normxxx ruminates...

Europe Stumbles Blindly Towards Its 1931 Moment

2010-11-16T17:58:00.000-08:00

¹²Europe Stumbles Blindly Towards Its 1931 Moment

It is the European Central Bank that should be printing money on a mass scale to purchase government debt, not the US Federal Reserve.

It was a grave error for Germany's Angela Merkel and France's Nicolas Sarkozy to invoke the spectre of sovereign defaults and bondholder 'haircuts' at this delicate juncture Photo: EPA

By Ambrose Evans-Pritchard, Telegraph.co.uk | 16 November 2010

Unless the ECB takes fast and dramatic action, it risks destroying the currency it is paid to manage, and allowing a political catastrophe to unfold in Europe. If mishandled, Ireland could all too easily become a sovereign version of Credit Anstalt— the Austrian bank that brought down the central European financial system in 1931, sent tremors through London and New York, and set off the second deeper phase of the Great Depression, the phase when politics turned ugly.

"Does the ECB understand the concept of contagion"? asked Jacques Cailloux, chief Europe economist at RBS. Three EMU countries have already been shut out of the capital markets, and footloose foreign creditors hold €2 trillion of debt securities issued by Spain, Portugal, Ireland and Greece. "If that is not enough to worry about financial contagion, what is? The ECB's lack of action begs the question as to whether it is fulfilling its financial stability mandate," he said. That is a polite way of putting it.

The eurozone's fiscal fund (European Financial Stability Facility) is fatally flawed. Like Alpinistas roped together, an ever-reduced core of solvent states are supposed to carry the weight on an ever-widening group of insolvent states dangling beneath them. This lacks political credibility and may be tested to destruction if— as seems likely— Ireland is forced to ask for help. At which moment the chain-reaction begins in earnest, starting with Iberia.

It was a grave error for Germany's Angela Merkel and France's Nicolas Sarkozy to invoke the spectre of sovereign defaults and bondholder "haircuts" at this delicate juncture, ignoring warnings from ECB chief Jean-Claude Trichet that such talk would set off investor flight from high-debt states. EU leaders have since made a clumsy attempt to undo the damage, insisting that the policy shift would have "no impact whatsoever" on existing bonds. It would come into force only after mid-2013 under the new 'bail-out' mechanism. Nobody is fooled by such a distinction.

"This is a breath-taking mixture of suicidal irresponsibility and farcical incoherence," said Marco Annunziata from Unicredit. "If by 2013, countries like Greece, Ireland and Portugal are still in a shaky position, any new debt issued will carry exorbitant yields. The EU would then have to choose between a full-fledged, open-ended bail-out, and reneging on the promise that existing debt would not be restructured. Will German voters then accept higher taxes to save their profligate neighbours?"

In May it was enough for the EU to announce a €750bn 'safety-net' with the IMF for eurozone debtors. Bond spreads narrowed. A spike in economic output— led by Germany's rogue growth of 9% (annualised) in the second quarter— beguiled EU elites into believing that monetary union had survived its ordeal by fire. It had not, and this time they will have to put up real money.

Sadly for Ireland, events have snowballed out of control. Confidence has collapsed before Irish export industries— pharma, medical devices, IT, and backroom services— have had time to pull the country out of its tailspin. Premier Brian Cowen— who presides over a budget deficit of 32% of GDP this year— still insists that 'no rescue is needed'. "We have adequate funding right up until July," he said. Mr Cowan must know this is not enough. Funding for Irish banks has evaporated, and with it funding for Irish firms.

As we learn from leaks that "technical" talks are under way on the terms of any EU bail-out, it can only be a matter of weeks, or days, before Ireland has to tap EFSF— for €80bn to €85bn, says Barclays Capital. Portugal is in worse shape than Ireland. Total debt is 330% of GDP. The current account deficit is near 12% of GDP (while Ireland is moving into surplus). Portuguese banks rely on foreign wholesale funding to cover 40% of assets.

The country has been trapped in perma-slump with an over-valued currency for almost a decade. Successive waves of austerity have failed to make a lasting dent on the fiscal deficit, yet have been enough to sap the authority of the ruling socialists and revive the far-Left. Former ministers are already talking openly of the need for an EU-IMF rescue.

It is hard to see how Portugal could avoid being sucked into the vortex alongside Ireland. Europe and the IMF would then face a cumulative bail-out bill of €200bn or so. That stretches the EFSF to its credible limits.

The focus would shift instantly to Spain, where economic growth stalled to zero in the third quarter, car sales fell 38% in October, a 5% cut in public wages has yet to bite, and roughly 1m unsold homes are still hanging over the property market. The problem is not the Spanish state as such: the Achilles Heel is corporate debt of 137% of GDP, and the sums owed to foreign creditors that must be rolled over each quarter.

The risks are obvious. Unless 'core' EMU countries [[Germany, maybe France?,: normxxx]] raise fresh funds to boost the collateral of the rescue fund, markets will not believe that the EFSF has the firepower to stand behind Spain. Will Germany's Bundestag vote more funds? Will the Dutch? Tweede Kamer, where right-wing populist Geert Wilders now holds the political balance, adamantly opposes such help, and might well use such a crisis to launch a bid for power.

Moreover, it is far from clear what would happen if Italy were forced to provide its share of a triple bail-out for Ireland, Portugal and Spain. Italy's public debt is already near the danger point at 115% of GDP. It is also the third-largest debt in the world after that of Japan and the US. French banks alone have $476bn of exposure to Italian debt (BIS data).

While Italy has kept a tight rein on spending, it is not in good health. Growth has stalled; industrial output fell 2.1% in September; and the Berlusconi government is disintegrating. Four ministers resigned on Monday.

It is clear by now that IMF-style austerity and debt-deflation is not a workable policy for the high-debt states of peripheral Europe, since it cannot be offset by the IMF 'cure' of devaluation. The collapse of tax revenues has caused fiscal deficits to remain stubbornly high. The real debt burden has risen further.

The ECB is the last line of defence. It can halt the immediate Irish crisis whenever it wishes by buying Irish bonds. Yet, instead of pulling out all the stops to save monetary union, the bank is winding down its emergency operations and draining liquidity. It is repeating the policy error it made by raising rates into the teeth of the crisis in July 2008.

Yes, the ECB is already propping up Ireland and Club Med by unlimited lending to local banks that then rotate into their own government debt in an internal "carry trade". And yes, the ECB is understandably wary of crossing the fateful line from monetary to fiscal policy by funding treasury debt. Bundesbank chief Axel Weber might fairly conclude that it is impossible at this stage to reconcile the needs of Germany and the big debtors.

If the ECB prints money on the scale required to underpin the South, it would set off German inflation, destroy German faith in monetary union, and perhaps run afoul of Germany's constitutional court. If EMU must split in two, it might as well be done on Teutonic terms. All this is understandable, but is Chancellor Merkel really going to let subordinate officials at the ECB destroy Germany's half-century investment in the post-war order of Europe— and risk Götterdämmerung?

ß§

Normxxx
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The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

The Cliff

2010-11-16T16:05:00.000-08:00

¹²The Cliff
Click here for a link to ORIGINAL article:

By John P. Hussman, Ph.D. | 15 November 2010
All rights reserved and actively enforced.

Last week, the return/risk profiles that we estimate for stocks, bonds and even gold declined abruptly, based on the metrics we track. We don't know how long this shift will persist, but at present, investment risk appears to have spiked considerably, and our estimates of prospective market returns have deteriorated. The abruptness of the shift in market conditions is exemplified by the weakness observed in Irish, Greek and Spanish debt, as well as the plunge in municipal bonds. Particularly, as Barry Ritholtz observes, in CA issues— see the chart below— which was steep enough to erase nearly a full year of progress in just three days.

Click Here, or on the image, to see a larger, undistorted image.

On the NYSE, hundreds of stocks achieved new 52-week highs, but ended down on the week, with technical evidence suggesting a uniform reversal from a "high pole" buying climax. The percentage of bullish investment advisors reached 48.4%— the highest since the April peak, while the AAII sentiment poll shot to 57.6% bulls— the highest since 2007. Our bond market measures shifted to an unfavorable status for yield pressures, putting the stock market in an overvalued, overbought, overbullish, rising-yields conformation despite QE2, which as anticipated, has been met with fairly eager offers from bondholders.

Whenever one evaluates market conditions, the entire context matters. Various economic and market indicators provide only partial views— much like the group of blind men who identified an elephant as a snake (trunk), a spear (tusk), a fan (ear), a tree (leg), a wall (side), and a rope (tail), depending which part they touched. While various positive indicators can be identified, what matters to us is the full context. In stocks, we have overvalued, overbought, overbullish, rising yield conditions. In bonds, we have unfavorable yield levels and now unfavorable yield pressures. In precious metals, conditions are mixed, so the negative overall conditions in that market at present are somewhat more subtle and may be short-lived.

I don't want to make a fanfare of these concerns. They are simply the average implications we observe based on historical market relationships— even in post-war data. Longer-term, based on our standard methodology, we estimate that the S&P 500 is priced to achieve sub-5% returns, albeit with significant risk, for every horizon out to a decade. Treasury securities are clearly priced to deliver similarly low returns. It's possible that internals will improve sufficiently to shift the expected return/risk profiles we observe in stocks, bonds and precious metals. For now, we are tightly defensive.

The Cliff

I've reviewed the valuation conditions of the stock market extensively in recent months, emphasizing that stocks are not a claim on a single year's earnings, but rather on a whole stream of future cash flows that will be delivered to investors over time. At present, investors and analysts who focus on simple price/earnings multiples (rather than modeling the entire stream of cash flows) are placing themselves at tremendous risk, because simple P/E multiples are being distorted by unusually wide profit margins. Part of this can be traced to weak employment conditions, which have held down wages and salaries. But there is more to the story— the rebound in profit margins also reflects a heavy contribution from financials (which may be more indicative of accounting factors than sustainable earnings), as well as the tail-end of stimulus spending.

The chart below underscores the relationship between high current profit margins and poor subsequent earnings growth. The blue line shows U.S. corporate profits as a percentage of GDP (left scale), which is currently just over 8% and at the highest level since 2007. The red line depicts subsequent 5-year growth in profits, but on an inverted right scale (higher values are more negative). In effect, it should not be a surprise if present levels of corporate profits are followed by negative profit growth over the coming 5 years. Indeed, the 2009 burst of stimulus spending is most probably the only factor that has prevented profit growth from being negative over the most recent 5-year period.

Click Here, or on the image, to see a larger, undistorted image.

Municipal bond investors are clearly re-evaluating the prospects for additional fiscal stimulus from the federal government. Indeed, many state and local governments (as well as health and disability service providers that benefited from stimulus dollars), are beginning to talk about "the cliff"— an abrupt reduction in revenues due to the loss of current stimulus funding which has been used to bridge existing budget shortfalls. My impression is that equity investors face a similar "cliff" which they may not have adequately recognized yet.

The essential point is that stocks are much more richly valued than simplistic P/E multiples would suggest. Investors may pay a heavy price if they fail to adjust valuations for the level of profit margins. The only proper way to value stocks is in relation to measures of sustainable, long-run, full-cycle financial performance.

Singularity

From my perspective, an "economic recovery" that requires a tripling in the Fed's balance sheet, continues to average 450,000 new unemployment claims weekly, and relies on fiscal 'stimulus' to counter utterly stagnant personal income, is ipso facto (by the fact itself) not a "standard" economic recovery. We have swept an enormous volume of bad debt under rugs, behind dams, and in back of curtains (not to mention in off-balance sheet vehicles such as 'Maiden Lane' that were created by the Federal Reserve). But it is all effectively still there, festering. Meanwhile, our policy makers are trying to reignite financial bubbles in order to create an illusory "wealth effect" to propagate spending patterns that were inappropriate in the first place.

It is a bizarre notion that a credit crisis can be solved by bailing out lenders while doing nothing about the obligations on the borrower side. Think about it— what we have said to lenders is, 'here you have these homeowners who can't pay for their houses. Foreclose on them, sell the homes at half the price, and the public will make you whole' (largely through Treasury bailouts to Fannie and Freddie, made necessary by Federal Reserve purchases of these securities).

Heck, if the public is going to be on the hook anyway, at least notice that at equivalent cost to the public, the mortgage could simply be written down to half its value, with the homeowner now able to pay the balance off and the lender getting the public handout to make up the difference. But of course, that would reward the homeowner. So instead, we simply make the lenders 'whole' while people lose their homes and foreclosure investors flip the homes at a profit in return for providing liquidity at the auction. That way, the same amount of public funds can be spent through the back door without Congress even getting involved.

Memo to Ben Bernanke— throwing money out of helicopters isn't monetary policy. It's fiscal policy. How is this not clear?

The proper way to deal with a major debt crisis— indeed, the only way nations have ever successfully dealt with major debt crises— is through debt-equity swaps, restructuring and writedowns. There are numerous ways to achieve this with mortgages. My preference would be swaps of principal for pooled property appreciation rights (administered, but not subsidized by the Treasury). In any event, until our policy makers wake up to the need to restructure debt, so that the obligation is modified for both the debtor and the creditor, our financial system will increasingly tend toward a giant Ponzi scheme. We are racing toward the financial equivalent of a mathematical singularity, where the quantities become so large and outcomes become so sensitive to small changes that the whole system becomes unstable.

Market Climate

As noted above, the Market Climate for stocks last week was characterized by an overvalued, overbought, overbullish, rising-yields conformation that has historically been unusually hostile to stocks. The Market Climate in bonds likewise shifted last week, to a condition of unfavorable yield levels and upward yield pressures. The Strategic Growth Fund and Strategic International Equity Fund are tightly hedged. Strategic Growth holds a staggered strike position where our put strikes are generally quite close to the existing level of the market, and Strategic International Equity has less than 10% of unhedged market exposure, though only a portion of the Fund's currency risk is hedged (currency fluctuations typically represent only a fraction of the total variance of international equity investments). Strategic Total Return presently carries a duration of less than 1 year, with about 1% of assets in precious metals shares, 2% in utility shares, and 1% in foreign currencies.

These investment positions will change as market conditions evolve over time. As I noted last week, post-1940 data now includes a wide enough range of conditions— major recessions, inflation, deflation, expansion, bubbles, crashes, credit crisis, terrorism, war, and peace— that it should provide a representative basis on which to set investment expectations without appealing to Depression-era data. For more than a decade, investment conditions have been largely "out of sample," first on a valuation basis, and then on the basis of major credit strains that had never been observed in the postwar period. Whether it proves effective or not in hindsight, the appropriate response to events that have no context in one set of data is to find an alternative sample of data that is more representative. Though it's likely that we'll continue to see outcomes that have no counterpart in post-1940 data, I do expect that the postwar dataset is sufficiently encompassing that we can put last year's "two data sets" problem behind us.

It bears repeating that $850 billion of QE2 ($600 billion, plus $250 billion funded by bailed-out Fannie Mae and Freddie Mac securities) will not even absorb the new issuance of U.S. Treasury securities over the coming year. That means, in turn, that holders of existing Treasury securities will, in equilibrium, have to continue holding Treasury securities. The only effect of QE2 will be to change the maturity profile— not the overall quantity— of Treasury debt held by the public. At the same time, it will create an enormous overhang of what will effectively be "new issuance" of Treasuries at some future point if/when the Fed reverses its position. Long-term Treasury investors tend to be more forward looking than long-term stock market investors because the stream of payments is known perfectly. It's doubtful, aside from brief rounds of hot potato and musical chairs, that these investors will be moved in any persistent way by the Fed's manipulation.

— -

Prospectuses for the Hussman Strategic Growth Fund, the Hussman Strategic International Equity Fund, and the Hussman Strategic Total Return Fund, as well as Fund reports and other information, are available by clicking here.

M O R E. . .

Normxxx
______________

The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Speculative Phase Of Gold Bull Lies Ahead

2010-11-15T14:34:00.000-08:00

Speculative Phase Of Gold Bull Lies Ahead

By Richard Russell | 15 November 2010

Richard Russell is not only the preeminent expert on Dow Theory, he is one of the most prolific newsletter writers (Dow Theory Letters) and thanks to his epic longevity, will hopefully go on to break records for many years to come. The "Oracle of the Dow" is not omniscient, unfortunately. Otherwise, we mere mortals could simply follow his sage advice to riches.

He was definitely in fine form in the summer of 2000 when he prophesied that "we're in the first phase of a bear market that could be long, tedious, grinding and very painful. Before it's over, I believe we'll see big pools of money moving out of stocks and into cash".

But since then Russell has had an especially tough time with deciphering the stock market. Especially so these past few years. He was bearish for some time but then in May 2007 Russell switched to the bullish camp and pronounced that "an unprecedented world boom lies ahead." It would seem that Russell has basically given up on trying to time the market's gyrations, writing recently that "the stock market is too unsettled, too questionable, for me or my subscribers to assume an all-out bullish or bearish position."

But he continues to be an unabashed gold bull. This is the one market he has been pounding the table about for quite a long time and he has been absolutely correct. To my chagrin, it took me far far too long to realize that gold is indeed in a secular gold bull market. And, of course, the next thought after that is the dread that I will 'overstay' the market.

Russell puts those thoughts to rest writing recently:

"I'm going on the thesis that the highly speculative phase of the gold bull market lies ahead. Now I'm depending on my experience with other bull markets:

Most great bull markets go higher and further than almost anybody thinks possible.

Most bull markets progress in three psychological phases.

I believe the first phase of the gold bull market has passed. It's over. This is the phase where students of great values take their initial positions.

I believe we are now deep into the second phase [[§oand nearing the end of that phase?§c: normxxx]] of the gold bull market. This is the phase where the institutions and funds join in the bull market show.

Often, more money is made in the third or 'speculative' phase of a bull market than is made in the first and second phases combined. This can mean that the late-comers to bull markets often make a fortune, more than those who had the courage to buy early in the game, but they have to have fortitude to sit in the highly volatile second/third phases.

Obviously, I could be wrong, but I believe that gold and silver are both still a buy.

I've said this before, but I'll repeat it. You do not trade in-and-out in a confirmed primary bull market. You take an early position and add to your position as the bull market progresses.

Great bull markets don't usually provide marvelous entry points. Those who are waiting for the ideal or "safe" place to enter the bull market in precious metals may have a long and frustrating wait.

In a great primary bull market, you just "shut your eyes and buy."

Are you buying right or are you buying wrong? Great bull markets tend to bail you out of your mistakes. Perfect timing is nearly impossible in a great bull market. You're either in or you're out.

Great or fabulous primary bull markets may come along once or maybe twice in a generation. I believe the bull market in precious metals is just such a one— a once-in-a-generation bull market. We may never see another one to match this one in our lifetimes.

I started writing Dow Theory Letters 52 years ago in 1958. Three times I've staked my reputation and my business on a bullish market call.

The first instance was in 1958, when I told my subscribers that the third phase of the bull market lay ahead, and it was time to load up on stocks. I said so in my first Barron's article. That call and that article put me in business. I thank Barron's late, great editor Bob Bleiberg (who had faith in me and went out on a limb for me).

In late-1974 at the end of that horrendous bear market, I told my subscribers that I thought the bear market was over, and it was time to buy stocks.

In the year 2000 I told subscribers that I thought the bear market in gold was over, and that it was time to buy what was left of the gold stocks and "put 'em away". I told my subscribers that we should treat the gold shares (many under five dollars) as perpetual warrants. "Buy 'em and forget them."

Lucky thirteen. I'm confirming what I said in 2000. Buy gold and silver, put 'em away and sit tight. The great speculative phase of the precious metals bull market lies ahead. My advice is concentrated in four words— "Buy, and be patient."

Looking at the very long term chart of gold, the base at the millennium is apparent, as is the unrelenting march of the secular bull market. While it does deviate from time to time away from the long term trend, it quickly returns to it. Right now we are above the trend but not at an extreme point that has historically lead to regression to the mean:

Currently the price of gold is trading at 16.3% premium relative to its 200 day moving average. Historically tops have corresponded with a premium of 20%+ so we still have some room the upside in this most recent cycle. And as Russell so eloquently puts it, quite a ways still from the "highly speculative phase".

10 Market Bubbles That Could Soon Burst

2010-11-15T13:22:00.000-08:00

10 Market Bubbles That Could Soon Burst

By Charles Wallace | 15 November 2010

The president of the Minneapolis Federal Reserve, Navayana Kocherlakota, recently published a paper in which he argues that government guarantees helped fuel the bubble in real estate. While his paper was largely aimed at prescribing solutions to this problem, it raises the question: What other bubbles are lurking out there in the global economy? We asked several experts and to our surprise, they had a long list:

1. Gold. The price of gold bullion has risen from $294 an ounce in 1998 to $1,404 today, an increase of 377%. "It's the biggest, baddest bubble of them all," says Robert Wiedemer, author of Aftershock: Protect Yourself and Profit in the Next Global Financial Meltdown. Gold has no intrinsic value. A telltale indicator that gold is a bubble: incessant cocktail party chatter about buying gold and endless TV commercials offering to buy gold jewelry. The SPDR Gold Trust ETF (GLD) is up 28% since the beginning of the year.

2. Real estate in China. Chinese real estate prices are up only 9.1% this year, which may seem more frothy than bubbly. But rising prices are generating rising demand, which is a clear sign of a bubble, says Vikram Mansharamani, whose book, Boombustology: Spotting Financial Bubbles Before They Burst, will be published early next year. The participation of amateur investors like waiters and maids in the property boom is a clear sign of a property bubble in China. The fact that developers are building more apartments than there are buyers is another giveaway.

3. Alternative energy. Solar technology is still uneconomic, yet governments all over the world are subsidizing solar energy firms. "There are plenty of people who shouldn't be in the solar energy industry who are," says Mansharamani. Do we really need 250 venture-capital-backed solar cell companies? The Market Sectors Solar Energy ETF (KWT) had a 100% gain this year, before dropping back.

4. Commodities. Blame it on the weather, China or the Fed, but commodities have shot higher in recent months. Wheat is up 60% this year, and other food commodities like corn have also risen dramatically. "The focus is on the food category for bubbles," says Wiedemer, but industrial metals like copper are also very frothy.

5. Apple (AAPL). OK, everybody loves their iPad and iPhone (except if they live in New York or San Francisco, where signal strength is a problem). But Apple shares are up 1,200% since 2001, which has to come close to being the definition of a bubble. "Apple is a high-fashion company," says Wiedemer. "If CEO Steve Jobs either leaves or dies, I think they will have trouble maintaining that incredible fashion sense, and as such it's time will go," he says.

6. Social networking. Sure, Facebook has 500 million members, but what is that worth? Some estimates put the company's market value as high as $35 billion, but shares in these social networking companies are not listed and are so far only traded by a few insiders. Twitter, with almost no income, is said to be worth $1.5 billion, and LinkedIn is also estimated to be trading at a market value of $1.4 billion. "There aren't any anchors or valuation methods to guide investors in terms of valuation," says Mansharamani. "When you have that lack of clarity, almost anything is possible". Many in the tech world try to figure out what these companies might be worth some day far in the future and then discount that back to some reasonable price today. Remember Boo.com?

7. Emerging market stocks. As an asset class, these shares have risen 146% in the past two years. "We're only halfway along the way to a gigantic eventual bubble in the emerging markets," says Barton Biggs, the former Morgan Stanley Asset Management chairman who accurately predicted the U.S. stock market bubble in the late 1990s. These countries, such as Indonesia, Australia, Russia and Brazil, are growing wildly even though there's no growth in the world economy. Much of their gains is backed by commodity prices, which are also a bubble (see item No. 4). "I have every reason to believe this will turn into a bubble," says Mansharamani.

8. Small tech companies. It's only been a decade since the tech bubble burst, but cash-rich large tech companies are gobbling up smaller firms without regard to price. For example, Hewlett-Packard (HPQ) got into a bidding war with Dell (DELL) over computer storage company 3Par and ended up paying a whopping $2.4 billion, 325 times the firm's earnings before interest, taxes, depreciation and amortization.

9.The U.S. dollar. Although the dollar is down 10% against the euro so far this year, Wiedemer believes the greenback is firmly in bubble territory. He believes it will pop when foreigners stop buying U.S. assets such as stocks and bonds. "Foreigners say, 'I'm worried about inflation— you're going to pay me back in dollars worth less than when I invested'". While China may hold its dollar bonds forever, he says, pension funds in Japan and insurance companies in Europe will start dumping dollars as U.S. inflation climbs.

10. U.S. government debt. "When this bubble pops you're out of bubbles— nothing is too big to fail any more," says Wiedemer. The debt bubble is growing very rapidly and will continue to grow, he says. Basically, there's no way the U.S. government can ever pay back the $13.7 trillion it currently owes (mainly to foreigners), and eventually they will stop buying. The bubble pops when the government has trouble selling its debt— just like Ireland and Greece are experiencing at the moment. Instead of borrowing money, the government starts printing money, which is what's happening now. The Fed's balance sheet has gone from $800 billion in 2008 to $2.2 trillion, and the central bank just announced it was printing another $600 billion. Says Wiedemer: "The medicine starts to become poison."

The Nouveau Poor: Recession Shadows America's Middle Class

2010-11-15T10:57:00.000-08:00

¹²The Nouveau Poor: Recession Shadows America's Middle Class

By Marc Pitzke, Der Spiegel | 15 November 2010
Translated from the German by Christopher Sultan

American society is breaking apart. Millions of people have lost their jobs and fallen into poverty. Among them, for the first time, are many "middle-class" families. Meet Pam Brown from New York, whose life changed overnight.

The crisis caught her unprepared. "It was horrible," Pam Brown remembers. "Overnight I found myself on the wrong side of the fence. It never occurred to me that something like this could happen to me. I got very depressed."

Brown sits in a cheap diner on West 14th Street in Manhattan, stirring her $1.35 coffee. That's all she orders— it's too late for breakfast and too early for lunch. She also needs to 'save' money.

Until early 2009, Brown worked as an executive assistant on Wall Street, earned more than $80,000 a year, lived in a six-bedroom house with her three sons. Today, she's long-term unemployed and has to make do with a tiny one-bedroom in the Bronx. It's only luck that she's not outright homeless.

"One thing came after another— boom, boom, boom," Brown recalls. "I kept getting up and dusting myself off, but I could never get ahead again. I spiraled further and further into the abyss". Her voice is trembling now. "I've done everything America told me to do. I went to school. I've never been to jail. I've kept my nose clean. My kids are great kids."

She laughs a sarcastic laugh. "And now?"

Wall Street Up, Incomes Down

Pam Brown is one of millions of Americans who, during the recession, tumbled from their idyllic middle-class existence to near-poverty— or beyond. For many, like Brown, the downfall is a Kafkaesque odyssey, a humiliation hard to comprehend. Help is not in sight: their government and their society have abandoned them.

Wall Street is preoccupied with chasing new profits again. Yet for large sections of the nation, that old myth of 'working your way up', of "bootstrap" success and its ultimate prize, homeownership, has evaporated. The "middle class", America's backbone, is crumbling. The American Dream has turned into a nightmare.

Last year the US poverty rate reached 14.3 percent, 1.1 percent higher than in 2008. Almost five million Americans skidded below the poverty line ($22,050 annual income for a family of four), many from hitherto sheltered circles, where poverty was a foreign word. The number of long-term unemployed keeps rising. Worst off are families with children. Every fifth child in the US lives in poverty today.

