Should the Feds Create Inflation? This Time It Is Different

Through the bombs bursting in the Korean Peninsula’s air, minutes of the FOMC meeting were released Wednesday. The division over Quantitative Easing II (QE II) wasn't as intense as the 58 year old NoKo/SoKo conflict. However, I have reservations with this logic in 2010 of affirmative voting Fed members’ confidence behind QE II theory of inflating asset prices will put a halt to deflation. 

That QE II will create a wealth effect and stimulate consumer spending, the easy stuff like the dubious weekly Jobless Claims dropped to 407,000 from a previous week upward revision to 441,000, from 439,000 is showing a positive trend. 

Also, The Reuter's/University of Michigan's Consumer sentiment index rose for November to 71.6 and third quarter GDP growth was revised up to a 2.5% annual growth from an estimate of 2.4%. The hard stuff, physical things like durable goods and housing (found below) tell a different story. Durables orders in October fell 3.3 percent, a figure below the median market forecast decline of 0.1%.  

Unfortunately, the Fed’s beautifully elegant thesis isn’t growing inside a sealed petri dish with exact ingredients from the 1930’s or 1970’s. Therefore, past performances do not guarantee future results.  

For those of us old enough to remember the 1970’s it was a far different world. During that period, current dollars had greater purchasing power than holding them until tomorrow, so it was logical for consumers to spend money immediately. However, the basic financial infrastructure for consumers was the opposite of what it is today. 

Take credit cards; this was a relatively new consumer product. Interest rates were fixed, unlike today. Shoppers would hand their credit card to a merchant and the merchant would pick up the phone and call an authorization center for approval. Then, the card would be placed in a manual charge card machine to make an impression on carbon paper for the shopper to sign after approval was granted. 

Holding and servicing fixed debt during “normal” inflationary times is easier to do if incomes are rising, mirroring the change in inflation. Virtually every credit card issued today has a variable rate. Wages have been stagnant in the US for ten years and Ireland just announced an austerity plan which includes cutting minimum wage which could become a harbinger of things to come in America. 

If we experience prolong inflation, the interest rate on consumer debt will be adjusted upward to cover issuers rising costs, accordingly. This will cancel any presumed benefits for creating inflation. 

Mortgages were different then, too. Adjustable rate mortgages did not exist. When you purchased a 30-year fixed mortgage, you could plan for your next 360 mortgage payments. This became problematic during the real estate bubble of 2003-2007. Teaser rates tied to Prime, LIBOR, the 11^th district, T-bills, COSI, etc, that allowed borrowers to qualify disappeared after 12, 24, or 36 months. Real mortgage payments undermined the false real estate prosperity of the day.

In the 1970’s mortgages were also assumable in many instances. The fixed mortgage came with your home. Think what our current housing market would look like if residential real estate came with mortgages. Would housing markets have experienced 30%, 40%, 50% in value or more, with assumable loans attached? Is a house easier or harder to sell with an assumable mortgage? 

Maybe this is an opportunity for the Department of Treasury to self-refinance mortgages directly with borrowers. New Home Sales reported the average price fell 8.0 percent to $248,200 while sales of new homes which fell 8.1 percent to a much lower-than-expected annual unit rate of 283,000. The median price of a new home plunged 13.9 percent in October to $194,900, a seven year low. 

Existing home sales were even worse. Sales fell 2.2 percent in October to a 4.43 million annual unit rate. The year over year change is a staggering 25.9%. Supply on the market has returned to 10.5 months. The median price fell an additional six tenths to $170,500. The average price moved two tenths higher to $218,700. 

Consumers were protected in other ways. In 1980, Congress passed the Depository Institutions Deregulation and Monetary Control Act exempting federally chartered savings banks, installment plan sellers and chartered loan companies from state usury limits. This effectively overrode all state and local usury laws. Heretofore, banks were limited by law as to what interest rate they could charge customers. 

