Monday, December 28, 2009

Give Us Something To Believe In

I wrote this article and submitteed it to Tim Knight's Slope of Hope. He usually will post my contributions only on the weekends because they are so long, so I will go ahead and publish it here in case it doesn't fit with his year-end line up. I will post a very quick (I know-I promise it will not be lengthy) updates on where I think the market is from a trading perspective and how to look at the positions we've mentioned in the past. Right now other than the last piece of my KSU that I exited this morning I have no positions.

I've documented the history of actions that caused our crisis and outlined the steps our government has taken to "bail us out". You may find the most recent post at Goatmug's Blog where we discuss The Best Cup of Coffee Ever and how it seemed wonderful and solved all of my problems, yet ended up bitter and disappointing. As I've mentioned, I believe many of the steps taken have either not worked at all, created other problems, or simply hidden the problems. Let's take a few of the items I pointed to in the last post and review the impact and results of their actions

A) The Federal Reserve and Treasury along with other world central banks stepped in and offered their fiscal support and immediately lowered rates again to near zero. Remember, these are front month rates and are the interest rates the government charges banks for overnight money. The Fed voted in recent weeks to keep rates stable at effectively zero percent interest. They voted to do so some 18 months since the beginning of the crisis and 9 months after the beginning of what we now know as one of the largest rebounds in stock market history. In spite of the rally we are still around the 10,500 level on the Dow which is where we traded in January of 2006 and well below the lofty 14,000 area of October of 2007. Am I saying that we cannot return to these areas? No, in fact if the Treasury department remains committed to devaluing the dollar, I can paint a scenario where that might be a real outcome. I doubt it seriously, but it could happen.

Timothy Geithner gave an interview last week on NPR that should put us all on notice. In his words, we will not have a retest or slowdown after this recession. Although many of his other predictions have been flat out wrong, I have a strange sense that he is committed to not letting that happen no matter what. http://www.npr.org/templates/story/story.php?storyId=121778778

Mr. Geithner is only speaking of a short term pull back that he'll help us avoid, for it is too obvious that the Fed and Treasury actions create bubbles and meltdowns and they are coming with increasing speed. I liken this to a drug addict. At first there is pleasure in the use of the substance. Next there is dependency, and then an increasing need for the larger portions of the drug in greater frequency. Think about friends, family members, and others that fit this drug addict description. It usually never has a happy ending does it? I think what we're about to experience is "tough love" provided by our investors. Our friends, (Chinese, British, folks in the Middle East), are about to hold a frightening intervention with the addict and therefore we will be told that we need to shape up and cut out our drug abuse. Unfortunately, I don't think the addict will listen. It is too tempting to let all of that debt go to waste and too hard to cut spending and cut promises and entitlements.

So what are the results of these actions? Interest rates are still low and creating asset bubbles. - Banks and other bank holding companies...er investment banks and insurance companies can now borrow at zero overnight and buy stocks, bonds, and commodities. Is there any wonder why all markets are screaming? What happens when that money is taken back? Remember, this money was intended to buttress balance sheets and also intended to be lent out to companies and consumers, not find their way to the casino!

Banks receive this money and will lend. - NOPE! This has not happened. This I believe is one of the greatest lies that has been made in this crisis. Why would any smart banker lend in the teeth of a nasty, jobless recession? Would you? If you looked at a firm that is asking for credit and he tells you that their business is slowing and they need a loan to make payroll, do you think they are a good risk? Asking bankers to lose money on bad loans is not a solution to the crisis. On a positive note, I am hearing some of my clients being contacted by banks that are desiring to lend on decent terms now. This may be an indication of some thawing.

B) The Fed also bought toxic securities outright from troubled financial institutions and traded those assets for treasuries. Our government offered the TARP funds to help institutions and even made outright purchases of banks and insurance companies. (AIG, Citbank, etc.) We even used these to buy and lend stakes to great car companies like GM! We keep reading that many of the banks and insurance companies that we lent TARP money to have repaid us and we (the US taxpayer) may have actually made some money on these loans. The reality is that we may have made some money on loans that have been repaid, but we have taken a bath on the loans that will never be repaid. Making AIG a government controlled entity makes certain that more losses are headed our way. The Treasury Department and Fed's lack of negotiation with AIG's creditors should be enough to convince anyone that the well connected firms like PIMCO, Goldman Sachs, and Blackrock were feasting on the carcasses of weakened and dying financial firms. In addition, these same favored companies have become the mechanism by which the FED and Treasury actually implement their policies. These companies are providing transaction support (spreads), participating in deals, and also offering consulting services

So what are the results of these actions?
AIG is a mess and still 85% owned by the US. Isn't it great we are in the insurance business?
GM - is still GM.
Goldman, Blackrock, and PIMCO are killing it .

Remember too big to fail? - As a result of the forced marriages between JPM and Washington Mutual, BAC and Merrill Lynch, Wells Fargo and Wachovia, we now have a greater concentration of larger institutions. Seems like the US government has now created larger risk pockets and concentrated more power in less hands. Finally, the repaid TARP money is being used like a slush fund now. The administration and Geithner said they had "extra TARP money" that they could use! Excuse me, just because it is appropriated doesn't mean we need to use it if everything is all fixed, right?
C) In concert with these actions our government also looked to perform direct support (cynics would call it manipulation) in the mortgage market and the treasury market. By guaranteeing and supporting the FHA the US taxpayer became the lender/insurer to 80% of the post-collapse mortgage market. With the announcement of quantitative easing by the Fed we began buying our own treasuries to try to keep prices low and contain rising interest rates.

While short-term manipulation has been successful, it is just that - short term. The bond market is bigger than any one central government and the bet made by Bernanke is going to be called. Once that happens interest rates will climb (and as I type this we are seeing 30 year mortgage rates 10bps higher in one day last week!). THIS IS A HUGE MOVE BY THE WAY! Who will step in to fill the void of the government in this volume at these rates? Stabilizing the home market is job #1 - The government has artificially lowered interest rates and become the dumping ground for all banks to offload their paper on the US taxpayer. Few banks are doing direct lending to residential borrowers without FHA backing. Home sales look to be moving up, but we must ask how long this will continue if rates jump substantially, cash for houses go away, the FED stops buying MBS (stops being the market), or banks actually release the huge backlog of foreclosures that they have kept on their books.

Don't get me wrong, the government is having an impact here and this is positive for the economy. I'm very concerned that this could change if any of the government "help" is removed or investors demand higher rates and push mortgages rates over 6%. For example, in November we were to have the final expiration of the first time home buyer credit. Sales were pulled forward and suddenly we have a reported drop in new home purchases in November. The following Bloomberg article demonstrates what the threat of pulling stimulus does. A mad rush of buyers that would have bought anyway step forward to take advantage of the taxpayer-paid windfall, and then demand dries up in the following months (Cash for Clunkers anyone?). http://www.bloomberg.com/apps/news?pid=newsarchive&sid=al3GTnIut0Ao

Obviously I'll have this prediction in my top predictions for 2010, but I'll suggest here and now that we have a dip in the sales trend in existing homes as much of the inventory that has been clearing has been foreclosures and investors (not occupants) have been swooping in to pick them up. Hopefully those investors have been buying smart and have deep pockets because I will predict that we'll see the new generation of home flippers that have emerged get sunk in 2010. They'll find that there won't be many buyers for these homes when mortgage rates hit 6% or 7% since we're all spoiled and believe that 4.75% is what we should expect! These investors will also get hit hard when banks like Wells Fargo and Bank of America actually release their piles of inventory instead of letting them trickle out. Look for these inventory clearances after 1st quarter reports come out.We were told that housing is the key to recovery - housing has not recovered yet, so I guess there is no recovery yet.

