An Economy Still At The Brink

An Economy Still At The Brink

By Sandy B. Lewis and William D. Cohan | 7 June 2009

Sandy B. Lewis, an organic farmer, founded SB Lewis & Co., a brokerage house. William D. Cohan, a contributing editor at Fortune and former Wall Street banker, is the author of "House of Cards: A Tale of Hubris and Wretched Excess on Wall Street."

Whether at a fund-raising dinner for wealthy supporters in Beverly Hills, or at an Air Force base in Nevada, or at Charlie Rose’s table in New York City, President Obama is conducting an all-out campaign to try to make us feel a whole lot better about the economy as quickly as possible. "It’s safe to say we have stepped back from the brink, that there is some calm that didn’t exist before," he told donors at the Beverly Hilton Hotel late last month. Mr. Obama thinks that the way to revive the economy is to restore confidence in it. If the mood is right, the capital will flow. But this belief is dangerously misguided.

We are sympathetic to the extraordinary challenge the president faces, but if we’ve learned anything at all two years into the worst financial crisis of our lifetimes, it is that a capital-markets system this dependent on public confidence is a shockingly inadequate foundation upon which to rest our economy. We have both spent large chunks of our lives working on Wall Street, absorbing its ethic and mores. We’re concerned that nothing has really been fixed. We’re doubly concerned that people appear to feel the worst of the storm is over— and in this, they are aided and abetted by a hugely popular and charismatic president and by the fact that the Dow has increased by 35 percent or so since Mr. Obama started to lay out his economic plans in March.

(Disclosure: One of us, Mr. Lewis, was convicted on federal charges of stock manipulation in 1989, pardoned by President Bill Clinton in 2001 and had his lifetime trading ban overturned by the Securities and Exchange Commission in 2006; documents relating to the case can be found at sblewis.net.)

But wishing for improvement and managing by the Dow’s swings are a fool’s game. The storm is not over, not by a long shot. Huge structural flaws remain in the architecture of our financial system, and many of the fixes that the Obama administration has proposed will do little to address them and may make them worse.

At another fund-raising event, for Senator Harry Reid, President Obama said: "We didn’t ask for the challenges that we face. But we are determined to answer the call to meet those challenges, to cast aside the old arguments and overcome the stubborn divisions and move forward as one people and one nation …. It will take time but I promise you, I promise you, I’ll always tell you the truth about the challenges we face."

Keeping that statement in mind— as well as an abiding faith in the importance of properly functioning capital markets— we have come up with a set of questions meant to challenge a popular president, with vast majorities in Congress, to find the flaws in the system, to figure out what’s being done to fix them and to get to the truth about the difficulties we face as we set out to restore the proper functioning of our markets and our standing in the world.

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Six months ago, nobody believed that our banking system was well designed, functioning smoothly or properly regulated— so why then are we so desperately anxious to restore that very model as the status quo? Nearly every new program emanating these days from the Treasury Department— the Term Asset-Backed Securities Loan Facility, the Public Private Investment Program, the "stress tests" of major banks— appears to have been designed to either paper over or to prop up a system that has clearly failed. Instead of hauling out the new drywall to cover up the existing studs, let’s seriously consider ripping down the entire structure, dynamiting the foundation and building a new system that rewards taking prudent risks, allocates capital where it is needed, allows all investors to get accurate and timely financial information and increases value to shareholders and creditors.

As a start, the best-compensated executives at the top of these big banks, hedge funds and private-equity firms should be treated like those general partners of yore. If a firm takes prudent risks that pay off, this top layer of management should be well compensated. But if the risks these people take are imprudent and the losses grave, they should expect to lose their jobs.

Instead of getting guaranteed salaries or huge bonuses, they should have the bulk of their net worth completely at risk for a long stretch of time— 10 years come to mind— for the decisions they make/made while in charge. This would go a long way toward re-aligning the interests of these firms with those of their shareholders and clients and the American people, who have been saddled with their risks and mistakes.

