economic theory that believes an increase in perceived wealth leads to an increase in spending.  According to the Fed Chairman, QE 2 has boosted asset prices and most notably, stocks.  Some studies have calculated that QE2 in fact has been responsible for an approximately 25% rise since August 26th, when the program was announced.  The idea is that as the Fed continues to purchase its planned $600 billion of Treasury securities the extra liquidity finds its way into stocks temporarily lifting prices and gives pension funds and individuals the perception of having more money to spend. 

So, on the one hand, you have the Chairman telling you that the Fed has had no role in rising commodity prices and on the other hand he takes credit for lifting the stock market.  This kind of policy-talk thinking is hypocritical at best and a flat out lie at worst and, believe me, the rest of the world ain’t that dumb!

For investors, we believe we that we are entering a time that will be challenging for equities.  This is especially true if the Fed continues with its current path of low rates, causing further pressures on commodity prices.  We especially believe that oil prices are set to rise further as geopolitical tensions continue especially in the oil rich Middle East.  We also believe that we are going to see much more of the kind of political upheaval we have seen in the Middle East so far during the early part of this year.  Some of the countries we are watching that may indeed suffer the same fate as Egypt and Tunisia would be Pakistan, Iran and Syria for example.  These are countries with low per capita incomes so when food prices rise, people and families end up getting hurt badly. The per capita income in Egypt, for example, is a mere $1,800.  When food prices rise in these countries they end up taking any of the disposable income people may have had.  

As the year plays out, all we can do is watch and hope that the moderates in these countries end up taking over, but as we have learned time and time again with the Middle East, anything can and will happen.  In the short term, what we are witnessing now, which is the potential overthrow of some of the most brutal regimes in history, has truly caught even the most respected security officials by surprise.  In the long term, what we know for sure is that the spreading revolution will bring about dramatic changes throughout the Middle East. 

Regardless, the point we are trying to make is that sometimes we need to connect the dots between the actions and policies we make at home and the effect that they will have on people halfway across the world.  This is especially true if we are trying to promote our companies, political system and way of life to the rest of the world.  We aren’t blaming all of the world’s problems on the Federal Reserve but we do believe that the Fed needs to take responsibility for its actions and the American people deserve to know what the true side effects are from certain Fed policy actions.  Higher and higher food prices are just adding more gasoline to an already very combustible Middle East.  At a certain point if the Fed continues to devalue the dollar, hurting more and more people and economies as basic necessities such as food and water become more expensive and scarce, this story can quickly evolve from a monetary one to one of national security.  
 

 
  

A To-Do List for 2011

To start out the New Year we’d like to suggest a to-do list with the hope that we can make 2011 better than 2010:

1)     Recognize that the major problem in Washington is and has always been spending

To understand just how ineffective Washington has become, look no further than the recent debate about the extensions of the Bush tax cuts.  Although Democrats and Republicans both know that we can’t afford the tax cuts and that raising taxes when the economy is in such a fragile state would make things much worse, the country had to sit through months of ideological wrangling when the nation’s real and most pressing problem is spending.  At the end of the day, the Republicans can claim a small victory regarding the tax cut extensions, but all that was really accomplished was the addition of even more debt to our national balance sheet and to speed up the day of reckoning when we will eventually have to deal with the consequences of all this debt.  Up to now we have basically destroyed the economy on Uncle Sam’s credit card.  While some members of Congress are starting to introduce inspiring legislation, such as Ron Paul’s “Audit the Fed” movement, until we, as a nation, begin to recognize and tackle the root of our problems, which is plain and simply too much spending, we will end up continuing the downward spiral towards defaulting on our debt or the destruction the dollar. 

2)    Remember how we got here in order to find a solution

When the financial crisis first hit, our elected politicians chose to save the insolvent baking system by putting up taxpayer money to buy securities.  We are now two years into the crisis and broken companies like Fannie Mae and Freddie Mac are still asking for and receiving billions for dollars from the government.  We have wrote about the unintended consequences of the government entering the financial markets extensively on this blog for over two years now so we will not go into detail today.  Basically, as expected, while the bailouts may have been effective in stabilizing the financial sector, they have come at a steep price since we are not seeing real demand return and are experiencing a very weak labor market.  The country’s unemployment rate has been at an elevated 10% level for over two years and things will only get worse as people reach the critical 99 week mark when unemployment benefits are exhausted and no additional extensions are planned.  People are tired and scared and want their government to start being held accountable for its actions. 

