PART ONE - STEP ON THE GAS!

I have been sent several email questions over the last month about inflation and deflation and why our Federal Reserve would "print" all of this money. This blog entry may be a bit long (I've had to break it into two parts), but I feel it is important that we all understand the motivations of the players (central banks) in this economic turmoil. For an introduction into how the Fed and administrations have acted, please review the first four paragraphs in the blog back in August where I discuss asset bubbles created by cheap money in Proof that this Recovery Has Been Engineered.



IT ALL COMES DOWN CREDIT.

Let's quickly review a description of inflation and deflation. While most of us think inflation is a measure of rising prices, it really is a measure of an expansion of the money supply and credit. Once a bank lends you money, you can spend it or invest it as you please. Because banks only need to maintain about 1/10 of the dollars deposited with them in their reserves, we get significant growth and expansion of available money when banks actually lend. Think about it. When a company or account holder deposits $1,000,000 in a bank, the bank can then lend out $900,000 of that same money to someone else. If that borrower then deposits that same $900,000 in an account, the bank can lend out $810,000 to another borrower. Do that over and over again and you see the impact of the original $1,000,000. Fractional reserve lending is very stimulative and pushes significant dollars into the economy.



Once those dollars enter the economy through creation new money supply and credit, they tend to find assets like houses, cars, commodities, commercial real estate. These additional dollars often burn a hole in people's pockets and this extra demand allows retailers and suppliers to raise prices. This is how we often believe that inflation is the same as pricing increases.



Well, that's easy enough to understand right? When folks borrow from banks to build a house, add a pool, or create a business they trade those dollars for a service and the recipient of those dollars deposits that same cash in their bank account and the magic money creation machine keeps churning out opportunity for all. This scenario is in fact exactly what happened for years in 1996 to 2001 and then from 2003 to 2007. Keep one other thing in the back of your mind. fractional reserve lending requires the guy that borrows the money to spend it and repay it. In fact if your thought is that it sounds a lot like a ponzi scheme, guess what, you are right!



PLANET REALITY

If this situation is so good, what could be the problem with all of this lending and borrowing? Nothing really, unless you complicate this scenario with something called "reality". In real life, banks are often required to examine the credit worthiness of borrowers. The bank loan officer takes into consideration if the borrower has a job, has good credit history, and also if they have any assets. Finally, a good loan officer examines this picture of the borrower and should demand a suitable rate of interest for the loan. If a potential borrower has good collateral, a great project, awesome credit history and is well capitalized, they should be charged a lower interest rate for the amount they desire to borrow as compared to a riskier prospect. In fact, riskier borrowers should be charged significantly higher rates or be declined. So one of the first things a lender must evaluate is the ability of a borrower to repay the loan and the appropriate price for that loan.



Ok, sounds good. What could possibly go wrong? To save time I'll just bullet point these next items and then make just a few comments.

• Mispricing of risk at the lender level - What if the loan officer has a bad day and he doesn't notice that the borrower has poor credit history. This error can result in charging too low of a rate for the loan. Other issues could be that the collateral of the loan was in bad condition or the borrower didn't make enough income to justify the amount requested. This mispricing of risk could be detrimental to the bank as they don't get paid enough for the risk they take or take on a loan that will ultimately default.


• People lie - Imagine that people in this process didn't tell the truth! If the lender didn't take the time to verify an applicants income or credit history, the integrity of the entire process could be in jeopardy. In recent times, lenders gave loans to people with "stated incomes" meaning that they simply said an amount that they made.


• People lose their ability to repay their loans - In the current economy we can easily see that a borrower could lose their job. If an applicant loses their ability to pay, often they cannot keep their homes.


• Collateral values decline - In recent history from 1996 to 2007, home prices and other asset values always rose. One of the problems in lending evaluation methods was to assume that prices would not drop. Unfortunately we've realized that prices of homes and collateral can drop and may do so all at once over large regions of our country.
• Government Intervention - We also had a situation where the government told lenders that they needed to lend in certain regions of cities and states. Typically these were areas where borrowers were less credit worthy
  

ARE THERE ANY OTHER PROBLEMS INVOLVING CREDIT THAT WE'VE FAILED TO DISCUSS?

