Big One in 2008

This is from the latest issue of Forbes, and nicely encapsulates the upcoming debate in 2008; namely, which direction will the U.S. go? I have read other editorials which suggest, correctly I think, that the U.S. is in a generational battle between an FDR vision of the world and a Ronald Reagan vision of the world. These are fundamental questions that have huge implications for our future GDP growth rates, taxes, technological advances, and the types of policies we implement to try to solve big problems (Social Security, Medicare, healthcare, etc.)...

Big One in '08Steve Forbes 01.07.08, 12:00 AM ET
by Steve Forbes

The upcoming presidential election will be the most critical one since 1980. Back then Ronald Reagan decidedly defeated incumbent Jimmy Carter, ushering in radical new policies that would successfully set the course of this country for the next quarter-century. Unlike previous administrations, Reagan's dramatically cut taxes (the top income tax rate dropped from 70% to 28%). Reagan pushed government deregulation and reined in nondefense, nonentitlement spending. And, most important, he won the Cold War, an extraordinary victory that few experts had thought possible. We have been living off Reagan's dividends ever since.

What course will the country take now? Will we significantly simplify the tax code and cut tax rates, as Rudy Giuliani and some other GOP contenders advocate? Or will we raise taxes to stagnant, old-Europe levels, as all the Democratic presidential wannabes favor doing? Will we push for consumer control of health care or will we have a de facto socialized system, such as that Hillary Clinton is pushing? Will we turn Social Security from a liability into an asset by allowing people under the age of 50 to have personal accounts that are owned by them, not by Washington politicians--a system that will yield far greater returns than the current Social Security system could possibly do? Or will we go the Democratic way of heavier payroll taxes and reduced benefits?

Regarding foreign policy, will we take a broader, more vigorous approach to combating terrorism, deploying not only our military (which must be beefed up) but also a Reagan-like type of "soft diplomacy," such as far more effective use of radio and Internet broadcasts to troubled parts of the world? Will we push pro-growth economic policies that emphasize sound money, low taxes and property rights for developing countries or the detrimental high-tax, cheap-money policies of the current Treasury Department and the IMF?
Fundamental questions all.

While the mud will fly, there will also be a vigorous debate on where we go from here. How that debate is resolved will determine the course of our economy and the direction of the stock market. If the optimistic example of Ronald Reagan triumphs, we'll have sound, noninflationary growth, and we'll lead the world in technological innovation. The stock market will soar easily to new heights. But if the current Democratic platform wins, we are in for troubled times.
I am an optimist. I believe the spirit of Ronald Reagan still reigns in this land.

Who's Paying the Most Taxes?

Today's WSJ ran an editorial showing recently released IRS data for tax year 2005. Take a look:



This chart shows that more and more people in the U.S. are entering the ranks of the truly affluent. This represent upward mobility in a truly competitive and dynamic system.

The amount of capital gains taxes and dividend income declared has increased by 50% since the cap gains and dividend taxes were lowered to 15%.

Bullets and The Gun

Since the massive liqudity injection post-9/11, I have said (when rates were around 1.5%) that the Fed was going to need to reflate the economy by putting "bullets" back in the "gun". This has occurred over the last 24 months, and this is what needed to happen, since there has simply been too much liquidity in the system, and this has led to excessive risk taking, and low risk premiums. Historically, an environment with low risk premiums fares very poorly, and the recent credit crisis shows why.

So why did I think way back when that the Fed needed to put more bullets in the gun? Because those "bullets" represent Fed flexibililty in the face of another economic emergency. If we had been stuck in the 1.5% range, in the face of another Black Swan event, the Fed wouldn't have much wiggle room to move downward, and we certainly wouldn't want to end up in a Japan-style conundrum of a .5% rate environment. So by ratcheting up rates over the last 24 months, the Fed soaked up some liquidity, which is a good thing, since as Milton Friedman always said "inflation is everywhere and always a monetary phenomenon".