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Why is so much effort being put into propping up those at the top of the economic pyramid— the money-center banks, the insurance companies, the hedge funds and so forth— when during a period of [asset] deflation like the one we are in, any recovery will come only by restoring the confidence of the people down at the bottom of the pyramid? [[6.0 million of whom have already lost their jobs and a far greater number of whom have undergone foreclosure (since the peak in housing prices) or have fallen behind on payments but have not yet received foreclosure notices.: normxxx]]

Confidence will return only when jobs can be found and mortgage payments made. Even if Mr. Obama’s claim is true that his $780 billion stimulus package "saved or created" some 150,000 jobs, we seem a long way away from the point where those struggling to get by will feel like spending again. What happens when people buy a car once every 10 years instead of once every two or three, especially now that we taxpayers own such a big percentage of the American auto industry?

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Instead of promising the imminent return of good times, why isn’t Mr. Obama talking more about the importance of living within our means and not spending money we don’t have on things we don’t need? We used to be a frugal nation. The president should be talking about kicking our addictions to easy credit, to quick fixes and to a culture of more is better (and Congress’s new credit-card legislation, while perhaps eliminating some of the worst aspects of that industry, certainly didn’t send the right message about personal finance). Gas-guzzling S.U.V.’s, cigarette boats, no-income mortgages and private jets should be relegated to the junk heaps of history, or better yet, put in a museum dedicated to never forgetting the greed and avarice that led us so far astray.

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Why is the morphine drip still in the veins of the financial system? These trillions in profligate federal spending are intended to make us feel better again even though feeling pain, and dealing with it responsibly, would be healthier in the long run. It is time to stop rescuing the banks that got us into this mess. If that means more bank failures on a grander scale or the dismemberment of Citigroup, so be it. Depositors will be protected— up to $250,000 per account— but shareholders, creditors and, sadly, many employees will, for the long-term health of the system, need to feel the market’s wrath.

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Is there to be any limit on bailouts? We have now thrown money at the big banks, any number of regional ones, insurance companies, General Motors, Chrysler and state and local governments. Will we soon be bailing out Dartmouth, which just lost its AAA bond rating?

Is there no room left for what the Austrian economist Joseph Schumpeter termed "creative destruction"? And what is the plan to get the American people out of all these equity stakes we now own and don’t want? Furthermore, for government leaders to decide who shall live and who shall die in an economic sense opens them up to legitimate charges of crony capitalism and favoritism. [[And, arguably, it destroyed the Soviet Union.: normxxx]] We will benefit in the long run from a return to market discipline.

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Why has Mr. Obama surrounded himself largely with economic advisers who are theoreticians and academics— distinguished though they may be— but not those who have sat on a trading desk, made a market, managed a portfolio or set a spread? In our view, one of the ways out of this economic conundrum is to have experienced traders— not hothouse flowers— design incentives that will encourage the market to have buyers and sellers meet anew around the proper valuations of assets.

This market, propped up by a pliant Financial Accounting Standards Board and/or government-sponsored programs that appear to be virtually giving money away so that financial firms will buy assets they would not ordinarily buy, cannot long endure. We’re not talking about putting the fox in charge of the henhouse— just about adding people who know how markets function in the real world into a few of those important seats in Washington. [[We should take a leaf from FDR's book, who appointed Joe P. Kennedy, a Wall Streeet banker and financier, to head up the newly created SEC. JPK did a bang up job during his tenure. It took some 60 years to destroy what he put together.: normxxx]]

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Why isn’t the Obama administration working night and day to give the public a vastly increased amount of detailed information about what happens in financial markets? Ever since traders started disappearing from the floor of the New York Stock Exchange in the last decade of the 20th century, there has been less and less transparency about the price and volume of trades. The New York Stock Exchange really exists in name only, as computers execute a very large percentage of all trades, far away from any exchange.

As a result, there is little flow of information, and small investors are paying the price. The beneficiaries, no surprise, are the remains of the old Wall Street broker-dealers— now bank-holding companies like Goldman Sachs and Morgan Stanley— that can see in advance what their clients are interested in buying, and might trade the same stocks for their own accounts. Incredibly, despite the events of last fall, nearly every one of Wall Street’s proprietary trading desks can still take the same huge risks and then, if they get into trouble, head to the Federal Reserve for 'short-term rescue' financing. [[…without even blushing: normxxx]]

Here’s something that should change in terms of transparency. The most recent price that any stock traded for should be published online in real time for all to see. And the public should have access to a new type of electronic ticker that provides market information in language that all can understand, not just the insiders.