D) The Obama administration got in the act and began programs like the Housing Tax rebate for first time home buyers, Cash for Clunkers, and now Cash for Caulkers. In addition, the federal government has continued its payment of extended unemployment benefits. In addition, as a country we are now running a huge fiscal deficit (nothing new, just the magnitude of it is) and our government's expansion has required us to raise the debt ceiling (allowable debt of the country) to $1.8 Trillion Dollars! This doesn't even account for the addition of any new health care program or new stimulus. As I've mentioned several times, I believe that the Fed and Treasury must be cussing the administration for their interference. The Obama administration has kept to their strategy that they wouldn't waste any crisis and by goodness they haven't. In the hysteria they have continued to plunder the US taxpayer and add more programs and benefits to the entitlements for anyone that will take them.

We are now seeing that COBRA subsidy benefits are being extended to the unemployed (they have been offered for 9 months) and will be provided for another 6 month period. The program pays 65% of the premiums that someone that has been laid off of work must pay to keep their health insurance. It seems odd to me that the US Government and US taxpayer would pay for health plans at rates that are significantly higher than what can be obtained by families in the open market with individual policies. Of course we shouldn't be amazed at all about this, this is what happens when government makes decisions. This one example illustrates how the new health reform plan cannot and will not be an improvement or a cost savings for anyone.

While Obama has added his pork to the budget, the US treasury buyers will not tolerate the bloated debt of the USA. The market will require higher rates of interest and this will cause significant pain for all of us.
Crisis Management- Administrations have added pork laden projects and plans to the backs of taxpayers as an excuse to stimulate the economy. There are no plan for fiscal restraint or management of the budget. What simply blows me away is that I hear Obama speak about finding waste in government programs to pay for more stuff! Where is the idea that you cut costs and if necessary, benefits?

I'll comment more about the health care reform bill in another post, but you need to understand that the winner here is the health insurance industry (for now). As these bills are written they will have a captive audience of buyers. Many of you know that I own a health insurance brokerage and I saw a huge swing in commentary by insurance companies. If you don't think they are giddy, you are WRONG! Check out this email link I received from Aetna. These guys were hammering the Senators and then suddenly came out with this gem. Mind you, if this goes through I hope to sell everyone one of you a policy because I would hate to see you go to jail or pay stiff fines, but everything about this stinks and reeks of over promising and under delivering at a terrible cost to tax payers. A key provision in the plan is the elimination of pre-existing conditions as a basis for exclusion or rating up. Once this exclusion provision is removed we will witness the elimination of INSURANCE! Why would you obtain insurance till you have something serious now? GDP was revised downward and we are seeing that the government is responsible for most of the production for last quarter. I understand that

For all of these programs, what are the results? - We were told we need these programs to stimulate the economy- all have been short term and have done nothing to change the fundamental situation. We still have 10% unemployment and 17% U-6 unemployment. We were told that everything would begin to get better once housing is stabilized, we haven't seen housing stabilize and won't for a while. More appropriately we'll see things stabilize when people have jobs.

E) The accounting standards board (FASB) bowed to pressure from financial institutions and our government by suddenly recommending that accounting standards be thrown out the window. The accounting standards board have been complicit in this crime against investors as the boards were threatened and frightened into thinking that they would be responsible for imploding our economy. Where is the leadership in our country? I am afraid that the move to take a time out on reality simply makes it easier to do it again. The accounting standards board should have stood up and emphatically stated that accounting standards don't change or take a time out because the truth hurts! Future collapses will be much worse because the ponzi schemes the government and banks have set into motion were not stopped here. Clearly now that the banks are bigger and risk more concentrated similar meltdowns will be even more destructive. Accounting standards were thrown out resulting in a lack of understanding of true value of banks and insurance companies.

Where are we now? We still don't know what banks are worth and they are still raising capital and still lying about the risk on their balance sheets.

F) Finally, as we saw in the previous October post called Public Enemy #1-Deflation we see that the Fed and Treasury unleashed its last desperate weapon, Dollar Devaluation. The dollar devaluation trade is simply a move to destroy the value of the dollar relative to other currencies. This makes our dollars worth less and hence our debt worth less. We could also argue that it makes our goods cheaper as we hope to sell them abroad. The Fed has been true to its words that it would implement this strategy if faced with the prospect of deflation. When the government went to work in March the DXY was at $89.20 and they did not disappoint. They have moved the value down by as much at $15.00. The DXY is now trading at 77.64, well off its lows of $74.27 in late November and early December. So as the dollar has been pelted since March, EVERYTHING has gone up. Think about it, stocks, bonds, bread, gas, oil, gold, and the kitchen sink have all increased. http://www.marketwatch.com/investing/index/DXY/charts?chartType=interactive&countryCode=us So now, we've been told that everything is better and that we are recovering. In fact about 3 weeks ago, we had a surprisingly strong jobless claims report that stunned the market and boom, the dollar reversed course and interest rates began to rise. They rose because the strong jobless report indicated that things were stronger than expected and the Fed might need to remove stimulus (increase interest rates or as we know it, take the drugs away from the addict). Since that day there has been a resurgence of the dollar. Bernanke tried to tell the market that they would not raise rates because there were no indications of inflation in the market. Fed governors tried to tell us there was no evidence of inflation, and now Geithner has come out and told us that there is not a chance that we'll have a double dip.

So why are rates starting to rise and the dollar increase? How have we seen the dollar rise and the markets increase? First we have had some credit issues with Dubai, Greece, and Spain. All of those have reminded investors that there really is risk in the credit market and we aren't fully recovered. Scared investors tend to go to safety, and therefore we have seen a flight to safety in the dollar. Having said that, treasuries are a poor investment as the Fed has made sure to destroy any reality in that market (and value too). Therefore it is easy to see how liquidity could move to other dollar denominated assets allowing for the strengthening dollar AND rising equities and bonds (at least here in the last few weeks). Remember, this move up in interest rates and increase in the value of the dollar is contrary to what the Fed and Treasury desire (even though they say they want a strong dollar for the sake of our Chinese buddies). The increase in rates immediately translates to greater borrowing costs for the tax payers AND devalues the value of the treasury assets we already own. The government states that it wants to keep rates low to stimulate lending, but I can also see that we need to keep rates low to keep from blowing our own foot off since we have been purchasing our own debt through quantitative easing. Zerohedge has another good post that captures exactly what I've been saying and leading up to here.

What are the results? - So we have an administration that says they want a strong dollar, but we have a Fed Chief that has stated his strategy to save the economy would rely on a devaluation of the dollar. We have had an engineered rally in all asset classes and treasury rates that are way too low for the risk and duration of the trade. In essence we have a bubble in Treasuries!
My isn't it obvious, where ever we see the footsteps of the Fed, we see bubbles? So what is on the horizon for the Fed and Treasury? In 2010 we will see greater rates as buyers decide to wait it out and purchase their mis-priced treasuries at a better risk-reward. The greater rates will hurt bond holders and most of all the US tax payer. The bond market at some point will change the behavior of our current administration and the corrupt politicians that look to hand out entitlements and lack the idea of being representatives of the people.

We will see drastic cuts in city and state budgets and services before we see anything on the Federal side, but cuts will come at the national level.

If the Fed and Treasury want to keep the charade of low rates going then a fall in the equity markets will be the mechanism to deliver lower funding rates, unless they announce a new set of Q.E.

