Government Wins The Early Rounds

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As we head into the last hours of 2010, the U.S. stock market is celebrating the generosity of government. Money has flowed into stocks from a variety of sources since the most magnanimous expansion of the Fed’s balance sheet in history. Major stock indexes have jumped by five to six percent in December alone, and investor confidence is growing stronger by the day. Common stocks, which were down for the year through August, reacted precisely as government wanted after Fed Chairman Ben Bernanke announced the second round of quantitative easing at his August speech in Jackson Hole.

The always-informative Ned Davis Research highlighted the Fed’s objectives by listing four quotes, first offered in The Chartist service.

(1)   “Nevertheless, balance sheet policy can still lower longer term borrowing costs for many households and businesses, and it adds to household wealth by keeping asset prices higher than they otherwise would be.” Brian P. Sack, New York Fed, October 4, 2010.

(2)   “What happens to the equity markets, what happens to the dollar, and what happens to interest rates. Don’t be concerned with printing money! Don’t be concerned with the growing Fed balance sheet or how to unwind it! The primary purpose of QE2 is to improve our financial condition. A higher stock market is good for aggregate demand, a falling dollar improves our global competitiveness, and lower borrowing costs improve aggregate demand.” Larry Meyer, former Fed Governor, on CNBC, November 3, 2010.

(3)   “And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.” Ben Bernanke, Washington Post, November 4, 2010.

(4)   “I think we are underestimating and continue to underestimate how important asset prices, very specifically equity values are, not only for shareholders and the like, but for the economy as a whole.” Alan Greenspan, CNBC interview, December 3, 2010.

Increasing liquidity in an economy normally leads to higher asset prices. The process is not a sure-fire winner, however; otherwise government would do it constantly. Obviously there are dangers inherent in any expansionary policy. One merely has to examine the Fed’s history of success over the past decade and a half to recognize the potential negative consequences of flawed expansionary policies. Unwilling to permit a deflation of the nation’s debt bubble, the Fed attempted to promote asset inflation at the end of the last century and halfway through the current century’s first decade. Both attempts resulted in asset bubbles that burst, with terrible pain experienced in the securities and real estate markets. Not dissuaded by the failure of their most recent efforts, the Fed governors are once again attempting to ward off consequences of the debt bubble by infusing even more debt. Could it work? Of course it’s possible, and the Fed has certainly succeeded in the short run. But history argues against it, as illustrated in copious, well-researched detail by Carmen Reinhart and Ken Rogoff in This Time Is Different. Even current Fed governor Thomas Hoenig has characterized QE2 as “a bargain with the devil.”

Notwithstanding the Fed’s initial success, each investor has to decide whether it makes sense to bet on the Fed’s continued success, or whether it is more likely that debts will unwind over time as they have after most financial crises for centuries in a great variety of countries throughout the world. We’re certainly seeing those debt strains in several European countries, and governments are doing their best to prevent any countries from falling into default. We can’t know today whether the best efforts of governments will be able to keep the debt balloons floating. The risks of failure are high, and the consequences could be sudden and severe.

I wish all of our readers and their families a happy, healthy and prosperous new year.


Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

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The Danger Of Hyperinflation

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Long-time market observer Victor Sperandeo penned a well-worth-reading editorial commentary in the December 20 issue of Barron’s.  He argues from history that when governments cannot borrow, hyperinflation is frequently the result.

Developing his thesis, Sperandeo points out that since the French Revolution in the late 1700s, hyperinflation has frequently occurred when governments borrow more than 40% of their expenditures over an extended period of years.  If the U.S. Government had borrowed the full amount of its budget deficit in fiscal years 2009 and 2010, the borrowing rate would have exceeded 40% in each year.  While the Congressional Budget Office projects that rate coming down in the years immediately ahead, the projection is based upon a real GDP growth assumption of 4.4% annually from 2012 to 2014. Such growth looks highly unlikely in light of Fed Chairman Ben Bernanke’s recent projections about housing and unemployment.

For several years we have asserted that the ability of the U.S. Government to fund its deficits at reasonable interest rates will depend upon investor confidence that they will ultimately be repaid in dollars that retain the vast bulk of their purchasing power.  With the Fed’s having committed to inflate its balance sheet from $850 billion to over $3 trillion in just three years, that prospect of retained purchasing power has to be called into question.  When confidence disappears, investors sell their bonds, rates rise and, in extreme situations, hyperinflation unfolds.