"The situation was bad before, don't get me wrong," Bich Ha Pham, research director with the Federation of Protestant Welfare Agencies (FPWA), a welfare organization in New York City, told SPIEGEL ONLINE. "But this time, it could happen to anybody."

And nobody seems to care. Poverty wasn't an issue during the midterm elections— and it won't be an issue now that the 'spendthrift deficit hawks' of the Republican Party have reclaimed the House of Representatives.

"Nothing's going to happen," Curtis Skinner, head of Family Economic Security at the National Center for Children in Poverty (NCCP), told SPIEGEL ONLINE. The political swing to the right, Skinner fears, is "extremely hurtful" and "absolutely disastrous" to the interest of the weakest. Indeed, what Washington is debating now is not more help for the poor— but extending the former President George W. Bush's tax cuts for the rich.

It wasn't long ago that Pam Brown, too, rarely worried about those who fell through the social safety net— or even feared that fate for herself. "I wish I had been more engaged," she says now. "Wall Street gives you such a comfort with its bonuses. I didn't understand the stringency of your life not being your own anymore, of losing control like that."

How this could have happened is a cautionary tale about the dark side of the 'affluent' society. That's where Brown lived happily for a long time— until the floor fell out from under her feet.

Downsized Jobs And Privatized Welfare

It fell out despite her exemplary resume. Raised in modest circumstances, the African-American woman managed to get ahead on her own. She attended high school in the Bronx and college in Brooklyn, after which she started as an intern at Citigroup. Soon she joined her boss, a 'wealth manager', on the trading floor of the New York Stock Exchange, then moving on with him to Morgan Stanley, then HSBC, then Barclays.

As executive assistant, Brown had a front row seat "watching capitalism work". She had her "pulse on what was going on" in Wall Street finance, leaving her convinced that "everything is possible". Not least for herself: She was about to buy the house where she rented from her landlady.

But just as they were moving on to Bank of America, her boss died of a heart attack— at the height of the financial crisis. The bank took on Brown as a temp, then sold her division to French BNP Paribas and 'downsized' her job. At the same time, her marriage fell apart.

And so she ended up on the street, having to provide for her sons Said, 15, Yusuf, 20, and Malik, 21, all by herself. It was a devious trap. Since Brown only had worked as a temp for Bank of America, she couldn't claim unemployment insurance. It was a straight line to the ranks of the poor, hungry and welfare rolls.

"It was very difficult to identify myself as poor," she says. She recognized her own "little individual prejudices" against people on welfare, the shame and stigma that came with it. "I learned compassion— the hard way". This hard way turned into an odyssey. Instead of finding a job soon, Brown got entangled in the maze of the US welfare system.

Bill Clinton's "Welfare Reform" of 1996 'privatized' welfare in the US, turning it into a for-profit business. Nowadays, welfare seekers have to adhere to such strict criteria that "a large number of applicants will have their applications denied, mainly because of purported non-compliance with certain requirements," the FPWA recently found in a study. Many others would just give up.

Brown wasn't spared either. First the agencies couldn't determine how much help she was due. Then, because of a still-unresolved 'computer error', her cash allowance was denied completely. She now gets just $242 in food stamps and $400 in rent subsidy per month. Every payment requires a new "application," for which she has to produce dozens of documents.

'We're in a Crisis'

The food stamps last about two weeks. Beyond that, Brown has to rely on soup kitchens or private welfare organizations, like the West Side Campaign Against Hunger (WSCAH), which runs a food pantry and provides counselors and cooking programs in a church basement on West 86th Street in Manhattan. "There's been an enormously dramatic increase in clients," says WSCAH Executive Director Doreen Wohl.

"This is the worst it has been in our 31-year history. We're in a crisis." The white-haired lady is standing in the little "supermarket" where the needy can choose food by a point system— grains, proteins, vegetables, fruit, milk. The demand is so high their meat freezer looks plundered.

For Pam Brown, last winter was the worst. One day she ran out of food completely and had to go through trash cans. She fell into a deep depression. Her son Malik finally got her out of it by dressing up as Santa Claus. The toughest part is watching her kids suffer. "Parents should fulfill their children's dreams," she says. "Instead, my sons are pulling me through."

Odd Jobs

Economists claim things are 'looking up'. Brown doesn't feel any of that. To this day she spends up to eight hours a day, several days a week, in the waiting room of a "Job Center," her neatly printed resume in her bag, only to be sent to dead-end training programs and interviews leading to nothing. "There are no jobs," she realized. "Too many people, not enough jobs."

In the meantime, she feels treated like cattle. "They don't know what to do with educated people like me," she days of her overwhelmed social workers. "They're looking for the angry black or Latino woman."

She did have two jobs, temporarily. A real estate firm employed her for a week to help out with a project. "I was able to buy soap, toilet paper, dish dertergent, and I wasn't washing my clothes on a washboard anymore," she remembers. And last winter, she "swept and shoveled" the streets for the New York City Sanitation Department— in a dark, remote corner of the Bronx, underneath the expressway, with parked rigs and "condoms all over the place… I was scared for my life."

She would be homeless if it weren't for her lenient landlady. But the house is up for sale, and she isn't sure how the next owner will handle it. Brown is terrified of homeless shelters. Just the other day she went to visit a girlfriend in a shelter: "It was like jail, with steel bars and a curfew". Her friend had lost her home in spite of her MBA.

The waiter refills her coffee. Brown takes a sip and apologizes for her grievances. "No matter what," she says. "I will not allow this to take away my optimism in the human spirit". Then she's off, to another interview. Who knows.

Where Does The Money Go!?!

2010-11-15T09:50:00.000-08:00

Click Here, or on the image, to see a larger, undistorted image.

20 Stocks With Big Insider Selling

2010-11-11T11:10:00.000-08:00

¹²20 Stocks With Big Insider Selling
Click here for a link to ORIGINAL article:

By Roberto Pedone | 10 November 2010

The selling being done by corporate insiders of S&P 500 companies seems to have momentum that is just unstoppable. According to a report out of Blooomberg.com, the week ending Oct. 29 saw one of the highest amounts of corporate insider selling in S&P 500 companies on a weekly basis for all of 2010. A total of $662 million in stock was sold in the open market last week— and a paltry $1.6 million was purchased— by the people who know the most about the future prospects of their companies.

The buyers once again aren't buying anywhere near the dollar amount of stock that the sellers are selling. Last week, the most significant insider buying was seen at American Express (AXP), Procter & Gamble (PG) and QLogic Corp (QLGC). Insiders at American Express purchased 20,000 shares, or $787,658 worth of stock, at an average price of $39.38. Insiders at Procter & Gamble bought 6,423 shares, or $407,534 worth of stock, at an average share price of $63.45, and insiders at QLogic bought 10,000 shares, or $169,300 worth of stock, at an average price of $16.93.

These three buys just aren't enough for me to get excited about corporate insider buying. Not one purchase even came in above $1 million. This continues to show that insiders at S&P 500 companies have little to no interest in buying stock in their companies. On the other hand, insiders continue to sell stock like crazy. Here's a look at some of the S&P 500 stocks with the largest amount of insider selling.

Enterprise software player Oracle (ORCL), which saw the largest amount of insider selling last week, is not a new name to the insider-selling list. Corporate insiders at Oracle sold 7.8 million shares, or $210.9 million worth of stock, at an average price of $28.95. The insiders at Oracle are apparently taking advantage of selling their stock into strength, with shares trading very close to its 52-week high of $29.71. But my take, since Oracle has shown up so many times on the insider-selling list in recent weeks, is that Oracle insiders probably don't see a ton of upside left in their stock.

It's also worth noting that the guy who would know the most about the company, CEO Lawrence Ellison, continues to be a big seller of the stock. From a technical standpoint, shares of Oracle have been struggling for the past two weeks with getting above $30 a share, while at the same time, insiders have been dumping stock regularly. Now, this doesn't mean the stock can't go higher, but if the Oracle insiders continue to flood the market with supply it will continue to leave an overhang on the shares.

Personally, I would have a hard time pulling the trigger from the long side on Oracle when insiders are selling so much stock— and so persistently. For me, the insider selling at Oracle is moving the stock into "red flag" territory. Another tech name that saw big insider selling last week was Apple (AAPL). Corporate insiders at Apple sold 197,125 shares or $60.5 million worth of stock, at an average share price of $306.72.

So far year-to-date, Apple shares are up 47%, but the stock is currently trading about 9 points off its 52-week high of $319 a share. My take is that Apple insiders are also taking advantage of the strength in their stock to book some profits. From a technical standpoint, I wouldn't get concerned about the price action in Apple unless the stock broke below some key support at around $300 a share. If you're a bull on the stock, then I would definitely want to see Apple take out its pre-earnings highs of $319 sometime in the next few months.

Three more large tech players that showed up on the insider selling list last week were storage player EMC (EMC), network infrastructure company Juniper Networks (JNPR) and information technology king IBM (IBM). Insiders at EMC sold 999,847 shares or $21 million worth of stock at an average share price of $21.08. Insiders at Juniper Networks sold 577,500 shares or $18.3 million worth of stock, at an average price of $31.76 and insiders at IBM sold 101,046 shares or $14.2 million worth of stock, at an average share price of $140.57.

It's worth noting that the Juniper's chairman of the board Scott Kriens was one of the big sellers at that company. And the chairman, president and CEO of EMC, Joseph Tucci, was also a significant seller. I never like to see such 'significant' insiders dumping a lot of stock.

Even more insider selling was seen among well-known tech names such as cloud computer players Citrix Systems (CTXS) and Salesforce.com (CRM). Insiders at Citrix Systems dumped 150,000 shares, or $9.1 million worth of stock, at an average share price of $60.98. Insiders at Salesforece.com sold 70,670 shares, or $8 million worth of stock, at an average share price of $113.64.

What's interesting here is that all of these companies, as well as Oracle, operate in the information technology sector. Could this heavy selling among so many IT leaders be a 'tell' that this sector is going to see a slowdown a lot sooner than many market players are expecting? Only time will tell, but it sure isn't a confidence-building move by these insiders to be dumping so much stock all at the same time.

One new name that showed up on the insider-selling list was manufacturer of complex metal components and products Precision Castparts (PCP). Insiders at Precision Castparts sold 181,300 shares, or $24.7 million worth of stock, at an average share price of $136.07. This stock has been another big winner year-to-date, with shares up around 30%. What I really don't like about the insider selling at PCP is that the chairman and CEO Mark Donegan was one of the top sellers.

As a rule, I never like to see the most knowledgeable person at a company selling large amounts of stock. And to me, it doesn't matter if it's the exercising of options or an open market sale of stock. Corporate insiders book profits at a certain level for a reason, and that reason usually isn't because they see a ton of upside in the future. Of course, it's always important to see how much of their overall stake in the company the insiders have sold, and you should evaluate the timing of any sale on a stock chart.

From a technical standpoint, shares of Precision Castparts are running into some overhead resistance at around $141 share. In order for the uptrend in this stock to continue, it will need to take out that resistance level— or a selloff back towards previous support around $135 to $133 could be in the cards.

The bottom line: Insider selling isn't a tell-all indicator. I like to look at it as a trend indicator, where if the trend in selling is consistent and the buying is not showing up, then it should be viewed as a red flag. That is the current trend we're seeing right now, no doubt, but that doesn't mean that stocks are about to fall off a cliff. Often the insiders can be a bit early in the timing of their sales.

To see more stocks with heavy insider selling, including McDonald's (MCD), Coca-Cola (KO) and Apollo Group (APOL), check out the Top 20 S&P Stocks With Big Insider Selling portfolio on Stockpickr.

M O R E. . .

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¹²Ten Companies That Will Never Recover From Their Mistakes

By Douglas A. Mcintyre | 10 November 2010

Most companies that fail over time do so because of a series of modest mistakes made by generations of management. Markets shift and corporations are slow to adapt. Strategic acquisitions, which could change a company's future for the better, are ignored or passed up. And, perhaps most common of all, a company begins to decline because it loses the creative spark of its founder or the input of employees that are the company's creative engine.

The firms on the 24/7 Wall St. list of companies that will never recover from their mistakes are all still in business. Each firm was a leader in its industry, if not the leader, but made a critical error or errors that destroyed their chance to have a brighter future. For want of a nail, …the kingdom was lost.

Motorola did not produce a product that leveraged the huge success of its RAZR handset, a product that propelled the company to the No.2 position among cellphone manufacturers worldwide. Boston Scientific decided that it was not enough to be a large and highly successful company. Instead, it bought another company to be even larger…. Blockbuster believed that video rental stores would remain the dominant way to distribute DVDs. It did not see that the DVD industry [[and, thanks to Netflix, its entire business model: normxxx]] was faltering.

It is easy to say that good management never makes disastrous strategic errors. But, the results of good management may be, in part, a product of luck. GM's prospects fell apart while rivals VW and Toyota did well. Did GM fail to see something on the horizon that its rivals did? [[Based on the unanimous opinions of the government conservators sent in to rescue them— they didn't have a clue!: normxxx]] Or was GM unlucky because its home base was the US where the labor movement was powerful and mediocre quality, heavy cars with large engines sold well [[until they didn't: normxxx]]?

There are ten companies on this list. The fortunes of each have been badly damaged. Whatever the reason, what each lost is irretrievable.

1. Motorola

The handset company sold 50 million of its Razr handsets in two years and 110 million over four years. The company shipped 12 million units in the third quarter of 2005 alone. The success of the Razr made Motorola the No.2 handset company in the world in the second half of 2006, behind perpetual leader Nokia.

Motorola failed to use its huge advantage in the early days of higher end handsets to become one of the leaders in the emerging 'smartphone' business, which is now dominated by Apple and Research In Motion. Today, it must also compete against larger companies with stronger balance sheets such as Nokia, LG, and Samsung. These corporations are aggressively pushing for global smartphone market share. Motorola's new Android-based handset cellphones sell well, but the momentum the company lost in 2007, 2008, and 2009 means that it will never be more than a niche supplier.

Motorola's sales hit $42.9 billion in 2006 and the company made more than $4 billion. Motorola's revenue, which included discontinued operations, was $4.9 billion in the most recent quarter of 2010. On that same basis, the company made only $109 million. Motorola is on a pace to reach $20 billion in revenue and $400 million in net income this year. Motorola's stock traded for over $26 in late 2006. The shares change hands at about $8 today. The DJIA is up 10% over the last five years. Motorola is down more than 60%.

Today, Motorola's leadership has disappeared, and it struggles near the bottom tier of an extremely competitive market. Motorola shipped only 8.3 million handsets in the second quarter of 2010. In comparison, Nokia shipped more than 90 million in the same period. More forcefully, handset manufacturers shipped 346 million units worldwide in the most recent quarter.

Also Read: The E-Commerce Assault on the Cell Phone

2. GM

In 1962, the largest of the Big Three sold more than 50% of the cars bought in the US. That number is less than 20% in most months today. The reasons for the decline run into the dozens, but there are a few that are most important.

GM did not forcefully respond to the Japanese imports which began to reach the US in real numbers in the 1970s. The Japanese cars got better gas mileage than GM vehicles in a period when US drivers were worried about fuel costs. American car companies, GM included, also wrongly assumed that domestic buyers would always think that Japanese vehicles would be of 'lower quality' than American vehicles.

GM never forcefully addressed its rapidly rising labor expenses [[nor the clearly discernable quality superiority of the Japanese products: normxxx]]. The average cost per hour to employ a GM blue-collar worker rose well above those of Japanese rivals during the 1990s. GM could have gone through a painful nationwide strike to challenge the UAW to bring down labor costs.

Such a move would have been risky. But such risk was not nearly as significant as building a worker cost base that could not be sustained. The high costs were particularly problematic in light of falling market share in years like 2008 and 2009 when US car sales slowed.

[ Normxxx Here: And, its eventual, belated moves to address the quality issues were never more than half-hearted tokenism intended largely for PR effect which fooled neither its workers nor the buying public. ]

GM also decided to 'diversify' in the early 1980s. It bought tech outsourcing company EDS from Ross Perot in 1984 [[a doomed merger if ever there was one, considering the beaurocratic culture of GM and the individualistic culture of EDS: normxxx]]. GM became a large defense contractor in 1985 when it acquired Hughes Aircraft and merged it with its Delco division. Both acquisitions were major failures.

GM is no longer the world's largest car company. That distinction belongs to Toyota. In the US market Ford and Toyota sell nearly as many vehicles each month as GM does.

3. MGM

The studio company, founded in 1924, recently filed for bankruptcy. It has produced some of the most famous films in history including "Gone With The Wind" and most of the James Bond movies. The Metro-Goldwyn-Mayer library of movies includes more than 1,400 titles.

The most extraordinary mistake that the firm made was a 2005 leveraged buyout through which several media companies and private equity firms Providence Equity Partners and TPG took control of the studio. MGM took on more than $4 billion of debt in the process and never generated adequate cash flow to support it. MGM has recently been the target of raider Carl Icahn and other investors who have hoped to buy the company's assets at a huge discount.

The recent Chapter 11 filing by the company will allow a number of creditors to exchange equity for debt. The new structure means that MGM will probably make a very modest number of films a year to keep down costs— perhaps a half a dozen. This is a tremendous drop from the production schedule that the company had in its prime.

The greatest error that the MGM made was to assume that its large film library would fuel sufficiently huge DVD sales to cover the firm's debt. This worked in the very early stages after the 2005 buyout, but as the DVD business collapsed and more films moved to TV video-on-demand and Internet streaming, MGM's major source of revenue quickly eroded.

4. Gannett

Gannett was once regarded as one of the most innovative media companies in the world. It started USA Today in 1982. The paper became the most widely circulated daily in the US.

The largest newspaper chain in the US had a stock price of $62 in 2007. The share price is now under $12. Gannett had revenue of $8 billion in 2006 and had net income of over $1.7 billion each year from 2002 to 2006. In the third quarter of this year, Gannett had revenue of only $1.3 billion, and net income of just $101 million.

Gannett's mistake was not unlike that of other newspaper chains. It took too long to realize how rapidly news consumption patterns would change and move to the Internet. It was late to market with a major national news site like CNN.com or MSNBC.com. Gannett did not take advantage of its size and cash flow five years ago, when it could have bought a growing Internet company like MySpace. Although, the MySpace purchase has not worked for News Corp, that may be due as much to poor product management and lack of innovation as anything else.

Gannett's management failed to look forward and realize that the print media industry's prospects were beginning to dim.

5. Moody's

It says a great deal when Warren Buffett buys a significant stake in a company and then sells much of that position only a short time later. He invested in Moody's because it was one of the leaders of the rating industry and had been for a century. Along with S&P, it was the 'gold standard' of its industry.

Moody's has been blamed for misrepresenting the independence of its rating of mortgage-backed securities. The rapid drop of the value of these securities was the major cause of the credit crisis. Referring to the ratings on subprime paper, The Week reported that the head of the US Congressional Financial Crisis Inquiry Commission said "flipping a coin would have been five times more accurate in making an investment decision than trusting Moody's ratings of sub-prime backed securities before the credit crunch". The magazine added, "Of the (sub-prime backed) securities given the highest AAA-rating in 2006 by Moody's, 89 per cent were downgraded to junk status in a year."

There was no one in the management of Moody's at the time that these ratings were offered to investors who did not know that independence and integrity were the most critical values for the company's success. This is true with all securities that Moody's rates— its action with sub-prime paper had the effect of calling all of its research into question. In early 2007, Moody's shares traded above $73. Today the stock sits just above $26. The "trust" issue will dog the company into the future. [[No investor today would rely on a Moody's rating; its rating's "Value Added" on any security is virtually nil.: normxxx]]

6. Blockbuster

The video rental giant is destined to make any list of companies which took a wrong turn that cost it its entire franchise. The once dominant force in the industry recently went through a Chapter 11 to restructure its debt. Blockbuster held the lead position in the distribution of feature content for nearly a decade. It was the top retailer of VHS and then DVD products and held a significant enough part of that market that there was no clear second place competitor.

Blockbuster's business began to falter and it lost money in 2002, 2003, and 2004. Raider Carl Icahn gained de facto control of the company in 2005 to turn it around, but the trends in the industry had already moved toward DVDs-by-mail. Netflix took a lead in this business which became insurmountable even after Blockbuster launched its own mail service. The delivery of digital entertainment has since moved to streaming premium content over the Internet directly to people's homes, a business in which Blockbuster has never gained a significant presence.

7. Level 3

The company has one of the largest data networks in the US with 67,000 miles of wire and fiber which can deliver voice and video via broadband across most of the country. The firm's technology is unrivaled. A number of cable and telecom companies have been Level 3 customers. Level 3 is also one of the key networks for Voice over IP, which is rapidly replacing standard landline telecom service for millions of people.

Level 3's strategic error was that the company did not stick to its core competency. The firm became as much an M&A machine as an operating company which left it with more than $9 billion in long-term debt. Level 3, however, did not have the cash flow to cover such a large obligation [[and especially not upon entering into a serious recession: normxxx]].

Management always had the same excuse about its performance. Acquisitions had 'not performed well'. These also cost the parent company management's time and integration expenses. Level 3's lack of focus allowed its former customers— large telephone and cable companies— to flank it in the delivery of data to the 160 cities that it serves.

A focus on operations rather than building the company through buyouts would have allowed management to take advantage of the most advanced data infrastructure in the world. Level 3's stock was above $6.50 in early 2007. It now trades for $.89.

8. Boston Scientific

Boston Scientific was one of the leading medical device companies in the world with a huge market share in the "less invasive medical device market". It was also highly profitable. The company posted earnings of $1.6 billion on revenue of $5.6 billion in 2005.

In early 2006, the Boston Scientific board and executives implemented a seemingly 'sure-fire' strategy. If it bought another sizable company within its industry, it would markedly increase its dominance of the industry and hence its margins tremendously. Boston Scientific paid $27.2 billion in cash and stock for Guidant, outbidding Johnson & Johnson. But, the buyout increased the Boston Scientific debt eight-fold to $6 billion.

Boston Scientific hit some bumps as government studies questioned the the effectiveness of its own products. And, to compound the problems with the buyout, Guidant products began to have quality-related problems, which made the acquisition even more troublesome and excessively costly. Guidant became a tremendous burden less than two years after the transaction. As Morningstar pointed out at the time, "Lingering quality problems and more product recalls from the acquisition of Guidant could amount to more bumpiness through 2008."

From 2006 to 2008, Boston Scientific posted total losses of $4.5 billion. The combined company also showed no growth in revenue or meaningful expense savings. Boston Scientific has taken a large, successful business and, in a bid to become the single dominant corporation in the medical device industry, it ruined its own balance sheet and bought a firm with significant product problems. Boston Scientific shares were above $25 before the Guidant deal. They now change hands for well under $7.

9. Abercrombie & Fitch

The specialty retailer did a poor job of judging its market beginning in early 2009. Its clothes were aimed at older teens and college aged customers. Abercrombie & Fitch kept margins high because it had built a powerful brand which allowed it to charge premium prices for its products. Although it had competition, Abercrombie believed its brand could overcome the need to ease prices when same-store sales began to drop. But the plunge was unprecedented.

Same-store sales dropped nearly 30% in 2008 and in 2009 and have only just begun to recover. Abercrombie & Fitch's stock traded between $60 and $80 from 2005 to the summer of 2008. At that point, it became clear to Wall St. that consumers may have viewed the retailer as a merchant of premium clothing, but that the teen buyer was not willing to pay a large premium price for similar products available elsewhere.

Lower priced retailers had begun to copy Abercrombie styles and marketing practices. Shares fell to $15 in late 2008. Abercrombie is a clear example of a company which misread the willingness of its customer to stay with the brand when that brand had become relatively too expensive.

10. Office Depot

There are three major companies in the retail office supply business: Office Depot, Office Max, and Staples. Over the last five years, the share price of Staples has been relatively flat. The share price of Office Max is down about 35%. Office Depot's stock is down over 80%.

Office Depot never took advantage of its brand or retail experience to develop a beachhead overseas. In contrast, almost a quarter of Staple's sales are from outside the US. This failure cost Office Depot dearly.

The margins at all three of the office supply retailers were pressed by the recession. More importantly, big-box retailers like Sam's Club and Costco moved into office supplies and used their broad purchasing power to offer lower prices. Office Depot could not turn to overseas operations which have helped a number of companies like Walmart in recent years to offset a slowdown in its home market.

By deciding that the US market was the only one that really mattered, Office Depot almost guaranteed that its growth rate would eventually turn to a sales contraction. [[The office product market is peculiarly sensitive to recession; in any HQ cost cutting exercise, the first thing cut are office supplies.: normxxx]]

Also Read: Fedex Capitalizing On Growth Trends In India

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¹²Four Smacked-Around Stocks Likely To Rise Again

By John Dorfman | 10 November 2010

Stocks that have been smacked around often make the best buys. I regularly compile a 'casualty' list of stocks that have been beaten up in the previous quarter, and that I think have excellent recovery potential. This fits with my favorite investment technique, which is to buy stocks of good companies on bad news that I believe is temporary.

The Standard & Poor's 500 Index rose 11 percent in the third quarter. A quarterly decline of 10 percent was enough to relegate a stock to casualty status this time. Among approximately 2,100 U.S. stocks with a market value of $500 million or more, 92 were down 10 percent or more in the third quarter. Most of them flunked my basic value criteria: a stock price 15 times earnings or less, and debt less than stockholders' equity.

Among the 19 banged-up stocks that met my criteria, I recommend four. Let's start with Sanderson Farms Inc. The Laurel, Mississippi-based chicken producer was down 15 percent in the third quarter, and 18 percent since I recommended it Feb. 21.

Clearly, my recommendation was badly timed. A poor U.S. harvest contributed to a 53 percent increase in the spot price of No. 2 yellow corn in the past eight months. High prices for feed grains make the lives of chicken farmers harder.

Tough Times

Also, the economy hasn't rebounded as strongly as I thought it would. My notion that people would buy more chicken proved premature. It's still Hamburger Helper time.

I jokingly define the 'long term' as that period of time over which I am proven right. In the case of Sanderson Farms, I think that day will still come. Over the next few years I believe corn prices will moderate, and some measure of prosperity will return to the U.S.

Today, Sanderson Farms shares sell for about $42, which works out to less than nine times earnings and 0.5 times revenue. Those valuations make me feel very comfortable.

The price ratios at Skechers USA Inc. are even better: six times earnings and 0.5 times revenue. A year ago I said it would be a "small mistake" to buy Skechers. Since then the stock has dropped about 12 percent while the S&P 500 has gained about 12 percent.

Following a 36 percent decline in the third quarter, I consider Skechers is a better buy than it was when I wrote about it earlier. Analysts expect earnings to climb to about $2.90 a share this year compared with $1.16 in 2009. The Manhattan Beach, California, company had a hit with Shape-Ups, an athletic shoe that promised to help customers "get in shape without setting a foot in a gym". Now the No. 2 U.S. sneaker maker behind Nike Inc., Skechers is opening more stores this year, bringing its total to about 300.

Amedisys Inc., the largest U.S. home-nursing provider, fell 46 percent in the third quarter. Propelling the drop were allegations that the Baton Rouge, Louisiana, company may have improperly billed Medicare. The company is suffering through investigations by the Securities and Exchange Commission, the U.S. Justice Department and the Senate Finance Committee. I predict the controversy will end in a negotiated settlement.