To wrap this up, we see that in each instance the failed efforts of the government to fix the situation have either simply done nothing or helped to kick the can down the road. As we've elaborated since our first post in August, the game of extend and pretend has been in full force. The problem is that at some point (2010, 2012, or 2015....) there will not be a way to extend it and a creditor will call our bluff and call in our debts. What I am really longing for is for a responsible leader to stand up and say NO, we won't offer this entitlement, no- we are actually going to cut services. Americans are going to be forced to live through these boom and bust cycles at an increasing level of speed and magnitude because our current leadership will not speak truth. The best result of all of this crisis is that average Americans are beginning to wake up and live a paradigm based on their needs and not their wants, based on their own ability and assets, not based on what their neighbor has. I am seeing a genuine reversion to true values of healthy financial management in peoples financial lives and in their businesses. Unfortunately, they had better be ready quickly because our government is saddling them with more debt and taxation to pay for promises and entitlements we can't afford. As an example of the crisis that consumers are facing check out this closing study.

Almost half (46%) of 2,148 consumers surveyed recently said they weren’t confident they could come up with $2,000 within a month in a crisis–from savings, family, friends, credit cards or other sources.Even among those earning $100,000 to $149,000 a year. almost 25% doubted they could raise it, according to the survey conducted by research firm TNS with academics from Harvard Business School and Dartmouth College. “We wanted to know if people could fix a broken car or furnace,” says Harvard finance professor Peter Tufano, who adds that most studies he has seen measure “how much cash people have… not how much they can access.” The survey results surprised him. “The ability to cope with emergencies is much less strong than we might have thought.”

I saw this in reality as people in the South dealt with Hurricane Ike. After 1 day people were cashless and without resources to make it through this terrible emergency. Americans need to wake up and save and communicate to their leaders that it is unacceptable to continue in this fashion. We had a final emergency and the US leadership chose to fake it till they made it rather than employ real fundamental solutions to problems of our own creation. At the end of the day I feel like the Bush Administration, Obama Administration, Treasury, and the Fed have just tried to spin whatever story we would fall for in order to get us to give them time. What they have figured out is that we just want them to give us something to believe in to quote a favorite from Poison (yes, I'm still into 80's hairbands). Guess what, they've given us a few tales, let's hope that no one actually figures out that what we've believed in isn't worth the trust we've placed with them.

Goatmug

Wednesday, December 9, 2009

THE BEST CUP OF COFFEE EVER


I have to admit, the older I get, the more spoiled I am. When I was younger (college) I lived on a diet of Taco Bell, Top Ramen, and Keystone Light. You might be able to discern with that line up that I paid for college myself and you'd be right on. Fortunately, those items contain just enough of the four food groups to sustain me. I didn't eat or drink any of these things because they were awesome, they were simply life sustaining and served their purpose.

As I earned my undergrad degree, I became a coffee fiend as well. I often tried drinking coffee black, but found that coffee with a bit of that white powdered gluten laden non dairy creamer improved the taste. As I've aged, I developed a taste for better quality beverages and I often won't even drink coffe when half and half is not available. I've learned that I don't care for the manufactured taste of the powdery drink additive.

Why do I take this trip down memory lane? Yesterday I took a new leap. In the quest to create the perfect brew of coffee I purchased hand roasted whole bean coffee from a local roaster. I purchased organic turbino sugar, and also organic half and half. Why such a special concoction? I was celebrating the completion of several major work projects I've been tackling for months. (By the way, I would have never dreamed of making a cup of coffee like this in college). After grinding the beans, brewing the coffee, adding the sugar, and adding the half and half, I realized something was horribly wrong. Something was not as it should be. Flakes of creamy white rotten half and half floated to the top of my "perfection in a coffee cup". A few explicatives and a drive down to the corner grocery quickly rectified the situation, but as you can see I was clearly scarred by the experience.

What is the purpose of relating this story? Easy, things are not always what they seem. I bought the best of the best in all of the ingredients in my coffee. Unfortunately, organic, rotten half and half is still just as nasty as non-organic rotten half and half. While the packaging was prettier, the marketing better, the price tag greater, the end results were disappointing. In fact, after the entire ordeal, the results were probably more tragic!


I think that is a great starting point for our story of the marketing job our Fed, Treasury, world central banks, and two Presidential Administrations have served up. Recall that the problems over the last 18 months started in the following manner;

1) The Federal Reserve attempted to restart our economy after the tech wreck by lowering interest rates to stimulate spending. As usual, low cost money for a prolonged period spurred irrational exuberance, and a mis-pricing of risk. American investors felt that real estate was the new "money tree" and either gobbled up investment properties or used their home equity as an ATM for rampant consumption of stuff they didn't need or access to additional debt to buy other investments.

2) As more Americans borrowed and spent, more and more less qualified borrowers were wooed by President Bush's goal that 70% of Americans could own homes despite that the long term average percentage of home ownership in the US is 63%.

3) Realtors, mortgage brokers, mortgage lenders, and Wall street were more than happy to oblige these lower tiered borrowers and like a drug pusher helping an addict they continued to offer their wares.

4) As home prices continue to go higher the merry go round had all of the kids on board and so therefore there was no one left to keep pushing. Sub-prime borrowers began defaulting as mortgage resets hit them with higher interest rates and caused them to lose their undeserved homes.

5) As the tidal wave of defaults hit, Wall Street became a victim of its own success. Bear Stearns and Lehman Brothers exploded bringing down Wachovia and Washington Mutual. All of these firms were involved in lending to marginal borrowers or the securitization of pools of these loans. Merrill Lynch, AIG, and more also were involved in this mess.

6) The Federal Reserve and Treasury along with other world central banks stepped in and offered their fiscal support and immediately lowered rates again to near zero. Remember, these are front month rates and are the interest rates the government charges banks for overnight money. The Fed also bought toxic securities outright from troubled financial institutions and traded those assets for treasuries. Our government offered the TARP funds to help institutions and even made outright purchases of banks and insurance companies. (AIG, Citbank, etc.) We even used these to buy and lend stakes to great car companies like GM!

7) In concert with these actions our government also looked to perform direct support (cynics would call it manipulation) in the mortgage market and the treasury market. By guaranteeing and supporting the FHA the US taxpayer became the lender/insurer to 80% of the post-collapse mortgage market. With the announcement of quantitative easing by the Fed we began buying our own treasuries to try to keep prices low and contain rising interest rates.

8) The Obama administration got in the act and began programs like the Housing Tax rebate for first time home buyers, Cash for Clunkers, and now Cash for Caulkers. In addition, the federal government has continued its payment of extended unemployment benefits. In addition, as a country we are now running a huge fiscal deficit (nothing new, just the magnitude of it is) and our government's expansion has required us to raise the debt ceiling (allowable debt of the country) to $1.8 Trillion Dollars! This doesn't even account for the addition of any new health care program or new stimulus.

9) The accounting standards board (FASB) bowed to pressure from financial institutions and our government by suddenly recommending that accounting standards be thrown out the window. Clearly they were pressured and threatened that if they did not create new "rules" for accounting for troubled assets and balance sheet holdings economic collapse would surely follow. A better translation for this should be, "If you don't allow banks and financial institutions to continue reporting false values and lie the whole ponzi scheme will collapse". You know what, that is exactly what would have happened. Am I amazed that FASB suspended its own rules and took a break from truth telling? NO, NOT A BIT! Am I amazed that for a while I was duped to believe that there was ever any truth in the markets, truthfully, yes. What these accounting standards amount to now is that they are standards as long as they are convenient. When accounting standards are not, they are no longer required.

THIS SHOULD BE A WARNING TO ALL OF US! WHEN OUR FREE MARKETS AND FREEDOM ARE CONVENIENT, THEY WILL BE FREE. WHEN THEY ARE NOT CONVENIENT, YOU WILL HAVE YOUR FREEDOM AND FREE MARKETS SUSPENDED.

10) Finally, as we saw in the previous October post that was published in http://www.slopeofhope.com/ we see that the Fed unleashed its last desperate weapon, Dollar Devalution. I've posted that blog article here if you missed it PUBLIC ENEMY NUMBER ONE . This speech given in 2002 highlights all of Bernanke's contingency plans for a bust cycle. Guess what - he's done it all and now the bullets are expended.