Then, there was collective wage bargaining. The apex of organized labor existed in this time frame. For employees, price inflation was met with multi-year wage contracts, negotiated wage increases, and Cost Of Living Adjustments (COLA). Employers could better plan their labor costs and workers would not fall too far behind, too quickly. In retrospect, these automatic triggers helped exacerbated moderate inflation as it fulfilled structural price increases. 

Manufacturing as well as capital was neither nimble nor mobile in the pre-digital age. Employers were more inclined to sit down with workers and arrive at a schedule of wages and benefits both sides could live with. Relative labor peace in the US resulted from this tack verses a more confrontational civil disobedient approach on the European continent. 

The America I just described no longer exists. Instead of a fairly closed economic system capturing Ben Bernanke’s domestic asset price inflation action, the global economy will absorb our inflation, spilling into overheating emerging economies. This will cause resentment toward our predatory monetary policy. 

At home, stubbornly high unemployment continues as more hiring of temporary and contract workers identify firms that are practicing company before country, and a deteriorating financial system that is biting disproportionately into financially vulnerable consumers’ thinning disposable income. 

Municipalities are moving closer to default, just like Europe, under the weight of this radical redistribution upward of capital since the repeal of Glass-Steagall Act. The probability of a double-dip recession followed by uncapped interest rates and a widening chasm between Tiffany & Co. and Target customers, and rising corporate profits grows. 

The Ben Bernank offers other lesser reasons why QE II is necessary, such as a goal of optimal employment, without any major tax or infrastructure jobs initiatives coordinated with other quarters of government. I think their reasoning and aiming needs more work. 

The Market Is Just Not Into Main Street Anymore

August Commentary: The Market is Just Not into Us, Anymore

I’m reminded of the story about the recently deceased arriving at the gates of Heaven and being told that he has freedom of choice he may visit both Heaven and Hell before making his eternal decision. After visiting Heaven for the day he journeys down to Hell.

The most incredible party witnessed in history is going on. The most beautiful people he had ever seen were there. The finest food and drink from the four corners of the planet was being served. The greatest band he had ever heard played every one of his favorite songs and sounding never better, from each stage of his life.

The next morning he returned to Heaven, rendered his decision and apologized for choosing Hell, along with conveying his thanks for the heavenly hospitality.

Upon returning below, the music was gone; so too were the beautiful people and the fabulous food and drink. All that remained in the dark cave was coal, fire, shovels, and heat. When he demanded to know where everyone and everything went; Lucifer winked and replied:

“Yesterday, you were a prospect. Today, sir, you are my client.”

Throughout 2010, and for the last decade, equity returns have produced practically nothing for all its troubles. Then, why do investors continue tolerating an insane amount volatility and risk of principal, for punk rewards - we are holding on to a once profitable relationship that no longer exists.

There; it had to be said.

This 30-year affair between the American middle class and financial markets has been counterproductive over the previous decade. Analysts and money managers are like your mate’s best friend who looks straight into your eyes and lie to your face. “The relationship is fine.” “You are imagining things.” “Every relationship has its highs and lows; you two are experiencing a temporary low period, that’s all.” “You think you could do better without her?”

These examples mirrors a few mindless talking points investors hear bantered about each day on business channels, describing investors’ net worth reduction and why any concern, on your part, is totally unnecessary. Let’s recall how this relationship started by returning to the beginning of this latest chapter.

Wall Street was a rich man’s playground - until the inflationary 1970‘s. At that point, the rich stop buying stocks. P/Es on stocks fell to hat size levels. Prior to the stagflation and inflationary 1970’s, it mattered little that commissions were fixed and burley. The last secular bill market ran from 1950 to 1965. Potential brokers were invited and groomed, by white shoe firms, to introduce themselves to and to form relationships, with the affluent.

In 1962, self-employed individuals or unincorporated businesses became eligible to self-direct retirement accounts through Congressional legislation with the establishment of (Eugene) Keogh or HR (10) plans. Twenty years later, employers asked the same question, differently: Why shouldn’t employees have the same freedom to self-direct their retirement account (thereby, removing corporate responsibility for employees’ retirement).

