Milton Freidman vs. Ben Bernanke

Milton Freidman vs. Ben Bernanke

“There are two kinds of people who lost money: those who know nothing and those who know everything. With two Nobel Prize winners in the house, Long-Term Capital clearly fits the second case.” – Henry Kaufman

June 29, 2009

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

INDU: -1.2%
SPX: -0.3%
COMPQ: 0.6%
RUT: 0.1%

Market
This week marks the end of the 1st half of the year, and what a wild ride it has been. At one point the S&P 500 had fallen over 25% for the year, and is now up almost 2%. If you closed your eyes for the first half of the year you would have thought nothing had happened, yet the past six months have been full of action including major corporate bankruptcies, government takeovers of banks and auto manufacturers, accusations of strong-armed tactics by the Federal Reserve, and one major bear market rally.

I wondered how the year to date action would compare to my beginning of the year predictions (http://weeklymarketnotes.blogspot.com/2009/01/january-4-2009-happy-new-year-to-all-of.html). I won’t go through all of them, just the ones that appear to be really accurate (kidding). Actually, I’ll just cover a few of them.

1. I suggested the market would be range bound (which was correct), although I missed the bottom of the range by a country mile. I ball-parked 840-1020 for the full year while the actual range has been 666-950.
2. I said the economy would stay weak for 2009, but that we could see improvement throughout the course of the year if credit (among other factors) improved, which it has. I also said that credit would continue to loosen throughout the year and we could see more normal levels of credit measures (see chart below from Bloomberg, the 5 year Libor-OIS spread, which is almost back to normal levels).
3. I was (and still am) bearish on the dollar, but it has held up pretty well for the first half of 2009, although I still expect it to have issues. I recommended looking at China as a hedge to the dollar, and that market has outperformed the US handily.
4. As I read that note from January, I was surprised I was turning bullish on oil because I didn’t cover my shorts until later. I suggested a $60 year end price for oil, which is now at $69 after bottoming in the mid $30s. Oil has rebounded, and as I said a couple of weeks ago, I think it has overshot to the upside and there is another opportunity on the short side.
5. If you look closely at that note, I predicted the Lakers would win the NBA title (they did), and that the Angels would win their division (they moved into first place yesterday). California may be falling off a financial cliff, but our sports teams are looking good.

Based upon recent sector movement (see chart below courtesy Bespoke Investment Group), strengthening of treasuries, and fund net outflows, it appears investors are pulling back their risk exposure. The question is will this be a pause in the rally or the beginning of another correction? A few weeks ago we discussed a theory that the Q2 reporting period would be the inverse of Q1, that weaker numbers wouldn’t be met with rising stock prices. While that determination is yet to be made, the recent rotation to more defensive sectors (with the exception of technology, which continues to lead) certainly waives a yellow flag.



In global markets the MSCI has now officially entered the “correction” zone, falling by 10% from its recent high. Russia has technically entered another bear market, with its market down 20%. The Russians have been making a ton of noise about the dollar’s suitability as the global reserve currency, US financial and foreign policy, and our green energy efforts. It might be wise for them to take care of business at home, which remains one of the worst and most dangerous places to conduct business.

Of course, it also might behoove our government to begin leading the world again instead of following it, and to stop trying to recreate Europe here in North America.

Economy

Actual Consensus Prior
Existing Home Sales 4.77 4.82 mil 4.68 mil
House Price Index -0.1%
Durable Goods Orders 1.8% -0.9% 1.8%
Durable Orders ex-Transportation 1.1% -0.5% 0.4%
New Home Sales 342K 360K 344K
Initial Claims 627K 08K 612K
Q1 GDP-Final -5.5% -5.7% -5.7%
Personal Income 1.4% 0.3% 0.7%
Personal Spending 0.3% 0.4% 0.0%
PCE Core 0.1% 0.2% 0.3%
Michigan Sentiment 70.8 69.0 68.7

Durable goods orders jumped in May, rising 1.8% ex-transports versus an expected decline of 1.9%. Leading the way was a 68% jump in orders for commercial aircraft as Boeing received orders for 20 jets in May versus 17 in April. Orders for military equipment jumped 7.4%, computers 9.4%, and machinery 7.7%. Sustained new order growth is necessary to absorb the excess capacity here in the US and eventually (maybe late 2010 or 2011) turn around the massive job losses we are experiencing.

