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

W.I.L. Finance Digest :: August 2009, Part 2

This Week’s Entries :


In the previous Finance Digest, the article “Make Sure You Get This One Right” concluded – of course not with total certainty – that the economic environment would most likely be deflationary for the next several years. Gary Shilling would agree, and makes the case for slow economic growth and deflation in meticulous detail here. And this is the condensed version! We frequently post Shilling’s Forbes columns is these pages – here is the background work behind those iceberg tips.

The essentials of Shilling’s deflation case have been heard before, both from Shilling himself and Robert Prechtor, Mike “Mish” Shedlock, and others: The attitudes towards debt by borrowers and lenders alike has changed from love-it to hate-it. One needs credit expansion to get inflation. (See Shedlock article “Fiat World Mathematical Model” for details.) The massive “money printing”, aka “quantitative easing,” by central banks, will not counterbalance the credit contraction resulting from the newfound debt aversion.

That is the case for deflation. Believe it or don’t.

This week I am really delighted to be able to give you a condensed version of Gary Shilling’s latest Insight newsletter for your Outside the Box. Each month I really look forward to getting Gary’s latest thoughts on the economy and investing. Last year in his forecast issue he suggested 13 investment ideas, all of which were profitable by the end of the year. It is not unusual for Gary to give us over 75 charts and tables in his monthly letters along with his commentary, which makes his thinking unusually clear and accessible. Gary was among the first to point out the problems with the subprime market and predict the housing and credit crises. His web site is down being re-designed, but you can write for more information at insight@agaryshilling.com. If you want to subscribe (for $275), you can call 888-346-7444. Tell them that you read about it in Outside the Box and you will get not only his recent 2009 forecast issue with the year’s investment themes, but an extra issue with his 2010 forecast (of course, that one will not come out until the end of the year. Gary is good but not that good!) ...
Slow Long-Term Growth, And Government’s Response
by Gary Shilling

(excerpted from the August 2009 edition of A. Gary Shilling’s Insight)

Beyond the current recession, the worst since the 1930s, lies years of slow growth, as we have discussed in past Insights. The next economic recovery, which will probably start around mid-2010, will likely be so subdued that it may not feel like the recession has ended. And economic growth in the bulk of the next decade will probably be slow – so slow that it will force the federal government to take continuing actions to prevent high and chronically rising unemployment.

Six Causes of Slow Long-Term Growth

As explored in detail in past Insights, six forces will promote slow long-term growth in the U.S. and, indeed, on a global basis – U.S. consumer retrenchment, financial sector deleveraging, weak commodity prices, increased government regulation and involvement in the economy, protectionism and deflation.

Consumer Retrenchment. First and foremost is the dramatic switch by American consumers from a 25-year borrowing and spending binge to a saving spree that should extend a decade or more. As we pointed out last month, in the 1980s and 1990s, U.S. consumers regarded their soaring stock portfolios as continually filling piggybanks that would fund their kids’ education, early retirements and a few round-the-world cruises in between. So they slashed their saving rate and pushed up their borrowing to fund spending growth that consistently exceeded the rise in after-tax income. When stocks nosedived with the collapse in the dot-com bubble in 2000-02, leaping house prices seamlessly took over to finance oversized consumer spending growth.

But now stock and house prices – the vast majority of most Americans’ net worth – are not only depressed but also unlikely to revive to their former glory days for many, many years. Furthermore, our earlier research found no other major consumer assets that could be borrowed against. So consumers are being forced to embark on the saving spree we have been predicting for some years.

For the next decade, we are forecasting an average one percentage point rise in the saving rate annually, raising it to 10% in 10 years. That still would not return the saving rate to the early 1980s level of 12% even though the demographics for saving have gone from the worst to the best in the interim. And even a decade of vigorous saving will probably not return household net worth even close to its former peaks or eliminate completely the three decades of ever-increasing household financial leverage.

Financial Deleveraging. Financial deleveraging will also reduce long-term economic growth. As we have discussed in many past Insights, the recession really started in early 2007 in the financial arena with the collapse of subprime residential mortgages. Then it spread to Wall Street in mid-2007 with the complete mistrust among financial institutions and their assets, too many of which were linked to troubled mortgages. A huge gap opened up back then between the 3-month LIBOR and Treasury bill yields, and that panicked Washington into opening the money floodgates. The Fed started its interest rate-cutting campaign that ultimately drove its federal funds rate target to the zero-to-0.25% range (Chart 1).

But the central bank soon found the banks were too scared to lend and creditworthy borrowers did not want to borrow when Bear Stearns and Lehman collapsed and other large banks and Wall Street houses were on the brink. So the Fed embarked on quantitative easing that exploded its balance sheet. And Congress and the Administration joined in with the $700 billion TARP, the $787 billion fiscal bailout and many other programs, as witnessed by the exploding federal deficit.

The Bank for International Settlements recently said only limited progress has been made in clearing up the global financial system, and any economic recovery will be short-lived and followed by a long period of stagnation unless bank balance sheets are corrected.

Except for hotels, commercial real estate woes are not so much the result of overbuilding, as is the case with residential. Rather, the problems are due to aggressive refinancing and pricing in earlier years as well as current slumping demand. As retailers close stores or fold completely, mall space becomes vacant. Warehouses are empty as consumer retrenchment curtails goods imported from Asia and elsewhere. Excess space and weak business and leisure travel is axing hotel room rates and occupancy. Layoffs result in sublease office space competing with landlords for tenants.

Furthermore, a great deal of real estate debt must be refinanced soon amidst falling occupancy, rents and sales prices as well as tight credit markets. Estimates are that $155 billion in securitizations are coming due by 2012 and 2/3 will not qualify for refinancing as prices drop 35% to 45% from their 2007 peaks. Meanwhile, $525 billion of commercial mortgages held by banks and thrifts will come due by 2012. About 50% will not qualify for refinancing since they exceed 90% of the underlying property value. Lenders prefer loans of no more than 65%.

Deleveraging of the financial sector will obviously have negative ramifications for the real economy it finances. We have already seen plenty of effects. Many small businesses that depend on outside financing are starving as banks tighten lending standards. In a sense, many derivatives were financial cobwebs spun among bank and other speculators, but they did finance much of the housing boom.

Commodity Crisis. The earlier collapse of the commodity bubble (Chart 2) will also subdue global economic growth in future years. Sure, commodity consumers benefit from lower prices by the same amount that producers lose. But the share of total spending on commodity imports by consumers, especially in developed lands, is tiny while they account for the bulk of exports for producers, many of them developing countries such as Middle East oil producers.

Furthermore, security losses last year devastated sovereign wealth funds, many of them in oil-rich countries as well as Asian exporters. A year ago, they were estimated to hold $3 trillion in assets on their way to $10 trillion. Now the estimate is $1.8 trillion and optimistically forecast to rise to only $5 to $6 trillion by 2012. Lower oil prices have a lot to do with the downward revisions. Singapore’s huge Temasek Holdings fell more than $28 billion, or 22%, at the end of March from a year earlier.

More Government Regulation. So, U.S. consumer retrenchment, global financial deleveraging and weak commodity prices will keep worldwide economic growth subdued for many years. So, too, will vastly increased regulation here and abroad, the normal reaction to financial and economic crises, as noted in our earlier reports. When a lot of people lose a lot of money, there is a cosmic need for scapegoats and increased regulation. Sure, many embarrassed financial wizards have sworn off their wayward ways and will be cautious for years, probably the balance of their careers. But that will not stop witch hunts.

The Administration has proposed a substantial overhaul of financial regulation. It does not plan to combine regulators to eliminate overlaps and gaps, as originally discussed. Still, it would empower the Fed to monitor financial risks to avoid systemwide instability; create a Consumer Financial Protection Agency with control of mortgages, credit cards, savings accounts and annuities; push public companies to give shareholders say on pay; bring hedge funds under federal regulation; require firms to hold some of mortgage securitizations they create and sell; force derivatives to be traded on exchanges; beef up oversight of insurance; force industrial loan companies to obtain bank holding company charters; urge the SEC to stem runs on money market funds and to strengthen regulation of credit rating firms; create a mechanism for government to takeover large, failing financial institutions; and amends the Fed’s lending powers to require the Treasury Secretary’s approval.

The first Obama federal budget also points clearly to more government regulation and involvement in the economy, in health, education and the environment. Beyond the financial sector, the bailout of U.S. auto producers led to considerable government control of that industry, almost day-to-day management by Washington.

Rising Protectionism. Without question, protectionism will slow or even eliminate global economic growth as international trade slumps. As noted in earlier Insights, recessions spawn economic nationalism and protectionism, and the deeper the slump, the stronger are those tendencies. It is ever so easy to blame foreigners for domestic woes and take actions to protect the home turf while repelling the offshore invaders. The beneficial effects of free trade are considerable but diffuse while the loss of one’s job to imports is very specific. And politicians find protectionism to be a convenient vote-getter since foreigners do not vote in domestic elections.

As noted earlier, initially this recession was in the financial arena – the collapse in the residential mortgage market led by the Subprime Slime that started in early 2007, and the follow-on Wall Street woes that commenced in the middle of that year when two big Bear Stearns hedge funds imploded. So it is not surprising that protectionism began in the financial arena and took the form of competing to safeguard a country’s financial institutions. But at least that competition was positive for financial systems and economies, even if expensive for taxpayers.

Now, however, protection has spread to its more classical import-export arena with the advent late last year of massive U.S. consumer retrenchment and globalization of the downturn. Both forces are severely depressing the goods and services sectors as U.S. consumer spending falls the most since the 1930s and unemployment here and abroad leaps.