Of course! When we borrow using our credit cards from banks we usually have our loans tied to some benchmark rate. You've heard of LIBOR (London Inter-Bank Offer Rate). This is the interest rate that one bank will lend to another. When you borrower, you generally must pay the LIBOR rate plus some percentage rate. Other benchmarks could be the 10 Year Treasury Note rate. These benchmark rates are important because central banks can control or direct the price of these rates. Our Federal Reserve sets the overnight bank lending rate called the Fed Funds rate. By raising and lowering this rate, the Federal Reserve can influence interest rate costs globally. Yes, some will argue that these are overnight funding rates, but the reality is that the Fed Funds rate does have an impact on other credit interest rates in the market.

What would happen if the Federal Reserve significantly lowered the Fed Funds rate? The impact of a lowered Fed Funds rate would be that other rates would fall as well. From this simple example you can see that the Federal Reserve has some ability to change interest rates and in this scenario lower borrowing costs for banks, companies, and borrowers.

WHY IS THE FED'S INFLUENCE A PROBLEM?

A central bank's role is a tough one (in the USA at least). They must try to create a perfect balance between growth and recession. The Fed uses its control over the Fed Funds Rate to stimulate and restrain the economy (think of it as an accelerator pedal on a car). As we covered earlier, when rates are low, people are incented to borrow. Their borrowing is used for investment and an expansion of the economy often results in pricing increases due to the availability of ample credit. When the Fed over does the credit available, borrowers are flush with cheap money and they tend to buy everything in sight and prices result. Using this concept of mispricing, we can therefore see that when the "Fed over does it", it really has mispriced rates and created too much demand and too much easy money!

If you are a banker you are subject to pricing your loans off of a benchmark rate. If a potential borrower barely qualifies for a loan you examine rates of your benchmark and add a premium or mark up over that rate based on their credit. The real issue here is that if the Federal Reserve has driven rates lower during this period, (artificially controlled them and pushed them lower), then the banker has really priced his loan too low for this borrower. The impact of the Fed's decision to make cheap credit flow is that they have heaped on additional risk into the banking system in an effort to expand the economy.

Perfect, what happens when the Federal Reserve raises rates? Just like taking the foot off of a gas pedal, raising the Fed Funds rate cools off the economy by removing additional credit stimulus. Rates go higher and investors and borrowers costs rise. Imagine if you were going to build a pipeline or factory. Increased borrowing costs negatively impact your rate of return and make investments and projects seem less appealing than when rates were low.



ARE THERE RECENT EXAMPLES OF THE FED MAKING CREDIT AVAILABLE THROUGH THESE TECHNIQUES? WHAT WAS THE RESULT?

Absolutely. Recall the fears that all computers would crash as a result of the Y2K bug in 1999. (When computers were going to switch to the year 2000. Many computers tracked dates with only 2 digits before this). The Fed responded by flooding the market with liquidity (lower rates and buying treasury bonds). As the market was awash with credit and money, guess what happened? All of that money found its way into our technology sector and the internet mania began!



As the Fed began raising rates after Y2K, we suffered the bursting of the internet bubble.



After the tech crash and the September 11th attacks the Fed again began lowering rates to fight the economy's recession. What happened next? Credit found its way into the hands of real estate investors and speculators. The ingredients of a new real estate bubble were combined and areas in Nevada, Arizona, and California enjoyed 100% growth in real estate prices in the course of one or two years. Clearly the free flow of credit as a result of low rates bought us a ticket to Planet Credit Fantasy. As the good times were rolling, the Fed began to raise interest rates in an attempt to manage price inflation in 2003 and continued to slow the economy through 2006.



HAS THE FEDERAL RESERVE BEEN GOOD IN ITS ABILITY TO TIME ITS RATE DECISIONS?

Unfortunately, the answer is flatly no. Typically the Fed's tools like Fed Fund rate changes and open market operations are slow working. The influencing mechanisms work through the economy and are difficult to start up and stop. Many often use the analogy of trying to turn an oil tanker when describing the amount of control the Fed has in making adjustments to the economy. I'm highlighting this because we have had very low rates for a significant amount of time. As our credit bubble burst in late 2007 and early 2008, the FED stomped on the accelerator and eventually lowered the Fed Funds rates to .25%.



