The US Federal Budget (and my 10th Grade teacher)

No, John Maynard Keynes was not my 10th Grade teacher. But it was in Grade 10, from my history teacher, that I learned about famous economist John Maynard Keynes.

It was Keynes who first proposed that markets move in cycles - in repeating booms and busts - and that the best way to lessen the impact of these booms and busts is to implement countermeasures.

Prior to Keynes, governments taxed less and spent more during good times (when they could afford to do so), and taxed more and spent less during bad times (when they couldn't). It all seemed very straightforward. After the Great Crash of 1929, for example, the US government cut back on myriads of projects and social services in order to save money.

Keynes argued that such seemingly sensible measures only worsen recessions. Instead, he argued that in bad economic times we need to cut taxes, cut interest rates, and increase government spending in order to “stimulate” the economy back to life. Then, in boom times, we need to increase taxes and curtail spending (since the economy is sustaining itself), and pay back that debt.

My 10th grade teacher pointed out that Keynes was foolish and that his ideas would never, ever work. The problem was not with Keynes' theory, but rather that his plan ignored human psychology and the reality of politics.

In bad economic times, people enjoy having their taxes reduced and interest rates cut, even though this leads to the large government deficits that these same people become angry about (rather like being pleased to receive expensive presents from your wife, then complaining that she spends too much).

As the economy improves, it gets even harder for the government to implement Keynes’ ideas. Despite being angry about large government deficits (“debt for our children!”) people are nonetheless unwilling to pay more in taxes to reduce it.

In the United States, any proposed tax changes are complicated by the remarkable fact that low-income earners have been led to believe that rich people need lower taxes, but that they personally don’t need them! Yes, only in America, prefabricated home owners and squirrel hunters can actually be seen protesting against higher taxes for the rich, even if that results in higher taxes for themselves.

The US budget promises to be a Frankenstein-like creation. The US Democratic Party hits walls of opposition because they propose ideas that only economists can appreciate. The US Republican Party is politically successful because they propose simple and intuitive economic ideas, no matter how unworkable those ideas may be.

Like John Maynard Keynes, Barack Obama expects people to be as logical and practical as he is – except that they aren’t. Even my tenth grade teacher knew that.

____


"The avoidance of taxes is the only intellectual pursuit that still carries any reward."

John Maynard Keynes

____

For an example of the class divide in America see:


____

American Economic Dictionary 2010

Knowing this list of terms will not help you make money in the stock market. It will, however, give you a few laughs at a cocktail party (or a few nods of agreement, depending on your crowd).
____

Bankster – n. A banker, since bankers and gangsters have the same profession (stealing).

Bernanke Clown Confetti – n. Common stock certificates.

Big Casino (The) – n. The New York Stock Exchange.

Corporapists – n. Evil organizations (corporations) that no one can trust, despite the fact that most people who believe this belong to one.

Green Shoots – n. Any hint of economic recovery, no matter how small. Popularized by CNBC’s Larry Kudlow.

Helicopter Ben – n. Ben Bernanke, Chairman of the Federal Reserve Board. The nickname comes from a speech he gave in 2002, in which he referenced economist Milton Friedman's metaphor of a helicopter dropping money on the community as a way to rescue the economy.

Hummer – n. A heavy, unaffordable, and somewhat useless off-road vehicle. Also denotes buxom women who date only wealthy men (ie. “Watch out, she’s a hummer.”)

McGlobalization – n. The evil result of cultural export (ex. Hamburgers in France, or rap music at nightclubs in Mongolia).

Nuclear Banana Republic – n. The USA

Perceived Recession – n. An economic situation that makes life uncomfortable for an extended period of time. The technical definition of recession (two consecutive quarters of negative GDP) no longer applies, since by this definition the US is already out of recession.

Sheeple – n. Individuals who do not recognize that the world’s economy is under the control of big business/Jewish Zionists/communists/hedge funds/The Federal Reserve/ Literati/Right-Wing Christian Fundamentalists/The Freemasons, or any combination of the above.

Staycation – n. A vacation spent at home, since one can’t afford to go anywhere.

Toxic Waste – n. Income products composed of sub-prime loans. Named by the traders who sold them to unsuspecting clients.

Turbo-Tax Timmy – n. Timothy Geithner, United States Secretary of the Treasury. Named for an incident during his stint at the International Monetary Fund, where he blamed his late income tax filing on the popular tax preparation software “Turbo Tax."

Zero Interest - n. The basic rate of interest during the credit crisis. Also used to denote the lackadaisical attitude caused by the credit crisis (ie. "I'm not going to the party. Zero interest.")
____

“Men can acquire knowledge, but not wisdom. Some of the greatest fools ever known were learned men.”

Spanish proverb

Is the US Recovery in Danger?

This week saw low sales numbers in housing, lowered (but still rising) durable goods orders, and a generally pessimistic attitude all across the board.

In fact, “pessimistic” may be an understatement. One website effectively summarized the prevailing mood: “Things will never get better. We are all doomed.”

One of many problems with doom and gloom reporting is the resulting dialectical materialism (George Soros calls it “reflexivity”). When people believe something it can become a reality, even if it wasn’t a reality at the time people began to believe it. For example, if people believe there is an increasing chance they will lose their jobs or homes due to recession, they will curtail their spending, thereby causing the recession that they feared. Despite the reflexivity effect, however, I do not believe that this recovery is endangered.

Consumer “entrenchment mentality” is already in full force, and has been for some time. As noted earlier in The Frost Report (The Spending Zone), Americans have been paying off their debts and increasing their savings for seven months straight, and are almost at the point where their free cash flow will increase substantially. As a result of these debt repayments and savings, consumer credit scores are already the highest they have been since 1998.

