Economy

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Gold broke another record today, closing just over $1,700/oz. The Dow Jones Industrial Average dropped 634 points (5.5%) and not surprisingly, US Treasuries jumped.

This was the expected response to S&P’s cut in US credit rating.

The irony is the jump in US Treasury prices caused a decline in the interest rates.This is because bond prices and interest rates are inversely correlated.

Usually, when your credit rating is cut, the interest rate at which you can borrow goes up.  But, in the case of the US government, it has gone down.

The current yield on a 10-year Treasury is 2.31%.  Last month it was 3.02%. Similarly, the yield on a 30-year Treasury bond is 3.65%, down from 4.28% last month.

Maybe S&P should take down the US’s credit rating another notch, and cause interest expenses to fall even further!

Okay, I’m being facetious.

But I don’t like the way it’s playing out. The current economic scenario reminds me of Japan over the past two decades.

Will the US economy continue to flounder for the next several years just as Japan did?

Will the government continue to prop up failing banks and poorly run business at the expense of the tax-payer?

Will interest rates continue their downward spiral?

Will real estate continue to slide for the rest of the decade?

Are we really turning Japanese?

I really think so!

The QE2 leaving Southhampton

The QE2 leaving Southampton

Today the Federal Reserve launched the highly anticipated QE2, announcing that it will buy $600 million of Treasuries in 2011 ($75 million per month). It will also continue to reinvest payments on its securities holdings which could bring the total capital injection closer to $1 trillion dollars.

I’m still waiting to see any evidence of  “Change You Can Believe In” and for the $8.5 trillion bailout to kick in and create jobs. But since Bernanke seems that it hasn’t been working too well, we’re going to do exactly the same thing that got us in to this mess – keep interest rates low and turn on the liquidity spigots!

One point of interest is these policies seem to benefit banks the most. Here’s an excerpt from an article on Yahoo! News:

Meanwhile, market watchers noted the Fed’s plan is to focus its QE2 purchasing power on the middle of the Treasury curve, i.e. securities from 2.5 years to 10 years. As a result, prices of shorter-term bonds rose while the price of the 30-year bond tumbled, sending its yield sharply higher.

So the real result of the Fed’s action today is a steepening of the yield curve, which most benefits (wait for it)…the banks. The ability to borrow from the Fed at effectively zero and then reinvest in “risk-free” Treasury securities at a higher yield is a huge reason why bank profits rebounded so quickly from the depths of the 2008-09 crisis.

Despite loads of evidence to the contrary (and very little lending) the Fed is effectively doubling down on its bet that boosting the banks’ balance sheets is the best way to revive the economy.

I can’t believe that this is the best policy to revive the economy. However, it definitely makes sense to align yourself with the Federal Reserve’s determined course of action. Seems like there are 2 things you should do:

  1. If you’re currently unemployed, find a job at a bank. Most banks are hiring like crazy. Bank of America has thousands of job postings (I’m not making this up)
  2. If you’re looking to invest, look for companies that benefit by borrowing at zero interest and reinvesting in risk-free Treasury or Treasury-like products.

There are several companies that fall in this category. Not only do they benefit from the current scenario, but they also pay high dividends and enjoy REIT status (meaning there’s no double taxation of profits) without actually investing directly in real estate.

Any guesses? I’ll talk about them in my next post.

Today the US debt broke the $13 trillion level. Considering that the US GDP or the US economy is $14.2 trillion (according to the World Bank), that makes our debt level just over 91% of the GDP. Greece’s debt-to-GDP ratio is currently at 115%  (or 133% depending on who you ask – I don’t think even the Greeks know for sure!) and look at the trouble it’s facing!

Professor Morici, of the University of Maryland, is critical of excessive government spending. He claims that whenever the debt-to-GDP ratio exceeds 150%, you run the risk of hyperinflation or “the Chinese buying up Wall Street”, a reference to China being the largest foreign lender to the US government. Either way, he claims that we will run the risk of losing our financial standing.