So to wrap this up, we entered a credit led bubble in 2003 that artificially created a real estate blow up waiting to happen. Credit lenders mispriced risk and the Fed purposefully mispriced risk to stimulate the economy. As the wheels were coming off beginning in August of 2007 we faced many "unforeseen" circumstances.

1) A recession was forming and people were losing their jobs
2) Because folks were out of work, they were not making their home payments.
3) As payments were missed, banks began foreclosing on homes in record numbers.
4) Investors and lenders began to understand that home prices don't typically go up every year.
5) People began to doubt each other. Banks failed and lenders tightened up lending standards considerably.
6) The Fed reacts to the collapse of Bear Stearns and Lehman Brothers (securitization of mortgages) and takes FF rates from 1.50% to .25% in two months.
7) Congress passed the $700 Billion TARP funds bailout and other scandals. They end up adding trillions to your debt and you don't even know it. Your debt is used to keep failed banks alive and prevent write downs and destruction of credit...... in other words, your balance sheet and future income was used to stave of DEFLATION, which is the destruction of credit.



WAIT A MINUTE! LET ME GET THIS STRAIGHT!
Ok, so you say that the Fed helped create this mess by lowering rates and now their response to this crisis is to what? LOWER RATES!!! You got it! When you are a hammer, everything looks like a nail. Each crisis the Federal Reserve is involved in will evoke the same reaction, lower rates!

Ok, why would the Fed do this if it knows that another bubble will form? The real question is what will we find if another bubble is NOT formed.

Presently, the Federal Reserve has been able to lower the cost of a 30 year mortgage to 5% for a borrower with good credit! A 30 year US government bond is paying only 4.16%! This is even cheaper than when we were in the throws of the real estate boom. Why are cheap rates essential? Our leaders have just told us if we can stabilize real estate prices that will bolster demand for furnishings, dishwashers, cars, and more. In other words, in the eyes of your government, if you perceive that your house value is not dropping you'll get out there and spend more than you have and put it on credit cards and you will save the economy. It is staggering that 70% of our annual GDP is comprised of us buying stuff rather than production and manufacturing stuff in the USA. Now you can understand that if there is a situation where Americans don't spend, the economy of the USA grinds to a halt.

In the next post we'll cover what deflation looks like and what the Federal Reserve plans to do about it.

Also, a quick thank you to Michael Shedlock for his comments on this post and the clarification he suggested. You can read his views on the broad economy here. He has the number one financial blog in the world with over 28,000,000 visits to his site and I believe that he is a must read daily. I frankly am flattered that he commented on this post.

http://globaleconomicanalysis.blogspot.com/

October Summary

OCTOBER - TRICKS OR TREATS

Unemployment Data - http://www.bls.gov/news.release/pdf/empsit.pdf

Unemployment numbers for September were higher than anticipated and this helped shake the markets. The truth is that the trend of lower losses is continuing and the market is still focused on everything getting less bad. While the data was worse than expected, we need to look at these numbers as 1 or 2 month averages and there is clearly and improving trend.

Rail Data -
Rail traffic looks flat as of the last part of September. Optimists will say that we are turning south and pessimists will suggest that we aren't improving. As we enter this season we should begin to see shipping and transport data ticking up because we are entering into the part of the year where Christmas inventory and orders are being stocked. If we don't begin to see an uptick in these charts as we normally would we will have our first indications that the rally may be ending.

Lumber and Crushed Stone are indicative of the pipeline for growth in commerical and residential real estate. No trend changes are apparent in these items. As we've stated before, no matter how high banks, REITs, and home builders go, we would avoid them.

Financial Conditions Index - Source / Bloomberg

The Financial Conditions Index continues to maintain it's trend of improvement. There has been a slight dip over the course of the last week, however we won't do much more than raise an eyebrow at this metric unless we see other data that confirms this warning. Index numbers over 0 (zero) indicate that the economy as measured through fixed income and money market liquidity metrics is growing and expansionary. We are not going to signal the end of the recession, but possibly could as we near zero.