Now don't get me wrong if you are reading this and saying that "Goatmug sure does hate prosperity and the government!", the truth is that would be absolutely wrong! What I do hate is waste, entitlement, theft, and intentional distraction and lying. I admire honesty, consequences, discipline, entrepreneurialism, and nationalistic pride.

My aggravation with the government's scheme is that it avoids almost all of the things which I've highlighted as worthy of admiration. As I've mentioned before, I believe that the government has done unprecedented acts and while it appears to have done amazing things, in reality has accomplished little but to raise asset prices of stocks, bonds, and commodities. We have not addressed the underlying asset destruction on the balance sheet of banks and in fact it has not forced them to write bad loans down at all. The FASB's actions simply reinforced that our approach would be to "extend and pretend" rather than taking a disciplined approach and closing these Too Big to Fail Institutions. We've allowed Goldman Sachs and others to literally use the US balance sheet and make billions while it would have been more economically reasonable to cut a check to each American family for $200,000 or more.

As usual, this post is way longer than I thought it would be, and I haven't even gotten to the main point. Therefore, I will highlight in the next post what has changed for the US economy due to the actions of our government and how they are simply surface level improvements. I'll outline how the global economy and its linkage will ultimately lead to a double dip recession or worse despite our best efforts.

I found this quote in a piece done last week by Chris Pulplava, who is also one of my favorites. If you are not reading him weekly on Wednesdays you are missing out. (By the way, he is quite bullish now, so please know that I read all perspectives and don't dismiss them when they don't agree with my point of view). http://www.financialsense.com/Market/daily/wednesday.htm

FDR’s Secretary of the Treasury, Henry Morgenthau came to in 1939 after initially being a proponent in massive fiscal stimulus to cure the depression and employment. His comments are provided below:


"We have tried spending money…We are spending more than we have ever spent before and it does not work. I say after eight years of this administration, we have just as much unemployment as when we started… And an enormous debt to boot!”

I wonder if that sounds familiar? We'll discuss what improvements have been seen in the economy and how they have been manipulated and engineered to create them. We'll also discuss how these improvements will abate in the next several months as counter-vailing forces moving to limit and undo the positive moves of the last 9 months. In other words, we'll put the economy to the "Best Cup of Coffe Ever" test and see if it really pans out to be as good as we envison it.

By the way, I no longer drink, I haven't eaten Taco Bell in 5 years, but MSG addictions and bad habits are hard to break. I must admit that I have a stack of Top Ramen Roasted Chicken Soup in my cabinets. God, family, great coffee, Tabasco, and Top Ramen are essentials for a fulfilled life. You might pick up a packet, heck even with inflation a packet is still 20 cents! (Remember when it was 12 cents?)

Tuesday, December 8, 2009

DECEMBER OUTLOOK



I hope everyone had a wonderful holiday. As I have been speaking with many of you over the last two weeks you have seen that I have become more and more concerned about a period of decline in the market. The last couple of days have proven those thoughts to be right on target. I will keep the monthly summary pretty short and provide a fuller explanation of my concerns and how to trade it.

Many of the data items I look at are now beginning to show real positive momentum. Many folks might look at these new and building trends and decide to get into the markets now that it is clear we are on the verge of exiting the recession. I urge caution in that thinking. As usual, we want to think like the banksters and corporate robbers that live to take our money. When these trends are readily visible, we should probably do what they do and exit the market following the old adage, "SELL THE NEWS".

WLI - DATA

The ECRI WLI data continues to press onward and upward. Remember this is a compilation of 6 or 7 leading indicators to give us an idea of the direction of the economy. Because they are leading indicators, they should turn up before we feel or see the impacts in the economy. The indicators have done a great job highlighting the change in trend in the economy. As I've pointed out though, more than half of the indicators are reliant on data that is liquidity or FED driven. We've discussed at length that the flood of liquidity provided by the FED is intentional and historic. If the WLI data didn't turn up with the amount of cheap money in the system, we'd really begin to worry. I'm not discounting the information here, just want to be sure that it is clear that the vast improvement rests solely at the feet of the FED.



WEEKLY RAIL DATA
OK, same trend follows here as well. slight improvement, but nowhere near the 2008 levels. We are going to see big changes in year over year comparisons starting next month simply because we began a waterfall like descent in the 4th quarter of 2008. This chart measures the weekly loaded units. They are 4 week rolling averages.














Recovery Watch - As usual, I'm watching crushed stone and lumber shipments to show us any indication of a pick up in commercial and residential construction.......nothing.













On a positive note take a look at this carrier. Kansas City Southern's shipments have achieved 2008 levels. Before you run out and buy the stock, notice that it is trading at just under $29.00 which is a 100% increase since July of this year. I point it out because it has had the best recovery of the rails and obviously the market has rewarded it for its return. In September of 2008 it's price was around $50, so this is one to watch. I see some overhead resistance at $30.00, if you see it punch through, you might look deeper at it. (I'M NOT RECOMMENDING IT, JUST SAW IT AND FOUND IT INTERESTING FROM A FUNDAMENTAL AND TECHNICAL PERSPECTIVE).


KSU - Total shipping units beginning to eclipse last year's performance.














MIT TRANSACTION BASED INDEX -
We see a very slight uptick in prices for commercial real estate. Yes, commercial real estate is a disaster! Yes, regional banks are crippled with commercial real estate loans that are not performing. Yes, MIT is seeing someone come in and pay a bit more than they did in previous weeks. Let's watch it. DO NOT GO OUT AND BUY REITS BASED ON THIS!



















FINANCIAL CONDITIONS INDEX -

The Bloomberg Financial Conditions Index continues to march forward. This index is comprised of money market and bond market pricing and liquidity inputs. We know the bond market has improved substantially in recent months. A print above 0 indicates that we are out of a recession. We continue to inch closer. Does a proclamation by the FCI or Obama or the Economic Council mean that everything is better? No. We will see a proclamation that the recession is over, but we'll still have U6 employment (or should I say unemployment) at greater than 15%.













AAII SENTIMENT -

Investor sentiment is usually wrong when they are at extremes. Unfortunately, we are stuck right at 50 which indicates balance between greed and fear. We'll keep monitoring it. This week's data should get interesting with the dollar being up 3 days in a row.













US DOLLAR -

The US Dollar rose like a phoenix from the flames, ok, let's not get carried away here. The dollar has been up against a basket of currencies for the last couple of days. This does make trading a bit harder because it means that the trend for the last 8 months is being challenged. As of this writing the DXY or USD Index is over 76 which is a critical area. We'll keep watching. Read below to revisit how many of our trades are underpinned with the notion that the dollar will continue to decline at the hand of the FED and US Treasury.