The private sector, as late as the early 1980’s, offered new workers employer-sponsored defined benefit (DB) retirement plans. Investment risk and portfolio management are entirely controlled by the company. Payouts are calculated on factors such as salary and duration of employment. If there is a short-fall on investment returns, companies are obligated to dip into earnings to cover the difference.

Luckily, for corporations, bottom line margins and much of today’s $1.6 trillion in cash, sitting on the balance sheets of corporations, is safe from being encumbered by DB plans and their retirees.

DB plans are still owned by many public sector workers. Currently, these plans are routinely vilified in the press as parasitic in nature. Defined Contribution (DC) retirement plans, enthusiastically launched in the 1980’s as DB plan’s chief competitive product, and were sold primarily by ridiculing DB plans as being inferior to self-directed accounts. DC plans’ major weakness, an unknown future payout to retirees, became its major marketing strength.

Men with ambition, real men, theoretically, could make untold millions playing the stock market. Accepting a DB plan’s corset over unlimited retirement income potential was the providence of the dull-witted or the lazy, lacking in motivation, vision and imagination.

The tiny requirements for raking in bushels of filthy lucre, for your golden years, as the pitch went, were reading Peter Lynch books and by faithfully watching Louis Rukeyser’s Wall Street Week; “as you know, over time, all stocks increase in value.”

Because of the internal logic of DC plans’ supposition from 1980’s Wall Street, it was antithetical for Human Resource departments and mutual fund companies to argue, at the beginning of a secular bull market, in favor of capping pedestrian, formulaic, DB plan payouts. Unrestricted, free market-based, DC plans were vastly superior on every count.

Beside, where did DB plans’ returns really come from? They came from the stock market! Eliminate the middle man; keep for yourself all the returns your hard earned dollars generate in the stock market. Mr. Hare, meet Mr. Tortoise.

The accelerants fomenting this new mindset, when stocks such as Boeing, Walt Disney, Mattel, and many others, sold for $5 dollars a share or less, were de-regulated commissions, Merrill Lynch’s new Money Market Account, and Sears acquisition of Dean, Witter, Reynolds (now Morgan Stanley). Additionally, declining inflation and interest rates, tax cuts, and deficit spending, helped deliver to Wall Street the middle class aspiration of champagne wishes and caviar dreams.

Over the next 20 years it was a world wind affair with unbridled infatuation. Mutual fund sales loads were cut from 8.5% to 4.5%. Exchange privileges inside mutual fund complexes were established. Letters of Intent, reducing sales fees further, became standard. Investors began choosing stock investment over precious metals, over real estate, over all other asset classes.

Stock market DC plans, became the preferred method of saving for retirement. Dividend Reinvestment Plans (DRIP) and stock purchase plans, compounding returns, also became more popular, adding fuel to the roaring stock market fire. Owning equities were touted by every financial services company. Consequently, more workers chose DB plans, year after year, playing at the big boys table.

Fictional character Gordon Gecko became the Pontiff of American financial idolatry and fictional prosperity. In the late 1980’s, banks begin selling mutual funds and insurance; and vice versa. Charles Schwab introduce the no load mutual funds Fund companies created A, B, C, and D shares, offering various sales load configurations.

In the 1990’s, everyone made money playing the stock market. The beginning of online trading even made it easy to do. The WSJ ran a recurring article featuring a chimp throwing darts, selecting stocks, and comparing his returns with professional money managers. That’s when you know when you are in a secular bull market.

The 14-member investment club from Beardstown, IL, the Beardstown Ladies became national celebrities for reporting earning compound annual average returns of 23.4%, over 10 years, thru 1993 - until they were audited.

Their actual return was 9.1%. By 1997, the Ladies had upped their stock picking skills and annual average returns over 10-years increased to 15.3%, yet, they still lagged the S&P 500’s 10-year return, during this period, of 17.2%.

Yes, we were so in love with each other. Then, dark clouds appeared and forever changed the future – Glass-Steagall was repealed.

Early in the next decade, Wall Street’s wandering eyes caught a glimpse of augmented proprietary trading and underwriting fees. Enhanced leverage, donning smaller and more provocative capital reserves, heretofore, disapproved of among prudent men, became desirable and lusted after by all. Scandalous risk was in vogue.