Source - http://www.bloomberg.com/apps/quote?ticker=DXY%3AIND

CFO OPTIMISM - Source Duke Fuqua School of Business - http://www.cfosurvey.org/
Duke released its September CFO survey results again. CFO's believe that things are looking better for the overall economy and their own firms. In general they are more positive. This change is not overwhelming, but given that most CFOs are going to more conservative than their CEO or COO counterparts, we should take heed here to recognize the potential for real growth during earnings season (starts later this week) and then next two months.

WLI Data
The Weekly Leading Indicator data from ECRI shows sustained improvement. Admittedly 50% of the data that comprises the WLI Data is "Fedcentric", meaning that it has more to do with the amount of money that the Federal Reserve has sloshing around rather than real economic improvement. Having said that, the flood of money sloshing around is making an impact and we cannot ignore it or discount the impact that those dollars will have when they chase assets. Source - http://www.businesscycle.com/resources/

AAII Sentiment -

The AAII Sentiment numbers continue to remain in no-mans land. Remember, when sentiment reaches an extreme (bullish or bearish), we usually want to do the opposite. In this case there are a mixed number of folks that believe in this rally and an appropriate amount of investors that are bearish. The confusion confirms exactly what we are seeing with big up and down days as traders attempt to sort out the direction of the market.
Source - http://tal.marketgauge.com/dvMGPro/charts/charts.asp?chart=AAIISR

US DOLLAR INDEX -

Anyone seeing anything familiar here? We had a couple of days worth of a head fake last week that was just enough to ensure that we were on our toes. This has merely provided us an opportunity to buy more of the types of holdings we've discussed in the last several months. "Carry on, nothing to see here!"

Source - http://www.bloomberg.com/apps/quote?ticker=DXY%3AIND

Home PX Index -

I've left the home price index graph up here simply as a placeholder since it hasn't been updated yet. Why is it important? It is important for several reasons. First, home price stabilization is the basis for much of this rally. If you recall, Ben Bernake and Hank Paulson repeated told us that if we can simply stabilize the home market, we'll see the economy recover. In their efforts to stabilize home prices they have become the mortgage lender of choice for most of the deals getting done. Directly you ask? No, but lenders are being supported as the government backstops the entire mortgage market. By buying these mortgages and also controlling treasury rates, the fed has created an artificially low interest rate environment.

What else is going on here? We are hearing that banks continue to pile up foreclosures on their books, but refuse to release them for sale on the market. Other stories highlight that many ex-homeowners still remain in homes they haven't paid a mortgage on for many, many months. How can they stay and not pay? By keeping foreclosed properties in "defaulting" status rather than taking receipt of the properties, banks don't have to recognize the huge losses they are saddled with. Our regulators sit idly by as banks game the system and overstate the assets on their books and earnings. The hope is that by controlling the flow of foreclosures coming to market they can extend the period until the market recovers.

Is it working? Well, according to the graph, it might be. I would guess that as soon as there is a noticeable stabilization or increase in pricing a new wave of sellers will come to drive prices down. No matter what, banks and the government are both giving it all they have to keep prices afloat. Their ability to sustain this is a key driver to the continued resurgence in the market.

Are there still concerns in the housing market? Yes, people continue to lose jobs and people continue to stop paying mortgages. We are coming into more trouble as a new barrage of bad loans are due to reset to higher interest rates. These are the option ARM loans. Many of these loans were "interest only" loans for a period of 5 or 7 years. Borrowers took these loans out with the assumption that they would have increasing home values they could then use as equity to refinance with, or they were used by folks that needed low interest loans because they were maxed out and didn't have the ability to pay more. These loans are due to reset in 2010 and should unleash a new wave of homeowners that cannot afford to own.

Ok, so everything is possibly negative, does it impact our trading? No! Why would reality impact the way we trade? Of course I'm being silly here, but the reality is that the numbers are showing that the pricing data is turning north and this alone will be the basis for optimism in the market. We need to be constantly watching for further improvement to reinforce our short term bullishness. If we get socked with negative news, it is another warning shot across the bow that we need to exit long trades and be more conservative.