Amedisys will probably pay a fine, but not one that cripples the company. Health care in the U.S. is too expensive. Amedisys and its competitors help to reduce the need for hospitalizations, thus saving the health-care system a lot of money. When it comes to cost containment, I see this company as part of the solution, not part of the problem.

Legal Trouble

Amedisys had a 21 percent return on equity last year and has reported profits in 11 consecutive years. In the past five years, its earnings per share rose at a 29 percent annual clip. Yet because of its legal woes, the stock now sells for less than six times earnings.

Beckman Coulter Inc., located in Brea, California, makes laboratory instruments and supplies. For the past five years, it has sold, on average, for 18 times earnings. Today investors can buy it for 14 times earnings. The stock fell 19 percent in the third quarter, hit by a triple whammy.

In June the company received a warning letter from the U.S. Food and Drug Administration concerning failure to pre-clear one of its medical-test products. In July it announced earnings that fell short of analysts' expectations. And in September, Chief Executive Officer Scott Garrett resigned.

The circumstances surrounding Garrett's departure were unclear. The company said that his leaving was "not related to one event or issue". A search for a successor is underway. A year from now, I suspect that all three of those adverse events will be forgotten.

Disclosure note: I own shares in Amedisys personally and for clients. I have no long or short positions in the other stocks discussed in today's column.

Here's How You'll Know Bernanke's QE2 Has Failed

2010-11-10T17:09:00.001-08:00

¹²Credit Suisse: Here's How You'll Know Bernanke's QE2 Has Failed

By Business Insider | 10 November 2010

Credit Suisse actually believes that the Fed's fresh round of quantitative easing will prove far more successful than its numerous skeptics are forecasting. The firm's Andrew Garthwaite believes that if we see U.S. inflation expectations rise at a moderate rate, a yield curve with a sharp steepening point 2-3 years out, a strong rebound in auto sales, or just a stabilization of housing prices over the next year, then it will be clear that QE is working. However… here are the warnings signs of QE's failure:

Credit Suisse's Andrew Garthwaite:

If real bond yields start to rise significantly, on the back of worries about future sovereign risk or potential losses for foreign owners of US bonds due to a weaker dollar (bearing in mind 50% of US government bonds are held by overseas investors, down from 55% two years ago). We would not worry if nominal yields rise slightly as long as inflation expectations are rising more, allowing real bond yields to fall.

For now, this continues to be the case (nominal 10-year bond yields have moved to 2.7%, from their trough of 2.4% at the beginning of October). Ironically, a funding problem in the US may in part be caused by foreign central banks selling their holdings of treasuries but then this would require them to revalue their currencies against the dollar, something they are unwilling to do.

If inflation expectations start to rise meaningfully above 4% (the level at which equities have in the past started to de-rate). The irony here is that the Fed is aiming to push up inflation expectations, to engineer low real rates— however, if they are too successful in doing so, this might scare markets and lead to increased worries within the FOMC that current policy is inconsistent with the goal of price stability.

The Fed's favourite measure is the 5-year forward implied inflation rate at 2.7% (while our US fixed income strategist, Carl Lantz, believes that the 30-year breakeven inflation rate— currently 2.6%— is a more appropriate measure of inflation expectations as they are not distorted by the Fed's asset purchase program— which is concentrated in the 5-10y maturity buckets).

If the dollar fell too far. We think that ultimately QE would become unsustainable if the dollar weakened to a level that caused the Fed to worry about inflation. Each 10% off the dollar trade-weighted typically adds about 0.2% to inflation, according to our US economists, yet core inflation is currently at 0.8%, 0.7pp below the lower end of the Fed target band (1.5-2%).

Thus, technically, a further 20-25% depreciation of the dollar (10% has already happened since June) would alter the inflation outlook sufficiently for the Fed to change course (see Appendix 1 for details)— and this is without taking into account the fact that, according our models, core CPI inflation could fall to zero (given an output gap of 3.2% on OECD estimates).

If the oil price rose significantly, that would undo some of the benefits of QE. Yet, so far, the oil price has remained surprisingly subdued (it is up just 9% year-to-date— and just 4% in SDR terms).

Why The Economy Is Doing Much Better Than It Seems

2010-11-10T14:33:00.000-08:00

¹²Political Economics: Why The Economy Is Doing Much Better Than It Seems

Two percent GDP growth is nothing to write home about, but a surge in imports suggests consumers and businesses are spending.

By Brian S. Wesbury and Robert Stein | 10 November 2010

Brian S. Wesbury is chief economist and Robert Stein is senior economist at First Trust Advisors in Wheaton, Ill. They write a weekly column for Forbes and write on the First Trust Economics Blog daily. Wesbury is the author of It's Not As Bad As You Think: Why Capitalism Trumps Fear and the Economy Will Thrive.

Back in 1992 the Democrats' mantra was "It's the Economy, Stupid." The economy was recovering from the 1990-1991 recession, but job growth was slow and the unemployment rate held stubbornly in the mid-7% range. Despite real GDP growth of 4.3% in 1992, Republicans could not overcome negative feelings about the economy and lost the election to Bill Clinton.

We bring this up because we were struck by how unanimous the Republican attack on Friday's third-quarter report on GDP growth was. Republicans are using the same playbook that worked so well for the Democrats back in 1992. The first estimate of real GDP for Q3 put annualized growth at 2%.

Taken at face value, this rate of growth is not enough to create new jobs at a pace that will bring the unemployment rate down significantly. Growth also looks like it's slowing— real GDP grew at a 1.9% annual rate in Q2 and Q3 vs. a 4.4% growth rate in the previous two quarters. But this overall number masks turmoil underneath.

Quarterly GDP data go back to 1947 and never— never!— in the past 63 years has the trade deficit widened as quickly (even relative to the size of GDP) as it has in the past two quarters. And because GDP is designed to measure production inside the U.S., imports are subtracted [[from GDP: normxxx]] because they're produced elsewhere. But a surge in imports suggests U.S. consumers and businesses are spending.

But compensating for these trade flows provides us with a measure of Gross Domestic Purchases— how much stuff we buy, not how much we produce. These purchases grew at a 3.9% annual rate in Q3 after a 5.1% growth rate in Q2. In the past year domestic purchases rose 4% at an annual rate vs. a 3.6% annual rate during the same time period in 1992. That's right: The spending side of the economy is even stronger today than it was when the Democrats were berating the economy in 1992.

To be fair, some of the imports ended up in inventories. So to adjust for that, economists use a measure of final sales to domestic purchasers, a metric that rose 3.4% at an annual rate in the past two quarters. This is slightly slower than the 3.9% rate of growth in this category of spending in 1992. In other words, while a 2% growth rate in real GDP is not worth writing home about, it certainly masks an underlying strength in demand that investors should not ignore.

Political spin is ubiquitous these days. But it's important for investors to know that it's just spin. The underlying economy is doing much better than it seems.

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Rail Traffic Continues To Grow

By Pragmatic Capitalism | 10 November 2010

The recovery in rail traffic continues at a solid clip. According to the AAR total carloads grew 6.3% over 2009 while intermodal traffic jumped 14.2%. The breadth of the expansion remains healthy with 13 of the 19 commodity groups showing growth:

The Association of American Railroads (AAR) today reported that weekly rail traffic continues to gain over 2009 levels with U.S. railroads originating 292,884 carloads for the week ending Oct. 30, 2010, up 6.3 percent compared with the same week last year. AAR will no longer report 2010 weekly rail traffic with 2008 weekly comparison data since October 2008 marked the beginning of the recession-related downturn in rail traffic. Intermodal traffic for the week totaled 232,717 trailers and containers, up 14.2 percent compared with the same week a year ago, with container volume up 15.7 percent and trailer volume up 6.5 percent.

Thirteen of the 19 carload commodity groups increased from the comparable week in 2009, with significant gains in metallic ores, up 128.2 percent, and crushed stone, sand and gravel, up 27.5 percent. Commodity groups posting declines included primary forest products, down 13.4 percent, non-metallic minerals, down 9.3 percent, and grain mill products, down 7 percent.

Carload volume on Eastern railroads was down .3 percent compared with last year. In the West, carload volume was up 11.1 percent from the same week in 2009.

For the first 43 weeks of 2010, U.S. railroads reported cumulative volume of 12,324,661 carloads, up 7.3 percent from last year, and 9,364,481 trailers or containers, up 14.6 percent from the comparison week in 2009.

Source: AAR

The Feds Biggest Fear

2010-11-10T13:49:00.000-08:00

¹²The Feds Biggest Fear

By Greg Hunter, USAWatchdog | 10 November 2010

Last week's decision by the Fed to start another round of 'Quantitative Easing' was met with but one dissenting vote by the Federal Open Market Committee. That does not mean anybody in the rest of the world thinks this is a good idea. Any country holding dollars is faced with a decrease in buying power. Some of the most powerful members of the G-20 are highly critical of the Fed's money printing.

Germany, Brazil and China all made negative comments about the Fed's latest round of QE in a Bloomberg article over the weekend. It reported, "It's our problem as well if the U.S. is no longer certain that the old recipes don't work anymore," German Finance Minister Wolfgang Schaeuble said yesterday in Berlin. The Fed's injection of $600 billion was "clueless" and won't revive growth, he said.

Brazil's central bank president, Henrique Meirelles, said "excess liquidity" in the U.S. economy is creating "risks for everyone." In China, Vice Foreign Minister Cui Tiankai said "many countries are worried about the impact of the policy on their economies." He also said the U.S. "owes us some explanation on their decision on quantitative easing."

Still, Fed Chief Bernanke is unwavering in the decision to print money to revive the economy. The same Bloomberg article quoted Mr. Bernanke, "Our first objective, the first goal that we have, is to meet our mandate to get price stability and maximum employment in the United States…. A strong U.S. economy, a recovering economy, is critical not just for Americans but it's also critical for the global recovery". But the rest of the world is clearly not buying the idea that the Fed is 'saving' the world economy.

So what would make the Fed so defiant in the face of such global criticism? I think the Fed is really worried about mortgage interest rates and declining home prices. I bring out my favorite updated chart of mortgage resets for adjustable rate mortgages. The chart below shows a tsunami of resets that will not crescendo until late 2012. Study it for yourself:

Headlines: "ARM rates hit new all-time record lows!" That is precisely what the Fed wants. Lower rates are what anyone with an adjustable rate mortgage needs. Lower rates mean lower monthly payments, and that will hopefully keep people in their homes. And, if homeowners continue paying their mortgages, that will keep trillions of dollars of mortgage-backed securities from becoming even more devalued. So, the Fed has chosen to support housing prices— and let the dollar be damned— by printing money.

John Williams at Shadowstats.com says the Fed's policies are not helping the economy get better. The 151,000 jobs that were 'created' in October "were largely the result of seasonal-adjustment gimmicks," according to Williams' latest report (published last Friday). If unemployment was computed the way Bureau of Labor Statistics did it before 1994, it would actually be a stunning 22.5% (also, according to shadowstats.com).

The economy is not getting better–just the opposite, according to Williams,

"As the double-dip recession and the federal deficit and related Treasury funding horrors get worse— irrespective of today's (November 5th) happy report on payroll employment— the Fed's monetization of Treasury debt will be increased out of necessity, as part of an ongoing effort at systemic salvation."

The Fed wants to support housing prices and, thus, support mortgage bonds. If those two legs of the housing market are knocked out, the whole economy could come crashing down. In my mind, that is clearly the Fed's biggest fear.

Warning: Retirement Disaster Ahead

2010-11-09T13:15:00.000-08:00

¹²Warning: Retirement Disaster Ahead

By Brett Arends | 9 November 2010

Don't let the rally in the stock and bond markets fool you. Many Americans are still hurtling towards a retirement disaster. Few realize it. Even many of those running the big pension funds don't know. That's the conclusion of John West and Rob Arnott at Research Affiliates, an investment management firm, in Newport Beach, Calif. In their latest report, "Hope Is Not A Strategy," they have some numbers to back it up.

"I worry a lot about people reaching their golden years and discovering, 'Oh, I should've saved more,' and 'Oh, I don't qualify for Social Security any more because it's means tested'," says Mr. Arnott, a widely respected market strategist. "We're headed for a retirement train wreck, and it's going to get really ugly over the next 15 years."

Alarmist? Perhaps. But follow the math.

The returns you will get from your stock funds can only come from four things, they note: Dividends, earnings growth, inflation and changes in valuation. Right now the dividend yield on U.S. stocks is about 2.2%, they note. Historically, earnings have only grown by a surprisingly low 1% a year in real, inflation-adjusted terms.

Mr. Arnott tells me the average since 1900 is only about 1.2%, and in the last half century just 0.6%. Will we get more in the future? With the U.S. population ageing and heavily in debt? It's hard to imagine.

Throw in a 2% inflation forecast— more on this later— and Research Affiliates forecasts a long-term return of 5.2%.

What about changes in valuation? Some generations are lucky. They invest in the stock market when it's depressed and shares are cheap in relation to earnings. This was the case in the 1930s and the 1970s. Then they retire and cash out when the market is booming and shares are expensive in relation to earnings–such as in the 1960s and 1990s.

People today are not so lucky. The stock market's latest rally has lifted shares already to pretty high levels in relation to average cyclically-adjusted earnings. This so-called "Shiller PE" (named after Yale professor Robert Shiller, who popularized the notion) has been an excellent indicator of market value. Right now it's at about 22— well above its historic average of 16. The only time the market has boomed from these levels, was in the late 1990s bubble— an atypical moment unlikely to be repeated any time soon.

Now look at bonds. Thanks to the recent boom, the picture for investors here looks even worse. And there is less room for ambiguity, because bond coupons and the repayment of principal are fixed. Based on the yields of prices across all investment grade bonds, Mr. West and Mr. Arnott calculate likely long-term bond returns from here of about 2.5%. So an investor with 60% of his portfolio in stocks and 40% in bonds, a standard, if conservative, allocation, can expect a weighted average return from here of only about 4.1%.

To put this in context, they notice that the typical big pension fund is still 'expecting' to earn about 7% to 8% a year. When you strip out 2% inflation, that means pension fund managers are expecting 5-6% percent a year in real, inflation-adjusted terms. But, by Mr. West and Mr. Arnott's numbers, investors can only expect about 2.1%. Gulp.

Here's what this means for you. Someone who saves $10,000 a year for 30 years and invests the money at 5.5% a year will end up with $760,000. Someone who only manages to earn 2.5% on their investments: Just $420,000.

If you're running a pension fund, this kind of shortfall leads to a funding gap that must be made up by the plan sponsor. For a private investor trying to build their own savings, it leads to a dismal retirement. Is there any hope?

I asked Mr. Arnott about two possible sources of higher returns.

The first: Stock buybacks. Will they help? Many companies are trying to return more money to investors, on top of dividends, by buying back stock. In theory, at least, this ought to boost returns, because it reduces the number of shares, and therefore increases the value of those that remain.

But Mr. Arnott cautions against relying on it. We don't know how big these buybacks will be, and we don't know if they're sustainable, he says. Furthermore, the gains are usually offset by the issue of new stock and options to management. "Most buybacks are done to facilitate the exercise of management stock options," he says.

The second possible source of better returns: Emerging markets. Investors have been throwing money into emerging market funds recently like a hail mary pass— in perhaps a last, desperate bid to snatch a decent retirement from the jaws of defeat. But they may be substituting hope for reason.

By Mr. Arnott's math, even the most heroic calculations cannot plausibly predict that earnings growth in emerging markets will be more than a couple of percentage points faster than in developed countries. And there are plenty of people who argue it won't be markedly higher, over time, at all. Why? Where economies grow more quickly, new capital flows in. Current investors find their returns diluted by new enterprises and new stockholders.

Meanwhile, look at the valuations. Stock markets in emerging economies have skyrocketed in the past two years. Hot markets like Brazil and India have nearly recovered their 2007 manic peaks. As a result, your dividend income is even worse than in the U.S. The yield on the Indian stock market is down to about 1%, according to FactSet. Brazil has dipped below 2% and China, 1.6%.

Bottom line? Neither pension funds nor private investors seem to have fully absorbed the grim lessons of the past decade. Returns are going to be much lower. People need to save more, much more, for their retirement. If the market rally this year has given them false hope, it will have turned out to be a curse more than a blessing.

23 'Doomsayers' Who Say We're Heading Toward Depression

2010-11-09T10:57:00.000-08:00

23 'Doomsayers' Who Say We're Heading Toward Depression In 2011

By Michael Snyder | 9 November 2010

Could The World Economy Be Headed For A Depression In 2011?

As inconceivable as that may seem to a lot of people, the truth is that top economists and governmental authorities all over the globe say that the economic warning signs are there and that we need to start paying attention to them. The two primary ingredients for a depression are debt and fear, and the reality is that we have both of them in abundance in the financial world today.

Meet The New Doomsayers

In response to the global financial meltdown of 2007 and 2008, governments around the world spent unprecedented amounts of money and got into a ton of debt. All of that spending did help bail out the global banking system, but now that an increasing number of governments around the world are in need of bailouts themselves, what is going to happen? We have already seen the fear that is generated when one small little nation like Greece even hints at defaulting.

When it becomes apparent that quite a few governments around the globe cannot handle their debt burdens, what kind of shockwave is that going to send through financial markets? The truth is that we are facing the greatest sovereign debt crisis in modern history. There is no way out of this financial mess that does not include a significant amount of economic pain. When you add mountains of debt to paralyzing fear to strict austerity measures, what do you get?

What you get is deflationary pressure and financial markets that seize up. Some of the top financial authorities in the world are warning us that unless something substantial is done, that is exactly what we are going to be seeing as 2010 turns into 2011. Of course some governments around the world could try to put these economic problems off for a while by printing and borrowing even more money, but we all know by now that only makes the long-term problems even worse.

For now, however, it seems as though most governments are opting for the austerity measures that the IMF seems determined to cram down the throats of everyone. So what will austerity measures mean for the global economy? Think "stimulus" in reverse.

Yes, things are going to get messy. It looks like there is going to be a great deal of economic fear and a great deal of economic pain in 2011 and the years beyond that. So are we headed for "the depression of 2011"?

Econoday Weekly International Economic Summary

2010-11-08T15:31:00.000-08:00

¹²Econoday Weekly International Economic Summary:

Many people think that the stock market only lifts when the economy grows, but China's GDP growth rate was exceeding 10% per year when the Shanghai Stock Exchange composite index was crashing about -73% from 6124 to 1664 from October 2007 to October 2008. So don't be surprised if the US stock market indexes grow when the Fed starts to lift rates, which would constrain growth but also serve to tighten up and improve the prospects of the nation's banks. India just has raised its bank rate for the 6th time this year, and yet the Bombay Stock Exchange Sensex Index continues to soar as has the share prices of the country's leading banks, ICICI (IBN) and HDFC (HDB).

Market focus was squarely on the U.S. last week. The midterm elections Tuesday went about as expected with the Republicans winning a majority in the House of Representatives while the Democrats retained control of the Senate. Wednesday's long awaited Federal Reserve decision to begin a new round of quantitative easing (aka QE2) was greeted at first with circumspection then with glee. However, not everyone was happy about it, especially those policy makers in emerging markets who are concerned about inflows of cash.

There were a plethora of central bank meetings— the largest concentration since the first week of October 2008 when they met in emergency sessions to fight the global financial crisis. The results of last week's meetings include two interest rate increases (Reserve Banks of Australia and India), three with no policy change (European Central Bank and the Banks of England and Japan) and one that expanded its quantitative easing program (US Federal Reserve). On Thursday, the S&P 500 and Dow hit two year highs.

Elsewhere, the FTSE and DAX were at their highest since June 2008. Many analysts attributed the rally to the removal of the uncertainties surrounding the elections and the Fed. Stocks however have been supported by strong corporate profits— and possibly stronger economic growth. Policy makers in emerging market nations criticized the Federal Reserve for its decision to pump more money into the U.S. economy, a measure that they fear could escalate the worrisome influx of cash into fast-growing economies around the world.

Officials from Brazil to South Korea threatened more measures to curb the flood of money that has pushed up currency values and fueled concerns that asset price bubbles might be in the making in their countries. The unusually sharp backlash against the Fed's action underscores the divide among some of the largest economies in the world over appropriate economic policy and is likely to overshadow a gathering of leaders of the Group of 20 leading economies in Seoul at the end of the week.

The consumer sector softened in September on both the income and spending facets. Personal income in September slipped 0.1%, following a 0.4% boost in August. The headline number came in noticeably below the market consensus for a 0.3% gain. Weakness was led by a sharp drop in government unemployment insurance benefits. Also, the wages & salaries component was unchanged, following a 0.2% rise in August.

Clearly, the consumer sector decelerated in August but part— emphasis on part— of the slowing may be related to coming off strong numbers in August. But without a doubt, the government sector [[ie, primarily the states and municipalities: normxxx]] is a negative in terms of wages and unemployment benefits. The PCE price index firmed only 0.1% in September after rising 0.2% in August.

The manufacturing sector surged in October led by a burst in new orders and supported by strong employment gains. The composite headline index jumped nearly 2.5 points to 56.9. New Orders are the standout, up nearly eight points to 58.9 to indicate strong month-to-month growth for the best reading since May. Employment rose more than one point to 57.7 indicating no let up in hiring The demand for labor reflects strong production needs. Production at 62.7 is up more than six points and, like new orders, is at its best level since May.

While the consumer sector may be slowing, we are seeing improvement in construction and manufacturing. Construction spending rebounded in September, gaining 0.5% after a 0.2% dip the month before. The median market forecast called for a 0.5% decline. The boost in September was led by a 1.8% increase in private residential outlays, following a 4.2% decline in August.

These numbers reflect recent improvement in housing starts. In contrast, private nonresidential spending fell 1.6% in September, following a 0.8% increase the prior month. While not a huge drag on the economy, businesses simply are not at a high enough rate of utilization to want to boost expansion through new construction of facilities. Overall, economic news is net positive and earnings reports are favorable.

Factory inventories rose 0.7% in line with the gains underway for orders. Shipments rose 0.4% while unfilled orders, in an especially healthy sign, rose 1.0% A key reading in the report is a 0.4% rise for new orders excluding transportation, offering a baseline view of progress. The factory sector is beginning to pick up new steam and is re-exerting its leadership for the economy.

The bulk of the economy picked up steam in October according to the ISM's non-manufacturing index which rose 1.1 points in October to 54.3. New orders show special monthly acceleration, at a 56.7 level for a nearly two point gain. Backlogs orders moved back over 50 at 52.0 to indicate a month-to-month build. Rising orders and rising backlogs point squarely at rising employment.

Taken together, the FOMC Desk anticipates conducting $850 billion to $900 billion of purchases of longer-term Treasury securities through the end of the second quarter. This would result in an average purchase pace of roughly $110 billion per month, representing about $75 billion per month associated with additional purchases and roughly $35 billion per month associated with 'reinvestment' purchases. Purchases of nominal coupon Treasury securities will be in the range of 1.5 years through 30 years, although most will be in the 2.5 years to 10 years range. The New York Fed anticipates that the assets purchased will have an average duration of between 5 and 6 years.

The favorable productivity and cost numbers were largely due to an improvement in output growth. Compensation actually rose modestly. Businesses need to see a boost in production to see this pattern continue. But for now, the overall news is good. However, the numbers are tempered a little by a bump up in initial jobless claims.

The employment index has been stubbornly slow, inching seven tenths higher to 50.9 to indicate only mild month-to-month hiring for October. But, this report is positive, indicating that prior and once again accelerating gains in the manufacturing sector are now spilling into the non-manufacturing sector. Payroll jobs finally returned to positive territory as the impact of layoffs of temporary Census workers has dwindled and the private sector is strengthening. Payroll employment in October rebounded 151,000, following a revised 41,000 decline in September and a 1,000 decrease in August.

The October gain came in higher than analysts' projection for a 60,000 increase. The August and September revisions were net up 110,000 Private nonfarm employment posted another gain, advancing 159,000 in October, following a revised boost of 107,000 in September. The consensus called for an 85,000 boost for private payrolls. The average workweek for all workers edged up to 34.3 hours from 34.2 hours in October, marginally topping expectations for 34.2 hours….

For only the second time in the last 20 months consumer credit shows a monthly increase, up $2.1 billion in September. If August, at $2.41 trillion, remains the cycle low after revisions, the peak-to-trough decline from the July 2008 peak of $2.58 trillion will be 6.6% September's gain is due solely to a $10.4 billion rise in non-revolving credit, a component boosted by strong auto sales. Revolving credit, reflecting the move away from credit cards, contracted $8.3 billion during September.

Initial jobless claims for the October 30 week rose 20,000 to 457,000. The latest report offset the prior week's dip of 18,000. The swings focus attention on the four-week average which rose a mild 2,000 to 456,000 for a slight improvement from the month-ago readings. Continuing claims extended their decline, down 42,000 to 4.340 million in the October 23 week with the four-week average down 43,000 to 4.411 million.

The U.S. international trade gap increased sharply in August to $46.3 billion from $42.3 billion the prior month. Exports edged up a modest 0.2%, following a 2.0% gain in July. Imports rebounded 2.1%, following a 2.1% decline in July. The worsening in the trade gap was primarily in the nonpetroleum deficit which grew to $35.9 billion in August from $33.2 billion the previous month.

The Reuter's/University of Michigan's Consumer sentiment index for the final October reading came in at 67.7 just below mid-October's 67.9 and compared to 68.2 for final September. The October figure is the weakest of the year but at least moderately above recession readings in the 50s.

Fed Bond Move Spurs Backlash From Asia To Europe

2010-11-07T14:47:00.000-08:00

¹²Fed Bond Move Spurs Backlash From Asia To Europe

By The Associated Press | 7 November 2010

China's central bank chief Zhou Xiaochuan speaks at a business conference in Beijing, China, Friday, Nov. 5, 2010.

China, Germany and Brazil warned the Federal Reserve's move to inject money into the U.S. economy might harm the rest of the world, though Beijing said Friday the tactic was understandable because of the slow recovery. China's central bank chief Zhou said the debate about the Fed's attempt to spur growth by pumping $600 billion into the economy through purchases of Treasury bonds highlighted the need to reform the global financial system. Some governments worry the tactic, which will lower interest rates and is known as quantitative easing, might send money flooding into their markets seeking higher returns. That could push up exchange rates, hurting exports by making their goods more expensive.

The conflict might hamper efforts to fix strains in the global economy at next week's Group of 20 summit in Seoul. Leaders from the United States, Japan, Germany, China and other governments that account for 85 percent of the global economy hope to make progress on reducing trade and current account gaps. Some nations such as the U.S. buy far more than they sell to the rest of world while many developing countries including China run vast surpluses.

"If the domestic policy is optimal policy for the United States alone, but at the same time it is not an optimal policy for the world, it may bring a lot of negative impact to the world. There is a spillover," said Zhou Xiaochuan, governor of the People's Bank of China, speaking at a business conference. "We have to solve this problem by reforming the international currency system," he said, without giving details of possible reforms.

The Fed said it will make Treasury bill purchases over eight months in an effort to lower long-term interest rates and revive economic activity.

Germany Joins In The Criticism

"I don't think the Americans will solve their problems with this and I think they are creating extra problems for the world," Finance Minister Wolfgang Schaeuble told ARD television late Thursday. Brazil's finance minister, Guido Mantega, also criticized the Fed, saying Thursday its move would devalue the dollar and hurt Brazil and other exporters. He said bond-buying would not be effective without changes to stimulate domestic consumption.

