Holy Carp...

During this time of fear and panic I would like to offer readers the below points of information that I find particularly relevant:

According to investopedia.com, capitulation is described as “giving up any previous gains in stock price as investors sell equities in an effort to get out of the market and into less risky investments. True capitulation involves extremely high volume and sharp declines. It usually is indicated by panic selling. After capitulation selling, it is thought that there are great bargains to be had. The belief is that everyone who wants to get out of a stock, for any reason (including forced selling due to margin calls), has sold. The price should then, theoretically, reverse or bounce off the lows. In other words, some investors believe that true capitulation is the sign of a bottom”.

http://www.reuters.com/article/hotStocksNews/idUSN1737041320080917

Today gold had a massive movement to the upside, possibly revisiting the days when the commodity was viewed as a safe haven to investors in times of currency or inflation concerns. To quote Reuters, “The $81 rise in the benchmark U.S. gold contract for December delivery was gold's biggest one-day rise in absolute terms since 1980 and the biggest one-day percentage gain for gold futures since February 2000”. This would seem to indicate that confidence in the US banking system has been severely shaken.

For a brief moment today, the improbable occurred in the bond pits: the 3-month U.S. Treasury bill yield traded in negative territory. Take a moment to digest this information; for a short time traders paid for the privilege to loan the U.S. government money, a concept that under rational thought is completely perverse. If your friend asked you to borrow money in return for an IOU, would you say “sure, and because I take such pleasure in making this loan I will pay you in the transaction”? This shows that investors, who are usually out to make a profit, were satisfied with simply preserving capital.

http://www.reuters.com/article/bondsNews/idUSNYG00128420080917

Massive selling has been seen across the board over the last few trading sessions. Companies with no exposure to the banking sector have been punished relentlessly as the market tries to digest an unreasonable blanket of bad news. The S&P 500 sold off on heavy volume at the end of the day and now sits well into bear market territory. Panic is surely being felt among retail investors as described by CNBC’s market reporter Bob Pisani: “On Monday, for example, mutual fund investors panicked and pulled $10.9 billion out of the market (TrimTabs), with particularly large outflows ($4 b) from global funds. So far, there's $13 billion in outflows in the first ten trading days of September. If we stay at this level, it will be shy of the $35.8 b outflow we saw in January and well short of the record $49 b outflow in July 2002, but it will still be a big month for outflows. July 2002? Remember the stock market bottomed in October 2002! That's the rule: retail investors tend to panic near market bottoms. So the big outflows this year were in January, July…and September”. When retail investors pull out in herds, the big money players sense the bargain and bring in capital from the sidelines to drive the market higher.

A market bottom can only be seen through the rear view mirror; the next few trading sessions will provide an excellent guide for the future direction of prices. If the market recovers tomorrow or Friday with a sustained rally on higher volume going into the close, I believe a bottom will have been marked at this level. With concerns over government involvement we may oscillate around this mark, however, I do not expect a large or prolonged decline below where the S&P 500 closed today.

http://www.cnbc.com/id/26758934

Wall St. Socialism

The Bailout Nation has arrived and it is in full force. When problems arise, bad decisions are made, or Wall Streeters decide they want a financial mulligan, fear not because interventionist government stands ‘ready, aye ready’! In an article written by George Will shortly after the unlikely Fed orchestrated marriage of JP Morgan Chase and Bear Stearns, he commented on this topic by stating that “The description of the Fed as the ‘lender of last resort’ is accurate without being informative. Lender to whom? For what purposes? Last resort before what?”. Over the last year we have witnessed the most expansive examples of state control over private sector matters since the days of the ‘New Deal’ and the Great Depression.

http://www.nypost.com/seven/04212008/postopinion/opedcolumnists/wall_st__socialism_a_brave_new_federal_r_107433.htm

To take this away from a political debate and turn it to an economic one, the entrance of government into the private sphere has many consequences for taxpayers and consumers alike. The conservatorship that Freddie Mac and Fannie Mae were placed into is not directly inflationary because the Federal Reserve is not monetizing the plan; however, this exercise will undoubtedly affect future fiscal policy decision because of the added obligation to the federal deficit, which could in turn be inflationary. Therefore any governmental intervention of this nature should be very short term or it risks restricting the options of both fiscal and monetary policy.