3)    Study Argentina and Japan’s experience with a debt crisis

Until recently, we have been using Japan’s two decade long fight with deflation as our metaphor for current and future economic policies.  Unfortunately due to a corrupt and ineffective government in Washington, the United States’ economic decline is starting to instead resemble Argentina’s economic collapse, which started in 1998 and landed Argentina in a depression by the end of 2000.  What began as a recession in Argentina, mushroomed into a full-fledged depression due to bad economic and monetary policies.  In our opinion, the Obama administration and Congress are on the precipice of following Argentina’s disastrous economic and monetary policy decisions.  Just like Argentina in 2000, the US must begin to at least attempt to pay down its debt and reduce its budget deficit from 3 different revenue sources: taxing, borrowing, and inflating.  Any sensible person realizes that we cannot tax our way out of $13 trillion debt or sustain existing entitlement programs, much less a government run health care system.  The government can also borrow money by selling government backed securities but eventually those investors will demand higher interest due to the increased risk of a government default.  The only feasible alternative for the government is to monetize or inflate the debt.  Just like Argentina in 2000, the elite in our government are driving economic policy in an attempt to preserve power. 

4)    Protect yourself from the possibility of further dollar devaluation

During a crisis, the political class is not concerned that there is a record amount of people now receiving food stamps or unable to find jobs. The political class is only concerned with preserving its own power and if that means creating an illusion of prosperity by propping prices up and engineering inflation then so be it. Never mind the fact the inflation taxes the poorest in our society who will not be able to afford price increases on basic necessities.  In Argentina, after the politicians were allowed to make matters worse from the 2000- 2002 period, 2002 turned out to be an utter disaster economically as the peso suffered a huge depreciation to the tune of 80%, which then raised prices on imports and caused severe inflation.  Many businesses closed or went bankrupt, bank accounts were frozen in an attempt to stem the currency devaluation, many imported products became virtually inaccessible and unemployment was devastating.  One can only imagine what would happen if the dollar lost 80% of its value and suddenly all of the things we buy on a daily basis doubled or tripled in price.  Today, due to the mistakes made in dealing with its own financial crisis, Argentina has to watch as its neighbor Brazil enjoys strong growth and prosperity and quickly overtakes it as the main economic power in South America.  This fate could be exactly where the US is heading.

5)    Get reacquainted with your new government

The Republican win last month will have implications on just about every industry group both global and domestic.  Leading up to the election, you didn’t have to be a political strategist to know that the country was moving to the right as the first two years of the Obama Administration were coming to a close.  If the past year saw the US economy stabilize, then hopefully 2011 will see us make the right decisions as a nation so that we ALL can enjoy some level of comfort and prosperity.  While some are beginning to understand that debt is not actually money, most in Congress still think that the economy can get stimulated enough by additional spending (or at least until the next election) simply by cutting taxes or raising the debt ceiling again.  The last thing the US needs right now is another economist or so- called financial expert telling us that we need to go into further debt to fix our problems.  What we do need right now is a leader who can inspire us to make sacrifices and the difficult choices that will have to be made.  Soon there is going to be an entire generation of young people who will pretty much have to put their careers on hold because of the gross mishandling of our economy.  The leader this country needs is going to have to inspire these young people into jobs or service they never would have thought they'd be involved in.  Before any of this can happen though, we the people must continue to educate ourselves and learn from our mistakes both financially and politically.  We need to keep the pressure on Washington, our state, and local leaders so they know that we are watching them and will hold them accountable. Sometimes our elected officials need to be reminded that our government was set up to work for “We the People”, and not the 5 biggest banks on Wall Street so when all else fails, send your representatives an email.
  
6)    Get your news from multiple sources

Take your family and friends to see movies like “Inside Job” or the many other great documentaries now available which show just how we got into this mess and now Washington is dealing with the crisis.  Also, it’s pretty obvious that major news outlets have become more entertainment than actual news sources, so get your news from as many different sources as possible.  For many of us, we go to the same website or pick up the same newspaper every day, so we end up getting relatively the same views on issues depending on the political ideology of the source.  The more informed and mobilized we are as a nation, the more we can hold Washington accountable to make decisions that are in the best interest of the long term health of the country.

Aside from the commercialism of the holidays it does give us a moment to reflect on the good in our lives.  As we read so many of the horrible headlines of people losing their jobs, homes and life savings, we are thankful that we live in a country that has always put its neediest first.  This basic principal must not change and we as citizens must strive to understand and listen to those in our society who need the most help.  Best wishes to everyone for a healthy and happy 2011.

Note to Chairman Bernanke: When You Reach a Dead End, The Worst Option is Full Speed Ahead

Now that the “robo-signing” scandals have achieved full notoriety through the media, it is time to address the real issues facing investors and the country as a whole with respect to both the foreclosure debacle and the Fed continuing to print money.  As usual, the media is staring at the wrong target. Each major media outlet is copying what is popular or what their competitors are doing versus analyzing where the true economic problems lie.   The real story is that the United States is losing its hegemony as the financial capital of the world!  Mind numbing amounts of capital have been destroyed in the past 2 years because we did not liquidate the “zombie banks” when this crisis began.   Instead, we simply allowed politicians to shovel hundreds of billions of taxpayer dollars into failed institutions. Then we watched as those failed institutions ultimately paid much of that money out as bonuses to their employees.   As a result, the original problem has metastasized; the banks are still in “zombie status” and resources have not been redirected towards truly productive ventures.  For investors, equity prices are at extreme multiples of the actual values of the entities that they allegedly represent, leading me to believe that we are looking at a perfect storm for a market crash that will make 2008 look like a bull rally. 

