The Next Decade: Best of Times, Worst of Times

The global economy is no longer in freefall. The rubbernecking by all markets in 2008 has morphed, short-term, into an abrupt reduction of consumer and municipal consumption. Furthermore, falling tax revenue, plus the injection of deficit federal spending equals the antithesis of growth. These simultaneous realities are the legacy from 2008. Meanwhile, cheap stocks and frantic money managers, with plenty of cash, are driving stock prices irrationally higher, despite reported weaker quarterly revenue and earning numbers for many companies.

The back-of-the-envelope calculation promoted by a growing chorus of pundits is cheering the equivalent of a sugar high. Everyone likes sweets but the consequences that follow vary. In today’s market, this sugar rush is erasing from memory last year’s brutal stock market and the lingering problems that caused it.

Taking the macroeconomic view of domestic and global economies, monetary policies, demographics, supply and demand, and the new ingredient – 21^st century nano-digital information, a new and peculiar economic state of being – InDation - will occur in the upcoming decade. This economic mutation is possible and probable because, heretofore, it was near impossible to calibrate daily, or hourly, reasonably valuations, arrive at informed decisions, and implement actions, for either side of any transaction, on a sustainable basis. Today, the world contains seven billion individual economies, tethered together, communicating, and constantly reformulating, digitally.

There are primarily two schools of economic thought in predicting the future from where we are; either inflation or deflation will accelerate. The basis for these conclusions is 19^th and 20^th century econometric modeling. I submit that these established models are imprecise in today’s world. Just as the portmanteau stagflation, coined by British Politician Ian Macleod, in a 1965 speech to Parliament, appropriately described the 1970’s phenomenon of no growth and inflation in America, in the coming decade inflation and deflation will occur side by side, separated by micro supply and demand curves, thus, requiring a new expression, too. I am confident about this prediction.

What have we learned from 2008? Just six months ago, central bankers and financial titans around the world, prayed each night like ancient agrarian farmers to their personal earth god for one more chance, if the western financial system did not disappear into oblivion. Today, the Standard and Poor's 500 Index closed above 1,000 and everything is ok. This cognitive dissonance behavior is tantamount to a morbidly obese man having a massive coronary last September, and this afternoon, lunching on a deli’s accordion pastrami sandwich, a slice of cheesecake standing by for desert, and a pack of cowboy killers in his shirt pocket, for that indispensible after meal smoke. We buried our financial problems but they are not yet dead and they will attack us again soon from their grave. Sell stocks into this summer rally.

Individuals, corporations, and nations of the wild debt and derivatives binge earlier this decade, that did not restructure debt reflecting current cash flows, expenses, and market share, will suffer a qualitative lifestyle decline. Conversely, success faces demand-pull inflation for energy, food, water, raw materials, and other natural resources, as three billion people, mostly non-westerners, scramble to elevate theirs, and emulate our standard of living, through export manufacturing, cheap labor, and individual education.

The next decade will be the best of times and the worst of times. It will be a world of inflation and deflation and the Standard and Poor's 500 Index trapped in a trading range between 600 and 1,500.

Macro Economic Trend Outlook: January 2009

Happy New Year, everyone!  This is my first letter in several weeks.  Because the economic data reported in December was just plain awful, I decided to stop delivering the drip, drip, drip, of negative news and allow everyone to enjoy the holidays.

Now, that we are in 2009, I feel comfortable in resuming the transmission of data to describe the current state of affairs.  In a word – ugly – will be the operative word for 2009.  As you know, 2008 was the most brutal year, for virtually all assets classes, except for treasury and municipal debt.  Holding these specific assets, while our financial, banking, and credit systems imploded, not only protected your principal, they increased your account value.  Individual stock portfolios, mutual funds, ETFs, and so forth, meanwhile, experienced declines of 20, 30, 40 percent or more.

Last year’s margin call on global assets played havoc on the global financial structure to the point of its near collapse.  The forecasts and predictions for 2009 are grossly overly optimistic.  Analysts and money managers behave as if 2008 was a routine year.  Nothing could be further from the truth.  This year, the pain will appear from the beneficiary of ongoing de-leveraging; negative GDP growth and rising unemployment.  