Since the early 1980s, world trade has functioned in a smooth but unsustainable fashion. The rest of the world produced and America consumed. In many foreign lands, households were weak consumers and big savers, so production exceeded domestic consumption. Their production surpluses were exported, directly or indirectly, to the U.S. where consumers were saving less and less and spending more and more. With their growing trade surpluses, foreign nations had growing piles of dollars that they recycled into Treasurys and other American investments, helping to hold down interest rates and making it cheaper for spendthrift American consumers to borrow easily and cheaply to fund their leaping debts.

Now, with American consumers embarking on a saving spree, the U.S. will no longer be the buyer of first and last resort for the globe’s excess goods and services. Furthermore, with slower global growth for years ahead, virtually every country will be promoting exports to spur domestic activity. When every country wants to export and none want to import, the pressure for protectionism leaps

Deflation. Chronic deflation is the 6th reason we forecast slow economic growth in the next decade or so. Chronic deflation spawns self-fulfilling deflationary expectations. Today, who would have the guts to tell a friend he paid the full sticker price for a vehicle? Years of rebates have trained car buyers to expect continuing and even bigger rebates. So they wait to buy. That leads to excess inventories that require even larger price concessions. Buyer suspicions are confirmed so they wait longer, promoting more inventory buildup, more price cuts, etc. in a self-feeding cycle. A key effect, of course, is to retard spending and slow economic growth.

Long-time Insight readers know that we have been forecasting chronic deflation to start with the next major global recession. Well, that recession is here. We earlier forecast chronic good deflation of excess supply because of today’s convergence of many significant productivity-soaked technologies such as semiconductors, computers, the internet, telecom and biotech that should hype output and depress prices. As a result of rapid productivity growth, fewer and fewer man-hours are needed to produce goods and services. Big output growth also results from the globalization of production and the other deflationary forces we discussed in and since we wrote our two deflation books a decade ago. With U.S. consumer retrenchment and a shrinking pool of global imports, export-dependent lands will be competing even more fiercely for the remaining markets.

In contrast to good deflation, bad deflation reigned in the 1930s as the Great Depression pushed demand well below supply. Japan also suffered bad deflation over the last two decades after the collapse of her 1980s housing and stock market bubbles. But in Japan, the lack of demand was not caused by a dearth of employment and income as in the U.S. in the 1930s, but because the government delayed cleaning up her financial institutions while consumers refused to spend their incomes.

We have consistently predicted the good deflation of excess supply, but we have also said clearly that the bad deflation of deficient demand could occur – due to severe and widespread financial crises or due to global protectionism. Both are obvious threats, as explained earlier.

Few agree with our forecast of chronic deflation.

Few agree with our forecast of chronic deflation. They have never seen anything but inflation in their business careers or lifetimes, so they think that is the way God made the world. Few can remember much about the 1930s, the last time deflation reigned. Excessive monetary and fiscal stimuli are also key reasons why most observers forecast chronic and severe inflation in future years. They may concede that deflation is more likely in the balance of the recession (Chart 3) for the reasons we have cited in past Insights. Past weakness in commodity prices is still working its way through the production and distribution system. Surplus inventories (Chart 4) – the result of producers, wholesalers and retailers being caught unaware when consumers suddenly retrenched last fall – are still being worked off and depressing prices in the process.

Wage cuts and mandatory furloughs for the first time since the 1930s, as well as layoffs are obviously deflationary as they depress purchasing power. In addition, the excess of supply overdemand has clear implications for deflation.

Nevertheless, the vast majority still maintain that inflation is inevitable in the long run. All the money being pumped out by the Fed and the Treasury deficits is sure to stimulate too much demand in relation to supply, they believe. But before money can promote excess demand, it has got to get into circulation, and scared lenders and creditworthy borrowers are unlikely to convert massive bank reserves into money until rapid economic growth resumes. And that, we believe, is unlikely for many years. Furthermore, if economic growth and loans mushroom, contrary to our forecast, major central bankers, with their congenital fear of inflation, will no doubt withdraw much of that liquidity.

Slow And Weak Recovery

We continue to forecast that the recession will extend into early 2010. Only by then is enough fiscal stimulus likely to be pumped out to stabilize consumer retrenchment. By then, most of the global financial woes should be at least stabilized. And by then, enough excess house inventories may be absorbed to end the downward pressure on prices.

Excess house inventories were built up in the 1996-2005 boom and still number about 1.5 million new and existing houses above normal working levels despite the collapse in housing starts and recent stabilization in sales. Excess inventories are the mortal enemy of prices in any goods-producing industry, especially housing. We continue to believe it will take at least until the end of next year before excess house inventories are reduced to levels that no longer depress prices. [Emphasis added.] Meanwhile, prices – already down 32% from their 2nd quarter 2006 peak – are likely to fall to reach a total 37% decline we have forecast for the last two years.

The decline in house prices is evaporating home equity. In the early 1980s, those with mortgages had almost 50% equity in their houses on average, after subtracting all mortgage borrowing from the market price of their homes (Chart 5). Due to increasing mortgage leverage and, more recently, collapsing house prices, that equity was only 20% in the first quarter and continuing to fall.

If house prices drop about 37% from their peak to their final bottom, that equity will be down to about the 15% range. At that point, over 25 million homeowners, or half those with mortgages, will be under water, compared to about 25% today.

After the recession ends as the economy stops falling, a weak recovery is likely to follow, one so tepid and with such high unemployment that you may not know it has arrived. The two normal forces that generate economic recoveries are missing this time. As usual, the Fed eased monetary policy once it saw that the economy was headed for recession.

But unlike the past, Fed action is not reviving housing (Chart 5), given the overhang of excess house inventories. And the normal pop in production when the liquidation of overall inventories ends (Chart 6) will be muted and overshadowed by the unusually large slashing of consumer spending. It is hard for businesses to cut inventories fast enough to keep up with dropping consumer demand.

2.0% GDP Growth

A chronic 1 percentage point annual rise in the consumer saving rate for the next decade or so will knock around 1 percentage point off real GDP growth after its effects work their way through the economy. That is a big contrast with 0.5 annual percentage point declines in the saving rate over the previous quarter century that added around 0.5 percentage points to growth. That total swing of 1.5 percentage points will reduce real GDP growth from 3.6% per year in the 1982-2000 salad days (Chart 7) to 2.1%.

So with the five other inhibitors to growth in coming years – financial deleveraging, weak commodity prices that will retard spending by producing countries, more government regulation and involvement in the economy, rising protectionism and deflation – our forecast of 2.0% real GDP growth is probably even optimistic.

With 2% to 3% deflation, nominal GDP might not gain at all. And with slower growth in the years ahead, economic expansions are likely to be shorter and less robust while recessions will probably be deeper and more frequent.

Consumer Spending Growth

We are also forecasting real consumer spending growth of 1.4% per year in the next decade. That, too, may be optimistic as consumers retrench and slash real debt which far outran real housing wealth even before it collapsed, outran real annual growth in real stock wealth before it nosedived, and bested real disposable income growth. Much of the explosion in debt was residential mortgage-related borrowing in the mid-1990s to mid-2000s housing bubble, fueled by low borrowing costs, weak lending standards, exotic mortgages and securitization, which distributed toxic mortgage loans to unsuspecting investors.

The deleveraging of consumers that we expect to continue for years is a reversal of the same longrun phenomenon of past decades that was measured in different ways – the decline in the saving rate, the rise in debt and debt service rates and the rise in consumption’s share of GDP, reflecting what consumers did with the money they did not save and did borrow.

Consumption vs. GDP

With real consumer spending forecast to grow 1.4% annually over the next decade and real GDP 2.0%, real consumption’s share of GDP falls from 71.0% last year to 66.5% in 2018 (Chart 7). That would bring it back to the level of the early 1980s when the consumer spending binge began (Chart 8). It may seem inconsistent that we are forecasting a rise in the household saving rate of 10 percentage points but a decline in real consumption’s share of real GDP of only 4.5 percentage points from 71% to 66.5%. But note that the reverse occurred in the last 25 years – the saving rate fell from 12% to zero, or 12 percentage points while consumption’s share of real GDP rose from 67.5% to 71%.

Eyeballing the chart, we find a telling indictment of the policies pursued by the Fed and Clinton/Bush administrations starting in the mid-1990s. The normalized consumption share of GDP over the post-War era was roughly 65% through 1983. Even the 1980s consumption binge only brought the average share to apx. 67% for the 1984-1997 period. Then the credit bubble inflation policies took effect and raised consumption’s share all the way to 72% in 2006-07 – an extraordinarily reckless and easy to see increase.

These differences are in part because household saving is being measured as a percentage of disposable (after-tax) income, which is less than GDP, so the effects of the change in the saving rate on GDP are muted. In the earlier 1980s, real disposable income was about 78% of GDP. Furthermore, the rise in consumption’s share of real GDP in the 1982-2000 boom years (Chart 8) was actually held back by the drop in the real DPI/real GDP ratio. That in turn was largely the result of employee compensation’s share of national income falling while corporate profits’ share leaped during those years.

In the years ahead, however, it is unlikely that DPI will decline as a share of GDP. As we discussed in earlier years when profits’ share was at its zenith, a big decline in corporate earnings’ piece if the pie was probably in the cards. In a democracy, we noted, neither capital nor labor can continually increase its share indefinitely while the other one’s share chronically shrinks. We also suggested that the recession and financial mess we were forecasting, the worst since the Great Depression, would depress profits. We also opined that Obama Administration and Democratic-controlled Congress would be adverse to shareholders while smiling on their labor constituents.

Where’s The Growth?

If consumer spending grows slower than GDP in the next decade, other GDP components must grow faster. Which ones? As shown in our forecast table (Chart 7), it is unlikely to be residential construction, which we see growing 1.0% per year in real terms compared with 5.2% in the 1982-2000 years. Housing should remain weak even after the huge excess inventory is worked off. Earlier, homeowners were convinced that house prices never declined – and they had not on a nationwide basis since the 1930s.