One of the reasons why the economy is so bad right now is because the general public does not understand the complexities of the mortgage backed securities and other derivatives markets. The public believed that the Securities and Exchange Commission was actually doing its job looking out for major fraud in some of the countries’ biggest banks, but the public was wrong then and they are even more wrong today.   Instead the SEC allowed banks to create secondary markets which allowed them to trade with each other for one purpose only- to collect more fees.   This was highlighted in the Goldman Sachs case, where Goldman flat out admitted to betting against the same securities that it created, marketed and sold to investors as a good investment.  In the span of approximately the last month, we have managed to negate the past two years of the Federal Reserve’s trillion dollar spending spree in an attempt to reignite a failed economy. 

The scary part about the “robo-signing” fiasco is its simplicity. As unbelievable as it may seem, the banks have lost the titles to some of the homes they claim they own.   If no one holds the title for a house, then why the heck should that homeowner pay his mortgage?  As the banks have yet to produce the necessary forms that show that they own the property, we are now seeing people who have already moved out of their foreclosed homes break back into those homes to squat.  And who can really blame them?  The US middle class has gotten absolutely CRUSHED the past 10 years. The last 2 years have seen some of the worst hypocrisy by politicians towards the hardworking middle class people of this country.  The anger is starting to reach a boiling point as more potential fraud and crooked behavior will only make things worse.  Let me make this perfectly clear, without clear property rights and a legal system that insists on proof of those rights before transferring ownership by force, the economy will fall apart like nothing we have ever imagined.

As we have expressed on this blog for over two years now, the Federal Reserve is fueling the fire and only prolonging the agony.  The Fed was by far and away the biggest reason we got into this mess with cheap money flooding the system and now THEY have spent a gazillion dollars of taxpayer money on failed policies that can quickly turn our society upside down.  For a good example of what cheap money can do to nations, just look at the period leading up to World War I, where the Central Banks of France, Britain and Germany all printed money in order to pay for their War efforts.  With endless money, European Generals believed that they could build trenches for their troops and simply wait for the enemy to run out of supplies.  Thus, instead of the War being “ quick and glorious” as many Europeans believed at the time, the fighting lasted for 4 years (1914-1918), nearly destroying an entire generation with over 9 million men dead and millions more wounded.

After the war, Britain and France wanted the Germans to pay reparations, but the Germans, who obviously expected to win the war, had financed their own war effort and were now effectively broke.  After a couple of years of back and forth between politicians, Germany would eventually be forced to pay reparations and the only way for that to happen, the leaders concluded, was to print even more money.   We have all seen the photos in history books of Germans burning paper marks to heat their homes because it was cheaper than coal, or as incredible as it may seem, how the cost of a loaf of bread went from 13 cents in 1914 (in US dollar terms) to just around $100 billion (in US dollar terms) by the end of 1923.  Needless to say, the effect of hyperinflation on the German population over the next twenty years (1925-1945) was disastrous.  In the end, Germany was essentially dissolved, but only after millions of lives were lost in WWII.  All of which could have been avoided if politicians weren’t allowed to fund deficits by printing money in the first place.  After the war, politicians again had a chance to save Germany from the hyperinflation that ultimately engulfed it had they created a fair restructuring program for the German debt.  Instead, the Germans were pushed and embarrassed into printing more Marks to pay back their loans which led to the collapse of their economy.  One doesn’t have to go far to draw parallels between the actions of the Central Banks from 1915-1945, to the money printing orgy of our current Central Bankers/ Planners.

Today there are at least 12 conflicts around the globe involving countries that have a clear agenda against the West and America.  One of the most dangerous unintended consequences of the Fed’s money printing is that it props up not only failed economic systems like ours, but it also props up failed political systems and our enemies.  Take Iran for example, which was months away from being completely shut down after the crash of 2008 due to $30 oil prices (Iran’s major export).  Now, after two years of the Fed printing money, oil is back to over $80 and the leaders of Iran are again enjoying the windfall of cheap American dollars which inevitably go to finance the countries’ nuclear program.  The same can be said for Venezuela, Russia, and, to a lesser degree, China.  It’s a vicious circle because as we all know, in the eyes of our political leaders, war is one of the best ways to get inflation going.  And the scariest part is that the Fed obviously knows all of this, yet their actions are telling us that they believe saving a few “zombie bank” bondholders is more important than the potential for another major war. 

Thankfully, the internet has made media less centralized so the policies out of Washington and the Fed are scrutinized and exposed on a daily basis before things are allowed to spiral completely out of control.  We are two years into this fiasco, dealing with another fraud relating to mortgage backed securities, and the Fed is expected to print at least another $500 billion in a second attempt to get the economy growing again.  This November 2nd, expect to see a full scale revolt on voting day as most people are beginning to understand that the Fed has to stop printing money and unwind the “zombie banks” now. Any politician who doesn’t understand that this is what’s needed in order to get our economy growing again will hopefully be sent back home.  This horrible chapter in American history should have been put to bed two years ago when we had a chance, but as the old saying goes, better late than never.