The troubles that Lehman Brothers is currently experiencing has people wondering if the government and/or Federal Reserve will step in to facilitate a rescue of the Wall Street firm. Unfortunately, it is because of two unlikely and utterly bizarre factors that the 150-year-old company is in the grips of utter catastrophe: Perpetual negativity and the FASB. It has become a self fulfilling prophesy through the fear of sellers perpetuated by media and credit rating agency negativity that Lehman Brothers’ stock has plummeted, thereby impairing the firm’s ability to operate normally as a going concern and raise capital in the open market. Rating agencies such as Standard & Poors and Moody’s played an important part in creating the current credit crunch through their lack of understanding of many structured financial products; now after the stock of Lehman falls into obscurity they decide to seal the firm’s fate by restricting the company’s access to capital markets because of their issuance of a negative downgrade on the firm. The judgment (or lack thereof) displayed by the rating agencies is despicable and must be recognized as playing a major role in the country’s current credit debacle. Additionally, the introduction of FASB 156 and 157 causes market participants to value assets based on current determinable fair value – a doctrine that is useless in a severely depressed, cyclical, and illiquid market. By improperly valuing these assets, financial ratios are skewed forcing unnecessary dilution of the company to satisfy liquidity and capital requirements.

There are many rumours floating around concerning the fate of Lehman Brothers, so I won’t waste time dissecting any possibilities. I will only end this topic by saying that I am partial to the creation of a so-called good bank-bad bank solution, similar to the outcome seen with Long Term Capital Management. The reason I would favour this idea is because the assets that cannot be properly valued, and are likely to have a relatively higher value at some future date, can be isolated from the bank’s other assets.

The current focus of policy makers should be towards that of credit stability and housing recovery, both of which are inseparable. The rescue of Freddie and Fannie in the short-term can be a net positive because of the shrinking effects on mortgage lending rates. The government guaranteeing to buy MBS through Freddie and Fannie removes default risk from these securities serving to tighten the spread over treasury paper. If banks have a secured buyer of repackaged mortgage debt, they should be more willing to lend to the public, which should serve to lower mortgage rates of all shapes and sizes: A huge positive for the consumer and the economy!

My advice is to take advantage of the market’s current distraction with bailouts and the like, because these events are unlikely to affect the profitability of the majority of publicly listed companies or the business cycle itself. The strengthening dollar, weakening commodity prices (inputs of production) and a soft labour market are all forces to be mindful of when making investment decisions. Potentially fading inflationary pressures means that the Fed’s bias should be toward neutrality; this is no time to sacrifice price stability for further monetary easing pushing rates deeper into negative territory. Remember that the market will bottom before the economy does and lower inflation, potential stability in credit and housing and a strengthening dollar are all signs to be optimistic about the future.

S&P 500 - (4.76%)
Aaron's Picks - 1.65%
XOM - (1.08%)
MSFT - 4.50%
FCX - (32.00%)
IBN - 10.03%
STP - (1.08%)
UYG - (7.58%)
SPF - 35.58%
TIM - 5.00%

Financial Ambiguity

The past week has brought about a mixed bag of economic data that as a whole points towards… umm… who knows. With a softening of commodity prices, inflationary indicators such as CPI and PPI should begin to moderate in the months ahead (as long as commodities don’t spike back up again). This in turn should help propel manufacturing from the cost side giving a needed boost to a battered industry. Although ISM and factory orders have held up amongst a broadly soft economic picture (as further indicated by the Fed’s latest beige book), they should continue to show resilience even in the face of a slowdown in the major overseas economies. The export industry has propped up the US economy, as the dollar’s 7-year downward spiral apparently doesn’t systemically hurt everyone. Just because the dollar is again regaining traction, don’t expect it to have an immediate detrimental effect on exports; however, if the growth of the BRIC (Brazil, Russia, India and China) countries falls off a cliff, as the eurozone seems to be at this time, US industries focused primarily on exports may weaken substantially. In the face of all this uncertainty, the labour market will stand out as a key indicator of future economic growth. Although the consumer has held up remarkably amidst skyrocketing energy prices and plummeting home values, he may begin to retrench if job losses continue to accelerate. Worldwide easy money policies have caused these extreme moves, and it is tighter money in the form of wider mortgage and credit spreads that will choke it out. If the labour market can hold it’s own as housing begins to turn the corner, the economy may skirt by with only the scratches of stagnant growth (which is better than a recession). But what will be the leaders of the looming recovery? Maybe with the impending bailout of the GSEs, large financial institutions may take over the MBS market and start a new wave of funky credit derivative products (one can only hope)… but for my money, the eventual market recovery will be lead by new technology and energy companies focused on solving the most pressing global and environmental problems of humanity. Luckily for them, alternative energy is also a hot political topic that is likely to get government funding under any administration.

I apologize to the faithful contingent of RMEconomics readers out there to have taken a 2 week posting hiatus; I am currently on the hunt for a new home... and hope to have it resolved ASAP. If your life has been severely impacted by the drought of intellectual financial commentary caused by my absence, please feel free to email me and I will send you a free RMEconomics Screen Print T-shirt (limited one per reader).