Zhou said he understood the Fed's focus was on the U.S. economy and helping to create jobs while keeping inflation low.

"We have a slower recovery of the economy, high unemployment and low inflation. Under these circumstances, from that perspective, when we have a policy for a very low rate that is very close to zero, and for quantitative easing, it is reasonable. We can understand under current circumstances, of course," said Zhou. He was speaking at a conference organized by Caixin, a leading Chinese business magazine.

Zhou said Chinese central bank officials met regularly with their Fed counterparts, including Chairman Ben Bernanke, and the Americans gave detailed explanations for the monetary changes. Also Friday, a Chinese diplomat said Washington should act responsibly and give other governments a thorough explanation. "The international community has every reason to feel worried, so the U.S. side owes it a proper explanation for the move," Vice Foreign Minister Cui Tiankai told reporters.

The Philippine central bank said Thursday it would "remain vigilant" about the possible impact of the Fed's action. A bank deputy governor warned the money flows from the Fed's move might add to instability in emerging markets. Zhou said Beijing's controls on capital flows should shield China from a possible surge in speculative "hot money" triggered by the Fed's move.

Beijing keeps its financial markets isolated from global capital and tightly controls the exchange rate of its yuan, which has risen more slowly against the U.S. dollar than some Asian currencies such as the Thai baht. Zhou defended Beijing's decision to move gradually in easing currency controls despite U.S. and other foreign pressure to let the yuan rise faster. Beijing promised a more flexible exchange rate in June and has allowed the yuan to rise by 2.5 percent since then— far less than critics want. They say Beijing's controls keep the yuan undervalued and give China's exporters an unfair price advantage, swelling its trade surplus and costing jobs abroad.

Comparing policy changes to the multiple ingredients used to make traditional Chinese medications, Zhou said currency changes were part of a package of reforms including encouraging domestic consumer spending that would boost imports and narrow China's trade gap. "We do not want to emphasize that one ingredient will deliver a cure," he said.

Be Careful What You Wish For

2010-11-04T22:27:00.000-07:00

¹²Be Careful What You Wish For

By John Mauldin | October 29, 2010

It's Softer Than It Looks
Not Finer for the "99er"
Be Careful What You Wish For

People only accept change when they are faced with necessity, and only recognize necessity when a crisis is upon them…. — Jean Monnet, father of the European Union

This week we turn our attention to the elections and their aftermath. Long-time readers know I am a Republican, but I offer some sobering advice to my friends on my side of the aisle: Be careful what you wish for. It's one thing to get a few votes. It's quite another to live up to promises that simply can't be kept. We will start our analysis by looking at the GDP numbers that came out today, and we will end by pointing out that there will be no easy choices.

It's Softer Than It Looks

The GDP number came in at a rather soft 2% growth, up slightly from last quarter's 1.7%. From the standpoint of creating new jobs, 2% just doesn't cut it. We need about 100,000 - 125,000 new jobs a month just to keep up with population growth, and a 2% GDP will not give us half that, as we saw last quarter. Most economists say you need about 3.5% GDP growth to get solid job reports.

And the prospect for getting that robust a number any time soon is not looking good, as the soft number mentioned above looks even softer when you delve into the details. 70% of the total growth in GDP came from growth in inventories, up by over 40% from the second quarter. Now normally a build in inventories is a positive, as it shows confidence on the part of businesses. But business confidence surveys have not been all that good, which suggests that businesses may be cautious, as this cycle does not seem to resemble past cycles. How likely are we to see that same type of growth in inventories in the last quarter? Not very, I think.

Sidebar: For the non-geek reader, when inventories are increasing, that is a "plus" for GDP. When those inventories are sold, that reduces GDP. That may seem backwards, but that is just the way the math works. So if inventories are 'sold' in the 4th quarter (think Christmas sales), that will be a drag on the GDP numbers.

In every previous post-recession cycle, GDP growth would typically be around 5% at this time. But this is not a business-cycle recession; it's a deleveraging, credit-crisis recession. Thankfully, those do not show up all that often, but sadly one has come home to roost in much of the developed world this decade. The aftermath of credit-crisis recession is a slow growth period of 6-8 years, punctuated by more volatility and more frequent recessions.

What economists call the "final sales" portion of GDP has just been growing at less than 1% over the last 18 months. That is a lukewarm number, to say the least. That is not the stuff of a strong GDP.

And export growth is slowing, which rather surprises me, as the dollar has been weaker. If imports rise and exports do not rise as much, as has been the case, that is a drag on GDP. State and local governments reduced GDP by 0.2%, and this 12% of the economy is likely to be under continued pressure, not adding to GDP for quite some time.

It would not surprise me to see GDP growth be closer to 1% in the 4th quarter, unless we start to see evidence of more inventory building. That is not good for jobs, personal income, tax collections needed to cover deficits at all levels, or consumer confidence. My worry is, what if we get some kind of shock to our economic body when growth is so anemic?

Not Finer for the "99er"

I had dinner last Sunday night with David Rosenberg. He is beginning to look at the possible effects from what he calls the "99ers" going off extended unemployment benefits. I knew this was coming but had not really looked into the fine print. He wrote me later:

"The looming expiry of the emergency unemployment benefits in the U.S. poses a very large risk to aggregate personal income over the next few quarters. Currently, combined with state programs, someone who loses their job is entitled to 99 weeks of unemployment benefits (a "99er"). However, the extended benefits are set to expire on November 30th, and our back-of-the-envelope calculations shows nearly a million 99ers will be cut off in December alone, with the remainder (about 3 to 4 million) falling off the rolls by April.

"Given that the average weekly unemployment cheque is about $300/week, this amounts to nearly $80 billion (annualized) loss of aggregate income over the next few quarters. This means that personal income could fall by 1.0% QoQ annualized for each of the next three quarters, starting in Q4. The 2% QoQ real GDP estimates pencilled in for Q4 2010 to Q2 2011, will look far too optimistic if such a loss of income does occur. Given that material downside risk to growth going forward, we intend to do more detective work on this file."

Government checks of one form or another are about 20% of total personal income in the US. Will the lame-duck Congress extend those benefits? Will they extend the Bush tax cuts? I just (literally) got off the phone with Suze Orman. She said she thinks they should raise the limit to $500,000 or $1 million. That higher number would be a reasonable compromise, in my humble opinion. Will the Republican Congress and Senate agree when they come back?

I don't want to get into the small-business person making $300,000 and living in a very volatile business climate where they feel the need to save rather than invest and create new jobs. These guys need all the working capital they can get. And let's be clear, this year's "profits" becomes next year's working capital when you are a small business owner. Your credit line at the bank just isn't cutting it anymore.

Be Careful What You Wish For

Everyone by now is predicting the Republicans to take the House and pick up anywhere from 6-8 Senate seats. We'll see. This is going to be a very interesting election, as there is a whole new dynamic in place. Let's look down the road. I think we will at best be in a Muddle Through Economy for the next two years.

Unemployment is going to be above 8%, best-case, in 2012. If the Bush tax cuts are not extended, in my opinion it is almost a lock that we go into recession next year, unemployment goes to 12%, and underemployment gets even worse. That is not a good climate for Obama and the Democrats in 2012. It is especially bad when you look at the number of Democratic Senate seats up for re-election that are in conservative states. The Republicans could take a serious majority in the Senate.

And then what? Right now Republicans are running on promises that they will not cut Medicare and Social Security, but are going to reduce spending and get us closer to a balanced budget. But everyone knows that the only way to get the budget into some reasonable semblance of balance will be to either cut Medicare benefits or increase taxes. There are only the two options.

Yes, you can reform medical care, and I think much of Obamacare should certainly be repealed, but that does not get us anywhere close to dealing with the real issue, and that's a fact. There are tens of trillions of unfunded liabilities in our future, which must be dealt with. Let me be very clear on this.

I am not really worried about the supposed $75 trillion in unfunded Medicare liabilities in our future. That is an impossible number. If something can't happen it won't happen. Long before we get to that apocalypse, we find a bond market that simply refuses to fund US debt at anywhere near an affordable cost. Crisis and chaos will ensue. Remember the quote that led this letter?

People only accept change when they are faced with necessity, and only recognize necessity when a crisis is upon them.. — Jean Monnet, father of the European Union

The simple reality is that if We the People of the US want Medicare, in even a reformed and more efficient manner, we must find a way to pay for it. It will not be cheap. Raising income taxes on the "rich" is not enough. You have to go back and raise income taxes on the middle class, too. Oh, wait, that will be a drag on the economy and consumer spending. And in any event it will not be enough.

The only real way to pay for those benefits will be a value-added tax, or VAT. And while it could be introduced gradually, let there be no mistake that it will be a drag on economic growth. Government spending does not have a multiplier effect on the economy. It is at best neutral. What creates growth is private investment, increases in productivity, and increases in population. That's it. Tax increases have a negative multiplier.

A significant VAT along with our current income taxes will give us an economy that looks more like the slow-growth, high-unemployment world of Europe. Can we figure out how to deal with that? Sure. But it is not growth-neutral.

Republicans in 2013 will be like the dog that caught the car. What do you do with it? The last time they (embarrassingly, we) really screwed it up. The defining political question of this decade will not be Iraq or Afghanistan, or the environment or any of a host of other problems.

The single most important question will be what do you do with Medicare? Cut it or fund it? Reform it for sure, but reform is not enough to pay for the cost increases that will come from an increasingly aging Boomer generation. There is no free lunch.

At some point, you cannot run on "no cuts in Medicare" and "no new taxes" and be honest. At least not this decade. Maybe when we have cured cancer and Alzheimer's and heart disease and the common cold at some future point, medical costs will go down, but in the meantime we have to deal with reality. You may be able to fool the voters, but you will not be able to fool the bond market. Not dealing with reality will create a very vicious response. Ask Greece.

And that is the national conversation we must have with ourselves. There is a cost to government. There is a cost to extended Medicare benefits. (I am blithely assuming we deal with all the "easy" stuff like Social Security, and make real cuts in other areas.)

And for my international readers, this is an issue that the entire developed world must deal with. We all have our problems created from years of very poor choices, overleveraging, and deficits. It will not be easy. I must admit to smiling when I see the protests in France over raising the retirement age from 60 to 62. Really? Amazing.

And while France causes me to smile and shake my head, the refusal on the part of the US leadership to give more than lip service to solutions that might disrupt their slim majority of voters is maddening. This election next week will change very little in real terms, the things that matter, like whether the US economy can grow or will face a very real crisis and a true depression. That potential is in our future, and it is coming at us faster than you think.

I will spend the next four long days with co-author Jonathan Tepper of Variant Perception, finalizing our book, The Endgame, which will be out early next year from Wiley. I intend to have the book finished about then. It will be good to have this two-ton gorilla off my back.

The book will deal with the realities we face all over the world. We are trying to write a book that even politicians can understand. The choices we face are not fun, and not without costs, but to avoid making them means that we really do drive the car into the ditch. My bet? We figure out how to Muddle Through. Maybe that makes me a Pollyanna, but I think that here in the US we will get through. The choices are tougher if you are Greece or Spain. But even then, individual responsibility must take over.

The Scary Actual U.S. Government Debt

2010-11-03T12:51:00.000-07:00

Economy Is Running Out Of Gas
Recession Lurking With Demand Still Weak

By Rex Nutting, Marketwatch | 3 November 2010

WASHINGTON (MarketWatch)— The U.S. economy is in danger of sliding back into another recession, even before we're fully recovered from the last one. There's nothing surprising about the economic outlook. We know from reading our history that it takes a long time to recover from credit bubbles, but we've become impatient, expecting trends that evolved over decades to reverse themselves quickly. We want the economy to fix itself, right now!

But it won't. The economy is slowly readjusting and rebalancing, but in the meantime it's also suffering from a lack of demand to keep everyone employed. The federal government has taken on a lot of debt, but it's mostly offset deleveraging in the rest of the economy.

Our political system tried some half measures to keep demand up, but has apparently given up on even those. The economy is running out of gas, and there's no fueling station in sight. Consumers are still hunkered down, and without further growth in consumer spending, businesses won't have the profits they need to justify expanding their companies. Housing is still dead. Exports are benefiting from a weaker dollar (DXY), but foreign markets aren't expanding as fast as they once were.

Forever Blowing Bubbles

The Fed has been inflating asset prices as part of policy since at least the mid-1990s. The 'wealth effect' is the primary indicated mechanism: make people 'richer' and they'll spend more. So QE is there primarily to goose asset markets. But this'll end badly. And the next time the Fed won't have any silver bullets left to kill recession.

And you can forget about any increased demand from the government. Add it all up and you have to wonder: where is the growth going to come from? Despite this gloomy assessment, few economists are predicting an outright recession, just very slow growth.

Levy Forecasts Recession

One exception is David Levy, chairman of the Jerome Levy Forecasting Center, who looks at the economy from the unusual perspective of profits, not gross domestic product. Levy says he sees "domestic profits eroding, corporate earnings becoming increasingly disappointing, and a 60% chance of a recession in 2011". Read more about the Levy Forecast.

Broadly speaking, a 'recession' is a period of contraction in economic activity, usually associated with job losses, reduced output and reduced sales. By that definition, the economy began to recover from the recession in July 2009. Since then, GDP has grown about 3.5%, but employment is still down about 400,000.

Levy doesn't use the typical economic models, which might be why he was one of the few who accurately predicted the housing bubble and the 2008 recession. Instead, he focuses on flows of funds through the economy, especially the flows that lead to profits, which play a central role in business cycles.

Betting On A 317-Year Pattern

2010-11-01T15:32:00.000-07:00

Betting On A 317-Year Pattern
Today is start of 6-month seasonally favorable period

By Mark Hulbert, Marketwatch | 1 November 2010

CHAPEL HILL, N.C. (MarketWatch)— Did you sell in May and go away?

If so, and you're a follower of the seasonal pattern known as the Halloween Indicator, now is the time to get back into the stock market. But how strong is this pattern, really? How can we know for sure that it genuinely exists, and is not just a statistical fluke?

Those are the right questions that investors should be asking. Fortunately, just in time for Halloween and the beginning of the six-month seasonally favorable period, a new academic study has begun circulating with lots of data to help answer those questions. The study, "Are Monthly Seasonals Real? A Three Century Perspective," was written by Ben Jacobsen, a finance professor at Massey University in New Zealand, and Cherry Zhang, a Ph.D. student at the same institution.

The researchers carefully analyzed monthly returns for the U.K. stock market back to 1693, more than 300 years ago, looking for evidence of any seasonal patterns— not just the Halloween Indicator. Of all the well-known patterns— including the most famous of all, the so-called January Effect— the Halloween Indicator is the only one that persisted throughout the three-century sample. To be sure, they didn't find that the Halloween Indicator existed in each and every year. But that's hardly surprising, since no indicator works all the time.

But over progressively longer horizons, the success rate grew to very impressive and consistent levels. It beat the market in 71% of all two-year periods since 1693, and 82% of five-year periods. When the researchers focused on 10-year periods, they found that the strategy beat the market 92% of the time.

Consider the strategy's performance in the U.S. in recent years. According to the Hulbert Financial Digest, you would have beaten a buy-and-hold by 3.6 percentage points per year over the last five years if you had invested in riskless Treasury bills from May Day through Halloween and been 100% invested in stocks the other six months of the year. As always, however, the usual caveats apply: There are no guarantees. Even if this new study helps to convince you that the Halloween Indicator is the Real Deal, you still don't have any assurance that the future will be like the past.

And even if the future is like the past, you need to be prepared for the strategy failing in individual years. The most recent failure in the U.S. came during the recent bear market: From Halloween 2008 to May Day 2009, the Dow Jones Industrial Average (DJIA) fell 12.4%. But, especially when compared to almost all other popular indicators, which have no statistical significance whatsoever, it's comforting to come across one that's been working for more than 300 years.

Insider Selling Volume At Highest Level Ever Tracked

2010-11-01T14:58:00.000-07:00

Insider Selling Volume At Highest Level Ever Tracked

By John Melloy | 26 October 2010

The overwhelming volume of sell transactions relative to buy transactions by company insiders over the last six months in key leading sectors of the market is the worst Alan Newman, has ever seen since he began tracking the data. The editor of the Crosscurrents newsletter looked at insider trading activity amongst the top ten companies that make up the Nasdaq such as Apple [AAPL], Google [GOOG] and Amazon [AMZN]. Then he analyzed the biggest members of the Retail HOLDRs ETF like Gap [GPS], Target [TGT] and Costco [COST], as well as the top insiders in the semiconductor industry at companies such as Altera [ALTR], Broadcom [BRCM] and Sandisk [SNDK].

The largest companies in three of the most important leading sectors of the market have seen their executives classified as 'insiders' sell more than 120 million shares of stock over the last six months. Top executives at these very same companies bought just 38,000 shares over that same time period, making for an eye-popping sell to buy ratio of 3,177 to one. The grand total for the three sectors are "as awful as we have ever seen since we began doing this exercise years ago," said Newman, who was ahead on such trends as the dangers of high-frequency trading and ETFs before the 'Flash Crash'. "Clearly, insiders are seeing great value only in cash. Their actions speak volumes for the veracity for the current rally."

But the overall market doesn't seem to care. The S&P 500 is up 16 percent since its 2010 low hit on July 2nd on the back of strong earnings driven by cost-cutting and the hopes for even more quantitative easing from the Federal Reserve. The insider data "is good reason for considerable caution once the price action fades," said Simon Baker, CEO of Baker Asset Management. Still "insiders normally buy early and sell early too [[§othey traditionally sell into rising markets and buy into falling markets, on a proportionally increasing scale§c: normxxx]]. Longer term— 12 months out— it is more of a red flag."

Newman isn't alone in warning about insider selling. The latest report from Vickers Weekly Insider, a publication that makes investments based upon these transactions, shows that total insider sell transactions relative to purchases on the New York Stock Exchange are running at a ratio of more than four to one over the last eight weeks. The 'normal' reading, because of options selling and other factors, is about two to one, or two sales for every buy, according to Vickers.

To be sure, many investors feel the heavy insider selling is just an anomaly based on other reasons. "These are folks that have had to dip into their stocks for the first time in years, as their salaries have been cut and their bonuses, outside Wall Street, have been significantly curtailed," said J.J. Kinahan, chief derivatives strategist for TD Ameritrade. "This may speak more to a cash flow problem, then a market belief."

Still, Newman, who is also a favorite commentator of Barron's columnist Alan Abelson, sees the insider selling as just the latest reason to be cautious on the market— along with other reasons such as the mortgage foreclosure mess and fully invested mutual fund managers with no fresh powder to put to work. "At the risk of sounding like a broken record, we expect a significant correction," said the newsletter editor.

ß§

Normxxx
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The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Mortgage Mess: Shredding The Dream

2010-11-01T13:46:00.000-07:00

¹²Mortgage Mess: Shredding The Dream

The foreclosure crisis isn't just about lost documents. It's about trust— and a clash over who gets stuck with $1.1 trillion in losses

By Peter Coy, Paul M. Barrett and Chad Terhune | 25 October 2010
Coy is Bloomberg Businessweek's Economics editor. Barrett is an assistant managing editor at Bloomberg Businessweek. Terhune is a senior writer for BusinessWeek based in Florida.

Joseph Lents hasn't paid his mortgage Ofer Wolberger

In 2002, a Boca Raton (Fla.) accountant named Joseph Lents was accused of securities law violations by the Securities and Exchange Commission. Lents, who was chief executive officer of a now-defunct voice-recognition software company, had sold shares in the publicly traded company without filing the proper forms. Facing a little over $100,000 in fines and fees, and with his assets frozen by the SEC, Lents stopped making payments on his $1.5 million mortgage.

The loan servicer, Washington Mutual, tried to foreclose on his home in 2003 but was never able to produce Lents' promissory note, so the state circuit court for Palm Beach County dismissed the case. Next, the buyer of the loan, DLJ Mortgage Capital, stepped in with another foreclosure proceeding. DLJ claimed to have lost the promissory note in interoffice mail. Lents was dubious: "When you say you lose a $1.5 million negotiable instrument— that doesn't happen". DLJ claimed that its word was as good as paper. But at least in Palm Beach County, paper still rules. If his mortgage holder couldn't prove it held his mortgage, it couldn't foreclose.

Eight years after defaulting, Lents still hasn't made a payment or been forced out of his house. DLJ, whose parent, Credit Suisse, declined to comment for this story, still hasn't proved its ownership to the satisfaction of the court. Lents' debt has grown to about $2.5 million, including unpaid taxes, interest, and penalties. As the stalemate grinds on, Lents has the comfort of knowing he's no longer alone. When he began demanding to see the I.O.U., he says, "I was looked upon like I had leprosy. Now, I have probably 20 to 30 people a month come to me" asking for advice. Lents is irked when people accuse him of exploiting a loophole. "It's not a loophole," he says. "It's the law."

The Lents Defense, as it might be called, doesn't work everywhere. Thousands of Floridians have lost their homes in lightning-fast "rocket dockets". In 27 other states, judges don't even review foreclosures, making it harder for homeowners to fight back. Now, though, allegations of carelessness and outright fraud in foreclosures has become so widespread that attorneys general in all 50 states are investigating. So are the feds.

Even if the documentation problems turn out to be manageable— as Bank of America (BAC) and others insist they will be— the economy will still suffer long-term consequences from the loose underwriting that caused the subprime housing bubble. According to an Oct. 15 report by J.P. Morgan (JPM) Securities, some $2 trillion of the $6 trillion in U.S. mortgages and home-equity loans that were securitized during the height of the bubble, from 2005 through 2007, are likely to go into default. The report says the housing bust will ultimately cause losses of $1.1 trillion on those bonds.

While banks and investors take their hits, millions of homeowners continue to be punished by unaffordable mortgage payments and underwater home values. Laurie Goodman, a mortgage analyst at Amherst Securities Group, said in an Oct. 1 report that if government doesn't step up its intervention, over 11 million borrowers are in danger of losing their homes. That's one in five people with a mortgage. "Politically," she wrote, "this cannot happen. The government will attempt successive modification plans until something works."

Wall Street's unspoken strategy has been to kick mortgage losses down the road until an economic recovery reinflates the housing market. The faulty-foreclosure crisis has forced the issue back into the present tense, triggering a fight over who will bear the brunt of those losses. The combatants— all of whom are trying to minimize their share of the damage— include homeowners, lenders and mortgage brokers, loan servicers and the underwriters of mortgage-backed securities, the buyers of those securities, title insurers, rating firms, and the federally controlled mortgage buyers Fannie Mae (FNM) and Freddie Mac (FRD).

J.P. Morgan predicts that bondholders will absorb most of the estimated $1.1 trillion loss— but may succeed in foisting about $55 billion on banks. If the bank losses turn out to be steeper than J.P. Morgan and most other analysts expect, taxpayers may be asked to inject more capital into the financial institutions. Fannie Mae and Freddie Mac, already wards of the state, might require more capital as well.

The last five years of rising foreclosures, to the highest rate since the Great Depression, have exposed the carelessness with which banks lent money. The banks figured they could always seize ownership and resell at a profit, assuming they hadn't already dumped the loan on an unwary investor. And they wouldn't let 'technicalities' impede the process. The website 4closurefraud.com, which is operated by the Carol C. Asbury Save My Home Law Group, has links to documents from Nassau County, N.Y., in which someone entered "BOGUS" as the grantee for the mortgage— i.e., the party entitled to foreclose.

During the housing boom, transactions were flowing so fast that banks couldn't keep up with the paperwork. The mortgage industry depended on a digital overlay of its own invention, Mortgage Electronic Registration Systems (MERS), a database owned by Fannie Mae, Freddie Mac, Bank of America, CitiMortgage, Chase Home Mortgage, Wells Fargo, and others, including title insurers. No matter who bought the loan, MERS was purported to be the mortgagee— i.e., the party that would foreclose if a borrower stopped paying. Ridiculous? Of all newly issued U.S. mortgages, 60 percent list MERS— a unit of Reston (Va.)-based MERSCorp that has no employees of its own— as the mortgagee. "It's a total attack on the public system," says Christopher L. Peterson, a law professor at the University of Utah who has consulted in cases against MERS.

As MERS sped up loan processing, it created a giant legal hairball. According to Peterson, state judges in Kansas, Arkansas, and Maine have said that MERS has no standing in foreclosure proceedings under their states' laws if they can't produce the promissory note. In early October a federal judge in Oregon blocked Bank of America as trustee from foreclosing on a home in the MERS system. (MERS spokeswoman Karmela Lejarde says its standing has always been upheld, "either in the initial court proceeding or upon appeal".) Judges also resent that would-be foreclosers show up in court representing themselves as vice-presidents of MERS even though they work for various loan servicers. Fixing the paperwork won't be easy because many of the notes have been lost or even deliberately shredded. The Florida Bankers Assn. told the state Supreme Court last year that in many cases "the physical document was deliberately eliminated to avoid confusion immediately upon its conversion to an electronic file."

As staggering as the projected stakes are in the housing crisis, at least you can put a number on them. What's incalculable is the psychic cost of a legal system that may well have let banks skirt the law. "The whole financial system is becoming a lot less transparent," says Hernando de Soto, a Peruvian economist who has written on the importance of well-defined property rights. "You can't size up risk anymore."

"We are killing our competition"! says Greg Whitworth. It's a perfect October day on the Jacksonville, Fla., campus of Lender Processing Services (LPS), and Whitworth, a division president, is rallying a crowd of 200 employees inside a big white tent on the sun-drenched banks of the St. Johns River. The company is celebrating what it calls "the Year of the Megas"— key customers Bank of America, Wells Fargo (WFC), and JPMorgan Chase— with a picnic of Mediterranean chicken salad, lemon cooler cookies, and sweet tea.

LPS is America's biggest mortgage-and-foreclosure outsourcing firm. Last year its revenue from default services climbed to $1.1 billion; its nearest rival, Santa Ana (Calif.)-based CoreLogic (CLGX), takes in less than half of that. One gray patch hovers over the celebration: The back-office technology provider's runaway success means it is tangled up in the foreclosure crisis. "I was thinking about the dark clouds over the company," Joe Nackashi, the chief information officer, tells the crowd. "Sure, we have made mistakes. But I don't want to let that cloud this day."

LPS supplies much of the digital plumbing for the convoluted home-finance system. At the start of 2010 it said its computer programs were handling 28 million loans with a total principal balance of more than $4.7 trillion— or more than half the nation's outstanding mortgage balances. With 8,900 employees and total revenue of $2.4 billion, it sells software and manpower to most of the largest U.S. lenders and loan servicers. "The banks were not prepared for this volume of foreclosures, and that has played to the company's advantage as the outsourcer," says Brett Horn, associate director of equity research at Morningstar (MORN).

Consider for a moment the mountains of paper that a buyer signs at closing. The industry uses LPS computer programs and sometimes LPS employees to code, store, and transfer many of these records. When things work smoothly, mortgage servicers rely on LPS software to help monitor payments. When homeowners fall behind, LPS helps assemble the information needed to foreclose.

The business has a fast metabolism; as described in an in-house newsletter published in September 2006 by Fidelity National Foreclosure Solutions, a predecessor of LPS, a single 18-person "document execution" team brings Henry Ford's mass-production techniques to the foreclosure business. "The document execution team is set up like a production line, ensuring that each document request is resolved within 24 hours," the newsletter said. "On average, the team will execute 1,000 documents per day". That was four years ago, when the foreclosure rate was a quarter what it is now.

