Big bad banks?

Just a quick note: the U.S. Federal Reserve made $78.9 billion in 2011, second only to its 2010 record haul of $81.7 billion.

Feeling curious, I decided to look up how much money the U.S. big four banks made in their peak years.  Combining their best, Bank of America (2006), Citigroup (2006), JPMorgan (2007) and Wells Fargo (2010) had combined peak earnings of only $70.1 billion (full disclosure: my clients and I own shares of Wells Fargo).

In other words, the banks that are supposedly the cause of all our earthly problems didn't together, looking at their peak earning years(!), match what the Federal Reserve made by itself in either of the last two years.

The bozos of Occupy Wall Street and everyone else who believes all our problems are due to the greedy, too powerful big banks need a reality check.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

QE3, Operation Twist and Balderdash

"What's in a name?  That which we call a rose
By any other name would smell as sweet."

--Juliet, from Romeo and Juliet, William Shakespeare

Balderdash - A senseless jumble of words; nonsense, trash (spoken or written)

-- Oxford English Dictionary 

The Federal Reserve is likely to take action today to "boost the economy."  This is yet another attempt in a long line of failed efforts that not only won't work, but will almost certainly make problems worse.

Whether they call it QE3 (quantitative easing, part III) or Operation Twist (named for the 1960's dance and first tried during the Kennedy administration) or Glimdragbig (a word I just made up), it will feature the Fed toying with interest rates (most likely by creating money) in an attempt to get the economy "moving."

The Fed may call it something other than what it is, but it will still smell.  They may use elaborate jargon (nonsense) to mask its true nature, but that won't change the facts.

The Fed's underlying premise is that free markets work...until they don't.  Has the Fed ever correctly forecast when markets will stop working?  Of course not.  In fact, they are almost always too ebullient when they should be cautious, and overly worried when they should be upbeat. 

But, despite these consistent failures, they still pass judgment on markets and they supposedly know when markets have stopped working, and therefore when they should intervene to "get things going." 

As Dr. Phil likes to say, "how's that working for you?"

In case you haven't noticed, economic growth is anemic at below 2%, and unemployment is high at over 9%.  And, this is after countless fiscal and monetary (and regulatory) interventions over the last 3 years.

Why aren't interventions working?  Because the first part of the Fed's premise is right: markets do work.  If you let people freely choose and act, and prevent them from initiating force against each other, they will--over time--rationally allocate capital and other resources to productive ends, thus resulting in real growth and higher employment. 

What the Fed has been doing is preventing this mechanism from working.  Interest rates are at the heart of any modern economy.  It's the time value of money, and therefore drives economic choices at the most fundamental level.  If you screw with those rates, people will mis-allocate capital and the economy will stagnate or shrink.

Sound familiar?  If you need more empirical support, please see Japan over the last 20 years and America during the 1930's as examples of interventions galore resulting in anemic growth, stagnation, or shrinkage (or the Soviet Union, or China under Mao, or North Korea, or Cuba, East Germany, Venezuela, you get the picture!).

Stock, bond, and commodity markets are likely to respond favorably to any Fed intervention--just like they always do (after all, everyone loves a party when someone else is paying).  The dollar is likely to sink (except perhaps relative to Europe, which is even more of a basket case than America) and gold is likely to rally.

That doesn't mean the economy will grow, nor does it mean unemployment will shrink.  Once again, interventions are leading to greater and greater mis-allocations of capital and thus will cause slower growth than would otherwise occur. 

There is good news in all this, and that's that much of the American economy is relatively free.  In such places, people are innovating, adapting, employing and growing.  As long as the bone-heads bureaucrats don't intervene too much, such productive people will eventually create enough growth to overcome the negative effects of repeated intervention.

It may take time, though, so patience will be necessary.  In the meantime, lets all hope the interventionists will stop distorting markets so they can do their thing.  At that point, we'll have an upward spiral to be truly optimistic about.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The Fallacy of Too Big To Fail

I've tried to stay away from the Too Big to Fail discussion, but after doing research on the banking sector recently, I decided to put in my two cents.

First off, "too big" assumes some standard.  It assumes that something of a certain size is "good," but when that size becomes "too" much, it becomes "bad."  (What, like too much health, too much peace, too much prosperity, too much happiness, too much virtue?)  By what standard?  For what goal?  By whose judgment?  No data or references are provided by most of those who make this argument, which makes me suspicious right-off.

Lately, this argument has been made with respect to banks.  "XYZ Bancorp is so large that it can take down the whole financial system" seems to be the implicit line of reasoning behind the Too Big to Fail discussion.  Does that mean breaking XYZ into 10 or 100 or 1000 small banks that all fail at once is better simply because they are each small?  Are lots of small failures good and one large failure bad?  Is smallness somehow an implicit good?  No. 

I guarantee that if you break XYZ into lots of pieces that all have the same debt to equity ratios and loan exposures as XYZ as a whole, they will all fail at the same time.  And, you'll end up in an even worse situation than if an integrated XYZ bank had failed.  Too big or small isn't the issue, the real issue is leverage and loan exposure. 

The Too Big to Fail argument assumes that somehow lots of smaller banks will not fail at the same time but one large one will.  Oh, like lots of small banks did so much better than large banks because the housing market can't possibly crash nationally (note: I'm being sarcastic).  Oops, that argument didn't float.

The housing sector crashed nationally and that almost took down our financial sector and the rest of the economy for reasons other than large banks.  The banks were a symptom, not a cause. 

If banks weren't back-stopped by the FDIC and Federal Reserve and driven to hold low equity to capital, they wouldn't have crashed due to too much leverage. 