The corporate world largely reflects the personal one: businesses have vast amounts of emergency cash, have paid down and/or refinanced debts, and have streamlined staff and operations. Corporate America is mean and hungry. With solid balance sheets and low stock prices, M&A activity should rise soon and remain high for months.

The combination of high cash flow, lower debts, higher savings, and excellent credit ratings simply does not match the “we are all doomed” mentality. Similar to cult members who wait for the mother ship, at some point people will realize that the economic apocalypse they are preparing for is simply not going to occur.

Based on the numbers, I suspect that this revelation will strike the US consumer within the next 3 quarters. Regular (if not exceptional) spending will resume shortly thereafter, and corporate America will follow suit with mergers, expansions and hiring.

Though the international picture is deteriorating, it will not be enough to derail the US turnaround.
____

“Hysteria has now disappeared from Wall Street.”

The Times of London, November 2, 1929
____

FOR and "The Spending Zone"

AND ITS IMPORTANCE TO THE US ECONOMIC RECOVERY





The FOR, or “Financial Obligations Ratio,” is a surprisingly overlooked indicator of a nations economic health; specifically, an indicator of the financial health of its citizens. If the US is to truly experience an economic turnaround, the FOR is the number to watch.

The Financial Obligations Ratio is a ratio of the amount of debt that citizens of the US pay in comparison to income. For example, an individual with an income of $4000 per month (before tax) that makes monthly payments (rent, car, credit card, and other payments) of $2000 has a FOR of 50% ($2000 / $4000). The “safe zone,” where living is easy and spending is comfortable, is a FOR or 40% or less, with 32-35% being optimal. The higher the FOR, the more difficult it will be for a person to save for emergencies, spend, or invest.

As we well know, during the boom ending in 2007 many US citizens overextended themselves. In some cases, people were running at debt levels of 50% of more – a completely unsustainable level. Sometimes this was to “get rich quick” by investing in real estate. In other cases it was merely to keep up appearances.

In 2008 - with the collapse of housing and the markets in general - people finally woke up to the dangers of borrowing and started paying off their debts. In some cases, credit was cancelled and they were forced to start paying off debts.

The FOR statistic, as reported by the Fed, is somewhat deceptive. Retired people who tend to have almost no debt whatsoever skew the reported numbers downward. Most people in the U.S. do not actually have a FOR as low as 16%, for example. In reality, the average working person runs at 30% - 45% (even though 40% is the maximum recommended).

The most important thing to know is that free cash flow (spending money) becomes vastly more available as FOR declines. Say, for example, that someone has an income of about $50K, or $4167 per month. If they have a FOR of 45%, they will have approx. $1000 spending money available per month after paying bills and taxes. That's $1000 for groceries, evenings out, vacations, clothes - everything. However, if they pay down their debts to get a FOR of 40%, they will have approx $1210 per month. That's a 21% increase in spending money from a FOR only 5% lower!

Economists - ignoring reality, as usual - refer to the process of people paying off their debts and saving money as “consumer weakness.” The media often laments the currently high US savings rate, saying that it is “bad” for the economy. I could not disagree more. In order to have a long-term, sustainable economic advantage, the US needs to be a creditor nation, whose people use debt wisely and sparingly.

After people started paying off their debts in 2007, dramatic things happened. The national FOR rate for homeowners has dropped from 17.64 to 15.93 – the lowest level since 2002.

Since debts have been paid down and savings increased, credit ratings have consequently improved. The media routinely tells us about the thousands of consumers whose credit has been ruined since the crisis, but they ignore the millions of consumers whose credit has vastly improved. Equifax Inc. (commonly known as “the credit bureau”) reported that as of July 2010, the average credit score of the US consumer rose to 704 – the highest level since 1998.

Once people pay off enough debt to get into the spending zone (15.5% average), they will have enough cash flow to simultaneously spend freely and save. In addition, they will have better credit ratings than at any point in the last decade. It is a pivotal point that will cause the economy to turn around faster than anyone expects.

If current trends continue, this magic 15.5% cash flow level will be reached by the end of 2010.

For additional information, see
The Federal Reserve - household debt
____

"Never keep up with the Joneses. Drag them down to your level. It's cheaper."

Quentin Crisp, Raconteur

US Foreclosures – The “Las Vegas Index”

In the past few months, foreclosure rates have climbed.



Under any normal circumstances, an increasing rate of foreclosures would indicate that the housing market and economy are declining/struggling/suffering. But, these are not normal circumstances.

As everyone knows, US banks are sitting on large numbers of properties where the owners have not paid in months. Previously, the banks wanted to foreclose on these properties but could not, since any increase in foreclosures would have only added to the already large glut. The fact that foreclosures are climbing means that banks are actually able to foreclose. Put another way, foreclosure rates are climbing because the economy is improving, and banks are able to sell their foreclosed properties faster than they were several months ago.

To illustrate, I give you The Frost Report’s “Las Vegas Index.” I chose Las Vegas to measure the nation’s real estate health because it is, officially, the worst housing market in America - with the highest percentage of foreclosures and the largest peak-to-trough drop in prices. The Las Vegas Index is simple: it measures the number of detached foreclosures and listed properties available for sale between 0-$1 million USD, with 1 bed and 1 bath or more.



There are two things that are clearly evident by studying this chart. First, non-foreclosed properties are simply not selling. Therefore, many of the existing home sales statistics are, at this point in the economic recovery, essentially meaningless. Foreclosures will have to clear before regular home sales will make any meaningful recovery. Secondly, the number of foreclosures on the market has not increased in recent months, despite a larger number of properties being foreclosed upon: this means they are selling.