Obama: The Era of Hypocrisy

If you had heard that the CEO of one of the country’s biggest and most influential companies met and scolded the senior staff of a major TV business news station (which is also owned by the company) to persuade them to run political stories that would be favorable for the company would you think there was anything wrong with that?  If you said yes, then you would be correct, but would you believe that this type of behavior happened not in Russia, or China, or Iran even, but right here in the US?  Unfortunately, “spinning” news stories in its favor is just the tip of the iceberg for General Electric which, in our view, has lost its way and in the process has become a detriment to the growth and well being of the US middle class.  Moreover, as the past two years have shown, the Obama Administration, like its predecessors, is really nothing more than a combination of the interests of the most powerful corporations in the country.  Call it an oligarchy or whatever you like, but the link between big business and politics is becoming more obvious everyday with the American middle class suffering the biggest loss from the relationship.  Our newest entry to the LRG Capital Report will explain in detail just how this cozy big business (GE in this case)-Washington relationship is, in effect, screwing over the working class American and making everything this Administration and Congress say about hope and change sound like nothing more than a lot of hot air.

The real issue with US economic policy today is that no one in a position of power has a clue how to address the structural issues in the US economy.  Either that or they are willing to ignore the obvious for the sake of not risking their career.  The fact of the matter is that the US economy on a structural basis is broken.  Starting in the 1970’s, we outsourced our manufacturing sector and began shifting to a services economy (financial services in particular). Companies like GE, who’s former CEO Jack Welch made a career from borrowing at cheap rates, buying out companies and outsourcing the jobs overseas.   We can’t blame the CEO’s, who saw an opportunity to make profits for their companies, but the cost to the working class in the US has been huge and Washington has only aided the handoff of our nations prosperity to Asia, OPEC and Wall Street with misinformation, and a tax policy that promotes gutting US jobs.  What Americans are slowly starting to figure out is that globalism isn’t beneficial to ALL Americans as our government and business leaders have led us to believe.  In theory, globalization sounds like a positive concept in a world of free trade, but if you are the only one in the game that is following the rules while other countries manipulate their currencies and put tariffs on their resources then you stand to lose more than anyone since the game is rigged against you. 

Over 5 million manufacturing jobs have been off shored since 2000.  Because of these policies, the average American has seen his income dramatically fall over the last 30 years.  Forty years ago one parent worked and people got by.  Today, both parents work (if they can find jobs) and can still only barely get by.  On the flip side, CEO salaries have increased from 30 times the median salary of the average worker to 300 times the average where its stands today.  Are today’s bosses 10 times more capable than their peers 40 years ago?  Does anyone see a shortage of management talent with more MBA’s being pumped out from our nation’s schools than engineers?  The answer is an obvious and resounding NO.  But instead of focusing on wage disparity and income gaps, the media and Washington shifts the focus to keeping the stock market over 10,000 or housing prices up, both of which are important to the US economy, but not nearly as important as jobs and income.  While the stock market and real estate are important in terms of retirement and savings, they don’t pay for goods and services (at least not since the housing bust).

We are in an era where the line between politics and media has been blurred.  Most Americans know that the economic readings that the government publishes are skewed in the governments favor at best, and at worst complete lies (like the unemployment rate). One might ask why the CEO of GE would have to yell at the heads of CNBC because he felt they were being too “anti-administration”. What is it that GE does not want the public to know?  Well, a good place to start is by looking at GE’s 2009 tax bill which, when all said and done, was $0. This is the same company that has outsourced millions of US jobs and got bailed out by American taxpayers in the form of $139 billion in FDIC guarantees and support by the Fed for its commercial paper.  If you put it all together, you get a story of national suicide with taxpayers funding corporations in the form of cheap credit to outsource workers. 

Unfortunately, GE is not alone.  About 2/3rds of corporations operating in the United States did not pay taxes annually from 1998 to 2005.  Goldman Sachs, who made a fortune over the past decade by advising on deals that would eventually offshore US jobs, and also got a $10 billion bailout from the government, paid a whopping $14 million in taxes worldwide in 2008.   These numbers are simply staggering and are a testament to just how bad the lobbying efforts in Washington have become.  Members of Congress have shown time and time again that they will sell out to the highest bidder. 

The only way out of this economic depression is to reverse the policies that have gotten us here.  The loss of our manufacturing sector impoverished Americans while producing oversized gains for Wall Street, shareholders and corporate executives.  These jobs can be brought home where they belong by taxing corporations according to where value is added to their product.  If value is added to their goods in China, then those corporations would have a higher tax rate.  If value is added to their goods in the US, they would have a lower tax rate.  This change in corporate taxation would offset cheap foreign labor that has sucked jobs out of the US, and at the same time increase the total tax base and revenue for the government.  Obviously corporations and Wall Street will fight to block any legislation that would potentially reduce short term earnings, but the alternative will be an America that we will not recognize.  If we stay on this current course of borrowing and spending inflation will, without a doubt, at some point get out of control putting further pressure on an already weakened and frustrated labor force.