Investors’ trading commissions and management fees were a competent and faithful, if somewhat, plain way for firms to earn revenue. It was like home cooking five nights a week and backyard grilling on the weekends – safe, predictable, fulfilling, and bland.

Conversely, trading the firm’s capital and collecting securitization fees was the long-legged, redheaded, man-eating, gorgeous knockout, swinging from your arm each night, walking into your favorite hangouts.

Are you still dollar-cost averaging into your funds? Maximizing 401k and IRA contributions? Sporadically purchasing round lots of a few hundred or a few thousand shares of stocks, at discounted prices? This was no longer enough for descendants of the Buttonwood Agreement.

Once Wall Street felt the rush from mainlining mortgage-backed securities, the relationship with John and Jane Q. Public was doomed.

Any hope of salvaging this fraying union ended in 2008. We were unsuccessful in getting American finance off the narcotic of toxic assets; kicking this addiction to fast money, infinite fees and profits, and nympholeptic bonuses. A clean and sober banking system, facing tough new regulations, would function properly, yet again.

Regrettably, the wrong crowd appeared to offer help – Buffett, Paulson, Geithner, Blankfein, Bernanke, and Geithner – peddling TARP, Quantitative Easing, credit facilities, and government guarantees.

Immediately, overnight loan orgies were being held at the Feds’ discount window. The decency of mark-to-market accounting was scoffed at and ignored. Banking hedonism ran amuck on the streets of Manhattan and through the halls of Congress. Someone had shot the sheriff and the deputy, too.

It’s over. In a world of globalization, high frequency trading, melt-ups, flash-crashes, and algorithms, Wall Street doesn’t need the American middle class anymore; Need proof? Here is a snapshot from the internet of an Investment Company Institute chart displaying flows into LT Mutual Funds thru 07/21/2010:

The stock market was up 7% in July despite the fact that equity mutual funds experienced outflows in each of the last 12 weeks.

Wall Street borrows pure, uncut, scratch – at 0% - directly from Mr. Big; Washington DC. Treasury auctions are co-dependent enablers of this bankrupt practice. There is no turning back. Investors will make the wrong choice during a flash crash or flash bounce and will lose.

Somehow, that someone is always John and Jane Q. Public.

An Alternative to the Trillion Dollar Deficit

Am I the only one who thinks that a trillion dollar deficit, proposed by the President-elect, is financially insane?

True, as we head into the deepest recession since the Great Depression of the 1930's, we may succeed in becoming the Great Depression II. However, before we touch a lit match to a fuse on a trillion dollar budget deficit (not to mention funding for the wars in Iraq and Afghanistan occuring outside the annual budget, which will surely detonate our country in the future), let us try to address the original problem.

We all agree residential real estate began this current economic slide and that residential real estate's recovery is necessary to end this slump. So, let us rethink the solution.

Since a trillion dollars is on the table, why not try the following; The US government enacts a new program to refinance the following mortgages: 1) all sub-prime mortgages that have reset and will reset. 2) Any mortgage that is underwater by more than five percent; 3) mortgages of homes repossessed in the 4th quarter of 2008 and currently unoccupied, if the previous owners are interested in returning.

Once the government has identified these mortgages, borrowers may apply for a new, 30-year, fixed-rate mortgage, issued at one percent over the current 30 year T-bond.

Do not stop reading. Here is how we save residential real estate and America.

All refinanced mortgages are backed by the full faith and credit of the US government. All refinanced mortgages are assumable.

Yes, I said ASSUMABLE.

Catalog the benefits. Currently, a raging debate about mortgage cram-downs by banks is taking place. Both sides have valid points. By refinancing existing mortgages and paying off lenders immediately, investors holding MBSs are "made whole", per the terms of the mortgage, and contract law is preserved.

Is a home more valuable or less valuable with an assumable loan? The current inventory of vacant and unsold homes would quickly reduce while prices stabilized. Ask a real estate agent if a home with a 30-year, fixed rate mortgage, at 4.25%, completely assumable, is marketable.

