First Quarter 2012 Commentary

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For more than a quarter century, we have urged investors to maintain a high degree of portfolio flexibility. With countries and banks around the world currently on the edge of insolvency, that message has never been more important. Since Y2K, investors with traditionally structured portfolios containing relatively fixed allocations to stocks and bonds have not fared well. Despite two rallies of more than 100% each, the S&P 500 has returned a mere 1.35% per year since the market peak in 2000, a dozen years ago. Despite not participating heavily in those strong up phases, Mission’s clients have seen portfolio values rise by 70% century-to-date before fees, which vary based on portfolio size. In addition to long-term portfolio performance advantage, clients have benefitted by being able to sleep soundly. Their portfolios earned positive returns in eleven of the twelve completed years of the 21st century. Only a loss of less than 1% in 2008 marred an unblemished record. With the S&P 500 dropping by 37% in that ill-fated year, few lamented a fractional loss. We anticipate that our flexible asset allocation approach will continue to provide great benefit in the years ahead with massive uncertainty affecting world economies and virtually every investment asset class.

Investors’ attention has become focused on the powerful rally that started in October and turned 2011 from a weak year into one with a 2.1% positive return for the S&P 500. That equity strength continued into the New Year and has prompted in many investors the kind of enthusiasm earlier exhibited during the dot.com boom that ended the 1990s and the housing bubble rally that peaked in 2007. As is the case today, the Federal Reserve was the great facilitator of those earlier booms. We find ourselves again in a familiar position urging caution, as we did in those two prior instances of financial excess. Long-term clients, readers and attendees at our seminars since the late-1990s have heard our warnings about unsustainable debt burdens. While the Fed and other central banks around the world have supported periodic stock market rallies by printing money, those positive effects have not been permanent, and central banks have had to resort to repeated printing to prevent economic collapse. Each episode increases already dangerous debt levels for today’s population and makes the burden on future generations ever more onerous.

Despite the greatest flood of rescue money in history, world economic recoveries have been muted at best. Europe may already have fallen back into recession. The U.S. recovery is the weakest in the post-war era. Japan can’t seem to get out of its two-decade-long funk. Even the BRICs (Brazil, Russia, India, China) are slowing perceptibly. Whole countries have had to be bailed out. Now comes Spain with Italy waiting in the wings. Can central bankers continue to pull financial rabbits out of their hats? Will investors maintain their faith that these masters of the improbable will be able to solve crises of excessive debt by creating ever more debt? Or will they be seen eventually to resemble the wizard behind the curtain in the Wizard of Oz?

Cracks in that edifice of investor faith are becoming more apparent. Notwithstanding unlimited loans to European banks to shore up their shaky balance sheets and to enable them to buy otherwise hard-to-sell sovereign bonds, interest rates on Spanish and Italian debt are rising ominously once again. Perhaps investors are beginning to doubt the efficacy of European central bankers’ attempts to solve sovereign debt problems that are probably unsolvable.

I have written frequently about the comprehensive studies that Carmen Reinhart and Ken Rogoff have profiled in This Time Is Different. In analyzing 800 years of financial crises, they describe a common phenomenon they refer to as the moment at which markets go “bang.” That moment refers to the point at which borrowers can no longer borrow at reasonable interest rates, because potential lenders doubt they will be repaid. We witnessed this event most recently in Greece. When the “bang” occurs, interest rates skyrocket, and funding markets essentially shut down. As rates on Spanish and Italian debt rise, investors have every reason to ask why, if those countries are unable to pay the interest and principal on existing debt, there should be confidence that they will be able to repay even greater levels of debt in the future.

Money is starting to flee the endangered countries in Europe. Foreign investors are selling an increasing amount of those sovereign bonds. Governments are barring withdrawals of capital from countries and are prohibiting cash transactions above relatively small levels to make the transfer of large amounts of money difficult. These are symptoms of countries whose citizens fear default and currency devaluation.

So far, such worries are not typical in the United States. In fact, faith persists that Chairman Bernanke has the resolve and the power to keep our securities markets healthy. While that conviction could be well founded, I believe it unlikely. The mantra “Don’t fight the Fed” is well known and, more often than not, sound. Following it slavishly, however, would have periodically led to spectacular losses. It is important to remember that the Fed was aggressively dropping interest rates throughout the 2007-09 stock market collapse, when the S&P 500 declined by 57%. Today people are focusing on the Fed’s successful actions from 2009 to present. The resulting stock market rally, however, has not even brought prices back to the levels of five years ago. Investors who followed the Fed throughout that period are still under water, and, by historical standards, this rally is long in the tooth.