As for those impossibly complex securities that caused so much of the trouble— among them derivatives, credit-default swaps and asset-backed securities— the S.E.C. should have the power to make public all the documentation surrounding these weapons of mass financial destruction. This should include all data about the current costs of buying and selling them and the cash flow underlying them. We also need widely accessible, real-time reporting of all trades in the bond market. We bet Mike Bloomberg’s company could help design such a system for our benefit.

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Why is the government still complicit in making the system ever less transparent, even when it comes to what should clearly be considered public information? For instance, it took more than a year for the Federal Reserve to disclose that it had agreed to pay BlackRock— the huge money manager that is 45 percent owned by Bank of America— and others, $71 million in a no-bid contract. They were hired to 'manage' the $30 billion of toxic assets [[that they themselves had helped to create and: normxxx]] that JPMorgan did not want when it bought Bear Stearns in March 2008. And that is only one of the five contracts BlackRock has with the government as a result of this crisis— the nature of the other contracts remains secret.

Treasury Secretary Timothy Geithner has made much of financialstability.gov, the Treasury’s new Web site dedicated to "transparency, oversight and accountability." But try to find, for example, just one record of a bona fide credit-default swap, or the names of the hedge-fund and private-equity investors who have participated in the Term Asset-Backed Securities Loan Facility bonanza. It was only a lawsuit filed by a watchdog group that convinced the Treasury to divulge any details. Such as former Secretary Henry Paulson’s secret October meeting with the chief executives of the 10 largest Wall Street firms to force them to take money from the Troubled Asset Relief Program. A lawsuit filed last November by Bloomberg News to force the Federal Reserve to reveal the details on more than $2 trillion in loans that went to banks including Citigroup and Goldman Sachs is still pending in federal court.

And what has become of the S.E.C.’s year-old investigation into who made short-dated, out-of-the-money bets in March 2008 hoping Bear Stearns would fail— bets that were suddenly worth millions of dollars when the company did collapse later that month? Why do we still not know why Mr. Paulson, Mr. Geithner and the Federal Reserve chairman, Ben Bernanke, allowed Lehman Brothers to file bankruptcy last Sept. 15 but then, a day later, saved A.I.G.? [[Because the downfall of A.I.G. would also have taken down GS, Paulson's old company!?!: normxxx]] Or why last November this trio decided to absorb potential losses on $301 billion of Citigroup’s shaky assets, when conventional wisdom among insiders held that they were worth only $150 billion at best?

Also, before Dick Fuld, Lehman Brothers’ chief executive, appeared before the House Committee on Oversight and Government Reform last October, the Committee demanded from company executives boxes of documents about what happened at Lehman and why. Where are those documents? Why hasn’t President Obama insisted on public hearings over what happened during this financial crisis?

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Not a single top executive of a Wall Street securities firm responsible for causing the worldwide financial crisis [[and for which the world justifiable or not lays most of the blame on the US: normxxx]] has had the courage or the decency to step forward in front of the cameras and explain to the American people in his own words exactly how and why he allowed his firm to cause the crisis. Both Mr. Fuld and Alan Schwartz, the chief executive of Bear Stearns at the end, in their Congressional testimony blamed the proverbial once-in-a-century 'financial tsunami'. Do they or any of their peers really think this is true? [["De debil made them do it!?!": normxxx]]

There may be a way to find out. There is much talk nowadays coming from top bankers— Lloyd Blankfein of Goldman Sachs, Jamie Dimon of JPMorganChase, John Mack of Morgan Stanley and even Ken Lewis of Bank of America— about seeing how quickly they can repay to the Treasury the TARP money Mr. Paulson forced on them. One precondition of their being allowed to repay the funds should be a requirement that each gives a public deposition and explains, under oath, what truly happened and why.

Such a public hearing would be meant only to offer a truthful assessment of the errors in judgment made at each firm and to promote understanding, so that we— somehow— can avoid repeating the same mistakes again. It would not be about indictments. These men should be offered use immunity from prosecution for their honest testimony, but only with a clear understanding that the failure to tell the truth at any point would result in serious legal consequences.