Economics of Equality

I believe that equality is a state of being, one in which all people are given the same opportunities to live a life that is physically, mentally or spiritually stimulating. If one person chooses to squander an opportunity while another can take advantage, then equality is served because both persons had at least the option. Inequality arises when one group of people thrive at the expense of others; whether they are marginalized due to race, gender, or otherwise is inconsequential. The logistics of control as it relates to the public and private realms is a debate that is very important, however it is one that will be left for another time. In this post, I would like to discuss an article that was written by famed economist Walter Williams: http://www.gmu.edu/departments/economics/wew/articles/08/A%20Nation%20of%20Thieves.htm

Without regurgitating the column, Mr. Williams raises some questions regarding the practice of attempting to equalize income through taxation and redistribution of money amongst citizens. This action creates disincentives for hard work and the pursuit of success in ones career. Additionally, a substantial economic burden is created when the highest income earners are taxed at ‘unfair’ rates considering these income earners contribute to the majority of personal consumption figures. In a recent interview with CNBC’s Larry Kudlow, Walt Williams described redistribution of income in a nutshell by saying that “reaching into your own pockets to help your fellow man in need is praiseworthy and laudable… reaching into somebody else’s pockets to help your fellow man is despicable and worthy of condemnation”. Stealing is stealing, whether you are a man holding up a liquor store with a gun, or you are a member of a national government. Opportunity is Equality.

It is my hope that politicians in both Canada and the United States can see the benefits of a balanced tax and budget structure. Flat personal income tax, lowered consumption and corporate tax levels and an end to double taxation of dividends and capital gains are all net positives for economic growth. These policies would benefit the local currency, standard of living for all residents and increase trade and foreign investment. Any type of revenue collection and redistribution through government is fatally flawed because of the money drain arising through ineffective program management by the government ‘middleman’. Bureaucracy and lobbying are commonplace in government and if one thing is for certain, one dollar in revenues collected for an intended social program arrive as only a fraction of their initial value. Unfortunately, this type of reform may be a long way away, because as Mr. Williams stated in the aforementioned interview, taxation and redistribution in the name of fairness “sells with people who have the politics of envy”.

This Time it's (never) Different...

July 15, 2008 seems to have thus far marked a temporary bottom in the major US stock indices. I honestly did not believe that the low put in at the time of the Bear Stearns rescue would be broken so dramatically when it was retested. It seems that the major economic event to push the markets over the edge was the concern over the financial viability of the GSE’s: Fannie Mae and Freddie Mac. However, this was not really new information; These two companies have been on regulators radar screens as having a myriad of problems that only with a set of sweeping reforms could these institutions continue operating (with confidence) as a going concern. To be an institution in corporate purgatory stuck with the task of appearing to be profitable while at the beckon call of bureaucratic legislators and lobbyists is an exercise in futility. Nevertheless, Wall Street woke up to the troubles of Fannie and Freddie and the fact that the housing downturn and credit crunch could have a long way to go before it’s all over. Thus, financial stocks and the broader market were severely beaten down to the point of ridiculousness; some of the larger financial institutions that had a very limited chance of default (further confirmed by tight CDO spreads) were trading at fractions of their book value. When this type of old news hits the market so hard (and with very heavy volume on financials) a capitulation environment of forced selling is a very real possibility. In light of this information, it is my opinion that this low point in equities will hold, unless some sort of doomsday scenario (see last weeks post) actually comes to fruition.

A lot of talk in popular financial media has been the argument concerning the current market as being in a bear or bear-cub stage. The former indicates a more pronounced size and duration of declining equity values from peak to trough. Obviously the outcome will be determined by my favorite economic indicators: jobs, inflation (monetary tax), fiscal tax policy and the ever important home and credit lending conditions. Of course, this really can only be determined once we are through it all; but until that point, speculation will remain rampant… and I will participate whole-heartedly!

I would like to turn now to the topic of inflation, as it is a troubling factor whose cause has of late been a mystery to me. As a friend and colleague at my work, Paul Tabak, pointed out to me recently “Inflation is always and everywhere a monetary phenomenon”; those are of course the words of the legendary liberal economist, the late Milton Friedman. As too much money chases too little goods, prices are bid up as inflation accelerates. Friedman advocated a slow and steady growth rate in the money supply that was tied to some formulae accounting for GDP growth (as well as other factors). The most important feature of this regimen is that a steady and predictable monetary base would provide an anchor for prices allowing businesses to make decisions based on more reliable and known pricing information. I am a great believer in this philosophy; however, careful examination of current data seems to point to contradictory causes of the current inflation position. Firstly, growth in M1 since 2006, and most importantly through the Fed’s latest easing period has shown no signs of increasing. How should one interpret easy money policy on the part of the Federal Reserve when growth in the monetary base has been stagnant? In light of this information I would tend to focus on two pieces of information that could help in uncovering inflation causality: growth in a wider measure of the money supply (such as M3), and the cost-push inflation scenario. Unfortunately the Fed no longer tracks M3, which would make it difficult to speculate how this wider money aggregate (which includes the total amount of money held by both bank and non-bank institutions) is currently behaving. Perhaps the velocity of money is consistently declining as hard commodity and inflation speculation has caused cash hoarding among the most influential institutions (thankfully, this is a topic that is outside of the realm of this blog and reserved mostly for academia).