But the recent collapse in house prices and the prospect that they will move with overall prices in the future – which means chronic declines with chronic deflation – are shattering the scales that blinded homeowners. So they are beginning to separate places to live from investments. That means they will want smaller quarters, and the new houses that are built will be smaller and less expensive.

Capital Spending

Real spending on nonresidential structures grew only 0.6% per year in the 1982-2000 era as overexpansion in the earlier years curtailed spending later on. With slow economic growth in the years ahead, demand for warehouse, factory, office and hotel space is likely to be subdued. Ongoing consumer retrenchment will keep retail vacancies high and new building low. On balance, we project about the same growth rate for real nonresidential construction, 0.5% per year, in the next decade.

Equipment and software real spending advanced briskly in the 1982-2000 years, 8.2% annually as new technologies such as computers, semiconductors, the internet, biotech and telecom absorbed tremendous amounts of spending. Furthermore, inflation and interest rates were declining (Chart 9) to the benefit of the corporate sector, and operating rates were generally high while profits growth was robust. Those new technologies will continue to attract heavy spending in the next decade, but their initial huge bursts of spending are probably over. Furthermore, although the interest costs to finance capital investment will probably remain low, especially with deflation, profits will probably remain under pressure in an era of slow revenue growth and deflation. And most important, capacity utilization rates are likely to remain low.

A statistical model that we have run many times over the years and just updated shows that year-over-year changes in corporate profits, interest costs and capacity utilization in the post-World War II era are all statistically significant in explaining year-over-year growth in both the equipment and software component of GDP and equipment and software plus nonresidential construction. But in either case, capacity utilization is much more important with coefficients almost three times as large as those for interest costs and even bigger relative to those for profits in both models (Charts 10 and 11).

We forecast annual real growth in equipment and software investment of 3.0% per year in the next decade, faster than the 2.0% we foresee for real GDP but much less than the 8.2% in the 1982-2000 golden years.

Imports and Exports

With weak consumer spending growth and overall muted economic advance, real imports are likely to rise only 2.8% annually in the next decade, much less than the 9.0% growth in 1982-2000 when U.S. consumer spending was booming and free trade ruled the world. This forecast is even lower than suggested by our 1.4% annual growth in real consumption. Historically, a 1% rise in consumer spending results in a 2.8% rise in imports, but rising protectionism is likely to dampen that relationship.

This weakness in U.S. imports will leave profound effects on the many foreign economies that have depended for growth on American consumers buying the excess goods and services for which they have no other ready markets. The net effect of subdued growth in U.S. imports will be sluggish economic growth abroad, perhaps even slower in other developed lands than in the U.S. That should limit the growth in U.S. exports to 3.0% per year compared with 7.4% in the 1982-2000 years (Chart 7). Still, government policies in Asia and elsewhere that promote consumer spending are likely to result in U.S. exports growing slightly faster than American imports, the reverse of earlier years. Severe protectionism, however, may stymie even these low growth forecasts for foreign trade.

State and Local Government Spending

Real state and local government spending, as recorded in the GDP accounts, rose slower than real GDP in the 1982-2000 years, 3.2% vs. 3.6%, and no doubt would in the years ahead – except for federal government stimuli that is spent by municipalities, as discussed later. State governments are in terrible financial shape and likely to continue so in the years ahead. In the first four months of this year, state income taxes plunged 26%. In the economic climate we foresee, corporate, sales and individual income taxes will all remain depressed.

At the local level, collapsed real estate prices will hold down property tax collections in the years ahead while reductions in aid and revenue-sharing from state governments will persist. In a recent survey, 18 states reported cuts in local aid. California Gov. Schwarzenegger proposed that low-level crimes like auto theft and drug possession be considered only misdemeanors so those convicted would do time in county jails. That would reduce state prison expenses and save the state $1.1 billion in the next three years, but raise local government costs. Furthermore, California’s latest budget stopgap will take, temporarily, $4 billion from local government funds.

We are forecasting 5.0% annual growth in state and local government spending in the next decade, but the majority of it will probably come from Washington, which will be forced to spend heavily to prevent high and chronically rising unemployment.

Rescued By Slow Productivity

Some suggest that slower economic growth will bring slower growth in production. That would reduce the upward pressure on unemployment since more people would be needed for work than with faster productivity growth. But there is no evidence that productivity growth necessarily slows with a chronically weak economy. In the depressed 1930s, productivity grew 2.39% annually, among the highest decades since 1900. In that decade, much of the new technologies of the 1920s – electrification of homes and factories and mass-produced automobiles – was being implemented, despite the Great Depression and its slow growth aftermath.

Similarly, the new tech burst of the last decade or so in computers, the internet, biotech, telecom and semiconductors will no doubt promote rapid productivity growth in coming years.

Finally, the mindset of American business will probably promote robust productivity growth in future years. Throughout this decade, the emphasis has been on producing more with fewer people. Note (Chart 12) that even at the top of the expansion in 2007, job openings were fewer than in 2000 at the peak of the previous expansion, despite the growth in the economy in the meanwhile. And since 2007, job openings have collapsed.

Unemployment will also remain high since many of the people who have lost jobs were in construction and finance, two areas that will probably do little net hiring for many years. Normally, a 2 percentage point drop in real GDP causes a 1 percentage point rise in the unemployment rate. But June’s 9.5% rate is 1.5 percentage points higher than this rule of thumb would predict, given the drop so far in real GDP.

Big Federal Spending

If we are right, then, on our forecast of slow economic growth in the next decade, unemployment will be high and chronically rising – absent huge federal intervention. And that intervention is assured since no government – left, right or center – can withstand high and rising joblessness for long. And do not forget current as well as future increased federal immersion in the economy builds constituencies that fight fiercely to preserve their government goodies.

Some of this federal intervention will probably take the form of more federal employees and direct purchases of goods and services, which show up in the GDP breakdown (Chart 7). But most of it will not be recorded as the federal spending GDP component since it will be transferred to individuals as federal unemployment benefits, extra Social Security checks, etc. and to state and local governments to fund leaf-raking and other make-work projects.

Notice that in 2018, we project real federal spending to account for only 7.2% of real GDP, up from 5.9% in 2008. Of course, nobody but economists look at these measures of federal spending, but instead concentrate on the ratio of total federal budget spending to GDP. This ratio mixed apples and oranges since budget spending includes transfers that GDP does not, but it does measure federal involvement in the economy.

In 2008, federal spending equaled 21% of GDP, outdistancing the 17.7% from revenues. This gap is likely to widen even after the current extraordinary spending to combat the recession and financial mess is over. Anti-unemployment spending will jump to higher levels while federal revenues languish. How will the resulting large deficit be financed?

Savers To The Rescue

In the past, federal deficits were financed by foreigners as they recycled back to the U.S. the dollars gained from their trade surpluses, as noted earlier. The growing U.S. current account deficit measures the increasing gap between domestic saving and investment, or, in effect, and the need for foreigners to not only finance government deficits but also make up for declining U.S. consumer saving.

But now, the current account and trade deficits are shrinking as American consumers retrench and slash imports. Further declines will accrue in future years if exports grow faster than imports (Chart 7), so foreigners will have smaller American current account deficits to finance. At the same time, much more of federal deficits will probably be financed by rising U.S. consumer saving.

Household saving is basically what is left from wages, salaries, rent, interest, dividends and transfers like pension benefits after subtracting spending on durables like autos and appliances, non-durables such as food and clothing and services like recreation and medical services. That amount, divided by the after-tax income in the period in question, is saving rate. Saving can be used to either reduce debt or increase assets.

Debt Reduction

Although the stock bulls may salivate over the prospect that increased saving will mean more equity purchases, we believe that most of the money will go to debt repayment – the flip side of a saving spree. The 6.9% saving rate in May, mentioned earlier, was a result of consumers saving their tax cuts and extra Social Security payments, and is unsustainable. Still, since after-tax income was about $11 trillion at annual rates in May, this saving rate produced annual rate saving of $769 billion. That money was basically used for debt reduction and since money is fungible, it ended up financing a major part of the mushrooming federal deficit. As consumer saving grows in future years, it will increasingly finance the federal deficit, indirectly.

Repaying debt will be attractive to many Americans in future years as they shun many investments after their huge losses in stocks throughout this decade and their shocking setbacks in real estate. A number will want to be less leveraged as slower economic growth makes employment less stable and unemployment more likely. Chastened lenders, pressed by regulators, will be pushing individuals to lower their leverage by repaying debt.

So will the deflation we foresee. Incomes may grow on average in real or inflation-adjusted terms, but shrink in current dollars. Still, debts are denominated in current dollars and therefore will grow in relation to current dollar incomes and the ability to service them. This will be the reverse of inflation, which reduced the value of debts in real terms and makes it easier to service them as incomes rise with inflation.

Future Insights

In future Insights, we will update our 2006 study that showed that over 50% of Americans depend in a meaningful way on government spending. The number will probably be much higher in the coming decade of likely slow growth and greater government involvement in the economy. We also plan to discuss our investment themes for an era of slow growth and deflation.

Meanwhile, do not expect the burst of federal government spending and immersion in the economy to disappear with economic recovery. It is likely to persist, not only because it spawns self-perpetuating constituencies, but also because the slow economic growth in the years ahead and threats of high and chronically rising unemployment will force continuing high levels of government involvement.


Rising U.S. stock prices – particularly following a 50% decline – mean nothing regarding the health of the U.S. economy or the prospects for a recovery. In fact, relative to the meteoric rise of foreign stock markets over the past six months, U.S. stocks are standing still.

Like Doug Noland below, Peter Schiff’s take on the U.S. stock market recovery is that it is not indicative of economic recovery. He does not think the U.S. economy is improving, and thinks the comparatively stronger performance of overseas stock markets is evidence for his long predicted “decoupling” of the global economic train from “the American caboose.”