If home ownership weren't explicitly supported by Congress, the Executive branch, tax policy, FHA, GNMA, Fannie Mae and Freddie Mac (government supported enterprises), etc., then all kinds of mortgage derivative instruments would never have been created and crashed.

If the government hadn't driven the creation of rating agencies and given three of them exclusive control of debt ratings that banks, insurance companies, etc. must use in the purchasing of securities, then risky securities would never have had a huge, captive markets in the first place.

If the Federal Reserve weren't encouraging speculation with interest rates below free market equilibrium, there never would have been massive mis-allocation of capital to the housing sector all at once.

The only thing that seems too big here is government intervention in banking, housing, debt ratings, and interest rates.

Back when banking was more free (it's always had lots of government interference), banks carried 40% equity against 60% in liabilities.  With government back-stopping and lots of regulation, that ratio is now 10% equity to 90% liabilities (it was 7%/93% right before the financial crisis).  Perhaps things were safer when banking was more free.

The history of bank failures in the U.S. has smallness written all over it.  Our regulatory structure has long encouraged lots of small banks.  But, a small bank in Iowa is very likely to crash and depositors to be wiped out when an inevitable bad corn crop occurs.  In contrast, a large bank with loans to corn farmers in Iowa, gold miners in Nevada, cotton growers in Mississippi, steel manufacturers in Indiana, orange growers in Florida, cheese producers in Wisconsin, etc. is unlikely to have all loans default at the same time, thus protecting depositors and borrowers.

Unless, of course, speculation is encouraged on a national level, or large banks are driven to hold 10% equity to 90% in liabilities.  That doesn't happen, though, without national coordination--in other words: without a national regulatory structure that lines up the dominoes to fall at the same time and in the same direction. 

If leverage and loan exposures were the problem, wouldn't greater regulation of those issues fix the problem?  No.  Not all banks are the same, and so no regulatory body can foresee all the potential business mix issues that might come up (only someone omniscient could).  JPMorgan, with international operations, investment banking services, and proprietary trading operations, has very different risk exposures than U.S. Bancorp's community banks.  You can't come up with one-size-fits all prescriptions for either debt ratios or loan exposures.

In addition, any attempt to prevent problems is more likely to create systemic risk, because a bunch of banks marching to the same music are much more likely to fall together than several separate banks marching to their own drummer (each might fall on their own, but not together systemically).  This is the same reason why periodic recessions and small fires that burn the underbrush prevent catastrophic problems.

The road to hell is literally paved with good intentions--which frequently take the form of national (or international) regulation.

I can't help but point out one other blatant inconsistency of the Too Big to Fail argument.  If bigness is inherently bad, then why have a BIG, super-governmental body to oversee, break-up, regulate and control banks or any other sector of the economy?  Wouldn't its bigness be an inherent threat? 

Please keep in mind, too, that no markets in the world are as highly regulated as housing and banking, the epi-center of our latest financial crisis.  Big regulation didn't help there.  In fact, I strongly argue it created the problem. 

When looking at bigness, it's useful to recognize that the regulatory bodies are already much bigger and more powerful than the regulated. The Federal Reserve made $80.9 billion in "profits" last year (by trashing our currency and punishing savers, no less) compared to the two most profitable non-governmental businesses: Nestle's $37 billion and ExxonMobil's $30 billion.  At least Nestle and ExxonMobil produced things people wanted to buy!  I won't even mention the ridiculous spending power of other federal government branches. 

If bigness is the problem, then banks or any other non-governmental businesses are the wrong target for concern.  But, even there, the concern is not size, per se, but what an organization does.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

There's no free lunch

One of the most succinct propositions in economics is that there's no such thing as a free lunch.  Put more plainly, when you think you're getting something for nothing, you'd best check your premises.

Take free Internet search.  Is that really free?  No, it's paid for by advertising.  Free news from over-the-air broadcasters ABC, NBC and CBS?  Advertising.  Free advice from financial planners?  Commissions on mutual fund sales.  Free roads?  Check out the taxes you pay on fuel.  Free lunch from an insurance salesperson?  Commissions, too (an insurance salesperson once bragged to me that he only needed 1 out of 20 people to buy insurance at those events--so you should know right away the "product" is a rip-off!).

There's no such thing as a free lunch. 

In no case should this be more obvious than government support of the economy.  Hey, if all it really took were the Federal Reserve printing money to promote prosperity, then Wiemar Germany and Zimbabwe would have been the most thriving economies in history.  They weren't/aren't (both disasters on scales that make earthquakes and hurricanes economically boring in comparison).

And so, when the Fed ends it's quantitative easing program this summer, we should all be on the lookout for economic tremors.  We ate the lunch, now the bill's coming due.

I'm actually quite surprised market participants have been short-sighted on this issue.  I naively thought the quantitative easing program hinted at last summer would be seen for what it was--quite costly.  Instead, the market started partying like it was 1999.

This attitude will, however, prove short-sighted.  Unfortunately, John Q. Public has joined the stampede.  As usual, he waited until the herd reached full speed, long after the lead steers saw the Fed's policy as a license to speculate.  My guess is that he'll leap off the cliff only to look back and see the lead steers observing the slaughter from the sidelines. 

So was it ever.

Perhaps we'll get a third round of quantitative easing and the day of reckoning will be put off.  If so, that lunch will be no more free than the last several. 

It will be interesting to observe how the lead steers react, and how long it takes for John Q. Public to learn that there are no free lunches.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Creating instability

I don't envy the Federal Reserve.  They have an impossible job.  Can you imagine trying to set the price of t-shirts for the whole economy, much less the clearing price between suppliers and demanders of funds in capital markets? 