Cost- push inflation occurs when a set of important goods (such as food and oil) increase in price while there is no close substitute for consumers. This theory has been largely debunked citing that a central bank would have to accommodate this scenario by increasing the stock of money available to the public to chase the price of these goods. Without an increase in the money supply, the price rise in these goods would simply eat up a greater proportion of spending ultimately resulting in either behavioral shifts in production or consumption or it would give rise to recessionary conditions. Since the stock of M1 has not increased during this time, inflation from this source would seem to be an unlikely occurrence. Similarly, there seems to be no hangover effects from past inflationary periods causing a wage/price spiral putting upward pressure on the price level. More to the contrary, a low level of inflation coupled with mounting data pointing towards a weak job market should put to bed any concerns over a wage effect on prices. So what are we left with??? The only thing I can surmise from this stockpile of ambiguity is that broader measures of the monetary base, such as M3, are likely to be trending upwards, which is causing a steady increase in the core level of inflation. Volatile commodity and food prices are likely to have short-term impacts on the aggregate CPI basket of goods, which should however be mitigated over time as expectations are adjusted for the price appreciation of these goods.

Inflation is a significant concern to both the economy and the health of the ongoing long-term secular bull market in US equities. Inflation is the most significant tax on growth, can be a destroyer of currencies and therefore should be of the utmost concern to policy makers at all levels of government.

Uncertain Times

Volatility has ruled as of late, now is the time to be a trader and certainly not the time to be a long-term investor who checks his portfolio on a daily basis. I still maintain that given the bottom that was put in both the financial sector and the stock market on July 15, 2008 could hold over the short to medium term and definitely provides a good entry point for a focused investor with a long time horizon. The amount of negativity, fear and panic that was felt at that time has not been seen since the dot-com bubble, making it very difficult to break that floor on anything less than horrible economic or geo-political news. Lucky for us, I may have just the thing to take the market through that low and on down to some very nasty territory….

The credit market, at this point in history, is the most important factor in determining business activity, which in turn establishes the health of the labour market. On the other side, the credit market is integral in the housing sector, which not only has an effect on personal consumption and consumer confidence, but also carries a direct link to the asset values of structured debt instruments on the books of large financial institutions. It is easy to see how the borrowing and lending environment for consumers and businesses connect the pieces of the economy and how small disruptions in that market can have large impacts on broader economic growth. I don’t want to paint a doomsday scenario, but conditions exist today that could precipitate sub-prime credit woes to spread into so-called prime and upper-tranche level assets. Both the major North American auto manufacturers, as well as credit card giant American Express, have told us lately that customer defaults on credit obligations are showing no signs of abating. Leases may become a thing of the past because the values of the asset (SUV, truck, or car) are worth substantially less at expiration, which is affecting resale values of the assets and the ability of these companies to break even on such a transaction. American Express also warned in its latest earnings release that defaults on consumer debt remain high and spending by even the most affluent of consumers has begun to curb. Auto loan and credit card receivable structured debt is a significant portion of the CDO market and if weakness extends to these assets, as it so famously has with MBS, this may spark a whole new round of asset write-downs and fears of general economic weakness. Institutional buyers of these assets, commercial banks and financing companies would most likely feel the brunt of this pain as it spreads throughout the economy.

Mortgage lending remains very tense; as the combination of tightened credit standards and heightened inflation expectations have pushed up long-term lending rates. The Fed in its statement today tried as best it could to balance the need for real inflationary concerns with a watchful eye on risks to the downside as generated in the credit market. The Fed, through it’s policy instruments, can only affect the short end of the yield curve; however, through it’s hawkish rhetoric on inflation it has the power to affect future inflationary expectations of the bond market and thus, long term yields. The only thing the Fed can do at this point is to talk tough on inflation, and be vigilant on credit lending conditions and the health of the banking system. Hopefully time will mend the credit market, at which point the Fed can concentrate it’s efforts on restoring confidence in the long-term stability of prices. If things don’t turn out so rosy, meaning credit defaults spread and inflation is again put on the backburner… the sky is the limit for commodities, inflation and an all out crappy economy.

