Wealth International, Limited (trustprofessionals.com) : Where There’s W.I.L., There’s A Way

W.I.L. Finance Digest :: July 2009, Part 4

This Week’s Entries :


This time the risk is not in the private markets but the public ones.

iTulip.com’s Eric Janszen, major articles from whom were previously featured here and here (see the former for some context-setting on Mr. Janszen), posits that the acute phase of the fallout from the bust of the “FIRE” – Finance, Insurance and Real Estate – economy has based. What lies ahead is a long depression a la the U.S. 1933-World War II or 1989-date Japan. But the U.S. does not have the balance sheet Japan had in 1989 which enabled the country’s financial system to gradually exchange private debts for government debt. So when do we hit the Argentina ca. 2001 threshhold? Therein lies a question.

Janszen concludes: “With the end of the FIRE Economy and the start of the Debt Deflation Era in 2008 we entered an economic and financial market forecasting environment only Kafka could love. Our forecasting perspective since we started in 1998” – which has been “Get out of debt, horde savings in Treasury bonds, CDs, and gold, and do not hold any money in stocks and real estate that you cannot afford to lose for the next 10 to 20 years” – must adapt to this change.

Janszen has warned previously that transition to inflation will be chaotic and untradeable. In other words, if you are not confused you just do not understand the situation. The meter on his “Financial Risk radiation detector,” after dipping near the “Safe” range is back in the red “Unsafe” zone. You are warned. But: “This time the risk is not in the private markets but the public ones.” The ghost of Argentina beckons.

In a nationally televised speech last week, referring to the financial crisis President Obama announced that the “fire is out.” Indeed it is – in the 10-mile wide smoldering crater in the middle of the U.S. economy left by the explosion of a $20 trillion securitized nuclear debt bomb that went off in 2007. First the blast flattened the financial markets, then the “real” economy. Who could have known?
Who do we spy through our periscope poking up from our underground bomb shelter lined with Treasury bonds, CDs, and gold where we hid out from the blast since December 2007? Seven million bewildered formerly employed automobile, finance, and retail trade industry workers wandering the blackened pit, along with millions of mutual fund holders, blinking and stuttering, bombed out 401K statements in hand.

We see White House economic adviser Larry Summers standing by an abandoned, half-finished housing development, or is that an RV town occupied by airline pilots and mechanics on Los Angeles International Airport’s Lot B? He is yelling to us, and any everyone else who is still in one piece financially, that the “worst is over.”

There is Warren Buffett telling us if we do not buy stocks we will “miss the big gains.”

There is Jim Cramer barking his latest hot stock tips, fully recovered from his ear boxing by Jon Stewart just a few months ago, imploring us to buy, buy, buy.

And why not? These guys have never led us astray before, right?

Above us, the sky is dark with vultures. They swoop in waves to buy up foreclosed McMansions in California and Arizona, bankrupt restaurants in Ohio, and mountains of consumer goods – trucks, cars, furniture, televisions, clothing – thrown onto the market by consumers on eBay and Craig’s List desperate for a few bucks.

Is that Mad Max approaching from afar through the heat ripples, government money in hand, to bottom-pick Microsoft stock and put a bid on a vacant strip mall in Las Vegas?

Maybe Buffett is right this time. An economy in such a state can only get better. How can it get worse?

Yet, tapping the meter on our Financial Risk radiation detector, we notice that after dipping near the Safe range the needle is again pegged in the red Unsafe zone.

This time the risk is not in the private markets but the public ones.

Through trillions in bank bailouts and fiscal stimulus our leaders are shifting bad private debts to public account. In the process they substitute one kind of credit risk for another, public for private.

No wonder a Brazilian credit rating agency recently downgraded U.S. Treasury bonds.

Q3 2009 on-time arrivals from previous forecasts
FIRE Economy Depression Quick Review – because if we don’t remind you, you’ll forget

In 2002, establishment economists tell us that no credit and housing bubble exists. We tell you otherwise and warn the bubble will go on for years.

In 2007, these same geniuses admit the existence of a credit and housing bubble but claim that the economic impact of collapse will be inconsequential, that no economic recession will result. We warn in 2006 that the crashing housing and securitized debt bubble will lead to a Great Depression class recession starting in Q4 2007.

Today, the rocket scientists opine that the economic catastrophe, brought on by conditions they previously failed to see, will end like a bad dream and be replaced by a new cycle of borrowing for consumption and financial speculation, if only we click our heals together and collectively chant “There’s no place like 1999.”

(For an independent analysis of our methods for forecasting the FIRE Economy Depression starting in Q4 2007 and Debt Deflation Bear Market in 2008, see “No One Saw This Coming”: Understanding Financial Crisis Through Accounting Models, Dirk J. Bezemer, Groningen University, 16 June 2009.)

“Buy stocks” broken record is back on the turntable

Warren Buffett, the world’s best stock picker and worst macro-economic forecaster weighed in Friday [July 24] with the assessment that the economy is still a mess but, as he said in 2007 and never stops saying, staying out of the stock market until recovery is clearly evident will cause investors to “miss the biggest gains.”

Such as in his investment in Goldman Sachs, for example, arranged last year by Hank Paulson.

With the S&P leaping 40% since March 2009 when we noted the First Bounce of the Debt Deflation Bear Market, it appears that everyone agrees with Buffett, especially the poor shorts whose covering turned a garden variety relief rally financed by fund managers into a runaway excess liquidity freight train.

The latest meme making the rounds: A full bore recovery is six to nine months way, and the stock market is now pricing it in.

“Recovery” is a big word. To most, it means a return to “normal,” an economy 71% driven by consumer spending, half of it debt financed. The economy bulls like Cramer are not just talking about an end to desperate selling of the family jewels to Cash4Gold to pay mortgage, auto, student loan, medical or other economic rents from the FIRE Economy that consume household income and savings. No, they mean a full-blown regression to the good old days: Eating out three days a week, a vacation in Europe, buying a new car and a second home, all on credit. The fantasy life of middle class Americans.

But the U.S. economy will never revert to its pre-crash past, based as it was 30% on financially engineered credit expansion and 70% real, based on productivity growth. While that does not lead us to a forecast of soup lines and dust bowls, it does not mean happy days are here again, either.

Recession ends, depression begins

The Great Depression did not end when the economy stopped shrinking in the first quarter of 1933, after contracting in real terms by 27% over the previous three years. At the time economists heralded the event as the end of the depression. In fact, they were less than a third of the way through the 10-year period between 1930 and 1940 that came to be known as The Great Depression.

Real GDP grew by 33% in the next six years that followed, but the economy needed 54% growth just to get per-capita GDP back to where it was in 1929, 10 years earlier.

Even after expanding by a third over 6 years from the official end of the Depression, unemployment in 1939 exceeded 17% and did not decline to pre-Depression levels until 1943, three years into the war. Most historians mark the end of the Depression at the start of WWII.

Today, with the benefit of hindsight, no one claims that The Great Depression ended in 1933. Likewise the Japanese figured they were out of the woods in 1993, but 16 years later the Japanese economy still has not fully recovered, and recently took a major hit.

Debt deflations are like that.

Several years from now, no one will say that the FIRE Economy depression ended in Q3 2009, either.

The acute crisis phase of the FIRE Economy Depression is over. However, the FIRE Economy Depression will go on for many years in its own unique way.

A sharp economic contraction caused by the mass extinction of the purchasing power of private credit that followed the securitized debt bomb explosion of 2007. That acute crisis phase of the FIRE Economy Depression is over.

By the end of the first half of 2009 reverberations from that detonation died down to a dull, distant rumble. Surveying the scene we see that many areas of the economy, by geography and industry sector, suffered permanent blast damage.

By the end of the year you will hear an official announcement by the National Bureau of Economic Research that the national recession that started in Q4 2007 ended in Q3 2009. This will signify that GDP stopped declining on a quarterly basis year over year in nominal terms. However, the FIRE Economy Depression will go on for many years in its own unique way. National echo recessions are likely, and ongoing contraction in areas of the country and particular industries is guaranteed.

Not as bad as The Great Depression, not as good as 1983, like Japan 1992 to 2009 but without the cheap manufactured goods.

There is no question that this time around the U.S. economy did not experience the degree of demand destruction that occurred in the early 1930s. The Fed and Treasury in 2008 were also far more aggressive than the Bank of Japan in 1992.

Government spending intervention did work to prevent the incredible scale of economic mayhem that occurred in the three years of after the crash of 1929 when nearly 40% of the banks failed and millions of depositors lost their savings. Yet anyone who expects that the end of economic contraction will be quickly followed by a sharp V shaped recovery will be disappointed. Recession attended by debt deflation, or “balance sheet recessions” as they are called by some economists, tend to drag on and on.

Irrational Recovery Exuberance

U.S. stock market investors are throwing money at the self-sustained economic recovery story, and a short squeeze is driving up stock indexes sharply.

As signs of the short term economic recovery are mistaken for organic economic growth, we will see more stories like this one, imploring the Fed to raise interest rates before inflation takes off.
Raise Rates Now! Fed Risks “Major Bout of Inflation,” Economist Warns

Posted July 22, 2009 (Aaron Task – Tech Ticker)

Ben Bernanke is right to talk about exit strategies but risks a “major bout of inflation” by waiting, says Brian Wesbury, chief economist at First Trust Advisors.