No matter how hard you try, you'd always set interest rates too high or too low, or supply too much or too little money.  This would lead to the inevitable shortages or surpluses that any Economics 101 course teaches to new students.  If you don't believe me, please see the terrible record of any centrally planned economy.

And yet, the Federal Reserve still tries to make the economic system more stable through its control of the money supply and interest rates.  You'd think they'd learn.

Their failure can be seen, most recently, in the swing of commodity prices and interest rates.  Increasing the money supply to bring down interest rates has led to un-intended, but inevitable, consequences, like surging commodity prices and civil disorder in the third world. 

The Fed keeps insisting that inflation is low by reference to a) the corrupt Consumer Price Index (CPI) and b) the spread between bonds with and without inflation protection. 

The circular reasoning required for b) above just boggles the mind: 1) The economy is inherently unstable, so we need a Federal Reserve to prevent that instability from hurting people (they claim), 2) The Federal Reserve refers to free market interest rates (on the premise that market players aren't just reacting to Federal Reserve talk and action) to decide whether they need to intervene, 3) So, if the Federal Reserve is supposed to prevent an inherently unstable system from becoming unstable, why is it using supposedly unstable misinformation from that unstable system to validate its need to act or not?

It sounds like a recipe for creating an even more unstable system.  And, so it has.

Below are three graphs.  A) shows a stable system where equilibrium is restored with damped oscillations over time.  B) shows a stable system where oscillations aren't damped, but the system returns to equilibrium periodically and doesn't fall apart.  C) shows an unstable system where the oscillations become greater and greater until things blow up or whatever is causing the divergent oscillations is removed. 


The claim is made that we need a Federal Reserve because the systems is inherently like B) or C) and the Fed will make things look like A).  But, look at the graph below of S&P 500 profit margins.  Does it look like the Federal Reserve is making A) happen, or C)?  Looks a lot like C) to me!



It is my contention that the economic system is inherently like A) above, not B) or C), and that Fed intervention is turning the economy into first B) and then C) above. 

This is by no means a proof or validation, but it should raise a question in your mind that perhaps markets should be setting interest rates and money supply just like it sets the price of t-shirt, TVs, computers and millions of other products.  Every experience with price controls in history has led to surpluses and shortages, and yet we have a Federal Reserve trying to set the most important price in the economy--the price of money. 

Maybe it's time to dampen our oscillations by removing the thing that's making our system unstable: the Federal Reserve.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The Fed wants MORE (?!) inflation

I know, everyone is taking pot-shots at the Federal Reserve (the YouTube video is hilarious!).  I, however, feel especially privileged to do so not because I read a lot of finance, investing and economics, but because I've always been critical of the Fed.

The Fed was originally created in 1913 after the financial panic of 1907 to prevent banking crises.  Bankers and the government had decided that banking crises could be prevented with a lender of last resort, and many judged that a government agency would be better for this purpose than the ad hoc committee of New York bankers, led by J.P. Morgan, who had previously and successfully dealt with banking crises in the past.  The original goal of the Fed was to be this lender of last resort.

Fast forward to the present, and the Fed's mandate is to maintain price stability and full employment (never mind that the Fed has a lot of control over the former and none over the latter).  As you may have quickly surmised, this has nothing to do with its original mandate.

The people at the Fed long ago decided that deflation (declining prices) was the bane of human existence after the experience of the Great Depression and watching Japan's last 20 years.  They seem to have forgotten, however, that both of those experiences were due to bad loans and not an inadequate supply of money. 

With this background, those at the Fed would much rather experience inflation than deflation.  In their infinite wisdom, they are now working hard to create inflation to fight off the boogie-man of deflation  They want to increase inflation to boost employment (never mind that inflation won't boost employment). 

But, to normal people, declining prices seem like a good thing.  In fact, during a deep recession and recovery with 10% unemployment, most people think declining prices might be a very good thing.

That's because most people haven't been lobotomized by a PhD in economics to believe that declining prices (deflation) or stable prices (gold standard) are a bad thing. 

Most people, too, understand that printing money to create inflation won't create prosperity, but will lead to extremely negative economic consequences (Zimbabwe or Weimar Germany, anyone?). 

Why don't the people at the Fed possess such common sense?

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The week that was...

Most weeks, I choose one topic on which to spout my thoughts and opinions.  But, this week, there were just too many interesting things to ponder, so here are 8 brief points of interest.

1)  Earnings season is over and the results were better than expected.  Revenues didn't dazzle, meaning that end demand is slow, but cost cuts more than made up the difference.  This just goes to show that companies and the stock market can do well even in a slow economy.

2)  Economic numbers continue to improve.  Unemployment claims improved, railroad loadings are up, leading economic indicators surprised on the upside as did the Philly Fed's survey.  The economy is improving ever so slowly, but it is improving.

3)  There's been a lot of speculation that the Fed's quantitative easing program is merely an attempt to puff up the stock market to get rich people to spend, thus improving the overall economy.  Andy Kessler and Don Coxe made convincing arguments that the Fed is really worried about real estate and the financial institutions that depend on real estate values, and thus quantitative easying may be an attempt to support bank balance sheets.  Why did the economy roll over in 2008?  Oh, that's right, real estate values tanked and financial institutions froze up.

4)  The mortgage documentation mess promises to have much more lasting impacts than most realize.  This issue goes to the heart of real estate titles and ownership, and the dinosaurs are going toe to toe to find out who will eat losses.  If the banks end up losing this fight, like they should, then we could be right back into a 2008 crisis again.  See 3) above.