Interestingly enough, the stock market has responded quite positively to the precipitous drop in crude oil prices as of late. However, optimism should be met with great trepidation. The initial rally in equities caused by the price drop in oil was broad in nature and on very high volume; as oil has continued to drop, volume has dried up and some sectors have stopped responding all together. I think the market realizes that the increase in commodity prices came with a loosening of monetary policy; now, no catalyst exists to bring prices down to acceptable levels, except for the recently popular (and even more fragile) ‘demand destruction’ theory. The trend in commodities, as of now, seems to be broken. However, I foresee a consolidation at some level in the near future as traders run out of reasons to sell. Now if the dollar holds this temporary bottom and gains ground against other major currencies, this may be another mechanism to press down on commodity prices in general. With the ECB and the UK central banks convening policy meeting this week, they may favour risks to economic growth as inflationary pressures seem to be taking a back seat to surprising weakness in some of the more resilient eurozone economies (ie. Germany).

I would like to end this post with a short commentary on the possibility of the U.S.A. turning red. Yes, being a ‘greenie’ (or environmentalist) is a thing of the past; the new wave in popular American politics is socialism. Let’s review some of the recent events on both the political and economic fronts: FHA bailout legislation, government rebate stimulus package, Bear Stearns bailout, provisions and increased guarantees for Fannie and Freddie, restrictions on short selling and the popular support for regulating ‘speculators’ in oil futures. Add to this list the fact that the presidential candidate leading the polls is a severe left leaning liberal who publicly states that his economic platform revolves around taxation and redistribution of income. Mr. Obama’s latest stunt aimed at appeasing voters at the expense of free market economics is to tax oil companies and give the proceeds to consumers in the form of an ‘energy rebate’. The most surprising thing is that such a radical policy of taxing a private entity to support a social agenda would likely be met with support from the middle class who are largely uneducated on the dire consequences of such an egregiously disrespectful and socially irresponsible policy. Unfortunately there is not enough space on this blog for me to discuss the buffoonery of Congress, and specifically Nancy Pilosi, to adjourn to a summer holiday without even a vote on critical energy policy issues. It is a slap in the face to the voting public for elected officials to be so unproductive and subsequently complacent in the face of a national crisis. For the last word, I will digress to the wisdom and supreme importance of the Kudlow Creed…

"We believe that free market capitalism is the best path to prosperity"!

Breaking The Trend

For quite some time, the trading strategy du-jour has been to short financials and go long energy; however, at least temporarily this trade is dead. Let me take you on a journey that began in the fall of 2007. At this point in history it was common knowledge that the housing market was in the midst of a great decline, information about losses tied to structured financial instruments began to come to light and fears about the general strength of the U.S. economy started to creep into the public consciousness. At it’s September meeting, the Fed began down the road of monetary easing by slashing the Fed Funds Rate by 50 bps, taking us from 5.25% at that time to our current level of 2.0%. Additionally, the CPI was around 2.0% and NYMEX light sweet crude oil for the front month delivery was in the mid $70’s; most recently, CPI is at 5.0% and oil traded at the top end of the $140’s.The aforementioned information is fact, what I am about to portray is my opinion as to the series of events that lead us to our current market and economic position. In an attempt to add liquidity to a credit strapped market, the Fed lowered its key-lending rate; unfortunately, this action had the effect of further depreciating the value of the dollar, adding steam to a phenomenon that began in 2001. As time passes, the market begins to realize that loose monetary policy does not translate into easing credit conditions as banks begin to tighten their lending standards and mortgage rates perversely increase. Problems begin to accelerate as job growth turns negative and commodity pressures begin to have an effect on business activity and consumer confidence. Market confidence is shaken as one of the oldest investment-banking institutions, Bear Stearns, is ‘saved’ from bankruptcy by the Federal Reserve and JP MorganChase, prompting concerns about others in the industry. As the financial sector continued to weaken and the broader market went with it, large pools of funds began to search out a new temporary nesting ground. Energy and commodities began to rise in a parabolic fashion as the U.S. dollar weakened and these ‘real’ sectors were now seen to investors as a genuine asset class. As money chased after run away gains in the energy and commodities sectors, inflation concerns crept into main-street further exacerbating an already fragile situation. Now, take all this info and fast-forward to the present day…

Some indicators like existing home sales and the S&P/Case-Shiller Home Price Index seem to suggest that a bottoming process for the housing market may be underway, or at least we are starting to eat away at the glut of housing inventory currently outstanding. Although most data, as well as reasonable judgment, seem to point to a housing bottom somewhere in 2009; especially given the fact that today the average rate for a Jumbo loan is now around 8%! The banking sector has been riddled with asset impairment charges related to sub prime securities, and profits are being squeezed as many institutions are de-leveraging and limiting potential for future earnings growth. It was the strength of the housing and banking sectors that brought the US economy and stock market from its recessionary lows of 2001-2002; now these 2 sectors are the key to weakness (and recovery) in 2008. Over the past week and a half, both financial and housing related stocks have seen great gains. I believe this is due to a fundamental shift of funds out of energy and commodities and back into traditional investment vehicles; and since housing and financial companies have taken a dive into serious value territory, the market shifted to bring these 2 laggard sectors back to life. I would argue that this is a function of the combination of a pull back in oil prices and a strengthening (or at least bottoming) greenback. Unfortunately for the financials, worries remain as to how these institutions will generate profits without much of the structured finance boom coupled with a shrunken balance sheet. The one thing these companies do have on their side is that many are trading at fractions of book value, even after write downs have been taken into account. In fact, if the underlying assets stabilize, the value of these complex securities may not be as low as they are currently being priced at, creating the potential for a future upside asset write-up surprise.