Schiff thinks that although the worst of the global financial crisis may have passed, the real impact of the much more fundamental U.S. economic crisis has yet to be fully felt. For America, genuine recovery will not begin until current government policies are mitigated. Ben Bernanke has been an enabler for the counterproductive policies. “That fact that Ben Bernanke remains so popular both on Wall Street and Capital Hill is indicative of just how badly he has handled his job.”

Rather than continue to pursue these policies Schiff proposes the strategy developed by Seinfeld character George Costanza: Wisely recognizing that every instinct he had up unto that point had ended in failure, George decided that to be successful, he had to do the exact opposite of whatever his instincts told him.

There is an inexplicable, but somehow widely held, belief that stock market movements are predictive of economic conditions. As such, the current rally in U.S. stock prices has caused many people to conclude that the recession is nearing an end. The widespread optimism is not confined to Wall Street, as even Barack Obama has pointed to the bubbly markets to vindicate his economic policies. However, reality is clearly at odds with these optimistic assumptions.

In the first place, stock markets have been taken by surprise throughout history. In the current cycle, neither the market nor its cheerleaders saw this recession coming, so why should anyone believe that these fonts of wisdom have suddenly become clairvoyant?

According to official government statistics, the current recession began in December of 2007. Two months earlier, in October of that year, the Dow Jones Industrial Average and S&P 500 both hit all-time record highs. Exactly what foresight did this run-up provide? Obviously markets were completely blind-sided by the biggest recession since the Great Depression. In fact, the main reason why the markets sold off so violently in 2008, after the severity of the recession became impossible to ignore, was that it had so completely misread the economy in the preceding years.

Furthermore, throughout most of 2008, even as the economy was contracting, academic economists and stock market strategists were still confident that a recession would be avoided. If they could not even forecast a recession that had already started, how can they possibly predict when it will end? In contrast, on a Fox News appearance on December 31, 2007, I endured the gibes of optimistic co-panelists when I clearly proclaimed that a recession was underway.

Rising U.S. stock prices – particularly following a 50% decline – mean nothing regarding the health of the U.S. economy or the prospects for a recovery. In fact, relative to the meteoric rise of foreign stock markets over the past six months, U.S. stocks are standing still. If anything, it is the strength in overseas markets that is dragging U.S. stocks along for the ride.

In late 2008 and early 2009, the “experts” proclaimed that a strengthening U.S. dollar and the relative outperformance of U.S. stocks during the worldwide market sell-off meant that the U.S. would lead the global recovery. At the time, they argued that since we were the first economy to go into recession, we would be the first to come out. They claimed that as bad as things were domestically, they were even worse internationally, and that the bold and “stimulative” actions of our policymakers would lead to a far better outcome here than the much more “timid” responses pursued by other leading industrial economies.

If the U.S. economy really were improving, the dollar would be strengthening – not weakening.

At the time, I dismissed these claims as nonsensical. The data are once again proving my case. The brief period of relative outperformance by U.S. stocks in late 2008 has come to an end, and, after rising for most of last year, the dollar has resumed its long-term descent. If the U.S. economy really were improving, the dollar would be strengthening – not weakening. The economic data would also show greater improvement at home than abroad. Instead, foreign stocks have resumed the meteoric rise that has characterized their past decade. The rebound in global stocks reflects the global economic train decoupling from the American caboose, which the “experts” said was impossible.

Ben Bernanke’s popularularity on both on Wall Street and Capital Hill is indicative of just how badly he has handled his job.

Though the worst of the global financial crisis may have passed, the real impact of the much more fundamental U.S. economic crisis has yet to be fully felt. For America, genuine recovery will not begin until current government policies are mitigated. Most urgently, we need a Fed chairman willing to administer the tough love that our economy so badly needs. That fact that Ben Bernanke remains so popular both on Wall Street and Capital Hill is indicative of just how badly he has handled his job.

Contrast Bernanke’s popularity to the contempt that many had for Fed Chairman Paul Volcker in the early days of Ronald Reagan’s first term. There were numerous bills and congressional resolutions demanding his impeachment, and even conservative congressman Jack Kemp called for Volcker to resign. Had it not been for the unconditional support of a very popular president, efforts to oust Volcker likely would have succeeded. [It is to Jimmy Carter’s great credit that he supported Volker, perhaps at the cost of his reelection.] Though he was widely vilified initially, he eventually won near unanimous praise for his courageous economic stewardship, which eventually broke the back of inflation, restored confidence in the dollar, and set the stage for a vibrant recovery. Conversely, Bernanke’s reputation will be shattered as history reveals the full extent of his incompetence and cowardice.

As congress and the president consider the best policies to right our economic ship, it is my hope that they will pursue a strategy first developed by Seinfeld character George Costanza. After wisely recognizing that every instinct he had up unto that point had ended in failure, George decided that to be successful, he had to do the exact opposite of whatever his instincts told him. I suggest our policymakers give this approach a try.


Problematic market dynamics have taken over, with prices increasingly disconnected from reality. In short, the market is in the midst of one major short squeeze.

Doug Noland turns his attention specifically to the stock market this week. Rather than being some great discounting mechanism, he believes the frothy market “is indicative of the current dysfunctional financial backdrop,” i.e., the government finance bubble he has fleshed out in previous columns. Being blunter, he claims the market is going up due to a massive short squeeze.

Noland concludes: “I have great confidence that government finance bubble dynamics ensure ongoing distortions in the markets’ pricing of risk and, as well, a continued misallocation of resources (financial and real). And it is increasingly clear that the stock market is embroiled in this problematic dynamic. But that is a dilemma for another day, as surging stocks fan optimism and risk embracement ... And speculative equities and credit markets will spur increased economic output in the short-run. ... Everything has been extraordinary; the boom, the bust, policymaker interventions, and now the bear market rally.

I will restate my thesis as concisely as I can (not my strong suit): The deeply maladjusted U.S. “bubble” economy requires $2.5 trillion or so of net new credit creation to stem systemic (credit and economic bubbles) implosion. Only “government” (Treasury, agency debt, and GSE MBS) debt can, today, fill the gigantic void created with the bursting of the Wall Street/mortgage finance bubble. The private sector credit system is severely impaired, and there is as well the reality that the market largely lost trust (loss of “moneyness”) in Wall Street obligations (private-label MBS, CDOs, ABS, auction-rate securities, etc.). The $2.0 trillion of U.S. “government” credit creation coupled with the $trillion-plus expansion of Federal Reserve credit over the past year has stabilized U.S. financial and economic systems.

The synchronized global expansion of government deficits, state obligations, and central bank credit amounts to an historic government finance bubble. Markets have thus far embraced the surge of debt issuance. This U.S. and global reflation will have decidedly different characteristics when contrasted to previous Fed and Wall Street-induced reflations.

The debased dollar has provided China and the “developing” world credit systems unprecedented capacity to inflate.

First off all, the most robust inflationary biases are today domiciled in China, Asia and the emerging markets generally. The debased dollar has provided China and the “developing” world credit systems unprecedented capacity to inflate (expand credit/financial claims without fear of spurring a run on their currencies). Asian and emerging markets are outperforming, exacerbating speculative inflows. Things that the “developing” world need (energy/commodities) and want (gold, silver, sugar, etc.) should demonstrate increasingly strong inflationary pressures. Their overflow of dollars provides them, for now, the power to buy whatever they desire.

The unfolding reflation will be of a different variety than those of the past – and, importantly, largely bypass U.S. housing.

Here at home, the post-Wall Street bubble financial landscape ensures the old days of the Fed slashing rates and almost instantaneously stoking mortgage credit, home price inflation and consumption have run their course. Accordingly, the unfolding reflation will be of a different variety than those of the past – and, importantly, largely bypass U.S. housing. This sets the stage for a lackluster recovery in consumption and economic revival generally. Household sector headwinds will likely be exacerbated by higher-than-expected inflation (especially in energy and globally-traded commodities), higher taxes and rising interest rates.

There is a confluence of factors that expose the market to an upside surprised in yields. The bond market has been overly sanguine, emboldened by the prospect of the Bernanke Fed maintaining ultra-loose monetary policy indefinitely. Bond bulls have been further comforted by the deep structural issues overhanging both the U.S. financial system and economy. However, massive government credit creation has, for now, put systemic issues on hold. Especially in Asia, unfettered credit expansion creates the backdrop for a surprisingly speedy economic upsurge. The weak dollar plays a major reflationary role globally, while also raising the prospect for inflationary pressures here at home. Massive issuance, global economic resurgence, heightened inflation and a weak currency are offering increasingly tough competition to the bullish “forever loose policy” view.

Fixed income must gaze at the feverish equities market with disbelief – and rising trepidation.

Meanwhile, fixed income must gaze at the feverish equities market with disbelief – and rising trepidation. The bond market discerns incessant economic impairment, a historic debt overhang, 9.4% unemployment, and begrudging recovery. An intoxicated stock market ganders something altogether different, with the Morgan Stanley Retail Index up 61% year-to-date, the Morgan Stanley High Tech Index up 47%, the Morgan Stanley Cyclical Index up 52%, and the Broker/Dealers up 45%. The bond market has been content to laugh off the silly equities game. The chuckles may have ended today.

My secular bearish thesis rests upon a major assumption: The U.S. economy is sustained by $2.5 trillion (or so) of new credit. Only this amount will stem a downward spiral of asset prices, credit, incomes, corporate cash flows and government finances. On the other hand, if forthcoming, the $2.5 trillion of additional – chiefly government-directed and non-productive – credit will foment problematic Monetary Disorder. In simplest terms, another bout of credit inflation leads further down the path of unhinged market prices, destabilizing speculation, and unwieldy flows of finance.

The stock market has become illustrative of what we might experience in the way of monetary disorder. Speculation has returned with a vengeance, galloping blindly ahead of fledgling little greenish shoots. Those of the bullish persuasion contend that the marketplace is, as it should, simply discounting a rosy future. I would counter that problematic market dynamics have taken over, with prices increasingly disconnected from reality. In short, the market is in the midst of one major short squeeze.