In fact, were he Fed chairman, Wesbury would be raising rates now – as in today – rather than waiting.

Contrary to popular belief, Wesbury does not believe a little inflation is a “good thing” and says Bernanke and certain members of Obama’s economics team are too worried about the Great Depression.

Also contrary to popular belief, Wesbury does not believe rate hikes will kill the economy, which he views as being much stronger than the consensus, as we’ll discuss in a forthcoming segment.
The Fed has never raised interest rates following recession until after unemployment has declined for at least six months. The Fed is wired with Non-Accelerating Inflation Rate of Unemployment (NAIRU) neoclassical economic orthodoxy to believe that inflation is impossible if unemployment is rising.

Unemployment is still rising and will continue to rise before finally leveling off in Q4 2009.

The Fed will not raise interest rates because the Fed believes in NAIRU. While they wait for high unemployment to magically fight inflation for them, they will stall by hiding inflation for 6 to 9 months the usual way, behind changes in the composition of inflation indexes, substitutions of lower for higher cost versions of goods (e.g., hamburger for steak), and other tricks of the trade. But you will see it, in food prices especially.

iTulip on Inflation: “Inflation is always and ever a political phenomenon.”

The primary long term risk that we have discussed here at length is that fiscal stimulus will not produce a self-sustained recovery, that additional stimulus will be demanded by politicians, and that the U.S. may run out of foreign credit before it gets even two years down the path of moving debts from private to public account that Japan has followed for nearly 20 years. The risk is heightened by the fact that America’s IMF, China, is itself a bubble economy (see Does USA 2009 = Argentina 2001? Part I: Falling economy reaches terminal velocity).

No Next Bubble

Now it appears that re-inflation policy will not create a Next Bubble in Alternative Energy and Infrastructure to bail us out of the crash caused by the Housing Bubble (see The Next Bubble); the U.S. will have to recover the old fashioned way, via saving and investment.

Do we have time?

In January we estimated a 25% decrease in income tax receipts nationally for FY 2008. The actual decline: 26% nationally.

Where will the federal government get the money to cover stateswt unemployment insurance costs?

Where will the federal government get the money to finance a second stimulus program?

If not from foreign borrowing or taxes, where will the money come from?

If from taxes on capital, what will drive future productivity gains that will create organic growth?

If you believe that the economy is neither in the early stages of organic growth nor about to experience a next bubble, a bullish scenario for stocks is hard to conceive.

If you believe that the economy is neither in the early stages of organic growth nor about to experience a next bubble, a bullish scenario for stocks is hard to conceive. By the same token, the forecast for [U.S. federal] fiscal deficits and the dollar are equally bleak.

Where will we get the money? The usual place.

Lower per-capita real GDP translates into lower living standards, especially for the bottom 50% of the net worth group that went into this with little or no liquid net worth.

When we started posting our distribution of income, debt, and net worth charts back when we reopened in 2006 many readers thought we were making some kind of socialistic point about how unfair the distribution is.

In fact, every time we posted these charts we made the point that in the coming economic depression, the majority who have little savings to fall back on and most of the debt will need the government to bail them out at a time when tax receipts from that group evaporate due to rising unemployment and falling incomes.
Our question: Which economic group will government go after for money to pay unemployment benefits and other economic disaster support?

Our forecast: Lousy distribution of wealth in boom times means high taxes on capital and wealth redistribution during busts. It has always been so throughout history.

Our fear: Wealth redistribution becomes structural. Then we are sunk.

The lesson: In the future boom aim policy at the wealth distribution problem so it would cause the usual backlash later. That means get rid of the rent seeking FIRE Economy and focus on productive enterprise.
Now what?

FIRE Economy Fallout – Part II: Theme Change

For those among you who have been following my forecasts over the years, my purpose in warning you about this depression since 2005 was to give you time to prepare, especially those of you who have children. Long, drawn out periods of economic hardship are tough on kids in profound ways.

But that was then.

The iTulip theme before the depression: Get out of debt, horde savings in Treasury bonds, CDs, and gold, and do not hold any money in stocks and real estate that you cannot afford to lose for the next 10 to 20 years.

With the end of the FIRE Economy and the start of the Debt Deflation Era in 2008 we entered an economic and financial market forecasting environment only Kafka could love. Our forecasting perspective since we started in 1998 must adapt to this change.

Five main challenges define our forecasting task going forward, now that the FIRE Economy Depression is here:
  1. FIRE Economy legacy debt taxes the cash flows of struggling business and households
  2. Chronic high unemployment and under-employment as debt finance-based industries shrink or fade away but before labor markets retool to meet new national and global production needs
  3. High energy costs due to Peak Cheap Oil
  4. Dysfunctional political responses to challenges one, two, and three
  5. Dysfunctional financial market response to the dysfunctional political responses to challenges one through four
The iTulip theme from here on out: pace ourselves and stay attuned to changes that create tactical opportunities. This will not be an environment for buy and hold, nor for placing large bets in any one area.

To get the full text of Part II one must subscribe to Mr. Janszen’s service.

Selling to the Debt-Averse Consumer

Promoting value and utility over luxury and brand.

This Eric Janszen piece appeared in the most recent Harvard Business Review. With thriftiness now mandatory rather than an optional virtue, how to win over the newly tightfisted consumer market? “[C]ompanies will need to follow the path of firms that succeeded in previous downturns by promoting value and utility over luxury and brand. Consumers ... will react positively to marketing that allows them to feel their newfound thriftiness is a lifestyle choice rather than a constraint imposed by the economy. Messages that center on family, life simplification, and getting back to basics will appeal.”

The successful consumer-oriented companies in coming years will be those that can figure out how to make do without the former life of the economic party: the monthly payer.

In his heyday, this kind of consumer asked himself not whether he could come up with the whole cost of a vacation or landscaping or a car but whether he could afford the resulting increase in his monthly bills. His answer was invariably yes. He was a creation of the no-money-down and low-interest incentives that proliferated in the FIRE (finance, insurance, real estate) economy over the past 25 years.

In his 1939 book Business Cycles, Joseph A. Schumpeter predicted trouble whenever a load of debt was “lightheartedly incurred by people who foresaw nothing but booms,” and he was right. Now that the credit and housing bubbles have collapsed in the United States and around the globe, the era of unbridled, debt-financed consumer spending is over, and the monthly payer is out of action.

To win over newly tightfisted, debt-averse consumers, companies will need to follow the path of firms that succeeded in previous downturns by promoting value and utility over luxury and brand. Consumers will not be able to buy as many goods as before, but they will react positively to marketing that allows them to feel their newfound thriftiness is a lifestyle choice rather than a constraint imposed by the economy. Messages that center on family, life simplification, and getting back to basics will appeal.

Will the monthly payment consumer ever come back? The Federal Reserve wants to reinflate the credit bubble and engineer a return to the old days. But that is not possible. When a nation’s businesses and households take on too much debt and the economy stumbles, the cash flow needed for financing dries up, defaults rise, and a vicious cycle of falling incomes, asset prices, and collateral values begins. That cycle ends only when asset prices, debt levels, and incomes get back into balance. Misuse of consumer credit is gone for good.


Bernanke errs again, as he disregards unfolding asset bubble risk by promising to maintain the Fed’s current ultra-loose monetary policy stance for an “extended period.”

News of Bernanke’s headline promise brings to mind a question: Was he born stupid and naïve or did he have to work at it? Bernanke is most assuredly well acquainted with the “rational expectations” school of economic thought, which in its strong form theorizes that markets learn to anticipate government policy (with a mean error of zero) and thereby render it useless. So why would he telegraph his intentions to traders, who could care less about the Fed’s intentions as long as they can profit from its actions, and are likely to create more problems than they solve? It is akin to a party host announcing in a loud voice that unlimited punch will be supplied no matter how many people get drunk and pass out.

Whatever. The promise amounts to a “whatever it takes to get the bubble economy going again” announcement. But the current bubble, the government finance bubble, is, in Doug Noland’s opinion, the most dangerous one yet. A global reflation is taking root, and the critical questions are how quickly inflationary pressures will reemerge and how soon foreign central bankers will begin feeling the heat. “All eyes on China.”

Chairman Bernanke committed another mistake this week. Removing monetary stimulus before inflation takes root was the focus of both his Wall Street Journal op-ed piece and this week’s congressional testimony. While I consider inflation to be a risk, it is definitely not the dominant systemic risk in play these days. Continuing its now traditional approach, the Federal Reserve is content to disregard unfolding asset bubble risk. Today’s bubble inflates rapidly throughout government finance – more specifically the enormous Treasury, agency debt and GSE MBS marketplace.

The most dangerous bubble yet, with the Fed once again the designated enabler.

Actually, Dr. Bernanke did worse than ignore bubble risk. The markets were promised the Fed would maintain its current ultra-loose monetary policy stance for an “extended period.” This is the same type of policy commitment that fostered speculative bubbles in mortgages, housing, private-label MBS and CDOs. The Fed today is determined to peg short rates and market yields. Sure, there are obvious short-term reflationary benefits to such an approach. But such an endeavor also nurtures speculation and leveraging, especially in the Bubbling Treasury, agency and MBS markets. From my perspective, this is the most dangerous bubble yet. It is addressed by no one.