5)  Ireland will likely take a bailout from the European Union (EU).  If you think this means Ireland is in a weak position, think again.  When you owe the bank $10,000, it's your problem; when you owe it $10 billion, it's the bank's problem.  The EU is more worried about Greece, Portugal, Spain and Italy than Ireland, so they are hoping to draw a line in the sand at Ireland (after Greece).  Ireland has the stronger hand in this game.  Oh, and by the way, why is another bailout in Europe good news for markets?

6)  China is working hard to slow down their economy, mostly by slowing bank lending, because food inflation is making the natives restless.  China may succeed more than world markets anticipate.  Initially, markets will probably take that hard.  But, over time, this will lower the prices of input commodities, thus improving developing economies.  This may be a case where slowing for them is good news for us.

7)  Many state and local governments in the U.S. look like Portugal, Ireland, Italy, Greece and Spain in terms of fiscal health.  When these issues hit the front page, likely next year or the year after, it will rattle markets and lead to huge bailouts by the federal government.  This will be good in the long run (because budgets are out of touch with reality), but I don't think many people, especially investors, are paying attention to the short term impacts.

8)  Long term bond yields spiked over the last couple of weeks.  An almost 5% decline in the 10 year U.S. Treasury bond over a couple of weeks should be a wake up call for investors who think bonds are risk free.  It should also give pause to equity investors who should know that stocks should go down when long term bond yields spike.  But, why worry about that, the market is rallying!

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

QE2 launched to much fanfare

This was no buy the rumor, sell the news week.  This week, it was buy the rumor, buy the news...whatever you do, just buy, buy, BUY!

The Federal Reserve will create dollars out of thin air and use them to buy debt issued by our Treasury Department, and this was good news to markets.  Everything, except the U.S. dollar, rallied. 

Happy days are here again.  A chicken in every pot, a car in every garage, prosperity for all.  Print away, dear Fed!

Okay, I'm just bitter because I thought  more than 3 people might see election outcomes, quantitative easing part 2, and 9.6% unemployment as less than good news.  I was wrong.

But, the little voice of reason in my head is screaming in protest, "How can printing money with no backing create prosperity?!  I know, for a fact, it can't!!!" 

A lower dollar means a little extra business for a couple of U.S. exporters.  But, the U.S. imports vastly more than it exports, so it means higher costs for the majority of us. 

If you don't believe me, look at commodity prices--they're up 19% since August.  The rocketing price of cotton is jacking up clothing costs.  Oil at over $86 a barrel will translate into high gasoline and heating oil prices.  Copper closing in on $4 means higher prices for electronics.  Et cetera, et cetera, et cetera.

Soon, this will translate into higher costs and lower profits for U.S. companies.  It will also mean higher prices for all U.S. consumers.

Quantitative easing will not create jobs in the U.S. or increase lending to U.S. businesses (although both of those things are occurring completely separate from and despite federal action).  The Fed's printed dollars are going to find their way into emerging markets, commodities and government bonds.  In the short run, it means "party on, Wayne"; in the long run, it means more inflation.

Oh, by the way, the last 2 times the Fed tried to create prosperity with the printing press (and the economy was not on the brink of financial collapse) ended in the dot-com crash and the housing crash. 

While the party is going, it will seem great, just like the NASDAQ and housing bubbles back in 1999 and 2006.  But, when it ends, and few will see it coming or be prepared, it's going to hurt like no hangover we've ever experienced.

In the meantime, the markets will rally and the prudent will look foolish.  And, yes, I'm looking like a fool.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Expectations...fulfilled?

There's a lot of news coming out next week, both mid-term elections and the Federal Reserve meeting to announce the much-anticipated launch of QE2 (quantitative easing, round 2). 

The key question for markets is: how much of the news is already factored into prices?

This points to one of the most difficult concepts for investors to grasp--prices do not reflect current or past information, but investor expectations.

Many investors are surprised when good news comes out--"company earnings grew 50%"--only to see a stock's price tank.  Why?  Because market price already reflected greater than 50% growth. 

Or, they're surprised to see bad news--"the economy shrank by 2%"--lead to a jump in the stock market.  Why?  Prices reflected a more than 2% economic decline. 

Prices, whether for bonds, stocks, commodities or currencies, reflect investor expectations.  Prices move up when actual news is better than expectations and down when it's worse than expectations.

Which raises the question in my title: will news next week exceed, fulfill or disappoint expectations?  If fulfilled, prices won't move much; if exceeded, prices will jump; if disappointing, prices are likely to fall.

Right now, investors clearly expect the Federal Reserve to announce a quantitative easing package that is favorable to bonds, stocks and commodities and bad for the dollar.  Will that announcement fulfill, exceed or disappoint?  Markets seem too optimistic to me, but as the old Wall Street saying goes: "don't fight the Fed."  On the other hand, is the Federal Reserve printing dollars really a cause for stocks and bonds to appreciate?  Something to think about.

Investors currently expect Republicans to take back the House of Representatives and make gains, if not restore a majority, in the Senate.  Do market prices already reflect that expectation, or will they be disappointed?  For that matter, are market participants correctly reflecting what will actually happen if their expectations are fulfilled?  Will Republicans cutting spending be good or bad for stock prices in the short run?  Something to ponder.

The S&P 500 is selling for around $1180 right now, reflecting an expectation of 14% per share earnings growth over the next year.  With the economy likely to grow at around 2% and profit margins at cyclical highs, is overly optimistic earnings growth expected?  What will happen to stock prices if those expectations go unfulfilled?

In the long run, investing success is all about paying the right price for an asset.  In the short run (which is what Wall Street does with less than 6 month holding periods), investing success is all about guessing investor expectations.  For those focused on the long run, next week is a non-issue.  For those focused on the short run, next week will be a nail-biter.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Buy the rumor, sell the news

An old saying on Wall Street is "buy the rumor, sell the news."  It means that markets tend to react to rumors by bidding up prices and then selling (pushing prices back down) when the news actually hits.