TRADING SUMMARY - NEXT 30 DAYS
The dollar is still our benchmark and its new found strength has me watching our overseas and commodity investments even more intensely. The dollar is clearly still in a long term downtrend and nothing has changed, but I am more vigilant in monitoring it's daily moves because we are seeing other signals that the equity markets may be near a top.
US EQUITIES
We are nearing the end of the year and with the holiday season comes declining trading volumes in the market. We are seeing a narrowing of market breadth. Market breadth simply measures the number of advancing stocks versus the number of declining stocks. In a rising market the market breadth shows more advancers than decliners. As a market's rise slows, market breadth begins to contract.
In addition to the number of companies rising, we are also seeing two key items happening now. We are seeing only major leaders in the market advance while the rest of the market declines or languishes. Think of companies like Apple and Amazon as these leaders. What this means is that the surge in the market over the last couple of months has been extremely concentrated, not broad. This usually indicates that investors don't have conviction to go out and buy the market and fear holding anything other than the best names. As the rally continues to tire, even those names begin to fall. This is where I believe we are at the moment.
FINANCIALS
Finally, the market's rise has not taken financials with it over the last several months. Without financials any rally will be doomed. After hitting $193 in late October, Goldman Sachs is now at $162. This does not convey that we are in a position of strength.
OIL
Oil has sold off over the last few days which is no surprise due to the dollar's strength. Compounding the pressure on oil is that we are in a season that is typically very weak in last part of the year. At this time oil is $73. I have been looking for an entry into oil back in the $60's. I'm not in any hurry to buy here as I continue to believe longer term we'll see a double dip recession.
GOLD & PRECIOUS METALS
Gold has been crazier than a bucking bronco over the last several weeks. I have been pleased to have done well with highly speculative positions in gold while it was moving higher. I was even lucky enough to have caught some of the move down over the last two days. If you get the sense that I am glued to my computer during these times, you'd be correct. These are highly risky trades and I limit the amount I have invested, knowing that I could lose 100% on the trade if I get it wrong.
Because of the huge volatility in gold, I am suggesting that you exit any positions.
Gold has some significant support at the $1000 level. I would be inclined to add positions back if we neared that mark.
OK, so what do we do? Due to the weakness in many of the indicators I watch I am moving my stock holdings to a more conservative position. During this huge rally I have not committed all of my capital, with only about 50% of my long term account in the market for the months since August. The gains have been good and I do not desire to give them back. As always, I value preservation of principal and while not happy to miss gains, am always willing to pass up potential gains if I think there is a great probablity for loss. This selling of positions includes all overseas etfs, precious metal and commodity positions.
LONG TERM OUTLOOK (2 to 6 MONTHS)
Even though I suggest moving out of all positions here I want to give you a sense for what I perceive will happen over the next several months to a year. As I wrote earlier, the USD is in a long term downward trend and I believe it will maintain its direction. Understanding this trend allows me to not be too concerned about commodity positions unless I see the dollar index move above the $79 to $80 level.

Don't be mistaken though, a move in the dollar index from $76 to $80 could be EXTREMELY PAINFUL if you are in commodities or precious metals. Don't read this and say, I'll just watch $80 as a level and keep my positions on! While this is just a few points in the dollar, we could see a significant drop in the price of these commodities if you are still in them.
Even if we just churn here in a range or see mild weakness materialize in the short run, there may be a temptation to enter back into equity positions in January through February. Be careful, because after that period I believe we will head for a significant drop.
Gold and commodities will continue to perform well on a relative basis, but they too will be caught in a down draft, so watch out!. Overseas investments will continue to out perform US Stocks. I am still favoring holding ETFs like EWY, EWM, and EWZ. Of the three mentioned here, I like EWZ the least. I do continue to keep it in mind because EWZ is a proxy for trade with China as Brazil is natural resource rich and will benefit from its trade with the Asian super-power. Even if US stocks do not decline, holding overseas assets will help you significantly to counteract the dollar devaluation you will be experiencing.

Bonds - I believe with the coming correction in stocks, we'll also see a decline in bond prices. We won't see the traditional disconnect between bonds and stocks like we should as when fear arises, all asset classes will be sold.
If you are holding bonds right now that have appreciated significantly, I suggest you sell them and capture your gains.
Last, I am working on another post to explain why I believe we'll have dollar strength and how my contention that despite this HUGE rally, nothing has changed in the credit markets. I am extremely busy working on a few projects, but will hopefully finish the post by this weekend if not before. I think this is an important post if you don't quite understand how all of these instruments fit together.
Goatmug

Tuesday, November 24, 2009

THANKSGIVING TRADING OUTLOOK

MOUNTAIN TOP PERSPECTIVE
Thanksgiving! What an awesome time of the year. This is the time of the year that my family and I gear up for an aggressive 2 or 3 day whirlwind tour of our state. We jump in the car on Thursday morning, drive for hours, pile out of the car and eat. We pile in cars the next day, drive 5 more hours and share a few precious moments with another side of the family.... and then scurry out. Finally we usually make one or two more stops and enjoy another Thanksgiving meal on the weekend and draw names for an annual Christmas gift exchange we'll have when we do it all again in about a month!

Sounds great huh? Believe it or not, it is! As I've gotten older and more of my family members have passed away, I've found that I cherish these encounters with family even if they last a few hours. It took me years to get past trying to put on a good face and sharing with folks that everything with me was "perfect". I've found that as I've shared with my family and extended family challenges in my life and business, they draw closer and are more real as well. I still have a few family members that want to show off and act like they never have a set back, but those are the ones I encourage more and affirm how proud I am of them and all of their hard work. Funny, that's all they want anyway right? I actually have amazing cousins that are very successful, so it isn't hard to support them in this way.

In closing, remember, Thanksgiving really isn't about turkey, football, or a marathon road rally, it is about giving thanks to God for the blessings he has provided. All things come from Him and we should remember this daily anyway.

TRADING -
I've had several emails and calls from family over the last week asking how we should approach the holiday and year end. As usual, I set out to create my own stuff, but Guy Lerner at thetechnicaltake.com has uncovered some historical data on trading for this week and next that does a great job. As time is short, let's just look at the great work he uncovered. Thanksgiving Week Trading History - Technical Take

According to Guy's sources, this week could be pretty positive as traders and managers take the week off and the market kind of melts upward (sound familiar). Today's GDP revisions may change that a bit and that is why I've stated to friends and family that we should simply avoid this week and look to enter on more weakness next week. This data actually confirms this as well as the week following Thanksgiving is usually negative as well. It is often very negative so it may present a good opportunity to come in.

No matter what, keep both eyes on the dollar. A Fed governor came out again yesterday stating that there will be no end to the stimulus and no rate hikes on the horizon. This all means that we'll continue to play weak dollar trades and buying metals, agricultural commodities, overseas market etfs, and begin looking at energy and oil trades too. Gold and silver are on fire and while I hesitate to take off my positions there, I continue to realize that the trend is still down for the dollar and I'll continue to enjoy profits by letting these positions run.

Have a safe and blessed Thanksgiving!

Goatmug

Thursday, November 12, 2009

EVERYONE WAS BULLISH --- ALERT

Ok, just another thing to keep an eye on. The AAII sentiment indicator was updated and we now see that as of 11/6/09, investors are getting very bullish. Keep watching the dollar. Just like on a boat, if everyone is on the same side of the boat, something bad may happen. Although this data is delayed by 1 week, we must be watchful.

The chart shows a dip down to 30 in sentiment. A dip to 30% or lower indicates everyone is too bullish!


There are some issues with the size of this chart and its display. I purposefully imbedded it too large so you can see a clean picture. Click on the image to see it in its true size.




Tuesday, November 10, 2009

INFLATION OR DEFLATION - MISHISMS...../ Dollar Charts

As many readers know, I read as much as I can with the time I have. The economic crisis we have endured is not over and I feel strongly that we are in the grips of deflation even though our government and Federal Reserve would like you to believe we are on the back end of a recession.

Michael Shedlock or "MISH" is one blog I read almost every day and I happen to agree with him on his ideas of inflation and deflation and what we're in. In a recent post, I feel like he knocks the cover off the ball with a lengthy piece that describes what these words mean in the real world and where we're at right now.

Please take a few moments to read it!

http://globaleconomicanalysis.blogspot.com/2009/11/what-is-inflation-and-how-does-one.html


Oh yes, and let me add a link to this post by Karl Denniger. - Click here and look at the performance of the USD and the S&P500. Absolutely inversely correlated. When the dollar stops going down, watch out. Until the dollar stops going down, everything else will melt up as we've been saying.

http://www.market-ticker.org/archives/1611-FedSpeak-Translation-There-Is-No-Recovery.html



Goatmug

Friday, November 6, 2009

THANK YOUR NEW NEIGHBOR FOR THAT FREE $6,500!