Mission has discussed at length our belief that the long weak cycle that began in 2000 likely has several years to run. That period will probably encompass both rising and falling markets but with a downward bias that will work against a traditional buy and hold approach, as has been the case century-to-date. We anticipate that flexibility and liquidity will be rewarded as volatility powerfully influences all asset classes.

We are attempting to maximize risk-free returns in today’s difficult, high priced environment. With the plethora of stress points throughout the world’s economies, however, we expect that patience will provide numerous opportunities over the months and years ahead to add stocks, bonds, gold and possibly non-U.S. dollar denominated assets at prices that will prove very profitable over the long term.

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Searching For Income – Keep Your Job

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Employment data colored the news again this week. Markets opened the week reacting to Good Friday’s disappointing announcement that a mere 120,000 new jobs had been created in March, roughly half the anticipated total. On Thursday, the Labor Department reported that 380,000 people filed initial claims for state unemployment benefits and that the prior week’s total had been revised up by an additional 10,000. Such data are notoriously subject to revision, so these disappointing numbers could yet be tempered in subsequent reports. On the other hand, they were supported by the National Federation of Independent Business’s Small Business Economic Trends data that “indicate growing weakness in the job market and portend a rising unemployment rate.”

The concentration of news items about unemployment brought to mind a blog entry that I wrote nearly two years ago in August, 2010, entitled “Keep Your Job.” The point there was that economic, market and employment conditions were likely to remain so uncertain that a predictable paycheck was the most prudent safeguard. Except for those wealthy beyond the need to worry about income, maintaining that paycheck remains the best advice.

Stock dividends are extremely low, yet common stocks have provided an excellent return if one focuses solely on the past three years. Dangerous conditions, however, have penalized stockholders intermittently to such a degree that equity prices are no better today than they were in 1999. Some of those conditions–like excessive debt–are even more perilous now than they were a decade or more ago. Bonds have benefitted from direct purchases by the Federal Reserve in unprecedented amounts, and interest rates are near all-time lows. If rates rise in the years ahead, bondholders could endure significant losses. Returns on safe, short-term investments, of course, continue to yield virtually nothing. Investment income is hard to come by.

Glusken Sheff economist David Rosenberg made some interesting observations this week while commenting on recent employment statistics. He noted that: “…those over 55 years old have seen their employment ranks expand four million since the Great Recession began while the job level for everyone else has fallen eight million. The older folks are coming back into the labor market and at lower wages than they retired previously since they are desperate for jobs as they need the income as an antidote to their lost wealth from two asset bubbles bursting less than a decade apart.”

In his current Weekly Market Comment, the insightful John Hussman noted that in the post-recession period since mid-2009 total U.S. non-farm payrolls have grown by 2.0 or 2.3 million jobs, depending on the survey used. Workers in the 55 and over category, however, have added just over three million jobs. That leaves workers in all other age categories losing from 700,000 to one million jobs. The employment picture remains precarious.

Compounding uncertainty in the investment markets is the question of whether we are likely to experience inflation or deflation in the years ahead. Clearly, Fed Chairman Ben Bernanke has vowed that we will not experience deflation on his watch. Toward that end, he has bent every effort to ward off deflationary forces through money printing. The logical ultimate consequence of such a course is inflation. At the moment, neither inflation nor deflation is a major problem, but that could turn quickly in either direction for a variety of reasons. For the most part, the most effective defenses against inflation or deflation are dramatically opposite from one another. Investors are as likely to make the wrong choices as the right ones. If you’re still in a position to make an employment choice, keep your job and the predictable income stream that comes with it, at least until the investment landscape clears.

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The Fed May Be On The Wrong Track

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The equity markets this week revealed how dependent they have become on the free flow of newly printed money. When the most recently released Federal Reserve minutes indicated declining support for another round of quantitative easing, stock prices fell sharply on increased volume. Ironically, the potential for no further monetary stimulus trumped the Fed’s acknowledgement of slight improvement in the U.S. economy’s sluggish recovery. This development reverses the past few years’ scenario in which economic malaise has been rewarded by higher stock prices, because such sluggishness promised additional direct Fed interference.