The hearing could be complemented by a truth-seeking commission established to hear the accounts of several people who have departed the scene, including, among others, Mr. Paulson, former Treasury Secretary Robert Rubin and former Wall Street chiefs like Mr. Fuld, Hank Greenberg of A.I.G., Sanford Weill of Citigroup, Jimmy Cayne of Bear Stearns and Stan O’Neal of Merrill Lynch. While far removed from their positions of authority, these men have tales to tell about how this crisis got started and why.

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Why are we not looking to change our current civil and criminal racketeering statutes, which are playing a perverse role in investigations of the crisis? Statutes meant to give prosecutors extraordinary powers of seizure before an indictment is handed up, or to impose treble damages, are appropriately used to break up rings of criminal behavior like the Mafia or drug cartels. But a few clever prosecutors could use such laws to bring charges against people or firms in the financial services industry whose innocent patterns of "bad behavior" played important roles in the collapse.

Do we have to wait for the state prosecutors to lead the way? Such outright seizure of capital or assets through use of the racketeering statutes can do much harm by giving prosecutors an unnecessarily powerful role in our capital markets. There must be a way to keep what is good about the statutes and to make sure they are not used for ill in trying to get to the bottom of the financial meltdown.

We are in one of those "generational revolutions" that Jefferson said were as important as anything else to the proper functioning of our democracy. We can no longer pretend that our collective behavior as a nation for the past 25 years has been worthy of us as a people. Many of us hoped that Barack Obama’s election would redress the dire decline in our collective ethic.

We are 139 days into his presidency, and while there is still plenty of hope that Mr. Obama will fulfill his mandate, his record on searching out the causes of the financial crisis has not been reassuring. He must do what is necessary to restore the American people’s— and the world’s— faith in American capitalism and in our nation. Answering our questions may help us get back on track. But time is wasting.

[ Normxxx Here:  P.S. Alan Greenspan no longer believes that "markets are self-correcting"— at least not without destroying the world economy as a byproduct!  ]

Option Arms Threaten Housing

Option Arms Threaten Housing Rebound As Resets Peak

By Brian Louis | 11 June 2009

June 11 (Bloomberg)— Shirley Breitmaier’s mortgage payment started out at $98 when she refinanced her three-bedroom home in Galt, California, in 2007. The 73-year-old widow may see it jump to $3,500 a month in two years. Breitmaier had taken out a payment-option adjustable rate mortgage (ARM), a loan popular during the housing boom for its low minimum payments before resetting at higher costs 'later'. [['Later' has arrived about now and doesn't even peak until 2011!: normxxx]]

About 1 million option ARMs are estimated to reset higher in the next four years, according to real estate data firm First American CoreLogic of Santa Ana, California. About three quarters of those loans will adjust next year and in 2011, with the peak coming in August 2011 when about 54,000 loans recast, the data show. Option ARM borrowers hit with unaffordable monthly payments are another threat to the housing recovery and the economy, said Susan Wachter, a professor of real estate finance at the University of Pennsylvania’s Wharton School in Philadelphia.

Owners who surrender properties to the bank rather than make higher payments for homes that have plummeted in value will further depress real estate prices and add to the inventory of properties on the market, she said. "The option ARM recasts will drive up the foreclosure supply, undermining the recovery in the housing market," Wachter said in an interview. "The option ARMs will be part of the reason that the path to recovery will be long and slow". Option ARM recasts will mean more pain for California, the state with the most foreclosures in the U.S.

$750 Billion Problem

More than $750 billion of option ARMs were originated in the U.S. between 2004 and 2008, according to data from First American and Inside Mortgage Finance of Bethesda, Maryland. California accounted for 58 percent of option ARMs, according to a report by T2 Partners LLC, citing data from Amherst Securities and Loan Performance. Shirley Breitmaier took out a $315,000 option ARM to refinance a previous loan on her house. Her payments started at 3/8 of 1 percent, or less than $100 a month, according to Cameron Pannabecker, the owner of Cal-Pro Mortgage and the Mortgage Modification Center in Stockton, California, who is working with Breitmaier. The loan allowed her to forgo higher payments by adding the unpaid balance to the principal. She’ll be required to start paying principal and interest to amortize the debt when the loan reaches 145 percent of the original amount borrowed.