The increasing rate of foreclosures is a positive sign, not a negative one, for the US economic recovery. The sooner bad mortgages and loans clear out, the sooner bankers (and citizens) can get on with their lives. The US real estate market, though it has a long way to go, is improving steadily.

PS - If you were ever considering purchasing real estate in Las Vegas, now would be a very, very good time.
____

"...the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be more modest in the near term than had been anticipated."

The Federal Reserve, Aug 10th 2010

Truth or Dare - The Fed vs CNBC

In past articles I have emphasized the importance – no, the necessity – of getting the facts and then forming your own opinions, rather than having your opinions formed for you.

In a hilarious exchange (to me), the Federal Reserve on Wednesday released the minutes of their June 22-23rd meeting, while CNBC simultaneously released a series of articles and commentaries on the same topics as seen in the Fed’s report.

The Frost Report today contrasts the differences between fact and opinion, or, more specifically, the impressions created by a non-emotional source versus the impressions created by a source that is necessarily dependent upon ratings.
__

The Fed
“The rise in consumer spending slowed in recent months after a brisk increase in the first quarter….The moderation in spending appeared, on balance, to be aligning the pace of consumption with recent trends in income, wealth, and consumer sentiment. Real disposable personal income moved up at a solid rate in March and April, reflecting increases in employment and hours worked as well as slightly higher real wages, but home values declined in recent months and equity prices moved down since the April meeting. Measures of consumer sentiment improved in May and early June but were still at relatively low levels."

CNBC
Economic Recovery Is Faltering As Shoppers Head to Sidelines
"Even Federal Reserve officials have rolled back their economic outlook for the first time in more than year, saying Wednesday that continued weakness in the job market is hampering growth."
__

The Fed
“The anticipated expiration of the homebuyer tax credit appeared to have pulled home sales forward, boosting their level in recent months. Sales of existing single-family homes rose strongly in April, and, although they moved down in May, these sales were still above their level earlier in the year. Purchases of new single-family homes also jumped in April, but then fell steeply in May.”

CNBC
Home Sellers Slashing Prices, While Banks Mow the Lawn
"That heady buzz from the home buyer tax credit is now turning into a grinding headache, as home sellers realize their very temporary, government-induced catbird seat has now fallen back to earth."
__

The Fed
"The staff's forecasts for headline and core inflation were also reduced slightly. The changes were a response to the lower prices of oil and other commodities, the appreciation of the dollar, and the greater amount of economic slack in the forecast. Despite these developments, inflation expectations had remained stable, likely limiting movements in inflation."

CNBC
White House Economic Adviser Sees Deflation Risk
"'Yes, it is a risk,' Romer replied when asked during a congressional hearing whether deflation was a risk. Romer also said she did not expect the economy to slip back into recession."
__

The Fed
"In sum, the changes to the outlook were viewed as relatively modest and as not warranting policy accommodation beyond that already in place. However, members noted that in addition to continuing to develop and test instruments to exit from the period of unusually accommodative monetary policy, the Committee would need to consider whether further policy stimulus might become appropriate if the outlook were to worsen appreciably."

CNBC
Fed Discussed Steps to Bolster Sputtering Recovery
"Federal Reserve officials cut their forecasts for growth this year and signaled they stood ready to take new steps to keep the recovery alive if the economy takes a turn for the worst."
__

Great investors read annual reports (at least the financial sections) before purchasing a stock. They read complex Federal Reserve statements firsthand. They know that in order to be ahead of the game, they need to do the things that average investors do not. When it comes to information, they never take the easy way out. Great investors know that second-hand information results in second-rate decisions.
____

Sources used in this article:
Minutes of the Federal Open Market Committee, June 22-23, 2010
Economic Recovery Is Faltering As Shoppers Head to Sidelines
Home Sellers Slashing Prices, While Banks Mow the Lawn
White House Economic Adviser Sees Deflation Risk
Fed Discussed Steps to Bolster Sputtering Recovery
____

"I am suspicious of the idea of a new paradigm, to use that word, an entirely new structure of the economy."

Paul Volcker, former chairman of the Federal Reserve

Buy High, Sell Low!

Or is it the other way around?



Ridiculed by professionals, “retail investors” are known for making terrible errors of financial judgement, including selling at the worst possible times, and keeping money in worthless investments. So what is a retail investor, and how do you avoid acting like one? To find out, ask yourself the following questions...

What is the difference between a stock and a bond?
What is the difference between nominal and real rate of return?
What is a P/E ratio?
What does a balance sheet tell you?
Why does the Federal Reserve raise interest rates to “cause” a recession?
What are the contents of a balanced mutual fund vs. an aggressive mutual fund?

If you do not know the answers to these basic questions, then you are a retail investor. That is, you are a person who invests money without really knowing what you are doing; therefore, you rely on news and opinions to make your investment decisions. What this article will explain then, is how to save you from yourself.

What marks the retail investor (RI) is fear caused by lack of understanding, occasionally accompanied by greed and Hubris - the belief that you know more than you actually do. The goal then, is to accumulate just enough understanding not to be a menace, while at the same time recognizing your limitations. The first step in this process is to understand how RIs behave, and how this differs from professionals. As a rule, RIs follow a pattern similar to the following scenario…

As the economy begins to recover from a recession, RIs remain sceptical (or scared and angry) and stay on the sidelines, putting their money into low-yielding GICs and money market funds, or under a mattress. They aren’t aware that when inflation is at 2% and their GIC yields 1.5%, they are actually losing money.