Over the past few weeks, James Grant, an eloquent writer of several books and the insightful Grant’s Interest Rate Observer and an ardent proponent of free markets, has made several guest appearances on financial television. In each, he decried the Fed’s blatant and persistent “market manipulation.” He characterizes these Fed actions as “terribly dangerous.” Among other concerns, Grant sees the Fed “manipulating perceptions of risk.” In an era of financial repression, retirees need far more cash than ever prior to leaving the workforce. With yields on secure financial assets driven close to zero by Fed actions, those in need of income have been driven, in accord with Fed intent, to riskier assets. Grant contends that the effect of these Fed manipulations has been to make higher yield markets–like junk bonds and distressed debt–appear far stronger than they really are, which is especially dangerous to less experienced investors. He sees Fed actions as dulling the risk sensors of the entire marketplace.

Grant argues that, besides distorting markets and individual investments, policymakers are prolonging the consequences of the last recession. Fed Chairman Bernanke, an acknowledged expert on the Great Depression of the 1930s, is using examples of mistakes from that horrific economic episode as his rationale for repressive interest rates and huge budget deficits. Grant suggests that the depression of 1920-21 could be a more prudent example from which to draw potential central bank policy prescriptions. He points out that, in that instance, the economy fell off a cliff with GDP declining by more than 20%. In contrast to actions taken in the depression that followed a decade later, in the ‘20s the Treasury balanced the budget, the Fed raised interest rates and the economy recovered. Within one year unemployment fell back to just 3%.

Bernanke has chosen the far more perilous path of financial repression and massive budget deficits with no guarantee that it will work. Grant proposes that the Fed let capitalism work. He sneers at a group of “mandarins” central planning our economy and our markets.

I am very much in agreement with Grant’s positions and have argued long and loud against such central bank intervention. By all accounts, Chairman Bernanke is an intelligent, well-intentioned man, who has studied past financial and economic problems in detail. He has used his position, however, to make the biggest financial bet ever, spawning great risk of unintended consequences. If he is wrong, he will go down in history as possibly the worst central banker ever. And generations to come may have to bear the burden of his folly.

To view James Grant’s recent TV interviews, see below:

March 7 CNBC

March 13 Bloomberg

March 29 CNBC

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A Powerful Ally Against Too Big To Fail

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Clients and others who have attended our seminars and read our publications know that we have for years railed against the existence of “too big to fail” (TBTF) financial institutions.  Since the 2008 near-meltdown of the financial system, world governments and central banks have unrelentingly kept alive even the most moribund of the world’s big banks.

In the majority of developed countries, there exists an article of faith that life as we know it cannot survive without resident financial giants in robust condition.  In recent years, that conviction has resulted in multi-billion dollar rescues and the availability of a flood of nearly free money with which to bolster balance sheets and income statements.  Senior executives in these government-supported enterprises have rewarded themselves with pay packages unknown through history but to kleptomaniacal dictators or founders of vast corporate empires.  Besides providing relatively pedestrian traditional banking services, these entities have made their mega-bucks by structuring and peddling securities, some of which were instrumental in triggering recent financial crises.  Such inequity has to be particularly galling to people whose efforts are providing real benefit to humanity.

Finally emerges an ironic but powerful ally in the fight against TBTF.  The Federal Reserve Bank of Dallas devotes its 2011 Annual Report to that end.  Titled “Choosing the Road to Prosperity: Why We Must End Too Big To Fail – Now,” the report presents a cogent, straightforward argument against the existence of giant banks.

Reading the entire report will serve up the meat of the argument, but the following quotes will offer some of the flavor.

In his introductory letter, Dallas Fed President Richard Fisher made the following points:

“More than half of banking industry assets are on the books of just five institutions.  The top 10 banks now account for 61 percent of commercial banking assets, substantially more than the 26 percent of only 20 years ago; their combined assets equate to half of our nation’s GDP.”

“In addition to remaining a lingering threat to financial stability, these megabanks significantly hamper the Federal Reserve’s ability to properly conduct monetary policy.  They were a primary culprit in magnifying the financial crisis, and their presence continues to play an important role in prolonging our economic malaise.”

“The lackluster nature of the recovery is certainly the byproduct of the debt-infused boom that preceded the Great Recession.…”

“The TBTF institutions that amplified and prolonged the recent financial crisis remain a hindrance to full economic recovery and to the very ideal of American capitalism.  It is imperative that we end TBTF.  In my view, downsizing the behemoths over time into institutions that can be prudently managed and regulated across borders is the appropriate policy response.”

Harvey Rosenblum, the Dallas Fed’s executive vice president and director of research, wrote the body of the report.  Several of his contentions follow.

“As a nation, we face a distinct choice.  We can perpetuate too big to fail, with its inequities and dangers, or we can end it.  Eliminating TBTF won’t be easy, but the vitality of our capitalist system and the long-term prosperity it produces hang in the balance.”