Hoping For Help

Breitmaier, who has been in the home for 45 years and lives with her daughter, now fears she will lose the off-white stucco house that’s a hub for her family. "I wish the government would bail us out like the banks and the car businesses," she said. "I’d like to go from here to the grave next to my husband". Paul Financial LLC originated the loan and it was sold to GMAC, Pannabecker said.

"This loan is a perfect example front to back, bottom to top, of everything that has gone wrong over the last five to seven years," Pannabecker said. "The consumer had a product pushed on them that they had no hope of understanding". GMAC is working with Breitmaier and will review all of her options, said Jeannine Bruin, a spokeswoman for the company. Bruin declined to be more specific, citing the firm’s customer confidentiality policy.

Inexpensive Payments

Peter Paul of Paul Financial, based in San Rafael, California, said he wasn’t familiar with Breitmaier’s loan agreement but disagreed with Pannabecker’s characterization. "The problem is, real estate values went down[!?!]" Paul said. Paul said he’s winding down the company and hasn’t made any loans since the fall of 2007.

Option ARMs typically recast after five years and the lower payments can end before that time if the loan balance increases to 110 percent or 125 percent of the original mortgage, according to a Federal Reserve brochure on its Web site. These home loans were primarily marketed to people with good credit scores, said Dirk van Dijk, director of research at Zacks Investment Research in Chicago. They were also sold to the elderly and immigrants who were lured by inexpensive payments, said Maeve Elise Brown, executive director of Housing and Economic Rights Advocates in Oakland, California.

Refinancing is impossible in many states given the nationwide drop in prices. Mortgage rates are also rising. The average 30-year rate jumped to 5.59 percent in the week ended June 11 from 5.29 percent a week earlier, Freddie Mac said today. In California, the median existing single-family home price dropped 37 percent in April to $256,700 from a year earlier, according to the state Association of Realtors.

Late Payments Soar

"Once you start amortizing that loan, the payment is going to shoot up," said David Watts, a London-based strategist with research firm CreditSights. The delinquency rate for payment-option ARMs originated in 2006 and bundled into securities is soaring, according to a May 5 report from Deutsche Bank AG. Over the past year, payments 60 days late or more on option ARMs originated in 2006 have almost doubled to 42.44 percent from 23.26 percent, Deutsche Bank said. For 2007 loans, the rate has climbed from 10.1 percent to 35.25 percent.

"We’re already seeing much higher levels of delinquencies of these option ARM loans even before you reach the point of the recast," said Paul Leonard, the California director of the non— profit Center for Responsible Lending. The threat of soaring payments has counselors at Housing and Economic Rights Advocates busy. "There’s a level of hopelessness to the phone calls now," said Brown.

Get Ready For Inflation…

Get Ready For Inflation And Higher Interest Rates
The Unprecedented Expansion Of The Money Supply Could Make The '70s Look Benign.

By Arthur B. Laffer | 10 June 2009

Rahm Emanuel was only giving voice to widespread political wisdom when he said that a crisis should never be "wasted." Crises enable vastly accelerated political agendas and initiatives scarcely conceivable under calmer circumstances. So it goes now.

Here we stand more than a year into a grave economic crisis with a projected budget deficit of 13% of GDP. That's more than twice the size of the next largest deficit since World War II. And this projected deficit is the culmination of a year when the federal government, at taxpayers' expense, acquired enormous stakes in the banking, auto, mortgage, health-care and insurance industries.

With the crisis, the ill-conceived government reactions, and the ensuing economic downturn, the unfunded liabilities of federal programs— such as Social Security, civil-service and military pensions, the Pension Benefit Guarantee Corporation, Medicare and Medicaid— are over the $100 trillion mark. With U.S. GDP and federal tax receipts at about $14 trillion and $2.4 trillion respectively, such a debt all but guarantees higher interest rates, massive tax increases, and [some kind of] partial default on government promises. But as bad as the fiscal picture is, panic-driven monetary policies portend even direr consequences. We can expect rapidly rising prices and much, much higher interest rates over the next four or five years, and a concomitant deleterious impact on output and employment not unlike the late 1970s.

