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Friday, September 28, 2012

QE III: Pushing On A String

Initially, the stock market interprets inflation as a positive, as price increases on goods sold fall to the bottom line. Subsequently, rising costs wipes out all benefits of inflation to companies.
It has now been two weeks since Ben Bernanke announced that he would join European Central Bank President Mario Draghi in unleashing unlimited printing at a monthly rate of $85 billion dollars to save the economy [read asset prices] from further deterioration. Unfortunately, the cure does not match the true disease.
The S&P 500 Index closed September 27, at 1,447.15, up 13.83 points, but, lower than the September 13 close of 1,459.99, when the Federal Reserve Board Chairman held his news conference. Thursday's price action was achieved with the market positively and enthusiastically embracing a spotty economic report, the announcement of a new budget by Spain, and the news item that China had injected more stimulus money into its softening economy.
The nominal effect is tantamount to pouring a third cup of Starbucks coffee down a drunk to sober him. Actually, evidence of diminishing returns from various stimuli programs had been seen in earlier macroeconomic data.
The Commerce Department reported Thursday orders for goods meant to last at least three years, excluding demand for airplanes and automobiles, fell 1.6% last month after a 1.3% decrease in July. Total bookings plunged 13%, the most since January 2009, attributed to a decline in demand for civilian aircraft.
Also reported by the Commerce Department, the U.S. economy expanded at a 1.3% annual rate, the slowest pace since the third quarter of 2011 and down from last month's 1.7% estimate.
The Labor Department said new claims for unemployment benefits fell to 359,000 last week from an upwardly revised 385,000 the week prior. Claims were expected to fall to 378,000 from an initially reported 382,000.
Helping the upbeat mood of the market on Thursday, according to CNBC, China's central bank injected a net 365 billion Yuan ($57.92 billion) into money markets this week, reportedly, the largest weekly injection in history.
Mr. Bernanke promised to keep interest rates down for institutions and mortgage seekers by purchasing mortgage-backed securities at the expense of savers. This program ignores altogether other forms of outstanding debt weighing down consumers such as revolving and non-revolving lines of credit and student loans, which now stand at over one trillion dollars.
According to a Pew Research Center analysis of newly available government data published today, 19% of the nation's households owed student debt in 2010, more than double the number in 1989, and more than 15% that owed student debt in 2007. The Pew Research analysis also reported that 40% of all households headed by someone younger than age 35 owe such debt.
Some of the more salient statistics from the Pew research analysis include; the average outstanding student loan balance increased from $23,349 in 2007 to $26,682 in 2010. Most debtor households had less than $50,000 in outstanding student debt in 2010, but the share of households owing elevated amounts has increased.
In 2007, 10% of student debtors owed more than $54,238. By 2010, that number had risen to more than $61,894. Interestingly, average household indebtedness fell from $105,297 in 2007, to $100,720 in 2010.
Every remedy seriously discussed and/or enacted since 2008 by the federal government or the Federal Reserve Bank in the wake of the Great Recession has been a top-down solution. Most of the problems Congress, the White House, and the Feds addressed required a bottom's up approach to succeed long-term in helping Main Street. Avoiding this reality, addressing total household debt servicing requirements and a sharp drop in disposable income, was at the core of their failure in rescuing the economy.
Case in point, real estate; Washington DC, pushing trillions of taxpayers' dollars through the banks over the last four years, hoping that the dollars would find their way to individual mortgage borrowers and rehabilitate the national economy, has proven to be a squander of time, effort, and resources, given the skimpy results.
A simpler and more effective approach would've been for the government to utilize the treasury auction one time to issue $50 billion in 30-year bonds, with a 3% coupon, and refinance 250,000 mortgages at $200,000 each month. Over the last four years millions of home owners would have been better served with this approach and at a fraction of the cost to taxpayers, versus the many cumbersome and failed homeowner relief programs Washington tried.
Instead we are being tortured with an L-shaped recovery, consisting of lethargic growth, flat tax revenue receipts, and stubbornly high unemployment figures, unknowingly, for as far as the eye can see.
What about those underwater mortgages? Any difference between the original mortgage amount and the newly appraised value of the home could be split from the new mortgage (as in a second) and would become a tax obligation to the borrower over 30 years.
With this approach, many of the tens of thousands of entrepreneurs that went out of business in 2009 and 2010 would have found their shops located in neighborhoods with homeowners struggling less, or not at all, making their mortgage obligation and finding a few hundred dollars extra each month in their pockets to spend.
Lastly, making these new mortgages assumable, as in days gone by, and GNMAs, would have given the real estate market natural buoyancy during a period of free fall. Backed by the full faith and credit of the U.S. government, institutions could then legally purchase this new debt.