Unless you've never read my blog before, you know that I don't tend to pay much attention so this short-term, trader-oriented approach.  However, I am sometimes so completely baffled by the way markets react to news and rumors that I can't help but remember the old saying.

Since late August, the stock market has rallied strongly, as have commodities and gold.  Over the same period, the dollar has tanked.  Since spring, the bond market has rallied strongly, too.  What's going on?

In my opinion, bonds have rallied strongly because economic numbers have been weak.  Unemployment remains high, GDP growth has slowed, the ECRI weekly leading index has tanked (but is recovering), and new unemployment claims have stayed stubbornly over 450,000.  I think bond holders are forecasting a sustained slowdown or recession and continued deflation.  This should not be good news for stocks, commodities and gold, and should be good for the dollar.  So, why is the opposite happening?

In short, the answer is that Federal Reserve board members, since late August, have been strongly hinting that the economy is so weak it may need another round of "quantitative easing."  For those of you blissfully ignorant of what the heck quantitative easing is, it's economic jargon for central bankers printing money (without physical backing).  In this case, they will print dollars, creating money from nothing, and use those dollars to purchase government bonds on the open market.

Why is that good for every market except the dollar?  Good question.  It's good for bonds, because the government will buy bonds in large amounts.  It's good for stocks because this will supposedly goose the economy.  It's good for commodities and gold but bad for the dollar because it means inflation.  If you're confused now, good for you.

Let me summarize: the U.S. economy is doing so badly that the Federal Reserve is going to try to intentionally create inflation.  Somehow that's good for stocks, bonds, commodities and gold, but not the dollar?  That can't be so.  Inflation may be good for commodities and gold and bad for the dollar, but it's definitely not good for stocks and bonds.  Something's amiss.

Which brings me back to: buy the rumor, sell the news.  The Fed has not officially announced its second round (the first was in 2008) of quantitative easing (colorfully dubbed QE2 by market watchers).  That is most likely to occur in early November.

I think that markets are buying the rumor of QE2 and may very well sell the news come early November.  Markets may be particularly unhappy if the news of QE2 doesn't meet its grand expectations. 

In the long run, bad economic news can't be good for stocks and commodities.  If the Fed does manage to create inflation with QE2 (which is not a given), it won't be good for bonds, stocks or the dollar. 

How can bad news about the economy be good news for markets?  In the long run, it can't be.

My ability to time the market is somewhere around zero, so take what I have to say with a big grain of salt.  I'm not buying this rumor, nor selling the news, but caution is highly recommended.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Pushing on a string?

If you've ever water-skied, you know you must keep slack out of the line to stay on your feet.  If the line loosens, you have little time to take out the slack or you'll be swimming.

The Federal Reserve, too, must keep the line tight.  Otherwise, it finds itself pushing on a string.  And, as any water skier knows, pushing on the string is of little use.

Why is the Fed pushing on a string?  Because it--like a boy with a hammer--has only one tool at it's disposal: creating money out of thin air.

When the economy slackens, the Fed reduces interest rates (by printing or threatening to print money).  This is supposed to encourage borrowers to borrow, thus increasing economic activity.  As long as borrowers think they will get higher returns on the money they borrow than the interest rate they owe, they'll borrow. 

But, a problem occurs if borrowers either can't or don't think they can get good enough returns on the money they borrow.  When that happens, the Fed can lower rates and print money all they want and the economy won't improve.  That's when the Fed finds itself pushing on a string.

There are serious questions about the U.S. economy being at this point.  Very smart people are concerned the Fed can't get the economy going again, and they have powerful historic examples like the Great Depression and Japan to support their thesis.

During the Great Depression, the U.S. experienced a huge drop in economic activity, high and sustained unemployment, and significant deflation. Shrinking money supply was one of the things blamed, and so most economists have taken that as the solution to a similarly deflationary scenario like now.

Japan has been in a 20 year on-again/off-again recession.  Over this time, its stock market is down 75% and its economy hasn't grown.  Its central bank, like the Federal Reserve, has tried lowering interest rates and quantitative easing (a euphemism for printing money).  These solutions have kept unemployment from spiking, but have done nothing to improve economic growth and have left the Japanese government with a huge load of debt.

I think these two examples are important in understanding our present situation, but most analysts and commentators miss the point.  I do think the Fed is pushing on a string, but not for the reason that most suggest.

Borrowers will only borrow if they think they can get good returns on capital.  Such lending will only be effective if positive returns on capital are earned.  For the economy to grow and standards of living to improve, you need positive returns on capital. 

The issue is not employment, nor printing money, nor interest rates, nor fiscal stimulus.  The issue is positive returns on capital.  Without that, there is no growth, only decline.

The U.S. government tried all sorts of things during the Great Depression to improve employment and get the economy going (both Hoover and Roosevelt).  The result: the worst economic decade in U.S. history.  The U.S. economy finally started growing again during World War II.  Was that because killing people and destroying property is growth?  NO!!!  It's because the government boondoggles finally ended and individuals were able to get positive returns on capital.

Japan will not improve until positive returns on capital becomes its focus.  As long as employment and consumer demand are the focus, Japan will not grow.  Only when the Japanese economy refocuses on generating positive returns on capital will it grow again.

The same is true here in the U.S.  Printing money, lowering interest rates, giving loans to negative return on capital projects, and creating boondoggle employment will not create growth. 