If the Fed realizes that main-street credit conditions have essentially decoupled from the target Fed Funds Rate (take a look at treasury securities, the TIPS market and mortgage lending rates) they should turn their attention from attempting to prop up economic growth and focus on price stability. The Federal Reserve is already adding liquidity into the system by allowing non-bank financial institutions access to the discount window, now if they could come up with other creative ways to keep the market liquid and support new residential mortgage lending, prospects for the economy would improve dramatically. If a policy shift towards reducing inflationary expectations and managing price stability was undertaken, I believe continuing growth in the economy is a real possibility. Although dollar management is not a mandate of the Fed, a strong dollar is correlated to higher domestic interest rates and would help to ease commodity induced inflationary pressures. Thankfully, there appears to be no threat of wage-price inflation, and thus it is not unreasonable to assume that this type of policy would return CPI to the Fed’s comfort zone and create a supportive environment for economic prosperity.

The government should also do it’s part by lowering taxes and investing revenues in infrastructure programs instead of rebate checks that are the equivalent to giving a terminally ill patient a Tylenol and a pep speech. The American people need to stand up for the economy and say no to higher income taxes, corporate taxes and capital gains taxes, which is basically the economic platform of Barack Obama. The Congress needs to wake up and realize that although it would be stupendous if people drove around with windmill powered cars; in order to assert energy independence and curb the rising price of oil a drilling strategy to exploit reserves within American borders is absolutely essential. An ideal comprehensive plan would include investment incentives for renewable energy, increased reliance on nuclear power as well as exploration and extraction of energy sources like crude oil, natural gas and coal. I hope the public took note of the fact that the fall in oil, and rise in the stock market came when President Bush lifted the Federally imposed moratorium on offshore drilling, as this should indicate that this type of policy is very bullish for the stock market and the economy. The issues of taxation and spending policy as well as a comprehensive energy plan are crucial to the future outlook for growth in the US economy, and I hope that the upcoming election is centered on these important topics.

Maximum Pessimism?

Ahhhhh, the exciting, action packed, topsy-turvy, ridiculous week that was: Fannie and Freddie seemingly on the brink of failure; rumours swirling about PIMCO pulling business and money out of Lehman and refusing to engage in counterparty transactions with the Investment Bank; a new all time high for oil reached on intraday trading above $147 a barrel; and reports of military activity from both Israel and Iran, as that potential conflict becomes more possible each day. When taking all of these negative factors into consideration, you would probably guess that this past week would have been a bloody one on Wall Street; but you would have been wrong! The S&P 500 was down a measly 1.85% for the week, and the Dow Jones Industrial Average was off even less. Has the market priced in all the possible negative scenarios and is finally coming to a point where a temporary bottom may be formed? That is of course the million-dollar question. I am, by no means, proposing that a floor is now on the market and we can assume that prices can only go up from here; what I am suggesting is that I think we may have reached a point where a piece of bad news would have less of a detrimental effect in relation to the positive gains associated to a piece of good news, of comparable size and meaning. In this type of environment, I expect to see volatility decrease as the market moves sideways before deciding which path it will commit to for it’s next run.

I would like to take a moment to discuss the situation surrounding Fannie Mae and Freddie Mac. Although I am not an expert on these companies, I feel the need to express my views on the broader economic consequences of having a pseudo governmental agency holding over half of the mortgage debt in the United States. When such an entity attempts to operate in both the public and private spheres, conflicts that reach down to the very fabric of socioeconomic goals come to light. Public and private enterprises have starkly contrasting mandates, while commonalities in their function are few. The concepts of equality and fairness, freedom and property can spawn a heated debate among political economists. At the centre of that debate would be the distinction of public and private boundaries surrounding socially sensitive sectors of society. To create a GSE that has an obligation to produce profit for shareholders, when at the same time is forced to take on a portfolio of shady loans due to a government decree is counterintuitive and thus is less efficient in its current form than it would otherwise be if it were either completely public or private. The private sector has shown time and again that it has the ability to satisfy a popular need, and can do so without added bureaucracy and cost inherent in public ventures. It would be a very difficult undertaking to rearrange these GSEs, especially at such an inopportune time; however, action needs to be taken to ensure that these companies have the ability to stand on their own without having the government telling it how to do business.