Monday Morning

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Last week, the markets continued its volatile decline.  The DJIA and the S&P 500 indices tested their October 10 lows, Thursday, but rebounded, to close up 552.59 and 58.99, respectively, for the day.  For the week, however,  they were both down following an about face by Treasury Secretary Hank Paulsen on buying toxic mortgages from troubled banks; deteriorating economic and housing data; and the impending showdown between congress and the auto industry.  At stake, another taxpayer bailout for the challenged carmakers versus bankruptcy for General Motors and the loss, of perhaps, millions of auto and auto-related jobs.

For income investors, fear is currently keeping treasury yields low prices high.  The public is piling into municipal bonds as the last safe haven for cash, too.  In 2009, headwinds will appear that will disturb all fixed income markets.  The US, next year, will issue two trillion dollars in new treasury obligations.  Markets will not be able to absorb this much debt without raising yields.  The Chinese domestic stimulus package of 500 billion dollars will inhibit one of our largest buyers of treasuries.  The collapse in oil prices will take petrodollars away from Middle Eastern oil producing countries that deposit those dollars into US banks and purchased treasuries.  At some point, our issuance of debt will also weaken the dollar.

I wish that there were more positive news items to report.

This morning in Barron’s, Jacqueline Doherty wrote a story on which defensive stocks to own in a severe recession.  Colgate Palmolive (CL), Clorox (CLX), Procter & Gamble (PG), and Kimberly-Clark (KMB), sell products people use in good times and bad.  I know stock investors are salivating current prices and yields, but I believe the stocks will go much lower over the next six months.  Still, we can improve on her strategy by using long-term options (LEAPS).  Look at the chart below:

Stocks versus LEAPS

Stocks	Friday Closing Price	500 Shares	LEAP Call Jan. 2010 Strike Price	Friday Closing Ask Price	5 Contacts	Difference
Colgate Palmolive	62.06	$31,030	WTPAM - 65	8.80	$4,400
Clorox	59.30	$29,650	WUTAL - 60	10.00	$5,000
Procter & Gamble	63.11	$31,555	WPGAM - 65	8.70	$4,350
Kimberly-Clark	57.37	$28,685	WKLAL- 60	7.10	$3,550
Total Cost		$120,920			$17,300	$103,620

 

By using LEAPS, you are risking $17,300 to control two thousand shares of high quality stocks until January 2010.  In addition, the difference of $103,620 is available to invest in deeply discounted closed-end equity income funds such as Nuveen’s non-leveraged JPZ, JSN, JLA, or JPG, yielding 13.84%, 15.56%, 16.07%, and 14.01%, respectively, as of Friday’s price.

The Dow futures are lower this morning, and its Monday.  Buckle up; this morning could be a bumpy ride in the markets.

Slipping Into Darkness

From October 29, 2008

The Federal Reserve Board today, at 2:15 pm, announced their obligatory 50 basis point cut of the Federal Funds Rate, from 1.5 per cent to 1 per cent. This is the latest action taken to assuage investors’ fears about the hydra-bear market that has engulfed all capitalism. A triple digit rally was quickly vaporized with an erroneous General Electric rumor concerning the company’s 2009 earnings.

What are not mistaken rumors are the disastrous economic data that continues to flow. On Tuesday came the U.S. consumer confidence index, by the Conference Board, reporting an all time low of 38, down from 68 the previous month. That same day, the S&P Case-Shiller home price index fell 1 per cent, in August from July, and 16.6 per cent, from the previous year. The Census Bureau estimates for the 3rd quarter of 2008, of some 130 million housing units, nationwide, 18.6 million stand empty; 13.8 million year-round, 4 million for rent, and 2.2 million for sale.

On Wednesday, Durable Goods Orders were reported a curved up .8 per cent versus an expected decline of 1.8 per cent. For Thursday, the October 25th week Initial Jobless Claims are announced. Expect a drop of 3,000. Why, I’m not sure.