The Fed is pushing on a string, but that's because it doesn't understand where growth comes from.  It doesn't come from creating money or lending, it comes from positive returns on capital, and there's nothing the Fed can do to bring that about. 

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Bonds aren't as safe as they may seem

When stock markets tank, most people think, "boy do I wish I owned bonds."

Let me make this clear--bonds are NOT riskless. Although people perceive them as riskless, they are not! Bonds face risks from default and inflation.

Many people wish they owned bonds because U.S. Treasury bonds have done so well over the last year and a half. That doesn't mean all bonds have done well. Junk bonds, corporate bonds, investment grade corporate bonds, municipal bonds, mortgage backed bonds, etc. have all been decimated.

To have done well with bonds during this downturn, you'd have needed to be prescient enough to know exactly which bonds to buy and no others. Very few people are that good at forecasting beforehand. Everyone is afterward--but those are profits you can't eat.

So, what are the risks for bonds. The first risk is the same as for stocks--what you buy can become worthless. Government bonds rarely default, but rarely is not never. The second risk is inflation. Government bonds are very vulnerable to inflation risk (the exception being inflation protected bonds, but even they face inflation risk if the consumer price index differs from your cost of living increases).

How can a bond become worthless? A bond has a senior claim on a business's assets. That means bondholders get paid before equity holders. But, that claim comes after customers and after the tax man. If a company goes bankrupt, bond holders can still be wiped out. They get paid before equity holders based on what's left, but that doesn't mean they will get paid back in full, and it doesn't mean they will get paid back with certainty.

The bigger threat to bondholders is inflation. And, here, I believe stockholders are actually better off than bondholders.

Suppose you buy a 3% bond and inflation goes up. If you own a short term bond, your impact is smaller than if you own a long term bond. A short term bond can be rolled over into a higher yields as inflation goes up. A long term bond doesn't have this luxury.

How much of an impact am I talking about? Pretty big. Suppose inflation goes up by 3% more than the market expects: the value of a 10 year bond would decline by around 20% (all things equal). A 30 year bond would decline by almost 40%! If inflation went up 6% more than people expected, then a 10 year bond would decline by 40% and a 30 year bond would decline by over 60%! If you believe bonds can't go down like stocks, think again!

The price declines I referred to above would happen quickly, but you'd still get back your full principal at maturity, right? The problem is that those dollars will be worth a lot less than they are now. Whether you sold right away or held to maturity, higher than expected inflation will hammer long term bond holders.

That's true for government bonds as much as any other bond. In fact, I believe government bonds are much more risky than usual now. Almost every other type of bond is trading at record high relative yields, so they are safer from inflation risk than government bonds that are at record low yields. Government bonds are extremely unlikely to default, but the dollars you'd receive may not be worth much.

Most people seem to under-estimate the risks of bonds. Default risk and inflation risk make them risky, whether people recognize it or not. Talk to anyone who owned bonds in the 1970's, and they'll tell you what owning bonds felt like in an inflationary and recessionary environment.

Stocks may have a lower priority claim on a business's assets, but they do adapt to inflation better. The revenues and costs of most businesses tend to keep up with inflation over time and so do their earnings. This protects them, over the long run, from the ravages of inflation. Stocks may not do well when inflation increases, but they do very well when inflation levels off or decreases. In the long run, they protect shareholders from inflation better than bonds.

Is unexpected inflation likely? Perhaps not in the short term, but over the next 3 to 5 years, I believe high inflation is very likely, and perhaps more than the 3% or 6% I referred to above.

Stocks aren't riskless, but neither are bonds. Stocks face more risk from default, but less risk from inflation. When government spending is expanding like never before and the Federal Reserve is printing money at a rapid pace, it's a good time to consider inflation protection and the fact that stocks may turn out to be less risky than bonds over the long run.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Lessons from the Panic of 1907

Few remember that the Federal Reserve was created in 1913 because of the panic of 1907. This panic was caused by the failure of several banks that were overly indebted and had made a lot of bad loans. If this sounds familiar to you, you're not alone.

The lessons of 1907 were that when a banking panic occurs, the smart bankers of the world need to get together, examine the books of questionable banks, draw a line in the sand on which banks are solvent and should be supported, and let the rest go into bankruptcy to be sold off piecemeal to solvent institutions and investors.

Back in 1907, the leader of the smart bankers was J.P. Morgan. Although vilified for the power he displayed in this role, Morgan managed to save the economy from complete collapse because he understood banking better than most and had the knowledge, experience, and iron will to make things happen.

The Federal Reserve was originally created to serve this purpose (so that some would-be J.P. Morgan would not have so much power), but its mandate has drifted significantly. Instead of drawing a line in the sand between solvent and insolvent bankers, it now tries to set monetary policy to provide full employment and manage inflation at reasonable levels.

Note how markets have reacted to the Federal Reserve's policies over the last 2 years. At first, markets were assured (early 2007 to mid 2008). Now, markets are tanking because of the Fed's actions. If you believe markets are tanking because of conditions beyond our control, you're not alone, but I don't think you're right. Markets are tanking in reaction to inept policy, not because of economic circumstances, per se.

Instead of allowing bad banks to go under and supporting good banks, the Fed is doing the opposite. Its supporting the bad banks, thus punishing good banks for their prudence. Markets are tanking for good reason.

Letting bad banks go under would hammer the bond and equity holders of such institutions, but their customers need not suffer. In almost every bail-out so far, banking customers were safe. What was threatened were the bond and equity holders, including the stupid banks who had invested in such bonds and equities.

Bailing out the ineffectual at the expense of the effective is a recipe for disaster, and markets will continue to tank as long as such a policy is followed.

In the long run, the truth will out. The bad banks will go under anyway, and the day of reckoning will merely be delayed at great expense, pain and frustration.