Notwithstanding today’s uncomfortable budget statistics, such a hyperinflationary event remains an outlier.  Countries around the world all have a stake in maintaining a relatively stable financial system.  At the same time, recent Fed actions are increasing the potential for hyperinflation.  Sperandeo reaches essentially the same conclusion that we have voiced for the past several years since interest rates approached half century lows.  We retain our conviction that while the Fed may succeed in keeping rates low in the short run with its aggressive buying program, the penalty for being wrong in the bond market over the next couple of years is far greater than the reward for being right.  That’s a poor risk/reward equation.

Despite the longer-term concern, we committed twenty percent of our Controlled-Risk Flexible Allocation portfolios’ assets to the 30-year U.S. Treasury bond last week at 4.6%.  That was just two ticks below the 4.62% peak in the bond’s rate surge from below 3.5% in late-August.  While we are not making a long-term judgment about interest rate direction, we believe that the rate rise has been overdone, at least in the short run.  Should deflationary or disinflationary conditions prevail in the period ahead, we might hold the position for quite a while.  On the other hand, should inflationary pressures appear, we may move away fairly quickly.  So far rates have come down rapidly in the first week of our holding the position.

The dramatic rate rise of the past four months has turned investors’ earlier strongly bullish outlook on bonds to strongly bearish. At extremes, such sentiment levels can be helpful contrary indicators. In light of inflation, economic growth and budgetary prospects, the run-up in yields has returned the long bond to fair valuation relative to other securities’ yields. And the spreads between the 30-year yield and yields on much shorter maturities have ballooned to record levels, promoting the probability of a profitable flattening of the yield curve.  At the very least we anticipate a positive short-term return, which could turn into a longer-term position if inflationary expectations can be harnessed.  Hyperinflation, however, cannot be ruled out.

We wish you and yours a very Merry Christmas.


Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

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Sentiment Suggests Caution

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At our October seminar I highlighted how attitudes of investors had changed, largely from negative to positive, toward a number of investment asset categories.  In early 2008 the equity markets were collapsing and investors couldn’t get away from stocks fast enough.  What almost two years and a couple of trillion dollars of government support can do!  Now after the major stock averages have recovered more than half of their decline from the 2007 highs, investors are once again confident.  The front page of today’s USA Today trumpets the opinion of several experts that it’s time to get back into equities.

Within the last week, several measures of investor sentiment have reached extremes.  The latest figures from the American Association of Individual Investors (AAII) show an extremely bullish 50-27 bull/bear reading.  Elliott Wave International points out that the 10-week moving average percentage of bulls poll is at a six-year extreme, far surpassing the bullish levels at prior market peaks.

This week the Investors Intelligence Poll showed more bulls and fewer bears, with the spread between the two camps approaching the all-time high reached in October 2007, just as the stock market began its decline of more than 50%.

This morning Lowry Research Corporation pointed out that the Chicago Board Options Exchange equity put-call ratio continues toward its bullish extremes.  Its 10-day moving average has fallen to levels not seen for several years except for this past April, immediately preceding the April to July market decline.

Last week’s ISE Sentiment Index recorded its highest reading in almost five years.  The 10-day moving average of the New York Stock Exchange TRIN reached its most overbought point in 20 years.

Sentiment readings can remain elevated in a bull market, but extreme levels serve as a warning that the market’s price move can be approaching a point from which prices need at least a meaningful correction. In an environment in which entire countries are dependent on bailouts for financial survival, extreme bullishness should act at least as a warning flag.


Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

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Bond Rates SoarPrices Plunge

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The President’s National Commission on Fiscal Responsibility and Reform concluded its work last week. The bipartisan group released a list of politically difficult recommendations, which predictably raised hackles on both sides of the aisle. The committee was unable to garner the necessary 14 of 18 votes needed to bring the deficit-cutting proposal before Congress. In the days following the failed vote, the committee has effectively been patted on the head and told to go away.

With Fed Chairman Bernanke’s appearance Sunday on 60 Minutes and President Obama’s Monday announcement of the next chapter in the government’s rescue package, the die has obviously been cast in opposition to the recommendations of the deficit reduction committee. The ongoing policy can be summarized as: spend more, tax less. There is no pretense of fiscal or monetary probity. This is, of course, a continuation down the politically easy path we have traveled for a few decades. Nobody is ever reelected for advocating the unpleasant medicine of fiscal austerity. The argument is always that we can’t possibly promote austerity measures in the current dire circumstances (whatever those conditions happen to be in the instance being examined) . We’ll take the tough steps when the environment is more favorable. History makes clear, however, that the time for unpalatable financial retrenchment and discipline never arrives. And it never will until either a crisis forces it or we establish term limits so that legislators can focus beyond the next election.

