Oct 17, 2010

A Dangerous Game of Chicken

October 17, 2010

A Dangerous Game of Chicken

“Bottoms in the investment world don't end with four-year lows; they end with 10- or 15-year lows.”—Jimmy Rogers, Investment Biker

Weekly percentage performance for the major indices
Based on last Friday’s official settlement...

INDU: 0.51%
SPX: 0.95%
COMPQ: 2.78%
RUT: 1.35%


Against the backdrop of the Fed pushing hard for another round of easing, aka QE-2, equity markets advanced this week along with commodities, while bonds had one of their worst weeks of the year. The dollar, which Chairman Bernanke has been treating with as much respect as Bill Clinton gave to the infamous blue dress, is likely to be the victim of QE-2, along with 200 million plus US consumers. A bout of low rates (for now), accelerating inflation, a weak dollar, and weak economic activity reminds us of 1970’s stagflation, and if we return to that type of environment the comparisons of Helicopter Ben to Arthur Burns (Fed chair from 1970-1978) will echo throughout the land. How we long for the fortitude of Paul Volcker.

Gold, long a barometer of investor concern about inflation, has been ripping for half a decade or so in response to Mr. Bernanke’s irreverence towards our currency. The recent action in gold, which smells of an intermediate term top, has been relentless in its rise (see chart below of the GLD ETF courtesy of Finviz.com). The deflationary crowd has been somewhat quiet lately given the rise in gold, corn, wheat, oil, and any other commodity priced in dollars. While the economy could easily shift back into recession mode, we prefer to focus on the old axiom “don’t fight the Fed”. In that case, it makes sense to position for inflation, because both the Fed’s actions and words suggest they won’t stop their easing until we see the white’s of inflation’s eyes. The problem with their strategy is that it doesn’t address what ails the economy-jobs and incomes.

A stagflationary environment is bad for most asset classes, except commodities, gold and possibly agriculture. Savers get penalized because the income on their savings doesn’t offset the rise in the cost of goods. Pensioners are hurt because the returns on their portfolios pale in comparison to inflation as both stocks and bonds suffer. Social security beneficiaries are already being penalized by the artificially low rates as it was announced they wouldn’t be receiving a COLA increase for next year. In other words, it’s not good.

M&A activity has been strong lately, and many a market prognosticator has referred to this increase in activity as a bullish sign. Unfortunately, history doesn’t support this position as the level of M&A activity has had a mixed record as a bullish market signal. Corporate chieftains and buyout firms have been poor at picking market tops and bottoms.

Rising corporate cash levels have also been cited over the past three years as bullish, however, the chart below shows that corporate cash levels have been rising since the early 1980’s (chart courtesy FT.com). It is estimated that up to 2/3 of the cash presently residing on corporate balance sheets is sitting overseas as non-repatriated foreign profits. It would make sense for the Obama administration to temporarily, or permanently, lower the rates on foreign profits to allow corporations to bring that capital back to the US. Then, instead of investing that capital overseas, a lower tax rate would help make that capital available for job creating domestic investments. A tax rate of 5% would also generate roughly $330 billion for the treasury, not chump change when we are running trillion dollar deficits.


Actual Estimate Previous
Initial claims 462K 450K 449K
Continuing Claims 4399K 4450K 4511K
PPI 0.4% 0.2% 0.4%
Core PPI 0.1% 0.1% 0.1%
CPI 0.1% 0.2% 0.3%
Core CPI 0.0% 0.1% 0.0%
Retail Sales 0.6% 0.4% 0.7%
Retail Sales ex-auto 0.4% 0.4% 1.0%
Michigan Consumer Sentiment 67.9 68.5 68.2
Business Inventories 0.6% 0.5% 1.1%

Economic activity appears to have stabilized for the time being after an extremely scary set of numbers from July and August. While the economy is anything but robust, it appears that a below normal recovery is in the cards. Any systematic shock could knock this economy back into recession (yes, we officially exited the recession).

The Fed is relying upon irrelevant core CPI and PPI measures of inflation. We have discussed the issues with these measures multiple times in the past, so we won’t reiterate the argument again. Suffice to say that the actual cost of living for most consumers is rising at a much greater rate than the Fed acknowledges, either because it is anathema to their deflationary dogma or because they like to be seen as needed.

The chart below, courtesy dshort.com, shows the impact on retail sales of the most recent recession. Note that sales haven’t come back to pre-recession levels yet, and are 8% below where trend line sales would have been, which is probably why it doesn’t feel like this recession has ended yet.

Criminals, Politicians and Bankers-What a Mess

As if the mortgage crisis wasn’t enough to tilt this country off its axis, more mortgage problems are coming to light at the back end of the process. First, the banks lent to obviously unqualified borrowers at ridiculously low rates on overvalued and overleveraged properties, now it appears that when they securitized those mortgages they failed to properly file the required paperwork. This “oversight” has created questions as to the legality of foreclosure activity. At an extreme, each foreclosure proceeding could actually be considered breaking and entering.

The politicians are stuck between a rock and a hard place. They can’t allow the banks to fail and certainly can’t reward deadbeat borrowers, yet they don’t want to be perceived as giving even more handouts to the banks at the expense of homeowner’s right before an election. What’s a spineless politician to do?

How big could the problem be? The cost to buy back the mortgages which were improperly originated could be up to $10 billion. Last week JP Morgan increased their mortgages repurchase reserve from $2bil to $3bil. The problems at Bank of America could be larger.

That Explains It
“When Stephan says in an affidavit that he has personal knowledge of the facts stated in his affidavits, he doesn’t. When he says that he has custody and control of the loan documents, he doesn’t. When he says that he is attaching ‘a true and accurate’ copy of a note or a mortgage, he has no idea if that is so, because he does not look at the exhibits. When he makes any other statement of fact, he has no idea if it is true. When the notary says that Stephan appeared before him or her, he didn’t.”—Thomas Cox, a lawyer describing GMAC’s foreclosure process and the work of Jeffrey Stephan, its signing officer.

In spite of the banks holding back on foreclosures, filings were reported on 930,437 properties in the third quarter, a nearly 4%increase from the previous quarter but a 1% decrease from the third quarter of 2009.

Dow Theory
Dow Theory suggests that it is bullish for the market when the transport and the industrial indices are both strong. Today both are moderately strong, however, Richard Russell, the esteemed caretaker of the Dow Theory, has expressed his concerns about the market, valuation, and low dividend yields.

I am finding a lot of stocks trading at low multiples with good growth prospects, a great recipe for long term gains. I don’t think we’re in for a sustainable up market for quite some time, however, with the Fed printing money like crazy and an economy that doesn’t seem to have a need for liquidity, it would certainly seem that the equity market could be a short term beneficiary. If the market were to continue its upward velocity, I would be a better seller than buyer of equities.

As I mentioned in my last communiqué, I am hoping to get back to writing a couple of times a month. Thank you for the hundreds of requests to stay on my distribution list. If you would like to be dropped, please let me know.

Have a great week.


"We do not inherit the Earth from our parents; we borrow it from our children." - Antoine de Saint-Exupery

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