It was when some of those documents proved difficult to track down that trouble set in. If a foreclosure lawyer working on behalf of a bank or servicer asked LPS for an errant mortgage, for example, some company workers may have gone to extremes to keep the foreclosure assembly line moving, according to prosecutors and plaintiffs' lawyers. The Florida attorney general's office has alleged that in some cases, corners may have been cut, signatures forged, documents backdated. Industry employees have said in sworn depositions that "robo-signers" executed paperwork without reviewing it.

The U.S. Attorney's Office in Tampa and the state of Florida are investigating whether LPS and affiliated companies have fabricated documents and faked signatures. LPS employees "seem to be creating and manufacturing 'bogus assignments' of mortgage in order that foreclosures may go through more quickly and efficiently," the Florida Attorney General's Office says in an online description of its civil investigation. "We're concerned that people might be put out of their houses unfairly and unjustly," Bill McCollum, the attorney general, told Bloomberg Businessweek.

In a third investigation, the U.S. Trustee Program, the branch of the Justice Dept. that polices bankruptcies, is looking into whether LPS is "improperly directing legal action" to hasten foreclosures, according to a 2009 opinion issued by the bankruptcy court in Philadelphia. A Trustee spokeswoman declined to comment.

On Sept. 29, U.S. Representative Alan Grayson (D-Fla.) denounced LPS on the House floor. "The system is so organized that there is a company, Lender Processing Services, who allegedly has created the means to systemize fraud," he said. Foreclosure-defense lawyers have filed suit against LPS in Mississippi and Kentucky, seeking class-action status and accusing the company of improperly splitting fees with pro-foreclosure lawyers. LPS shares have fallen sharply on the New York Stock Exchange and as of Oct. 20 were down 33 percent for the year.

LPS executives acknowledge slip-ups, but nothing amounting to fraud. In a federal securities filing in February, the company said it had "identified a business process that caused an error in the notarization of certain documents, some of which were used in foreclosure proceedings". LPS says it fixed the problem and closed the subsidiary in Georgia where it occurred.

As for the processing team described in the in-house newsletter, LPS spokeswoman Michelle Kersch says the company decided such affidavit-execution services were "not an appropriate use of resources," and ended them in September 2008. Still, she adds, LPS "signs a limited number of documents for clients," including assignments of mortgage. "We are dealing with sensationalism vs. facts," Jeffrey S. Carbiener, the company's chief executive officer, told analysts in an Oct. 6 conference call.

"Isolated instances of errors" are bound to occur, but they "are now being brought out and pointed back to that robo-signing, making it sound like a large percentage of these transactions are invalid. That is just simply not the case." He called the class-action suits "fishing expeditions."

To keep the paperwork moving, LPS uses a variety of incentives. Top-performing workers receive monthLY "Drive for Pride" awards that sometimes include $500 in company stock and a spot in an underground parking garage. LPS also devised a coding system to grade outside foreclosure attorneys based on their speed in completing tasks.

Fast-acting attorneys receive green ratings; slower lawyers are labeled yellow or red and may receive fewer assignments. "Bill will move quickly and expect you to be there to pull your weight," says Jerry Mallot, executive vice-president of the Jacksonville Regional Chamber of Commerce. "I wouldn't call the environment at his company kind and genteel."

Bill is William P. Foley II, a 65-year-old West Point graduate, real estate lawyer, and wealthy vintner. He made a fortune assembling the country's largest title-insurance company, beginning with his purchase in 1984 of Fidelity National Title. By 2003, Fidelity National, then based in Santa Barbara, Calif., had $10 billion in annual revenue and 32 percent of the U.S. title-insurance market.

Frustrated by the high cost of operating in California, Foley was convinced by Mallot and then-Florida Governor Jeb Bush, an occasional golfing companion, to relocate to Jacksonville. A spokeswoman said Foley, who left the LPS board last year, wasn't available to comment. Spun off in 2008, LPS is one of the city's largest employers, with 2,400 local workers.

Its headquarters is in a 12-story office building on palm-lined Riverside Avenue, part of a complex that also houses Fidelity National Financial, the original title insurer, and Fidelity National Information Services, a 2006 spin-off now called FIS. Foley and his wife, Carol, split time between a home in Jacksonville's Ponte Vedra Beach, a ranch in Whitefish, Mont., and California, where Foley owns seven wineries. His compensation last year from LPS and the Fidelity National companies was $45.9 million, according to company filings.

The growth of LPS and other foreclosure outsourcing has dismayed even some professionals deeply involved in the process. Judge Diane Weiss Sigmund of the U.S. Bankruptcy Court in Philadelphia last year published an unusual 58-page opinion scrutinizing LPS because, she said, she wished "to share my education" with others in the system "who may be similarly unfamiliar with the extent that a third-party intermediary drives the Chapter 13 process". Her opinion described an attempt by the multinational bank HSBC to foreclose on the home of Niles and Angela Taylor, who had filed for bankruptcy protection from their creditors.

Judge Sigmund ruled the bank's outside attorneys mistakenly tried to take the Taylors' home because of three disputed flood-insurance payments totaling $540. She blamed lawyer incompetence, exacerbated by a "slavish adherence" to an LPS computer system called NewTrak. What bothered the judge, she wrote, was the way HSBC and its lawyers entrusted "the NewTrak system [with] the management of its defaulted loans in bankruptcy…. With the HSBC data uploaded to an LPS system, LPS responds to the perceived needs of retained counsel…. The retained counsel does not address the client directly."

Overreliance on LPS contributed to six months of unnecessary hearings, the judge wrote. After she ordered the parties to settle the issue in person, they did so in just an hour. HSBC acknowledged that the property did not require flood insurance after all, and the truce cleared the way for resolution of the Taylors' bankruptcy plan.

Judge Sigmund, who has since retired, scolded one of HSBC's outside lawyers for being too "enmeshed in the assembly line" of managing foreclosures and ordered her to take extra ethics training. The judge instructed HSBC to remind all of its lawyers in writing not to defer excessively to computerized data systems. LPS, the judge added, did not deserve punishment because the outsourcer had merely provided tools that others misused.

McCollum, the Florida AG, suspects that in other cases LPS is more than an innocent facilitator. In April, he says, "a homeowner contacted us," alleging that LPS paperwork had been "forged in some way". His office opened a civil investigation. While McCollum, a Republican, would not provide specifics, subpoenas his office issued on Oct. 13 demand information on six employees of an LPS subsidiary called Docx.

The attorney general's office is investigating whether the employees had the authority to execute mortgage documents for lenders and servicers. One employee, Linda Green, at various times identified herself as a vice-president or representative of more than a dozen different banks and mortgage companies, according to the subpoena. "Docx has produced numerous documents, called assignments of mortgage, that even to the untrained eye appear to be forged and/or fabricated as the signatures of the same individual vary wildly from document to document," the AG's office says on its website.

LPS disclosed in February that the Tampa U.S. Attorney's Office is "reviewing the business processes" of the Docx unit. April Charney, a senior attorney with Jacksonville Area Legal Aid and an outspoken critic of LPS, says she was contacted by a federal prosecutor about the company earlier this year. The prosecutor informed her in April, she adds, that the Justice Dept. was seeking depositions from LPS and Docx employees.

LPS says it shut the Docx unit in April and is cooperating with investigators. "We feel like we have taken all appropriate corrective actions," Carbiener, the CEO, told analysts on Oct. 6. "We don't feel like this is going to have or will have a material impact on our financial results."

Quite the contrary, he added, the foreclosure chaos could be good for business. Dogged by foreclosure-defense attorneys and government investigations, lenders and servicers will have to retrace their steps. "Those services that we provided initially we'll provide again," Carbiener said. "For those loans that are held in review, we have the opportunity to earn additional revenues."

The big banks continue to insist that documentation problems are the legal equivalent of 'rounding' errors. On Oct. 18, Bank of America, which suspended foreclosures in all 50 states, played down that suspension and said it would resubmit foreclosure affidavits in 23 states after completing a speedy review of 102,000 files. Citigroup (C) said its foreclosure process was "sound". JPMorgan Chase Chief Executive Officer Jamie Dimon told investors on Oct. 13, "If you're talking about three or four weeks, it will be a blip in the housing market". He added, "If it went on for a long period of time, it will have a lot of consequences, most of which will be adverse on everybody."

The "blip" scenario may be too rosy. Ohio Attorney General Richard Cordray on Oct. 19 expressed deep skepticism that Bank of America had managed to complete its internal review in just 21/2 weeks, saying, "I would caution that they still have significant financial exposure in many, many cases". Even if the homeowners deserve to be foreclosed on, paperwork problems could stand in the way.

Mark J. Grant, a managing director for structured finance at Dallas-based Southwest Securities, wrote on Oct. 18 that what may lie ahead is a "Whangdepootenawah," a word from Ambrose Bierce's Devil's Dictionary ("disaster; an unexpected affliction that strikes hard"). Wrote Grant: "I doubt that you have followed the contagion down the path to the end because if you had, if anyone had, there would be a lot more retching in the streets and on Wall Street's trading desks."

Even if the I.O.U.s can be straightened out quickly, the fighting won't stop. Quoting unnamed sources, The Washington Post reported on Oct. 19 that the Obama Administration's Financial Fraud Enforcement Task Force is investigating whether financial firms committed federal crimes in filing fraudulent court documents to seize people's homes. Meanwhile, a high-stakes fight is breaking out between the banks that made loans and the investors who bought them.

A shot was fired on Oct. 18 when a group of major investors claimed that Bank of America's Countrywide Home Loan Servicing had failed to live up to its contracts on some of more than $47 billion worth of Countrywide-issued mortgage bonds. The group said Countrywide Servicing has 60 days to correct the alleged violations, such as failure to sell back ineligible loans to the lenders. According to people familiar with the matter, the group includes Pimco, BlackRock (BLK), and the Federal Reserve Bank of New York.

For banks that have just started making money again after near-death experiences in 2008, mortgage losses could delay the return to good health. Chris Gamaitoni, an analyst for Compass Point Research & Trading, a Washington financial advisory firm, estimates losses for the big banks of $134 billion from having to buy back bad loans from private investors and another $27 billion in losses from buying back loans from Fannie Mae and Freddie Mac. Other estimates are lower— from $20 billion to $84 billion— in part because those analysts are less certain than Gamaitoni that investors will succeed in court.

Bank of America, the nation's largest lender, has resorted to tough tactics in resisting repurchases of bad loans. Facing pressure from Freddie Mac, one of the two government-controlled mortgage financing companies, to buy back money-losing home loans with problems like inflated appraisals, overstated borrower income, or inadequate documentation, Bank of America issued a blunt threat, according to two people with direct knowledge of the incident. If Freddie Mac did not back off its demands for the buybacks, Bank of America officials said, the bank would take more of the new, more profitable mortgages it is originating these days to rival Fannie Mae, these people said. Freddie and Fannie, known as GSEs (government-sponsored entities), need a steady supply of healthy new loans to climb out of their financial hole.

The claimed threat from Bank of America, which was not put into writing, according to one of these people, was taken seriously enough that it has been discussed at several Freddie Mac board meetings, including one in mid-October. Some officials have urged the Federal Housing Finance Agency— the government conservator that has controlled Fannie and Freddie since they were bailed out in 2008— to confront Bank of America and prevent it from trying to play one against the other, which may be infuriating but is not illegal. "If the tactic worked, I'd be shocked and appalled," said Thomas Lawler, a former portfolio manager at Fannie Mae and now an economic consultant.

"The GSEs are supposed to be run now to minimize losses to the taxpayers. Freddie ought to ignore the threat." FHFA Acting Director Edward J. DeMarco declined to comment, as did officials of Freddie Mac. Bank of America also declined to comment.

For policymakers, the dilemma is this: Enormous losses will cause problems wherever they end up. They could further harm Fannie and Freddie, which insure the vast majority of the nation's mortgages and have already received nearly $150 billion in taxpayer support [[and are virtually the sole remaining purchasers of MBSs: normxxx]]. Or, if Fannie and Freddie succeed in pushing the burden back to the banks, the losses could cripple some of the major institutions that have just emerged from a government bailout.

Bank of America faces $12.9 billion in buyback requests, and mortgage insurers have asked for the documents on an additional $9.8 billion on which they may consider seeking repurchases, according to regulatory filings. (Bank of America has put aside $4.4 billion for buybacks, and CEO Brian T. Moynihan says the costs will be "manageable".) "The Treasury is very aware that they can't push too hard on this because if you do push too hard it might put the companies in negative capital again," says Paul J. Miller, an analyst at FRB Capital Markets. "There's a lot of 'regulatory forbearance' going on."

Aside from ignoring banks' bad debts, Washington hasn't done much to fix the crisis. Both houses of Congress easily passed a bill this year that would have undermined centuries of law by requiring every state to recognize MERS-type electronic records from other states. Only a pocket veto by President Barack Obama kept it from becoming law.

One option, opposed by the Obama Administration and most Republicans in Congress but favored by Senate Majority Leader Harry Reid and others, is a national moratorium on foreclosures. It would last until regulators assure themselves that lenders have straightened out their foreclosure procedures. Opponents say it would delay the recovery of the housing market by preventing qualified buyers from getting their hands on foreclosed homes. Supporters of the idea, such as Dean Baker, co-director of the Center for Economic and Policy Research, say there are plenty of already foreclosed homes available for sale and thus no urgent need to add to the supply.

Goodman, the Amherst Securities analyst, says banks need to reduce the principal that people owe on their homes so they have an incentive not to walk away. "Ignoring the fact that the borrower can and will default when it is his/her most economical solution is an expensive case of denial," Goodman writes. If the home whose mortgage was reduced happens to regain value, 50 percent of the appreciation would be taxed, she says.

Meanwhile, to discourage people from sitting tight in homes while foreclosure proceedings drag on, she would have the government tax the benefit of living in the home rent-free. CitiMortgage is testing an innovative alternative based on the legal procedure known as "deed in lieu of foreclosure". The owner turns the deed over to the bank without a fight if the bank promises not to foreclose, lets the family stay in the house after the agreement for six months, and gives relocation assistance.

Other ideas: In a New York Times blog post on Oct. 19, Harvard University economist Edward Glaeser suggested federal assistance to overwhelmed state and local courts, as well as $2,000 vouchers for legal assistance to low-income families that can't afford to fight foreclosures. Bloomberg News columnist Kevin Hassett, who is director of economic policy studies at the American Enterprise Institute, says in his Oct. 18 column that the newly created Financial Stability Oversight Council should make the foreclosure mess its first big project. "Take authority for solving it, and do so as swiftly as possible."

Speed is essential. The longer it drags on, the more the foreclosure crisis corrodes Americans' faith in their financial and legal systems. A pervasive sense of injustice is bad for the economy and democracy as well. Take Joe Lents. The Boca Raton homeowner hasn't made a mortgage payment since 2002, but he perceives himself as a victim. "I want to expose these guys for what they're doing," Lents says. "It's personal now."

ß§

Normxxx
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The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

99 Weeks: When Unemployment Benefits Run Out

2010-10-31T20:02:00.000-07:00

¹²99 Weeks: When Unemployment Benefits Run Out
Report On The Growing Number of Americans Who Are Exhausting Their Benefits

By Scott Pelley | 31 October 2010

Video: Unemployment Benefits: The 99ers
Even after an extension of unemployment benefits to 99 weeks, many of those about to go off the program are in a quandary. Scott Pelley talks to some of them in Silicon Valley.

Video Extra: Wiping Out Savings
Long-term unemployment is wrecking years of saving and planning by people like Lisa and Doug Francone. They tell Scott Pelley they have had to tap into the 401(k) and their kids' college funds.

Video Extra: San Jose and the Recession
San Jose Mayor Chuck Reed explains to Scott Pelley how not one but two recessions have hit his city, destroying thousands of jobs.

Link: Job Connections
Link: Second Harvest Food Bank
Link: Martha's Soup Kitchen

Scott Pelley, meeting people attending a workshop called "Job Connections." (CBS)

(CBS) The economic jam we're in has topped even the Great Depression in one respect: never have we had a recession this deep with a recovery this flat. Unemployment has been at nine and a half percent or above for 14 months. And congress did something that it has never done before— it extended unemployment benefits to 99 weeks. That cost more than $100 billion, a huge expense for a government in debt.

But now, for many Americans 99 weeks have passed and there's still no job in sight. Some have taken to calling themselves the "99ers". "60 Minutes" and correspondent Scott Pelley went to several communities in search of the 99ers, but we didn't expect to find such a crisis in Silicon Valley, the high tech capital that many people hoped would be creating jobs.

If you want to understand why the economy is stalled, come to San Jose, Calif., and talk with 99ers like Marianne Rose. "I remember it coming close to like six months. I was saying, 'I can't believe I'm out of work this long.' Then the year mark hit. And I just started just panicking seriously. Now that it's over two years I can't believe it. I just, I can't believe it," she told Pelley.

Rose was a financial analyst at a real estate firm. Age 54, she's single with a grown daughter. After being laid off with about 100 co-workers, she spent her savings, lost her home and finally found herself sitting in a truck with her dog and all of her possessions. She made a desperate call to a friend and found refuge upstairs in the home of strangers, her friend's brother and sister-in-law.

"How long did you think you would be in here?" Pelley asked. "Two weeks really. That's all I thought," she replied. But she told Pelley it has been six months. "And not really an end in sight, yet."

"What sort of things would you be willing to do at this point?" Pelley asked. "Well, I can say that probably the lowest level position for me has been now to apply for a clerk, a county clerk. And I just realized the competition is pretty stiff out there," she replied.

Asked what she meant by stiff competition, Rose explained. "There's a lot of people, speaking of the county. I had applied to those clerk positions. There's actually four positions that were open. I found there were over 2,000 people that applied for those four positions."

Rose is one of at least a million and a half Americans who've exhausted their unemployment checks. Now, Silicon Valley, the capital of American innovation has a new creation: revival meetings for the unemployed. On weekends, they come by the hundreds.

"60 Minutes" joined a gathering called "Job Connections," held inside a local church. It's part how-to-find-a-job workshop, part networking opportunity with the feel of a 12-step program. The people in the group are the faces of unemployment in Silicon Valley, people in their 40s, 50s and 60s who thought they had done everything right: earned a degree, stayed with their company, saved for retirement.

"I'm curious. How many PhDs in this room?" Pelley asked. "One, two, three, four several. Now leave your hands up. How many master's degrees? Oh boy. And how many of you went to college. Everybody keep your hands up if you have a college degree, a master's degree or a PhD."

Many in the room had their hands up. "How many of you expected to retire from the company where you were working"? he then asked. "More than half the room," he noted.

(CBS) "How many of you have cashed out your 401ks? IRAs? Savings accounts?" Pelley asked. Again, many hands went up. A lot of them are too young to retire and, maybe, too old to rehire. The longer they're out, the tougher it gets.

Judy Thompson was marking the time before she loses her home. "Three months maybe, and I've been in that house since 1982. I don't want to move," she said. Asked where she is going to go, Thompson told Pelley, "I don't know. I'm trying' not to think that far ahead. But anyway, didn't mean to get emotional. Sorry."

Sara Huber may lose her family business of 23 years. "Everything's gone and we can't survive 'cause these people can't survive," she explained. "Because these people don't have jobs, they're not coming to your business"? Pelley asked. "The equity lines are frozen, Right. People don't have credit. There's nothing there," she replied.

When asked how long her business can go on, Huber said, "We're going month to month, literally. I'm praying for more work." Jim Wild has been applying for jobs two years. "I've gone through the tier one companies. I've gone through the tier two companies and now I'm down to Target. I just got a job offer from Target to work a part-time job at 9.50 or 9.25 an hour," he explained.

The Target job is floor sales; previously, Wild was a fiber optics engineering manager. He's taking the job at Target and he's glad to get it. These folks aren't that unusual: today, nearly 20 percent of the unemployed in America have college degrees. Silicon Valley lost its jobs in construction, manufacturing and in high-tech engineering that went overseas. San Jose looks the same, but it shrank by 75,000 jobs. Many buildings there stand empty.

The national unemployment rate of about nine and a half percent sounds incredibly high and of course it is. But it doesn't nearly capture the depth of the trouble. It doesn't count the people who've seen their hours cut to part time. It doesn't count the people who have quit looking for work.

If you add all of that together, the unemployed and the underemployed, it's not nine and a half percent, it's 17 percent; and in California it's 22 percent. And what makes it so much worse is that, nationwide, one third of the unemployed have been out of work more than a year. That hasn't happened since the Depression.

(CBS) "60 Minutes" stopped by the soup kitchen in San Jose. Many folks used to think that they could see all the way to retirement. But now long-term unemployment is wrecking years of saving and planning by people like Lisa and Doug Francone. Doug was a $200,000-a-year personnel executive.

"You must have thought that you'd get another job pretty quickly," Pelley remarked. "Yeah. It really didn't cross my mind that I wouldn't find something. The question was trying to take the time to find the right job," he replied.

"You'd have a job in six months, a job that you liked in six months, and how long has it been?" Pelley asked Lisa Francone. "Two years and three months," she replied. They had saved for retirement and college for their son and daughter. But most of that is gone. "The unemployment checks were tiny, I can't remember what they were but…," Francone said.

"$475," his wife said. "Lisa, what were you doing with $475 a week"? Pelley asked. "Well, by the time we paid benefits, we had enough to pay a bill or two but certainly not meet the mortgage or property taxes or groceries," she replied. Now their son is going to the military instead of college; selling the house will be next.

Doug Francone took matters into his own hands: he created jobs for him and his son, buying a franchise that cleans air ducts. He spent his 401(k) on this. But, there hasn't been enough business to make money. "I don't wanna come off like 'Oh you know, woe is us.' There's other people struggling a lot worse than we are. But it's certainly very different for us," he told Pelley.

"You're surprised to be in this place?" Pelley asked. "Oh, absolutely. Yeah. Shocked really," Francone replied. Like the Francones, four and a half million Americans have taken hardship withdrawals from their 401(k)s. With savings gone, unemployment checks exhausted, many are coming to charities including the CALL Primrose Center, a pantry of free food.

Mary Watts has run CALL Primrose for 11 years. "Before the Great Recession began, you were sending out how many bags of groceries in a year"? Pelley asked. "When I started in '99 it was 4,000 bags a year," she replied. "It's going to be 32 to 35,000 bags this year."

"You know these people coming into the pantry now, they must look like professionals," Pelley remarked. "Oh absolutely, yes, absolutely professionals. Career professionals, people that never, ever would have thought they would be coming in our door other than perhaps as a donor," Watts said.

(CBS) We met Claudia Bruce at the center. She was an office manager making $70,000 a year when she was laid off. Now her 99 weeks of unemployment checks are running out. She never imagined she'd need free food. But then, she never imagined she would be picking out trash to sell to the recycler.

"You do what you have to do. I'm not delighted, but I'm happy to have the money that it provides," she told Pelley. "The day before you were laid off, what was your lifestyle"? Pelley asked. "I was a shop-a-holic. Yeah. I was trying to reform myself, but there's nothing like losing your job for a long period of time to completely reform a shop-a-holic," she replied.

Her car has turned into a garbage truck, filled with recyclables. She's learned a lot. Glass pays more than cans, and she has to be quick to beat the neighborhood homeless guy to the good stuff. She estimated her haul would bring in $28; instead, she got $33.81.

"Personal record," she told Pelley. "Did you ever think that $33 would mean so much"? he asked. "No. But then, I never thought $5 would mean so much either," Bruce replied. She has applied for hundreds of jobs, from office manager to clerical work. She's had four interviews in two years. She has kept a small apartment with help to pay the rent.

"I do get some help from my mom," Bruce said. Her mother is 83. "And so, she's helping you out even now," Pelley remarked. "Yeah, I'm her baby still, you know," Bruce said.

"You didn't expect to be her baby at this point in your life?" Pelley asked. "Absolutely not. I thought I'd be helping her now, that she wouldn't be helping me," she replied. Her benefits will end when she hits 99 weeks soon. No one is expecting Congress to vote another extension of unemployment checks given our historic budget deficits.

As government benefits run out, a lot of people are depending on kindness to take their place. Marianne Rose lived with her friend's brother for seven months, insisting on cooking and cleaning to earn her keep. In recent days she found a job in a public school. It'll pay about one third what she used to make. It's the best thing to happen in two years, but it's little and late.

"Do you imagine getting your lifestyle back?" Pelley asked. "No," Rose replied. "Not to the same point now because now I would have to worry about, you know, my old age, in my old age you know its rebuild a nest egg, pay off my debts that I have. That has to happen so now, my lifestyle will not be the same ever, ever again."

The Elephant In The Room: Debt Grows Exponentially

2010-10-31T18:06:00.000-07:00

¹²The Elephant In The Room: Debt Grows Exponentially, While Economies Only Grow In An S-Curve

By George Washington | 31 October 2010

Michael Hudson is a highly-regarded economist. He is a Distinguished Research Professor at the University of Missouri, Kansas City, who has advised the U.S., Canadian, Mexican and Latvian governments as well as the United Nations Institute for Training and Research. He is a former Wall Street economist at Chase Manhattan Bank who also helped establish the world's first sovereign debt fund.

Hudson says that— in every country and throughout history— debt always grows exponentially, while the economy always grows as an S-curve. Moreover, Hudson says that the ancient Sumerians, Babylonians, and Hebrews knew that debts had to be periodically forgiven, because the amount of debts will always surpass the size of the real economy in time.

For example, Hudson noted in 2004:

Mesopotamian economic thought c. 2000 BC rested on a more realistic mathematical foundation than does today's orthodoxy. At least the Babylonians appear to have recognized that over time the debt overhead became more and more intrusive as it tended to exceed the ability to pay, culminating in a concentration of property ownership in the hands of creditors.

***

Babylonians recognized that while debts grew exponentially, the rest of the economy (what today is called the "real" economy) grows less rapidly. Today's economists have not come to terms with this problem with such clarity. Instead of a conceptual view that calls for a strong ruler or state to maintain equity and to restore economic balance when it is disturbed, today's general equilibrium models reflect the play of supply and demand in debt-free economies that do not tend to polarize or to generate other structural problems.

And Hudson wrote last year:

Every economist who has looked at the mathematics of compound interest has pointed out that in the end, debts cannot be paid. Every rate of interest can be viewed in terms of the time that it takes for a debt to double. At 5%, a debt doubles in 14½ years; at 7 percent, in 10 years; at 10 percent, in 7 years. As early as 2000 BC in Babylonia, scribal accountants were trained to calculate how loans principal doubled in five years at the then-current equivalent of 20% annually (1/60th per month for 60 months). "How long does it take a debt to multiply 64 times"? a student exercise asked. The answer is, 30 years— 6 doubling times.

No economy ever has been able to keep on doubling on a steady basis. Debts grow by purely mathematical principles, but "real" economies taper off in S-curves. This too was known in Babylonia, whose economic models calculated the growth of herds, which normally taper off. A major reason why national economic growth slows in today's economies is that more and more income must be paid to carry the debt burden that mounts up.

By leaving less revenue available for direct investment in capital formation and to fuel rising living standards, interest payments end up plunging economies into recession. For the past century or so, it usually has taken 18 years for the typical real estate cycle to run its course.