A General Motors -Chrysler shotgun merger is one step closer to happening, according to reports. If completed, it may add an additional 25,000 auto blue and white collar auto workers to the unemployment line of fixed income investment bankers recently cashiered.

Employment is rising, however, in villages and hamlets across the land as Investment Advisors and Money Managers are deploying their minions to hotel banquet rooms and restaurant’s private cubby holes, armed with clever four-color handouts, PowerPoint Presentations, and empty explanations, as to why their propriety indicators and models could not see the greatest bear market since the Great Depression, sneak up behind them.

I have a feeling that the traditional holiday feathered vertebra – turkey; will not be served this Thanksgiving. Instead, investors will be dining, if they can still afford a meal, on black swan; only recently very, very popular fowl of spenders of others-peoples-money. Of course, it’s too late to sale stocks with portfolios down 30 to over 50 per cent. But, if these Money managers are wrong again, keep some Gray Goose handy.

Thursday Market Action

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After shaking off a worrisome inflation report before the opening bell and a dismal real estate report soon after the opening, the Dow rose steadily throughout the morning and settled into positive territory for the remainder of the day. The DJIA closed up 82.97 or .72 per cent at 11,615.93. The S & P 500 also closed higher 7.10 or .55 per cent to 1,292.93. NASDAQ likewise ended the day up 25.05 or 1.03 per cent to 2,453.67.

Volume on the NYSE was 1,003,398,038; advancing shares were 663,931,108 and declining shares were 332,074,290 with 7,392,640 unchanged. NASDAQ volume was 1,842,236,076; 1,414,017,121 shares were up, 358,110,252 were down, and 70,108,703 were unchanged.

Bond yields fell and prices rose as the market digested the early morning four week average jobless claims number which increased by 19,500 to 440,500 and the and a much higher consumer price number of 5.6 per cent, year over year. The Two-Year Note closing yield was 2.43 percent; the Ten Year Note was 3.89 per cent; and the Thirty Year Bond was 4.51 percent.

Foreclosures were up 55 per cent from a year ago, July. More than 272,000 homes received at least one notice, compared to 175,000 last July. This was eight per cent higher than June, as reported by RealityTrac. Lenders reprocessed 77,000 homes in July.

Existing home sales fell 16 per cent to 4.91M, annualized, in the 2nd quarter while prices fell 7.6 percent to $206,500 from $223,500 last year. One in three home sales was a short sale or sold out of foreclosure, according to the National Association of Realtors.

Crude oil finished the day at $114.70 a barrel and Gold closed at $807.4 an ounce.

Tuesday Market Action

Bears returned to the market today, our domestic credit crisis grizzly and the recent unexpected guest Russian bear, pushing pricing lower by the closing bell. The Dow finished down 139.88 or 1.19 per cent, the S & P was off 15.73 or 1.21 per cent, and NASDAQ lost 9.34 or .38 per cent.

Fresh downgrades by analysts on major banks stopped the stock market recent rally. The fighting between Russia and Georgia added anxiety to a market that was beginning to find its sea legs after a volatile June and July.

Moscow stated that it would withdraw its troops after days of intense warring, now that Georgian troops have pulled back from their Abkhazia and South Ossetia provinces. Movement by Russian troops leaving the area has not been detected, to date.

Oil and Gold both closed lower extending their unwinding from recent highs. The September contract for West Texas Intermediate ended its trading session $113.01 a barrel, off its low of $112.31. Gold dropped intraday to $802.90, then rallied to finish at $814.50.

The June trade deficit, reported by the Bureau of Economic Analysis, shrank to $56.6B from an expected $61.5B. This is one more clue suggesting that our economy is slowing down this quarter.

With state tax receipts down this year and in all likelihood going lower, states are considering a digital download tax. Retail e-commerce sales are expected to hit $130 billion this year.

The dollar traded mixed against major currencies.