Great, Now what? - Summary for October

Given the data we've presented lets summarize it like this.

Unemployment - Bad, but getting less bad

Rail Data - Unchanged

Financial Conditions Index - Still Improving

CFO Sentiment - Improving

WLI Data - Getting Stronger

Trading Sentiment - Mixed (no real trend here but uncertainty)
US Dollar - Declining. It took a pause and now continues its retreat.

Home Prices - Improving

Other items - Consumer Sentiment has still not improved as much as the rally in the market would suggest. We need to continue to eye these figures. Government's entire strategy is that stabilizing the housing market will cause a rebound in consumer spending which is 70% of our economy. If the consumer remains on strike and buys less and demands lower prices, the planned recovery will fail.

Earnings Season - I eluded to earnings season starting this week. I believe that most company reports will beat handily the lowered and managed expectations. We may have continued upward movement here to celebrate how "great" these firms are doing. I say take it while they are coming, but we need to watch carefully for a "sell the news" reaction as we close down earnings seasons. Next quarter's earnings will be easy to beat as well and this is the reason I continue to look at February and March of 2010 as really critical months. These certainly could be the months when the euphoria wanes and gravity reasserts herself after a 9 month vacation.

OK, How do we play it?

It seems pretty simple doesn't it? Keep doing what we covered the last three months. Watch the dollar and invest in base metals, commodities, foreign / overseas countries and etfs, and buy other currencies if you are sophisticated. Silver and Gold have been big recent winners along with Brazil. The Dow Jones Industrial Average has actually lagged in performance the other assets I watch with the exception of corporate bonds. High yield bonds though have continued to outperform. Dollar strength will indicate a turn, but at this point I don't believe that the Federal Reserve desires to change the dollar's direction or they would have already intervened. I think that they will allow for the USD Index to fall another $2 or $3 before supporting it. Therefore, we continue to believe that the types of trades we have on will perform well and I am adding more of my money in the market. Remember, I look at these trades on a daily basis, so my trades probably won't look like yours. Many are invested in mutual funds and are locked in for 30 days when buying. This time requirement should give you pause as you think through the possibility of a sudden reversal. Am I saying don't do it? No, but you can lose money and you need to be aware of the risks!

A couple of last words.

Energy and Utilities have also lagged lately, they may be areas to examine and enter as well.

Have a great month and watch the dollar!

USD $ Stronger - Be on alert

I will add more depth to this in the coming monthly report, but there has been a significant strengthening of the dollar in the last two days. The catalyst for this was the comment from the FED in their FOMC statement that although they didn't plan to change interest rates and didn't see inflation, they were going to reduce purchases of securities in the open market.

My translation of this is that they are beginning to signal that they will begin to drain the liquidity that is sloshing around. When they take excess liquidity out of the system, banks and investors retain their assets and don't have free cash to buy other investments like commodities, bonds, and equities.

Other bad news is out indicating that home sales were down which was a surprise to the market.

Summary
I'm not calling for a total reversal of the trend yet, but if you are nervous you might begin assessing where the exits are. This has been a great run and preservation of capital is what will make this year successful. It is not out of the question to see this dip in overall markets as an opportunity to buy as well, I simply want you to be aware that the USD is showing that it has something left in the tank and as I've described before, it is the key indicator we must watch. If the dollar maintains this new direction it will be a signal that we've reached a near term high of this amazing rally.

September Update
Last month’s analysis called for a further move up in all asset classes and the markets have served up healthy results. As we’ve marched into the highs made on August 25th in the S&P 500 at 1038 the index retreated to where it stands at todays close right at 1000.
30% to 40% of the rally has been a result of simply removing the catastrophic collapse option from the system. The remaining 10% or so can be understood as growth based on feelings of improvement in the economy.

It’s Bad; Although Fundamentals Continue to Be Less Bad
The rally we’ve witnessed has been the result of pricing all assets as though the end of the financial world was at hand (it was). Since the not so invisible hand of the government intervened to save the system, we’ve ridden the wave of excess government liquidity back to levels not seen since last September. Throughout the impressive rally bears have doubted the fundamentals and conviction of the bulls and have been the fuel source, pushing us to these levels.