On a brighter note, the UK is trailing right behind us with a debt-to-GDP ratio of 78%.  But the real leader of pack is Japan, with a whopping 227%! Not to worry, we’re nowhere close to Japanese levels yet!

After WWII, our debt stood at 125% of our GDP and we were able to bring it under control. Let’s hope we can do the same thing once again. Meanwhile, we can all watch our share of the federal debt over on http://www.usdebtclock.org, and how the national debt seems to be growing $50,000 every second!

With the passing of the Health Care Bill, there is a slew of tax increases that will go towards paying for it. I don’t think any of them are going towards paying down our ballooning debt. Congress probably feels that inflating it away is the easiest solution! And it is, provided the inflation comes in an orderly fashion. But what if it doesn’t?

If you believe the government or the popular press, the economy is out of recession and everything is business as usual again. Last month there was an increase in jobs by 162,000, home sales jumped 8.2%, the Dow is now almost at 11,000 and interest rates are inching upwards  in recognition of the economic recovery. It’s all peaches and cream isn’t it!

Unfortunately, I don’t believe the government or the popular press. I like to look at the facts and draw my own conclusions. First of all, the 162,000 new jobs includes 48,000 temporary census jobs. What happens when these jobs go away? And compared to the millions of jobs lost, 162,000 jobs doesn’t feel like anything to celebrate in the first place.

According the Associated press, in February the pending home sales number jumped 8.2%. This is not year-over-year but rather from January to February. Don’t know if anyone remembers but it was awfully cold in January. Historically home sales slow down during winter, especially when you have pretty bad snowstorms. An 8% increase doesn’t sound like newsworthy at all.  Additionally, the government has been offering a ton of incentives to home buyers, which is probably just cannibalization of future home buying. From the California Association of Realtors:

Californians have a brief window of opportunity to receive up to $18,000 in combined federal and state home buyer tax credits.  To take advantage of both tax credits, a first-time home buyer must enter into a purchase contract for a principal residence before May 1, 2010, and close escrow between May 1, 2010 and June 30, 2010, inclusive.  Buyers who are not first-time home buyers may use the same time frames to receive up to $16,500 in combined tax credits if they are long-time residents of their existing homes as permitted under federal law, and they purchase properties that have never been previously occupied as provided under California law.

And why is the DOW on the verge of breaking 11,000? Is it the fact that the government spent around a trillion dollars propping up the economy or could it be that consumer spending is back? May be its consumer spending. After all, the malls seem full around here. But did you hear that 25% of homes in the US are underwater on the mortgage on 14% of all houses are in some state of default? Being in default means that the monthly mortgage payments are not being made. Doing some back of the envelope calculations, TraderMark was able to put a figure on these numbers. By not paying their mortgage, Americans have an extra $160 billion per year to spend on clothes, cars, vacations and other random stuff.  To see the numbers, check out this post on the hidden stimulus package. No wonder the retailers have been doing well!

And are the interest rates trending higher because the market expects a recovery? Or is it because it expects inflation? If you look at the number of people clamoring for TIPS (Treasury Inflation Protected Securities), the number is trending higher as well. Seems like people aren’t big believers of the US Government’s ability to curb long term inflation.

So what is it – peaches and cream or doom and gloom? The truth is somewhere in the middle. With the government willing to spend money (it doesn’t have) to keep stimulating the economy, it looks like the economy is recovering pretty well. But it cannot come without consequence. At some point someone will have to pay the price of all these bailouts and packages. It might be us, our children or foreign bond holders, but that day will come. Just make sure you invest accordingly.

Here’s a funny video explaining the true unemployment numbers that the BLS just released.

The Bureau of Labor Statistics (BLS) announced today that the unemployment rate for November fell to 10%. This figure represents 15.4 million officially unemployed people.

In reality there are over 26 million Americans who are either jobless or underemployed. The “real” jobless rate takes into account part-time workers seeking full-time work, discouraged job seekers and persons furloughed from full-time to part-time status. The real rate of unemployment is 17.2% and is a more accurate indicator of the labor market.