Our generous government is at it again! I'll drop these comments into the November Update, but figured that they needed to be separate as well as I couldn't help but rant.


Extension of first time homebuyer credit of $8,000 and now other homebuyers may attempt to receive a credit of - $6,500

FREEBIES
The give aways continue. President Obama will sign a new bill in the coming week that will extend the new homebuyer bill that provides an additional $8,000 to new home buyers. If that wasn't enough, our CONgress is now providing more of your money to your friends and neighbors by allowing all potential homebuyers to get in the action and get some free money! Of course these giveaways do nothing but use government money to prop up the housing market and reward homebuyers that would buy homes anyway. Just like Cash For Clunkers we end up overpaying for the impact this and ultimately homebuilders and bankers will profit. As I have contended for some time, the supply of housing is just too high and prices must fall to compensate. Measures like these interfere with the market's price adjustment and simply delay the reductions in price. Buyers today that capture the $8,000 incentive will end up losing more than the $8,000 when prices reflect reality.


Only one question - WHO'S MONEY IS IT?

FHA Lending - FHA IMPLODING - Please click on the link. This is a link to a yahoo page with an article detailing the default rates on FHA loans are out of sight. Probably more important and entertaining is the video interview that starts on the page automatically in the upper left corner. This interview details that the FHA is the new Fannie Mae and is essentially the entire mortgage market and is taking on all of these new bad loans.

To wrap up our thoughts on housing we need to mention that the FOMC statement also mentioned that the FED would begin reducing its purchases of agency securities with the goal of stopping in March of 2010. These agency securities are the securitized market for mortgage loans. As I've mentioned above, FHA has become the only home lender and the FED has been buying FHA debt in securitized form and is really the only buyer of this garbage. As the Fed exits the market we will see a rise in the cost of debt for these securities meaning that residential home loan rates WILL rise. Perhaps we won't only see a rise in the cost of the debt (interest rates) we may see the housing mortgage market freeze completely. This is the problem when a market participant becomes the market, when they want to stop or reduce their impact the ramifications are huge!

So take a moment here and think about this. When a homebuyer applies for a home loan they use a mortgage company or bank to obtain the loan. As the process is completed your lender will decide to keep the loan or resell it to the FHA. As long as the loan meets all the requirements, the FHA buys the loan from the provider and now you, the taxpayer ,are lending money directly to homeowners.

Put yourself in the position of Bank of America or another lender. Would you keep ANY loans that seemed anything less than perfect? If you perceived ANY risk or potential trouble with the borrower wouldn't you sell it? Of course you would, in fact, you'd actually try to find as many borrowers that were marginal and then sell those loans you never intend to keep to the US government! You'd make loan origination fees and other income and take none of the risk! WE'VE LEARNED NOTHING!!!! But the banks have learned to make money at taxpayer expense and are getting rich doing it!

Ok, so we've established that the banks sell the loan to FHA and then they securitize the loans (bundled lots of them up and package them) and then sell these to the FED. In doing so, the FHA takes enormous risk by incenting the bankers to make bad loans, the FHA doesn't do a good job of scrutinizing the loans because they are an inefficient non-profit government entity that exists to destroy tax payer money, and finally the Fed buys these loans or essentially funds the operations of FHA and keeps interest rates well below what they should to reflect the risk and real cost of borrowing! Sounds like a great system huh?



We are doing all of this to prop us housing costs and make us FEEL better. The only problem about doing short term fixes and simply trying to "feel better" is that we often end up making the problem bigger and the resolution worse. The prescription is to address the problems and work through them as a responsible person would. When the government ultimately extracts itself from this market we will see that there are no buyers of this debt and the cost of loans for home mortgages will adjust MUCH higher.

Thursday, November 5, 2009

NOVEMBER UPDATE

Data continues to come in that bolsters the notion we've had that things were better than most have thought. Employment numbers are bad in the aggregate, but have been "less bad" and the trend is improving. GDP numbers were reported and were positive, and housing and retail sales are showing upticks.


For the last several months we've had a stance that things were getting better and therefore we needed to hold our nose and be invested even if it was based on the theory that the improvement might be short lived and based on the efforts of the Fed's liquidity flood and the Treasury's devaluation of the dollar. What has occurred? Well, exactly what we expected! While many folks were doubting the turn, we've seen it and now the numbers are coming in to prove it out.

IS THAT PRIDE I'M HEARING?
Does this mean we can rest now? Actually, no, this is the time when we need to be more aware and perhaps begin looking further out to clarify our strategy through the end of the year and the first quarter of 2010.

Let's look at the data;


UNEMPLOYMENT REPORT


This morning's unemployment report came in a bit higher than expected and shook the market briefly. While the market was shocked, we were not and now see that the payroll unemployment rate is now 10.2%. Weakness in manufacturing , construction and retail were the culprits while education and health services jobs were actually added over the month. The real story is that unemployment now tops 10.2% when you use the government's method of counting, however if you include all the unemployed that have simply given up or are working part time that would rather work full time you have a number closer to 17.5%. This larger number is the U-6 data. http://www.bls.gov/news.release/pdf/empsit.pdf



As you might expect, employers are squeezing more effort and productivity from their workers. This week the government also released productivity data showing that American workers are more 9.5% more productive in the 3rd quarter. How are we achieving these gains? FEAR! Yes, what a powerful motivator it can be in the teeth of a recession. We are willing to work harder, longer, and cheaper to avoid losing our incomes. The market loved this data point, I'm not so sure it is a good thing in the long run for the US economy.





WLI Data




The Weekly Leading Indicators continue to show improvement. It will not be long before the recession is declared over and we'll need to somehow continue to convince ourselves that despite 10% unemployment the good times are here again! I know, I know, employment is a lagging indicator and therefore will always lag a recovery. As I've explained previously, much of the WLI data is focused on the liquidity in the system and clearly the FED has provided liquidity. Therefore we'll have to keep trusting the Fed playbook that the liquidity that substantiates the recovery will stay sloshing around for banks and Wall Street to pump up asset bubbles.



























Rails Traffic

Rail traffic continues to improve. Tonnage is still well below last year's rates however we are clearly in an uptrend. If we continue on trend, we will see weekly traffic exceed those handled in the fourth quarter of 2008. We need to get used to this as comparisons between year's will be very easy for the next two quarters. This statement will cover many areas of the economy, not just rail traffic!














In specific areas we are beginning to see upticks in actual shipments. For example, last week grains and food actually exceeded shipments for the same week in 2008. We see this happen again in food and chemicals this week.


As I have mentioned before, I watch lumber and crushed stone shipments to give us an idea if we'll see growth in commercial real estate building or residential home construction. We are see a slight rise in crushed stone but lumber still looks weak. I've included a chart of spot lumber prices for a specific November contract

















LUMBER SPOT PRICING

The reason I post the lumber pricing is that I'm watching this as a leading indicator of an uptick in construction. Of course we'll see this manifest itself in construction starts and even the rail data, but it is important to try to determine if we are seeing real improvement. It is notable that there was a recent spike in pricing over the last week or so.











Bloomberg Financial Conditions Index -

The Financial Conditions Index took a spill over the last week. It enjoyed a mild recovery today, but the improvement clearly waned over this period. We need to watch this data for indications of trouble in the bond markets.