The newly proposed rescue efforts may or may not succeed in boosting our economy onto a self-sustaining trajectory that can function without ongoing government support. It will certainly further inflate the already humongous debt balloon that hovers over our heads. It will guarantee that many more IOU’s will be passed along to our grandchildren and their grandchildren. Moral hazard runs rampant.

These concerns and others are starting to worry the bond vigilantes. Since late August the 30 year U.S. Treasury bond yield has risen from just under 3.5% to slightly under 4.5% today. On an intraday basis the 10 year U.S. Treasury yield has risen in merely two months from just over 2.3% to scarcely over 3.3% Wednesday. This has happened despite the Fed’s clearly expressed intent to lower interest rates by direct purchases of Treasury paper. Over the same time frame corporate and municipal bond prices have likewise been hurt, their declines accelerating over the past several weeks.

One can never be sure why markets behave as they do. It is likely, however, despite current disinflationary conditions, that a growing number of fixed income investors are beginning to focus on the potential for serious inflation as the ultimate reward for uncontrolled spending and monetary stimulus. Precarious state and city budgets certainly concern muni bond investors, and the specter of a growing number of European countries in need of bailouts undermines confidence in a general sense.

Although not directly related to the level of rates, fear inevitably grows when Bank of America has to pay $137 million to federal and state authorities for municipal bid-rigging practices, and federal authorities are conducting an expanding insider trading probe.

We have been warning of dangers in the bond market for the last couple of years, albeit short of a negative forecast. We held a rather agnostic view of the probable course of rates through most of that period. We have, however, repeated our warning in numerous seminars and written commentaries that the risk of being wrong in bonds at these historically low yields is considerably greater than the reward for being right. We remain of that belief, although we will continue to look for strategic opportunities for bond ownership following sharp run-ups in rates.


Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

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Should You Trust Bernanke’s Forecast?

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Knowing my disdain for the current Federal Reserve Board as a group of omniscient economic forecasters, a friend sent me a quote from yesterday’s Market Commentary by Art Cashin of UBS Financial Services.  Art included part of an October 27, 2005 article from the Washington Post, which follows.

Ben S. Bernanke does not think the national housing boom is a bubble that is about to burst, he indicated to Congress last week, just a few days before President Bush nominated him to become the next chairman of the Federal Reserve.

U.S. house prices have risen by nearly 25 percent over the past two years, noted Bernanke, currently chairman of the president’s Council of Economic Advisers, in testimony to Congress’s Joint Economic Committee. But these increases, he said, “largely reflect strong economic fundamentals,” such as strong growth in jobs, incomes and the number of new households.

Many economists argue that house prices have risen too far too fast in many markets, forming a bubble that could rapidly collapse and trigger an economic downturn, as overinflated stock prices did at the turn of the century. Some analysts have warned that even a flattening of house prices might cause a slump — posing the first serious challenge to whoever succeeds Fed Chairman Alan Greenspan after he steps down Jan. 31.

Bernanke’s testimony suggests that he does not share such concerns, and that he believes the economy could weather a housing slowdown.

That Bernanke is the central banker with more power than any other in the world to affect the course of the global economy imparts less than a high degree of confidence.  Whether past and present rescue efforts will ultimately prove beneficial, they have at least put a temporary safety net under the economy and the U.S. securities markets.  Belief that the Bernanke “put” has replaced the Greenspan “put” has emboldened investors to accept market risk despite highly precarious fundamentals both here and abroad.  It’s a fair question as to whether Bernanke’s perception and curative prescription will be any more effective this time than was his appraisal of the danger of the housing bubble just five years ago.

Should the Fed’s rescue efforts prove less than effective–worse yet, possibly counterproductive–we will undoubtedly look back and ruefully ask:  “How could we have conferred so much power on an academic theoretician with such a flawed track record?  What were we thinking?”

As an aside, pay attention to Art Cashin whenever you have access to his insights.  Few others combine the historical background and incisive understanding of short-term market influences that Art possesses.  And he delivers his observations with a heavy dose of humor.  Do yourself a favor and catch his frequent appearances on CNBC.  He’s typically interviewed a couple of times a week in the 45 minutes that precede the market’s opening bell.  You can also replay his appearances on the CNBC website.


Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

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Point – Counterpoint

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Last week the New York Times published a thank-you letter from Warren Buffett to Uncle Sam. The letter expressed Buffet’s gratitude for the monetary and fiscal steps initiated and sustained to rescue the country from the economic and market collapses extending from 2007 to 2009. Although I have tremendous respect for Mr. Buffett, I disagree with his assessment that the government’s actions will ultimately prove beneficial. While they have rescued the economy and the markets from further imminent decline, they have done so at great cost, the consequences of which we can only dimly perceive today. Click here to review Warren Buffett’s letter. My opposing view follows.

Misguided, Even For Government
November 22, 2010

Dear Uncle Sam,

I know you’ve been busy rescuing many of the more prominent branches of the family from their own folly. And Cousin Ben and his friends apparently see an urgent need to continue to help. With so many matters still weighing heavily on your mind, I’m sure you appreciated Cousin Warren’s gracious thank you the other day. Although, to my regret, he and I have never met at family gatherings, I have enormous respect for Warren’s accomplishments and insights, and for his generosity in pledging his fortune to the betterment of mankind. He and I, however, value your rescue efforts quite differently.

No doubt, what you did in late-2008 kept our economy–floundering under an unmanageable debt burden–from collapsing into a full-fledged depression. You kept companies alive, kept millions of people employed and preserved trillions of dollars of securities value.

Unfortunately, we can’t know that these salutary results will last. Many of the underlying causes of the crisis remain, largely revolving around excessive leverage. And the rescue efforts to date and so far proposed have come at a massive cost. If consumer and investor confidence should once more wane, we could find the economy again at great risk of collapse. In any case, we will have firmly attached an anchor of debt around the ankles of future generations.

This introduces the question of morality into our deliberations. We tend to make our financial decisions without regard for moral consequences. The goal of policy-makers and financial professionals is typically to maximize return. It’s a numerical pursuit – far more quantitative than qualitative. The lack of a moral compass in the recent crisis, however, is becoming increasingly evident and burdensome.

Cousin Warren referred to having a pretty good seat as the crisis and rescue events unfolded. Sitting back in the Bob Uecker seats in the southwest corner of the arena, I had a far less precise view of the proceedings, but I could see the action. What became quickly apparent was that your financial commanders determined that the rescue could best be accomplished by throwing Grandma under the bus and bailing out the current working populace with money from future generations. It was easy to see that the primary beneficiaries were the majority of voters. Future generations obviously have no votes, and the elderly retired muster negligible lobbying pressure. The decision-makers clearly determined that rescuing us from problems of our generation’s creation was more important than the penalties we would apply to both earlier and subsequent generations.

Working with a great many retirees, I have an up close and personal appreciation for the damage done to this vulnerable segment of our family. Many of these seniors believed they had retired with a nestegg capable of supporting a reasonably comfortable lifestyle. The Fed’s zero-interest rate policy has eliminated their opportunity to earn any appreciable risk-free return. As recently as this week, NY Fed President Bill Dudley reaffirmed the Fed’s intention to “force” fixed income investors to deploy their assets in higher risk securities. There would be nothing wrong with that if the Fed could assure that such higher risks would never be realized. Unfortunately, that’s not possible. They are forcing these retirees, many of whom have no stomach for risk assumption, to do something uncomfortable and dangerous to earn a return. Should the Fed’s great gamble fail, who will make these people whole? Will you at least apologize? The prime beneficiaries of this great financial experiment might have the opportunity to rebuild their assets. Our elderly cousins will not.

You’re betting the ranch on a rescue effort with no guaranty of success, but with a certainty of future deleterious consequences. Many argue that you had no choice, that you had to do what you did. Letting the dominoes fall would very likely have introduced a depression with monumental pain felt around the world. Hundreds of millions of people with no responsibility for the problems would have suffered along with those who played an integral part in creating the crisis. Great pain would have been shared by huge numbers of otherwise innocent people who simply underestimated the consequences of excessive leverage and mean-reverting real estate prices.