Personal income increased the most in a year, up 1.4% versus expectations of 0.2%, and personal spending rose 0.3%, just under consensus of 0.4%. The big jump in personal income has been attributed to tax cuts and Social Security payments from the stimulus package, which averaged $250 per recipient. Without that stimulus, personal income rose by 0.2% and wages and salaries dropped 0.1%. The savings rate jumped as well, hitting a 15 year high of 6.9%.

Last week we discussed the moderate decline in new unemployment claims and suggested it could be due to benefits expiring after 26 weeks. Bill King provided us with the chart below showing the “exhaustion rate”, the rate at which US workers are losing their unemployment benefits because they have been on the roles too long. In other words, they have exhausted their benefits. The scale is in percentage.



For the first time since 2007 the OECD has revised its forecast upwards. They said that the economic downturn in its 30 member countries has nearly reached bottom. It predicted weak growth of 0.7% next year, a modest improvement from its previous estimation of a 0.1% contraction.

Fed Open Market Meeting
The Fed met this week and left its bond purchase program, which is nearly $2 trillion of treasuries and mortgages, in tact. They pronounced that the rate of contraction in the economy is slowing and inflation will be “subdued for some time” in spite of rising commodity prices.

Currency
This week’s title derives from the Fed Chairman’s view that inflation is caused by the output gap, whose key indicator is capacity utilization. During the ‘90’s I worked for Roger Engemann, an economist by trade but a very successful money manager. Roger was a proponent of Freidman’s philosophy that inflation is a monetary phenomenon, dependent upon a stable dollar and commodity prices. My bias is to agree with Roger and Milton, and let B-52 Ben prove himself over time.

The reason hard assets (i.e. commodities) continue to work this early in the cycle is due to the perception that Bernanke’s actions will ultimately tank the dollar. This view has been accepted by our most important trading partner, China. China is the largest holder of US Treasuries, but has been cutting those holdings to buy commodities, primarily industrial metals.

The Chinese have been on again off again backers of the dollar, and this past week they decided to be off again. China’s central bank reiterated calls from the other BRIC countries (Brazil, Russia, India and China) for a “super sovereign currency” to replace the dollar. This is the third call by the Chinese for a new reserve currency this year.

The ECB has shunned further rate cuts for now, and the Euro has been much more stable than the dollar. ECB member Axel Weber said “the past has shown that an overly generous provision of liquidity in global financial markets in connection with a very low level of interest rates promotes the formation of asset price bubbles.”

China
According to Business week, China recently stepped up measures to block foreign companies from selling goods there and also rolled out policies to boost exports -- and there is little the U.S. can do about it. Many of the protectionist measures criticized by the U.S. are perfectly legal under the rules of the World Trade Organization.

I’m sure we can appease them with some soft talk and apologies.

On a separate topic in China, they blocked Google’s website this week. The government censors want Google to block access to foreign websites via the local Chinese version of Google. China has always been at odds with Google and the internet in general, however, these types of actions make me wonder whether the rebound we are hearing about from China isn’t trickling down far enough, and the government wants to make sure the masses are suppressed (or at least censored).

Corporate Sentiment
According to a Reuters/CNBC poll, CEOs in the U.S. are not nearly as negative about the economy as they were in the first quarter, but they plan to continue rolling back capital spending and eliminating jobs. "The signs appear less negative than they were last quarter, but no one is ready to suggest they are going to begin hiring to start growth," said Business Roundtable Chairman Ivan Seidenberg, chairman and CEO of Verizon Communications.

Inflation
Long time readers know that I have been a critic of former Fed Chairman Alan Greenspan and his loose money policies, which not only helped to create the current financial crisis, but also baked inflation into the long term pie here in the US. Now he is on the inflation bandwagon, which of course makes me want to re-evaluate my position. He told Reuters:

“…the threat of inflation needs to be confronted because it poses a threat to economic recovery. Excess capacity is temporarily suppressing global prices. But I see inflation as the greater future challenge," Greenspan said. "If political pressures prevent central banks from reining in their inflated balance sheets in a timely manner, statistical analysis suggests the emergence of inflation by 2012."

I hate it when people whose opinions I completely disregard start adopting my stances.