If, instead, the government would draw a line in the sand and let the insolvent go under by effecting an orderly liquidation while supporting the solvent, the impact would be painful but over quickly.

Regardless of how the Fed and U.S. government try to solve this problem, the hardworking people of this country will provide the bailout. That bailout will come in the form of hardworking entrepreneurs, prudent businessmen, diligent workers, and rational consumers.

Inept policy will only delay recovery, it will not prevent it.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

At some point, inflation

Sometimes it's useful to look beyond the current headlines to what may be coming over the next 3 to 5 years.

From my vantage point, what I see coming is inflation.

Currently, the news is filled with signs of deflation. Asset prices are collapsing. Housing prices are down significantly. Almost anything, other than U.S. Treasury securities, seems to be down over the last year.

Commodities have been particularly hard hit. It wasn't that long ago that oil was at $147 per barrel and people were talking about it going over $200. Now, it's below $40.

But, what has changed? Mostly, demand has dropped dramatically. As Economics 101 will tell you, when the demand curve shifts down and the supply curve stays the same, you get lower prices. I think I can safely say that has happened.

So, why had demand been crushed. In a word, deleveraging. The economy as a whole--businesses and consumers, at least--have been paying back debts to keep from going bankrupt. Not everyone is succeeding.

This reduction in debt has led to a tremendous fall-off in demand for goods and services of all sorts. You can see that clearly in the GDP and employment numbers. For those those who thought only Wall Street was in trouble, take another look.

But, the biggest debtor out there--the U.S. government--has been borrowing and printing money like it's going out of style.

Eventually, such borrowing and printing will get credit markets going. And, when they do, we'll all owe a lot more debt and have a lot more dollars chasing the same number of goods. In other words, inflation.

I don't think it will happen soon. Although the Fed is printing money and Congress is finding all kinds of ways to spend it, economic activity has slowed down so much that all it's doing is making deflation happen less quickly. Eventually, and over the next several years, economic activity will pick back up again and this will be visible in the so-called velocity of money.

When that happens, the demand curve will shift back up and prices will recover. But--and there's always a but--the government will be in a lot more debt and there will be a lot more dollars chasing the same amount of demand.

In 3 to 5 years, and perhaps sooner, the news won't be about deflation, but inflation. And, that inflation will be a lot higher than in the 80's, 90's or 00's. In fact, it wouldn't surprise me to see $300 a barrel oil and double digit inflation rates (not the core rate, but including food and energy).

With that in mind, you may want to consider inflation-proofing your portfolio over the coming years. Think about companies that can jack up their prices and customers will still pay. Think about commodity producing companies. Be wary of bonds with low payouts or higher risk of default.

It may not happen right away, but over the next several years, get prepared for inflation.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

What's next for the banking sector?

What's made the stock market so jittery lately? Was it oil prices or commodity run-ups? I don't think so. I think what's bugging investors is: will something bad happen in the banking sector?

So far, the banking sector has suffered from defaults on higher risk mortgage investments. Some of these were subprime, some were Alt A (a step up from subprime, but not prime), and some have been home equity loans. All were bad loans and bad investments to begin with.

Because many market participants were buying mortgage investments with other people's money (read: borrowed money), this part of the market really suffered when it became clear that almost no one knew what the mortgage investments they bought were worth.

But, so far, the banking sector hasn't really suffered from major defaults on business loans, credit card loans, auto loans, prime mortgages, etc. In other words, the banking problems that started in March of 2007 have almost entirely been an investment phenomenon, not a broader bank lending problem, per se.

The question now is: could that change? Could the problems seen so far be the tip of a broader loan default problem? Could the economy be rolling over into recession and signaling that loan defaults will increase across the board?

If the answers to these questions are yes, the the problems in the banking sector, and the rest of the economy for that matter, may only be getting started.

Can the Federal Reserve fix these problems? Many people believe they can, but some strong dissenting opinions, even from within the Fed, are starting to question the validity of this premise.

The Fed may control interest rates and be able to bail out banks, but not without cost. The cost, in most cases, is higher inflation. With soaring energy and food prices, this will not be welcome news.

The other problem is that Fed actions are creating moral hazard. When you bail out stupid risk takers, they learn a bad lesson: they either make a ton of money making risky bets or they get bailed out. "Heads I win, tails you lose." This may be leading to even more bad lending and highly levered investing.

What's next for the banking sector?

It all depends on fundamentals at this point. Either banks have made good loans and have enough reserves to weather tougher times, or they don't.

If they don't, then expect the banking sector to hit new lows as more and more news comes out that broader loans--like credit card, auto, business, commercial real estate, prime mortgages--are hitting higher default levels.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The triumph of hope over experience

The Fed bailed out Bear Stearns and now everything is okay. Right? RIGHT???

Wrong.

The Fed bailed out Bear Stearns in a forced marriage to J.P. Morgan because they feared (and still fear) a collapse of our financial system. That isn't good news.

The Fed cut interest rates another 75 basis points, down to 2.25%, because it's trying to re-ignite economic growth. They are more worried about growth than inflation despite surging commodity prices and a tanking US dollar.

Economic reports this week showed worse employment data, worse leading economic indicators, worse business outlook, worse housing starts, worse producer price inflation, worse capacity utilization, worse industrial production, and worse forecast auto sales.

So why did the market rally this week?

The triumph of hope over experience.

The stock market is simply not reflecting economic reality or previous experience with economic slowdowns. Those who believe we'll ride this out without an even 20% decline in the major indexes need to prepare themselves for a bumpy ride.