As I said in last weeks post, inflation remains the primary concern for this economy, although it was on the proverbial backburner this past week. Import price inflation data, which was released on Friday, showed that even prices excluding petroleum have jumped markedly higher (you don’t want to know what they are when petroleum is included! J). This could pose a concern if these higher prices are passed on to the consumer, further solidifying and amplifying inflationary expectations. To take a cue from my personal role model, Larry Kudlow, inflation remains the single most significant tax on economic growth. In order to ensure a good long-term standard of living and stable economic progress and prosperity the Fed needs to take control of the inflation situation… like, yesterday!

Stagflation Stinks...

Although I have been predicting an impending period of stagflation since September 2007, I was secretly hoping my thesis would not materialize. Unfortunately, data continues to pour in from different sectors of the economy that point towards an inflationary induced profit squeeze and the dreaded no-growth high-inflation combo (the ‘un-happy meal’). The newly released data from the Institute for Supply Management (ISM) showed a developing trend towards a contraction in the non-manufacturing sector brought about by higher input prices. In fact, respondents of the ISM survey in the Transportation and Warehousing sector say that “Oil prices are affecting most every supplier we have” http://www.ism.ws/ISMReport/NonMfgROB.cfm. As input prices of production rise and businesses are unable to pass on those costs to the consumer, profits across the economy will be squeezed. It is my view that corporate profit expectations for the 3rd and 4th quarters are too high, and although those companies with an international presence could continue to benefit from a weak US dollar, growth across the broader economy will remain sluggish. A systematic lowering of profit expectations across the economy will be a negative for the stock market as traders discount prices for stagnant growth and a fragile profit environment.

Expectations are what drive markets, and the key to a successful turnaround in this economy will therefore come from a fundamental shift in this crucial area. It is inflationary expectations that are causing a decrease in production and a cut in jobs. Profit expectations are tied to input costs and capacity utilization, which is closely linked to inflation. Investment spending in the US is linked to the expectation of currency appreciation and tax policies; both of which look grim under the current easy money Fed and the strong possibility of the country having a Democratic President and Congress. All of the aforementioned expectations can be successfully controlled by a coordinated policy effort aimed at a strong dollar and low corporate tax rates to induce a sustained level of investment spending. I don’t think the fed has to worry too much about the classical negative effect that slightly tighter monetary policy has on growth as the linkages in private sector borrowing have already deteriorated from the fed funds rate. Also, if the Fed continues to hold open access for nonbank institutions to the discount window, sufficient liquidity will remain in the system to prevent the possibility of a crisis of confidence in the financial sector. Inflation will likely be the buzz word for the remainder of 2008 as the Fed tries to walk the tightrope of pursuing economic growth and price stability. I say let the government handle growth through a liberal tax policy and the Fed can unleash the inflation hawk that will soar in to contain the detrimental effects of protracted inflationary expectations.

The best type of strategy for investing in this uncertain environment is coincidently the model that I believe works best under any scenario: follow the trends that are paying off now while keeping an eye on contrarian opportunities. Many hard commodities are off their highs and provide a good entry point for an investor looking for a good hedge to inflation as well as to take advantage of continuing infrastructure growth in emerging markets.

Welcome to the Bear Market... We got everything you want!

Or, depending on your point of view you could just as easily use the other lyrics “it gets worse here everyday”. Strangely enough, I would argue that both lyrics are equally true in describing this current market environment; for it is in destruction where we often find opportunity. It has been said that Benjamin Graham (the father of value investing) made a fortune buying up stocks that had been unfairly punished during the darkest days of the Great Depression. Just as history repeats itself, we are starting to find the sort of prospective investments that would make any good value fundamentalist drool in a state of bargain bliss. Although markets, just like economies, are susceptible to periods of contraction they are also inherently cyclical. The good thing about stocks is that there exists a floor of intrinsic value represented by either future earnings power or liquidation value. The trick to generating superior returns in this environment is to identify the stocks that have a strong business model and a history of consistent earnings growth which have been brought down in price along with the broader market.

Friday marked the entrance of the Dow into bear market territory when it briefly touched 20% below the record close it reached in October 2007. The Dow has been trading mostly sideways in 2008, albeit with a slight downward bias, although June has been especially rough. The data received last week was mostly mixed and most likely not the main catalyst precipitating the large decline experienced by the markets. It is my belief that it is runaway oil prices and the weak US dollar that is the invariable source of angst for Wall Street. Case in point, the Conference Board’s Consumer Index reading declined to its fifth lowest reading on record, with the economic expectations outlook portion setting a new all-time low. Both the economic expectations and job market outlook sections seem to suggest that inflationary pressures are hindering growth in the economy and are severely impacting the spending and savings decisions of consumers. Such high inflationary expectations and a bleak employment outlook can cause the American consumer to go into hibernation, dragging the entire economy down with it. Inflationary expectations must be squashed with coordinated policy efforts on the part of the Fed and the US treasury to support the dollar and bring balance to the economy. Sustaining interest rates at this level will unfortunately not improve credit and lending conditions; it will only help to maintain the current commodities rally that is responsible for pushing up inflation and dragging down economic growth.