About eight months ago, starting in early September 2008, the Bernanke Fed did an abrupt about-face and radically increased the monetary base— which is comprised of currency in circulation, member bank reserves held at the Fed, and vault cash— by a little less than $1 trillion. The Fed controls the monetary base 100% and does so by purchasing and selling assets in the open market. By such a radical move, the Fed signaled a 180-degree shift in its focus from an anti-INflation position to an anti-DEflation position.

The percentage increase in the monetary base is the largest increase in the past 50 years by a factor of 10 (see chart nearby). It is so far outside the realm of our prior experiential base that historical comparisons are rendered difficult if not meaningless. The currency-in-circulation component of the monetary base— which prior to the expansion had comprised 95% of the monetary base— has risen by a little less than 10%, while bank reserves have increased almost 20-fold. Now the currency-in-circulation component of the monetary base is a smidgen less than 50% of the monetary base. Yikes!

Bank reserves are crucially important because they are the foundation upon which banks are able to expand their liabilities and thereby increase the quantity of money. Banks are required to hold a certain fraction of their liabilities— demand deposits and other checkable deposits— in reserves held at the Fed or in vault cash. Prior to the huge increase in bank reserves, banks had been constrained from expanding loans by their reserve positions.

They weren't able to inject liquidity into the economy, which had been so desperately needed in response to the liquidity crisis that began in 2007 and continued into 2008. But since last September, all of that has changed. Banks now have huge amounts of excess reserves, enabling them to make lots of net new loans.

The way a bank or the banking system makes new loans is conceptually pretty simple. Banks find an entity that they believe to be credit-worthy that also wants a loan, and in exchange for the new company's IOU (i.e., loan) the bank opens up a checking account for the customer. For the bank's sake, the hope is that the interest paid by the borrower more than makes up for the cost and risk of the loan. The recently ballyhooed "stress tests" on banks are nothing more than checking how well a bank can weather differing levels of default risk.

What's important for the overall economy, however, is how fast these loans are made and how rapidly the quantity of money increases. For our purposes, money is the sum total of all currency in circulation, bank demand deposits, other checkable deposits, and travelers checks (economists call this M1). When reserve constraints on banks are removed, it does take the banks time to make new loans.

But given sufficient time, they will make enough new loans until they are once again reserve constrained. The expansion of money, given an increase in the monetary base, is inevitable, and will ultimately result in higher inflation and interest rates. In shorter time frames, the expansion of money can also result in higher stock prices, a weaker currency, and increases in commodity prices such as oil and gold.

At present, banks are doing just what we would expect them to do. They are making new loans and increasing overall bank liabilities (i.e., money). The 12-month growth rate of M1 is now in the 15% range, and close to its highest level of the past half century. With an increased trust in the overall banking system, the panic demand for money has begun to and should continue to recede.

The dramatic drop in output and employment in the U.S. economy will also reduce the demand for money. Reduced demand for money combined with rapid growth in money is a surefire recipe for inflation and higher interest rates. The higher interest rates themselves will also further reduce the demand for money, thereby exacerbating inflationary pressures. It's a catch-22.

It's difficult to estimate the magnitude of the inflationary and interest-rate consequences of the Fed's actions because, frankly, we haven't ever seen anything like this in the U.S. To date what's happened is potentially far more inflationary than were the monetary policies of the 1970s, when the prime interest rate peaked at 21.5% and inflation peaked in the low double digits. Gold prices went from $35 per ounce to $850 per ounce, and the dollar collapsed on the foreign exchanges. It wasn't a pretty picture.

Now the Fed can, and I believe should, do what it must to mitigate the inevitable consequences of its unwarranted increase in the monetary base. It should contract the monetary base back to where it otherwise would have been, plus a slight increase geared toward economic expansion. Absent this major contraction in the monetary base, the Fed should increase reserve requirements on member banks to absorb the excess reserves. Given that banks are now paid interest on their reserves and short-term rates are very low, raising reserve requirements should not exact too much of a penalty on the banking system, and the long-term gains of the lessened inflation would many times over warrant whatever short-term costs there might be.

Alas, I doubt very much that the Fed will do what is necessary to guard against future inflation and higher interest rates. If the Fed were to reduce the monetary base by $1 trillion, it would need to sell a net $1 trillion in bonds. This would put the Fed in direct competition with Treasury's planned issuance of about $2 trillion worth of bonds over the coming 12 months. Failed auctions would become the norm and bond prices would tumble, reflecting a massive oversupply of government bonds.