As the economy improves further and stocks begin to rise, RIs remain in cash. The market continues to rise, but with occasional drops (corrections) that keep edgy RIs out of the market, and leads them to believe that the market is "rigged" against them. Eventually, after stocks have risen significantly and the economy is well on its way to recovery, news stories of “excellent markets” begin to make headlines. At this point, RIs begin buying mutual funds and stocks in quantity.

The return of RI money to the market causes markets to rise. Seeing their stocks values improving, RIs get excited and put even more money in the market. Markets rise dramatically and stocks become overpriced. The fantastic economy makes front-page news. Neighbours of existing investors, not wanting to miss out on getting rich, join the party. News reports explain that this economy is different from all others before it (due to the Internet, Globalization, rise of China, or some other excuse) and that therefore the good times will never end.

Consumers –flush with cash - go on a spending spree that causes wage increases, labour shortages and inflation. Workers in their early 20s skip work to go to the beach, confident that if they get fired they will be able to find a new job within days. Industrial workers who normally don’t save a dime start buying as if they are high-rollers in Vegas.

The Federal Reserve begins to warn professional investors using cryptic phrases such as “irrational exuberance” or “froth” to describe the overheated market. Professionals start selling their overpriced stocks to euphoric mechanics and pizza-shop owners. To cool down the economy, the Federal Reserve raises interest rates so that fewer people can get loans to buy homes, cars etc. With the decline in business -- or in anticipation of it -- stocks drop slightly. Professionals buy bonds or put their money in cash.

RIs don’t worry about the decline in their stocks, because they know that the economy is doing spectacularly well: the media says so. Stocks drop more. RIs still feel confident. Stocks drop more, making the news. Although RIs begin to worry, they remind themselves that they are “long-term investors” and will simply wait for prices to rise again. Analysts warn of a difficult market. Consumers spend less. Stocks drop further. Finally, unable to sleep at night, RIs start selling their mutual funds.

A wave of selling brings reduced prices and still more selling. Panic sets in. Financial news anchors start babbling hysterically and arguing with their guests. Retail news agencies announce that we are in a recession, that life is terrible, and that the horrors may never end. Retail stock writers pen articles warning people that they may lose “everything.”

After days or weeks of frightening stories, financial news anchors finally run out of adrenaline and become gloomy and exhausted. The evening news tells the story of a lady next door who saves $10 a week by using cooking oil to power her car. Another story explains how to save money by using coupons. Shortly thereafter, Wall Street professionals announce that the stock market has hit a low plateau – all the retail investors have finished selling! Professionals buy. As they are buying, they make TV appearances warning retail investors not to buy, since it is still very risky.

And so the cycle continues…whether it be (as is this story) with stocks; or, with oil, gold, real estate, tulip bulbs, or frozen concentrated orange juice.

Although everyone knows that to make money in the market you have to “buy low and sell high,” retail investors typically do exactly the opposite: they are so afraid of losing money that they consistently lose money.

To be successful in the market, you must conquer your fears surrounding money. You must "buy low and sell high," which in practice means “buy pessimism and sell euphoria.” That is, you have to buy at a time when everyone else is afraid to do so.
_____

"They are stupid, the dumb money that always gets beat up. Retail waits until a stock works, and only then buys it. They they complain when it goes down. Or they won't sell something that works, convinced it's going higher, and then blame you when it blows up. Stay away from all of them. Use garlic and crosses if you have to."

Tom McDermott, as told to Andy Kessler in "Wall St. Meat"

The US Economy - Headed in the Right Direction?

Today, Barack Obama announced that the US economy is "still headed in the right direction," a comment that induced a great deal of ridicule, especially after this week's dismal employment figures. Yet, Barack Obama is right - the economy is headed in the right direction, though it has little to do with his great leadership, or his lack of it.

Interest rates are low & housing prices are low, together creating the best affordability rates since the 1950s. At the same time, many stocks are trading at below book value (net asset value). These are prime conditions for economic recovery. No matter what other government programs or policies are in place (or not), the economy will be in far better condition two years from now than it is today.

The economic cycle is playing itself out, textbook style. If Bill Clinton, George Bush, Ronald Reagan (also a chronic spender) or anyone else were still in office, we would be at exactly the same point.

The tendency for people to overemphasize the significance of an individual's actions is known as "fundamental attribution bias." As an example, the Vice-President of a bank recently told me that he became Vice-President at the "worst possible time" – just before the recession hit - thereby making his sales and leadership abilities look terrible. The economy is still bad and people are frustrated, so they are blaming Obama for everything except breathing.

Now that the major requirements for recovery are in place, the actual pace of the recovery is not within Obama’s – or anyone else’s – locus of control. Just as Bush was unable to prevent the crash, Obama is unable to speed up the recovery.

This time of maximum pessimism is, as I have stated on previous occasions, a buyer’s dream. Take advantage of it by purchasing the stocks of great companies at low prices. That is, buy low and sell high – unless you really believe that the world is ending.
____

"Until people feel better about their own lives, they're not going to feel better about the president."

Bill Clinton, regarding Barack Obama, 2010
____

Barack Obama - Enemy of Business?

The same people who were clamouring for financial reform during the height of the crisis now appear to be taking a "if it's not broken don’t fix it" approach. Having seen their stocks go up since the lows of 2008, fear of change has taken hold. How can we be considering financial reform when talk of it makes markets drop? Don't the markets "know everything?"