Almost a year after the historic collapse of Lehman Brother, Fed Chairman Dr. Ben Bernanke announced that the worst recession since 1930 is finally over!

recession next exitHowever, this is only from a “technical perspective”, and unemployment for 15 million Americans (officially 9.7%) will continue, if not get worse. In fact, it may stay this way for nearly 4 more years according to other economists.

So what does this mean? The operation was a success but the patient still died!

Apparently pumping a trillion dollars in to the economy will create a technical expansion even if the net benefit to society is negative. What happens when the government pulls the plug on throwing money at the ecnomy? Won’t the GDP decline again, pushing us back in to a double dip recession?

And what happens if our lenders make this decision for us? Supposing China and Japan no longer want to buy our 30 years bonds at a measley 3 or 4%. What if the interest rates go up to 8%? Will we be able to afford $1 trillion dollars a year in interest payments? Will we start issuing notes for the interest payments? Nah, we’ll just devalue the currency and let inflation help us out of this mess. Either that or the government stimulus will continue indefinitely, aka monetary policy Zimbabwe-style! Oh wait, isn’t that the same thing?

Here are some must-read articles I’ve read this week. None of them talk about gold breaking a $1000, dividend stocks or things you’ve probably read in the news.

cheap home for saleSource: Miz Duke

As everyone knows the only thing wrong with America right now, is the lagging economy. If we could only boost our economy and increase our GDP we’d be able to unleash prosperity on everyone.  So building on the resounding success of its “cash for clunkers” program, the Obama administration just announced a cash for junkers or “we buy ugly houses” program. Since the median home price is about 10 times that of a median priced car, the government will offer 10 times the rebate for the purchase of a new home.  Other than that, the “cash for junkers” program is identical to the preceding program:

  • If you “trade-in” your old home, you’ll get $35,000 towards the purchase of a brand new one
  • If you had a jumbo-mortgage or your house was over 5,000 square feet, you qualify for $45,000
  • You must have owned the home for at least 1 year to prevent misuse of these funds
  • The “trade-in” house must be bulldozed and the debris shipped off to China
  • If your house is worth more than the rebate amount, you’re out of luck!

The government has earmarked $20 billion for this program and it estimates that the sales of 500,000 homes will cannibalized this year from future sales numbers. Wait, did I say cannibalize? My apologies, I meant to say that the demand for 500,000 new homes would be created.  The total effect will be to boost the economy by $100 billion dollars or nearly 0.7%! Since the destruction of the existing houses doesn’t count in GDP numbers it’s a net positive result!

The GDP is a number that calculates the amount of services and goods produces without the effects of taxation, so the negative effect of an extra $20 Billion burden on the taxpayers (or their unborn grandchildren) isn’t a part of the calculation either. So you see, it’s a win-win situation for everyone!

What’s that? Who do I mean by everyone? I mean the administration and the small sub-section of the population who own sub-$35,000 homes who are able to go out and get $125,000 mortgages. Now I’m not sure whether these are low-income families or rich slumlords, but that discussion is merely an academic argument.

Not only that, but demolishing the existing homes would help reduce the old inventory thats casting a dark shadow over the entire real estate industry.  So this we buy ugly houses program would really help the economy’s green shoots sprout in to a young sapling.  What’s that you say? We need job and income growth to actually boost the economy. No, that was the old economy.  This time it’s different!

Stanford professor John Taylor had an alarming op-ed piece in the Financial Times on the Trillion Dollar deficits

“I believe the risk posed by this debt is systemic and could do more damage to the economy than the recent financial crisis. To understand the size of the risk, take a look at the numbers that Standard and Poor’s considers. The deficit in 2019 is expected by the CBO [congressional Budget Office] to be $1,200bn (€859bn, £754bn). Income tax revenues are expected to be about $2,000bn that year, so a permanent 60 per cent across-the-board tax increase would be required to balance the budget. Clearly this will not and should not happen. So how else can debt service payments be brought down as a share of GDP?