Cousin Warren seems to condone the rescue effort, at least in large part, because a “mass delusion” confounded almost everyone. For example, “rapidly rising (real estate) prices…discredited the few skeptics who warned of trouble.” Should overt government action punish the skeptics who were right and who were waiting for lower prices that would logically result from forced selling by the overleveraged? If the overwhelming majority is deluded and wrong, is that justification for their rescue? Your rescue efforts, particularly the purchase of otherwise unmarketable mortgage-backed securities, compensated many miscreants and bad decision-makers rather than those who properly evaluated the growing risks.

That unfortunate rescue precedent had been set many times over many years. For decades you have felt compelled to bail out overleveraged bankers who failed to appreciate the dangers in their oil patch loans, their LDC (lesser developed countries) loans, their exposures in Mexico and Russia, their exposure to Long Term Capital Management, and most recently and most famously to virtually anyone who wanted to own real estate.

Although we had no dog in the fight back in 1998 when you rescued Long Term Capital Management, I marveled at the abrogation of free market principles, ostensibly because the financial system was in danger of collapse. I recoiled in horror at the thought that we could have been on the opposite side of the trade from LTCM, been right, and could have been handed huge losses when you coordinated an effort to rescue LTCM from its grievous market misjudgments.

While our clients did not lose because of your recent rescue efforts, neither were they compensated for what they sacrificed by not following lemming-like into higher yielding investments that ultimately failed but for your bailout. Correctly foreseeing upcoming problems simply consigned us to the lower returns available in safer securities. Perhaps we were naive not to recognize from your longstanding pattern that we should have ignored the risk and simply relied on your willingness to bail us out as well.

Your recent rescue effort sadly reinforces the lesson of the last few decades that investors should abandon intensive efforts to identify financial imprudence. It is more profitable simply to buy into the concept of momentum investing, especially if a trend is universally believed, because you will ultimately not let truly humongous errors damage the gullible multitude. The overriding lesson apparently is that it is acceptable to sacrifice true free market principles and penalize the foresighted minority for the common good. Isn’t that the essence of moral hazard?

Our family has proven that we lack the will to wean ourselves from the narcotic of financial rescue when our current well-being is significantly threatened. Pious words notwithstanding at the time of the rescue, we never quite find sufficiently effective solutions. Consequently, when the furor subsides, growing greed sows the seeds of the next financial debacle. Each new generation, sufficiently emboldened with the recollection of your willingness to bail, then forgive and forget, develops bigger and better methods of multiplying money before the next bubble bursts.

I’m afraid, kind uncle, that you are regularly conned into panicked belief by the self-interested financial industry that a failure to bail us out of whatever is the current horror of horrors will inevitably lead to a collapse too horrible to be imagined and endured. As a result, you bail and explain to the man and woman on the street that they couldn’t possibly understand the profoundly disastrous ramifications of inaction. Wall Street wins again and again. Moral hazard grows and grows. Even if we ultimately survive this crisis, tomorrow’s bubble promises to be even more extreme, imposing even greater damage on future generations, who had no responsibility for the problems you are trying to solve.

Uncomfortable as the immediate consequences could be, I strongly urge you to abandon the artificial–arguably immoral–support you are currently providing. The free market might penalize asset prices severely as excess leverage is unwound, but we will find a base and have a far sounder foundation for growth in the decades ahead. Our entire family will ultimately be far better served by the verdict of the free market than by your cadre of central planners.

Your discouraged nephew,

Tom

Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

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The Week Ends Unchanged

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The news of the week was the return to the public market of General Motors.  Stock prices fell fairly aggressively on Tuesday only to recover the losses on Thursday in the aftermath of the GM IPO.  A slow day today with mild buying in the last half hour brought the major indexes essentially to an unchanged reading for the week.  The jury is still out on whether the short-term decline that began two weeks ago has run its course.

I have been working on a longer analytical piece that we will post on this site sometime next week.  In the meantime, enjoy your weekend.


Tom Feeney is the Chief Investment Officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

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Is The Government Buying Stocks? Part 5

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Since last Friday’s blog post revisiting my ongoing speculation about the government buying stocks, I had dinner with a friend who once again characterized such a thought as “crazy.”  And the chorus continues to grow of people who have said over the past year that it’s unconceivable that such an action could escape detection and publicity.  Frankly, that lack of publicity surprises me as well and remains the biggest stumbling block to my making a more confident assertion of government interference.

As I have in each prior post, I acknowledge that I have no proof of such an intrusion in the equity markets.  There is also the possibility that supportive actions which might be interpreted as governmental in origin could be coming from very large trading interests with a stake in keeping stock price momentum positive.  As I mentioned in Friday’s post, however, there are not many organizations with the buying power needed to move markets.