Hudson calls for a debt jubilee, and points out that periodic debt jubilees were a normal part of the Sumerian, Babylonian and ancient Jewish cultures. [[In ancient Israel, all slaves and indentured debtors had to be freed at the end of each seven year period— so a seventh or 'Sabatical' year was a 'special' time; the Jubilee year was a seventh seventh year, ie, every 49 years— an 'extra'-special time.: normxxx]] Economist Steve Keen and economic writer Ambrose Evans-Pritchard also call for a debt jubilee. If a debt jubilee is not voluntarily granted, people may very well repudiate their debts.

And as I have previously pointed out, our modern fractional reserve banking system is really a debt-creation system, which is guaranteed to create more and more debts. As then-Chairman of the Federal Reserve (Mariner S. Eccles) told the House Committee on Banking and Currency on September 30, 1941:

That is what our money system is. If there were no debts in our money system, there wouldn't be any money.

The modern banking system is therefore really a debt-creation system. See this for details. One thing is for sure. The exponential growth of debt is a structural problem which— unless directly addressed— will swallow all economies which try to ignore it.

Angela Merkel Consigns Ireland, Portugal And Spain To Their Fate

2010-10-31T15:33:00.000-07:00

¹²Angela Merkel Consigns Ireland, Portugal And Spain To Their Fate

Germany has had enough. Any eurozone state that spends its way into a debt crisis or cannot adapt to a monetary union set for Northern rhythms will face "orderly" bankruptcy.

By Ambrose Evans-Pritchard | 31 October 2010

Angela Merkel needs a treaty change to prevent the German constitutional court from blocking the bail-out fund as a breach of the EU law

Bondholders will discover burden-sharing. Debt relief will be enforced, either by 'interest holidays' or 'haircuts' on the value of the bonds. Investors will pay the price for failing to grasp the mechanical and obvious point that currency unions do not eliminate risk: they switch it from exchange risk to default risk.

What were investors thinking when they bought Greek 10-year bonds at 26 basis points over Bunds in 2007, below the spread between British Columbia and Quebec? "We must keep in mind the feelings of our people, who have a justified desire to see that private investors are also on the hook, and not just taxpayers," said German Chancellor Angela Merkel. Or in the words of Bundesbank chief Axel Weber: "Next time there is a problem, (bondholders) should be part of the solution rather than part of the problem. So far the only ones who have paid for the solution are the taxpayers."

These were the terms imposed by Germany at Friday's EU summit as the Quid Pro Quo for the creation of a 'permanent' rescue fund in 2013. A treaty change will be rammed through under Article 48 of the Lisbon Treaty, a trick that circumvents the need for full ratification. Eurosceptics can feel vindicated in warning that this "escalator" clause would quickly be exploited for 'unchecked treaty-creep'.

Mrs Merkel needs a treaty change to prevent the German constitutional court from blocking the bail-out fund as a breach of the EU law, and a treaty change is what she will get. "This will strengthen my position with the Karlsruhe court," she admitted openly. One might argue that bondholders should have been punished for their errors long ago.

The stench of moral hazard has been sickening, on both sides of the Atlantic. An orderly bankruptcy along lines routinely engineered by the International Monetary Fund is exactly what Greece needs. It makes no sense to push Greece further into a debt compound spiral by raising public debt from 115% of GDP at the outset of the "rescue" to 150% at the end of the ordeal. If you strip out the humbug, the Greek package allows banks and funds to shift roughly €150bn of liabilities onto EU governments, or the European Central Bank, or the IMF. Greek citizens are being subjected to the full pain of austerity under false pretences, without being offered the cure of debt relief.

It is in reality a bail-out for investors. There is a touch of cruelty in this. Needless to say, the Greek Left has noticed. A socialist dissident from the "anti-Memorandum" bloc (ie, anti EU-IMF) is likely to win the Athens region in coming elections.

Note too that the ruling socialists have fallen to 25% in the Portuguese polls, while the Communists and hard-left Bloco are together up to 18%. Ain't seen nothing, you might say. Yet opening the door to bondholder 'haircuts' at this delicate juncture— with spreads reaching fresh records in Ireland last week, and Portugal struggling to pass a budget— is to toss a hand-grenade into the eurozone periphery. We now know that that ECB's Jean-Claude Trichet warned EU leaders on Thursday night that it was dangerous to stir up this hornets' nest, and moreover that the politicians did not understand what they were unleashing. He was slammed down acrimoniously by French President Nicholas Sarkozy, who later denied that he lost his temper.

"Mr Trichet expressed a number of reserves. There was a debate, there is always a debate, but the European Council took its decision," he said. "It is wrong to say I was irritated. You can reproach heads of state for all kinds of things in a democracy, but I don't think you can reproach them for not being aware of 'the seriousness of the situation'," he snorted.

Mr Sarkozy was not going to let his Brussels 'triomphe' slip away after stitching up EU affairs once again in a pre-emptive deal with Germany and imposing his will. The notion that the Franco-German axis still runs Europe is potent politics in France, even if the decisions actually reached are often of little value or— as in this case— ill-advised. Such is the chemistry of EU summits, where mad things happen.

Spain's premier Jose-Luis Zapatero knew he had been mugged. "We need to listen carefully to what the head of the ECB says about the rescue mechanism. Great care is called for because this message is risky," he said.

Eurozone sovereign states must issue €915bn in new bonds next year, according to the UBS, either to roll over debt or to cover very big deficits— though it is hard to outdo Ireland's deficit of 32% of GDP in 2009. Yet investors have just been told in blunt terms to charge a hefty risk premium on any peripheral debt that expires after 2013, with great confusion over what happens even before that date. Can any investor be sure what the terms will be if Ireland or Portugal needs to access the EU's bail-out fund next week, or next month, or next year? Are haircuts already de rigueur?

A study by Giada Giani at Citigroup entitled "Bondholders Moving Back Home" said data from the second quarter reveals a sharp drop in foreign ownership of debt from Greece (-14%), Portugal (-12%), Spain (-8%), and Ireland (-5%). Local banks have stepped into the breach, borrowing cheaply from the ECB to buy their own state debt at higher yields in a 'carry trade' that concentrates risk. These four countries account for the lion's share of the €448bn in ECB funding for banks (Spain €98bn, Greece €94bn). Frankfurt is propping up this unstable edifice. Mr Trichet may well fret.

A strong case can be made that Spain has decoupled from the other PIIGS in pain, though the deficit will still be 6% next year, and the economy is at serious risk of a double-dip recession as wage cuts and higher taxes bite in earnest. But none are safe yet. An ominous pattern has emerged across much of the eurozone periphery: tax revenue keeps falling short of what was hoped for. Austerity measures are eating deeper into the economy than expected, forcing further fiscal cuts. It goes too far to call this a 'self-feeding spiral', but such policies test political patience to the snapping point.

There is little that these nations can do in the short-run as EMU members. They cannot offset fiscal tightening with full monetary stimulus or a weaker exchange rate— as Britain can. All they do can is 'soldier on', sell family silver to the Chinese and Gulf Arabs, beg the ECB to join the currency war to bring down the euro, and pray that the fragile global recover does not sputter out.

Chancellor Merkel is ultimately correct. A mechanism for sovereign defaults is entirely healthy. Had it been in place long ago, EMU would have been stronger. The proper timing for this was at the Maastricht Treaty, or Amsterdam, or at the latest Nice, but in those days the EU elites were still arrogantly dismissive about the full implications of a currency union. To wait until now borders on carelessness.

.

EU 'Haircut' Plans Rattle Bondholders

Investors face large potential losses on eurozone debt under German plans likely to win backing from EU leaders on Friday— risking a boycott of Greek, Irish, and Portuguese bonds.

By Ambrose Evans-Pritchard, and Bruno Waterfield In Brussels | 28 October 2010

Front row left to right, European Commission President Jose Manuel Barroso, French President Nicolas Sarkozy, and Lithuania's President Dalia Grybauskaite. Back row left to right, Portugal's Prime Minister Jose Socrates and German Chancellor Angela Merkel at the EU summit in Brussels Photo: AP

Germany has agreed to give the EU's €440bn (£383bn) bail-out fund permanent status rather than letting it expire in 2013 as planned, but only as part of a "Crisis Resolution Mechanism" that forces bondholders to share losses from any future bail-outs. The fund must be anchored in EU law through changes to the Treaties in order to head off legal challenges at Germany's constitutional court. A draft proposal from Berlin— now serving as a working text for the European Commission— calls for "orderly insolvency" by eurozone countries in trouble.

Details are sketchy, but this "Chapter 11" for sovereign states would include an extension of debt maturities, a "holiday" on interest payments for as long as needed to let debtors recover, and a suspension of bondholder rights. The blueprint is akin to debt-restucturing schemes used by the International Monetary Fund. Under a Finnish proposal, there are likely to be "Collective Action Clauses" in all new bond issues to prevent minority bondholders blocking a default deal.

European President Herman van Rompuy will be tasked to draw up a blueprint for the crisis mechanism. There may also be a Sovereign Debt Restructuring Mechanism (SDRM). Berlin is determined to avoid a repeat of the €110bn bailout for Greece when banks were shielded from losses, leaving eurozone taxpayers facing the full cost.

Silvio Peruzzo, Europe economist at RBS, said talk of "haircuts" for bondholder at this delicate juncture could backfire. "The debt crisis in the eurozone periphery has not been sorted out. These countries need markets to keep buying the bonds, but investors are going to stay away if you open the door to private sector pain," he said.

It is unclear whether the latest bond jitters in Greece, Ireland, and Portugal is linked to growing awareness of the German plans. Each country has its own troubles. Yields on Ireland's 10-year bonds briefly rose to a post-EMU high above 7% on Thursday, partly due to a stand-off between Dublin and angry funds facing losses on the junior debt of Anglo Irish Bank. However, EU officials fear that the proposals could make it harder for such high-debt states to tap debt markets, risking a self-fulfilling [[and ultimately intractable: normxxx]] crisis.

Germany is likely to win backing in principle at Friday's EU summit in Brussels since it has already struck a deal with France, and Britain has dropped its opposition to treaty changes. Brussels believes it is possible to invoke Article 48.6, which allows changes to the Lisbon Treaty without the political trauma of referenda or full ratification in all 27 states. This "simplified revision" can be used to cover matters in Part III of the Treaty, but the EU risks a political backlash if it tries to push through such a controversial plan by these means. Viviane Reding, the EU justice commissioner, said it was "suicidal" to tinker with the treaties so soon after the Lisbon storm.

German Chancellor Angela Merkel is also demanding EU powers to strip countries of their voting rights if they breach eurozone rules, but this has been dismissed by Brussels as "totally unacceptable" and will be blocked by other states. The summit was intended to endorse plans by an EU taskforce for a beefed-up Stability Pact but, as so often at EU meetings, France and Germany have run away with the agenda. The German proposals have a logic since they let struggling states claw their way out crisis by reducing debt. Greece's rescue risks failure because it will leave the country with public debt of 150% of GDP, near the 'Point Of No Return'.

ß§

Normxxx
______________

The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Fraud Caused The 1930s Depression And The Current Financial Crisis

2010-10-31T12:28:00.000-07:00

¹²Fraud Caused The 1930s Depression And The Current Financial Crisis

By George Washington | 30 October 2010

Robert Shiller— one of the top housing experts in the United States— says that the mortgage fraud is a lot like the fraud which occurred during the Great Depression. As Fortune notes:

Shiller said the danger of foreclosuregate— the scandal in which it has come to light that the biggest banks have routinely mishandled homeownership documents, putting the legality of foreclosures and related sales in doubt— is a replay of the 1930s, when Americans lost faith that institutions such as business and government were dealing fairly.

The former chief accountant of the S.E.C., Lynn Turner, told the New York Times that fraud helped cause the Great Depression:

The amount of gimmickry and outright fraud dwarfs any period since the early 1970's, when major accounting scams like Equity Funding surfaced, and the 1920's, when rampant fraud helped cause the crash of 1929 and led to the creation of the S.E.C.

Economist Robert Kuttner writes:

In 1932 through 1934 the Senate Banking Committee, led by its Chief Counsel Ferdinand Pecora, ferreted out the deeper fraud and corruption that led to the Crash of 1929 and the Great Depression.

Similarly, Tom Borgers refers to:

The 1930s' Pecora Commission, which investigated the fraud that led to the Great Depression ….

Professor William K. Black writes:

The original Pecora investigation documented the causes of the economic collapse that led to the Great Depression. It … established that conflicts of interest and fraud were common among elite finance and government officials.The Pecora investigations provided the factual basis that produced a consensus that the financial system and political allies were corrupt.

Moreover, the Glass Steagall Act was passed because of the fraudulent use of normal bank deposits for speculative investments. As the Congressional Research Service notes:

In the Great Depression after 1929, Congress examined the mixing of the "commercial" and "investment" banking industries that occurred in the 1920s. Hearings revealed conflicts of interest and fraud in some banking institutions' securities activities. A formidable barrier to the mixing of these activities was then set up by the Glass Steagall Act.

Economist James K. Galbraith wrote in the introduction to his father, John Kenneth Galbraith's, definitive study of the Great Depression, The Great Crash, 1929:

The main relevance of The Great Crash, 1929 to the great crisis of 2008 is surely here. In both cases, the government knew what it should do. Both times, it declined to do it.

In the summer of 1929 a few stern words from on high, a rise in the discount rate, a tough investigation into the pyramid schemes of the day, and the house of cards on Wall Street would have tumbled before its fall destroyed the whole economy. In 2004, the FBI warned publicly of "an epidemic of mortgage fraud".

But the government did nothing, and less than nothing, delivering instead low interest rates, deregulation and clear signals that laws would not be enforced. The signals were not subtle: on one occasion the director of the Office of Thrift Supervision came to a conference with copies of the Federal Register and a chainsaw. There followed every manner of scheme to fleece the unsuspecting….

This was fraud, perpetrated in the first instance by the government on the population, and by the rich on the poor.

***

The government that permits this to happen is complicit in a vast crime.

As the Great Crash, 1929 documents, there were many fraudulent schemes which occurred in the 1920s and which helped cause the Great Depression. Here's one example of a pyramid scheme in Florida real estate:

An enterprising Bostonian, Mr. Charles Ponzi, developed a subdivision "near Jacksonville". It was approximately sixty-five miles west of the city. (In other respects Ponzi believed in good, 'compact' neighborhoods; he sold twenty-three lots to the acre.) In instances where the subdivision was close to town, as in the case of Manhattan Estates, which were "not more than three fourths of a mile from the prosperous and fast-growing city of Nettie," the city, as was so of Nettie, did not exist.

The congestion of traffic into the state became so severe that in the autumn of 1925 the railroads were forced to proclaim an embargo on less essential freight, which included building materials for developing the subdivisions. Values rose wonderfully. Within forty miles of Miami "inside" lots sold at from $8,000 to $20,000; waterfront lots brought from $15,000 to $25,000, and more or less bona fide seashore sites brought $20,000 to $75,000."

As DoctorHousingBubble notes [2009]:

This Mr. Ponzi of course is the man who gave name to the "Ponzi scheme" that many use today. He laid the groundwork for many of the criminals today in the housing industry. Yet during the boom he wasn't seen as a criminal but as a "big" player in the Florida real estate bubble. Here's a nice picture of the gentleman:

James Galbraith recently said that

"at the root of the crisis we find the largest financial swindle in world history", where "counterfeit" mortgages were "laundered" by the banks.

As he has repeatedly noted, the economy will not recover until the perpetrators of the frauds which caused our current economic crisis are held accountable, so that trust can be restored. See this, this, and this. No wonder James Galbraith has said economists should move into the background, and "criminologists to the forefront."

Note 1: I asked Professor Black to comment on this essay, and he said the following:

The amount of fraud that drove the Wall Street bubble and its collapse and caused the Great Depression is contested [keep reading to see what Black means]. The Pecora investigation found widespread manipulation of earnings, conflicts of interest, and insider abuse by the nation's most elite financial leaders.

John Kenneth Galbraith's work documented these abuses. Theoclassical economic accounts, however, ignore or excuse these abuses. The Justice Department did not respond effectively to the crimes that helped spark the Great Depression so we have far fewer facts available to us.

The decisive role that "accounting control frauds" played in driving the current crisis is clear. The FBI warned of an "epidemic" of mortgage fraud in 2004 and predicted that it would cause an economic crisis if it were not stopped. The mortgage lending industry's own experts reported that "liar's" loans were "an open invitation to fraudsters" and fully warranted their name— "liar's" loans— because fraud was endemic in such loans. Lenders and their agents led these lies.

They led the lies for an excellent reason— the strategy is a "sure thing" (Akerlof & Romer 1993— Looting: the Economic Underworld of Bankruptcy for Profit). It guarantees record (albeit fictional) profits, which maximize the CEO's bonuses. The same strategy for maximizing fictional income maximizes real losses in the longer term [[but only to the end 'investor' in those tainted derivatives based on those crappy mortgages, who are themselves merely another set of suckers in the "game": normxxx]]. When many lenders follow the same fraudulent strategy the result is a hyper-inflated bubble followed by a severe crisis.

Control fraud epidemics also produce "echo" epidemics of fraud in other fields. For example, when lenders are control frauds, the CEO establishes perverse incentives ("Gresham's dynamics") that corrupt other industries and professions.

By rewarding professionals who are willing to inflate asset values, and refusing to hire honest professionals [[and actively ridding themselves of honest professionals already on the payroll: normxxx]], control frauds cause the unethical to drive the ethical out of the markets. When one combines deregulation, desupervision, and the perverse incentives of modern executive and professional compensation the result is recurrent, intensifying crises.

Note 2: The Austrian economists point out that it is bubbles which cause crashes. I agree. But as Professor Black points out, fraud is one of the main causes of bubbles.

Note 3: Of course other factors, such as excess leverage and counterproductive actions by the Federal Reserve, also contributed to the 1930s Depression and the current crisis.

2010-10-30T14:18:00.000-07:00

As DoctorHousingBubble notes []:
This Mr. Ponzi of course is the man who gave name to the “Ponzi scheme” that many use today. He laid the groundwork for many of the criminals today in the housing industry. Yet during the boom he wasn’t seen as a criminal but a player in the Florida real estate bubble. Here’s a nice picture of the gentleman:

James Galbraith recently said that "at the root of the crisis we find the largest financial swindle in world history", where "counterfeit" mortgages were "laundered" by the banks.

Goldman Sachs: The Market Is At 7% Above The 55-DMA

2010-10-30T13:22:00.000-07:00

Goldman Sachs: The Market Is At 7% Above The 55-Dma;
It Is More Overstretched Than Just Once In Its History

By Tyler Durden | 22 October 2010

John Noyce, Goldman's arguably best technician, in his weekly Charts that Matter, has released one (among many) interesting observation on just how overbought the market currently is. More specifically, just how desperate the velocity of the pick up in the stocks since August has been, in order for levered beta players such as hedge funds to make up as much of their year as possible before seeing redemptions. (As we predicted at the end of August and, even so, many such players will not survive into 2011 as the entire 2/20 model is now crumbling.) Specifically, by looking at where the S&P is relative to its 55 DMA, Noyce notes that every time the market has gotten to above 5% of its trailing average, it has always entered a period of consolidation (read: at least modest selling).

Click Here, or on the image, to see a larger, undistorted image.

Furthermore, compared to the recent trend extreme of 7% above 55 DMA, the market moved meaningfully above on just one occasion in the past: in January 2009— just before the crash to the decade lows of 666 on the S&P occurred. In the FX realm, Noyce appears to stand behind our FX team's recommendation of long EURUSD, with some technical back up.

Our EUR/Broad Index appears to have completed a similar size bear market from the December '08 highs to the September '10 low to that which it completed from the September '98 high to the May '00 low.

While the bounce here need not be in a straight line, it certainly looks as though the EUR has stabilised on a broad basis and further recovery seems quite likely over time.

This supports the idea that after a period of consolidation/correction to unwind extreme moving average setups on the daily chart, the EURUSD should again begin to move higher.

As a reminder, the EUR/Broad Index shows the performance of the EUR versus an equally weighted basket of the other "Old World G10" currencies, it's EUR-based, so higher indicates EUR-strength.

Click Here, or on the image, to see a larger, undistorted image.

And last, looking at the 10 Year, Noyce notes a comparable record overstretching relative to the 55 DMA:

U.S 10-year yields have now spent 126 consecutive trading sessions below their 55-day moving average on a close basis. This is beyond the prior extreme set in July '95 of 124 consecutive sessions below the 55-dma.

Given the concerns we've expressed on the prior slide this does seem to be a warning sign that the market is becoming increasingly susceptible to an upside correction in yields.

The pivot to watch is 2.58-2.61% where the downtrend from the April highs and the 55-dma are converged.

A break above that point would leave the 200-dma as a possible target a long way above at 3.23%.

Overall, it now appears very important to watch for any signs of a turn higher in yields.

Click Here, or on the image, to see a larger, undistorted image.

There is much more in Noyce's latest, but it all just goes to confirm the old maxim that the market can frontrun the Fed for far longer than the 55-DMA can stay solvent.

Misconceptions About Gold

2010-10-28T14:09:00.000-07:00

¹²Misconceptions About Gold

By "Trotsky", Edited By Mike "Mish" Shedlock. See Addendum. | 26 June 2007

Few markets are as widely misunderstood and subject to so many misconceptions as gold. Many of those misconceptions stem from gold's dual role as a commodity and as money. This post will attempt to clear up some of those misconception with a few facts. Let's start with one key fact.

Gold Is Money

How can I actually claim that 'gold is money'? After all, it is not used as official money anywhere and barring isolated instances of payments made from a digital gold account, it is unlikely that one will ever make a payment in gold these days.

In addition, central banks seem intent on 'demonetizing' gold, as the biggest CB holders of gold (except the US) continue to unload it, ostensibly to earn the higher returns provided by bonds. [[This has ceased to be true for at least the last two years or so; indeed, most recently, gold has been under accumulation by any number of CBs, most notably that of China.: normxxx]] Selling gold for 'returns' is actually a spurious argument, because reserves are just that: reserves. And the primary purpose of reserves is not to produce a return.

In spite of all this, we still know that gold is money, because it trades in the market as if it were money. Let's see if we can prove that thesis.

Gold Supply And Demand

If gold's price were determined by fabrication demand alone (jewelry and industrial uses), it could not possibly trade at a price of $650 oz. [[NB: Currently, over twice that figure!: normxxx]]

Many gold analysts, from the mainstream to fringe groups such as the Gold Anti-Trust Action Committee (GATA) claim that they can 'predict' what the gold price will do, eg, by adding up annual fabrication and investment demand (as well as dehedging demand by miners [[which has also ceased, snce no miner is hedging its gold output at present: normxxx]]) and contrasting the resulting total with annual supply (mine supply, central bank selling, disinvestment and scrap). In short, they 'analyze' the gold market in [much] the same manner as they would analyze the copper market.

It should be immediately obvious that this can't be correct. After all, nearly the entire supply of gold ever mined (approximately 150,000-160,000 tons) is still here. In short, the total potential supply of gold is some 97-98% greater than the gold produced every year (approximately 2,600 tons).

On that basis it makes no sense to apply traditional commodity supply/demand analysis based on annualized trends in the gold market. Simply put, there is a big difference between commodities that are effectively used up (aside from scrap residual returning to the market every year) and a commodity the indestructibility and durability of which [has] made gold the 'money commodity' in the first place.

Jewelry Demand Vs. Monetary Demand

One can further illustrate gold's unique nature as money with a study of gold prices vs. jewelry demand. If record fabrication demand for gold (jewelry) must be good for the price of gold, then a historic high in jewelry demand should in theory coincide with a high gold price. However, record high jewelry demand in 1999-2000 in actual fact coincided with a 20 year bear market low in the gold price— the exact opposite of what traditional commodity supply/demand analysis would suggest.

We can therefore conclude that there must be a source of gold demand that is of far greater importance than the jewelry and industrial demand components, and that that demand constitutes the 'true' driver of the price of gold in terms of fiat money. Indeed, there is. This demand component is called 'monetary demand'. Monetary demand and the supply of gold is actually best described as the 'degree of reluctance of the current owners of gold to part with their gold at current prices' since, as mentioned above, some 160,000 tons are owned by somebody already.

De facto gold acts in the markets as if it were another currency rather than a commodity. It often keys off other currency cross rates, such as dollar/euro , and has a strong tendency to ignore all the typical supply/demand analysis thrown at it by the mainstream (including the World Gold Council, which should know better). A rising gold price usually begets falling jewelry demand, which is exactly what the theory of price elasticity would suggest. But at the same time, rising prices actually tend to stoke investment demand, just as a developing uptrend in the stock market tends to invite more demand rather than less as this chart, courtesy of Sharelynx Gold shows.

The above chart shows that the record high in jewelry demand coincided with the 20-year bear market low in the gold price. So what was driving the price of gold higher? We know it was monetary demand driving the price because the total fabrication demand for gold has been basically flat since 1999. Ironically enough, the chart also shows the price of gold was falling for over 20 years even as fabrication demand was rising. This is proof that fabrication demand is not an important driver of the price of gold. Finally, it should also be noted that some 'jewelry' demand, especially in India, is really disguised monetary demand.

The sin of attaching importance to jewelry demand in gold price forecasts is engaged in by all the major brokerage houses. This leads even the best of money managers to making mistakes, as evidenced by the following. Legendary value investor Jean-Marie Eveillard recently stated the following in a Fortune interview:

"When we started our gold fund in 1993— which proved to be six or seven years too soon— I mistakenly thought that my downside was protected by the fact that jewelry demand was fairly vibrant. But I was wrong. I think gold moves up and down based on investment demand mostly."

The WGC (World Gold Council) meanwhile tries to gauge 'implied investment demand', respectively 'dehoarding' retroactively, by adding up known new annual supply (from mining, scrap, central bank selling and hedging) and contrasting it with known annual fabrication [and other] demand. The difference, it reckons, must represent 'implied investment demand' (presumably the demand from gold ETF's figures in these calculations as well these days).

However, as we noted, investment demand is also expressing itself by the reluctance of current gold holders to sell at a given price. This reluctance can not be measured [[except after the fact: normxxx]], and actual investment demand is therefore also not measurable [[in advance, but can and has changed abruptly based largely on psychology driven by financial and fiscal events: normxxx]].

Gold Mine Production Vs. Total Demand

The above chart depicts another peculiarity of the gold market's supply/demand situation: As the price of gold rises, mine production actually flattens out and falls. There are two reasons for this unusual response to higher prices.

During low gold price environments, mines are forced to 'high grade' (i.e., to mine the higher grade portions of their orebodies). Once the price rises, they shift their mining activities to the lower grade portions of their orebodies, that hadn't been economic to mine previously. During periods of low gold prices, exploration spending falls, so that once prices rise, very few new mines are set to open and take up the slack from depleted mines. It can take up to 7— 10 years from the discovery of an economic orebody to the point when mining can begin.

What Motivates Monetary Demand For Gold?

To answer this question one must look back at how gold evolved to become money in the first place. First of all, it always was a commodity with a demand based on its usefulness for creating ornamentation and jewelry, so there was a prior demand for gold that made it useful in barter. In addition to that, its non-corrosiveness, divisibility, fungibility and easy portability weighed in its favor for use as money. Lastly, its scarcity and the fact that its supply is unlikely to suffer sudden increases, regardless of the wishes of the money issuing authorities, made it a prime candidate to act as a store of value.