There are myriad risks associated with the government’s unprecedented market interventions. Likely not well appreciated, policymaker actions have forced the destabilizing unwind of huge positions created to hedge against systemic risk (as well as to profit from bearish bets). This reversal of various bear positions has created enormous buying power, especially in the securities of companies (and sectors) most exposed to the credit downturn. The reversal of bets in the credit default swap (and bond) market has certainly played a role. Surging junk bond and stock prices have fed one another, as the highly leveraged and vulnerable companies provide phenomenal market returns. The markets are today throwing "money" at the weak and leveraged.

The resulting outperformance of fundamentally weak companies spurred short covering more generally, creating a dynamic whereby heavily shorted stocks became about the best performing sector in the equities market. This dynamic put significant pressure on so-called market neutral strategies that have proliferated over the past few years. The strategy of attempting to own the good companies and short bad ones is faltering, likely causing a flow out of these strategies - and a self-reinforcing unwind of positions. The “bad” stock soar and the “good” ones languish.

The stock market is indicative of the current dysfunctional financial backdrop.

There is nothing like a short squeeze panic to get the markets’ speculative juices flowing. Many will say all is just fine and dandy – let the fun and games continue! My retort is that the stock market is indicative of the current dysfunctional financial backdrop. At the end of the day, the financial system must be capable of effectively allocating finance and real resources throughout the economy. I would argue that this is not possible for a system that congenitally misprices risk and distorts financial asset prices. Today’s stock market will inherently finance mainly speculative bubbles and fragility. And the core systemic problem, the maladjusted “bubble economy,” well, the financial backdrop only worsens the situation.

I have great confidence that government finance bubble dynamics ensure ongoing distortions in the markets’ pricing of risk and, as well, a continued misallocation of resources (financial and real). And it is increasingly clear that the stock market is embroiled in this problematic dynamic. But that is a dilemma for another day, as surging stocks fan optimism and risk embracement – not to mention forcing many into the stock market with both nostrils plugged. And speculative equities and credit markets will spur increased economic output in the short-run.

Everything has been extraordinary; the boom, the bust, policymaker interventions, and now the bear market rally. I wish I could see some mechanism in the works that will help kick our system’s addiction to easy credit and commence the inevitable process of economic adjustment and restructuring. Instead, I see confirmation everywhere that policy and market dynamics are working in concert to sustain the existing financial and economic structure. I have huge doubts it will work and no doubt about the risks of failure.


The science of economic bubbles and busts.

The July Scientific American carried an article “The science of economic bubbles and busts” that summarized current biological research into the economic irrationality of human behavior. The short conclusion is that economic rationality appears to be an illusion; humans have a number of hard-wired brain impulses that make them economically irrational. Anyone possessed of any wisdom has already surmised this.

The research pointed to the following major conclusions: (1) Humans are wired up to undergo money illusion, thus it is not surprising that easy money monetary policies are popular. (2) Economic actors appear to be prone to a number of biases. Confirmation bias causes people to overweight information that confirms their viewpoint. Availability bias causes the most recent information to be heaviest weighted. Hindsight bias causes economic actors to “rewrite history,” believing for example that they had known all along that housing was a bubble. Finally, investors tend to herd in times of market optimism or pessimism; it becomes increasingly difficult to go against the flow.

Martin Hutchinson concludes: “As investors, we are particularly prone to make mistakes that are governed by our biology. We choose the popular, reinforcing our biases by doing so. We listen to the advice of our broker, always cheerful and upbeat about the market. In this respect, previous generations were much luckier. A dour conservative bank manager, rejecting risky ventures firmly and nagging his clients to save more, both gave better investment advice and interacted better with our biological failings than the cheery salesman we rely upon today.”

And finally: “Biology is our destiny. In both policy and our daily activities, we had better be aware of its demands, so that we can counteract them and make our world and our own actions more economically rational.”

July’s Scientific American carried a fascinating article “The science of economic bubbles and busts” that summarized current biological research into the economic irrationality of human behavior. At the risk of boring readers whose coverage extends to biological research literature as well as the Wall Street Journal, I thought it worth exploring its implications for how a well-managed economy should be set up. Current institutions, in any case not Adam-Smith-optimized, may need some new tweaks.

Both for biological reasons and because of their millennia hunting woolly mammoths, humans have a number of hard-wired brain impulses that make them economically irrational. One example is money illusion, the impulse to believe they are getting richer when the value of money is declining through inflation. This turns out to be hard-wired into the brain in the ventromedial prefrontal cortex; a recent experiment at the University of Bonn demonstrated that the VMPFC lit up a brain scanner when the subject encountered a larger amount of money, even though its value was no greater. It can be mitigated by careful use of indexation, as was done in Chile, where since 1967 the central bank’s “unidad de fomento” has mitigated money illusion even in periods of hyperinflation.

The greatest advance in biological understanding of economics is that economic rationality appears to be an illusion. Vast superstructures have been built upon the assumption of economic rationally, including notably the Efficient Market Hypothesis and all the trading systems, valuation models and investment management paradigms derived from it. As well as money illusion, economic actors appear to be prone to a number of biases. Confirmation bias causes people to overweight information that confirms their viewpoint. Availability bias causes the most recent information to be heaviest weighted. Hindsight bias causes economic actors to “rewrite history” believing for example that they had known all along that housing was a bubble. Finally, investors tend to herd in times of market optimism or pessimism; it becomes increasingly difficult to go against the flow.

A further finding is that happy faces cause investors to be more risk-seeking; thus the prevalence of optimists among stock and mortgage brokers. This column can thus make you richer in bubbles, by helping you to counteract excessive broker optimism!

Given biology’s insights into economic behavior, there are some pretty clear policy implications. First and foremost, if investors are biologically wired up to undergo money illusion, it is not surprising that easy money monetary policies are popular.

Given biology’s insights into economic behavior, there are some pretty clear policy implications. First and foremost, if investors are biologically wired up to undergo money illusion, it is not surprising that easy money monetary policies are popular. By endlessly inflating the money supply, easy-money Fed Chairmen Alan Greenspan and Ben Bernanke can make the populace doze in a sea of warm contentment, undermining the economy year by year but preserving their own political credibility and preventing major criticism from Congress.

Over the last six months, the Bank of England has monetized 60% of public spending. That is a higher level than that by the Weimar Republic in 1919-23 and the result will be the same.

The same is true in Britain also, where even in the face of a recovering economy, the Bank of England has added another £50 billion to its monetization of the British budget deficit, taking its total to £200 billion in less than 6 months. Even taken over a year, the bank is now monetizing over 30% of British public spending, or 13% of Gross Domestic Product (GDP). Over the last six months, it has monetized 60% of public spending. That is a higher level than the 50% monetization of public spending undertaken by the Weimar Republic in 1919-23 and the result will be the same.

In Britain’s case, the Bank of England seeks a quiet life from the current government, which is on its last legs and facing a General Election within a year that it is very likely to lose. In the U.S. case, Bernanke wants to get his Fed chairmanship extended beyond January 2010 from an administration that did not appoint him. In both cases, a sloppy monetary policy that devastates savings, rewards shysters on Wall Street and eats away at the foundations of the economy is by far the most popular course. Paul Volcker, the only chairman in Fed history to run an adequately tight monetary policy, is well respected and indeed included in the Obama administration, but his advice, sound on most matters, is conspicuously ignored.

If sloppy monetary policy is inevitably popular, yet economically damaging, it follows that mechanisms need to be designed to prevent the seductions of money illusion, and ensure that monetary policy is kept adequately tight at all times. The Reserve Bank of New Zealand’s 1988 idea, of tying the Governor’s salary inversely to inflation, so that if prices rose more than 2% he suffered a devastating pay cut, is the kind of incentive structure the system needs. If the Fed does not naturally follow a Volcker policy, and biology suggests there are very good reasons why it does not, then the Fed’s statutes must be rewritten so that a Volcker policy is unavoidable.

Far from extending the Fed’s remit towards banking supervision, its field of operations must be narrowed, with the employment objective removed from its policy goals, so that its only job becomes that of maintaining monetary stability, following as closely as possible the monetary path that would be dictated by a Gold Standard. Just as a man with tendencies to alcoholism is prescribed a regime of strict abstinence, so the discovery of tendencies towards inflationism in our society means monetary teetotalism must be written into the Fed's statutes, with backsliding and compromise strictly prohibited.

Policymakers need to be presented repeatedly with information that counteracts their preconceived ideas.

Counteracting naturally occurring biases is also essential. In the case of confirmation bias, policymakers need to be presented repeatedly with information that counteracts their preconceived ideas. The best example of this is Bernanke again. When presented with inflation figures; he switches between different reported statistics, always manages to find one that justifies him in lowering interest rates, and in his belief that the demon of deflation is perpetually lurking nearby.

In their early years after World War II, economic statistics such as GDP and inflation were presented with as much accuracy and straightforwardness as possible. Since their publication did not affect the real world much, the pressure on their producers was modest and so they were generally reliable.

That changed with the inflation scare of 1979, which spooked the bond market and forced the resignation of Fed Chairman G. William Miller and his replacement by Volcker. For a number of years after that event, both inflation and money supply statistics were watched like hawks by bond market economists, and so no fudging was possible. Then in 1993, Greenspan abandoned monetary targets, allowing broad money supply to expand rapidly.

Since politicians also liked rapidly expanding money supply and low interest rates, they “fixed” the price statistics in 1995-96 through the Boskin Commission, inventing the fictitious “hedonic pricing” by which improvements in computer processor power speeds were allowed to feed through directly into lower price indexes. As a result, GDP was inflated, inflation was reduced, reported productivity growth was inflated and the U.S. Treasury began to issue Treasury Inflation Protected Securities based on the new index, confident that bond market investors would accept their inflation protection as genuine.