I do appreciate that the Bernanke Fed has spent considerable time contemplating how to remove the past year’s unprecedented monetization. In a normal environment it would matter. But extraordinary circumstances would seem to completely rule out the possibility of Federal Reserve tightening. The risk of bursting the government finance bubble is too great – and will become only greater. With Treasury, agency and GSE MBS now accounting for the vast majority of system credit creation, economic and credit system “recovery” would be stopped dead in its tracks by a surprising jump in market yields. The Fed has, once again, delegated itself to the role of bubble enabler.

Tuesday, Bloomberg News went with the headline “Treasuries Rise as Bernanke Sees Limited Inflation ...” The Sydney Morning Herald captured the true underpinnings of the Treasuries’ big gain: “Bernanke to Keep Easy US Credit Policy.” Dr. Bernanke did a nice job showcasing his inflation-fighting toolkit, although the markets really just needed reassurance he is not going to back away from aggressive reflation anytime soon. And, here we are again, with Fed actions becoming a significant factor shaping/distorting market perceptions – hence the pricing and flow of finance throughout the economy. This becomes a critical dynamic with respect to the unfolding “government finance bubble” because this credit dynamic is capital markets driven (market perceptions of returns on securities dictating credit expansion).

With U.S. inflation well in check, a strong bullish consensus sees prolonged loose monetary policymaking ensuring low and stable bond yields indefinitely. There is today a tremendous amount riding on this market view. At the same time, it is difficult to envisage a financial system and economy more acutely vulnerable to a spike in yields. How could the sanguine consensus view on rates be wrong?

It appears that global reflationary forces have reached critical mass.

First of all, it appears that global reflationary forces have reached critical mass. China and Asia are bouncing back. Loose financial conditions throughout the developing markets appear poised to spur robust economic recovery. Two important unknowns are how quickly inflationary pressures will reemerge and how soon foreign central bankers will begin feeling the heat. All eyes on China.

I am struck by a market disconnect. Each passing year finds market and economic forces increasingly globalized. Yet the view regarding favorable prospects for the U.S. fixed income market seems to be driven by favorable expectations of U.S. inflation and U.S. monetary policy. For the markets, Bernanke trumps international forces. The dollar hardly matters. And globally, the view seems to be that low U.S. market yields will continue to anchor global yields. But with financial and economic power having shifted markedly overseas, will there come a point in time when global factors play a much more significant role in determining our market yields. Has the Fed commenced a game of tug-of-war?

With the Fed locked into monetary ease no matter what its power is waning.

Listening to Chairman Bernanke this week, I could not help but contemplate the prospect of waning Federal Reserve power. And I am not referring to regulatory power over our financial institutions. As I see it, the Fed is now locked into permanent monetary ease. They have let another bubble get away from them. Resulting dollar devaluation traps the U.S. economy into a more inflationary backdrop. Meanwhile, the dynamic of massive flows of outbound dollar liquidity, coupled with unconstrained developing-economy credit systems create powerful inflationary dynamics globally.

It would make sense to me that global forces increasingly tug U.S. yields upward. And we will have to wait and see how much the Fed is willing to use its balance sheet to try to tug them back down. Bernanke would clearly prefer to talk rates lower. It will be interesting to see how long talk suffices.


The State of California is attempting to overcome its budgetary problems by sticking it to the cities and towns. But even that is not working. Nor is Enron-style accounting. Will California’s problems ripple into the national economy? In the end it may be a matter of semantics. The U.S. has its own big enough problems. But in both cases the same counterproductive actions being taken assure that any recovery will be strangled in the crib.

We had better hope not, since the state’s economy is imploding so swiftly that it threatens to take cities and towns from Eureka to San Diego down with it. Consider the plight of El Monte, a city of 125,000 in Los Angeles County that recently cut expenditures to the bone in order to close a $9.5 million budget gap for the fiscal year begun in July. Working frantically against an inflexible deadline, local officials furloughed most of the city’s 375 workers, laid off 17 police officers and closed down an aquatic center for all but four months of the year. Then they got the bad news: Sacramento will not be sending them $2 million in gasoline taxes they were counting on. And that is not all: The state will be taking even more revenues from El Monte, but the city will not know how much until the legislators get their own house in order. “It’s devastating,” city manager Jim Mussenden told a reporter for the Wall Street Journal. “We’ve already worked very hard to reduce our budget, and now we will have to look at more cuts.”

Redlands, also in Southern California, is taking similarly dire measures to balance its $50 million budget. After cutting $5 million of outlays through June, the city of 70,000 is looking to save another $5 million by opening libraries just two or three days a week, closing some senior centers, asking volunteers to maintain parks, and furloughing employees for 10 days. In addition, Redlands is going to leave 15 positions unfilled on the city14s 83-officer police force. “This could really push us over the edge,” a city spokesman told the Journal.

L.A. Short-Changed

Big cities are getting hit just as hard. Los Angeles officials said they expect to lose about 2,300 construction jobs because the Community Redevelopment Agency will not receive $72 million that had been anticipated. The agency has a $688 million budget, according to the Journal, but most of it reportedly is earmarked for debt service on projects already under way. Things are just as bad in Northern California, where, for instance, Solano County has cut $100 million from its $1 billion budget, in part by laying off 200 employees. Now the county is looking to lay off another 10% of its 3,000 workers in anticipation of rapacious state raids on its funding. “The problems caused by the state’s mismanagement are now being handed down to cities and counties, which is just wrong,” a Solano County supervisor told the Journal.

Ranked as a country, California would boast the 6th largest economy in the world. Should we be worried, then, about a ripple effect across the U.S.? Not according to Steve Levy, director of the Center for Continuing Study of the California Economy. “It is a $26 billion issue in a $12 trillion [U.S.] economy,” he said. We think Levy will be wrong on both counts, since California’s problems are metastasizing even as the U.S. economy continues to shrink. Like policymakers in Washington, D.C., officials in Sacramento are counting on a resurgence in growth to balance the budget. But in both cases, taxes are slated to rise to levels that will all but asphyxiate any recovery that could conceivably cause revenues to uptick.

Postponing Disaster

Moreover, neither Sacramento nor Congress has faced its fiscal problems squarely. At the national level, a massive bailout effort has produced windfall profits for a few big banks but no measurable pick-up in economic activity. And in California, desperate attempts to balance a budget $26 billion out of whack have merely postponed disaster. In fact, much of the balancing has been done on a fulcrum of lies. Paychecks totaling $1.2 billion have been deferred into the new fiscal year, and $1.7 of income-tax withholding has been accelerated. These shenanigans all but guarantee that California will be mucking in deficits for years to come. Under the circumstances, any federal stimulus money that comes the state’s way is going to have about as much effect as food stamps raining down on a blighted neighborhood.


Above all, there are the two overriding reasons to own gold – one fundamental, the other technical.

In this next installment of Chuck Cohen’s series on investing in gold on Rick Ackerman’s website, he starts to make the case for junior mining shares. In normal times trading these shares are best left to specialists – a mine is a hole in the ground dug by a liar and all that. The industry itself is indeed full of crooks. Converting cash in investor’s pockets to cash in yours for the price of telling a story is a great business – for the insiders. The mining companies burn through capital at a prodigious rate, and if a company is by some small chance successful you will likely find yourself diluted when it comes to the market for more funds. We suspect, and we are not alone here, that as with with the airline industry the total amount of profits ever generated by the industry as a whole is negative.

These are not normal times. It is time to find a source of advice you trust and step up to the plate. If gold goes to the moon the junior mining shares will go to Alpha Centauri. Gold is back trading near its high while junior shares have yet to fully recover from last year’s general financial debacle. The time is right.

Very few Americans own gold in any form. Even though gold’s price has risen each year since 2001, about the only time we hear gold mentioned is in the ubiquitous “cash for gold” TV commercials. Don’t you wonder who has any gold or jewelry left to sell? The way it is shunned, you might think gold causes swine flu or greenhouse emissions. It is most baffling to me to see our profligate nation diligently avoiding the most rewarding investment of the last decade.

Under the circumstances, it is hardly surprising that only a miniscule number of investors have ever ventured into the most speculative field of gold, the exploration companies. These small and unproven companies might have market capitalization of anywhere from $5 million to over $200 million. Some contain proven reserves, while some are still searching for the mythical El Dorado. But even to many gold experts and believers they remain intensely speculative and risky, perhaps leaving you to wonder, why bother?

Here are some of the reasons often given for avoiding them. They Mine Money

Now there might be some truth in these claims if these were ordinary times. But just consider that if you had applied these same arguments in the early 1990s, you would have missed out on the greatest speculative binge of our time – the technology-stock boom. (Actually, most of us did miss it.) Few except for the true techies and the entrepreneurs who ran these companies really believed that these start-ups would ever succeed. But the shares of many of them increased in price 100-fold before the mania ended.

And that is what I expect this time, though to an even greater degree, since these companies are mining “money” in its most pristine form, and the wind is at their backs. Many will be virtual mints in a time of incredible paper currency turbulence and destruction. Yes, they are speculative, but I like the odds. Here is a very fundamental point in investing: The greatest gains have been in those investments that were shunned the most. As Mr. Buffett – Warren not Jimmy – likes to say when asked about his success, “I buy when everyone else in selling and sell when everyone is buying.” [A related quote is: “I am greedy when everyone else is fearful, and fearful when everyone else is greedy.”]