Why still suspect government?  We know they have a motive.  Former and present Fed governors have pointed to rising stock prices as the quintessential stimulus. They have applauded results of the dramatic jump in equity prices since Bernanke’s Jackson Hole speech in which he outlined the QE2 to come.  We know they have the firepower. Expansion of the Fed’s balance sheet over the past year and a half demonstrates no inhibitions about spending future generations’ money to solve today’s problems.

Would they dare interfere in free markets?  Clearly that has never been a concern with respect to fixed income markets.  Whereas in the past, such active involvement might have been limited to Treasury issues, no such compunction limits them today.  In their wisdom they have deemed it appropriate to paper the Fed balance sheet with mortgage-backed securities for which there was no other viable market.  Prior Fed governors would have shuddered at the thought of such balance sheet pollution.

But equity markets are clearly different, aren’t they? For years commentators have sneered at China for its widely reputed support of common stocks.  Within the last few weeks, however, Japanese monetary authorities have also expressed clear intentions to bolster prices in that giant world market.

Are U.S. monetary authorities so different from their compatriots elsewhere that they would never sully their hands buying stocks?  Are they comfortable pointing to higher equity prices as an objective of their jawboning efforts and applauding that result, but uncomfortable taking any direct action to promote it?  In the last two years they have indicated their unequivocal willingness to promote higher stock prices by direct ownership of banks, insurance companies and automobile manufacturers.  Is the concept of extending that support to the broader market so antithetical to their free market principles?

How might the government “buy stocks”?  Picture the Fed Chairman calling his broker: “John, this is Ben.  Markets have just broken short-term support.  Pick me up a quick 10 million Spiders (SPY).  Put it on my Fed account.”  Hardly!  Word might get out.

Imagine something like this instead.  We have long known that increased liquidity typically boosts asset prices.  Without trying to paint a detailed picture, let’s assume that one of Ben’s lieutenants assures one or more giant primary dealers that if they see the need to take a large proprietary position in equities in support of market prices that the Fed would follow with liquidity injections of a meaningful size.  “We won’t hang you out to dry.”  When we read statistics indicating trading profits for major investment banks on nearly 100% of market days, one has to assume that such firms receive a great deal of valuable information, at least in the form of order flow, if not in more explicit forms of support.

There remains no direct evidence of government market intervention, but patterns show significant buying in support of prices coming in at illogical technical points.  The government has an expressed incentive and clearly has the means. Fully recognizing the ongoing abrogation of free market principles throughout the government’s unprecedented rescue effort, my suspicion remains.


Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

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Is the Government Buying Stocks? Part 4

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Our most recent quarterly commentary, posted to this site on October 29, argues that investors are faced with a major dilemma: whether to speculate that the government will win its bet on rescuing the economy with a massive infusion of new money or to rely on fundamentals that point to a highly fragile economy struggling mightily to grow even moderately. I encourage you to read that commentary as background for the following analysis.

In the eyes of many, Federal Reserve Chairman Ben Bernanke’s Wednesday announcement of a massive second round of quantitative easing (money printing) was the last important arrow in the Fed’s quiver. Consequently, the Fed is doing everything in its power to make this rescue effort successful. The announcement in late-August that the Fed was again prepared to open the monetary floodgates achieved its purpose exquisitely. The promise of a further monetary infusion put a bottom under stock prices after the worst August since the 1930s and prompted equity speculators to push prices up by more than 14% from those lows to Wednesday’s Fed announcement. That push turned most equity market indexes from negative to comfortably positive for the year-to-date. Despite the market rally preceding the announcement, Wednesday’s actual revelation of the plan’s details spurred traders into action again, pushing the equity indexes up another 3% through week’s end.

Facing opposition from within the Fed’s membership as well as from without, Chairman Bernanke has taken great pains to explain the desirability of a second round of easing after the “shock and awe” first round failed to put the economy on a sustainable upward path. In both yesterday’s op-ed piece in The Washington Post and in a question and answer session today with college students, Bernanke ignored the Fed’s normal “quiet period” which normally extends a week beyond the date of a Fed announcement.

Reuters reported today from Seoul, Korea that former Federal Reserve Chairman Paul Volcker repeated his skepticism about the benefits of the Fed’s latest quantitative easing. German Finance Minister Wolfgang Schaeuble seconded Volcker’s opinion that QE2 won’t revive growth and added: “With all due respect, U.S. policy is clueless.” Apparently Minister Schaeuble doesn’t believe QE2 is due much respect. China and Brazil also criticized the Fed’s action.