Economic Updates

Employment
Employment in August is still sour as we lost 216,000 jobs, however this rate of job loss is significantly lower than the 650,000 losses we faced a few months ago. Our current unemployment rate is officially 9.7% as provided by the US Bureau of Labor Statistics. When you include job seekers that have given up searching or are “under employed” in part-time jobs, our unemployment rate is over 16%. The unemployment data is difficult to trust simply because the government doesn’t count folks that have stopped looking for jobs. These are the people that would probably work, but the prospects are so bad they simply quit the search.

Rails
Railcar shipping data through the August 29th shows some improvement in shipping rates, but comparisons to last year still reveal how much of a downward shift we’ve seen.

Transportation data often gives us a leading indication of recovery especially when you drill down to components like crushed stone and lumber. Last week’s information reveals that there has not been a recovery in these products. Shipping of these building inputs show that commercial and residential construction is not improving.





(Source of Rail Charts - http://railfax.transmatch.com/ )
We will probably begin to see further improvement in rail traffic as we see restocking of automobile inventories sold in the Cash for Clunkers tax money give away. The trick will be not to read too much into this data as we’ll see those cars sit on lots for an extended period of time.

Financial Conditions Index -
The Bloomberg Financial Conditions Index combines yield spreads and indices from the Money Markets, Equity Markets, and Bond Markets into a normalized index. The values of this index are z-scores, which represent the number of standard deviations that current financial conditions lie above or below the average of the 1992-June 2008 period. A value over 0 indicates an expansion and an end to the recession. Values under 0 show recessionary tones in the economy.

The Financial conditions index continues to improve suggesting that credit concerns have abated. As you can see from the chart, data in mid October of 2008 revealed how bad financial markets were at the time. We are still below zero and can’t proclaim the end of the economic turbulence and liquidity crisis.

WLI - http://www.businesscycle.com/resources/
Data provided by the group ECRI tabulates their Weekly Leading Indicator index. In crisis, the WLI turned down in October right before the decline and up in February before the market’s swing higher. The WLI continues to improve suggesting that the economic rebound is real. In addition, their data indicates that inflation is not currently present.

Dow Jones Sentiment
The Dow Jones Economic Sentiment Indicator moved higher for the sixth straight month to the 35.5 level. Data under a level of 50 indicates there is danger of an economic slowdown which we are clearly in at this time. We need to continue to watch this upward sloping data.
http://solutions.dowjones.com/economicsentimentindicator/


AAII Sentiment
The movement of the market last week helped to remove some of the bullishness and euphoria in the market. The AAII sentiment ratio was close to the 30 line last week indicating that everyone was happy. As usual, we would use this indicator to take the opposite side of the trade. When everyone is feeling one way, it is usually safer to bet against the crowd. Given the return to the mid range, we don’t glean much from this chart other than a confirmation of our feeling that the market was overbought.
Chart courtesy of http://tal.marketgauge.com/dvmgpro/charts/charts.asp?chart=AAIISR

CFO Survey – Like the market recovery the June release of the CFO Survey backs up what we have witnessed in the economy so far. CFO’s are feeling better than they were, but still reserved in their outlook. Because this data is from the June release, we’ll be carefully watching for the next quarterly update to see if the trend continues.

Commercial Real Estate – TBI Data
Source - http://web.mit.edu/cre/research/credl/tbi.html




MIT Center for Real Estate has supplied us with information about the first and second quarter pricing on commercial real estate transactions. In the graph below, we continue to see the pricing waterfall as deals are getting done at lower and lower levels. Second quarter data shows a pricing drop of 18.1% from the previous quarter and almost 39% lower prices from the peak in 2007. We must continue to watch this data as commercial real estate is the wound that could still kill the patient in terms of this recovery. At the local level, community banks are impaired because they are facing losses on their commercial real estate loan portfolios. Bankers over emphasized these loans and are paying the price for their over zealousness. We will continue to see banking failures and the pace will hasten. Larger regional players like Zions Bank and Regions Financial are in serious trouble and have disclosed serious asset impairment. I will not be surprised to see an arranged marriage of these two banks with larger national institutions backed by the FDIC soon (your tax dollars to absorb the losses of course). We do not see any improvement in these trends and in fact the downward pressure on CRE pricing will accelerate.