Pac-Man Effect

Further details concerning these stocks and a sound investment strategy will be coming up next week. For now, though, you should know that: Some Stocks to Consider

Above all, there are the two overriding reasons to own gold – one fundamental, the other technical. Concerning the former, the monetary landscape and the certainty of more and more fiat money will keep the gold fires burning brightly. As for technical reasons, on the charts, gold has been consolidating for years to launch into a parabolic rally.

For your consideration, here are some specific stocks that I like: San Gold (OTC: SGRCF); Detour Gold (OTC: DRGDF); Mauodore Minerals (Vancouver; MAO.V); Golden Predator (OTC: GPRXF); Pediment Gold Corp (OTC: PEZGF); Great Basin Gold Ltd. (AMEX: GBG); Skygold (OTC: SKYVF): Moneta Porcupine (OTC: MPUCF); Midway Gold Corp (OTC: MDW), and Evolving Gold (OTC: EVOGF). There will be others that I plan to discuss shortly.


Russia, the ugly stepsister of emerging economies, has plenty of promise for those who can stomach the wild ride.

The Russian stock market is sufficiently cheap that, in the words of this Forbes article, “you might make profits in this casino, and you might, conceivably, be able to get them out before they are stolen or devalued.”

Well put.

Russia’s economy contracted 10% in the first quarter of 2009, driven down by weakening commodities prices and a 24% collapse in manufacturing output. Economics Minister Elvira Nabiullina recently said Russia’s GDP might fall as much as 8% this year.

For fans of the Wild West stock market in Moscow, a recession is just a little blip to shrug off. Indeed, stocks in the world’s 8th-largest economy are among the best-performing in the world so far this year. In U.S. dollar terms the Russian Trading System Index is up 40% since January 1 and 78% from its January 23 low.

‘Have a crisis in the U.S., and it is really a crisis. People are not accustomed to it,” says John Derrick, director of research at U.S. Global Investors, a San Antonio, Texas firm that manages $2.1 billion in 13 funds. “In Russia there is a different mentality. Crises are just part of the cycles of the last 20 years.”

In mid-June, even after the run-up, stocks were trading at a mere 7 times estimates of 2009 reported earnings. Brazil’s P/E at that point was 14, India’s 16 and China’s 19. Why the steep discount in Moscow?

“There is a certain level of distrust from a good portion of the international investing community,” says Derrick. “They think the Russian market is a commodity-trading vehicle, not a long-term investing vehicle.”

A vehicle for property rights tramplings, abysmal corporate governance and currency devaluations?

Or they think it is a vehicle for property rights tramplings, abysmal corporate governance and currency devaluations. Since August 1998 the ruble has fallen 81% against the dollar. In May net portfolio investment in Russian funds from overseas was 1/10 of that into China and 1/6 the amount entering Brazil, despite Russia’s superior market performance.

Liam Halligan, chief economist at Prosperity Capital Management, a London firm overseeing $2.8 billion in the Russian market, sees things differently. “Corporate governance is a major risk when investing in Russia, but the political and macro risks are massively overstated, particularly in America,” he says.

Halligan notes that Russia sits on some of the world’s richest veins of natural resources – oil, gold, iron ore – and expects them to rise in value as a flood of Western currencies unleash global inflationary pressures. Russia’s stock market capitalization, at $484 billion, is valued on par with Pakistan’s or Jordan’s. To Halligan it is insanely cheap.

Russia’s foreign exchange reserves, $404 billion in May, are the world’s 3rd largest, after China’s and Japan’s. Russia’s net debt – private and government – totals only 40% of GDP, versus 380% in the U.S. From mid-February to mid-June of this year the ruble, which collapsed during the late 2008 global financial panic, has risen 13% against a dollar-euro basket.

What about the Russian judicial system’s rough treatment of Western investors? It is a concern. Norway’s Telenor was recently ordered to pay $1.7 billion in damages in an apparent power play over the VimpelCom mobile phone franchise. TNK-BP, Russia’s 3rd-largest oil company, is a joint venture between Russian’s TNK and Britain’s BP. Last year the tycoons behind TNK played Russian hardball to oust the BP-appointed boss of the joint venture. The parties have since negotiated a truce – of sorts – and TNK-BP’s preferred shares, aided by the rebound in oil prices, are up 63% this year. Prosperity Capital, TNK-BP’s largest minority shareholder, figures it will produce $4 billion in net profit this year on a consensus revenue forecast of $27 billion. Its current 15% dividend yield makes it the highest dividend payer among Russian oil and gas producers. TNK-BP trades at four times those expected profits.

The retail funds in the table below are heavily invested in Russia. U.S. Global’s Derrick believes that the Russian market will eventually rise to 10 to 12 times earnings, suggesting a further 35% to 60% appreciation, if the recession does not get in the way. So you might make profits in this casino, and you might, conceivably, be able to get them out before they are stolen or devalued.


To hedge against the Big One, buy an exchange-traded hurricane contract.

Capital markets thrive on information and uncertainly. Hurricane season certainly brings a lot of uncertainty, but information has been missing – truly useful information that is. The tradition category 1 through 5 measure of hurricane strength turns out to be woefully inadequate for assessing a storm’s damage-causing potential. The measure is based solely on wind speed, whereas other parameters such as storm diameter are very important as well.

Enter the CHI measure, created by risk-modeling consultancy Eqecat, which uses both storm wind speed and size to quantify a storm’s potential to inflict losses. A futures contract based on this improved measure started trading on the Chicago Mercantile Exchange last year. So far the primary buyers are insurers or oil companies with rigs operating in the Gulf of Mexico, i.e., parties subject to real risk. What a concept! Contract sellers have been speculators willing to take on the risk. Some of their risk can be laid off by going long natural gas.

This kind of innovation shows financial markets at their best, with risk-takers looking to profit from assuming risk from those who are willing to pay a premium – probabilistically speaking – to lay off the risk. And it looks like that cost is cheaper than going to a specialist insurer like Berkshire Hathaway. This will be interesting to watch.

Despite a quiet hurricane season so far, the capital-starved insurance industry remains nervous. Hurricane Ike caused $11.5 billion in damage last year. State Farm, Florida’s biggest home insurer, announced it will phase out its 1.1 million policies there. Florida’s state catastrophe fund is supposed to provide $28 billion in reinsurance but has only $10 billion. Reinsurance rates are up 30% this year. It was not this tough even after the $24 billion bill from September 11 or the $60 billion bill from Hurricane Katrina.

Is there a better way for insurers to off-load risk onto the capital markets? Here is one small solution that is gaining traction: Last year the Chicago Mercantile Exchange saw the first trading in futures contracts tied to something called the CME Hurricane Index, or CHI. Buyers put up some $10 million in premiums for contracts with $100 million in notional value. Contracts expire at the end of each hurricane season. Interest is up this year, with $40 million in notional value outstanding so far. [Do they mean $40 billion?]

As of mid-June a contract that would pay out $10,000 if a Hurricane Katrina-size storm hits the Gulf Coast by December 31 costs $700. Protection from an Ike-size storm hitting Florida costs $3,800. Why the price differential? Probabilities. Monster storms like Katrina are rare, while Florida gets hit often.

So far primary buyers are reinsurers or oil companies seeking to protect rigs in the Gulf of Mexico. But hurricane-prone areas like Florida’s Dade County are exploring them, and the contracts could even work for homeowners who have seen insurance rates soar on oceanfront mansions. A minimum trade is 20 contracts. Hedge funds are the main sellers of insurance protection.

The hedgies would not be willing to take on this risk if not for the CHI, which employs a new method of categorizing hurricanes, using both wind speed and size to quantify a storm’s potential to inflict losses. It is a huge improvement over the Saffir-Simpson scale, which ranks hurricanes 1 through 5 solely on wind speed but is close to useless in predicting damage. Ike was only a cat 2 on Saffir-Simpson, but its 240-mile diameter made it the second-most-costly storm in a decade. Ike rated 9.9 (Katrina scored a 19) CHI points. Eqecat, a risk-modeling consultancy, calculates storms’ index values for the CHI, using data from the National Hurricane Center.

Contracts come in a variety of flavors. You can get coverage against a storm of specific size hitting one of seven geographic areas. Or you can bet on the severity of the season. Convinced that four Ike-size storms are brewing? You might buy a “seasonal aggregate 40” contract – $2,500 premium for a payout of $10,000 when the CHI values of the season’s named storms surpass 40 points.

Then there are contracts tied to individual storms. Trading in these will pop when Ana, Bill and Claudette (this year’s names) form. CHI values and contract pricing for name storms will be updated constantly until the storm has made landfall. Trading will continue until the contracts settle, usually within 36 hours of landfall.

Kendall Johnson at Tradition Re, an interdealer brokerage that has so far handled 100% of the Merc’s hurricane trades, says that a common trade is for a hedge fund to sell hurricane call options to a reinsurer or an oil company, then use the premiums to buy out-of-the-money calls on natural gas, which tends to spike in price when a hurricane sweeps the gulf.


This bank is rolling in dough again. Will some flow shareholders’ way?

“Socially responsible investing” has typically referred to the practice of avoiding the stocks of companies who profit from tobacco, gambling, alchohol, war-making machinery, and whatever other businesses and activities the money manager or invester deems shameful. To our mind the money center banks and big Wall Street investment banks should be added to any such list. They steal money from everyone else via their political connections. Give us Philip Morris, Barcardi or Bet-the-Baby’s-Milk-Money-Online.com any day of the week.