Oil
Crude inventories had a drawdown of 3.8 million barrels versus expectations of a 950K barrel decline. Gasoline inventories rose by 3.9 million versus an expected decline of 1 million, and distillate inventories rose by 2.1 million versus an expected increase of 850K.

Mike Rothman of Cornerstone Analytics (www.thecornerstone.us.com) was kind enough to provide some supply/demand data for 2Q 2009. His research shows demand down 3.5 million barrels per day versus last year for the April/May timeframe. Mike feels that demand is actually running below that of the first quarter (could be the rise in prices at the pump). Further, he notes that inventories are at their highest levels since 1998 (when oil bottomed around $12 per barrel). On the flip side, non-OPEC supply has been declining more than anticipated.

Energy Legislation
The administration is pushing for caps on carbon emissions in an effort to push the US towards clean energy. As we have discussed in the past, the goal is a noble one, but the technology doesn’t exist to make this transition in the time frames proposed. In our April 20th note (http://weeklymarketnotes.blogspot.com/2009/04/less-bad-is-new-good.html), we compared the pros, cons and costs of alternative forms of energy, which demonstrated the technology is a number of years away from achieving grid parity.

The administration’s goals are in direct contrast with its other goals-restoring economic growth and employment and reducing dependence on foreign oil. The plan will force US producers of gasoline to purchase carbon dioxide allowances for CO2 coming from their plants AND for the autos that consume the fuel. Foreign producers wouldn’t be subject to the plant allowances, which would allow the offshore producers to develop fuels at a lower cost than domestic manufacturers. ConocoPhillips CEO Jim Mulva said the plan will “have an adverse impact to our industry, potential shutdown of refineries and investment and, ultimately, employment.”

The plan will push the cost of a gallon of gasoline up by $.77 to $1.00 per gallon. Electricity prices will also surge. According to President Obama “under my plan of a cap and trade system, electricity rates would skyrocket.”

Maybe when the refineries start closing the government can take them over in a massive bailout to save jobs? Sounds familiar.

The cartoon below was sent this week by a reader, and symbolizes where the US and China are headed.



Government Bailouts
From Casey Research: “In the wake of Penn Central filing for bankruptcy, America’s largest rail company at the time, Congress passed the Rail Passenger Service Act of 1970 and Amtrak was born. The new federal monopoly was expected to be self-sufficient by 1974. Today, 38 years of federal subsidies and over $33 billion tax dollars later, the company has yet to turn a profit.”



So what is Congress’s solution? Throwing the dysfunctional enterprise $13 billion more tax dollars over the next five years, plus another $1.3 billion towards infrastructure and security.

If the bureaucrats’ ongoing experiment with Amtrak is any indication of GM or Chrysler’s future, then American taxpayers are in for a world of hurt.

Healthcare
From Business Week: “If nothing is done about health care inflation in the U.S., rising costs could force small businesses to spend $2.4 trillion for health care in the next 10 years, effectively eliminating 178,000 jobs, according to a study by Jonathan Gruber, an economist at Massachusetts Institute of Technology. Reform could cut those costs to $1.8 trillion, reducing anticipated job losses by 72%, he said. "The notion that reform will lead to massive unemployment is simply unsupported by the data," Gruber said.

So, let me get this straight. We spend $2 trillion on a healthcare plan to save $600 billion? There was a former Presidential candidate who called this type of math “voodoo economics.”

All This for Just a Trillion Dollars?
Public works projects funded by the U.S. government's economic stimulus are boosting employment, according to data from a House committee. Stimulus spending had created or saved more than 21,000 jobs by the end of last month, according to the report. That compares with 1,288 jobs the committee linked to stimulus spending at the end of April.

Let’s toss in another trillion or two; maybe we can save 100K jobs.

Real Estate
According to ISI, the stock of unsold existing homes for sale continues to fall. In May, it fell 3.5% and is down 15.3% over the past year. The months-supply of homes for sale is down to 9.6 (10.2 on the current sales rate), though that reading is still elevated.

The problem of home sales falling through because of questionable appraisals is "snowballing," said Lawrence Yun, chief economist for the National Association of Realtors. "There's definitely a groundswell of frustration that's building right now," he said. The Appraisal Institute is worried that U.S. rules reward the fastest and cheapest appraisers rather than ones that are accurate in setting values.