Clearly the first two years of the Obama administration have been an economic disaster for the US with sky high unemployment and record foreclosures.  At some point, the Obama administration will have to stop blaming President Bush for our current problems.  We were promised transparency from the Obama administration but so far all we have gotten is more lies and spin about economic policies that benefit global conglomerates, while gutting the American middle class.  With mid-term Congressional elections only a few months away now, it will be interesting to see if Americans have begun to wake up to the idea that globalization was a big lie.  In the last election, Americans voted for the then Senator Obama thinking that his lack of experience would be a benefit such that he didn’t have to cater to the lobbyists and same corrupt networks who currently hold power in Washington, but the past two years have shown otherwise.  Wall Street understands the frustration and has already planned and paid for the change in leadership in advance with contributions to the Republican party surging to a near multi -year record, or 68% of the total. The sad conclusion for the Obama administration is that even those who the President burned so much political capital to bail out have turned against him and will almost certainly be one of the main factors to cost him his second term.

We Haven’t Been Wrong Since The Crisis Began, So Read This!

Major market indexes closed the month of May down sharply, with the Dow losing 7.9% during the month.  The loss marked the worst May the Dow has seen since 1940, which included a one day crash on May 6^th that took the index down 1,000 points intraday.  As we explained in previous posts, we expected for the bull run in stocks to reverse as the Federal Reserve concluded its Quantitative Easing program in April.   In late March, we wrote:

“In summary, with equity markets continuing to melt higher, we would currently not be over exposed to equities, but are beginning to look at industries and sectors if and when we get a 20-30% drop in the markets.”

With the S& P 500 beginning to break down, we believe that now is the time to start cautiously building up long positions in stocks or sectors that should do well over the next 3 to 5 years.  After the EU’s decision for a Greek bailout, what we know that governments around the world are going to stop at nothing to print their way out of this mess.  One of the events that received absolutely no mention over the past month was the release of the Treasury Department’s annual report on public debt.  In a nutshell, the report anticipated that US GDP will rise at a laughable 5% average per year for the next five years!  Just for comparison, the growth rate during the boom years of 1990-2009 was 4.9% on average.  Even more disturbing, is that with that miraculous GDP growth rate, total Debt/GDP will still be over 100% by 2015!  If you come to a much more realistic GDP growth rate of 1.5% for the next 4-5 years, total Debt/GDP will actually be 126% in 5 years.  Experts agree that when public debt levels reach 90% of GDP, rating downgrades become a reality and the cost of capital will begin to increase raising the risk of sovereign default. 

Investors need to realize what Central Banks are doing (ie printing money as far as the eye can see) and come up with a plan to protect and grow their assets.   The ramifications of the Treasury’s debt assumptions will have a direct negative impact on the US dollar which, as we have seen, affects everything from oil prices, to stock prices, to food prices.  Given all of the above, we have come up with a list of ten investments that we believe every portfolio should include.     

Agriculture:

As we have written about for almost a year now, we believe that the agricultural sector will see spectacular gains over the next decade as rising demand from Asia, coupled with falling supply due to less credit available for farmers will create food shortages at a level that hasn’t been seen in decades. 

Monsanto (MON) - The Agricultural Chemical Producer has seen its stock price fall from $85 to $50 this year as the rise in the dollar put pressure on agricultural commodities.  The company also has increased competition from China which will cut into its margins in its Asia division.  Monsanto will most likely end up purchasing one or more of its Chinese competitors to cement its position as the leading agricultural chemical producer in the world.

Potash (POT) - The fertilizer producer out of Saskatoon, Canada has traded in a range from $90 to $120 for over a year and half.  The Potash market is improving as China emerges as a substantial importer of corn.  In a recent conference call, the company told investors that it believes that global Potash demand is picking up and raised its earnings forecast from $1.30 to $1.50 per share. 

Powershares Double Long Agriculture ETF (DAG) - While there are numerous ways to play the coming price inflation in food, Agricultural Exchange Traded Funds may be the simplest way to do it.  DAG is a fund that allows investors to take a leveraged position in the actual agricultural commodities.  DAG is composed of roughly equal percentages of corn, wheat, soybeans, and sugar contracts. 

CHINA:

We continue to be positive on China in spite of increasing talk of a bubble. While we do expect more volatility in the short term, China’s mid-to-long-term outlook is bright.  We agree that there is a real estate bubble in some of the coastal areas of China, however there are many industries in China that will continue to grow regardless of the global economic climate as the country transitions to a modern economy.

PetroChina (PTR) - With a market cap of over $200 billion, China’s largest listed oil company will benefit over the coming years from higher crude prices and energy demand.  The stock is up over 35% since the March 2009 lows.  We expect PetroChina to begin to make acquisitions oversees (BP comes to mind) in the near future.