The tweaking of official statistics was so successful in deifying Greenspan and reelecting Bill Clinton that official statistics have been unreliable ever since.

That tweak of official statistics was so successful in deifying Greenspan and re-electing Bill Clinton that official statistics have been unreliable ever since. They are always likely to be “fudged” generally by modest amounts, to make them more politically palatable. Currently, Bernanke’s zero interest rate policy is being propped up by “spurious “seasonal adjustments” in consumer price indexes that deflate “seasonally adjusted” reported inflation figures below the raw data. GDP data over the next few quarters is also likely to be massaged so as to be politically convenient to the Obama administration’s preferred narrative.

The combination of fudged statistics and confirmation bias among loose-money-loving policymakers is truly deadly.

The combination of fudged statistics and confirmation bias among loose-money-loving policymakers is truly deadly, we will probably need true inflation in double digits for a year or more before interest rates are increased sufficiently to address it.

Availability bias, by which the most recent information is most highly weighted and hindsight bias by which we convince ourselves that “we always knew that,” have also been ubiquitous during this economic downturn. Home mortgages that were considered perfectly sound until 2006 are now believed to have been obviously a scam. Dean Baker of the Center for Economic and Policy Research is very good on this subject, questioning why economists, journalists and policymakers who were entirely oblivious of the housing bubble while it was in progress should now be taken as experts on housing.

The best cure for availability and hindsight biases is regular perusal of the conventional opinion of a decade ago. Beliefs that seem foolish now were taken as wholly obvious then, just as beliefs that seem obvious now will be regarded as laughable in 2019. With so much up-to-the-minute information available through the Internet, and pre-1995 information much harder to come by, this problem has become more severe in this generation. By reading the editorials of 2004, 1999 and 1984, we can remind ourselves what was believed by conventional wisdom at those dates. Through doing so, we do not simply enable ourselves to laugh at past shibboleths, but remind ourselves of past truisms that have been forgotten. Thereby we acquire a historical perspective on our economic activities, and are assisted to avoid those that make no sense.

As investors, we are particularly prone to make mistakes that are governed by our biology. We choose the popular, reinforcing our biases by doing so. We listen to the advice of our broker, always cheerful and upbeat about the market. In this respect, previous generations were much luckier. A dour conservative bank manager, rejecting risky ventures firmly and nagging his clients to save more, both gave better investment advice and interacted better with our biological failings than the cheery salesman we rely upon today.

We are also prone to overreaction to our recent investment performance, increasing our portfolio’s risk at the top of bull markets and moving into cash when performance has been bad. My own preferred solution to this is to buy a few long-dated out-of-the-money put options on the S&P 500 index, available on the Chicago Board Options Exchange. These cost money in bullish or flat markets, but turn into a bonanza in market crashes. That serves two purposes. It reminds us after crashes that we did not get everything wrong. And it provides a pool of cash that can be invested at the bottom, just when it is most useful.

Biology is our destiny. In both policy and our daily activities, we had better be aware of its demands, so that we can counteract them and make our world and our own actions more economically rational.


Money market cash, in comparison with the value of all stocks, is twice what it was in 1982.

Ken Fisher, who seems to be featured in practically every issue of Forbes these days, is still bullish – shades of Chevy Chase weekly announcement on Saturday Night Live ca. 1975 that Generalissimo Francisco Franco was still dead. Fisher has some reasonable suggestions for those who want to speculate that he is correct.

That 9% minicorrection between June 2 and July 13 was nothing to worry about. Pullbacks are normal early in a recovery. I can find only one bull market, in 1935, that did not have some material indigestion within its first 12 months. But bull markets roll on for years.

This rally has taken stocks up 55% from their March 9 low, as measured by the Morgan Stanley All World Index. That is far bigger than any global bear market sucker rally. Interestingly, the record rebound has gotten less ink than the corresponding fall in prices during the first quarter. Maybe the bulls should be making a bigger fuss about what is going on.

In my September 29 column last year I wrote about how we are in a reverse bubble. In this mirror image of a buying mania, people can see only the negatives. But the positives are there and will be reflected in stocks before long.

For example, few see that housing affordability is now excellent: The median home price in the U.S. is 2.8 times median family income, down from 3.9 times three years ago. Another positive is that global leading economic indicators in total (such as real money supply and the yield curve’s slope) are the highest they have been in a decade. Productivity is up 2% from a year ago, an impressive growth rate within a recession’s decline.

The financial crisis is over. Most rate spreads between risky paper like junk bonds to Treasurys have reverted to precrisis levels. U.S. bank cash on hand, at a trillion dollars, is (adjusted for inflation) three times what it was before the crisis. Cash in the form of U.S. money market funds comes to 42% of the stock market’s capitalization. That ratio is more than twice what it was in 1982 and 2003, as stocks were about to take off.

I have been saying for a while that stocks are dirt cheap, as measured by the degree to which prospective earnings yields exceed long-term interest rates globally. Stocks are also low in relation to commodity prices. In 2000 the S&P 500 matched the dollar price of 5 ounces of gold; now it costs you only an ounce. The price of the index in baskets of wheat and pounds of copper is down similarly. And what do the bears say? That earnings will be low this year. Old news. So what? I expect S&P earnings (before writeoffs) of $70 next year. The market is trading at 13.6 times that sum.

You should remain heavily committed to stocks like these:

Emerson Electric (EMR, 36) has $24 billion in annual revenue from motors, valves, switches, test equipment, compressors and much more – all depressed businesses now, but they will have much higher sales as the expansion evolves. The stock will move ahead of the sales gain. It now sells at one times annual sales and 10 times what I think it will earn in its September 2010 fiscal year. The dividend yield is 3.6%.

A similarly depressed high-quality industrial is Sweden’s SKF Industries (SKFRY, 13), which makes roller bearings, seals, lubrication systems and complex industrial parts that combine electronics and mechanics. Until this recession it grew steadily – and it will again. Like Emerson, this company will see its stock run up ahead of its sales. It also sells at 10 times my estimate of 2010 earnings and 70% of its revenue; yield, 2.1%.

Dow Chemical (DOW, 20) is the world’s best large chemical maker. It grows slowly but steadily gains on competitors. The stock lagged in the prior bull market and fell fully with the market in the bear, so it is cheap now. When can you buy a market leader at 40% of annual revenue? Dow is just breaking even now, but the stock is at four times my estimate of 2011 earnings. It sports a 3% dividend yield.

On March 30 I recommended France’s Lafarge (LFRGY, 17), the world’s largest cement and concrete maker, at $9.50. So what if you missed the low; it is still a buy. Despite the recession, we are going to keep using the stuff. Politicians will see to that. Even after the recent rebound this stock sells at only 3.8 times its prerecession earnings. It has a 4% dividend yield and sells at 50% of revenue and 70% of book.

Today’s China is more of a neo-feudal fascist state than a communist one – and a prime beneficiary of the governmental control system there is Petrochina (PTR, 115), China’s largest producer of oil, with 2.3 million barrels per day, and natural gas, with 3 million cubic feet per day. As China latches on to the world’s resources, Petrochina will benefit. It sells at 11 times likely 2009 earnings, with a 3.4% dividend yield.


One longtime investor finds crushed small-cap stocks in the bargain bin.

Irene Hoover, who manages the $383 million Forward Small Cap and $700 million more in institutional small-cap assets, likes the bargains she is finding in her universe. We do not find the case made in this article airtight, but nor does it look nonsensical.

As the financial crisis grew threatening last year, history buff Irene Hoover watched with a foreboding sense that the U.S. could be on the verge of another Great Depression. It was only after the Federal Reserve flooded the financial system with capital, and a few rays of light began shining through the storm clouds, that Hoover looked around and saw a silver lining for her Forward Small Cap Equity fund.

“It’s a once-a-generation opportunity,” says Hoover, 68, of the bargains she sees in her market. “Valuations of companies that have good growth potential are still reasonable.”

A particular fondness for fallen angels – companies that have proved themselves in the past, have fallen from grace but have good prospects to rise again.

Hoover, who has managed the $383 million Forward Small Cap since it launched 11 years ago, and who also manages $700 million in institutional small-cap assets, has a particular fondness for fallen angels – companies that have proved themselves in the past, have fallen from grace but have good prospects to rise again. One is Williams-Sonoma (WSM), a retail chain whose head office is not far from her own in San Francisco. The chain sells overpriced cookware and, through Pottery Barn, furniture and housewares. Sales were off 22% in the most recent quarter. But they will probably recover.

What is a reasonable valuation? There are two classic ways to compare a company’s price to its earning power. One is the ratio of the price (market value of common) to the net income, the P/E ratio. This ratio is meaningless for Williams-Sonoma, which will scarcely break even this year. Another method compares the enterprise value (market cap plus debt minus cash on hand) to the operating income, which is net income before deducting interest, taxes and depreciation. Hoover comes down in the middle between these two approaches. Among other tests, she compares market cap to pretax, pre-depreciation net (what you might call pretax cash flow). In short, she is willing to overlook a weak bottom line if noncash depreciation charges are the reason for it or if cash from previous earnings is still providing a balance sheet cushion.

Note that this really only makes sense if maintenance capital spending is notably less than depreciation. Required maintenance capital spending is for all intents an expense.

Williams-Sonoma’s market value is $1.5 billion. For the fiscal year that ends January 31, 2010, Hoover estimates pretax earnings of $34 million. Adding back $144 million of depreciation and amortization (high, because the company has continued to invest in and remodel stores even as sales have collapsed) she arrives at $178 million. So, for this company, the ratio of price to pretax cash flow comes to 8.4. That is low for this chain, assuming it recovers, Hoover argues. It is also low in comparison to certain other specialty retailers. For example, at much larger Bed Bath & Beyond (BBBY), the ratio is 10.9.

Hoover also owns ritzy grocer Whole Foods (WFMI) and mass marketer Dick’s Sporting Goods (DKS). The ratios there are 7.6 and 8.8.