There is a single historical exception to this gold supply dogma— when Spain imported (stole) [huge amounts of] gold from the New World in the 17th century it led to inflation throughout Europe [[ie, the value of gold in Europe dropped with respect to the value of the things it could purchase: normxxx]]. Nowadays, mine supply is around 2% of the total stock of gold per annum and it's highly unlikely there will be much deviation from this percentage. Thus a similar gold-based inflation today would be extremely unlikely [[unless everyone— but especially the U.S.— throughout the world were to suddenly embark on the 'austerity cure' espoused by the EC: normxxx]].

This latter point— that the 'State' [[nor anyone else: normxxx]] can't create gold out of thin air— is what lies at the heart of the monetary demand for gold.

In our modern day fiat money system with its fractional reserve banking systems and free-floating paper currencies, gold is the only form of money 'safe' from the depredations of central bankers [[well, relatively so; they can always sell off their individual hoards of gold— as they did until the last few years— to depress the value of gold in the CB's currency: normxxx]]. It therefore serves in the widest sense as a barometer of confidence in this central bank administered system.

Considering that the US dollar has lost about 97% of its value against gold since the Federal Reserve has been in business [[more like 98.5% today: normxxx]], one can conclude that confidence in fiat money has been waning rather precipitously [since the most recent abandonment of the gold standard]. This trend is certain to remain a one-way street over the long term, with occasional fluctuations as confidence in paper (or digital) money waxes and wanes. Unfortunately, this sad state of affairs doesn't seem to worry the engineers of inflation.

They only get worried when it happens too quickly (ie, so fast that everybody takes notice). One should add here that in the back of the mind of the typical monetary bureaucrat there is this little voice that says: "If push comes to shove, we can always take [that gold] back by force". After all, it wouldn't be the first time.

Time Preferences

In the shorter term, the motives of gold holders who refuse to sell (possibly even adding to their position) often depend on immediate concerns such as real interest rates, inflation expectations, the spread between short and long term interest rates as a proxy for the likely bias of monetary policy, and the exchange value of the US dollar. Typically gold is a counter-cyclical asset that does best in real terms when liquidity evaporates. At times however [[such as at present: normxxx]], there can be pro-cyclical demand when equity, commodity, and gold prices are all rising strongly, and liquidity is more than abundant [[indeed, overabundant: normxxx]].

In the end, such price fluctuations in gold are a bit like Warren Buffet's famous remark about the stock market being a 'voting machine in the short term and a weighing machine in the long term'. In the short term, all sorts of considerations can be used to 'explain' movements in the gold price, but in the long term, gold acts as the aforementioned barometer of confidence in central bank issued fiat money [[or, rather, as a barometer of the relative scarcity of gold versus that of a given fiat currency: normxxx]].

Addendum:Mish asked me if I would consider writing a series of posts on his blog about gold. I was pleased to take advantage of his offer. Together we came up with the topics, I did the writing, and Mish did the editing. A question came up as to what name to make these posts under. The name "Trotsky" had its origins as a joke handle I started using a long ways back on Kitco. I'm as anti-Leon Trotsky as one can possibly be. I'm not particularly fond of the handle anymore, but it's now the name I am associated with and we decided not to change it on short notice.

Tax Shortfalls Spur New Fear On Europe’s Recovery Bid

2010-10-28T10:49:00.000-07:00

¹²Tax Shortfalls Spur New Fear On Europe’s Recovery Bid

Debt Rising in Europe: Greece is not the only country in Europe with problems with credit and debt.

The Austerity Zone: Life in the New Europe

A Setback for Greece as Europe Says Deficit Is Larger Than Thought

By Landon Thomas Jr. | 28 October 2010

LONDON— The mathematics of austerity are getting harder. With economic conditions weaker than expected, tax revenue is coming up short of projections in parts of Europe. As a result, countries struggling with high deficits are now confronting the prospect that they will miss the budget deficit targets forced upon them this year by impatient bond investors.

Greece, for one, looks as if it will run a budget deficit for 2010 greater than the 8.1 percent of gross domestic product it agreed to as part of a rescue package from the International Monetary Fund and the European Union that amounted to more than $150 billion, according to a person briefed on the matter but not authorized to speak about it. The adjustment, at worst, would result in a deficit of 8.9 percent of Greece's output, this person said. Normally, such a small difference would not be cause for alarm.

But after the latest upward revision in Greece's 2009 deficit— to about 15.5 percent from 13.5 percent of output— the miss has spurred investor fears that the Greek government will be unable to close the gap and that Greece may ultimately be forced to 'restructure' its mountain of debt with foreign investors. [[That is, it will force its creditors to take a payback 'haircut' with respect to the principal sums borrowed. : normxxx]] As word seeped into the market on Wednesday, Greek 10-year bond yields jumped to 10.3 percent, from 9.3 percent.

That more or less reversed what had been an impressive bond market rally, when yields fell from more than 11 percent to just under 9 percent over the last month. The cost of insuring Greek bonds against a possible default also rose. A spokesman for the Greek finance ministry declined to comment. There has not been any suggestion from the I.M.F. or the European Union that this slip represents a lack of resolve by Prime Minister George A. Papandreou to maintain the harsh spending cuts, structural reforms and tax increases that lie at the heart of the Greek reform effort.

But it does highlight just how difficult it is for stagnating economies with rising unemployment rates to make fiscal adjustments exceeding 10 percent of their economic output in just a couple of years. In Ireland, which is expecting its third consecutive year of economic contraction this year, the government says it will need an additional 15 billion euros in budget cuts to reduce its deficit from 32 percent of gross domestic product to 3 percent by 2014. And in Portugal, the government is struggling to meet its deficit target of 9 percent of output as the economy continues to weaken.

Spain also faces a difficult task in slicing its deficit to 6 percent next year, from 11 percent last year, in the face of a slumping economy. "All the leading indicators for the peripheral economies are negative, so it is logical that these countries will fall short of their projections," said Jonathan Tepper, an analyst at Variant Perception, a London-based research boutique. "People tend to forget that when you are in a deflationary dynamic, your tax take will be going down."

In Ireland, the deficit has been swollen by the cost of bailing out the country's failed banks. But because there have been so many upward revisions in the deficit, investors are growing more doubtful that the government will be able to meet its target in the years ahead. The deficit misses by Europe's weaker economies also provide fodder for the critics of the I.M.F.-inspired programs who fear that these dire menus of spending cuts and tax increases will send economies into prolonged recessions from which they will be unable to recover.

Eurostat, the statistical agency for the European Commission, has had a team in Athens for a few weeks, digging through the Greek budget figures, and is expected to announce the [latest] 'final' revision of the country's 2009 deficit in mid-November— a change that could expose debt as more than its current level of 133 percent of G.D.P. Eurostat's investigation has the full support of the Greek government, which has said many times that it wants to put the nightmare of the ever-increasing 2009 deficit— initially estimated by the previous government at 5 percent— behind it.

So far, Greece has made solid progress in its austerity program, cutting expenditures by 11 percent through September from the comparable period last year. But revenue, always difficult to spur in an economy with a poor record of tax collection, has been hurt by this year's 4 percent economic contraction and is up just 3 percent. Government officials, while acknowledging that July and August were off target, are banking on increased taxes and measures to curb tax evasion to kick in during the second half.

Still, Greek officials are contemplating changes in their spending targets to reflect the lower revenue. This year, spending cuts will make up two-thirds of the deficit-cutting plan, with tax increases the remainder. In 2011, the plan was for tax increases to constitute 60 percent of the fiscal adjustment, with spending cuts the rest.

Now there is talk within the Greek finance ministry of reversing this ratio. The view is growing that it will be easier and quicker to cut expenditures rather than raise taxes— an approach that has been accepted by many economists and lies at the heart of the British government's deficit-cutting strategy. Though such an approach may look good on paper and produce quicker results, the political and social consequences of further cuts in wages and public sector services could be severe not just for Greece but Europe as a whole.

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Normxxx
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The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

The Great Deflation

2010-10-27T00:20:00.000-07:00

¹²The Great Deflation
Japan Goes From Dynamic to Disheartened

Dispirited Akiko Oka has worked part time in an Osaka clothing shop since her store closed in 2002. She said she lamented Japan's loss of vigor.

OSAKA, Japan— Like many members of Japan's middle class, Masato Y. enjoyed a level of affluence two decades ago that was the envy of the world. Masato, a small-business owner, bought a $500,000 condominium, vacationed in Hawaii and drove a late-model Mercedes. But his living standards slowly crumbled along with Japan's overall economy.

First, he was forced to reduce trips abroad and then eliminate them. Then he traded the Mercedes for a cheaper domestic model. Last year, he sold his condo— for a third of what he paid for it, and for less than what he still owed on the mortgage he took out 17 years ago.

"Japan used to be so flashy and upbeat, but now everyone must live in a dark and subdued way," said Masato, 49, who asked that his full name not be used because he still cannot repay the $110,000 that he owes on the mortgage. Few nations in recent history have seen such a striking reversal of economic fortune as Japan. The original Asian success story, Japan rode one of the great speculative stock and property bubbles of all time in the 1980s to become the first Asian country to challenge the long dominance of the West.

But the bubbles popped around 1989, and Japan fell into a slow but relentless decline that neither enormous budget deficits nor a flood of easy money has reversed. For about a generation now, the nation has been trapped in low to negative growth and a corrosive downward spiral of prices known as deflation. In the process, it shriveled from an economic Godzilla to little more than an afterthought in the global economy.

Now, as the United States and other Western nations struggle to recover from a debt and property bubble of their own, a growing number of economists are pointing to Japan as a dark vision of the future. Even as the Federal Reserve chairman, Ben S. Bernanke, prepares a fresh round of 'unconventional' measures to 'stimulate' the economy, there are growing fears that the United States and many European economies could face a prolonged period of slow growth or even, in the worst case, deflation, something not seen on a sustained basis outside Japan since the Great Depression. Many economists remain confident that the United States will avoid the stagnation of Japan, largely because of the greater responsiveness of the American political system and Americans' greater tolerance for capitalism's creative destruction.

Japanese leaders at first denied the severity of their nation's problems and then spent heavily on 'job-creating' public works projects that only postponed painful but necessary structural changes, economists say. "We're not Japan," said Robert E. Hall, a professor of economics at Stanford. "In America, the bet is still that we will somehow find ways to get people spending and investing again."

Still, as political pressure builds to reduce federal spending and budget deficits, other economists are now warning of "Japanification"— of falling into the same deflationary trap of collapsed demand that occurs when consumers refuse to consume, corporations hold back on investments and banks sit on cash. It becomes a vicious, self-reinforcing cycle: as prices fall further and jobs disappear, consumers tighten their purse strings even more and companies cut back on spending and delay expansion plans. "The U.S., the U.K., Spain, Ireland, they all are going through what Japan went through a decade or so ago," said Richard Koo, chief economist at Nomura Securities who recently wrote a book about Japan's lessons for the world.

"Millions of individuals and companies see their balance sheets going underwater, so they are using their cash to pay down debt instead of borrowing and spending." Just as inflation scarred a generation of Americans, deflation has left a deep imprint on the Japanese, breeding generational tensions and a culture of pessimism, fatalism and reduced expectations. While Japan remains in many ways a prosperous society, it faces an increasingly grim situation [[especially demographically: normxxx]], particularly outside the relative economic vibrancy of Tokyo, and its situation provides a possible glimpse into the future for the United States and Europe, should the most dire forecasts come to pass.

Scaled-Back Ambitions

The downsizing of Japan's ambitions can be seen on the streets of Tokyo, where concrete "microhouses" have become popular among younger Japanese who cannot afford even the famously cramped housing of their parents, or lack the job security with which to take out a traditional multidecade loan. These matchbox-size homes stand on plots of land barely large enough to park a sport utility vehicle, yet have three stories of closet-size bedrooms, suitcase-size closets and a tiny kitchen that properly belongs on a submarine. "This is how to own a house even when you are uneasy about the future," said Kimiyo Kondo, general manager at Zaus, a Tokyo-based company that builds microhouses.

For many people under 40, it is hard to grasp just how far this is from the 1980s, when a mighty— and threatening— "Japan Inc". seemed ready to obliterate whole American industries, from automakers to supercomputers. With the Japanese stock market quadrupling and the yen rising to unimagined heights, Japan's companies dominated global business, gobbling up trophy properties like Hollywood movie studios (Universal Studios and Columbia Pictures), famous golf courses (Pebble Beach), and iconic real estate (Rockefeller Center).

In 1991, economists were predicting that Japan would overtake the United States as the world's largest economy by 2010. In fact, Japan's economy remains the same size it was then: a gross domestic product of $5.7 trillion at current exchange rates. During the same period, the United States economy has doubled in size to $14.7 trillion, and this year China overtook Japan to become the world's No. 2 economy.

Hiro Komae for The New York Times. Over the past 15 years, the number of fancy clubs has declined sharply in Kitashinchi, Osaka's main entertainment district.

China has so thoroughly eclipsed Japan that few American intellectuals seem to bother with Japan now, and once crowded Japanese-language classes at American universities have emptied. Even Clyde V. Prestowitz, a former Reagan administration trade negotiator whose writings in the 1980s about Japan's threat to the United States once stirred alarm in Washington, said he was now studying Chinese. "I hardly go to Japan anymore," Mr. Prestowitz said.

The decline has been painful for the Japanese, with companies and individuals like Masato having lost the equivalent of trillions of dollars in the stock market, which is now just a quarter of its value in 1989, and in real estate, where the average price of a home is the same as it was in 1983. The future looks even bleaker, as Japan faces the world's largest government debt— around 200 percent of gross domestic product— a shrinking population and rising rates of poverty and suicide. But perhaps the most noticeable impact here has been Japan's crisis of confidence.

Just two decades ago, this was a vibrant nation filled with energy and ambition, proud to the point of arrogance and eager to create 'a new economic order' in Asia based on the yen. Today, those high-flying ambitions have been shelved, replaced by weariness and fear of the future, and an almost stifling air of resignation. Japan seems to have pulled into a shell, content to accept its slow fade from the global stage.

Its once voracious manufacturers now seem prepared to surrender industry after industry to hungry South Korean and Chinese rivals. Japanese consumers, who once flew by the planeload on flashy shopping trips to Manhattan and Paris, stay home more often now, saving their money for an uncertain future or setting new trends in frugality with discount brands like Uniqlo. As living standards in this still wealthy nation slowly erode, a new frugality is apparent among a generation of young Japanese, who have known nothing but economic stagnation and deflation.

They refuse to buy big-ticket items like cars or televisions, and fewer choose to study abroad in America. Japan's loss of gumption is most visible among its young men, who are widely derided as "herbivores" for lacking their elders' willingness to toil for endless hours at the office, or even to succeed in romance, which many here blame, only half jokingly, for their country's shrinking birthrate. "The Japanese used to be called economic animals," said Mitsuo Ohashi, former chief executive officer of the chemicals giant Showa Denko. "But somewhere along the way, Japan lost its animal spirits."

When asked in dozens of interviews about their nation's decline, Japanese, from policy makers and corporate chieftains to shoppers on the street, repeatedly mention this startling loss of vitality. While Japan suffers from many problems, most prominently the rapid graying of its society, it is this decline of a once wealthy and dynamic nation into a deep psychological, socialogical, and cultural rut that is perhaps Japan's most ominous lesson for the world today. The classic explanation of the evils of deflation is that it makes individuals and businesses less willing to use money, because the 'rational' way to act when prices are falling is to hold onto cash, which gains in value.

But in Japan, nearly a generation of deflation has had a much deeper effect, subconsciously coloring how the Japanese view the world. It has bred a deep pessimism about the future and a fear of taking risks that make people reflexively reluctant to spend or invest, driving down demand— and prices— even further. "A new common sense appears, in which consumers see it as irrational or even foolish to buy or borrow," said Kazuhisa Takemura, a professor at Waseda University in Tokyo who has studied the psychology of deflation.

A Deflated City

While the effects are felt across Japan's economy, they are more apparent in regions like Osaka, the third-largest city, than in still relatively prosperous Tokyo. In this proudly commercial city, merchants have gone to extremes to coax shell-shocked shoppers into spending again. But this often takes the shape of price wars that only end up feeding Japan's deflationary spiral.

There are vending machines that sell canned drinks for 10 yen, or 12 cents; restaurants with 50 yen beer; apartments with the first month's rent of just 100 yen, about $1.22. Even marriage ceremonies are on sale, with discount 'wedding halls' offering weddings for $600— less than a tenth of what such ceremonies typically cost here just a decade ago. On Senbayashi, an Osaka shopping street, merchants recently held a 100 yen day, offering much of their merchandise for that price. Even then, they said, the results were disappointing.

"It's like Japanese have even lost the desire to look good," said Akiko Oka, 63, who works part time in a small apparel shop, a job she has held since her own clothing store went bankrupt in 2002. This loss of vigor is sometimes felt in unusual places. Kitashinchi is Osaka's premier entertainment district, a three-centuries-old playground where the night is filled with neon signs and hostesses in tight dresses, where just taking a seat at a top club can cost $500.

But in the past 15 years, the number of fashionable clubs and lounges has shrunk to 480 from 1,200, replaced by discount bars and chain restaurants. Bartenders say the clientele these days is too cost-conscious to show the studied disregard for money that was long considered the height of refinement. "A special culture might be vanishing," said Takao Oda, who mixes perfectly crafted cocktails behind the glittering gold countertop at his Bar Oda.

After years of complacency, Japan appears to be waking up to its problems, as seen last year when disgruntled voters ended the virtual postwar monopoly on power of the Liberal Democratic Party. However, for many Japanese, it may be too late. Japan has already created an entire generation of young people who say they have given up on believing that they can ever enjoy the job stability or rising living standards that were once considered a birthright here.

Yukari Higaki, 24, said the only economic conditions she had ever known were ones in which prices and salaries seemed to be in permanent decline. She saves as much money as she can by buying her clothes at discount stores, making her own lunches and forgoing travel abroad. She said that while her generation still lived comfortably, she and her peers were always in a defensive crouch, ready for the worst.

"We are the survival generation," said Ms. Higaki, who works part time at a furniture store. Hisakazu Matsuda, president of Japan Consumer Marketing Research Institute, who has written several books on Japanese consumers, has a different name for Japanese in their 20s; he calls them the 'consumption-haters'. He estimates that by the time this generation hits their 60s, their habits of frugality will have cost the Japanese economy $420 billion in lost consumption.

"There is no other generation like this in the world," Mr. Matsuda said. "These guys think it's stupid to spend". Deflation has also affected businesspeople by forcing them to invent new ways to survive in an economy where prices and profits only go down, not up.

Yoshinori Kaiami was a real estate agent in Osaka, where, like the rest of Japan, land prices have been falling for most of the past 19 years. Mr. Kaiami said business was tough. There were few buyers in a market that was virtually guaranteed to produce losses, and few sellers, because most homeowners were saddled with loans that were worth more than their homes.

Some years ago, he came up with an idea to break the gridlock. He created a company that guides homeowners through an elaborate legal subterfuge in which they erase the original loan by declaring personal bankruptcy, but continue to live in their home by "selling" it to a relative, who takes out a smaller loan to pay its greatly reduced price. "If we only had inflation again, this sort of business would not be necessary," said Mr. Kaiami, referring to the rising prices that are the opposite of deflation. "I feel like I've been waiting for 20 years for inflation to come back."

One of his customers was Masato, the small-business owner, who sold his four-bedroom condo to a relative for about $185,000, 15 years after buying it for a bit more than $500,000. He said he was still deliberating about whether to expunge the $110,000 he still owed his bank by declaring personal bankruptcy. Economists said one reason deflation became self-perpetuating was that it pushed companies and people like Masato to survive by sharply cutting costs and selling what they already owned, instead of buying new goods or investing. "Deflation destroys the risk-taking that capitalist economies need in order to grow," said Shumpei Takemori, an economist at Keio University in Tokyo. "Creative destruction is replaced with what is just destructive destruction."

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Normxxx
______________

The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

The Best Investment Advice You'll Never Get

2010-10-26T17:27:00.000-07:00

¹²The Best Investment Advice You'll Never Get

Mark Dowie, who managed the municipal bond portfolio at Bank of America and all nonequity investments for Industrial Indemnity, and advised the Bechtel family on economic and investment strategy, now watches his modest portfolio of index funds grow from his home near Point Reyes Station.He says: "For 35 years, Bay Area finance revolutionaries have been pushing a personal investing strategy that brokers despise and hope you ignore."

By Mark Dowie

As Google's historic August 2004 IPO approached, the company's senior vice president, Jonathan Rosenberg, realized he was about to spawn hundreds of impetuous young multimillionaires. They would, he feared, become the prey of Wall Street brokers, financial advisers, and wealth managers, all offering their own get-even-richer investment schemes. Scores of them from firms like J.P. Morgan Chase, UBS, Morgan Stanley, and Presidio Financial Partners were already circling company headquarters in Mountain View with hopes of presenting their wares to some soon-to-be-very-wealthy new clients.

Rosenberg didn't turn the suitors away; he simply placed them in a holding pattern. Then, to protect Google's staff, he proposed a series of in-house investment teach-ins, to be held before the investment counselors were given a green light to land. Company founders Sergey Brin and Larry Page and CEO Eric Schmidt were excited by the idea and gave it the go-ahead.

One by one, some of the most revered names in investment theory were brought in to school a class of brilliant engineers, programmers, and cybergeeks on the fine art of personal investing, something few of them had thought much about. First to arrive was Stanford University's William (Bill) Sharpe, 1990 Nobel Laureate economist and professor emeritus of finance at the Graduate School of Business. Sharpe drew a large and enthusiastic audience, which he could have wowed with a PowerPoint presentation on his "gradient method for asset allocation optimization" or his "returns-based style analysis for evaluating the performance of investment funds". But he spared the young geniuses all that complexity and offered a simple formula instead. "Don't try to beat the market," he said. Put your savings into some indexed mutual funds, which will make you just as much money (if not more) at much less cost by following the market's natural ebb and flow, and get on with building Google.

The following week it was Burton Malkiel, formerly dean of the Yale School of Management and now a professor of economics at Princeton and author of the classic A Random Walk Down Wall Street. The book, which you'd be unlikely to find on any broker's bookshelf, suggests that a "blindfolded monkey" will, in the long run, have as much luck picking a winning investment portfolio as a professional money manager. Malkiel's advice to the Google folks was in lockstep with Sharpe's.

Don't try to beat the market, he said, and don't believe anyone who tells you they can— not a stock broker, a friend with a hot stock tip, or a financial magazine article touting the latest mutual fund. Seasoned investment professionals have been hearing this anti-industry advice, and the praises of indexing, for years. But to a class of 20-something quants who'd grown up listening to stories of tech stocks going through the roof and were eager to test their own ability to outpace the averages, the discouraging message came as a surprise. Still, they listened and pondered as they waited for the following week's lesson from John Bogle.

"Saint Jack" is the living scourge of Wall Street. Though a self-described archcapitalist and lifelong Republican, on the subject of brokers and financial advisers he sounds more like a seasoned Marxist. "The modern American financial system," Bogle says in his book The Battle for the Soul of Capitalism, "is undermining our highest social ideals, damaging investors' trust in the markets, and robbing them of trillions". But most of his animus in Mountain View was reserved for mutual funds, his own field of business, which he described as an industry organized around "salesmanship rather than stewardship," which "places the interests of managers ahead of the interests of shareholders," and is "the consummate example of capitalism gone awry".

Bogle's closing advice was as simple and direct as that of his predecessors: those brokers and financial advisers hovering at the door are there for one reason and one reason only— to take your money through exorbitant fees and transaction costs, many of which will be hidden from your view. They are, as New York attorney general Eliot Spitzer described them, nothing more than "a giant fleecing machine". Ignore them all and invest in an index fund. And it doesn't have to be the Vanguard 500 Index, the indexed mutual fund that Bogle himself built into the largest in the world. Any passively managed index fund will do, because they're all basically the same.

When the industry sharks were finally allowed to enter the inner sanctum of Google, they were barraged with questions about their commissions, fees, and hidden costs, and about indexing. 'Indexing' was the almost cost-free investment strategy the Google employees had been told delivers higher net returns than [[almost: normxxx]] all other mutual fund strategies. The assembled Wall Streeters were surprised by their reception— and a bit discouraged.

Brokers and financial planners don't like indexed mutual funds for two basic reasons. For one thing, the funds are an affront to their ego because they discount their ability to assemble a winning portfolio, the very talent they're trained and paid to offer. Also, index funds don't make brokers and planners much money. If you have your money in an account that's following the natural movements of the market— also called passive investing— you don't need fancy managers to watch it for you and charge big bucks to do so.

Brin and Page were proud of the decision to prepare their staff for the Wall Street predation. And they were glad to have launched their company where and when they did. What took place in Mountain View that spring might have never happened had Google been born in Boston, Chicago, or New York, where much of the financial community remains at war with insurgency forces that first started gathering in San Francisco 35 years ago.

It all started in the early 1970s with a group of maverick investment professionals working at Wells Fargo bank. Using the vast new powers of quantitative analysis afforded by computer science, they gradually came to the conclusion that the traditional practices guiding institutional investing in America were, for the most part, not delivering on the promise of better-than-average returns. As a result, the fees that average Americans were paying brokers to engage in these practices were akin to highway robbery. Sure, some highly paid hotshot portfolio managers could occasionally put together a high-return fund [[which, with extremely rare exceptions, invariably crashed and burned in a relatively few years: normxxx]]. But generally speaking, trying to beat the market— also called active investing— was a fruitless venture.

The insurrection these mavericks would create eventually caught on and has spread beyond the Bay Area. But San Francisco remains ground zero of the democratizing challenge to America's vast and lucrative investment industry. Under threat are the billions of dollars that mutual funds and brokers skim every year from often-unwary investors. And every person who has money to invest is affected, whether she's patching together her own portfolio with a broker, saving for retirement or college, or just making small contributions each year to her 401K. If the movement succeeds, not only will more and more people have a lot more money in their pockets, but the personal investment industry will never look the same.

I was once a portfolio manager myself, and like the industry folks Google was protecting its employees from, I was certain I could outperform market averages and confident that I was worth the salary paid to do so. However, I left the investment business before this revolt began to brew. In the intervening years, I never stewarded my own investments as judiciously as I'd managed those of my former employers— Bank of America, Industrial Indemnity, and the Bechtel family.

I was unhappy with the Wall Street firms I had been using, which had churned my account to make lots of money on the sales, and, despite instructions to the contrary, placed my money in their own funds and underwritings to make even more at my expense. So a couple of years ago, when it finally came time to get my own house in order, I knew I wanted help from an independent adviser, someone who was doing things differently from the big brokerage firms.

Eventually I found a small financial management firm in Sausalito called Aperio Group that, after only seven years in business, already had a stellar reputation. "Aperio" in Latin means "to make clear, to reveal the truth". Indeed, truth-telling is key to Aperio's mission, even if that means badmouthing its own industry in the process. One of the company's founders, Patrick Geddes, aged 48, is a renegade from the top echelons of his field.

For several years he served, first as director of quantitative research, then as CFO, at Morningstar, the nation's leading company for researching and appraising mutual funds. But when he left, not only was he disenchanted with his own company's corporate environment, he was also becoming uneasy with the moral underpinning of the entire industry. "Let's be straight," says Geddes in his soft-spoken but zealous way. "Being unethical is a good precondition for success in the financial business."