Many conservatives have branded financial reform or regulation as "socialist" or "communist," making the ridiculous conclusion that since the highly-regulated communist structure didn't work, a complete lack of regulation must be best. Such short-term and narrow minded thinking is bad for the nation. Financial reform is necessary - and has been a long time coming:
__

"If we bail out this one (Penn Square Bank)...then the markets will know that, no matter what risks they take, the government will bail them out. Eventually, its going to lead down the road to nationalization of the banking system."

William Isaac, FDIC chairman, 1982
__

"If this sounds like a warning, it is."

Gerald Corrigan, President of the Federal Reserve Bank of New York, telling bankers that the over-the-counter (OTC) market seemed to be expanding without adequate controls, 1992
__

"Improved 'transparency' - a favorite remedy of politicians, commentators and financial regulators for averting future train wrecks – won't cure the problems that derivatives pose. I know of no reporting mechanism that would come close to describing and measuring the risks in a huge and complex portfolio of derivatives."

Warren Buffet, Berkshire Hathaway 2008 Annual Report
__

"A key question: Should we opt for even more pain now to gain a better future? For instance, should we create new controls to stamp out much sin and folly and thus dampen future booms? The answer is yes. Sensible reform cannot avoid causing significant pain, which is worth enduring to gain extra safety and more exemplary conduct."

Charles T. Munger, 2009, in the Washington Post
__

"A clear lesson of this crisis is that any strategy that relies on market discipline to compensate for weak regulation and then leaves it to the government to clean up the mess is a strategy for disaster."

Timothy Geithner, Secretary of the Treasury, 2010 in the Washington Post
__

"It is simply unacceptable to walk away from this recession without fixing the system's basic flaws that helped to create it."

Timothy Geithner, Secretary of the Treasury, 2010, in the Washington Post
__

"A clear lesson from the events of the past few years--and a recommendation in the report with which we strongly agree--is that the government must not be forced to choose between the unattractive alternatives of bailing out a systemically important firm or having it fail in a disorderly and disruptive manner. The government instead must have the tools to resolve a failing firm in a manner that preserves market discipline--by ensuring that shareholders and creditors incur losses and that culpable managers are replaced--while at the same time cushioning the broader financial system from the possibly destabilizing effects of the firm's collapse… The financial reform legislation in both the House and the Senate would provide for such a resolution regime."

Ben Bernanke, Chairman of the Federal Reserve, 2010, Fed Speech
__

In my estimation, one of the reasons people hate Obama is because he is forward thinking and logical, and therefore does things that voters hate (a rare combination in politics). In doing what's necessary, he successfully manages to piss off every possible segment of his support base. He makes poor people get health insurance coverage, even if they don't want it. He institutes financial reform at a time when the market is recovering and when each word from his mouth causes the market to drop. His logic, rather than his strict adherence to political philosophy, makes him "difficult" and "impossible to predict." Personally, I like the fact that Obama ignores popular opinion and just gets things done. No doubt he will be a one-term president.

Enemy of Business: no.
Enemy of dangerous, unregulated, pre-1929 style business: yes.
____

"Issues are never simple. One thing I'm proud of is that very rarely will you hear me simplify the issues."
Barack Obama

Reflexivity and the Decline in Home Sales

Recent headlines confidently announced that the 33% reduction in U.S. new home sales for May 2010 was due to the expiration of the new-home buyer’s tax credit at the end of April.

In other words, we are supposed to believe that home sales were robust due to an $8000 tax credit, and now that this credit is over the housing market is bust. Nonsense.

In fact, the reversal in new home sales was primarily caused by an equally large decline in psychological wealth that occurred at the beginning of May - which had nothing to do with tax credits.

Rapid declines in consumer spending are caused by rapid declines in asset values, such as stocks or real estate. While there is much talk about how a drop in stock prices can “predict” an economic downturn, there is little notice that a drop in stock prices, rather than predicting a downturn, may actually be the cause of one.

When people see their net worth decline, they compensate by saving. That is, they decrease their spending and increase their margin of safety, further exacerbating the symptoms of the decline.



The “flash crash” of May 6th 2010 punched the confidence out of retail investors, psychologically forcing them to transfer billions of dollars out of equity investments. So, while April saw inflows to equity mutual funds of $13.89 billion, May saw outflows of $29.94 billion (www.ici.org). Negative headlines caused retail investors to run for the hills - and they haven’t stopped running. These days, the market fluctuates wildly from the trades of hedge funds and volume traders, while those working with retail clients (such as Financial Planners and Brokers) sit at their desks, bored.

Stocks are reasonably priced, with little room for a disastrous collapse like the one from the peak. Home prices are low. Interest rates are low. Despite problems in Europe and Asia, the U.S. economy has all the logical conditions which make it ready to rise from the ashes. However, retail investors and consumers are anything but logical.

Until the chat-room anger and gloom subsides, both stock and housing markets will linger - and the buying opportunities for rational long-term investors will be sublime.
____

“…the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be moderate for a time.”
The Federal Reserve, Press Release, June 23 2010

“Housing cannot lift the United States from its new state of Marxist depression, you bunch of morons. The American Dream is just that. Rest in Peace, USA.”
Anonymous comment on a financial news website, June 24 2010
____

See also: Reverse Attribution

The World Housing Bubble - Part II

Just in case you thought it was over...

Back in March, The Frost Report noted that during the economic crisis of 2006 and beyond, countries around the world drastically lowered interest rates to spur economic growth. Like the Frankenstein monster, the good intentions of these low interest rates have morphed into a hideous mess: a multinational, worldwide housing bubble.

Some economies have already moved from the "we don't have a bubble" stage to the "bubble is beginning to burst" stage, while others are still recovering from the first one. In case you missed the original article or it has faded from memory (see: World Housing Bubble), here is another selection of this year’s headlines to remind you that the problem is far from over.