Her nose for value has enabled Forward Small Cap to return 4.8% annually since inception, edging out the 4.5% earned by the Russell 2000 index despite the drag of the fund’s 1.65% in annual fees and 0.6% in annual brokerage costs.

Hoover insists that high-quality but beaten-down small caps have a year or more still to run.

Hoover, who works with six analysts, insists that high-quality but beaten-down small caps have a year or more still to run. Historically, stocks of small companies have been more volatile than those of large ones, in part because of fears they will be hurt by insufficient earnings cushions and access to capital. They also tend to recover quickly. “It is a riskier asset class,” says Hoover, “but I think we are on the upside of that risk now.”

Hoover grew up in Chicago, the daughter of a South Side banker. After studying Renaissance history at Stanford and American history at Northwestern, she began teaching high schoolers in Winchester, Massachusetts and, in summers, in New York City’s Harlem neighborhood. Along with a broker friend, she began picking stocks for her own account in the late 1960s and grew interested in investment management. Fascinated with the West since childhood, Hoover moved to San Francisco in 1968 and began working as a securities analyst in the brokerage industry.

She took off 11 years beginning in 1974, while her children were young, and also used that time to earn her credentials as a chartered financial analyst. She got her first gig managing money in 1991 and, after her eldest child graduated from college, opened Hoover Investment Management in 1998. Her two sons now work there. One is an analyst, and the other handles the computers.

Hoover spends weekends at her country home in Sonoma County. Weekdays she is in the office at 6:30 a.m. She screens the entire stock market weekly, looking for cheap sectors and stocks. She and her analysts meet with an average of 15 companies a week. She holds off buying until a stock has fallen to the low end of its historic multiple of either earnings or pretax cash flow.


Penned by the Barron’s reporter who sounded the alarm in 2001.

Erin Arvedlund raised serious questions about Bernard Madoff’s claimed investment returns in a 2001 Barron’s story, “Don’t Ask, Don’t Tell”. The article subtitle was: “Bernie Madoff might as well hang that sign on his secretive hedge-fund empire. Even adoring investors can’t explain his enviably steady gains.” Note that this article was written about 7 1/2 years before the roof caved in.

We now know, of course, that there was no explanation for the steady gains because the steady gains did not exist. Arvedlund has just finished a book about Madoff, Too Good To Be True. Two excerpts explain the key function played by the Madoff London office in funneling money into his pockets, and raise a “What did they know and when did they know it?” question regarding when JPMorgan Chase realized Madoff was a fraud. Miraculously, JPMorgan Chase got out before the fraud was exposed.

In 2001, long before Bernard Madoff burst into the spotlight with his massive Ponzi scheme, Erin Arvedlund wrote an exposé for Barron’s questioning Madoff’s claimed investment returns. When Arvedlund, then a staff writer for the magazine, pressed Madoff on how he did it, he replied: “It’s a proprietary strategy. I can’t go into it in great detail.” Well, sorry, Bernie – Arvedlund now has the details. Her book about Madoff, “Too Good To Be True,” will be published August 11 by Portfolio, a division of Penguin Group (USA). In the exclusive excerpts that follow, she explains the key roles played by Madoff’s London office, and raises questions about just when JPMorgan Chase realized he was a fraud.
Madoff’s London office played a large role in helping hide his fraud. London may have started out legitimate, but over the decades it morphed into a financial outpost for the family, a place where they felt comfortable stashing what they considered their personal money – which by 2008 amounted to some 113 million British pounds.

Madoff Securities International Limited, as the London operation was called, opened its doors in 1983. The business entity was owned by Madoff, his wife, their sons, and a longtime friend of Bernie’s, Paul Konigsberg. Later, Konigsberg’s accounting firm would show up hundreds of times on the list of victims, since Madoff often referred his investors to the firm – as good accountants for handling securities.

The London office had electronic terminals that made it possible to log in directly to and trade on the Nasdaq exchange from overseas. As usual, the Madoffs were early adopters of technology, and they were among the first to use these market-making terminals outside the U.S. This meant the U.K. office could trade when traders in the United States could not: domestic U.S. trades were allowed only when the U.S. markets were actually open.

By 1989, however, the Nasdaq extended its hours and traded several hundred over-the-counter stocks during the predawn hours in the United States, thus allowing firms there to trade during London hours – part of the gradual globalization that would one day overtake securities trading. This may have made the London office less essential to the daily operations of Madoff’s broker-dealer and proprietary-trading businesses.

Over time, however, the London branch would become the family bank teller. It was offshore as well, so Madoff could wire money from his U.S. operations to London, in transactions of hundreds of millions of dollars that covered fake trades, or simply wash the funds out of his American accounts and then spend them on luxury items like the Leopard speedboat he purchased in France. (This is also known as money laundering.)

Although the sons, Mark and Andrew, were located in New York, they held ownership and titles as directors in the London operation. And Bernie’s wife, Ruth, and his brother, Peter, also held shares, as did his old friend Sonny Cohn, at least originally. Paul Konigsberg was another director. Charles Stillman, an attorney for Konigsberg, said Konigsberg received nonvoting shares for work he did to help open the London operation, in the 1980s. Konigsberg, he added, did not have any “meaningful business role” in the London operation, which suggests he didn’t have any say in how the business was run.

Konigsberg, however, was a major fund-raiser for Madoff’s New York hedge fund at least since 1998, according to Madoff investor Steven Leber. Leber filed a $4 million lawsuit in Florida against Konigsberg and his accounting firm, Konigsberg Wolf & Co., charging negligence and professional malpractice with respect to a Madoff account opened by Leber in 1998. In that suit, Leber alleged that Konigsberg offered to act as a conduit to Madoff for Leber’s $4 million or so in family money – but only if Leber started using Konigsberg’s accounting firm as well. Konigsberg Wolf has offices in New York and is listed on the Madoff victims’ trustee list. Konigsberg himself, as well as his firm and some of his family members, also appears on the victims’ list more than 300 times – sometimes on his own behalf, other times on behalf of accounts set up for others, such as the Norman F. Levy Foundation.

It is possible the London operation was a way to repay Konigsberg for his fund-raising services without the commission money being traced. After all, through Madoff Securities International, Madoff was able to handsomely compensate other family members. In 1998, for example, directors of the London operation received emoluments, or payments, totaling £688,570 while the operation reported profits of £1.03 million, according to the Wall Street Journal. In 2007, Madoff directors altogether received £1.09 million, with the highest-paid director alone receiving £301,437.

Madoff always had the money ready for withdrawl requests, no matter how large the amount. It was one of his biggest selling points.

Meanwhile, Madoff had two primary bank accounts set up for him in New York. One account was with the Bank of New York Mellon, account number 866-1126-621 (referred to as BONY 621). It was supposed to be the broker-dealer’s primary cash account. He also had an account at JPMorgan Chase, numbered 140081703 (referred to as JPM 703), which was the account investors used to wire money or send checks to the fake advisory business. This was also the account used to pay investors when they withdrew funds. Many were able to get hold of their money within days; Madoff always had it ready, no matter how large the amount. It was one of his biggest selling points.

After his arrest, Madoff would claim in court that the legitimate brokerage firm and the criminal hedge fund, the advisory business, were completely separate. However, in 2001, money began to slosh back and forth between the two accounts, and this continued up until the day Madoff turned himself in. Money was regularly transferred from both the Bank of New York and the JPMorgan Chase accounts to the London office. Madoff personally wired roughly $500 million over to London and then back again between 2001 and 2008, according to copies of the documents filed by the Madoff trustee, Irving Picard. Over those seven years, Madoff also withdrew cash from the broker-dealer’s account with Bank of New York, sometimes as much as $2 million in a single day.

Madoff Securities International in London also “traded for Bernard Madoff’s personal accounts and members of his family,” said Picard. And the trustee’s revelations did not stop there. In a filing with the U.S. Bankruptcy Court, Picard laid out how the London accounts had been used as Madoff’s personal piggy bank. Madoff began regularly wiring money to the London office to pay for personal luxuries.

He purchased the $7 million Leopard yacht in the south of France by sending cash through his U.K. office. The yacht, named The Bull, just like his cruiser in Palm Beach, was built for Madoff in 2006. The boat was also registered in Ruth Madoff’s name, as were many of the couple’s high-priced trophies. The 27-meter (89-foot) Leopard, built by French luxury boat-builder Rodriguez Group, was moored at Port Gallice, France, between Cannes and Nice. The annual fee to keep a yacht of this size there is nearly $50,000. Madoff told employees in London to transfer money to the shipyard, reasoning that the builders already had euro-denominated bank accounts, which would make the transaction easier – or at least, that was the explanation he gave. The employees sent the money after receiving an invoice from the boatyard, and Madoff later transferred cash to the London firm’s accounts to cover the expense. At least $250 million was allegedly wired back and forth between Madoff's New York and London offices for such purchases.

In November 2008, Madoff phoned Chris Dale, the finance director of Madoff Securities International in London, and told him to sell an entire portfolio of British bonds. Madoff then instructed Dale to transfer the money – $165 million – to his New York business, so he could buy U.S. Treasuries on London’s behalf. Madoff claimed he was worried about the return because of the pound sterling’s fall against the U.S. dollar. “He was worried about the British economy and said he preferred his investments in U.S. Treasuries,” Dale told The Independent on Sunday, a British newspaper. “This seemed perfectly realistic at the time, because of the banking crisis and the pound’s weakness.”

Madoff’s London employees did not think to question the wires, what they were for, or any other transactions. After all, he was the boss. One employee told the London Times: “He was the chairman of the company and it was his capital in the business. If he phoned up and told us to move money for him, we did it.” Employees in London claimed they had no clue that Madoff was using his British outpost as a money launderette.