Pirates
Since I have written about the Somali Pirates on numerous occasions (Dave, I promise I’ll write about your Pittsburg Pirates when they do something newsworthy), I thought I’d include this from a website forwarded by a reader. I haven’t confirmed whether it’s legit or not, but it is entertaining (Tom, I know you’ll check Snopes for me, thanks).

Luxury ocean liners in Russia are offering pirate hunting cruises aboard armed private yachts off the Somali coast. Wealthy punters pay £3,500 per day to patrol the most dangerous waters in the world hoping to be attacked by raiders. When attacked, they retaliate with grenade launchers, machine guns and rocket launchers, reports Austrian business paper Wirtschaftsblatt. Passengers, who can pay an extra £5 a day for an AK-47 machine gun and £7 for 100 rounds of ammo, are also protected by a squad of ex special forces troops.

The yachts travel from Djibouti in Somalia to Mombasa in Kenya. The ships deliberately cruise close to the coast at a speed of just five nautical miles in an attempt to attract the interest of pirates.

"They are worse than the pirates," said Russian yachtsman Vladimir Mironov. "At least the pirates have the decency to take hostages, these people are just paying to commit murder," he continued.

Anyone have a free weekend?

Time to Retire, Permanently
Former IBM Louis Gerstner, who was the king of manipulating earnings while he was running the firm, told Bloomberg TV that short term capital gains should be 80%, gains held for six months 60%, and over five years 0%. He feels that would be beneficial to getting investors to think long term.

Personally, I’m opposed to capital gains taxes-period! However, if we are going to tax capital gains, why are we creating a “good versus bad” classification on the gains? Who cares how long it takes to make a profit?

The (not so) Golden State
Within a week, California will have to start issuing IOUs to pay its bills, the state's controller said. "Next Wednesday, we start a fiscal year with a massively unbalanced spending plan and a cash shortfall not seen since the Great Depression," Controller John Chiang said.

How did the Golden State get in such a pickle? There have been a handful of key issues that have led to this budget mess. First, the incessant gerrymandering that has occurred over the decades redrawing voting districts into partisan strongholds. The vast majority of districts in California have been created to ensure incumbents keep their office, which ultimately has led to districts leaning either heavily left or right. Second, as a result of the distrust arising from this process, the state’s voters have the ability to place initiatives on the ballot, designating spending, tax cuts, etc. This has led to a large percentage of the budget to be locked in by voter initiative, and has created caps on certain taxes and fees. Third, state contracts have a prevailing wage clause that requires union wages must be charged on all government contracts, even if someone else could do it cheaper. Our neighborhood found out the disadvantage of this law last year when we decided to air condition our local elementary school. The prevailing wage law required us to pay nearly double the amount of our other bids. Finally, during the late 90’s when somewhere near 90% of incremental state revenue was being derived from state capital gains taxes, the legislature irresponsibly ramped spending under the assumption that these tax revenues were a stable source of income instead of treating them as a non-recurring source of revenue. The capital gains taxes went away just as the spending on big projects began ramping.

The Big 3
Edmunds prepared a report for ABC News on the worst selling cars in America. Unsurprisingly, 11 of the bottom 15 selling cars come from either Chrysler or GM. The problems cited amongst the various models are consistent: cheap parts, poor build quality, and lack of styling. My favorite description was written for the Chevrolet Cobalt “an example of America's inability to build a decent compact automobile” and “less refined than competitors, bucket-of-bolts start-up noises, the last hurrah of an old design, anonymous looks.” So much for following the maxim of Lee Iacocca, who said “There is no great mystery to satisfying your customers. Build them a quality product and treat them with respect.”

Amazingly, the Cobalt is the #1 stolen car in America. Attention thieves, head to the nearest dealer, they have plenty!

Farrah
Partially overshadowed by the other big celebrity passing this week, Farrah Fawcett lost her long battle with cancer. As a good friend said about the timing of her death “it’s like having your birthday on Christmas.” For those of you who had the poster in your room as a kid, and the older group who remembers her “creaming” Joe Namath in what has been ranked one of the 10 most memorable Super Bowl commercials ever, this one’s for you:



Conclusion
The economic calendar features the Case-Shiller Home price index, the ISM index, the usual assortment of employment data, and factory orders. Earnings have started trickling in, and should really start moving the following week.

Have a great week.

Ned


“If you are in a spaceship that is traveling at the speed of light, and you turn on the headlights, does anything happen?”- Steven Wright