A Gold Medal for Last Week's Bull Rally

It was beautiful. It was wow. It was unbelievably exciting. It was indescribable. It was beyond superlatives, and no, we are not talking about the spectacular display at the Beijing National Stadium. It was the bull rally last week on Wall Street, riding the back of falling oil prices and the reversal of the dollar.

The opening ceremony of the Games of the XXIX Olympiad was magical. The collective life force of 1.3 billion people that poured into the "Bird's Nest" had one objective; to make the world's viewers speechless. Mission accomplished. A gold medal for people of China; their repressive government...

The European Central Bank and the Bank of England, facing acceleration in the decline of growth, at just .2 percent in the 2nd quarter, left interest rates unchanged on Thursday, earning silver medals; two days after the FOMC did likewise. This unanimous decision indicates an acknowledgment that inflation is no longer the sole concern of central banks in Europe. With less pressure on the dollar, now, the meme of possibly lower rates later this year fired the starter pistol for the equity Olympics.

The DJIA advanced 302.89 or 2.65 percent on Friday to 11,734.32. The S&P 500 moved higher 30.25 or 2.39 percent for the day at 1,296.32. NASDAQ climbed 58.37 or 2.48 percent Friday to close at 2,414.10 for the week, the Dow increased 3.60 percent, on two 300-plus point rallies, the S&P 500 up 2.86 percent, and NASDAQ rose for the week 4.46 percent.

The implications of a stronger dollar include companies with major overseas sales and earnings may experience softer numbers in the 3rd and 4th quarters. Exporters will notice headwinds as well and a firmer dollar will aid job losses. The tradeoff is lower oil and gold prices unless the military action by the Russians in Georgia threatens the flow of oil in the region. Speaking of which, the U.N. Security Consul held an emergency session to discuss this potentially grave regional/international matter.

This runs counterproductive to the impulse of the international Olympics. In theory, bringing together the various nations of the world to participate in athletic competition allows an exchange of communication and diplomacy that can forestall hatred, mistrust, and warring. If you don't buy this scenario, then you might want to check out gold medal Harvard historian Niall Ferguson's multi-part PBS series "War of the World". It's a fresh and sobering look at how the 20th century began and how several conflagrations converged into World War II. Hopefully, we will avoid global destruction this century.

Consumers added $14.3 billion to their credit cards in June, $8 billion more than expected, while personal income rose .1 percent and personal spending rose .6 percent. Initial jobless claims increased by 7k; a 23k drop in claims were expected.

Apparently there are still a few free lunches left on Wall Street. Bronze medals go to regulators who pressured Citigroup (C), Merrill Lynch (MER), and UBS (UBS) into buying back, from thousands of high net worth retail clients, Auction Rate Securities. This Dutch auction creature that paid above money market rates, for awhile to customers anyway, crashed and burned in the great liquidity squeeze of 2007/2008. Only a money market is as safe as a money market. Every chance I got, I attempted to talk customers out of chasing these minor differences in yield. The risk to reward wasn't there. But, if you are a hog, don't be surprised when you are slaughtered.

More silver medal analysts are glomming on to the idea that the current downturn will be deeper and will last longer than previously expected. Many, many more believe, however, that it is business as usual and that a soft landing will be engineered through Fed policy with some help from Treasury. If it were only that easy to manage the world's largest economy, no analysts would earn bronze medals. Mortgage rates are trending higher, underwriting standards are tightening, and, if residual real estate values drop another five to ten percent, that is a trillion dollars erased from household net worth.

Banks are beginning to freeze or reduce individual lines of credit. A gold medal goes to Oppenheimer & Co.'s Director of Equity Research, Meredith Whitney, who appeared on CNBC on August 4th, sharing a dismal overview of the banking industry and the economy for the balance of this year and next. Last year, 85 percent of mortgage liquidly came from securitization. Last year to date, that accounted for $900 billion in loans. In 2008, that number is $100 billion. Overall, there is $2 trillion less in liquidity in the marketplace. Also, she expects banks to reduce unused lines of credit to customers from $4.9 trillion by $2 trillion in 2009. Ouch.