In addition, a rapid contraction of the monetary base as I propose would cause a contraction in bank lending, or at best limit expansion. This is exactly what happened in 2000 and 2001 when the Fed contracted the monetary base the last time. The economy quickly dipped into recession. While the short-term pain of a deepened recession is quite sharp, the long-term consequences of double-digit inflation are devastating. For Fed Chairman Ben Bernanke it's a Hobson's choice. For me the issue is how to protect assets for my grandchildren.

Mr. Laffer is the chairman of Laffer Associates and co-author of "The End of Prosperity: How Higher Taxes Will Doom the Economy— If We Let It Happen" (Threshold, 2008).

Happy Days Are Here Again

Happy Days Are Here Again

By Frank Barbera | June 9, 2009 | 10 June 2009

Since we began getting cautious on the US Stock Market back on May 12th with the S&P at 912, the index has retained a bullish bias, but has nevertheless largely remained in a range (+/- 30 S&P Index points around 912) with lows in the 880 area and highs in the 940 zone, abutting the January 2009 peak. In a recent GST newsletter I told readers that I expected one final push to the low 940 area which then developed the following day. Nevertheless, the stock market has gone from "disaster central" six months ago to apparently ‘bullet proof’ right now, refusing to decline. This leaves investors with a difficult dilemma, either to jump on board the stock market advance or hold off and hope that prices relent.

At the recent Morningstar Conference in Chicago, I had a chance to catch up with legendary investor Jeremy Grantham who did an excellent job in discerning the recent market low. His advice to investors interested in ‘jumping on board’ the advance was a "go-slow" message. He likened the rally as the return of crazed institutional investors engaged once again in the lemming like ‘investment performance derby.’ Hence, there is no solid ‘logic’ for this advance, just a lot of panicked money managers who will lose their jobs if they don’t put money to work.

Can you believe how stupid this industry has become? All the research, all the analysis, and in the end, investment managers squander investor capital because they are too scared to take an independent stand. Well, ten years of that approach has produced, guess what? Negative returns— big surprise! In Grantham’s view, while he allowed for the possibility that the rally could move still higher as the herd of institutions continue to panic, he also cautioned investors that the current rally would be followed by seven lean years. That’s seven lean years. He told investors who felt compelled to try and trade to be sure to measure out their capital and keep a good chunk of it in reserve so that when prices begin to fall once again, and the negative psychology returns, they will have capital left to go shopping with.

At the same conference, legendary bond guru Bill Gross of PIMCO, told investors that the current recession was ‘structural’ and it could take an entire generation (20 to 30 years) for the US economy to pass through this difficult phase. He spoke of an economy set to endure chronically higher unemployment (NAIRU— Non-Accelerating Inflation Rate of Unemployment) on the order of at least 7 to 8%, and likely much higher inflation in the years ahead. None of this is good news for the equity market, and all of these important bearish fundamentals are delightfully being momentarily ignored by the herds mad-cap rush back into stocks. Of course, if individuals manage their capital in this manner, playing follow the leader, they won’t have capital to invest very long as institutional stock market psychology can change from one day to the next.

Speaking of crowd psychology, we can’t help but notice that investor sentiment has really continued to ‘bull up’ over the last few weeks. In my work, I track the Dollar Weighted Put to Call Ratio for Common Stocks in oscillator form, and believe it or not, over just the last few days this gauge has dropped down to some of the lowest daily readings of the last few years. There are times, for example in late 2006, when very low readings are a sign of a bullish kick off, and where the crowd is right.

Yet, more often than not, very low readings are a sign that a rally has matured and that a top is at hand. We also see the same kind of ultra bullish sentiment being reflected by the Investors Business Daily Call to Put Premium Ratio, which uses a more normal scale and resides at very high values at the current time. Perhaps even more importantly the IBD Call to Put Premium Ratio is sporting a bearish divergence, making a lower high versus its peak several weeks ago, and against the higher highs seen in the indices over the last few days.

…the investor sentiment polling data is also at levels right now that are mission critical. In the case of our Sentiment Composite, which rolls up Investors Intelligence, AAII, MarketVane and Consensus Inc. into one indicator, the Composite is all the way back up to its declining one year upper band. This is no small potatoes and a similar outcome took place in the middle of the previous 2000-2002 bear market leading directly into a bear market rally peak.