US DOLLAR INDEX
The US Dollar became a bit firmer over the last couple of days, but I am in no position to call a turn in the dollar's descent into the depths. As I've shown in PUBLIC ENEMY #1 - DEFLATION , our Fed and Treasury are absolutely committed to resolving concerns about deflation with inflation. As a last resort, Ben Bernanke has stated that a currency devaluation has been successfully used to combat deflationary forces, and could be used again. I do not think there is any doubt that we are currently employing every possible means to attack deflation and the intentional destruction of the dollar's value against other currencies is now the primary weapon being used. Yes, I'm watching that upturn and will report immediately if I see a continuation of this reversal. Remember, because much of the basis I have for investment is based on dollar weakness, if we see strength, we need to quickly exit our positions in commodities and overseas holdings. A rising dollar will typically hurt all of these.












AAII Investor Sentiment -

Investor sentiment has fluctuated wildly over the last couple of weeks. I was very concerned as market participant bullishness spiked, but the recent decline in the markets of approximately 4% to 5% has quickly turned many more investors bearish. Remember, we typically want to be on the opposite side to the trade when most folks feel really happy about the market or really gloomy. I'm more happy staying with these trades that there is fear back in the market.












FOMC Meeting
The FOMC (Fed) meeting occurred on Wednesday and we received word that they Fed will not increase Fed Funds Overnight lending rates. As we've discussed, there was no chance that these guys would hike rates and frankly there is little or no chance of that happening until the middle of 2010. Fed critics have often cited that the double dip crash of 1937 was caused by an overly aggressive Fed that raised rates too soon. As rates rose, the stock market dropped approximately 38%. Bernanke is the expert in depression Fed actions and we can rest assured that he will not duplicate the mistake. This Fed believes that they can manage the inflationary risk and would rather try to deal with that issue than a deflationary one.



HOME SALES AND HOME TRENDS


New home sales for September 09 were released in late October stating that sales were on target for 402,000 for the year. This was 3.6% below expectations. This represents a decline of about 7.8% from the 1 year period from September 2008 to 2009. http://www.census.gov/const/newressales.pdf




Extension of first time homebuyer credit of $8,000 and now other homebuyers may attempt to receive a credit of - $6,500 Read my new post - THANK YOUR NEIGHBOR


FHA Rules Changes - I cannot find a link to the story, but heard that beginning December 15th, the FHA will adjust the % of your income that is used to calculate the maximum loan you may receive. The current rate is around 65%, apparently that maximum monthly income amount will be reduced to around 45%. The impact of this change if correct will be to reduce the amount of house that you can afford if you are obtaining an FHA loan.

NOVEMBER TRADING -
During October we saw our trend continue where dollar weakness lead to increases in commodity and equity markets. As the dollar firmed, we sold off a bit which served as a consolidation to move back to highs. During that phase the indicators of fear (volatility) rose dramatically and that gave us significant pause as a spike in the VIX over 30 can warn of a significant sell off in equity markets.

VIX -







During the last 3 trading days though, we've recovered dramatically and are now below 25 on the VIX indicator as I type. This return to "bullish levels" and the readjustment investor sentiment away for all out greed reaffirms our notion to keep trading as we have. As the dollar goes, so will we trade!
We say this with conviction, but do not misunderstand that our attention and concern is hightened. We are seeing gold at new highs, the dollar at recent lows but trying to show some strength, and many other stock indicators showing that we are near levels where the market gains should be consolidating or rolling over.
I do use another indictor for trying to determine investor sentiment and have received permission from him to link to his website. Please consider Guy Lerner's site http://www.thetechnicaltake.com/ . Guy does an awesome job of looking at techincal indicators and always has excellent analysis. I am so happy that he has begun providing his insight for free as he previously had a service that charged for his analysis! I view his site everyday and I suggest that you follow it as well.
Guy's research often includes a review of positions of hedgefunds and investors in the Rydex Bullish and Bearish Funds. By examining the assets in the funds he can get a sense for how bullish (greedy) or bearish (fearful) sophisticated investors are at a given point and time. Recent findings show that investors are mixed rather than leaning one specific direction. As with the AAII sentiment indicator, when investors are really leaning toward one side, we should probably bet against them.
In the future, I will post Guy's charts in the place of the AAII sentiment numbers or right alongside them. Please check his site out, it is a great read.
In the next couple of days I will highlight my longer term investment thoughts (meaning the next 6 months). I started to post them here, but I've realized that many of my posts are really long and I need to break them up!

Thursday, October 22, 2009

PUBLIC ENEMY #1 - DEFLATION

Hi guys, this post was originally penned for the Slope of Hope site by Tim Knight. He was nice enough to take my contribution and suggest that you read his stuff daily if you are a trader. As you know, I try to give you the macro view of the economy to set up trade targets for investments that will tend to last longer than 30 days, but Tim's site can help with examining shorter time frames or turns within the month. Please check out the site at www.slopeofhope.com .

In previous posts in my blog www.goatmug.blogspot.com we've outlined the role the Federal Reserve has played in causing each asset bubble in recent memory. Each crisis evokes the same Pavlovian response from our central bankers in that they reduce interest rates and flood the market with easy money. In the most recent economic event our Federal Reserve pulled out all the stops and intervened with unprecedented measures to buttress the financial system and save us from collapse. We heard over and over again that stabilizing housing would save us and all efforts and letters of the alphabet were employed to prop up declining markets with asset purchase programs and low interest rate give aways.

Why does the Federal Reserve seem to desire inflation and fear deflation so much? Please find a 2002 speech given by our own Federal Reserve Chairman Ben Bernanke. If you ever wanted to know the play book of team Fed, here it is. As we read through the text it is now clear that they have used every bullet he described. As investors and traders it is critical for us to understand that the Fed will never give up and accept a deflationary scenario. Even eight months into a dramatic equity market rally, comprehending the Bernake strategy will provide us a concepual foundation for finding trades that will benefit from his unrelenting effort to inflate.
I originally had intended on writing my own text to outline the topic of deflation, but I'll be the first to state that Mr. Bernanke is much more capable to address the topic. Given the availability of his speech, I will make comments and outline themes that need further attention.


http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021121/default.htm


WHAT IS DEFLATION?
BERNANKE - "The sources of deflation are not a mystery. Deflation is in almost all cases a side effect of a collapse of aggregate demand--a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers. Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending--namely, recession, rising unemployment, and financial stress."
GOATMUG - HMMMMM SOUND A LITTLE FAMILIAR (Retailers, Auto Manufacturers, and Grocers drop prices)


WHAT IS SO BAD ABOUT DEFLATION?
BERNANKE - Deflation great enough to bring the nominal interest rate close to zero poses special problems for the economy and for policy. First, when the nominal interest rate has been reduced to zero, the real interest rate paid by borrowers equals the expected rate of deflation, however large that may be. To take what might seem like an extreme example (though in fact it occurred in the United States in the early 1930s), suppose that deflation is proceeding at a clip of 10 percent per year. Then someone who borrows for a year at a nominal interest rate of zero actually faces a 10 percent real cost of funds, as the loan must be repaid in dollars whose purchasing power is 10 percent greater than that of the dollars borrowed originally. In a period of sufficiently severe deflation, the real cost of borrowing becomes prohibitive. Capital investment, purchases of new homes, and other types of spending decline accordingly, worsening the economic downturn.
GOATMUG - So, people figure out that the money they save is MORE valuable tomorrow and therefore they opt not to purchase stuff based on a need for instant gratification. (Sounds like that would be real trouble for a consumer-based got to have it now economy doesn't it?)


IS IT A PROBLEM IF CENTRAL BANKERS ATTACK DEFLATION AND TAKE RATES TO ZERO?
BERNANKE - "It is true that once the policy rate has been driven down to zero, a central bank can no longer use its traditional means of stimulating aggregate demand and thus will be operating in less familiar territory."
GOATMUG - Is this guy good or what? He was read to open a can of "non-traditional" back in 2002. Wow!


IF WE WERE TO EXPERIENCE DEFLATION IS THE FED POWERLESS?
BERNANKE - "Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation."
GOATMUG - ooh, ahhhhh, a printing press! I put this in for the gold bugs too. You can just see them brewing a theory that Bernanke is conspiring against gold just by the mention of its name!