“If allowed to remain unchecked, these entities will continue posing a clear and present danger to the U.S. economy.”

“Moral hazard reinforces complacency.  Moral hazard describes the danger that protection against losses encourages riskier behavior.  Government rescues of troubled financial institutions encourage banks and their creditors to take greater risks, knowing they’ll reap the rewards if things turn out well, but will be shielded from losses if things sour.”

“The Fed kept interest rates too low for too long, contributing to the speculative binge in housing and pushing investors toward higher yields in riskier markets.  Congress pushed Fannie Mae and Freddie Mac, the de facto government-backed mortgage giants, to become the largest buyers of these specious mortgage products.  Hindsight leaves us to wondering what financial gurus and policymakers could have been thinking.”

“Mammoth institutions were built on a foundation of leverage, sometimes misleading regulators and investors through the use of off-balance-sheet financing.  Equity’s share of assets dwindled as banks borrowed to the hilt to chase the easy profits in new, complex and risky financial instruments.  Their balance sheets deteriorated–too little capital, too much debt, too much risk.”  (What would the Dallas Fed say about the Fed’s own balance sheet?)

“With size came complexity.…Complexity magnifies the opportunities for obfuscation.…They pushed the limits of regulatory ambiguity and lax enforcement.  They carried greater risk and overestimated their ability to manage it.”

“The term TBTF disguised the fact that commercial banks holding roughly one-third of the assets in the banking system did essentially fail, surviving only with extraordinary government assistance.”

“While reducing the interest burden for borrowers, monetary policy in recent years has had a punishing impact on savers, particularly those dependent on shrinking interest payments.”

“The machinery of monetary policy hasn’t worked well in the current recovery.  The primary reason: TBTF financial institutions.  Many of the biggest banks have sputtered, their balance sheets still clogged with toxic assets accumulated in the boom years.”

“The rationale for providing public funds to TBTF banks was preserving the financial system and staving off an even worse recession.  The episode had its downside because most Americans came away from the financial crisis believing that economic policy favors the big and well-connected.  They saw a topsy-turvy world that rewarded many of the largest financial institutions, banks and nonbanks alike, that lost risky bets and drove the economy into a ditch.  These events left a residue of distrust for the government, the banking system, the Fed and capitalism itself.”

“Capitalism…requires maintaining a level playing field.  The privatization of profits and socialization of losses is completely unacceptable.  TBTF undermines equal treatment, reinforcing the perception of a system tilted in favor of the rich and powerful.”

“[T]he country must find a way to ensure that taxpayers won’t be on the hook for another massive bailout.”

“It could be argued that zero interest rates are taxing savers to pay for the recapitalization of the TBTF banks whose dire problems brought about the calamity that created the original need for the zero interest rate policy.”

“Disciplining the management of big banks, just as happens at smaller banks, would reassure a public angry with those whose reckless decisions necessitated government assistance.”

“Big banks often follow parallel business strategies and hold similar assets.  In hard times, odds are that several big financial institutions will get into trouble at the same time.  Liquid assets are a lot less liquid if these institutions try to sell them at the same time.  A nightmare scenario of several big banks requiring attention might still overwhelm even the most far-reaching regulatory scheme.  In all likelihood, TBTF could again become TMTF–too many to fail, as happened in 2008.”

“The TBTF survivors of the financial crisis look a lot like they did in 2008.  They maintain corporate cultures based on the short-term incentives of fees and bonuses derived from increased oligopoly power.  They remain difficult to control because they have the lawyers and the money to resist the pressures of federal regulation.  Just as important, their significant presence in dozens of states confers enormous political clout in their quest to refocus banking statutes and regulatory enforcement to their advantage.  The Dallas Fed has advocated the ultimate solution for TBTF–breaking up the nation’s biggest banks into smaller units.”

“[T]he big financial institutions will dig in to contest any breakups.  Taking apart the big banks isn’t costless.  But it is the least costly alternative, and it trumps the status quo.”

“Greater stability in the financial sector begins when TBTF ends and the assumption of government rescue is driven from the marketplace.”

Former European Central Bank executive board member Otmar Issing in Financial Times, January 20, 2012, adds: “The problem of ‘too big to fail’ has made society–more precisely, the taxpayers–hostage to the survival of individual financial institutions.

“As a result, the basis of free markets has been shaken.…Thus, ‘too big to fail’ not only undermines a fundamental principle of market economies but also a principle of societies in which individuals are responsible for their actions.”

Let’s hope these influential voices get the ball rolling quickly and effectively before taxpayers are again put on the hook to bail out another megabank.