The Fed's decision to lower rates yesterday by .25% (Fed funds and discount rate) was seen as too little too late. The market already expected .25%, and "wanted" a reduction of .5%. Over the next year, the market expects rates to be lower by another 1%, which would greatly help out struggling financials and consumers. So while the Fed has wisely loaded it's Monetary Gun with additional bullets over the last couple of years, it needs to be able to pull the trigger! These gradual reductions will lead to more uncertainty and may lead us to the brink of a recession if not diligently handled.

Happy Thanksgiving

The image to the right shows what the Dow Jones Industrial Average has done over the last 3 months. This is not a pretty picture, and represents about a 9% slide in the stock market. This is all due to the recent credit "crisis", which is more appropriately a credit "loss of confidence", which started the cascading effect that we are still witnessing.

The silver lining is that we've had a recent upturn in the last 2 weeks, the Fed has signaled that it is in easing mode, and the big banks are starting to take huge (ultra-conservative) write-downs. Why is this important? Well, if the banks take a massive write-down now, each subsequent quarter these written-down loans are again marked to market. Eventually, there will be a market in these securities, and eventually these assets will be marked to market at higher prices than currently. At this point, maybe in 6-9 months, banks will stage a rally.

Curb the Curbs

The last week of stock market downside volatility is only made worse by the use of curbs by the stock exchange. As the market trades downward, the use of curbs only adds uncertainty to the mix, and keeps buyers away. Taking curbs out, and letting the market fall to a point where buyers will step in is what causes equilibrium in the markets.

For instance, let's say a curb is set to stop trading with a market decline of 250 points. What if a big buyer has a program trade in place to step in and buy securities if the market declines 275 points or more? What happens is....nothing. And with the added uncertainty, less liquidity due to curbs, etc. typically more sellers appear than buyers. This is not efficient, and increases the odds that more curbs and less liquidity will occur the next day-- this just exacerbates and slows down the process of reaching market equilibrium.

So I say "Curb the Curbs"!

Hot Air? Save the Whales

There was a very thought-provoking OpEd in today's WSJ by Daniel Botkin titled "Global Warming Delusions". It was a very sane piece lamenting the current political/societal debate over what global warming means. Botkin laments the fact that "beliefs" have pushed scientific facts and reasoning into the background, while along the way squashing the inconvenient findings of renowned scientists. For instance, one overlooked study attributes the causation of the melting of the snows of Kiliminjaro to increased solar radiation, not to changing air temperatures (i.e. global warming). Why is this significant? Because at that altitude the air is below freezing 365 days/year, and the melting patterns are consistent with increased solar radiation.

I of course bring up this controversial topic because it has huge implications for global policy, political rationing, and ultimately of the rationing and efficiency of future capital projects. Future estimated costs of $10 Trillion over 100 years is a big number; and this is just to prevent the rising of global temperatures by 1 degree Celsius. Reasoned discourse, intellectual curiosity and science must guide this debate, or we could go bankrupt trying to solve what could be a natural cyclical phenomenon. Climate change of course has merit; the real question is "how to we attribute changes in temperature"? And "how do we measure these changes"?

In terms of alternative fuels, a comprehensive U.S. energy policy that rewards exploration of any and all alternative fuel generation is paramount. Hand out tax breaks, and accelerated depreciation, and no taxes for 30 years! With oil at $88/barrell right now, the economics of making this a reality have never been better! This problem could be solved in 10 years using the ingenuity of free-market participants. In a little-reflected fact, oil actually is/was a free-market based alternative fuel; its discovery and plentitude actually saved the whales from extinction!

Necessity truly is the mother of invention; long may she thrive.

Inflation Reflation

With the Fed's recent lowering of the Fed funds rate by .5%, and the discount rate by .5%, the stock market experienced the largest one-day rally in 4 years. At the same time, commodities prices exploded higher. So what's going on? First, short covering in the stock market is part of the rise, and the added liquidity rushing into the market was caused by the surprise move. Commodities also pushed higher, including gold, because the Fed's move is seen as inflationary. Lowering rates like this will continue to weigh on the U.S. $, which is inherently inflationary to U.S. consumers who lose purchasing power, though certain asset classes have benefited in the short term.