China Eastern Airlines (CEA) - China’s recent decision to allow greater flexibility in the Yuan exchange rate will be a positive for its domestic airlines as a stronger currency will lower fuels costs and their borrowing costs on foreign currency debt.  One of the nation’s leading airlines, China Eastern operates over 80 international and regional routes out of its main hub in Shanghai.

Origin Agritech Limited (Seed) - Keeping with our agriculture theme, Origin Agritech’s business model and strategic direction is most easily equated to a mini- Monsanto.  The company currently generates its revenue from the sale of hybrid seed products, but has been heavily investing in the development of a pipeline of genetically modified seeds.

Metals:

With Central Banks around the world continuing to print money, metals will be an obvious beneficiary as people start to lose faith in paper currencies.  While we do like gold, we prefer silver or palladium as they are cheaper on a relative basis.

Freeport-McMoran Copper & Gold (FCX) - A one stop shop of mineral resources, Freeport McMoran engages in the exploration, mining and production of copper, gold, silver, molybdenum and cobalt deposits.  As of December 31, 2009, its consolidated recoverable proven reserves totaled 104 billion pounds of copper, 37 million ounces of gold, and 270 million ounces of silver.  These deposits will only gain value over the coming years as Central Banks devalue their currencies.

Novagold Resources (NG) -  Novagold primarily explores for gold, silver, copper, zinc and lead ores.  With a market cap of less than $1.6 Billion, Novagold is a more speculative play.  Novagold was trading at around $20 a share before the financial crisis, but is only trading at around $7 now even with metal prices higher since the crisis and the company holding essentially the same reserves.

Silver Wheaton Corp (SLW) - Silver Wheaton has quickly positioned itself as the largest metals streaming company in the world.  By 2013, annual production is anticipated to increase significantly to approximately 38 million ounces of silver and 59,000 ounces of gold.  The company currently has the right to purchase all or a portion of the silver production, at a low fixed cost, from high quality mines located in politically stable regions.

Protecting your Portfolio

Proshares Ultrashort Emerging Markets (EEV) - Given these uncertain times, every portfolio should include some downside protection.  Thanks to the proliferation of ETF’s, hedging long market exposure with short positions is easier than ever.  EEV trades twice the amount of the inverse of the daily performance of the MSCI Emerging Markets Index.  The addition of leverage allows the investor to participate with limited capital and given that we have positioned our portfolio to international companies, specifically in mineral rich, emerging economies, EEV is a great way to hedge our bets and protect the portfolio from extraordinary losses in down markets. 

Our near term forecast is that we will see more volatility in the markets over the next 6-12 months.  We believe that as the economy and market begin to falter, the US will introduce another stimulus package, whether in the form of income tax cuts, or more bond buying by the Fed.  This next round of stimulus will devalue the dollar further and be a big boost for emerging economies.  Some key technical levels we are watching are 950 and 840 on the S&P 500.  We expect that the next round of stimulus will be announced if and when the market does fall to the 950 level on the S&P 500.  However, if the political climate is such that more stimuli are not taken on, then we expect the market to fall to its next support level at 840.  If 840 doesn’t hold on the S&P 500, we would sell all or most of our long positions or add short bets because the next stop will be at the March lows of 666 or even lower. 

 

 

 

How Quickly We Forget

As the investment community and world focuses on the Goldman Sachs hearings and the unscrupulous practices seen on Wall Street over the past 10 years, investors should understand that no matter what the outcome of the hearings, the global economy is still extremely weak and even more vulnerable to shocks than it was two years ago.  The US markets have had a near record rally over the past 12 months, blowing away even the most aggressive estimates.  The Federal Reserve is once again begging us to speculate with 0% interest rates which hurt conservative investors like pensioners who cannot make a dime on their cash.  We would caution investors, those on a fixed income in particular, to not chase for higher returns even as equity markets continue to ramp up.  Despite going through this dance of speculation twice over the past 10 years due to abnormally low interest rates and getting punished for it severely, investors are again faced with the question of whether or not to participate in what is starting to look like another bubble forming in equities.

While no one can really say where the market is headed in the short run, one can make a reasonable observation of what the Fed is going to do with respect to interest rates and how that will affect the markets and economy.  Using the premise that stocks have disconnected from the economy, which in our view has occurred because stocks are far more sensitive to low rates and the Fed than the economy itself, we can make a reasonable assumption of what the Fed ‘s next move will be.  While we may get lucky and the economy suddenly gains strength, we must understand that the problems that plague our economy after this bubble implosion, i.e. mortgage and credit card defaults, will linger for at least a couple of years. 

The most likely outcome is that the economy will have an uneven recovery with interest rate affected areas of the economy doing better than the rest of the economy until the time that the Fed decides to raise rates.  However if the recovery is stronger than expected, interest rates will most likely rise before we reach further bubble territory.  As rates rise, equity markets will begin to settle down and will only be moderately overpriced until valuations catch up to the market or we get a long overdue correction in equities, which, believe it or not would probably not have much of a damaging effect on the economy.   However, if the recovery is slow and unemployment remains elevated, Bernanke will keep rates very low, as promised, certainly continuing to fuel the bubble which would be a disaster for the economy in the long run.