This bottom-up rescue would have lowered borrowers' monthly mortgage payments, paid off the original mortgage, saved bankers (they got the money, anyway) holding dubious collateral, and preserved contract law, while stimulating the economy.
The dollars' velocity would be rising instead of falling at this point in time in this recovery. More importantly, by quickly reducing the amount of debt per household and increasing household disposable income in the darkest days of 2009 and 2010, the true disease afflicting consumer spending then and today - lack of demand from truncated disposable income - would have significantly reversed that deficit.
Besides, the government had already guaranteed some 3 trillion dollars in money market funds in the dark days of 2008, so, did it matter if this money was guaranteed before or after it entered the bloodstream of our financial system?
But I digress.
Applying traditional economic stimuli to a changed economic system we are now learning is unproductive. The superstructure of the western financial system, forged during the depths of the Great Depression, has mutated over the past 30 years by a shift in political and social culture, financial product innovation, and retirement planning choices.
Since 2008, the post-World War II economic and financial ecosystem has been completely modified by both governments and their central banks and corporations, during crises after crises, to the benefit of industry and corporations, and at the expense of national economies and individual households, worldwide.
The 70% consumer driven U.S. economy, the world's largest single economy, is a product of the 20th century. The economy has not responded robustly to QE I, QE II, Operation Twist, and now, so far, to QE III, as policymakers apply outdated remedies for an economy that no longer exists.
The economy has, however, drifted listlessly, from misdiagnosing and mismanaging treatment. Archaic monetary policy tragically is, ultimately, unproductive in guiding outcomes desperately being sought by politicians and economists. We are traveling down a new economy road without a road map.
For long-term investors, there is no mystery to the disease afflicting the U.S. economy; we are living in a complex world plagued with 21st century globalization. The extreme ends of inputs for the marketplace to create opportunities, produce output, and generate wealth, are in fundamental conflict with each other and our expectations and sensibilities imported from the 20th century.
Whether the conflict is over wealth accumulation, labor and productivity, return on capital, education, natural resources, innovation and technology, or geopolitical rights of ownership, this clash between the past and the future economic systems will establish along the way new winners and losers.
Once upon a time, there was a financial theory called a business cycle. It quantified economic activity, measuring and marking its circumference from trough to peak to trough as one complete revolution. And, from this business cycle winners and losers were recognized by the marketplace. Somewhere along the way, we discarded the notion of recession as a natural and healthy part of this business cycle.
Historically, whenever central banks began pushing on a string with monetary policy, attempting to stimulate demand where none naturally exists, first stagflation, then inflation, occurs. This develops whenever the marketplace is prevented from deciding winners and losers.
Initially, the stock market interprets inflation as a positive, as price increases on goods sold fall to the bottom line. Subsequently, rising costs wipes out all benefits of inflation to companies.
The 32 year-old bull market in bonds is in its final weeks. The policies that set it in motion three decades ago, compelling interest rates to fall - no tolerance and complete vigilance to fighting inflation, are no longer recognized as prudent policies. The consequences of loose monetary policy can be seen appearing on the horizon.
Around the world, governments are struggling, in varying degrees, with escalating inflation from drought, scarcity of supply, debased currencies, and local conflict and violence inhibiting the free flow of goods.
How long can the U.S. bond market avoid these realities going forward is anyone's guess. At some point, however, bond investors will stare into the abyss recalculating risk and the time value of their money.
The unprecedented amount of funds that have flowed into fixed income investments since 2008 will reverse and regrettably, take many, sophisticated and unsophisticated investors alike, out to sea as the tide rolls away.
This summer's rally began June 4, at 1,278.18, which was induced by horrible May economic data, thus, anticipating QE III. Now that unlimited quantitative easing has arrived, central banks around the world are all in, where will the economy and fundamental global change take the market and investors' capital next?
To seek higher investment ground, investors should reduce exposure to fixed rate income investments and begin looking for variable rate fixed income products for long-term income. Also, the stocks to consider, if you must buy stocks, are essential companies such as: AT&T (T), Verizon (VZ), Google (GOOG), IBM, Exxon Mobil (XOM), Chevron (CVX), Disney (DIS) and Microsoft (MSFT), core companies that will only go out of business if society ceases to function as we know it today.
As inflation rises, it will be hard assets including gold, up 6.4% for the month and for the quarter 14.6%, and silver, up a sparkling 12.2% for the month, and for the quarter over 31.5%, farmland, natural resources, energy, companies that manage the new digital world and essential basic services, that cannot be re-produced on two-dimensional printers, which will retain their value.

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