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Living In Financial Fantasyland

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We’re living in an era of make believe.  With the acceptance of newly issued Greek bonds, holders of that nation’s debt are making believe that Greece is still a solvent country and will someday pay its debts.  To get to that point, bondholders around the world had to make believe that they “voluntarily” forgave an estimated 79% of the money Greece owed to them.

Now we have to make believe that many of the European banks that hold the debt of Greece and such other strong sovereign credits as Portugal, Italy and Spain really hold assets worth what they’re valued to be on the banks’ books.  Perhaps concerned that such a financial fiction was too much of a stretch, the European Central Bank twice in the last few months loaned Eurozone banks as much money as they wanted for three years at a mere 1% interest.  Where did that money come from?  In an era of make believe, there’s no good reason not to create it out of thin air.

In the United States, we have more debts and promises of future payments than we will ever be able to pay.  We are adding to that debt load by more than $1 trillion a year.  So far, stock and bond investors are making believe that an unpayable debt load doesn’t really matter.  Somehow, it will all work out in the end.

Right now, equity investors–at least in this country–are focusing on improving business conditions resulting from the most monumental rescue and stimulus effort in history.  If they view these debts as a problem, it’s clearly not today’s problem.  Analogously, this seems to be a case of concentrating on a relatively healthy grove of blossoming trees while overlooking a pernicious blaze growing in an adjacent section of the same forest.  The safety of the blossoming trees is heavily dependent on remaining isolated from the blaze.  Winds, however, are variable and unpredictable, like investor attitudes.  Should events like rapidly rising interest rates in Portugal, Italy or Spain or a political impasse over the U.S. budget deficit lead investors to focus on the long term debt realities, winds could shift direction and intensify.  The debt blaze has the potential to overwhelm even the healthiest grove of trees.

As we have stated repeatedly, markets can continue to perform well so long as governments and central banks can keep looming debt disasters out of investors’ consciousness.  And they are obviously bending every effort to do exactly that.  So far, they have kept the blaze from consuming the forest.

Firefighters frequently set small backfires to prevent potentially lethal forest fires from spreading.  World central bankers (as firefighters) have set any number of such backfires in the form of increased liquidity.  Unfortunately, by using massive blast furnaces instead of modest blowtorches, our firefighters have increased the risk that when the wind shifts, the ultimate conflagration will be far worse than the original blaze.

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Two Interesting Commentaries

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I have no time to write a full blog entry today, but I came across two interesting and thought-provoking written pieces that I want to pass along.

In his annual letter to shareholders, General Electric CEO Jeff Immelt wrote:

  • “We live in what most business commentators call a volatile world. I would argue that when the environment is continuously unstable, it is no longer volatile. Rather, we have entered a new economic era. It could remain this way for a long time.”

The instability of which Immelt speaks is a result of the monumental debt edifice that has been constructed over the past three decades throughout most of the world. That debt began to take its toll in Japan at the end of the 1980s. Notwithstanding dramatic rallies from time to time, the Japanese stock market today remains 75% below its high at the end of 1989. At the end of the 1990s, we began to identify debt along with excessive stock valuations as the precursors of the next long weak cycle in the United States. That cycle began in 2000 and continues through today. The Eurozone debt crisis has more recently grabbed the headlines from the U.S. Fully recognizing the scope of the problem, central bankers throughout the world have sprung into action. The Financial Times profiles their responses as follows:

  • “Indeed, central bankers have ramped up their efforts, seemingly planning for the worst. The Fed introduced a currency swap line to alleviate U.S. dollar funding concerns in Europe. The ECB conducted its three-year long-term refinancing operations. The Bank of England provided another dose of quantitative easing. The Bank of Japan pursues its newly anointed inflation target. These are all variations of printing money.

    With all major countries printing money, the problems in the Eurozone may ease for now. Add to that the large degree of short positions previously built up in the euro that still need to be wound down, and the single currency should do just fine for the time being.

    There’s a price to be paid, though: we don’t see how the ECB, in three years’ time, will be able to mop up the trillion-euro liquidity it has provided. The ECB has now introduced a structural rigidity into its monetary policy akin to what the Fed is faced with. In many respects, central banks have disrupted the natural transition of market-ascribed economic health by imposing their colossal might (balance sheets) on to the markets. This should be alarming. Central bankers are increasingly manipulating rates all along the yield curve.

    Such policies take away crucial economic gauges (market-based interest rates across the yield curve) from investors and policymakers. As a result, policymakers can no longer rely on these metrics in setting appropriate monetary policy.”