I'm not moving into a fallout shelter, but I'm also not ignoring a long and vivid stock market history, either. I'm ready for a rough couple of years that will, eventually, be followed by another economic and stock market boom.

This is not the time to think the Fed and Treasury can solve all economic problems (have they ever really succeeded in the past?). This is not a time to expect a mid-cycle slowdown or light stock market downturn. This is the time to prepare for tough sledding.

I'm ready for a downturn, and I'm finding good things to buy. But, I'm not expecting this to be a pleasant or smooth ride!

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

You can't get something for nothing

The market seems to be absolutely focused on the Fed.

Everyone seems to think the Fed has the power to make or break the economy, get lending moving again, support the dollar, etc.

The fact is, the Fed doesn't have that much power. If you don't believe me, go read John Hussman's article on the subject, or read any of his recent weekly commentaries that address the issue.

The thing that surprises me is how many people believe the Fed can take action with no seeming repercussions. As if the Fed could move interest rates, or lend money to banks without any adverse reaction.

The reality is that the Fed can only take action with consequences, just like the rest of us mortals.

When the Fed offers liquidity, they are printing money and creating inflation.

In the long run, the Fed doesn't matter much, although they do have a short term psychological impact on the market.

Even worse than that, the Fed's actions almost always come with some downside, and that long term impact can be profited from by smart investors.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Will the Fed cut rates?

The market certainly seems to think so.

Just look at interest rate futures and you'll see investors are expecting a 25 to 50 basis point cut in the Fed Funds Rate.

Or, more meaningfully, look at the gold market. Gold prices spiked to over $785 an ounce, today.

That's up 17% over the last month and 31% over the last year.

Why does the gold market indicate a cut in the Fed Funds Rate?

Because the Fed does not create growth--they do not possess some magical fairy dust that makes the economy run faster.

The Fed prints money to decrease interest rates. And, when the Fed prints money more quickly than the economy grows, they create inflation.

Gold prices are going up because gold investors believe the Fed will print money, also known as cutting the Fed Funds rate, thus creating inflation.

Gold is going up because investors are guessing the Fed will create inflation by cutting rates.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The Fed's interest rate cut hurts the prudent

For those who think the Fed's recent interest rate cut is an unmitigated good, read Allan Sloan's recent Fortune article titled, "Heads I Win, Tails I Get Bailed Out; The reckless are getting relief from Bernanke. How does that work?"

I've blogged in the past about the moral hazard implicit in the Fed cutting rates. I believe the Fed's large rate cut encourages imprudent risk taking.

But, I didn't highlight how the rate cut hurts the prudent, and Allan Sloan does a great job of that. As Sloan puts it, the "recent interest rate cut has done a lot of harm to those of us who've managed our finances prudently."

The Fed cut rates to calm market turbulence, and this was directed to helping the "players in the biggest trouble," those "who'd taken the biggest fliers in junk mortgages, ultra-risky leveraged buyouts, and other financial esoterica that proved to be malignant."

But, this rate cut not only helped the imprudent, it hurt the prudent. It hurt "those of us who keep score in dollars and didn't need to be bailed out" because we are now "less wealthy than we were in terms of anything other than our home currency."

Why? Because the rate cut "contributed heavily to the dollar's recent sharp drop in the currency markets...and to the price spike in hard assets like gold, silver, copper, and oil." In other words, prudent people's wealth, in terms of dollars, is worth less relative to the things we want to buy with dollars.

Added to this, the rate cut caused long term and fixed mortgage rates up. Once again, this benefits the imprudent who gambled on floating rate loans and punishes the prudent who may be seeking fixed rate loans at what are now higher rates.

Those investors who stayed away from toxic waste and invested prudently are also being punished because the Fed's bailout is helping toxic waste investors to the relative detriment of those who avoided subprime mortgage risks of all sorts (whether bonds, CDO's, stocks, swaps, etc.).

Finally, the prudent get to bail out the imprudent in that our tax dollars will be used to bail out subprime borrowers, subprime lenders (like Countrywide), subprime investors, and the investment banks and rating agencies who should have known that subprime investments were junk.

As Sloan puts it, the Fed's bailout allows the imprudent to play "heads I win, tails I get bailed out" whereas prudent investors get stuck with depreciated wealth, higher fixed rate loans, worse relative investment performance, and a higher tax burden.

If you've been imprudent over the last several years, you probably think the Fed's rate cut is wonderful. But, for those of us who were prudent enough to avoid bad risks, the Fed's rate cut is bad news.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Is the Fed cutting interest rates really a good thing?

It seems like market participants have been wishing, hoping and praying that the Fed will cut interest rates for over a year now. Unfortunately, this may not be a good sign for the market, but a clear signal of worse things to come.

You see, the Fed cuts interest rates not because things are going great, but because they are seeing clear signals the economy is headed for rough waters.

In fact, the stock market has historically dropped around 40% during an average recession, so the Fed cutting interest rates may not be a signal market participants should be cheering about.

Two weeks ago, John Hussman had a brief section on this subject in his weekly Market Comment. He posted a couple of graphs showing how the S&P 500 did during Fed rates cuts that led up to the 2000-2001 and 1981-1982 recessions.

From 2000-2001, the Fed cut interest rates from 6.5% to 1.25%, and yet the S&P 500 tanked around 41.1% over that same period.

From 1981-1982, the Fed cut rates from 20% down to 11%, and yet the S&P 500 tanked around 21.5%.

The Fed cutting interest rates is not a cure-all that makes the market go up. The market does sometime do well because of rate cuts, but not every time.

So, if you've been betting on the Fed cutting interest rates in hopes of making a killing in the stock market, you may want to consider buying short term bonds instead--they will much more likely benefit.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.