Banks' capital requirements and their need to raise cash for 2009 is lessened. Banks will also have fewer assets on their books. Retirees living on fixed income investments are starving for yield. T-bills and CDs today only reduce investors' disposable income and subtract purchasing power from the economy.

On a $200,000 mortgage, refinancing a 6%, or 8%, 10% mortgage, down to 4.25% mortgage is like getting a stimulus check, for several hundred dollars, every 30 days. Would a small business owner rather receive a lower tax rate and fewer customers or 10 or 20 homeowners in his neighborhood with additional money in their pockets?

Vacant homes lower property values. Vandalism occurs to individual properties, squatters break in and stay illegally, and crime can increase in the neighborhood.

The government could begin taking applications 30 days after Congress approves such a bill and begin issuing checks within 90 days, for immediate repayment of mortgages to lenders and injecting more disposable income, through lower mortgage payments, throughout the economy. The psychological benefits to the country alone, with such a program, are incalculable.

Mortgages are public records. This program is completely transparent. As the money is spent, its final destination is available for all to see.

Lastly, if the government is going to destroy the dollar by issuing two trillion dollars in obligations this year, why not try this approach first.

It is just as insane as a trillion dollar deficit for years to come.

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.  

The Lost Decade: Widespread and Furious

Last Friday morning before the US stocks markets opened, the American financial system was staring into the abyss – again. Complete liquidation had occurred throughout the night in Asia and Europe, and now it was our turn. The US was given a death row reprieve, at least for now.

Virtually every measurement for wealth, even if casually examined since the year 2000, shows a decline in value or no change. The S & P 500, the DJIA, and NASDAQ, closed on December 29, 2000, at the levels of 1,320.28, at 10,786.85, and 2,341.70, respectively. Friday, October 24th, their respective levels were 876.77, 8,378.95, and 1,202.27.

Also on December 29, 2000, the Wilshire 5000 Composite Index closed at 12,175.88 versus 8,806.20, October 24th; the 10-year Treasury note at 5.12 per cent versus 3.69 per cent, October 24th; and Value Line – Geometric closed at 393.47 versus 226.82 last Friday.

REITs, open and closed end mutual funds, individual stocks, and all classes of equity assets have been savagely beaten up by the Great Bear market of 2008, with the same ferocity as it counterpart, the Great Bull Market of 1982-2005, rose. Leverage and deregulation ushered in 30 years of miraculous wealth and prosperity. Now, the tide has reversed. Asset values, first real estate, ultimately all assets, in the short term, have nowhere to go but down.

The federal government is using all of its power to soften the landing, but historically, expansionary monetary policy will only debase our currency and opens the door for massive inflation once we exit the impending recession.

This summer I wrote about the inevitable pain deleveraging would inflict on the economy and why it had to occur. I think we are far from the end of this cycle. Municipal Market Advisors reported municipal bonds staged one of their biggest one day rallies in history on October 22 and the 30-year Treasury bond traded at an unbelievable 3.96 yield Friday. The cash price for gold is currently being pushed lower through forced liquidation.

Baby Boomers, still traumatized by their 3rd quarter retirement account and September brokerage account statements, are having a collective epiphany about their upcoming retirement years. Their careful planning and hard work to secure a comfortable 'golden years' lifestyle has been robbed.

What's next for the economy? Just as all other assets are unwinding, in time, so will the bond markets and the US dollar. By then, TIPS, gold, and non-credit dependent stocks should be your first line of investing defense.

Market Depending on the Kindness of Strangers

To paraphrase Blanche DuBois from “A Streetcar Named Desire”, the Tennessee Williams 1948 Pulitzer Prize winner for Drama for a play, which later became a 1951 movie nominated for 11 Academy Awards, winning four Oscars, the stock market this past week, as well as for the month of July, was beholding to the kindness of strangers. And the primary stranger for the stock market was the gyrating price of oil. Other commodity prices continued to recede from their late June/early July highs, too. The secondary stranger was a dastardly set of economic data that perturb the market in an unkindly manner.