As Jeff Immelt stated, instability could remain with us for a long time. The most recent central bank actions have succeeded in boosting investor confidence and stock prices, as they did in their last easing cycle until both confidence and prices collapsed from 2007 to 2009.

Current conditions leave investors in both stocks and bonds with the quandary of whether or not to follow the world’s central banks in the hope that newly printed money will, at least for the foreseeable future, overpower underlying financial and economic instability.

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Lessons From Margin Call

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Spending a couple of days at home recovering from a minor operation, I had an opportunity to watch Margin Call on DVD. Starring Kevin Spacey, Jeremy Irons and Demi Moore, the movie was a fascinating recap of one of Wall Street’s least auspicious moments. It’s a worthwhile two hours for anyone involved with investments. A warning, however, to those squeamish about crude language – such language is a Wall Street staple. You should, though, be ready to give these characters a pass, because they are, after all, masters of the universe – intelligent, aggressive, competitive, rich and filled with an exaggerated sense of entitlement. Why should they bend their language to society’s civility conventions?

The movie focused on the unraveling of the subprime mortgage market. Knowledge of that arcane segment of the fixed income market, however, is not necessary to appreciate the key messages of the movie. Most memorable are how rapidly the price of a basically flawed asset type can plummet and how vulnerable a major firm can be when overleveraged. Once the profiled firm’s senior executives recognized the severity of their overexposure to subprime assets, they quickly determined that they needed to sell their entire position in a single day before the rest of the street fully understood the implications of the fire sale. Bids in the low-90s on the opening bell had eroded to the low-60s by that day’s close. In the current crisis, only Greek debt has so far demonstrated such vulnerability, but there are definitely more candidates.

In the prior crisis, precipitated by subprime mortgages, Bear Stearns and Lehman Brothers were the most public failures, yet uncounted others were at the edge of the cliff but for history’s greatest-ever government bailout. AIG, with a longstanding reputation for sound business practices, bet the ranch on not having to pay off on widespread business failures. As in Margin Call, the egregious misjudgments of one of that company’s divisions sunk an otherwise successful firm. And if the government hadn’t bailed out AIG and its clients, would Goldman Sachs and others be alive today? Obviously, a great many people still question the propriety of using taxpayer money to rescue firms which made tremendously flawed business judgments. We could soon again face the uncertainty of whether or not some firms have badly miscalculated, this time regarding the prospect of Greek rescue efforts triggering an unknown, but still potentially dangerous amount of credit default swaps.

Judging from the frantic recent expansion of its balance sheet, the European Central Bank believes there is serious danger of both bank and sovereign failures throughout the Eurozone. So far that rescue effort has buoyed the spirits of equity investors who have faith that central bank efforts will succeed, at least for a while.

Realistically, there are only three alternatives for dealing with excessive sovereign debt: 1) repudiate it (with central banks so far trying to avoid that option at all cost); 2) grow fast enough to pay it down (not realistic for most developed countries); or 3) inflate it away. Thus far the major central banks have set themselves on the path of the third alternative, although they’re adamant about their commitment ultimately to withdraw all the newly created liquidity and about their ability to do it successfully. History casts serious doubt on central banks’ ability to accomplish that task, however, now that debt levels have reached current heights. In This Time is Different, authors Reinhart and Rogoff spell out in copious detail how inflating away the debt has been the method of choice for centuries.

Notwithstanding the already massive levels of debt, central banks around the world appear willing to lend even more if economic growth remains sluggish. How long will investors let governments and central banks play the game of inflating away excessive debt by printing new money? If currency is methodically being devalued by the printing press, investors will logically begin to demand higher interest rates to compensate for the anticipated diminished value of the currency at maturity. So far that has not happened except in countries in which creditworthiness is suspect. The situation could change quickly, however. Once again, Margin Call can provide insight. When the firm’s most senior executive foresaw the potential calamity in the subprime mortgage arena, he counseled others that while it might become a huge problem for the industry, it would not be as bad for the first one out the door. So far there has been no apparent move toward the door with respect to most central bank supported debt. Given the underlying insolvency of some of the guaranteed banks and countries, however, it is not farfetched to expect worried investors to consider being the first out the door. Investors have to evaluate whether or not Margin Call may be prophetic on a broader level.

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More On Wall Street’s Bullish Bias

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Two weeks ago I posted an entry titled Wall Street’s Bullish Bias. Take another look at that blog to get an appreciation for how Wall Street characterizes government and central bank rescue attempts. We’ll evaluate the effectiveness of those efforts in a future blog post.