According to James P. O’Shaughnessy’s book, What Works on Wall Street, there have been 9 periods of 10% or greater declines from peak to trough values for the S&P 500 index between Dec 31, 1962 and Dec 31, 2003. The average decline percentage and duration (in months) for this period has been 24.77 and 13.00 respectively. From where we sit today, the market is not far from the averages of either percentage decline or duration. Although I am of the opinion that the US economy is headed for an extended period of stagflation, this thesis is contingent upon policy actions (or lack thereof). So if an investor has a long-term time horizon, now is definitely an opportunity to search out undervalued opportunities - Go ahead, look for that baby thrown out with the bathwater; he’s out there!

The economic calendar is jam packed next week heading into the holiday weekend. The unemployment data and ISM index are two key indicators whose release will be closely watched so as to give some clue as to the health of the economy. I would not personally add to any positions going into this week, however I do believe that if any numbers come in to the upside this relief for traders may turn into a rally on the heels of such a prolonged decline. Volume will likely be light at the start of the week setting the stage for the market to extend it’s losses with no large buyers stepping up to the plate before the long weekend.

Welcome!

It is a remarkable time to be an observer of the financial markets.

So much has happened to both the United States and Canadian economies over the last 24 to 36 months I wouldn’t know where to begin. So instead of boring any readers with an anecdotal and undeservingly brief history lesson I will concentrate my efforts on what lies ahead. Since we are at the midpoint of the FOMC’s two day policy meeting, I believe it fitting to focus my first post on the state of the US economy. Firstly, how relevant is this meeting? A large portion of Fed observers seem to be of the same opinion that an interest rate hike could be exactly what the economy needs, however, the likelihood of this coming to fruition is extremely remote. This is in fact, in stark contrast to the treasury futures market which is pricing in the likelihood of a series of interest rate hikes, with the first round beginning by the fall meeting. It’s interesting to see how pundits’ policy expectations can change so dramatically when we can all use our short term memory to recall the cold days of winter when it seemed like the Fed was cutting rates on a daily basis and Wall Street was screaming for more. Unfortunately, these rate cuts have done little to ease the credit crunch and have arguably pumped more hot air into an already over inflated commodities bubble.

Commodity inflation, and its flow through effects on production and ultimately consumption, is ‘fueling’ the debate on interest rate increases. It is popular right now to believe that the Fed and the government should coordinate policy to prop up the lowly US dollar, thereby possibly deflating the commodities bubble and in effect helping to spur on a broader economic recovery. This type of action I believe would have a meaningful effect, however, the depreciation of the dollar has been slowly occurring over the last 5 years while the price of crude oil has jumped over 50% since the fed began its interest rate slashing. This tells me that if the dollar is truly the key to bringing down oil prices, the fed has a long way to go before we see levels even close to what we were previously accustomed to.

Unfortunately for the Fed, I believe they have lost what is possibly there strongest policy tool: Credibility. By cutting the target rate several times from 5.25% in September 2007 to the 2% level we are at today and now making the 180 degree turnaround to talk hawkish on inflation is not going to fly with anyone. The signaling effect the Fed has in its statements has the power to affect expectations; open market operations to manipulate the Fed funds rate only has an effect on the short end of the yield curve. By dramatically and systematically cutting rates, then talking tough on inflation when it appears as though they won’t back it up tomorrow, all at a time when the economy is teetering on the brink of recession shows that the Fed has lost touch with the economy. Without having the ability to sway inflationary expectations with signaling subtleties, the Fed is left only with blunt policy tools not fit for use at this stage of the game.

The economy is currently at a very sensitive state, and I believe it is jobs that hold the key to either prosperity or collapse. The media has not labeled this a recession because GDP has not actually turned negative, although those numbers may eventually end up being adjusted; but more importantly in my mind, unemployment is not yet at a point commonly associated with recessionary levels. As inflation moves through the inputs to the end users, producers and manufacturers are finding it increasingly difficult to pass on costs to an already strapped consumer. Herein lies the issue, if costs are passed on across the board, without job cuts, it is theoretically possible to see a wage-price spiral lead to out of control inflation. On the flip side, if labour is cut in an effort to trim costs, no one will be able to buy the very goods being produced (Not to mention the effects on the housing market). According to the Hoover Institution, personal consumption accounts for 70% of GDP, making the employed consumer the key to the economy. This is precisely why I am advocating for a tough stance on inflation to bring down commodity prices from such a blasphemous level and dig out any stifling inflationary expectations this market is creating. This action could lead to job market stability allowing the economy to skirt further deterioration in productivity.