Besides the amorality of their modus operandi, investment bank managements have a habit of helping themselves to outsized portions of company profits during good – and not so good – times. As the saying goes, an investment bank’s assets “walk out the door each evening.” They also like to walk off with the shareholders’ money. This tendency along with the inherent volatility of the profit stream and the hyper-leverage involved results in the market assigning low earnings multiples to investment banking company stocks. Forewarned is forarmed. So ... never ever buy the suckers? Depending on how “socially responsible” you choose to be we supposed they are bargains at, e.g., two times earnings. Heck, maybe even three.

Having said all this, it is somewhat interesting and probably useful to track the shenanigans of the IBs. They are among the most politically powerful companies in the world. This Barron’s update on the biggest and baddest of them, Goldman Sachs, is one such update. At 1.5 times book value and over 9 times 2009 estimated earnings we are not buyers even while possessed by our soulless alterego.

The money machine that is Goldman Sachs is humming again just a few quarters after the firm’s existence was briefly in doubt following Lehman Brothers’ collapse.

Goldman last week reported $3.4 billion in net income for the second quarter, its strongest showing ever. Stripping out a one-time preferred dividend related to the firm’s repayment of its $10 billion government TARP investment, Goldman earned $5.71 a share, up from $4.58 in the second quarter of 2008.

Late Friday afternoon [July 24], Goldman (ticker: GS) was around 157, up 10% on the week. Barron’s was bullish on Goldman and Morgan Stanley in a March 16 cover story, arguing that both firms had ample capital and were benefiting from weakened rivals. Goldman is not the bargain it was then when the stock traded under 100, but it could rise to $175 to $200 in the next year if the firm can continue to post quarterly profits of $4 to $5 a share, analysts say.

Amazingly, Goldman said that the outsized trading profits that powered its results did not stem from large proprietary trading positions in the sharply improving credit and stock markets. On the firm’s conference call, Chief Financial Officer David Viniar insisted that Goldman earned the vast bulk of its trading profits from simply making markets for customers at a time when many former rivals are gone or have scaled back their trading operations. “Virtually none was based purely on spreads tightening and inventory mark-ups,” Viniar said. Given Goldman’s limited financial disclosure, Viniar’s statement cannot be verified.

Some things do not change: Goldman is on course to pay each of its 29,400 employees a stunning average of $770,000 in 2009.

Known for its excessive pay packages in good times, Goldman is back to its old ways despite criticism from Washington that it is unseemly for the firm to dole out so much money so soon after a financial crisis produced a vast federal backstop that guaranteed the firm’s survival. Goldman is on course to pay each of its 29,400 employees a stunning average of $770,000 in 2009 based on money set aside so far this year. The $770,000 figure does include items like payroll taxes and health benefits, but the vast bulk is in cash and equity compensation. During 2007, its most profitable year, Goldman’s compensation was about $720,000 per employee before falling about 50% last year.

No major companies appear even close to Goldman in average compensation. A highly profitable JPMorgan Chase (JPM), which competes against Goldman in areas like trading and investment banking while running a huge commercial banking operation, is on course to pay its 220,000 employees an average of $130,000 this year.

Shareholders have not always been well served by Wall Street’s generous pay policies that have set aside 50% of profits for employees. While staffs at Lehman Brothers and Bear Stearns did wonderfully for many years, the firms ended being undercapitalized in a crisis and shareholders ultimately got a pittance or were wiped out.

In the first half of 2009, Goldman set aside about 49% of pretax profits in compensation. It is a good bet, however, that Goldman will set aside a lower percentage of profits for compensation in the second half of 2009 because the absolute pay levels are so high. That was true in 2007, when Goldman paid out 44% of profits in compensation after cutting the ratio in the final quarter.

Goldman says it does not adhere to any fixed ratio of pay to profits. The firm’s approach is to pay competitively to keep its best people – including traders, investment bankers and quantitative types. Yet given the depressed state of Wall Street, it seems a stretch that Goldman needs to set aside so much for employees.

One alternative would be for Goldman to pay employees less – say 40% of profits – and retain more of its earnings for shareholders. That way, the chances of Goldman needing any government backstop would become more remote. If more profits were retained, Goldman’s shareholder equity would expand more rapidly and that could boost the stock, although more employees might leave.

This idea probably will not sit well with Goldman and the rest of the Street. Do not expect compliant boards of directors to act for change.

Some believe Goldman now is overcapitalized, and it is under pressure from some analysts to repurchase stock. [That is truly insane.] Goldman’s Viniar resisted such suggestions on the conference call, saying the firm needs to husband capital in a still-difficult economic and financial climate.

Roger Freeman, the brokerage analyst at Barclays Capital, says investors are wrestling with several issues in evaluating Goldman: “Do we get multiple expansion from here and if so, when? Can Goldman trade for meaningfully north of 1.5 times book and can it consistently earn a return of equity of 20% or better?”

Goldman now trades for 1.5 times its second-quarter book value of $106 a share after earning a 23% return on equity in the period. Freeman believes Goldman is starting to “bump up” against a price/book ceiling and that it will be tough for the firm to regularly top a 20% ROE with a much greater equity capital base. He thinks the stock may track book-value growth. That would make it more like Berkshire Hathaway. If book rises to $120 to $125 a share in a year, the stock could hit $180 to $190, assuming a price/book multiple of 1.5 times.

Love them or hate them, the smartest guys on Wall Street are back – and raking in the dough. Goldman’s pay looks excessive, but there is still a lot now for shareholders. That is probably good news for the stock.


“Patient” value investor and Forbes columnist John Rogers notes that there were 42 days when the S&P 500 moved at least 3% in 2008, as opposed to only 5 such days in the previous 5 years! Yes, that is volatility. Whatever its sources – we would posit different theories on its originas than Rogers does here – it is undeniably here. And with volatility comes opportunites for a fundamental investor. Rogers has a few typically interesting but not supercheap suggestions.

The stock market was more volatile last year than in any year since 1933. There were 42 days when the S&P 500 gained or lost more than 3%. The previous five years had only 5 such days. The usual explanation for volatility is a combination of investor fears and deleveraging. But I think this era of hypervolatility began with Reg FD back in 2000. The so-called Fair Disclosure regulation was intended to level the playing field by taking away the advantages that institutions had in their access to information from issuers. Ultimately it caused company managements to clam up for fear of running afoul of the rule.

Then in 2002 New York Attorney General Eliot Spitzer revealed to the world what Wall Street insiders had known for decades: Sell-side research, written by the same firms that earned investment banking fees from the companies being covered, was biased. Spitzer forced the corporate giants to pay large fines and promoted the use of independent firms that do not rely on investment banking. The idea was that objectivity would yield better research.

The opposite occurred. Many big firms could no longer justify the cost of big research departments, and they were slimmed down. That meant fewer, less experienced analysts with smaller bonuses and, oftentimes, more companies to cover.

The explosion of hedge funds has also changed the character of research. Hedge funds tend to trade heavily. This drives commissions and volatility higher. With a holding period of only hours or days, you cannot measure value, so you make calls on prices, the bolder the better. Bold calls drive a lot more trading and commissions than nuanced, detailed analysis does. If you happen to be right, you become a star. Meredith Whitney was largely unknown before her iconoclastic and correct call on Citigroup. Her long string of dead-on forecasts made her the biggest analyst name on Wall Street, and now she runs her own firm.

My firm has always depended on our own research, not sell-side reports, and I think all the change represents a tremendous opportunity. If you are truly willing to go deep and ignore the crowd, you can really stand out.

The poster child for faulty analysis rocked the boat at Royal Caribbean (12, RCL) early in 2009. (It has been in my portfolios since 2007.) On January 28, the day before an earnings report, an analyst at a big bank slashed her price target from $20 to $1 and her 2009 earnings estimate from $1.98 to a loss of 92 cents. The company then reaffirmed $1.40 guidance for 2009. That moved the analyst just a little bit; she raised her earnings target to a loss of 26 cents but kept the $1 price target in place as the stock hovered above $6. Then, in mid-April, the company announced that it had secured financing that had been in doubt. The stock jumped to $13 and the analyst raised her price target to $6. If you find this a case of reacting to events rather than predicting them, so do I. Through it all, I have always believed that Royal would get financing. Royal is a leader in an industry with extremely high barriers to entry. I am still bullish and think the stock is worth $31.

I have owned the stock of advertising giant Interpublic Group (4.8, IPG) since 2001. In August 2006 a Wall Street analyst affirmed an underweight rating on Interpublic, listing 21 reasons you should not own the company. With the stock at $8, he cited the following as problems: valuation, growth, new business, cost structure, long-term potential for improvement, management, attracting talent and financial transparency. Five months later, after the stock had run up to $13, the same analyst released an overweight rating citing 13 reasons, including valuation, growth, new business, turnaround, cost structure, long-term potential for improvement, management, attracting talent and financial transparency. For me the story is simple: Interpublic has scale and scope in a consolidating industry. The company’s enterprise value is only 0.6 times its likely 2009 revenues. The stock is a buy.

I have owned broadcaster CBS (5.9, CBS) since 2006. Today everyone thinks television and other traditional media are going away. On April 8 a noted research firm published a report when the stock traded just below $5. It suggested that with EBITDA of $1.8 billion and dividends of $583 million the company would not have enough cash to pay off debts. A revised report appeared the same day, correctly listing dividends of $281 million, with $300 million more to pay down debt. The analyst did not get the math right. He mistakenly doubled the dividend payment. The stock is up 22% from where the analyst issued his pan. It is going to go higher.