Since writing that piece, I came across some additional Wall Street research from a reputable source that demonstrates how far the Street is willing to twist news to provide it with a bullish conclusion. The earlier article listed 14 “Positives” that the research contended were starting to dominate. Prominent among the “Positives” were government stimulus efforts. Now comes news that federal outlays have declined by almost 3% year-over-year–obviously a decrease in direct stimulus. If stimulus is good, this would seem to be a negative. Not so according to the recent research piece. The decrease is characterized as positive because it is good for the deficit.

In a similar vein, the same research piece reported that total government spending (state, local and federal) declined year-over-year in the fourth quarter. Since a decrease in government outlays diminishes GDP, one would expect this to be viewed as a negative. Again, not so. This reduction in government spending was spun positively as “making room” for private GDP to increase.

On a role, this same study took on unemployment. Along with housing, unemployment has been the most vexing problem facing our economy. In the worst unemployment crisis since the Great Depression of the 1930s, every job is precious, and government goes out of its way to trumpet any new jobs it has “created.” This research piece reported that since early 2010, total government employment has declined by 500,000. That is truly unfortunate for those who lost the jobs, but even that dire statistic was cast in a positive light as “making room for private employment to increase.” One might logically make that argument if government employment were depriving private employers of needed candidates. With almost four job seekers for every private job opening, however, such an interpretation is ludicrous.

While it’s clear that intelligent, informed people can disagree on interpretations of data, Wall Street is remarkably consistent. When reading any piece of Street research, never lose sight of Wall Street’s primary job – to sell product.

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Central Banks Bet The Ranch

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Since the greater than 20% stock market decline in last year’s third quarter, the excellent research staff at ISI has chronicled almost 100 stimulative policy initiatives by governments and central banks around the world. That coordinated effort to reverse the worldwide economic slowdown has succeeded in halting the stock market’s decline and in boosting prices back to the levels prior to last year’s market collapse.

Earlier this week ISI reported that for the first time ever the world’s five largest central banks were simultaneously conducting aggressive easing operations. In addition to our own Fed’s zero interest rate policy and willingness to buy bonds with no liquid market, the European Central Bank has launched its Longer-Term Refinancing Operations and has made virtually unlimited amounts of money available to European banks for three years at a mere 1%. The People’s Bank of China has just pledged ongoing Eurozone support and is expected to continue domestic stimulus. Although not directly involved in Eurozone operations, the Bank of England and Bank of Japan have both committed to additional aggressive quantitative easing.

Such widespread coordinated rescue efforts were unknown during 2008’s near collapse of the global financial system. Recent central bank actions appear to support legendary hedge fund guru George Soros’ contention that the current financial crisis is even more dangerous than that of 2008. According to Bloomberg, Soros characterizes this as the most difficult situation he’s seen in his career. Soros says that it’s more important to survive this crisis than to get rich.

It appears that the world’s central banks are in agreement that the global debt crisis is so severe that they will do what they must to ward off the normal corrective forces of recession. Recent actions are analogous to betting the ranch. All other resources have been spent. They have been forced into the ironic attempt to solve a problem of excessive debt by issuing far more debt.

So far the willingness of central banks to pump massive streams of new money into the system has elicited good feelings and rising stock prices. And there is no way to know how long such positive feelings will remain. However, unless the central banks are able to prevent recessions indefinitely (an unrealistic proposition), eventual economic slowdowns will spotlight the folly of would-be central planners who will be held responsible for the even more intractable levels of debt that we or our children and grandchildren will face in the years ahead. The mature economies of Europe, the United States and Japan have no realistic prospect of growing their way out this debt morass. The critical questions facing investors are how long central banks can defer the pain, how much they will inflate the debt bubble and on whom the inevitable defaults will fall.

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Wall Street’s Bullish Bias

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In 2011, most of the world’s equity investors suffered. Although business conditions have continued to slow on most continents, the majority of world equity markets have turned the tide and started 2012 on a strong note. As typically happens, perception of the news brightens after markets rise. Earlier this week the excellent researchers at ISI offered a litany of “Positives Starting to Dominate.” Notwithstanding the quality of their research, these points typify the bullish bias of the Wall Street establishment rather than portray an accurate rendering of underlying business fundamentals.

After each of ISI’s “positives,” I’ll offer what I consider to be a more relevant counter-balance from the perspective of investors rather than short-term traders.