Several weeks ago former Federal Reserve Chairman Alan Greenspan suggested that the most effective stimulus to the U.S. economy would be a rising stock market. In reflecting on the value of the August pre-announcement of Fed rescue intentions, Bernanke referenced the stock market advance as one of the successes of the Fed’s policy approach.

For more than a year, I have speculated on this site about the probability of active government intervention in the equity markets (September 8, 2009, January 22, 2010 and February 26, 2010). Bernanke has acknowledged rising equity prices as a desired result of Fed policy. Other countries, most recently Japan, have directly supported stock prices. Our Fed has openly intervened in the fixed income markets. Why not in the equity markets? While we have no explicit evidence of direct government buying, the recent trading patterns would certainly support the presumption of government involvement. Starting immediately after Wednesday’s Fed announcement, buying has come in each time the major stock indexes have broken below even short-term support areas. True investors would not buy there. They would prefer further selling, which would facilitate buying at more attractive prices. Clearly the buyers have not wanted to see technical sellers add to downward pressure. Such buyers need not be government. They could be large trading firms attempting to keep positive momentum alive. There are not, however, too many entities with the buying power necessary to turn markets in their desired direction. And we know that government wants to keep prices rising.

It has been fascinating listening to floor trader interviews since Wednesday afternoon. Most express serious reservations about underlying economic weakness and about the market’s current overbought and overbelieved condition. Most, however, say they have to be in stocks because the Fed is implicitly “guaranteeing” continuing support, at least for the economy. One trader characterized it as concentrating on the doctor rather than on the sick patient.

I redirect your attention to the dilemma referenced at the top of this post: Should investors bet on government success or on the underlying fundamentals? Clearly government has won round one. Consider carefully, however, whether you could withstand losses that could occur rapidly in most asset classes if confidence wanes and government efforts appear unsuccessful.


Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

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The Investor’s Dilemma: Bet With The Government Or Rely On Fundamentals?

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QUARTERLY COMMENTARY
Third Quarter 2010

Although stock market volume has declined markedly from its level earlier in the year, price volatility has increased.  Stocks plummeted in the second quarter by 11.4% then soared in the third by 11.3%.  A similar pattern unfolded within the third quarter as well, as a very strong September followed an extremely weak August.  Those violent fluctuations left the S&P 500 up for the year by 3.9% through the end of the September quarter.

For reasons we have been voicing consistently over the past dozen years, severe economic dangers provide the background for these sharp securities market moves.  In such an environment we have strongly counseled against the traditional buy-and-hold investment approach.  Our preferred value-based strategic allocation approach worked against us over this past year, as both stocks and bonds have rewarded risk-taking.  Quite a different picture emerges, however, over most longer periods of time.  Even including the recent underperformance, Mission’s portfolios have outperformed stocks over two, three, four, five, six, nine and ten years.  We underperformed the average equity return by just 2/100 of one percent over seven years and by 2.9% over the eight-year span.  For the century-to-date, our portfolios have outperformed common stocks by more than 5% per year.  Very few portfolio managers in the country can point to such a record of strength and consistency.

Stocks started their current rally at the beginning of September.  One particularly strong Friday performance was attributed largely to pre-opening comments made on CNBC by successful hedge fund manager David Tepper, who spelled out his bullish case as follows:  Equities are a good bet because either 1) the economy gets better and stocks rise or 2) the economy stays weak, the Fed intervenes again with QE2 and stocks rise. Hardly a fundamentally strong case for investment, his argument is instead a justification for speculation that hungry hedge funds and return-starved investors have seized upon.  It is a bet that government stimulus, past and proposed, will succeed–at least for the market.

On a fundamental basis, corporate earnings continue to grow from the extremely depressed levels of the 2008-09 recession, although they are still not back to pre-recession highs.  While we continue in a jobless recovery, businesses have aggressively cut fat and increased productivity, so profits have grown.

The fuel for continued corporate earnings growth, however, is running low.  Economic progress has stalled despite the largest stimulus efforts in history.  We remain in the worst unemployment situation since the Great Depression.  And housing makes new negative headlines weekly, with prices dipping again coupled with a huge backlog of probable foreclosures.  As we have frequently pointed out, our economy is highly unlikely to experience a sustained recovery until consumers regain confidence and increase spending.  Such a recovery remains unlikely with housing and employment in distress.