“Inflation will do it. But how much? To bring the debt-to-GDP ratio down to the same level as at the end of 2008 would take a doubling of prices. That 100 per cent increase would make nominal GDP twice as high and thus cut the debt-to-GDP ratio in half, back to 41 from 82 per cent. A 100 per cent increase in the price level means about 10 per cent inflation for 10 years. But it would not be that smooth – probably more like the great inflation of the late 1960s and 1970s with boom followed by bust and recession every three or four years, and a successively higher inflation rate after each recession.

A large tax increase would significantly hamper the economy growth and prolong the recession. So that’s probably not the path that the government will follow. On the flip side, 100% inflation over a 10 year period which causes the dollar to devalue significantly may not be an optimal solution either. (But if it is, you should be buying gold!)

May be a middle path which favors taxing the rich and a Europe-style Value-Added-Tax on certain items will be chosen. Whatever they chose, I hope they know what they’re doing.

Had dinner last night with an old family friend at a fancy restaurant. One of the topics that came up for discussion was the stock market and whether the recent rally was sustainable. While I didn’t have any concrete information about the numbers, I felt that the rally in the face of declining quarterly revenues, growing unemployment, increased savings and what could be a permanent drop in consumption didn’t make any sense to me.

But today I read an email from Joan Mauldin.  He always provides great information and sure enough, he had the very data I was looking for. I’ve omitted some of the information for the sake of brevity (and its still pretty long!).

Rising Unemployment and Inflation

When the employment numbers come out, my usual routine is to go the Bureau of Labor Statistics website and peruse the actual tables (www.bls.gov). I was rather surprised to see that the actual number of people employed in the US rose by 120,000. That has certainly not been the trend for a rather long time.

So, are things back on track? Is the recession just about over? Is that a green shoot? I don’t think so.
First, there are actually two surveys done by the BLS. One is the household survey, where they call up a fixed number of homes each month and ask about the employment situation in the household and then take that data and extrapolate it for the economy as a whole. So, while the number of employed rose, the number of unemployed rose a lot faster, by 563,000 to 13.7 million. In addition, there are 2.1 million who are “marginally attached” to the workforce. These individuals wanted and were available for work and had looked for a job sometime in the prior 12 months. They were not counted as unemployed because they had not searched for work in the 4 weeks preceding the survey.

According to the survey, headline unemployment rose 0.4% to 8.9%, the highest level since 1983. But if you count those who are working part-time but want full-time work, as well as the “marginally attached,” the unemployment rate (called the U-6 rate) is an ugly 15.8%.

For whatever reason, the markets were happy that the headline number of the other BLS survey, the establishment survey of lost jobs, was “only” 539,000, down from a negatively revised 699,000 in March. At least, the thinking was, the numbers were not getting worse, though it is hard for me to be encouraged by half a million lost jobs. That may not be the worst of it, however, since 66,000 jobs were temporary workers hired for the 2010 census, and the BLS estimated that the birth-death ratio added 226,000 jobs as a result of new business creation. Really? This will mean that there will likely be a major revision downward at some future point. The number will likely be well over 600,000 in the final analysis.

Further, it is likely that we will see at least another 1.0-1.5 million lost jobs over the rest of the year, taking unemployment very close to 10%. As an aside, the Treasury used an unemployment rate of 9.5% in their stress test of the banks, which suggests the test was not all that stressful. And, showing further weakness, there were 66,000 fewer temporary jobs. If there was really a nascent recovery, you would see a rise in temporary workers.

Average wages rose by a mere 3.2% on an annual basis, and by just 0.1% for the month, and the average work week was at an all-time record low of 33.2 hours. In nearly any inflation scenario, rising wages play an important part. This suggests that inflation is not in our near future.