His partner, a bright, high-energy Norwegian American named Paul Solli, 49, is another finance guy who didn't have the gene for corporate culture. After graduating from Dartmouth's business school, he tried investment banking but didn't like it. He went out on his own, starting an investment advisory business, but says he flailed about, searching for a business model that would support his desire to "live deliberately" in the Thoreauvian manner.

Solli and Geddes consider themselves heirs to the Wells Fargo insurgency and, as such, part of a movement that includes academics, some institutional investors, a couple of large index fund companies, and a handful of small firms like their own that are dedicated to bringing the indexing philosophy to badly advised investors like myself. And unlike most mutual fund investment firms, which have $5 million and $10 million minimums, Aperio was willing to take on a messy six-figure portfolio.

Solli took one look at my unkempt collection of mutual funds and said, "You're being robbed here." He pointed to funds I had purchased from or through Putnam, Merrill Lynch, Dreyfus, and— yes— Charles Schwab (which referred me to Aperio) and asked, "Do you know that you're paying these guys to do essentially nothing"? He carefully explained the many ingenious ways fund managers, brokers, and advisers had found to chip away at investors' returns.

Turns out that I, like more than 90 million other suckers who have put close to $9 trillion into mutual funds, was paying annual fees, commissions, and transaction costs well in excess of 2 percent a year on most of my mutual funds (see "What Are the Fees"?). "Do you know what that adds up to"? Solli asked. "At the end of every 36 years, you will only have made half of what you could have, through no fault of your own. And these are fees you needn't pay, and won't, if you switch to index funds."

All indexing calls for, Solli explains, is the selection of a particular stock market index— the Dow Jones Industrial Average, Standard and Poor's (S&P) 500, the Russell 1000, or the broader Wilshire 5000— and the purchase of all its stocks and bonds in the exact proportions in which they exist in that index. In an actively managed fund, managers pick stocks they 'think' will outperform a particular index. But the premise of indexing is that stock prices are generally an accurate reflection of a company's worth at any given time, so there's no point in trying to beat that price.

The worth of a client's investment goes up or down with the ebb and flow of the market, but the idea is that the market naturally tends to increase over time. Moreover, even if an index fund performed only as well as the expensively managed Merrill Lynch Large Cap mutual fund that was in my portfolio, I would earn more because of the lower fees. Stewarding this kind of investment does not require a staff of securities analysts working under a fund manager who makes $20 million a year. In fact, a desktop computer can do it while they sleep.

There are always exceptions, of course, Solli says, "a few funds that at any given moment outperform the indexes." But over the years, he explains, their performances invariably decline, and their highly paid cover-boy managers slide into early obscurity, to be replaced by a new hotshot managing a different fund. If a mutual-fund investor is able to stay abreast of such changes, move their money around from fund to fund, and stay ahead of the averages (factoring in higher commissions and management fees) it will be by sheer luck, says Solli, who then offers me pretty much the same advice John Bogle and his colleagues offered Google. Sell the hyped but fee-laden funds in my portfolio and replace them with boring, low-cost funds like those offered by Bogle's Vanguard.

It took Solli a couple more painful meetings and a few dozen trades to clean the parasites out of my account and reinvest the proceeds in index funds, the lifeblood of his business. Without exception, he moved me into funds that have outperformed the ones I was in, like the Vanguard REIT Index Fund, some Pimco bond and stock funds, and Artisan International. And he did it for an annual fee of .5 percent of money under management, saving me over a full percent in overall costs and a lot of taxes in the future. Then he did something I doubt any other financial manager would have done. He fired himself.

"You really don't need me anymore," he said, and closed my Aperio account that day, ending his fees, but not our relationship. I was curious. Who was this guy who was so open about the less-than-dignified ways of his own business? "You have to have lunch with my partner," he said. If Solli is an industry gadfly, Geddes, a modest, unassuming son of a United Church of Christ minister, is its chainsaw massacrer.

"We work in the most overcompensated industry in the country," Geddes admitted before the water was served, "and indexing threatens the revenue flow from managed funds to brokerage houses. That's why you've been kept in the dark about it. This truly is the great secret shame of our business."

"The industry knows they are peddling bad products," Geddes continued, "and a lot of people making the most money and getting the most prestige are doing so by gouging their customers." And Geddes is quick to differentiate between "illegal theft"— the sort of industry scandals Spitzer has uncovered, such as illicit sales practices, undisclosed fees, kickbacks, and after-market trading— and "legal theft," the stuff built into the cost of doing business that no attorney general can touch, but which in dollar amounts far exceeds investor losses to illegal activity.

Geddes wasn't always full of such tough talk about the industry. Not that he had any qualms about speaking his mind; in fact, he was let go from Morningstar in 1996 for being openly critical of the company's internal culture. "I still think of Morningstar as a potentially positive force in the industry," he says. "But let's just say they were weak at conflict management, especially at the senior levels". It wasn't until he took a freelance consulting job for Charles Schwab that he really saw the light about indexing.

"My job was to compile all the academic research on mutual funds, and that's when it really became clear that active management doesn't add any value," he says. When he finished the project, Geddes started teaching a finance class through the University of California extension, where he started preaching his anti-industry gospel. "I had to be careful, because there were a lot of brokers in the class. I started noticing that some of them would get sort of irritated with me."

Around this time is when he met Solli. Solli had a client, a doctor who was looking to learn about portfolio management and asked Solli what he thought of Geddes's UC course. When Solli looked into it, he was bowled over. "Here was this guy who'd been CFO at Morningstar and had this incredible background, and I thought, what the hell is he doing at Berkeley teaching this course to guys like my client? This is too good to be true— I have to meet this guy."

Slowly, inadvertently even, Aperio was born. But the fit was perfect. Geddes brought what he calls "the quant piece" to the table; Solli had the strategic vision. After a few months of brainstorming, they set out to see if a couple of guys who held themselves to high ethical standards could make it in the cutthroat financial industry.

And just how do these guys make money if they keep kicking out clients like me once they switch us into index funds, while alienating others with their irreverent critique of the entire mutual fund game? Geddes does take referrals from investment firms like Charles Schwab, which thrive on the sale of managed mutual funds. So why the rant? Isn't he, too, in business to make a buck?

"Absolutely," he admits. "I'm not Mother Teresa; I'm a capitalist who wants to succeed and make money. I just think the best way to do that is by building trust in a clientele by revealing to them honestly how this business works."

Geddes also offers a 'customized' version of indexing (on taxable returns) for wealthier clients, a service that requires an ongoing relationship and supplies Aperio a steadier source of income than my low-six-figure portfolio did. Aperio now has about $800 million under management. It's a paltry sum compared with those of the big brokerage firms, which deal in the billions or even trillions, but Geddes is fine with that. "If I were making what I could be making in this business, I just wouldn't like the person I'd have to be."

"San Francisco was the only place in the country where this could have happened," says Bill Fouse, a jazz clarinetist in Marin County who was present when the first shots were fired in the investment rebellion. It was 1970, and revolution was in the air. While hippies, dopesters, and antiwar radicals were filling the streets of America's most tolerant city with rage, sweet smoke, and resistance, a quieter protest was brewing in the lofty, paneled offices of Wells Fargo. There, a young engineer named John Andrew "Mac" McQuown, Fouse (who like many musicians also happens to be a brilliant mathematician), and their self-described "skeptical, suspicious, careful, cautious, and slow-to-change" boss, James Vertin, were taking a hard look at the conventional wisdom that for a century had driven American portfolio management.

Bank trust departments across the country were staffed by portfolio managers who, as I did at the time, believed that they alone possessed the investment formula that would enrich and protect the security of their customers. "No one argued with that premise," Fouse recalls. But McQuown suspected they were pretty much all wrong.

He had met Wells Fargo chairman Ransom Cook at an investment forum in San Jose, and at a later meeting at company headquarters, persuaded him that traditional portfolio management was merely an investment variation of the Great Man theory. "A great man picks stocks that go up. You keep him until his picks don't work anymore and you search for another great man," he told Cook.

"The whole thing is a chance-driven process. It's not systematic, and there's lots we still don't know about it and that needs study." Cook offered McQuown a job at Wells and a generous budget to conduct research into the Great Man Theory and other schemes to beat the averages. McQuown accepted, and a few years later Fouse came on as well. They couldn't have been more different: Fouse, a diminutive, mild-mannered musician, and McQuown, a burly, boisterous Scot. The two were like oil and water— McQuown even tried to have Fouse fired at one point— but their boss, Vertin, was the one who really was in the hot seat.

"You have to understand, Vertin's career was on the line," Fouse recalls. "He was, after all, running a department full of portfolio managers and securities analysts whose mission was to outperform the market. Our thesis was that it couldn't be done". Proof of McQuown's theory could lead to the end of an empire, in fact many empires. "The poor guy was under siege," says Fouse. "It was a nerve-racking time."

Vertin's memory of those times is no less vivid. "Mac the knife was going to own this thing," he once told a reporter. "I could just see the fin of the shark cutting through the water". Eventually, the research McQuown and Fouse produced became so strong that Vertin could not ignore it. "In effect it said that almost everything that every trust department in America was doing was wrong," says Fouse. "But Jim eventually accepted it, even knowing the consequences."

In July 1971, the first index fund was created by McQuown and Fouse with a $6 million contribution from the Samsonite Luggage pension fund, which had been referred to Fouse by Bill Sharpe, who was already teaching at Stanford. It was Sharpe's academic work in the 1960s that formed the theoretical underpinning of indexing and would later earn him the Nobel Prize. The small initial fund performed well, and institutional managers and their trustees took note.

By the end of the decade, Wells had completely renounced active management, had relieved most of its portfolio managers, and was offering only passive products to its trust department clients. And it had signed up the College Retirement Equities Fund (CREF), the largest pool of equity money in the world, and Harvard University, the largest educational endowment. By 1980 $10 billion had been invested nationwide in index funds; by 1990 that figure had risen to $270 billion, a third of which was held at Wells Fargo bank.

Eventually the department at Wells that handled indexing merged with Nikko Securities and was later bought by Barclays Bank, which created the San Francisco subsidiary Barclays Global Investors. Its CEO, Patricia Dunn, the scandal-tinged former chairman of Hewlett-Packard who had worked for 20 years at Wells Fargo, had been heavily influenced by indexing. Running Barclays, she became the world's largest manager of index funds.

Fouse, now retired in San Rafael, explains why all this could have happened only in San Francisco. "When we started our research, almost all the trust clients out here were individuals with small accounts. Anywhere else, particularly on the East Coast, trust departments handled very large institutions— pension funds, university endowments, that sort of thing. If Mellon, Chase, or Citibank had done this research and come to the same conclusion, they would have in effect been saying to their large, sophisticated, and very lucrative clientele: 'We've been doing things wrong for a century or more.' And thousands of very comfortable investment managers would have been out of work."

But even in San Francisco, as in the country's other financial centers, Fouse and McQuown's findings were not a welcome development for brokers, portfolio managers, or anyone else who thrived on the industry's high salaries and fees. As a result, the counterattack against indexing began to unfold. Fund managers denied that they had been gouging investors or that there was any conflict of interest in their profession.

Workout gear appeared with the slogan "Beat the S&P 500," and a Minneapolis-based firm, the Leuthold Group, distributed a large poster nationwide depicting the classic Uncle Sam character saying, "Index Funds Are UnAmerican," implying that anyone who was not trying to beat the averages was nothing more than an unpatriotic wimp. (That poster still hangs on the office walls of many financial planners and fund managers.) Savvy investment consumers, however, were apparently catching on.

As they began to suspect that the famous fund managers they were reading about in Business Week and Money magazine were taking them for a ride, index funds grew in size and number. And actively managed funds shrank proportionately. Even some highly placed industry insiders started beating the drums for indexing. From her perch at Barclays, CEO Dunn gave a speech at a 2000 annual industry meeting in Chicago.

As reported in Business Week at the time, she started out with some tongue-in-cheek comments about fund managers' "rare gifts and genius," and then shocked the crowd by going on to denounce the industry's high fees. According to the article, she even included this zinger: "[Investment managers sell] for the price of a Picasso [what] routinely turns out to be paint-by-numbers sofa art". It's not as if Merrill Lynch, Putnam, Dreyfus, et al, were being put out of business by this new consciousness, but like any industry threatened with bad ink, the financial community continued to strike back at every opportunity.

In May 2003, Matthew Fink, president of the Investment Company Institute, a mutual funds trade association, told convening members that his industry was squeaky clean and has "succeeded because the interests of those who manage funds are well-aligned with the interests of those who invest in mutual funds." At the same convention, Fink's remarks were echoed by ICI vice chairman Paul Haaga Jr., who, in his keynote address, pronounced that "our strong tradition of integrity continues to unite us". Indeed, 'integrity' had been the theme of every ICI membership meeting in recent memory.

Haaga then attacked his industry's critics, including former SEC chairmen, members of Congress, academics, journalists, even "a saint with his own statue" (John Bogle). "[They] have all weighed in about our perceived failing," lamented Haaga. "It makes me wonder what life would be like if we'd actually done something wrong."

He didn't have long to wonder. Four months later, the nation's first big mutual fund scandal broke when Eliot Spitzer brought civil actions against four major fund managers for allowing 'preferred' investors to buy and sell shares on news or events that occurred after markets had closed. Spitzer compared the practice to "allowing betting on a horse race after the horses have crossed the finish line". Multimillion dollar fines were issued against the firms, which were also required to compensate customers damaged by what were called 'market-timing' practices.

The market-timing scandals alone are estimated to have cost fund investors about $4 billion, and other industry violations were uncovered after that. But most experts are convinced that the amount pales in comparison to the tens of billions lost every year just to the fees and transaction costs by which mutual funds live and die. After the mutual fund scandals broke, Senator Peter Fitzgerald (R-Ill.) called a hearing before the Subcommittee on Financial Management, the Budget, and International Security, and said this in his opening statement: "The mutual fund industry is now the world's largest skimming operation— a $7 trillion trough from which fund managers, brokers, and other insiders are steadily siphoning off an excessive slice of the nation's household, college, and retirement savings."

No one running a university endowment, independent foundation, or pension fund could match his numbers during his tenure: over the last 21 years, chief investment officer David Swensen has averaged a 16 percent annual return on Yale University's investment portfolio, which he built with everything from venture capital funds to timber. He's been called one of the most talented investors in the world. But lately he's becoming perhaps even more famous for his advice to individual investors, which he first offered in his 2005 book Unconventional Success. "Invest in nonprofit index funds," he says unequivocally. "Your odds of beating the market in an actively managed fund are less than 1 in 100."

And there's more. A recent entry on the Motley Fool, the popular investment advice website, made the following blanket statement: "Buy an index fund. This is the most actionable, most mathematically supported, short-form investment advice ever". As long as 10 years ago, in his annual letter to his shareholders, Warren Buffett advised both institutional and individual investors "that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals."

One would think, with that kind of advice floating about, that the whole country would by now be in index funds. But in the three decades since Wells Fargo kicked things off, only about 40 percent of institutional money and 15 percent of individuals' money has been invested in index funds. So why is indexing catching on so slowly?

A big reason, according to Geddes, is that putting investors into index funds is simply not in the interest of the industry that sells securities. "They just won't accept indexing's minuscule fees," he says. By now, most major brokerage firms offer index funds in addition to traditional mutual funds, but money managers typically don't mention them at all. You usually have to ask about them yourself.

And it makes a certain kind of sense. If a naive investor calls a broker with $100,000 to invest, would the broker be likely to recommend the Vanguard 500 Index with its .19 percent annual fee, of which he receives nothing and collects but a small portion of his firm's approximately $100 transaction fee? Or might he suggest the client buy Putnam's Small Cap Growth Fund B Shares, which carry a 2.3 percent annual fee, 1 percent ($1,000) of which goes to him? And will he tell his client about the hidden transaction charges that further reduce the return on investment? It's simply not to his advantage to do so.

It's hard to find active fund managers who are willing to talk about these issues. I spoke to several, but no one was comfortable discussing the high cost of their practice, and few were willing to talk on the record. Ron Peyton, president and CEO of Callan Associates, a San Francisco–based institutional investment consulting firm, offered a list of advantages of active management, which essentially boiled down to the fact that it's more fun.

"They can raise and lower cash positions [read: buy and sell whatever stocks excite them at any given moment] and go into fixed-income or foreign securities [read: look for investments wherever they want]." I know from experience that he's right, but it's kind of beside the point. The most forthright comments came from Baie Netzer, a research analyst in the Orinda office of Litman/Gregory Companies, a San Francisco–based investment management firm specializing in mutual funds.

Netzer told me outright, "Eighty percent of active managers underperform the market. But we do believe that some managers add value, and those are the ones we look for." Still, if you factor in fees and transaction costs, you have to wonder how much that remaining 20 percent would slip.

But even if the number of active managers who consistently beat the market is small, Stanford's Bill Sharpe still sees a real need for their services. While he is a strong partisan of index funds, he is neither as surprised nor as concerned as Geddes that they don't represent a higher proportion of overall investment. "If you'd told me 35 years ago that indexing would one day represent 40 and 15 percent of investments, I would have asked you what you were smoking," says the personable Sharpe with his characteristic chuckle.

If everyone invested in index funds, he points out, the market itself would die a natural death. "We need active managers," he says. "It's buyers and sellers who keep prices moving, which is what drives the market. Index funds simply reflect what the market is doing". He believes we'd even start to see a decline in market efficiency if index funds rose to 50 percent of total investments.

Does this mean that, when we look at mutual funds, half our options would still be burdened with unconscionable fees and hidden costs? Hopefully not. With the call getting louder from financial experts and industry watchers to reform and regulate mutual funds, it's hard to believe that the fee system can last much longer, particularly with strong Republican voices like Peter Fitzgerald's in Congress. But while Wall Street has considerable soul-searching to do, full blame for the gouging of naive investors does not lie with the investment management industry alone.

There is an innate cultural imperative in this country to 'beat the odds', to do better than the Joneses. In some ways the Leuthold Group was right when it said that index funds are 'un-American'. It's simply difficult for most of us to accept average returns on our money, or on anything for that matter. The ultimate example of the nation's attraction to the big score is, of course, right now under our noses.

If on August 18, 2004, you had invested $100,000 in Google, that stock would now be worth $550,000. So while evidence mounts that it's almost impossible to hit the jackpot with cost-burdened mutual funds— and that for every Google, there's an Enron— we simply refuse to stop trying. Perhaps Solli and Geddes had it right when they selected the name for their company.

The real purpose of this whole revolution is "to make things clear, to reveal the truth." As Solli puts it, "As long as people know what they're dealing with, they can invest their money with full awareness. Whether it's playing it safe with indexing or taking a flier on a hedge fund— at least they're the ones in control."

What About Hedge Funds?

So, the bulk of your savings is safely tucked away in a sensible index fund or two. Why not set aside 5 or 10 percent and take a chance on the post-dot-com insider's investment craze? It's certainly tempting. The most high-profile manager, Edward "Eddie" Lampert, has reportedly earned investors in his ESL Investments hedge fund an average return of 29 percent a year since 1988. After successfully buying Kmart with his investors' money, Lampert turned the merged retailer around and in 2004 personally took home $1 billion.

Another of the world's most successful funds is San Francisco's Farallon Capital Management, which has amassed assets of $12.5 billion over two decades by delivering post-fee returns of 17 percent a year on its flagship fund, according to a 2005 article in Institutional Investor magazine. Forty-eight-year-old Tom Steyer's investors include universities, pension funds, and individuals; at any one time, the magazine said, the managers there might be nursing 300 to 500 investments in everything from real estate— Farallon recently bought into the Mission Bay development— to international finance. But the road from Wall Street is scattered with the bones of bitter hedge fund investors. Since 1995, more than 1,800 known hedge funds have folded completely. In the last few months alone, two large funds— MotherRock and Amaranth Advisors— have gone south.

The high failure rate should come as no surprise, given how hedge funds operate. There's no working model, so they vary widely, but the basic idea is that they rely on risky, untraditional investment strategies— ranging from arbitrage to taking over floundering companies, as Lampert did— to make big money fast. The industry is largely unregulated, and most funds involve 'private' partnerships that operate in strict confidence.

They're also extremely expensive, which limits their user profile. Though fees average just 2 percent of the investment, the same as in a typical Silicon Valley venture fund, managers also withhold a sizable chunk (averaging 20 percent, but sometimes going as high as 50 percent) of whatever profit the funds produce. The typical minimum required to get into a fund is between $1 million and $5 million.

The SEC periodically considers applying minimal rules to hedge funds, such as prohibiting pension funds from investing in them. Last October, the call for reform came from Congress when Senator Charles Grassley, chairman of the Senate Finance Committee, asked administration officials and Congress members for their views on how to improve hedge fund transparency. But so far, the hedge fund lobby has managed to keep all regulators at bay.

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What Are The Fees?

By Byron Perry | 26 October 2010

Every fee that a mutual fund charges should be outlined somewhere in its prospectus. But many people don't even think to look for it, and you can't necessarily trust your broker to bring it up. "The first step is simply getting people to pay attention to fees," says Patrick Geddes, chief investment officer of Aperio Group, in Sausalito. Hang tough in asking your broker for the full breakdown of what those fees will cost you each year.

If you need help, the National Association of Securities Dealers has a useful tool for computing fees, called the Mutual Fund Expense Analyzer, on its website (http://apps.nasd.com/investor_Information/ea/nasd/mfetf.aspx). You put in the name of the fund, the amount invested, the rate of return, and the length of time you've had the fund, and it tells you exactly how much you've been charged.

You can also compare past fees for different funds before you invest. For example, if you had put $100,000 into Putnam's Small Cap Growth Fund Class B Shares and held it for the past five years, you would find that Putnam would have charged you $13,809 in fees during that time. Vanguard's Total Stock Market Index Fund, on the other hand, would have charged only $1,165 for the exact same investment.

Which Index Fund?

In some ways indexing is a no-brainer: invest your money and let it do its thing. Still, there are varieties. Aperio Group's Patrick Geddes pushes two rules in choosing a fund: "The broader the better, and the cheaper the better". When you invest in a broad domestic fund, you're investing in the entire U.S. economy, or "owning capitalism," as it were, Geddes says. The Vanguard Total Stock Market Index Fund, which represents about 99.5 percent of U.S. common stocks, is a great one to start with.

If you choose a narrower fund, like a tech or energy index, you're basically just speculating (though you'll most likely still fare better than if you tried to pick the next Google). Narrow index funds also typically command higher fees. With indexing gaining in popularity, everyone's trying to get into the game and sneak in unnecessarily high fees. Geddes says there's no good reason to pay more than .19 percent.

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Normxxx
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The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Forget BRIC, It's Time For CIVETS

2010-10-26T11:39:00.001-07:00

¹²Forget BRIC, It's Time For CIVETS

By Stephen Simpson | 26 October 2010

Wall Street loves sound bites and handy acronyms. Whether it is ROE, NPV or NAV, there is no shortage of handy terms. For growth-oriented investors, BRIC has been one of the most important acronyms of the past ten years. Encompassing the dynamic economies of Brazil, Russia, India and China, BRIC was a guidepost for many investors and there is no questioning the strong stock performance of this group (particularly China and Brazil). (Historically, international investing has worked out well for investors, but this may no longer be the case. See Does International Investing Really Offer Diversification?)

Things change, though, and it may be time for investors to pay more attention to a new name. A civet may be an odd-looking creature (imagine a cross between a raccoon and a cheetah), but the CIVETS could be the next major destination for international investing.

Meet The Civets
CIVETS is an acronym, reportedly coined by Michael Geoghegan at HSBC (NYSE:HBC), for Colombia, Indonesia, Vietnam, Egypt, Turkey and South Africa. Investors may think of this as a 'second-generation' of emerging economies [[aka, Frontier Markets: normxxx]], as these countries generally have fast-rising (and young) populations, relatively well-established financial infrastructure, internal stability and a pathway towards significant economic growth and potential co-leadership in their economic spheres. Keep in mind, though, that not all of these countries posses these qualities to equal levels.

What's more, none of these countries is so stable or well-established that back-sliding and disappointment could not occur [[and seemingly abruptly and without warning, even if you are paying attention: normxxx]]. Corruption is still a significant problem in many (if not all) of these countries, and investors should not over-estimate the openness of these markets or the ease of investment. In others, an investor's options will be limited in comparison to a more-developed country like South Korea or even China and Mexico.

Of course, an assemblage of names like this is always at least a little arbitrary. Egypt, for instance, seems to have more value as a vowel than as a peer member of this group. Along similar lines, investors may find countries like Poland, Hungary or Sri Lanka to be more intriguing, even if they do not lead to a clever-sounding acronym. Accordingly, country-by-country economic due diligence is vital unless investors want to spread their bets across the entire group. (Find out how these worldly offerings can spice up your portfolio. Check out Go International With Foreign Index Funds.)

How Investors Can Make A Play
While each one of the CIVETS countries has a domestic stock market, it is not necessarily easy for the average American investor to take part. Relatively few American brokerages offer international trading, and those that do often restrict it to wealthy investors and/or charge handsomely for the service. Still, for those willing to do the work (and pay the price), direct investing is a viable option.

Although ADRs often give American investors a cheaper and more liquid investment alternative, here too that is not much of an option. There are a handful of CIVETS companies with ADR programs in the U.S.— like Bancolombia (NYSE:CIB), PT Telekom (NYSE:TLK), and Sasol (NYSE:SSL)— but most of the available ADRs are unsponsored and relatively illiquid. That leaves ETFs as the best option for most investors. In every case, there is at least one available country-specific ETF for the CIVETS members.

'Frontier Markets'; [1]; [2]; [3]
Columbia      Global X FTSE Colombia 20 (NYSE:GXG)
Indonesia     Market Vectors Indonesia (NYSE:IDX), iShares Indonesia (Nasdaq:EIDO)
Vietnam       Market Vectors Vietnam (NYSE:VNM)
Egypt         Market Vectors Egypt (Nasdaq:EGPT)
Turkey        iShares Turkey (NYSE:TUR)
South Africa  iShares South Africa (NYSE:EZA)
Poland        Market Vectors Poland (NYSEArca: PLND)
Hungary       Eastern Europe ETFs
Sri Lanka     To Be Determined

Investors frustrated by this narrow list of options should take heart in the BRIC example. It was quite challenging to invest in those countries in 2000/2001, but there has been a tremendous boom in the years since and there is no shortage of potential plays on these economies now (though investors still have a dearth of choice in individual company stocks). It seems reasonable to assume that the CIVETS countries will follow a similar trajectory— investing today will be expensive and inconvenient, but market growth and investor interest will ultimate lead to more (and better) choices.

The Bottom Line
Investors who want above-average portfolio performance need to be willing to take on more risks and to go where the growth is likely to be. Emerging economies like CIVETS certainly fit the bill— they have large, young populations, generally ample natural resources and favorable geography to fuel their progress. The path will be bumpy, punctuated with great steps forward and occasional stumbles, but patient investors may find that, like BRIC in the first decade of this century, investing in CIVETS is a growth opportunity they should not ignore. (Going global may help increase your portfolio return but is the unique risk worth it? Check out Why Invest In International Equity Mutual Funds?)

[[I have found that the best way to invest in an Emerging Market country is to wait for its stock market to crash— they invariably do so in synch with the golobal economy and in response to internal or regional events— acertain that the reason for the crash is not not likely to be of long standing, then invest. You only have to be patient.: normxxx]]