  • Housing starting to recover. While some measures of decline are improving, prices continue to fall and huge numbers of foreclosures remain a fact of life. It will take years for the housing market to return to conditions that existed before the bubble.
  • Labor market improving. This is a celebration of direction over level. At 8.3% unemployed, the labor market is only slightly better than its worst status since the Great Depression of the 1930s. The government’s U6 measure, combining both unemployment and unintended underemployment is above 15%. Additionally, a large number outside those measures have given up hope of finding a job and have left the labor force entirely.
  • Credit expansion unfolding. This is due more to the unprecedented creation of money from world central banks than from any greater willingness to lend by bankers, who are still licking their wounds from their mindless expansion of credit over the prior decade. Applause for credit expansion must also be questioned while we are still trying to recover from an unprecedented debt crisis.
  • Low dollar. While a cheap dollar does improve profit potential for exporters, no country today wants too strong a currency, and currency wars with unpredictable negative consequences are a very real possibility. It’s also hard to believe that the U.S. will long maintain its historic economic supremacy with a weak currency.
  • Low rates. While low rates clearly benefit the housing market and businesses financing operations or expansion, low rates penalize savers and pension plans. Furthermore, with central bankers artificially lowering rates and keeping them down for years, unintended negative consequences could be numerous and severe.
  • Pent-up demand. We hope there’s pent-up demand, because consumers have bought far less in recent years than had become customary before the bubble burst. It is certainly possible that personal deleveraging is continuing, however, as people realize that they had run up unsustainable debt levels before economic conditions deteriorated. With unemployment still extremely high and the fear of unemployment a real concern for many, the willingness to spend may be markedly diminished in the years ahead.
  • U.S. manufacturing renaissance. It has been encouraging to see manufacturing statistics and manufacturing employment improving over the past several months. After years of ceding our manufacturing dominance to the rest of the world, however, we need far more evidence to call this improvement a sustainable trend.
  • U.S. energy sector booming. As with manufacturing, it’s certainly welcome to see this industry improving. The durability of that improvement, however, will undoubtedly be determined by the success or failure of efforts to reignite world economic growth.
  • Double-dip fears minimal so far this year. How strong a positive is it when we’re celebrating the reduced potential for a serious negative? It’s damning with faint praise at best. And with Europe falling into recession, this potential must refer only to the U.S.
  • Inflation receding around the world. Receding inflation is testimony to weakening worldwide business conditions despite the huge monetary expansion being conducted by most major central banks. Ironically, our Federal Reserve is afraid of inflation receding too much, possibly leaving us with deflation, a condition Fed Chairman Bernanke has vowed to combat.
  • Europe financial strains have eased. Really? Why are heads of state and central bankers meeting daily for weeks on end to ward off the dangers of sovereign default? The pledge of unlimited supplies of new money to endangered banks for almost any quality collateral has eased the liquidity crisis, certainly not the solvency crisis.
  • Liquidity is building in the world economy. No question liquidity has improved. That’s what happens when central banks hand out newly created money. And many corporations have improved their liquidity by lengthening the average maturity of their debt. It is perhaps instructive to remember that when you or I borrow from a bank, we may have more cash in our pocket, but we still have to pay it back, and we have to pay interest while the loan is outstanding. Improved liquidity may only buy time for entities with intractable solvency problems.
  • There have been 83 stimulative policy initiatives announced around the world over the past 5 months. Why have governments and central banks done that? Because business conditions are so bad.
  • The Fed has rates on hold at zero and is doing Operation Twist. See the prior comment.
  • ECB is scheduled to further expand its balance sheet on February 29 by as much as 1 trillion euros. Ditto again. Moreover, do you suppose that bond buyers might start to worry about the value of the currency in which they are supposed to be repaid? Perhaps that concern helps to explain why the price of gold has exploded upward, a situation that central bankers and other proponents of fiat money hate to see.
  • There are no particular problems at the moment such as Japan disasters, Thailand floods, supply-chain disruptions, gasoline price spikes, and debt ceiling crises. Thankfully, although seasonally adjusted gasoline prices are up by almost 30 cents over the past two months, and we know we will soon again be wrestling with our own need to reduce deficit spending. Unfortunately, natural disasters happen all the time, and when any nation, company or individual is excessively leveraged, risks of bad outcomes are far more likely. The world and its institutions have never before been so dangerously overleveraged.

Is the glass half full or half empty? It largely depends upon what one chooses to look at. Do the listed “positives” foretell steadily improving world economic business conditions? Can governments and central banks print their way to wealth and prosperity? If so, why not do it all the time? Notwithstanding the possibility of central bank largesse creating periodic bursts of enthusiasm, current economic and monetary dangers are severe and the future very uncertain.

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