I kind of agree on the inflation part. It may not be in our near future. But it is definitely on the horizon. The Federal Reserve has expanded the base money in existence 100% in the past year by lending it to banks. Right now the banks are keeping it as their reserves in the Fed and the Fed is encouraging this by paying them interest on it. But they will slowly lower the interest rate paid to banks to encourage them to lend this money out. Due to fractional reserve lending, this money lent out will be several times more than the money the Fed gave the banks and the money supply will probably increase 100% too. This has to cause inflation, but it will hopefully be controlled and not like Zimbabwe’s 100,000% inflation per year! Although, one of the reasons the US can get away with this is the Dollar’s status as the world’s reserve currency. Still, I’m bullish on the long-term prices of gold.

While Wal-Mart and other low-cost retailer sales are up, Saks and other high-end retailers are down by as much as 30%. There is a new frugality in vogue. Consumer spending is going to fall, and when it does find that new level it is going to grow more slowly than in the past.

That is why the recovery is going to be a long slow Muddle Through. This recession will end, as all recessions eventually do. We will see a positive number, maybe as early as the 4th quarter. Employment should turn back up, albeit slowly, after that.

Typically, in a recession jobs are lost because sales slow and production is not needed. When sales recover, so do jobs.

But we are permanently destroying jobs in this recession, all up and down the food chain and in numerous industries. There will be fewer cars made, for a long time. Less demand for financial service jobs. Housing construction will be a long time recovering, well into 2011 or 2012. And less construction means fewer jobs.

Where Will the Jobs Come From?

Going forward, there are simply going to be fewer jobs to make “stuff,” as we consume less. We can’t rely on many of the old jobs and industries to come back in short order, as has been the case in the past. In order for new jobs to be created, we are going to have to create new businesses and expand current ones.

The vast majority of new job creation in the US is by small businesses and entrepreneurs. Yet today small business faces a tough environment. Banks have tighter lending policies. Venture capital is tough to find. Competition in a shrinking economy is brutal.

And the Obama administration wants to raise taxes on small businesses by raising taxes on the “rich.” 75% of those rich he targets are small businesses who need capital in order to grow, but are having trouble getting it from banks.

Sure, entrepreneurs will do what they have to do, and higher marginal tax rates will typically not keep them from working as hard as possible to make their businesses successful. If the tax rates of the large majority of businessmen and women go back to the pre-Bush level, it will not make us close our businesses, but it will cut down on the capital we have available to expand. It will slow down economic growth and hinder job creation. There is just no getting around that fact.

There is a reason that high-tax states have higher unemployment rates and lower job growth. Taxes have consequences for economic growth.

The sad reality is that it is going to take a long time to get back to acceptable employment levels in the US. It now takes an average of over 21 weeks to find a new job, a new record. Stories from friends in the financial services business are particularly difficult, as there are many very highly qualified people for every job that comes available. And it is not going to get better any time soon.

How could we add 120,000 new jobs while unemployment is going up? Because the number of people looking for jobs is growing far faster, as more and more young people come into the market place and couples now find they both must look for a job. And that is a trend that is going to continue.

So many bullish analysts talk about the second derivative of growth, by which they mean that we are slowing our descent into recession. But it is not the second derivative that is important. What is important is that the first derivative, actual growth, return. Until that time, unemployment will continue to rise, which is going to put pressure on incomes and consumer spending, and thus corporate profits.

Profits in the first quarter, with nearly 90% of companies reporting, are down over 50% from last year and are 18% less than estimates. Yes, inventories are down, but so is final demand from consumers and businesses. There is a reason that GM and Chrysler are shutting down for two months this summer. That will percolate throughout the economy.

As the realization that the economy is not due for a robust recovery sinks in, I think the chances for another serious bear market test of the stock market lows will become increasingly high. As David Rosenberg said in his final memo from Merrill Lynch (and good luck to him in his new position, where I hope we all still get to read his very solid analysis!), if a few weeks ago someone had said you could sell all your stocks 40% higher, most of you would have hit that bid.

Now that price has in fact been bid. Do you want to gamble on a renewed bull run in the face of a continually shrinking economy? I suggest you give it some serious thought, or at least put in some very real stop-loss protection.

Whether or not you believe that the rally is short-lived, definitely check out a restaurant in the Century City Mall called RockSugar. I highly recommend it.