Second Quarter Wrap Up and Random Comments

The quarter has officially ended and I wanted to take a step back and review where we stand and discuss further some significant issues and ideas we've got to address in this investing environment.

WHERE WE STAND -
As of the end of July 1st 2010 the indices have provided the following returns for the year;
Dow   -5.40%
S&P 500  -6.95%
Nasdaq   -7.82%


This is pretty tough, especially in light of the fact that the indices were actually up more than 10% in April of this year.  Now to be intellectually honest we also need to speak about the gains we've seen.  Remember the scary lows of March 2009?  Since March of 2009 the S&P has rebounded 53% to these current levels.  However we also need to make sure that we take into account that the same index is 34% lower today than it was at the market high in October 2007. 

Since that magical recovery on March 9th of 2009 we have been witness to the invisible hand of government (ok, not so invisible) aiding and assisting the citizens with all its power to create a rebound of asset prices.  We've seen efforts in autos (Cash for Clunkers), housing (Tax Rebates), bank bailouts, green energy programs (weatherizing), Fed open market actions in tandem with Treasury Department intervention to purchase mortgage backed securities, buy troubled assets in the open market, complete US dollar swaps with foreign banks and central governments, and finally outright devaluation of our currency.  We didn't stimulate small business efforts or make sound decisions about the use of government monies, we simply tried to micro manage little areas in the economy rather than making strategic plans that might actually work.  We didn't allow bad firms to accept their fates as failures, no we sloshed easy money around and wasted it in the typical corrupt government way.  All of these efforts have been in the name of "GETTING US BACK TO THE GOOD OLD DAYS", or as I like to recall our then President stated that "we needed to suspend free market capitalism to save free market capitalism!" - (WOW!  I still can't believe he said that!)

As I've noted several times the FED and Treasury gave us their play book, and I've written quite a bit about it in --- PUBLIC ENEMY #1 - DEFLATION .  Their goal is to raise asset prices to get you spending and using credit, essentially "growing" our economy on the backs of those countries that are willing to lend to us. 
These guys don't want us to do this because we need more plasma screens or anything else, it is simply because when the music stops the ponzi scheme falls apart and things end badly.  You must know that this government debt and over leverage is just that, a game of musical chairs that ends really badly when there is only one winner.  Ask Iceland, Greece, and more countries to come how it feels when the game of musical "credit" chairs comes to a screeching halt when the lenders decide to take all the chairs away.

Take a look at this graphic courtesy of Shadow Stats.  This is a graph of our money supply growth.  There are several ways people describe inflation and deflation and one of those is in terms of the growth of the money supply.  As the money supply grows (and its velocity) this is an indication of expansion in the economy.  When a bank obtains a deposit from a person, it must keep 10% of the deposit and then can lend out the rest.  So effectively the money supply or available credit and expand 9 times more and you have exponential growth as borrowers are successful and make their loans productive. 

When money supply growth drops, this is deflationary!  This means that banks are not leading or not receiving their money back.  The money supply in the US is not growing and this is confirming that access to capital is drying up.  So all the efforts of the Fed and Treasury have done nothing.

Source - http://www.shadowstats.com/

WHAT'S NEXT?
So we've been bleeding out here obviously since the highs in 2007, but since April of 2010 we've dropped some 20%. Is this just a correction or is this some bigger move?

Let's get this straight, the prescription that will heal the situation IS deflation, yet it is also very painful.  It is clearly the one that is not politically easy and therefore not the own chosen by our government.  Deflation comes with some of the following results;

Strong dollar
High interest rates
No growth
Loss of jobs
Angry citizens
Loss of equity (people investments in assets go to zero)
Angry elites in the political and wealthy classes

WHAT'S A GOVERNMENT TO DO? - SON OF STIMULUS WILL ARISE!
Since the deflation scenario is not too good for political incumbents and the leadership, what should we expect?  Well, I fully expect the Son of Stimulus to show up!  The Fed is going to have to step up again and begin buying mortgages and treasuries and we'll have a new round of home purchase and ownership incentives.  The result - don't rush out there and refinance, cause you are going to see a 30 year mortgage at 3% soon enough!