Federal Reserve Chairman Ben Bernanke sees the bleak picture clearly and has, therefore, pledged another massive infusion of new money.  At the very least, QE2 is an admission that the “shock and awe” of the greatest rescue effort in history was insufficient to push the economy into a sustainable upward trajectory.  This is likely testimony to the vast extent of our economic problems.

Not all agree with the wisdom of additional quantitative easing.  Ex-Fed official Robert Heller contends that the nation is in a liquidity trap, in which injecting additional funds will have no appreciable effect.  Former Federal Reserve consultant and Shadow Open Market Committee member Allan Meltzer maintains that the Fed is ignoring the deleterious long-term consequences of their expansionary actions.  The negative effect on savers and the retired is already apparent.  Fed monetary policy and bond purchases in the open market have pushed interest rates to negligible levels on fixed income securities, so important to risk-averse retirees.  Furthermore, the monumental build-up of debt has done potentially huge damage to the financial condition of future generations.

Beyond potential danger from additional quantitative easing, there is a serious question regarding its likely effectiveness.  A recent poll of Wall Street professionals revealed an expectation that QE2 would have very little positive effect on either the economy or the stock market.

QE1 put a floor under a plunging stock market and an economy that many commentators argue was headed for the next Great Depression.  The massive stimulus program is winding down, however, and with the economy still so unstable, the Fed has deemed QE2 necessary.

Many countries around the world are not eager to participate in a second round of stimulus.  Many European nations in fact are leaning toward austerity and fiscal integrity.

In evaluating the potential for Fed success with this new effort, it’s important to remember that many on the current Fed, including Chairman Bernanke, were the experts that promulgated the monetary policy which led to the real estate bubble and the later stock market collapse from 2007 to 2009.  Do we have reason to believe that they are any wiser today?  Or are they simply desperate in their search for any solution that might work today, regardless of longer term consequences?

Of course, quantitative easing is merely a euphemism for printing money.  Will other nations around the world simply sit back and let us try to print our way out of the current crisis by debasing our currency?  Or will they fight back, leading to a currency war?  Brazilian Finance Minister Guido Mantega has declared that war already under way.

I wrote at greater length about the potential for a currency war in my October 22 blog post at www.ThomasJFeeney.com.

The effect on the world economy of a currency war is highly problematic.  History argues that protectionism and trade wars would be likely results, with potentially serious consequences for world equity markets.  The sheer size and volume of trading on the currency markets creates an unstable condition when countries with disparate interests contest.  The potential for huge financial accidents is significant.

Investors are faced with an intense dilemma: whether to jump on assets that have been moving up – stocks, bonds and gold – in response to government stimulus and Fed rescue efforts, or to protect assets which could decline severely if those rescue efforts fail.  The proposed degree of government stimulus and monetary creation is a massive undertaking, which could push asset prices higher if the government wins its bet.  Investors are left to speculate on whether or not the monetary authorities can print us into prosperity.

Notwithstanding unprecedented money creation and more to come, if consumers remain cautious and continue to unwind debt levels, stocks could fail again as they did from 2000 to 2003 and from 2007 to 2009.  Contrary to Wall Street propaganda, stocks are expensive by traditional measures of valuation.  And the debt problems underlying the economy have been papered over, not solved.

Bond yields are near historic lows.  The Federal Reserve has been a huge direct buyer of bonds and may buy more.  A major question is how long China and Japan, our largest creditors, will allow us to debase the dollar, yet still hold and buy our bonds.  A reversal of that pattern for either financial or political reasons could push interest rates much higher, doing severe damage to bond portfolios, as happened for four consecutive decades from 1941 to 1981 in the last rising interest rate cycle.

Anyone can choose to speculate on a favorable outcome, but could be hurt badly if the Fed loses its gamble.  It is critically important to recognize, however, that a buy and hold approach to either stocks or bonds in this environment is not investment, but pure speculation.  This is an especially critical recognition for individual or institutional investors who could not easily replace lost assets if the Fed loses its bet.

We prefer to stay in sync with securities fundamentals rather than speculating on the success of the Fed’s efforts.  We will continue to maximize return on secure, short-term investments while looking for strategic opportunities in stocks, bonds, gold or foreign currencies on sufficient price retreats, as we have done successfully throughout the first difficult decade of the twenty-first century.


Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.

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