Expect the prices of commodities, including oil, to fall. Investors will head back into safe havens like Treasury bonds and the U.S. dollar.

Long-time deflationist A. Gary Shilling does not see the current market or economic recovery lasting. He sees things being still worse overseas, as everyone has to ween themselves from easy dependence on the American consumer. He expects the prices of commodities, including oil, to fall and “safe havens” like Treasury bonds and the U.S. dollar to rebound.

Despite a 31% gain in the S&P 500 since March 9 reports of the bear market’s demise are greatly exaggerated. There have been statistics that suggest otherwise – that the economic decline is tapering off or that green shoots are sprouting on the economic landscape – but before you kick your shoes off and frolic in the foliage, take a hard look at the stock rally and our economy.

The stock market is exhausted, and I think investors are again worrying about the reality of a deepening worldwide recession. They are beginning to shun stocks, sell commodities and buy the buck. And they are grasping Treasurys to their bosoms as they again fear deflation.

False signs of a recovery are common in recessions. Since World War II there have been 11 recessions, and in 8 of them real GDP rose in at least one quarter well before the recession was over. Recessions do not start at the top and go straight to the bottom. I see the current downturn as following a sawtooth pattern along a declining trend. It is quite normal to have upticks in an otherwise bad-news economy. A rebound from last fall’s financial and consumer spending nosedives was likely. If things continued straight down, this recession would not just be the worst one since the Depression, it would rival those dark days when unemployment rose to 25%. It is not that bad today.

The government has been pouring hundreds of billions into the economy, but so far most of its programs are off to slow starts. The Public-Private Investment Program, for example, may be mortally wounded by the emasculation of mark-to-market rules. Banks no longer have to mark their toxic assets down to the market prices where hedge funds and others will buy them. So they can sit on dead assets and pretend that nothing is wrong. The consequence is that our banks are at risk of becoming zombies like Japanese banks in the 1990s.

The folks in Washington are big fans of modifying mortgages to make them more affordable. Alas, this does not cure what ails homeowners. More than 50% are behind in payments only 60 days after modification.

It will get worse before it gets better. Consumers are treating payments on credit cards and student, auto and home equity loans as discretionary. If it is a choice between buying food and gasoline or making a credit card payment, financial responsibility disappears. Still, a Federal Reserve program that supports securitized consumer loans continues and will probably be extended to another danger zone: commercial real estate. Despite some recent refinancings, rents are plunging as vacancies are mounting in shopping centers, office buildings, warehouses and hotels.

This recession will not be over until current and unfolding financial ailments are contained. Consumers retrenched last fall after collapsing house prices wiped out the home equity they had relied on to fund their lifestyles. Excess inventories of homes and apartments still number 2 million. So housing prices will fall further, despite a 32% decline to date for single-family homes. This will put more mortgagors underwater, encourage walkaways and spawn more bad loans. Unless a new source of demand is found, it will take at least until the end of 2010 to work inventories down to size. New York real estate investor Richard LeFrak and I have proposed giving green cards to immigrants willing to buy.

Meanwhile, the self-feeding spiral of consumer contraction continues as falling retail sales bloat inventories, spur production cuts and depress labor income. This will lead to more spending declines. In April 2009 consumers saved 104% of their jump in aftertax income (from tax cuts). In May they saved 90%. By contrast, the upper-income folks – who normally are the biggest savers – got no tax cuts. Add it all up and the fiscal stimulus has so far been impotent. Expect another big stimulus package within a few months, but it may not help much until next year.

I see this economic downturn dragging into early 2010, followed by a recovery so weak you might not know it has arrived. I continue to forecast $40 per share in S&P 500 operating earnings in 2009. Put a generous stock market bottom P/E multiple of 15 on that and you get an S&P 500 of 600, 32% below where it is now.

Overseas, things will be worse. Both developed and emerging countries have relied on the American consumer for decades. That party is over. Expect the prices of commodities, including oil, to fall. Investors will head back into safe havens like Treasury bonds and the U.S. dollar.


All this market is lacking is: leadership, quality and volume. It also lacks a supporting economic recovery.

In this rambling discourse from David Rosenberg, former Chief Economist at the former Merrill Lynch and now in the same position at Gluskin Sheff & Associates in Toronto, looks at the recent stock market run-up, explains why he likes corporate bonds better than stocks, and more.

He finds the stock market runup to be “flashy” but weak technically. Perhaps more significantly, he makes the important point that without an economic recovery there can be no sustainable bull market – and he sees no recovery in the cards. Thus the preference for corporate bonds, which are only priced for a recession, over stocks which are priced for a recovery.

The Dow is coming off its best weekly performance since March 2000, and if memory serves us correctly, that month was marking the beginning of the end of the great bull market at that time. While the bear market rally has been of 1930 proportions, from our lens, that is what it remains and what is lacking in this extremely flashy runup in equity prices are: (i) leadership, (ii) quality, and (iii) volume. There were some very useful statistics in Barron’s (despite the fact that the headline in the “The Trader” column is “Why the Rally Should Keep Rolling ... for Now”): Recessions can end, but without a recovery there can be no sustainable bull market.

Let’s put aside the conventional wisdom that the stock market puts in its fundamental bottom 3-6 months ahead of the recession ending; it actually bottoms ahead of the economic recovery. That was the lesson of 2002 – recessions can end, but without a recovery there can be no sustainable bull market, though hopes can certainly bring on bouts of euphoric behavior as we saw in the opening months of 2002 when the Nasdaq surged 45% and as we are seeing currently in the major averages. Japan is another great example. Its economy was out of recession 80% of the time in the 1990s and yet the lack of any sustainable recovery was largely behind its secular bear market. For a great reality check on the situation, have a read of Henry Kaufman’s piece on page 37 of Barron’s (“A Long Road to Recovery”). To wit:

Some experts also expect the economy to get a boost from business inventory restocking. Maybe so, but most likely as a one-time event. Firms take on inventory if demand rises, if they expect higher prices and if they expect bottlenecks in the supply chain. But excess capacity is high, and there are no bottlenecks.

We also believe that the current edition of BusinessWeek is a must-read – there were lots of good stuff in there this weekend, some of it following in Mr. Kaufman’s footsteps (page 14 – “A Second Half Recovery Could be Fleeting”). To wit:

Will the upturn last? The question arises because the early stage of the recovery is going to be production-led, not demand-led ... to keep the production rebound – and the recovery – going into 2010, overall spending will have to pick up, and that is the big uncertainty given the headwinds facing consumers.

There is no doubt that inventories have been pared back over the past four quarters at a record rate, and that the ISM customer inventory index is running at extremely tight levels. That said, the NFIB inventory plan index remains very weak, so what we have contributing to GDP in the 3rd quarter is a mathematical boost to the economy from a lower rate of destocking; much of this in the auto sector. To actually move towards a sustainable inventory cycle, businesses will have to see final sales revive. What businesses have done is essentially recognize that the secular credit expansion has moved into reverse and the process of deleveraging in the consumer and financial sectors is ongoing. So, what companies have done in their reassessments is to realign their output schedules, order books and staffing requirements in the context that there will be a whole lot less credit to support any given level of production in the future.

What is very likely going to be missing going forward is the consumer because while it is the “back end” of the economy that helps bring recessions to an end as inventory withdrawal subsides, it is the “front end” that causes the expansion to endure – in normal cycles, that is. Historically, consumers end up adding 3.5 percentage points to real GDP growth in the first year of an economic renewal. As the economic editorial in BusinessWeek puts it, “this time, that is most likely impossible.

The risk that the end of the recession only manages to bring on a prolonged period of stagnation is non-trivial and is not priced into the stock market at current valuation levels.

Indeed, any student of the 2000-2003 cycle knows that in the year after that downturn, the consumer offered little help – contributing barely more than one percentage point to GDP growth, which was unprecedented and the cyclically sensitive spending segments exerted not one iota of positive contribution. The difference is that this 2007-2009 cycle was double the asset deflation and triple the job loss and coupled with a credit collapse, which means that it is going to take even longer for the consumer to come back this time around; the view that we have more stimulus this time around really misses the point. The government is merely substituting for the dramatic withdrawal in private sector spending and unless the Obama team manages to implement fiscal package after fiscal package, with the obvious distorting impact on the economy, the risk that the end of the recession only manages to bring on a prolonged period of stagnation is non-trivial and is not priced into the stock market at current valuation levels.

As we explain below, corporate bonds, while cyclical as well, are better suited for that sort of L-shaped economic environment.

Watch what the consumer does now that the fiscal stimulus is over for the time being. Year-to-date, total personal disposable income has risen at a 10.8% annual rate due to Uncle Sam’s generosity; however, wages and salaries (60% of the income pie) have declined at a record 3.1% pace. We realize that there is a lot of hype surrounding the “cash for clunkers,” which is a nice gimmick but only with transitory effects. Besides, just how many vehicles on the road today do not get at least 18 miles per gallon; this is the eligibility criteria – Jed Clampett’s jalopy! ... The chatter is that we are going to see motor vehicle sales improve to 10 million units (annualized) in July. Whoopee. The program is going to keep sales near 25-year lows.