The hope in these actions will be that we'll see an asset inflation in all asset classes (equities, corporate bonds, commodities).  The problem with these moves is that the effectiveness in terms of real bang for the buck is weakening and the effect is not lasting as long each time (just as drug addicts experience).  The other disconnect is that if they actually have success with these programs, we'll seen an INCREASE in treasury yields and this hurts our economy as we need to pay more for the service our debt.  Why do treasury yields increase if they are trying to levitate all the other asset classes?  Simply because investors sell treasuries in the market and buy other assets.  The flood from one area to the next bids up prices in equities, commodities, and corporate bonds and will leave prices lower on treasuries.  This is just the opposite of what has occurred in the last two months --- see the chart of TLT and my post about the signals of BIG THINGS HAPPENING from earlier this week.


NO OTHER POLICY TOOLS LEFT BUT TO KILL THE DOLLAR
Since we have Fed Funds rates at effectively zero and there is no chance of an increase in rates here, the only stimulative options are that the Fed and Treasury are going to need to begin outright purchases of securities (stocks) and or engineer a devaluation of the currency.  These will be effective in the short run, but just like Japan, cannot be carried on forever.  The end result will be just like Japan - slow or non existent growth after many painful years of credit and asset destruction.  Again, this is why the FED will do anything including destroying the purchasing power of your currency to avoid this fate.  The destruction of purchasing power means that assets and objects from outside your country cost significantly more than in the past.  Items like imported goods, oil, gold, and other commodities do really well if they can be effective in pulling the devaluation off.  Now you know the reason for the administration (Geithner and Congress) whining constantly about the revaluation of the Chinese yuan.  We desperately want other currencies to go higher and those Chinese continue to manipulate their currency and refuse to let it rise against our worthless buck!

Can their actions make a sustained impact - or I guess a better question is, can we have this hyper-inflation scenario?  The answer is, NO, not yet.  We cannot have hyper-inflation until we have growth in the economy, and we do not have any growth at all, we have deflation.

I commented earlier this week about the ERCI data showing that we are rolling over and that is just another validation that we are not growing.  Retail sales are falling, consumer confidence is falling, and even today's manufacturing data is showing that it is collapsing.  Just like I posted several times, the "growth" we saw was simply a replacement of inventory draw downs and now we have no one buying new stuff.  Thus I expect second quarter earnings numbers by companies to look and sound good, but when we pay attention to the outlook from company leadership we'll hear a scary story about a retreating consumer, eroding base of orders, and a poor or at least cloudy third quarter.

TRADING UPDATE -
Well the trend for the last several months has been down now, and that is not a shock  I actually expect some sort of bounce because you typically don't see this type of sustained destruction day in and day out.  The market psychology is turning very pessimistic here where market participants are simply going into treasuries at historically low rates simply because they are fed up with the ups and downs of the market and they want their money back rather than some type of unpromised return.
In the short run what have we discussed almost every time, when everyone believes something, it is probably wrong, so in turn, if everyone is negative we'll probably see some upward movement as we rebound (reload for another drop).  The wave of coming bad news is going to get larger, so you need to be unloading as the market goes higher.  I personally am not adding any longs here because I cannot foresee how long the thrust higher will last before giving way to a lower low.

Let me be clear, you need to take advantage of any move of 3% or 5% to get out of positions that you've been holding.  Be careful and sell your positions as we move higher.  Above this area we have lots of tough slogging for bulls and we'll see how the market can face this now tough resistance.  Key areas on the $SPX to examine are 1037 and also 1055.
If the market falls I'll be watching 1018 and then 993 and 978, after that, it is the low 900s. 

Again, the FED will attempt to do anything and everything to bounce and boost this market.  We might get more shorting bans, we might get more outright purchases of equities by the Fed, we might get dollar devaluations, and we might get a kitchen sink or two...... anything and everything to get something positive going, so don't go shorting the market here, but do get conservative because even a 15% move higher will be met with sellers that feel they have been given a gift from the Lord above and they will be very happy to unload their shares once they get back to their April levels.  (If they get there).

Oh yes, I have so many things I want to write about, but I'll give you a quick teaser topic.  Everyone loves gold, be prepared to witness gold trading down to $1040 or so.  The more you hear about Europe implementing austerity measures means that Gold (the alternative currency) will fall.  People have literally been running to gold because they fear a collapse in the Euro.  In the short run they are not going to profit by chasing gold in their fear.  DO NOT BUY GOLD HERE.  I wouldn't doubt that these buyers are ultimately correct, but you'll be able to buy 10% to 15% cheaper.  I will begin buying more again around this area.

As you can see, there is some support below, but lots of resistance overhead.  Doesn't that April high look far away?

GOATMUG

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?)