Break out the Dramamine and the Bourbon because after a roller coaster ride like this, six flags has been scratched off my things to do list for the remainder of the summer of 2008. Much of it had to do with short covering, end-of-the-quarter window dressing, and good old fashion profit taking.

The last week in July displayed an intense market; a triple digit decline for the DJIA Monday of 239.61, followed by Tuesday and Wednesday gains of 266.48 and 186.13, respectively, and a triple digit decline Thursday of 205.67. Finally, dry heaves Friday ended the day down 51.70. For the full week, the Dow lost just 44 points stopping at 11,226.32. The S & P 500 closed at 1,260.31 and NASDAQ finished the week at 2.310.96. Both were down for the week as well.

The auto industry had to come clean last week. General Motors (GM) led the way by reporting a $15.5 billion loss or $27.33 per share for the second quarter on revenues of $28.2 billion. GM also mismanaged to lose $39 billion in the third quarter of 2007.

The entire auto industry recorded dismal sales in July; Toyota (TM) was down 18.7 percent, Ford (F) was down 21.5 percent, General Motors was down 32.4 percent, Chrysler was down 34.2 percent, and Honda (HMC), winning the brass ring, was down 9.2percent. Total car sales in July were tracking at 12.55 million annual units, a million units below June. Truly ugly numbers for an economy not headed into recession.

Not to beat a dead horse, the S & P/Case Shiller Index for May reported a 15.8 percent YOY drop in housing prices. This was more than the 15.2 percent drop reported for April. Bank regulators shut down First Priority Bank of Florida on Friday. SunTrust Banks Inc. (STI) agreed to take over the insured deposits and to reopen the six branches on Monday. The deleveraging of America continues unabated.

Speaking of non-surprises, Exxon Mobil (XOM) only managed to save a lousy $11.6 billion on gross sales of $138 billion. Royal Dutch Shell PLC (RDS.A) pocketed $11.56 billion in profits from $131.42 billion, when they reported their second quarter earnings. This works out to almost $1 Billion in net profit each week or every 7 days. Wow. If only the U.S. government owned oil.

Second quarter Gross Domestic Product [GDP] advance report came out at 1.9% which proved that the economy is still expanding although the fourth quarter 2007 was revised down to a negative .2 percent from a positive .6 percent. It was a magnificent work of fiction. That second quarter GDP figure includes the $160 billion stimulus package rebate that was spread throughout the country beginning April 17th. The price of oil closed on June 30th at $140 a barrel which means the pain felt in the economy from the zenith in crude prices was fractionally captured in the 1.9 percent data. Do we need an asterisk next to this GDP figure like Barry Bonds homerun record? Juicing is juicing. The unemployment rate rose to 5.7 percent while an additional 51,000 jobs were lost; the seventh consecutive month for fewer jobs in the economy.

There was improvement in Treasury prices last week, the Two Year Note yield moved down 20 basis points to 2.51 percent and the benchmark Ten Year Note ended the week at 3.94 percent, down 16 basis points. The Ten Year Note auction will be held Wednesday August 6th and the Thirty Year Bond auction is scheduled for Thursday August 7th. The Federal Open Market Committee meets Tuesday, August 5th to review monetary policy. Rates are expected to remain at 2 percent.

August 4th, June Personal Income, June Personal Spending, and June Factory Orders will be announced. August 5th, the July Institute for Supply Management [ISM] Non-Manufacturing Composite Index comes out. August 6th, MBA Mortgage Application Survey Refinancing Index is due. August 7th, Initial Jobless Claims, June Pending home Sales and June Consumer Credit is revealed. August 8th, 2Q preliminary Nonfarm Productivity and Unit Labor Costs are reported.

Batman has now earned $400 million in domestic ticket sales in just 17 days. The caped crusader has still sold fewer tickets than the all time box office champ, the 1996 released “Titanic” that grossed $600 million, domestically. Batman ticket prices are also 50 percent higher than they were for the champ. That’s called inflation.