WHAT ARE THE CURES FOR DEFLATION?
BERNANKE - "Of course, the U.S. government is not going to print money and distribute it willy-nilly (although as we will see later, there are practical policies that approximate this behavior). Normally, money is injected into the economy through asset purchases by the Federal Reserve. To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting money into the system--for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities."
GOATMUG - Of course they wouldn't give money to just anyone! You have to be in the right club to receive Fed money! Bernanke has done exactly what he's outlined here. He's used TARP and more to buy assets, he's made low interest loans, provided loan guarantees, and more.
BERNANKE - "If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation."
GOATMUG - This is just a truly scary quote. It absolutely sounds like an arrogant guy married to a trade. We all know what happens to that guy. He ends up doubling or tripling down rather than cutting his losses and accepting that it was a bad trade.

WHAT HAPPENS WHEN RATES HIT ZERO, WHAT DO WE DO NEXT?
I call these the extreme measures list -
BERNANKE - #1 "Treasury term structure--that is, rates on government bonds of longer maturities. There are at least two ways of bringing down longer-term rates, which are complementary and could be employed separately or in combination. One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time--if it were credible--would induce a decline in longer-term rates. A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well.
BERNANKE - #2 - Of course, if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years. Yet another option would be for the Fed to use its existing authority to operate in the markets for agency debt (for example, mortgage-backed securities issued by Ginnie Mae, the Government National Mortgage Association).


OK, SOUNDS LIKE WE'VE DONE "EXTREME MEASURES" 1 & 2, WHAT HAPPENS NEXT?
BERNANKE - To repeat, I suspect that operating on rates on longer-term Treasuries would provide sufficient leverage for the Fed to achieve its goals in most plausible scenarios. If lowering yields on longer-dated Treasury securities proved insufficient to restart spending, however, the Fed might next consider attempting to influence directly the yields on privately issued securities. Unlike some central banks, and barring changes to current law, the Fed is relatively restricted in its ability to buy private securities directly. However, the Fed does have broad powers to lend to the private sector indirectly via banks, through the discount window. Therefore a second policy option, complementary to operating in the markets for Treasury and agency debt, would be for the Fed to offer fixed-term loans to banks at low or zero interest, with a wide range of private assets (including, among others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral. For example, the Fed might make 90-day or 180-day zero-interest loans to banks, taking corporate commercial paper of the same maturity as collateral. Pursued aggressively, such a program could significantly reduce liquidity and term premiums on the assets used as collateral. Reductions in these premiums would lower the cost of capital both to banks and the nonbank private sector, over and above the beneficial effect already conferred by lower interest rates on government securities."
GOATMUG - Try 2, 3 or 4 years worth of zero interest loans.


THERE CAN'T POSSIBLY BE OTHER TOOLS IN THE TOOL KIT CAN THERE BEN?
BERNANKE - The Fed can inject money into the economy in still other ways. For example, the Fed has the authority to buy foreign government debt, as well as domestic government debt. Potentially, this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchase by the Fed is several times the stock of U.S. government debt.
GOATMUG - Foreign debt? Currency swaps? Really?


COULDN'T THE PURCHASE OF FOREIGN DEBT AND OTHER INSTRUMENTS IMPACT OUR CURRENCY?
BERNANKE - I need to tread carefully here. Because the economy is a complex and interconnected system, Fed purchases of the liabilities of foreign governments have the potential to affect a number of financial markets, including the market for foreign exchange. In the United States, the Department of the Treasury, not the Federal Reserve, is the lead agency for making international economic policy, including policy toward the dollar; and the Secretary of the Treasury has expressed the view that the determination of the value of the U.S. dollar should be left to free market forces. Moreover, since the United States is a large, relatively closed economy, manipulating the exchange value of the dollar would not be a particularly desirable way to fight domestic deflation, particularly given the range of other options available. Thus, I want to be absolutely clear that I am today neither forecasting nor recommending any attempt by U.S. policymakers to target the international value of the dollar.
BERNANKE - Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934. The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt's devaluation.
GOATMUG - DID HE JUST SAY THAT INTERVENING IN THE CURRENCY MARKET CAUSED ONE OF THE BEST YEARS IN THE STOCK MARKET! He also failed to mention what happened in 1937 didn't he?


WHAT IF HOUSEHOLDS JUST DON'T STEP UP AND BUY STUFF?
BERNANKE - "Even if households decided not to increase consumption but instead re-balanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers. A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money."
GOATMUG - Are you getting this guys? The low rates in savings accounts and everywhere else are a mechanism to make you, me, and Grandma increase risk and buy assets we'd normally wouldn't purchase in this situation. The Fed is forcing you to move your money or you'll lose your purchasing power.

WHAT MAKES JAPAN'S SITUATION DIFFERENT (remember he's speaking in 2002)?
BERNANKE - First, as you know, Japan's economy faces some significant barriers to growth besides deflation, including massive financial problems in the banking and corporate sectors and a large overhang of government debt.
GOATMUG - Anyone want to bet me that there are some Japanese central bankers that are quite happy to see the USA right now given the tone of these types of comments?
GOATMUG - He goes on to say that political will didn't exist to clean up the messes of deflation in Japan.
There is a tremendous amount to digest there. To summarize his thoughts, Ben Bernanke will do almost anything to avoid deflation. Deflation is nasty. People lose money and a deflationary environment tends to feed on itself as folks resist spending money on anything. To his credit, Bernanke has completed in some form all of the measures he discussed in this speech. Mr. Bernanke is absolutely confident in the Fed's ability to use the device called a printing press to avoid deflation.

SOME WILL ASK, "GOATMUG, ARE YOU IN THE DEFLATION CAMP?"
The answer to that question is quite simply yes. Does that mean that I'm short the market since 670 on the S&P? NO! Clearly we are in the grips of a deflationary environment and we are experiencing the same issues that Japan was facing in Bernanke's speech. He said that Japan had a crippled banking system, troubled corporate sectors, and a large overhang of debt. I see a significant amount of similarities here even AFTER the heroic measures taken by the Federal Reserve.
Despite my belief that we are still locked in the grips of a long term deflationary spiral, I believe strongly that we need to position our investing and trading assets in vehicles that will profit from the efforts of the Fed as they attempt to rescue our economy from their worst fear. The strategies employed by the FED have had a HUGE impact in the financial markets as we only need to examine the 60% rally over the last 8 months.

Personally, I use this information to help me find swing or momentum trades that may last two months or longer. By understanding Bernanke's mindset, arrogance, and belief that the solution can be found in limitless printing, I can begin to develop strategies that play on the manifestation of inflation or simply the expectation of future inflation.
I find it very interesting that Bernanke addresses the USD and currency intervention in this speech. I believe that the Fed and Treasury viewed currency manipulation as the last option. I also believe that they have found it to be extremely useful in bolstering "confidence" and dealing with the cost of the bailouts. My opinion is that we have reached the end game where dollar devaluation is now the only reasonable course of action. The Fed, Treasury, and administration have their hands tied as political acceptance for more bailouts is low. As our deficit grows they will see that the only choice is a managed devaluation.

Although Bernanke didn't quite suggest that there are limits to our ability to wage war on deflation, I think he might confess that we are limited in how quickly they can devalue the currency. Our creditors will become more vocal in their protests as our policies create losses in their US treasury holdings and as we further damage exporting nation's economies. In my next post we'll discuss how the Fed and Treasury will continue to implement their plan to counter deflation through the use of currency devaluation, despite the protests of our creditors. We will also discuss specific trading strategies that anticipate the Fed's long term moves to devalue and also their mild and short term attempts to placate our international friends.

Goatmug