__


THE UK

House price rises ‘unsustainable’ as lending falls
The Times, June 2nd 2010

"Vicky Redwood, Capital Economics’ senior UK economist, said that the data 'continues to suggest that the recent rise in house prices is unsustainable'."

http://business.timesonline.co.uk/tol/business/industry_sectors/construction_and_property/article7142355


CHINA

May property sales plunge in Beijing, Shanghai, Shenzhen
Xinhua, June 2nd 2010

"Beijing, property signings slumped nearly 70 percent to 3,357 in May from April, the Shanghai Securities News reported, citing data from the city’s housing regulator. In Shanghai, transactions may have dropped about 70 percent to 2,550 signings, the paper reported, and in Shenzhen, sales fell 62 percent."

http://news.xinhuanet.com/english2010/business/2010-06/02/c_13328894.htm


AUSTRALIA

Interest rate rises subdue housing bubble
The Australian, June 1st 2010

"The Reserve Bank of Australia's rate rises have pricked the boom in housing prices and have also sent lending to businesses skidding into reverse."

http://www.theaustralian.com.au/business/property/interest-rate-rises-subdue-housing-bubble/story-e6frg9gx-1225873746105


KAZAKHSTAN

National Bank Chairman: Kazakhstan Focuses on Economic Recovery
Ministry of Foreign Affairs, May 4rth 2010

"Kazakhstan was one of the first countries to experience the global economic meltdown of credit. As a result, it was one of the first to respond with a comprehensive program to deal with problem sectors, such as banking, financial services and property development — the industries that created an economic ‘‘bubble’’ whose collapse the country is still recovering from."

http://portal.mfa.kz/portal/page/portal/mfa/en/content/news/ASTANA%20CALLING/2010-05-04


KENYA

As Nairobi Property Prices Rise, Home Buyers Suffer Low Returns
AllAfrica, Feb 22nd 2010

"Many people who have taken mortgages to buy rental properties are finding it increasingly difficult to service the loans since rents accrued are not sufficient to cover the monthly mortgage repayments.
At the heart of the problem is the fact that rents in many parts of Nairobi suburbs are facing a property price bubble."

http://allafrica.com/stories/201002221638.html


ISRAEL

Legal Ground: The end of easy mortgages?
The Jerusalem Post, May 28th 2010

"It was predictable that the Bank of Israel would move to cool the residential mortgage market. We have seen what anarchy of easy mortgages could do to a massive established economy like that of the US. Even more so, the collapse of a bank in a small economy such as Israel could be a disaster."

http://www.jpost.com/Business/Commentary/Article.aspx?id=176747


CANADA

House prices to drop: TD
The Globe and Mail, May 5th 2010

"House prices will fall in 2011, TD Bank said Wednesday as it revised its outlook for the Canadian real estate sector."

http://www.theglobeandmail.com/report-on-business/house-prices-to-drop-td/article1557540


TAIWAN

Taipei Real Estate Risks Grow After Record Rally
Bloomberg, May 20th 2010

"Investors should sell Taipei property now, taking advantage of a 21-month rally in prices before the government acts to make real estate more affordable, according to the Taiwan Real Estate Research Center and the island’s largest real-estate brokerage."

http://www.bloomberg.com/apps/news?pid=20601206&sid=a0cIUQ74Wfy0
__

After today’s “hot economies” become tomorrow’s “busted economies” and real estate prices return to normal, the world map of economic health will need to be redrawn. Those with developed infrastructure and the ability to raise taxes will fare better, while emerging markets will likely be hardest hit.

If you have a margin account and/or trade international stocks, it would be wise to raise some cash (if you haven't already), to take advantage of bargains as they come available in the next 18 months.

Despite ongoing domestic problems, it is my belief that in a few years the United States - whose massive deleveraging has preceded and superseded all others - will look enviously safe and stable.

____

"...in an environment in which the financial sector is prone to excess and the supervisory structure does not respond sufficiently, the interaction of low interest rates and financial vulnerabilities can clearly be dangerous."

Donald Kohn, Federal Reserve Board, 2010

How to Speak Fed

The Federal Reserve: seen by some as an economic savior, and by others as an evil force.

Through its direct manipulation of interest rates and other mechanisms, the Federal Reserve determines the overall pace of U.S. economic growth (or decline).



Since investors trend toward euphoria when times are good & panic when times are bad, the Fed’s mandate is to control the economy; for example, to stimulate a weak economy by lowering interest rates, or to slow down an overheated one by raising interest rates. Yes, that's right – the Fed sometimes purposely initiates recessions. This is not conspiracy, but rather a method of controlling human stupidity (or at least cleaning up after it).

In good times wages tend to increase, which in turn increases spending, which increases prices of goods, which increases stock and real estate prices, which induces inflation, which causes wages to increase and so on. When times are good and voters are happy, the government wants it all to continue. If an independent Fed did not exist, human greed and optimism would allow bubbles to grow to stratospheric levels, then come crashing horribly down. The recent crash and burn of the U.S. housing bubble is an example of the Fed's failure to do its job – it let the bubble grow for too long.

Importantly, while the Fed always hints at what it wants to accomplish in the future, it does so in a cryptic manner. So, while the Fed’s intentions may be crystal clear to professionals, they pass by virtually unnoticed to non-professionals – exactly as intended.

Buying reasonably priced stocks of good companies is always a good idea, but it’s an even better idea to buy them when the tide of the economy is moving with you. The purpose of this article is therefore to teach the rules of “Fed speak,” the cryptic voice that shapes the nation’s economy.