Right now this Fed move should favor two trends: commodities and commodities-related company earnings, and U.S. multinational corporate earnings (whose foreign receipts are converted back into a weak U.S. $, which greatly improves their net earnings due to currency translation).

Great OpEd from WSJ: The Greenspan Myth

I couldn't say it any better than this, so I've added this OpEd from today's WSJ...

The Greenspan Myth
By DONALD L. LUSKINSeptember 13, 2007; Page A17 of WSJ
(partial op ed posting)

"...Mr. Bernanke has already acted more pre-emptively than Mr. Greenspan did in 1998, and similarly to the way Mr. Greenspan did in 1987 and September 2001. And he has done so despite the fact that, judging by the stock market's sturdy performance through the current turmoil -- now down only about 5% from all-time highs -- today's crisis is less threatening than those earlier ones.

It's noteworthy that the enormous volume of Fed open-market operations in the fed funds markets over the last month has been completed at the current rate target of 5.25%. This suggests that no lower rate is required to meet the needs of the banking system. And the discount window has scarcely been used at all, which suggests that the system is not in quite the state of distress that has been advertised.

So why would Mr. Bernanke cut the fed funds rate, unless he became convinced that the overall economy was highly likely to be damaged by the present market turmoil? That was the call Mr. Greenspan made quickly after the 1987 crash and the 2001 attacks, and slowly in 1998 and early 2001. Where's the evidence to support Mr. Bernanke making such a call today? Almost all the evidence is that the economy is remarkably robust, credit crisis or no credit crisis, housing slowdown or no housing slowdown.

Yes, we've had one disappointing jobs report. But with jobs at a level historically regarded as "full employment," must we hurry to cut rates? By historical standards, rates are already low. Since the 1970s, no easing cycle, and no recession, has ever begun when the real funds rate was as low as it is today.

Yet Mr. Bernanke remains under tremendous pressure from markets to cut rates. The prices observed in short-term fixed-income and interest-rate futures markets clearly imply that the markets expect a cut -- and the balance of pundit commentary is calling for one.

If the principled case can be made that a robust economy is significantly at risk, then Mr. Bernanke should do what the markets and the pundits demand -- provided that he sees a rate cut as consistent with his mission to preserve price stability.

But the idea that he must act immediately, in order to be seen as a worthy successor to the "Maestro," is unfair to Mr. Bernanke and too generous to Mr. Greenspan. The current Fed chief deserves our admiration for having acted quickly and appropriately so far, and resisted the temptation to over-react..."

Mr. Luskin is chief investment officer of Trend Macrolytics LLC.

Old News is Good News

Today the stock market was down about 1.5% because of the recent jobs report, which showed the first negative numbers in 4 years. Not surprisingly, many of the jobs lost were in the financial sector (i.e. mortgage lenders). However unsurprising this is, the financial media seems to think that this "news" is new. In fact it is quite old, and has already been baked into the stock prices during the subprime lending meltdown, since who can seriously consider that mortgage lenders would not be cutting jobs in this environment?

So the fact that the market is acting this way, based upon old news, is actually good news. Why? Because the market is more attractively priced based upon a short-term over-reaction. Weakness in the financial sector and this type of "news" are making short-term investors more cautious, but for long-term investors we gain entry into a market that is setting up its next base. Remember that the stock market climbs a wall of worry, fundamental earnings are very positive, valuations are good, and interest rates are still historically very low.

Short-Term Bearish, Long-Term Bullish

That pretty much sums it up. Today we are awaiting the Beige Book report, and the market is nervous that the Fed will not cut rates. Of course speculation that they WILL lower rates has fueled a recent rally. However, nobody really knows what the Fed will do. In the short-term, my best guesstimate is that the Fed will do nothing, but will mention that it is monitoring closely any fallout from the sub-prime mortgage mess.