Retail Sales Data for July Release in August – Source BLS http://www.census.gov/retail/
Retail sales continue to falter. Total sales decreased .1% from the previous month and were -9% from last year in July.

USD Index & Commodities – From Bloomberg
The US dollar continues its slide. As it goes lower, the world adjusts asset values higher to compensate the erosion of value in the home currency. In other words, (in a perfect world) if the dollar goes down 1%, the value of companies (stocks) should rise 1% to compensate for the dollar’s decline. The same can be said for gold, oil, and other commodities priced throughout the world. Prices seem more expensive to US consumers because they are losing purchasing power. The dollar’s impact on pricing of the stock market and the commodities market is so influential now and I would suggest that much of the moves in the markets are almost based on the fall of our currency.

Consumer Credit Data - http://www.federalreserve.gov/releases/g19/Current/
July consumer credit outstanding was released this week and noted that consumer credit outstanding dropped $21.6 Billion for the month. This is concerning because our government’s plan to revive our economy centers on the resurgence of the US consumer. Rescue packages like the $8,000 home purchase tax credit and Cash for Clunkers are significant pieces of the revival plan. The destruction of consumer credit is driven by several key components. First, consumers with jobs are paying down debts as fast as they can. Second, consumers are refusing to spend using credit cards and loans (if they have access to them). Third, consumers are just not spending and delaying purchases or becoming accustomed to a new life style without instant gratification. Finally, there is another growing segment of consumers that are jobless, without credit, and without means to buy even if they wanted to.

Investing Strategy for September & Coming Months
As we pour through the economic data above you might get the feeling that the economy has had its better days. Facts show that consumer credit outstanding is still declining; unemployment is still rising, retail sales dropping, and rail shipments of construction inputs are still in a flat-line. Despite these sour tones, there are hints of recovery. ECRI data shows that the Weekly Leading Index is still heading higher, the rate of job loss is slowing, and company leadership also states that there are improvements coming. Americans that are working are more productive than ever and there are available stimulus plans to propel purchasing in targeted areas.

Given the prospects of further improvement in the economy, we continue to feel that there are opportunities in various markets in the short run. I hear daily that the market is “priced to perfection”, and in some sense those comments are correct, yet they are not factoring in new data. I agree that for the information we have, we have moved up significantly. Remember though, we were pricing in the apocalypse. As more information reveals the continuation growth, I suspect that we’ll see more moves to the upside as the market is caught off guard. An example of this is the following chart; again from ECRI. The orange line suggests an upturn in pricing in the housing market. A few more weeks of good data here will underpin more upside as this will show that housing may be bottoming. No doubt we'll see more foreclosures and a release of inventories that are building up on bank balance sheets. However, our focus in this discussion is on the next month or so rather than the next six months.

We continue to favor weak dollar plays in the market. If you have the ability to short the dollar or go long other currencies, there is no reason to fight an obvious trend. Stabilization of the dollar is important for the health of our economy, but until we see real intervention from the Fed or the Treasury to prop up the dollar, we must assume that they are paper tigers. As we’ve said often, the FED is motivated to have consumers spend every dime they have and also are committed to devaluing the dollar so that our debt is worth less. In response to the weak dollar, we will see equities move higher, metals, oil, and emerging markets. We will revisit these trades monthly, but as long as the dollar falls, these trades will be effective. Areas to avoid continue to be in the financial and commercial real estate sectors. No matter how far these run, they will be the center of the next liquidity event that may happen in the winter or early next year. Don’t mistake our short term view with a positive long term outlook. We still are of the opinion that the early months of 2010 will bring significant challenges for the markets and the overall economy.

If any significant changes happen in the dollar environment, do not hesitate to move to cash or if you are in mutual funds to US Government Securities that have short term maturities. This is a toppy market so you must be nimble. Establish thresholds for maximize loss before you enter trades and exit those trades if you exceed your limit.