Rule #1 - The Fed Understates Everything

The Fed is aware of its huge influence in the market, and takes care not to overstep its boundaries. If the Fed simply said, for example, “we intend to raise interest rates because we think there is a bubble in technology stocks,” the market would likely dive and the Fed would be blamed. For this reason, the Fed avoids stating anything of importance directly. Thus, “this market has a bit of froth,” really means, “this is a bubble of massive proportions.” Asking, “Is there a reason to think that homes are overvalued?” means that homes are terribly overvalued. Whenever the Fed states or suggests an opinion, you can safely magnify it tenfold.


Rule #2 –Recognize Moral Suasion

Moral suasion, also known as “jawboning,” is the name for scolding market participants in order to change behavior. By sending a warning to the market, the Fed hopes that it can delay or even avoid taking a negative course of action.

For example, in 2009 the Bank of Canada (Canada’s equivalent to the Fed) stated, “the recent sharp increase in the value of the Canadian dollar, if it proves persistent, could fully offset recent positive developments in financial conditions, commodity prices, and confidence.” This stern warning (see Rule #1) told market participants that if they keep buying the Canadian dollar, the Bank will take measures to devalue it (to improve exports).

In the long run moral suasion rarely works, but in the short run it can have the desired consequences. Moral suasion also indicates the course of action the Fed will take if moral suasion fails.


Rule #3 – Read the Speeches Verbatim

The introductions and conclusions of Fed speeches are made for public consumption (the media) and generally reflect useless broad opinions (such as, "the economy is improving.")

The subtle nuances with true predictive value are in the carefully chosen text. For this reason, any online news article about a Fed speech will include a link to the Fed’s word-for-word text. This verbatim text is meant for market professionals.

Examples of Fed Speak in Action:

“But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?"
Alan Greenspan, Chairman of the Federal Reserve Board, 1996 Speech

Translation: Stocks appear to be grossly overvalued (the Internet bubble).
_

"It's pretty clear that it's an unsustainable underlying pattern. People are reaching to be able to pay the prices to be able to move into a home."
Alan Greenspan, Chairman of the Federal Reserve Board, 2005 Speech

Translation: There is a housing bubble in the U.S., and it will crash.
_

“With recent improvements in the economic outlook, the need for such extraordinary policy is now passing, and it is appropriate to begin to lessen the degree of monetary stimulus.”
Bank of Canada, Press Release, Apr 2010

Translation: We will be raising interest rates soon.
_

The importance of understanding the Federal Reserve cannot be underestimated. To a large extent, the Fed determines the near-term growth or contraction of business, and therefore the direction of the stock market. In addition, the Fed is a reliable asset bubble "early warning system." Learning to speak Fed can save you a lot of anguish.

____

“Augmenting concerns about the Federal Reserve is the perception that we are a secretive organization, operating behind closed doors, not always in the interests of the nation as a whole. This is regrettable, and we continuously strive to alter this misperception.”

Alan Greenspan, Federal Reserve Board Chairman, 1996

The Financial Reform Bill

THE GOOD, THE BAD, AND THE....WELL, YOU KNOW


Both Democrats and Republicans who voted for the bill say that it is not about "revenge" against Wall Street, but merely about prudent regulation and control. Are they right?

In this article, we review the details of the bill that changes everything.


The Good

No Compensation for Lies – Requires public companies to set policies to take back executive compensation based on inaccurate financial statements (if you have been cooking the books, you have to give back the money).

SEC Registration - Hedge Funds that manage over $100 million will now be required to register with the SEC and disclose financial data. This should lesson the amount of false disclosures and scams, common for hedge funds.

Skin in the Game – Requires companies that create securitized investment products (ex. buying crappy mortgages and selling them to others) to keep at least 5% of them on the books. If the product is awful, the company selling them will suffer too, even if just a little.

Consumer Protections – Various excellent amendments for consumers. For example, not allowing credit card companies to increase - without warning - interest rates on those who already carry balances.

Consumer Financial Protection Bureau – A board that watches for consumer scams and abusive financial practices, with the ability to autonomously write new rules and regulations.

UpFront Fund – Large institutions will pay into a fund, similar to deposit insurance, that will pay for the liquidation of a company should it fail (taxpayers will no longer pay). Until now, a financial firm could take out the equivalent of life insurance on a fellow firm, and then short-sell it to death. Now, the firm doing the killing will have to pay for it. Creating the fund will damage profits in the short term, but should enhance stability in the long term.

OTC Derivatives Clearing Houses – Former OTC derivatives will now be cleared on an exchange, similar to futures. That means fewer shady, under-the-table, interconnected deals. It also means fewer cases of institutions falling like dominoes.

Vote on Executive Pay – Gives shareholders a non-binding vote on executive pay, beyond the voting rights that shareholders currently have.


The Bad

SEC Review – Requires companies to provide a chart comparing their executive's compensation to stock performance over a 5-year period. This is a little unfair, since a company that is well run can still have mediocre stock performance. Having said that, I couldn't think of anything better myself.

Federal Reserve Oversight – The Federal Reserve will now oversee companies with assets of over $50 billion. Although the idea sounds good in theory, I’m leery of anything that causes the independent Fed to cozy up to large firms any more than they already do.

Tough to Get Too Big – Larger institutions (whose failure would create more of a threat to the overall system) will have stricter requirements for leverage, capital, and liquidity. This provision somewhat penalizes companies for getting large, which is something I don’t like. Many argue that it is a necessary evil.