The over saturation of the auto market is unwinding, and this process will very likely take years.

What is important to focus on here is the “new normal.” The “new normal” nearly a decade ago was that 0% financing would bring in 20 million in sales (and think of all the sales that were brought forward). Today’s “new normal” is doing everything Washington can do to get to 10 million units. Has it dawned on them, or anyone else, that since 2000, the number of vehicles sold (net of replacement) rose nearly 30 million, doubling the 15 million increase in the number of licensed drivers? The over saturation of the auto market is unwinding, and this process will very likely take years.

Unlike the stock market, which has de facto priced in a 40-50% earnings surge in 2010, there is no such hurdle or high-hope in the corporate bond market, which is still largely priced for a deep recession.

While we are less enamored with the equity market as a whole, primarily the commodity-short U.S. averages, volatility does offer significant opportunities from a trading standpoint. For a perspective on this, have a look at “Old-Fashioned Stock Picking Back in Style” on page C2 of the Wall Street Journal. For the risk involved, we prefer to express our views in the corporate bond market. Unlike the stock market, which has de facto priced in a 40-50% earnings surge in 2010, there is no such hurdle or high-hope in the corporate bond market, which is still largely priced for a deep recession – a GDP contraction of 1-2% going forward and the unemployment rate heading towards 11-12%.

Insofar as the economy does not relapse to such an extent, there is a significant cushion embedded in the pricing of the corporate bond market this time, even after the impressive rally – from Armageddon levels, mind you – earlier this year. While the S&P 500 was certainly priced for bad news at the March lows, with an 11x P/E multiple and a 3½% dividend yield at the time, it can hardly be said that it was priced for nearly the disaster that Baa corporate bonds were when spreads were hovering near levels (over 600 basis points) not seen since the early 1930s. Have a look at “Bonds Look to steal Stocks’ Thunder” on page C1 of today’s [July 27] WSJ. The article cites analysis showing that default rates could hit 14% and high-yield bonds, as an example, could still generate significant returns – and our former colleague, the legendary Marty Fridson, is quoted in the article as saying that returns could “reach the mid-teens over the next year” so long as the recession does not deepen (unlike equities, the downturn does not have to end – just not get any worse).

Financials Lagging

Everyone we talk to believes that a new bull market began in March when the White House and the Fed gave the large banks blanket guarantees for their survival and Congress basically instructed FASB to switch back to “mark-to-model” accounting rules so the financials could show a profit. So the financials had their nice initial pop, but since May 6th, that is nearly three months now, they have basically done nothing. Not just done nothing, but have underperformed the market by 650 basis points. Financials do not have to necessarily lead the pack during a bear market rally, but no fundamental turning point has occurred with the financials lagging behind as they are currently. Food for thought.

Many pundits mistake a narrowing in credit spreads with some expectations that the economy is going to make a convincing shift into expansion mode. All spreads have done is go from pricing in a depression to pricing in a recession. Indeed, Baa spreads currently are still above the peaks of most prior recessionary phases. The credit crunch is far from over, even if we managed to emerge from the abyss last March. ... And keep in mind that no regional bank is too big to fail, and they are failing – seven more seized by the FDIC last week, making it 64 for 2009 thus far.

As an aside, the sectors that will likely lead the market in the future will be the ones at the forefront of energy innovation (clean-tech). And that means companies that are working on contracts with DARPA (the research arm of the Defense Department) may be worth a look – DARPA was the pioneer behind the development of the Internet, the computer mouse, GPS and others ...

But Not the Consumer

What has led the last leg of this rally has been the most discretionary of the consumer space: casinos/gaming stocks are up 44% from the mid-July lows; the homebuilders are up 30%; the automakers are up 28%; advertisers are up 20%; home furnishings are up 18%; hotel/resorts and specialty retailing stocks are up 15%. It is only a matter of time before these gains unwind if the early surveys are correct that this may well go down as the weakest back-to-school shopping season on record. It is seriously tough to square the bounce-back in these sectors when you take a look at where consumers are pulling back the most – discretionary spending items. See “Videogame Makers Can’t Dodge Recession” on page B1 of today’s WSJ for just one example. The article below also serves as a commentary on how spending patterns are changing – penny-pinching and nickel-and-diming are both in vogue (see “Organic Foods Get on Private-Label Wagon”).

The consumer shift away from vacations towards “staycations” is forcing hotels to cut their room rates at a record pace – have a look at “Starwood Offering Up To 50% Off Some Rooms” on page 2B of the USA Today. In addition, the airlines are now raising their baggage fees to make up for the decline in passenger volumes ... It seems as though as smoking is the only habit that is not dying, and the tobacco producers are actually raising their prices successfully ...

A key test for the back-to-school season may be when the kids come back from camp, and we see the extent of any possible H1N1 virus. ... The Center for Disease Control estimates that without a successful vaccine, 40% of Americans will catch the virus within the next two years. ...

The New Frugality Is Fashionable

We have been writing about the need for the boomers to start putting more of their money into savings and less into discretionary spending for some time. And, BusinessWeek ran with an article that may sound as if it is has been said before (“The Incredible Shrinking Boomer Economy” on page 27), but there were some fascinating factoids in the piece (from a McKinsey study): We have said before (repeatedly) that one of the more interesting demographic trends this cycle is that the only segment of the population that is gaining employment is the 55+ age cohort. But this has created a gaping hole in job opportunities for the younger age categories, where jobless rates are either at or approaching the 20% threshold. What is also fascinating is the denial over this demographic reality because many college graduates are holding out for what they believe are going to be lucrative offers – see “In Recession, Optimistic College Graduates Turn Down Jobs” on page A10 of the Sunday New York Times:

Job recruiters may be bypassing university campuses in droves and the unemployment rate may be at its highest point in decades, but college career advisers are noticing that many recent graduates do not seem to comprehend the challenging economic world they have just entered.” Indeed, as one example of where labor demand is heading, the article cites as an example a recent job fair at the University of Oregon, where just 55 corporate recruiters showed up compared to 90 a year ago.

What Is Happening With Revenues?

According to S&P, only 61% of the companies have beaten their low-balled profit estimates. Yet as we saw in the first quarter, this is being accomplished via aggressive cost-cutting efforts. With 53% of the S&P 500 universe reporting, revenues are down about 10% year-over-year and the worst is yet to come because the retailers and homebuilders have yet to report. Even so, on an apples-to-apples comparison, sales were -16% YoY in 1Q and -14% in 4Q of last year, so the bulls (who have thus far been correct) would say that this is a classic “green shoot” second-derivative improvement in the data. The revenue declines have cut a wide swath, with 9 of the 10 sectors and 3 in 4 companies posting contractions.

For those believing the recession is over, let us just say that in the context of an economy that is not in recession, the odds of seeing a negative quarter for revenues is 1-in-13. And, just how bad is a -10% quarter for sales revenues? Well, it would tie the 4th worst performance of the past decade. To put it into perspective, when the 2001 recession ended, sales were running at -1.0% YoY – what we have now is worse by a factor of 10. And, when the last bull market was confirmed in the spring of 2003, sales had already swung well into positive territory on a YoY basis.

Update on the Employment Scene

This got very little play, but the minimum wage was lifted on Friday to $7.25 an hour from $6.55 – a 10.6% increase. That may be great news for the 5 million workers that are affected, but it will likely trigger reduced job creation too as sectors like restaurants and hotels move to contain their aggregate labor bill.

We have said before that the unemployment rate is very likely to continue to rise for the next few years, not just quarters, and that it will take out the November-December 1982 post-WWII peak of 10.8%.

The unemployment rate is very likely to continue to rise for the next few years.

First, it should be noted that in the last cycle, the recession ended in November 2001 and yet the unemployment rate did not reach its peak until June 2003. Considering that the asset deflation and credit collapse this time around was so acute, why would anyone think that it will take less time to reach the peak in the current cycle?

Second, this cycle was most unusual in that 9 million full-time jobs were lost and of these, 3 million were pushed into part-time work. There are now a record 9 million people working part-time that would rather work full-time, which is about 5 million above the norm. On top of that, companies cut the hours worked by a record 2.3% to an all-time low of 33.0 hours this cycle, which is equivalent to another 3 million jobs being lost. So in sum, we have a total level of unemployment and underemployment that comes to 8 million and that is without precedent. So when it comes time to add to labor input again, what businesses are going to do is to raise the workweek and push the part-timers back to full-time work before embarking on a hiring spree. In the meantime, the usual 100,000-150,000 new entrants into the labour force every month will be looking for work with futility. Keep in mind that when we are talking about a total pool of existing labor totaling 8 million jobs, that is equivalent to over five year’s supply during a normal business expansion.

Third, the hallmark of this recession was the permanent nature of the job losses that were incurred. Normally, and this includes that period of Ross Perot’s “sucking sound” of post-NAFTA being siphoned to Mexico, we lose 2 million permanent jobs in a recession. This is classic Schumpeterian “creative destruction” as the recession expunges the old uncompetitive industries and paves the way for new more productive sectors – a recession is a painful but necessary transition to the net cycle as the torch is passed to new technologies.

It is productivity that is the key variable in the nation’s standard-of-living performance, and yet, this has somehow escaped the best and brightest economic minds in Washington.