So in the very short-term, the financial markets could be very rocky. Long-term though the markets are on solid footing with good earnings, still historically low interest rates, and good valuations. In the short term there could be a quick blip down, which I would call a very compelling buying opportunity for select Large Cap stalwarts across the board, especially in Financials, Healthcare, Global Telecomm, Auto, Semiconductor, Retail Grocery-- in other words, most of the sectors that nobody wants right now. Looking out 3-5 years, these sectors should rebound very well, and most of the companies in these sectors pay healthy dividends while you wait.

Credit Meltdown

The last week of trading has been dominated by an unwinding of positions on a global basis. The culprit; financial institutions and hedge funds that owned exotic re-packaged mortgages (Collateralized Mortgage Obligations, or Collateralized Debt Obligations) ended up facing an illiquidity crisis. They needed to sell in the short term, and it turns out that the crisis of confidence in the financials created an environment in which the pricing of these different CMO's or CDO's became increasingly difficult, thus illiquid. During illiquidity events, the hedge funds, mutual funds, and institutions sell whatever they can to create liquidity. Now, there is an expectation that the Fed will ease rates. However, they already have lowered rates by injecting nearly $45 billion in liquidity over the last week, equal to at least a 1/4 % rate cut.

In the financial markets, firms and individuals that made bad credit decisions must be allowed to pay the price for those decisions. Borrowers that took on too much debt, or lenders who lent too much debt, must learn that there are consequences for their actions. After all, the borrower likely experienced an increase in value, and the lender likely experienced an increase in earnings by behaving this way. Home builders that overpaid for land need to face the music. Wall Street firms that provided credit like drunken sailors must now pay the price. Homebuilders, mortgage companies, and banks have enjoyed exorbitant profits in recent years, as have shareholders and executives of these companies. Why now must the Fed give them all a pass? Nobody wants any company, or industry, to fail, and the Fed will obviously act as it sees fit to contain any contagion. However, to not permit losses now, a la a Fed bailout, is a direct violation of the principles of a free market that are the cornerstone of our economy.

Emerging Markets Riding the Wave

Emerging market economies have gone gangbusters in the last 5 years. In a world awash in liquidity, the flow of funds into emerging market stock markets has been tremendous. Not only are these emerging economies growing much more rapidly, they are producing goods and services competitively and building infrastructure. What do they need?: steel, aluminum, cement, oil, electricity, water, etc. As investment dollars have flowed into these emerging economies, returns have continued to be quite healthy despite the eventual compression of returns caused by large asset flows over time.

Some posit that the "disappearance" of risk in emerging markets will lead to an implosion. Perhaps, though it could be that there is simply lower volatility because of a credit upgrade cycle in emerging markets. As these economies grow and mature, these countries' debt goes through an upgrade cycle, which has the effect of improving the balance sheets of these countries, which in turn benefits the companies doing business there. As the level of risk appears to drop, even more fund flows enter these countries seeking higher returns from these higher growth economies with improving risk-adjusted fundamentals.

Sub-Prime or Sub-Slime?

All this talk about a sub-prime bailout for the mortgage companies who engaged in a bonanza of hay-making over the last 5 years is nonsense. We now have politicians talking about how to "solve" this "problem" in the future by creating more rules and regulations. All of this talk about introducing more rules and regulations just adds another layer of credit-tightening at exactly the wrong time. For 2 years the media has been talking incessantly about a correction in real estate in general; now that it's here everyone seems surprised! I have an idea-- how about letting the market mechanism work?

Let's allow prices to fall enough to a point where buyers will supply liquidity. Let's allow mortgage companies to fail that did a preponderance of risky adjustable rate mortgage financing. Let's allow all of those people who financed their not-really-affordable homes to learn a lesson and negotiate with their financial institutions-- these institutions do not want to hold millions of trust deeds, and would rather offer some flexibility to the homeowner anyway. Let's allow the publicly traded mortgage companies to be punished by their stock price declines; again, at the right prices, buyers will supply liquidity for these stocks. This entire process of correction, if left to the financial markets, would unwind, correct, and stabilize in a matter of months.