By the way, I know there are folks following on Twitter, I noticed that there is a follow me button here on this blog. Please use that to know when I post each month or intra-month.


Goatmug

Proof that this market recovery has been engineered?

Many of you may have probably been questioning my sanity as I rant and rave that the stock market is rigged and the last six months rally in all asset classes has been manipulated and purposefully created. While I don't believe I've found the smoking gun, we can piece together clues that suggest that the FED and other central banks have printed excess money and provided it at zero or low cost loans to ailing financial institutions. Because these banks have not loaned money to borrowers, the banks deposited their excess reserves directly into the commodity and stock markets.

I've mused several times that the FED, US Treasury, and Obama administration (and former Bush administration) desires nothing more than to have the spending habits of consumers return like the good old days of 2003 to 2007. During those times, you were prodded to use your home like an ATM machine and spend, spend, spend! What consumers didn't realize was that credit cards and home equity loans must be repaid and therefore reduce future earnings and limit lifestyle growth. We happily bought into the notion that instant gratification was our right and that the discomfort of tight budgets didn't matter. I can't tell you how many people told me they "needed" a house or new car when their current situation was absolutely fine.

Since the government’s plan is that you to return to those habits, your leadership’s response to this crisis was to immediately begin driving interest rates to artificial lows. They encouraged you to buy houses with tax credits, cars with cash incentives; tempted you to refinance your mortgage, and President Obama even suggested it was a great time to buy stocks! Ultimately Ben Bernanke and the financial elite want you to continue your path into financial bondage and reduce your savings. You are told when you spend, you rescue US firms from the economic slowdown and that will save US jobs. This financial crisis driven by a loss of jobs and a collapse of the real estate bubble has shaken the very principles of that false paradigm.

By pouring liquidity into banks that are insolvent and indirectly juicing the market, our leadership has opted to restore "confidence" in our economy by pumping stock markets. They are attempting to inflate another bubble. Previously I wrote in an article titled SUMMER & FALL OUTLOOK, "If the US federal government can guide us out of the deflationary cycle, we will be fortunate to enter a period of much greater inflation. In fact, this is the direction that the FED prefers now and is attempting with all of their might. Again, if the FED can break the deflationary cycle by prolific "electronic printing of dollars", deficit spending, and debt issuance it will lead to a significant devaluation of the US dollar. A decline of the dollar will usher in increased commodity prices, and future asset bubbles in other sectors.

In the article below, we have an interview with the Chairman of the China Investment Fund, Lou Jiwei.

http://www.reuters.com/article/ousiv/idUSTRE57S0D420090829?sp=true

Mr. Jiwei is charged with investing excess cash for China's sovereign wealth fund. A sovereign wealth fund is essentially a state owned hedge fund. They buy all types of assets including metals, real estate, and stocks. As the interview proceeds, Mr. Jiwei states plainly what I have been saying;

"It will not be too bad this year. Both China and America are addressing bubbles by creating more bubbles and we're just taking advantage of that. So we can't lose," he said.

The one thing we know about bubbles is that they are formed on the backs of herds of investors rushing to buy assets that are overpriced. In addition, bubbles burst leaving accounts and lives wrecked. Unfortunately, the damage doesn't affect those that choose to risk their capital; it entangles folks that seem to have nothing to do with investing at all. Just look at the crisis on Wall Street and see how it has caused layoffs in Middle America. Families suffer when asset bubbles collapse. The concerning thing for me is that these bubbles seem to be increasing in frequency and magnitude. My feeling is that our government leadership should be slowing down these investor led destructive manias rather than supporting and participating in them.

I also highlight Mr. Jiwei's statement that "We can't lose". The arrogance displayed in this statement is exactly what will lead to a "black swan" event that triggers another global financial meltdown. How many Wall Street traders and executives used those very words before this crisis? Think back to the Enron days, do you think that statement would fit well in that environment? Many friends of mine used those words in the late 90's investing in the internet craze. None of them escaped the market's powerful correction.

While it is so tempting to be a buyer in a market that goes up every day, we must remain prudent and watchful for signs that the markets asset bubble is beginning to burst.