Further, as we explained in our previous writings, we fully expected that the debt problems in Europe would sooner rather than later turn into a major headwind for the global economy as the sovereign crisis spreads to other European nations and eventually the United States.  The past couple of months had seen a back and forth between Greece, the European Union and the debt markets, as Greece attempted to put its fiscal house in order.   All the while, higher borrowing costs began to spread to other European nations including Spain and Portugal whose credit ratings were recently downgraded.  With the recently announced $962 billion bailout package, the Europeans knew that this was no longer a story about an IMF package for Greece, but rather a crisis of the fundamental structure of the entire Euro zone and the ability and, more importantly, the willingness of the international community to restructure government debt in an orderly manner, i.e. who will support whom and on what basis.  One of the comedies of the Greek bailout is that Spain and Portugal, who are deeply in debt themselves (and will eventually need their own rescue packages) were required to pony up billions of dollars for Greece as part of the package.  Once again, our political leaders think they have solved a problem of too much debt by robbing Peter to pay Paul and in the process just saddling Paul (Greece in this case) with more debt. 

In our view, Greece is the equivalent of Bear Stearns in context of the US financial crisis seen two years ago.  While our politicians and regulators believed that they were able to stave off a contagion to the rest of the financial community by papering over Bear Stearns’ problems, it only took 6 short months for both Lehman Brothers and Merrill Lynch to collapse and the entire financial industry to find itself at the brink of bankruptcy.  We have seen this story play out many times before.  Politicians cannot stop a contagion, they can merely delay it until the entity or country can no longer go to the market to raise capital.  Just for the record, Spain’s economy is five times the size of Greece, meaning that just the Spanish portion of the bailout requires approximately $500 billion. And after Spain, the European Union will have to figure out what to do with Italy, whose economy amounts to approximately 25% of total European GDP.  It’s no wonder that George Soros and other major players in the currency market have taken out massive short bets against the Euro.  In Greek mythology when Pandora’s Box was opened it was the start of many new and unexpected problems.  Likewise, we view Greeks bailout package as just the beginning in what will be a long road for Europe with challenges that may break up the Union or at the very least see the ejection of some of its weaker member countries.  There aren’t going to be any easy solutions or pleasant outcomes for Europe’s debt problems. 

Finally, as we wrote about in previous posts, the technicals of the market show that the individual investor is back in the markets hoping to cash in on the rising tide in equities.  Margin debt has surged since the crash of 2008 indicating that speculation is rampant and traders are speculating with leverage.  Additionally, as Europe’s debt problems continue, the dollar has surged to its highest level versus the Euro in over a year.  Our models indicate that global liquidity topped at the end of 2009, which also can explain why equity markets have lost momentum and gone virtually nowhere in 5 months.  As we have been explaining for months now, the rally that we saw in equities last year was mostly due to the Fed’s Quantitative Easing program which provided a massive shot of liquidity for financial markets.  All that extra liquidity found a home in stocks, bidding up prices.  Now as the programs wind down, the Fed is hoping that the market can stand on its own and that the economy will begin to pick up. 

History has shown that as the dollar rally begins to broaden, owners of risky assets such as stocks need to be extremely careful.  The last time the dollar rallied on a multi-month basis was when liquidity came to a virtual halt during the financial crisis that took down Bear Stearns, Merrill Lynch, and Lehman Brothers.  Before the financial crisis, major dollar rallies occurred during the Asian Contagion and LTCM blowups in 1998, and in 2000 during the Nasdaq/Dot-Com Bust.  While the recent strength in the dollar could just be an anti-cyclical move from the major multi- year trend (falling dollar), investors need to be wary that the strength in the dollar doesn’t manifest itself into another major liquidity event as capital leaves Europe and moves to the relative safety of the US.  While the European bailout package sounds promising, as we have been saying, the problem with the global economy is that there is simply too much debt and we need to start acknowledging it.  The train that always kills you is the one that you pretended wasn’t there. 