But this time around we are really talking about the law of large numbers because the total increase in the number of people who lost their jobs permanently exceeded 5 million or twice what is “normal.” What happens to these people remains to be seen but thus far we see nothing in any “fiscal package,” except for traditional goodies to induce consumption growth. The best fiscal policy of all, and the one that is still not being pursued since it does not offer a “quick fix,” is retooling these unemployed individuals, many of them in their 20s and 30s, and providing them with new skills that will bolster long-term productivity growth. It is productivity that is the key variable in the nation’s standard-of-living performance, and yet, this has somehow escaped the best and brightest economic minds in Washington – at least so far. If we can manage to improve education, and thereby income-per-capita, then a whole host of other problems get worked out too – such a affordable health care (and for a signpost of the problem Obama’s plan is running into within his own party, see “Blue-Dog Democrats Hold Health-Care Overhaul at Bay” on the front page of today’s WSJ (without the blue dogs, there are not enough votes on the floor to get the Obama health care plan through).

Another way of looking at the situation is that we are going to end up having some convergence between the popular definition of the unemployment rate and the more inclusive U6 measure – the former is 9.5% and the latter is 16.5% and this seven percentage point gap is without precedent. At the peak unemployment rate of the last cycle in mid-2003, the gap was four percentage points. As the unutilized labour pool starts to get absorbed again, the U6 is likely to come down and the U1 likely to go up, and if they converge at a four percentage point gap again, then look out – we will be talking about an unemployment rate well north of 12% before the jobless recovery comes to an end.

Not Giving Credit, Even When It Is Due

The front page of today’s WSJ also runs with “Loans Shrink as Fear Lingers”. The largest 15 U.S. banks cut their loan book by 2.8% in Q2 – and more than half of the loan volumes came from mortgage refinancings and credit renewals among small businesses (to show how broadly based the credit shrinkage is, 13 of these banks shrank their balance sheet in the second quarter). New credit creation is practically nonexistent. Capital conservation remains the order of the day. This is one critical reason why it would likely be foolhardy to be expecting a normal inventory cycle to come our way merely because of an arithmetic addition to growth from lower de-stocking in the current quarter.

Another Reason to Be Bullish on Emerging Asia

Government efforts are being stepped up to bolster the social safety net and help bring sky-high savings rates down as the U.S. consumer takes its savings rate up. This is good news for commodities since there is a much higher representation of “material” in the emerging market household consumption basket than is the case for the U.S. household who has become, at the margin, the buyer of services (recreation, medical, financial). “See Asian Nations Revisit Safety Net in Effort to Bolster Spending” on page A2 of the WSJ.

In our view, it is imperative that Asia finds a new source of growth beyond recurring public sector spending to offset the secular decline in export growth that will be associated with a retrenchment in demand growth in the developed world, primarily in the U.S.A. China currently is only the end-buyer of 22% of the rest of Asia’s exports – it alone is not large enough to provide a complete offset.


Hard Times for Microsoft

For the first time since it went public, Microsoft saw its revenue fall year-over-year. Tempted to buy? Don’t.

Microsoft (ticker: MSFT) investors are reeling today [Friday, July 24] and odds are they will be hurting for some time. The stock was off 9% in midday trading Friday as the market tried to digest the meaning of Microsoft’s fiscal 4th-quarter results.

We think the stock will be dead money, at least until the fall when all eyes will be on the October 22nd launch of Windows 7.

After the close Thursday, Microsoft reported that profit fell to 34 cents a share from 46 cents a share in the year earlier period, below the Street’s expectations of 36 cents a share. Sales tumbled 17% year-over-year to $13.1 billion, falling more than a billion dollars shy of the consensus $14.37 billion estimate. This sharp revenue drop represented the first time that the company’s annual revenue fell year over year.

Microsoft said it was behind in the PC cycle and was just now taking the hit from slumping demand that computer makers had previously reported. ... Although Microsoft increased cost savings in the quarter, it missed on nearly every metric, as four of its five divisions (Client, Server and Tools, Microsoft Business, and Entertainment and Devices) fell short of expectations without much hope of a near term reversal ...

Longer term trends could also be troubling.

Longer term trends could also be troubling. Canaccord Adams analyst Peter Misek noted that the fastest growing segments of the PC pie ew emerging markets and netbooks ew come with lower average selling prices than traditional PCs, a category that fell more year-over-year than Microsoft predicted last quarter.

Although CFO Chris Liddell said he believed the company was stronger in 2009 than in 2008, he conceded that the rest of the year will remain challenging. There was also a whiff of desperation in his remarks about the company’s efforts to trim travel and entertainment expenses and freeze salaries.

Some analysts ... maintained their positives ratings on Microsoft, but nearly all, including the bulls, meaningfully reduced their earnings estimates on the news, with the former shaving more than $2 billion off its 2010 revenue forecast.

While the quarter highlighted a number of Microsoft’s weaknesses, it also has other problems on its plate, including the increased competition from Google (GOOG), while Bing, its new search tool, has captured some market share from Yahoo! (YHOO) but is not showing material benefit yet.

Therefore headwinds and few catalysts are on the horizon for Microsoft until the autumn, when anticipation of the new operating system will begin to dominate trading.

Microsoft will be under intense pressure to deliver on Windows 7, given Vista’s tepid reception and the quarter’s dismal numbers. Still, there is no guarantee it will be a home run.

Operating system upgrades often do not translate into significant improvements in performing daily tasks. And cash-strapped companies that are looking to cut costs any may be more than willing to continue with their current version of Windows.

So if you are looking at the steep drop in Microsoft’s stock price and are tempted to buy, we recommend you wait until shares soften further.

Should They Risk Missing a Payment?

Some homeowners are being told they cannot receive help unless they fall behind on their payments. But if you were struggling would you take the risk of skipping a payment or two just to qualify?

You can see the fine hand of government at work in the homeowner rescue package that has been struggling to get off the ground since its inception last spring. The goal was to reduce foreclosures by lowering mortgage payments for homeowners who were struggling. But struggling how badly? For would-be lenders, that can be a tricky question to answer, and they are understandably reluctant to commit to the program without clear guidelines from the federal government. As it stands, some homeowners are being told they cannot receive help unless they fall behind on their payments. But if you were struggling yourself to stay on track, would you take the risk of skipping a payment or two just to qualify?

That is the dilemma facing millions of homeowners, and one we anticipated a while back in the Rick’s Picks chat room. When the program was announced, we suggested half-facetiously that subscribers start omitting mortgage payments now and then in order to secure a seat on the gravy train. It was not entirely in jest that we broached the idea, since that is the way government programs work, favoring basket cases over those who are managing to scrape by on their own, however precariously. Now, it would appear, the merely beleaguered are being advised to look more like basket cases by skipping payments.

Waste and Corruption

As for the 3 or 4 million homeowners who supposedly will be helped by the program, so far only about 200,000 reportedly have benefitted. We shudder to imagine what it will take to bring the others on board, since the waste and corruption associated with any government relief program seem to grow exponentially as “clients” are added. In the meantime, if you think you might have problems paying your own mortgage in the future, you might want to apply now, since you could face lengthy delays in getting approved. In fact, the delays are already so long that borrowers who are current when they ask for loan modifications are delinquent by the time they receive them.

Even in Boulder, Colorado, the News Is Lurid

Bob Prechtor would argue that interest in “lurid” news is evidence of a primary bear market in social mood being in force. Under that theory markets reflect and follow social mood, so you can fill in the blanks.

With the dog days of summer fast approaching, we wondered whether every small-town newspaper in America is entertaining readers these days with the same sort of lurid stories that fill the Boulder Camera. Boulder is not exactly the kind of place where you would expect to find luridness in newsworthy quantities. Half the people who live here are trust-fund babies who, one would surmise, spend their days hiking the local trails, writing letters to the editor, or working diligently to protect the rights of prairie dogs. Since these folks mostly lead quiet, unexceptionable lives, it must be the other half of the population that keeps turning up on the police blotter – or still worse, in the local morgue.

Today’s [July 23] dead-man story concerned a 19-year-old graduate of Fairview High School (my wife’s alma mater) who OD’d on something called – if you have not heard – poppy pod tea. This ultra-hip beverage contains opium, and although it is sold via mail order and over-the-counter, there is evidently enough opium in poppy pod tea to kill someone who drinks too much of it, especially when it has steeped for a long time.

Death by Tea

This was the second poppy-pod tea fatality in Boulder this year, the first having failed, apparently, to convince at least a few dopers hereabouts that the risk of death outweighs the pleasure of a good high. In both cases, the victims drank the tea, fell asleep, and never woke up. Yesterday’s incident was deemed sufficiently newsworthy (i.e., lurid) to go out on the Associated Press A-wire, so you may have read about it in your own local paper.

In other Boulder-area sordidness, a 6-car wreck on Highway 36 was reported after a few barrels fell off a truck and the driver tried to retrieve them. What made this otherwise mundane traffic story sordid was that the driver did not stick around to commiserate with the victims. He is now a hit-and-run suspect, his capture and incarceration an event eagerly anticipated by reporters and readers both. Ironically, the most lurid item in the paper was good news, reported as follows: “An 11-year-old boy was spared from giving excruciating testimony at a court hearing Tuesday when the man charged with sexually assaulting him two years ago suddenly decided to plead guilty in the case.”

If this is the kind of stuff that fills the news quota in Boulder, Colorado, for Pete’s sake, then what are they reading about in places like Newark, Detroit, Los Angeles and Miami?