The Ugly

Financial Stability Oversight Council – “Make Risks Transparent” mandate. The idea is that the council will identify systematic risks to the system before they occur. Yeah, right. If it were that easy, every financial crisis in history would have been avoided. The true crises are the ones you don’t see coming.

Office of Credit Ratings at the SEC – This office (more bureaucracy) is supposed to regulate the credit ratings agencies, and address poor performance. Good luck with that. No two analysts can look at a company and come to the same conclusion. Interestingly, the council actually has the authority to de-register a ratings agency for continued inaccuracy. Maybe in a few years all of today's ratings agencies will be gone.
____

In all, I welcome the Financial Reform Bill. It is what consumers were demanding, much of it makes sense, and it could be a lot worse. Will it prevent another financial collapse? Of course not. But it should make a next one a little less disastrous.

For further information, see:
http://banking.senate.gov/public/_files/FinancialReformSummary231510FINAL.pdf

Stay Away from U.S. Banks

Good advice, right?

Financial stocks are, once again, the scourge of Wall Street. There is talk of new financial regulation, rumors that the big banks will be broken up and sold, criminal investigations, and concerns about bad debts in Europe - all of which are making headlines daily. Will the horrors never end?

Professional money managers have been busy writing articles with frightening headlines, warning you that financial stocks are dangerous and to avoid them "at all costs." Yet, at the same time as they have been telling you to stay clear, they have been buying a lot for themselves.

Institutional ownership of Bank of America is 56%, Wells Fargo 75%, Morgan Stanley 75%, and Goldman Sachs 72%. For comparison, institutional ownership of Wal-Mart is 36%, Exxon 49%, Proctor and Gamble 58%, and General Electric 50%. If you want to have some real fun, go to the disclosure section of any article that tells you to sell stocks, and check the author’s holdings. You may find that while the author is telling you to sell certain stocks, the disclosure reveals that he owns them all. So yes, he does indeed want you to sell your stocks - so that he can buy them from you.

Here are the major reasons why financial institutions are set to outperform long-term:

The U.S. housing market
In 2008 and 2009, the price of real estate was plummeting, taking the net worth of the average American down with it. But prices have now stabilized, and at extremely low levels. The painful de-leveraging of America is over. The U.S. now has some of the most affordable housing in the industrialized world, and it won’t stay that way forever.

Client Purges
In the previous two years, numerous clients of major banks received letters telling them, for example, that their line of credit would be cancelled if they did not use it within the next 90 days. Clients were outraged, and many cancelled their cards just out of spite - which is was exactly what the banks wanted. This was money that the banks could have been lending out for a profit, but that was instead locked into credit with customers who would never use it. The banks, from their perspective, got rid of a lot of dead weight. They also got rid of a lot of credit risk.

Restructuring
During the height of the financial crisis, the industry was shedding 39,000 jobs every month. Although layoffs can hurt good employees as well as bad, it can safely be said that the best, brightest and most necessary were not the first to go. In addition to the widespread layoffs, many financial institutions streamlined their processes, eliminated business segments not related to their core business, and just generally refocused. The financial industry is leaner and hungrier than it has been in a very long time.

Solid balance sheets
The balance sheets of U.S. financials have been heavily scrutinized by investors, the SEC, the government, hedge funds, and the Federal Reserve. Tier 1 Capital ratios (measures of bank safety) are well above normal. Citigroup, generally considered one of the weakest, has a Tier 1 capital ratio of 11.92% - almost double the level necessary to be called "well-capitalized." In addition, many banks are sitting on extraordinary amounts of cash and have large loan loss reserves.

Financial Reform
The proposed financial reform legislation is often portrayed as a capitalism killer in the conservative media, but it is nothing of the sort. The bill proposes larger capital requirements for those who take more risks, greater transparency in general, and a federal body for winding down companies that nonetheless fail. In other words, large financial institutions will be more subject to scrutiny, require more fallback as their risk levels climbs, and if they fail their operations will be wound down in a manner that is least disruptive to markets and paid for by the industry itself (not taxpayers). Accountability makes for good capitalism.

Valuations
Many financial institutions belong in the single digit forward P/E club. JP Morgan has a forward P/E ratio of 8.2; Goldman Sachs 7.0; Morgan Stanley 7.5, and Citibank 8.9. Citi also has $5.61 of book value per share. Imagine if someone came up to you and said, "I'll sell you this genuine $5 bill for $4 dollars." You would probably assume it was fake, since in the real world this never happens. In the world of Wall Street, however, it happens all the time. At the moment, you can buy $5.61 worth of Citibank assets for $3.81, and get all their clients, brand names, and worldwide businesses for free: Morgan Stanley, Bank of America, MetLife, Travelers, Capital One, and many others are the same.

For small investors to get significant coverage in the financial industry, you need only buy two exchange traded funds - the XLF (large institutions) and the KRE (regional banks). Due to the present worldwide housing bubble, I recommend buying mostly regional banks (KRE) first, until the full brunt of International problems hit their markets (in the short term, psychology trumps value every time). But for value investors, buying time is now.

Statistics (at time of writing):
KRE $27.32
XLF $15.35

____

“You can’t make a baby in one month by getting nine women pregnant.”
Warren Buffett, 2009, explaining the importance of investment patience.
____

Disclosure and Disclaimer
I own all companies listed here as individual stocks, in ETFs, or both.
Do not buy stocks, or take this or any other financial advice without doing your own analysis; including, but not limited to: reviewing business models, financial statements, management style and philosophy, recent developments, market macroeconomic analysis, and chart analysis. If you do not know how to do these things, you shouldn't be buying stocks in the first place. Seek the advice of professionals, as appropriate.