History Repeating Again: Protectionism Rears its Ugly Head

With the equity markets now back at the highs of the year, albeit on very low volume (except on the down days), many people have asked LRG Capital Group of late if we are finally going to get back in the market.  While the 70% gain in the S&P 500 over the past year has been one for the history books, we are firmly sticking to our guns and will remain on the sidelines until we see a variety of things happen that we will explain below.  Our own view is that the markets are in a cyclical bull rally within a longer term bear market.  Over the past 6 months, investors across the globe have benefited from an extraordinary onetime event of central bankers pouring money into the system to paper over debt issues.  The Federal Reserve for example, has now purchased nearly $1.25 trillion (with a T) in mortgage backed securities through its Quantitative Easing program.  The QE program, which is just one of the many instituted by the Fed and Treasury over the past year in an attempt to liquefy markets, currently only has $30 billion left and the Fed is due to quit the program at the end of March.  Technically speaking, over the past week or so, the S&P 500 has broken through previous resistance at 1150, and has successfully bounced off that area giving us the impression that the market may indeed drift higher over the short term.  The next area of major resistance is at 1250 on the S&P 500, or approximately another 8% gain from here.  As of today, we see no imminent signs that the end of the rally is near, however, the closer we get to the day when the market believes a Fed removal of the accommodation is imminent, the closer we will be to a top.  In our view, the current 70% cyclical rally ends with an approximate 20-30% decline, followed by a broader trading range.  With the market only 8% from a major resistance level, our analysts are currently putting together a shopping list for stocks and industries which could be bought if we get a 20 – 30% decline.  We believe the best place to look for opportunities in equities after a correction will be the same areas that have benefited most over the past year.   This especially includes stocks in emerging markets such as China, India, and Brazil, and also major commodity producers both oversees and within the US. 

Readers of this blog know that we have been calling for major disruptions in the currency markets for this year and beyond with countries facing downgrades to their debts or otherwise defaulting as with the case of Dubai.  Most recently, Greece has stolen the headlines with the country facing an imminent cash crunch and a possible ratings downgrade by the rating agencies.  Greece’s problems have hurt the Euro and in turn strengthened the dollar which is now trading at the highs of the year.  The outcome of  the European Union’s decision regarding Greece will be a worry the market will have to deal with not only for how it pertains to Greece, but also to its neighbors, Spain, Portugal and Italy who are facing similar issues.  The simplest and smartest move on the part of the EU would be to let Greece default on its debts and clean up its public sector spending which would hurt the country in the short run, but would benefit the country longer term.  Unfortunately we are living in a an age where politicians only look as far as the next election, and would rather paper over problems in the short run at the expense of long run economic health.  The irony is that letting Greece default would immediately send a signal to the market that the EU is serious about not bailing out countries, which would strengthen the Euro greatly.  However, all of the back and forth regarding a Greek bailout tells us that the EU will print, borrow and spend in an attempt to fix its members’ problems.  We are now looking at a situation in which the fate of the Euro hangs in the balance.  By bailing out Greece, the EU is breaking one of its original laws which clearly states that member countries shall not come to the rescue of other nations due to budgetary shortfalls.  Thus, as the year plays out, we believe that we will see further weakness in the Euro as debt problems emerge in Spain, Italy and Portugal who will expect the same favorable treatment as Greece.  The weakness in the Euro will translate into dollar strength which will hurt US equities and multinationals who have enjoyed the benefits of a weaker dollar over the past year. 

Perhaps the most troubling development over the past few months has been the back and forth between Washington and Beijing over letting China’s currency float.  If Chairman Bernanke, or anyone in the administration understood history and the markets, pressuring and/ or angering China, would not be the course of action they would be pursuing.  Students of the 1930’s know that what ultimately threw the US into the Great Depression was protectionism that resulted in trade wars.  Our fear is that we are now following a similar path with some US Senators, including Senator Schumer and Graham, introducing a bill which would pressure China to appreciate its currency.  Not to be outdone, senior Chinese military officers proposed that their country sell some US bonds to punish Washington for its latest round of arms sales to Taiwan.  Additionally, various Chinese political leaders have come out and said that the country will allow its currency to appreciate but only on its own terms.  The war of words between the US and China has even made it to cyberspace with Google announcing plans to exit China due to a spat over censorship.  In our view, instead of grandstanding and calling China a currency manipulator in public, the US should simply sit down with the Chinese in private and explain to them that it is to their benefit to allow some flexibility in their currency.  For example, the Yuan’s appreciation will in turn lower the cost of China’s imports and its supply chain.  The Chinese understand that in order for their country and currency to become a major player on the world stage, they well have to allow their currency to appreciate.  Pressuring and angering the Chinese in public will not make the Chinese appreciate their currency any faster and will only cause more tensions between the United States and China, which in this volatile environment where people are short on patience in the first place, can turn very nasty very quickly. 

In summary, with equity markets continuing to melt higher, we would currently not be over exposed to equities, but are beginning to look at industries and sectors if and when we get a 20-30% drop in the markets.  Additionally, we would call upon investors to look at the foreign currency markets where we believe spectacular gains will be had over the next 3 to 5 years as countries look to devalue their currencies in an attempt to revive their exports.  The obvious play in the short to medium term would be to short the Euro or buy the dollar for reasons that we have stated above.  If Greece does get bailed out, which seems to be the case, the other weaker countries in the EU will ask for similar treatment which will result in a much lower Euro.  As political tensions heat up, investors should also keep an eye on what governments around the world are doing and saying with respect to their currencies and trade.  If nations continue on this path towards protectionism, all bets are off.  No nation has ever won a trade war.  Thus, if the administration mistakenly enters a trade war, we will all (yet again) have to pay for Washington’s mistakes.  CAVEAT EMPTOR.