The Friday after Madoff was arrested, Stephen Raven, chief executive of Madoff Securities International, was still unwittingly defending the London office against Madoff’s larger fraud, and issued an indignant statement: “We only became aware overnight of the news relating to our chairman, Bernard Madoff. His major shareholding in our firm is a personal investment. MSIL in London is a small proprietary trading firm – we are not client-facing and we trade only with the firm’s own money.” That was true, but the ultimate purpose of the London outpost was very different from what Raven saw: It was where the Madoffs washed their investors’ money and then spent it on expensive furnishings, yachts, automobiles, and other luxuries. ...

By September 2008, JPMorgan Chase may have had indications, or actually known, that Madoff was a fraud. How might they have found out before everyone else?

JPMorgan Chase is an enormous enterprise, which on one side – JPMorgan – operates as an investment bank, and on the other – Chase – runs as a typical commercial bank, with loans and deposits. On this commercial banking side, Chase was handling Madoff’s billion-dollar advisory business bank account, JPM 703. Earlier in 2008, JPMorgan Chase had taken over Bear Stearns’ operations in a government-orchestrated bailout.

Madoff was a close friend and business associate of longtime over-the-counter trader Aldo Parcesepe, a senior managing director and head of Nasdaq market-making at Bear Stearns. He regularly traded with Madoff’s broker-dealer firm. Between 2005 and 2008, Parcesepe served on the board of the National Stock Exchange (NSX), the electronic exchange for equities and options that the Madoffs had subsidized in the late 1970s. Peter Madoff served on the NSX board with Parcesepe, who retired from the board in 2008. Madoff owned 10% of the NSX, and Bear Stearns regularly traded through the exchange.

The NSX was familiar ground for the Madoffs. It had once been known as the Cincinnati Stock Exchange, and the Madoffs had refurbished and reinvigorated the exchange with their own money. It was the same exchange that had helped the Madoffs attract orders from Wall Street customer firms all over the country, and the hub for payments made to Madoff for order flows.

Brokers who traded at Bear Stearns used the firm’s automated equity order system to buy and sell stocks. A broker would enter the stock symbol and the number of shares he or she wanted to trade. The system was supposed to do the rest: work to find the best counterparty to trade with from among the many market makers that traded with Bear Stearns. However, for Nasdaq stocks, Bear Stearns had an unwritten code: the system automatically defaulted to trade with Madoff.

Madoff reportedly paid Bear Stearns substantial fees for this default setting on their equity order system, and he may have paid other customers to do the same as well. Between 2000 and 2008, Bear Stearns’ 400 or so brokers all used this system, and all their Nasdaq trades defaulted to Madoff. It was a big source of revenue for Madoff, and it vaulted Bear Stearns to a position as the largest counterparty trading with Madoff. The arrangement was in place when Bear Stearns went under in early 2008, and it continued under JPMorgan Chase.

Since at least 1992, and separate from the Bear Stearns connection, Madoff had that other strong relationship with Chase Bank: the account named JPM 703, which Madoff used for his phony advisory business. The account had swelled over the years; by 2006 he had billions of dollars in cash on deposit. These were “demand” deposits, meaning Chase had full use of the funds until Madoff withdrew them. All the funds were commingled in a single account, and Madoff could withdraw the money as he saw fit, without any limitation.

Between 2006 and 2008, Chase Bank’s accounts from Madoff averaged several billion dollars. However, in 2008, as the stock markets began dropping precipitously, so did Madoff’s cash balance. Between September 2008 and December 11, 2008, it had to be pulled out of numerous nose-dives. In November alone, the balance dropped close to zero several times, forcing Madoff to transfer roughly $160 million from Madoff Securities International in London. He was juggling payouts to investors demanding their money back and moving money around from different offices and bank accounts around the world.

And all the while, he continued to take in new investors. In the month of November, investors deposited $300 million of new cash in the Chase account while Madoff withdrew $320 million. Meanwhile, he was hitting up his old friend Carl Shapiro, one of his earliest clients, for a new investment – of $250 million.

Chase, meanwhile, was doing other business with Madoff besides banking. In 2006, JPMorgan Chase developed a derivative product for its wealthy clients. It was linked to the Fairfield Sentry Fund offered by the Madoff feeder Fairfield Greenwich. The bank offered investors – mostly in Europe – a note that paid three times the earnings, or returns, of the Sentry Fund. The note matured in five years. To hedge its risk on the derivative product, the bank invested in the Sentry Fund itself. This way, if the Sentry Fund did well, the bank’s returns would offset its obligation on the notes.

By the summer of 2008, JPMorgan Chase had deposited $250 million with the Sentry Fund. With the financial meltdown on Wall Street and around the world in full swing, most of the markets were down 30% or more, and yet the Sentry Fund reported gains of 5%. JPMorgan Chase began to grow suspicious.

Chase representatives from the commercial banking side met with Madoff. They wanted to discuss his cash flows and to know what percentage of his portfolio was leveraged, or invested using borrowed money – and with whom he traded options contracts. The simple math was just as many others had concluded: the options market was too small to handle the size and capacity Madoff was claiming to manage in his supposed options strategy. Moreover, it was implausible that Madoff could be generating substantial positive returns when the S&P 500 index was down 30%.

Madoff would not provide Chase with any of the key information, so managers from Chase’s London office, along with colleagues in New York, decided they would go through the back door.

Parcesepe’s trading desk had people who regularly traded with Madoff, and they knew the number of trades executed through Madoff. On its trading side, JPMorgan learned that Madoff’s trades with Bear Stearns – by then a part of Chase, and now Madoff’s largest counterparty – could not possibly sustain a portfolio returning 10% to 12% a year on what the bank knew from the deposit side had to exceed at least $7 billion. The Chase team had access to Madoff’s account records, which showed huge cash positions until the middle of 2008, when the stock market went into free fall. It was obvious: Madoff was a fraud.

In September 2008, JPMorgan Chase quietly liquidated its entire $250 million position in the Sentry Fund, even though it remained liable on the derivatives it had sold to the wealthy clients. At the time, the Fairfield Sentry investment notes were showing a 5% gain for the year. The bank had concluded Madoff was a phony, and the only way to protect itself was to liquidate anything connected with Madoff.

Not only that, but by September 2008 Chase may have known that if Madoff’s hedge fund was a fraud, he was likely diverting his advisory-side funds. Still, Chase continued accepting wires and checks from Madoff’s latest round of investors. Throughout the fall of 2008, according to one lawsuit filed against Chase (MLSMK Investments Co. v. JPMorgan Chase & Co. et al., SDNY 2009), the bank “continued to work in partnership with Madoff despite being privy to information that the fraud was collapsing and therefore consuming more and more of the victim proceeds.”

A JPMorgan Chase spokeswoman, Kristin Lemkau, told the New York Times the bank withdrew from the Madoff-linked funds after “a wide-ranging review of our hedge-fund exposure.” Lemkau acknowledged, however, that the bank also “became concerned about the lack of transparency to some questions we posed as part of our review.” Investors were not told because, under sales agreements, the issues did not meet the threshold necessary to permit the bank to restructure the notes, she said. Under those circumstances, she told the paper, “we did not have the right to disclose our concerns.”


The easy money has already been made. 2009 promises to get tougher.

The market is overbought but unlikely to correct more than 7% any time soon.

Here is a technical call from Rick Ackerman’s website which is dovetails well with the fundamental analysis covered extensively in these pages. Ignore or use at your peril!

Time for some straight talk about the stock market, since nothing has improved fundamentally. Congress has passed no financial reform, the Federal Reserve is financing a new equities bubble on Wall Street, and the real economy is on life support. According to our technical runes, the market is overbought but unlikely to correct more than 7% any time soon. Below is a daily chart of the S&P 500 showing the overbought condition.

The upper window contains my proprietary Overbought/Oversold Indicator, which peaked on July 28. Below that is the percentage of stocks over their 200-day moving average. This reached an overbought reading of 89.01. As the S&P 500 approached an overbought condition, investor sentiment has turned euphoric.

The upper window in the chart above contains my proprietary market sentiment indicator. The indicator shows that sentiment has moved from panic (last October) to near euphoric conditions.

P/E Ratio of 148

And here is something for all of you market-watchers who care about fundamentals: The current trailing Price/Earnings ratio of the S&P 500 is 148.47! If current earnings of $6.86 were to increase 4-fold by Q4 2009, that would leave the earnings at $27.44 and the PE of the S&P 500 at Friday’s close (1010.48) at 36.83. The 48% rally since March 6 has already priced in 2009’s earning’s growth.

The market rally has been fueled by the vapors of Fed liquidity. That liquidity will slowly disappear during Q2 and Q4 of 2009. Already, the 6-month rate-of-change in the Monetary Base is -2.7%, and the 6-month rate-of-change of M3 is -3.66%. The Fed is slowly moving toward a more restrictive monetary policy.

Take Profits Now

If you combine the sentiment readings with the overbought technical condition, you are given few choices but to take profits as we move into August. We must respect the fact that the six weeks from September 1 to October 15 are the most vulnerable weeks of the year.

The easy money has already been made. Traders will face a more difficult environment during the next six months.

U.S. Timberland May Be One of the Worlds’ Most Overvalued Asset Classes

The full text of this article is available to Barron’s subscribers only, but the headline certainly caught our eye. Thus who have bought into the idea that timberland provides better returns than equities with less volatility and correlation with the market, etc., etc. would be well advised to check out the full deal. A video, “Is Timber an Overhyped Investment,” is available here.

Timberland is a rarity because prices have risen steadily since the mid-1990s, with Southern timber properties more than doubling to around $1,700 an acre, even as the price of logs, lumber and other forest products scrapes multiyear lows. Last year, when almost all investment categories declined in value and the U.S. stock market fell about 35%, timberland prices rose 9%, atop a 17% gain in 2007. In the first half of 2009, prices are down 0.5%, according to the National Council of Real Estate Investment Fiduciaries, or NCREIF, ...