The gauge has also come back to the middle zero line which is often a line of demarcation between bull and bear market conditions. A lot will be gleaned from the market action over the next few trading days and over the course of the next few weeks as this is a prime zone from which a major correction should begin IF a bear market is still in force.

Next, to round out our parsing of the data, if we detrend the GST Sentiment Composite, converting it into an oscillator using the Bollinger %B formula, the full 180 degree turn in investor sentiment becomes blatantly obvious. Over the last decade or two, stocks have been really hard pressed to hold these kinds of levels for more then a few weeks. Usually, this type of sentiment is seen either (a) at the start of a new bull market, or (b) at the very end of a major bear market rally.

We will be straddling the thin dividing line between the two over the next few weeks. If the market does not go down and the indicator unwinds toward more neutral values, that will be a win for the bulls. Alternatively, if the indicator rolls over and prices correct meaningfully, that will embolden the bears. Much truly valuable insight lies directly ahead.

Another factor that I like to watch in tandem with analysis of Sentiment gauges is the action of other market internals such as breadth, volume, momentum. Usually if all of these gauges are acting well and making new highs in tandem with price, then excessively bullish sentiment is not a huge concern. However, when breadth, volume and price momentum are diverging negatively against prices AND Sentiment becomes excessive, that combination is usually a recipe for a one-two punch to the jaw. And big hurt!

That seems to be the condition right now as internal market gauges have been steadily weakening for some time. Always an art and never a science, the only technique I know of in gauging this is a "weight of the evidence" approach. To that end, I start with NASDAQ that has been the rally leader and, even as I write this column, continues to reside at new higher highs to which I might add, unaccompanied by virtually any other major average (DJIA, SPX etc…).

…the Medium Term Money Flow Volume Oscillator for NASDAQ peaked at a reading of +322 back on May 4th. Since then the oscillator has pulled back and is now back up to fully overbought values at +161 as of last night, but is diverging negatively against prices. The same type of thing was seen back in 2006 when NASDAQ rallied off its April 19th lows and rose for a number of weeks before exhausting itself and rolling into a downside correction. As the top approached, Money Flow had been trailing off on the downside for weeks. Against even its own prior history, this current advance seems to have come a very long way in a very short period of time.

In addition to Volume, the 21 day Advance-Decline Breadth Oscillator is now diverging against price, along with the 30 day Open Arms Index and the 14 day RSI. We also note that while the NASDAQ A/D Line is still making higher highs, the gap between the A/D Line and its own 50 day moving average has been steadily narrowing over the last few weeks, and that is also a sign of deteriorating internals. On a very long term basis the current spread between the value of the NASDAQ A/D Line and its own 50 day average is still at levels rarely seen, hideously extended and therefore at levels that at least in the past have been very difficult to sustain. In my view, the weight of the technical evidence continues to suggest that the equity markets should be close to a downside reaction, a correction of real size.

While the vast pool of Central Bank liquidity (i.e. newly printed dollars) has kept these markets aloft and created a near impossible period for shorts— in the near term— the NASDAQ initial support comes in at the 1807 level while 924 is initial support for the SPX. Over the next few days, any closes below these levels would be a first blush bearish indication that a downside correction of substance could be getting underway.

That’s all for now.

Frank Barbera

An Incredible Shorting Opportunity Is At Hand

[ Normxxx Here: WARNING—  If You Have Never Shorted A Stock Before; DON'T START NOW!!!  ]

By Jeff Clark | 8 June 2009

The stock market is poised to collapse.

There's no other way to put it, and I'm hoping that sentence gets your attention. Your financial wellbeing depends on it. Stocks are in truly dangerous territory. The rally over the past three months has done exactly what bear-market rallies are supposed to do— get everyone excited that a new bull market is underway.

This is not a new bull market. It's the biggest bull trap investors are likely to encounter this decade… And you need to avoid it. The problem for potential short sellers has been a persistent bid underneath the stock market and an absence of overwhelmingly bearish chart patterns. Now, however, with the market rally extending into its third month and the investing public growing more and more excited about jumping back into the stock market, many charts are taking on bearish characteristics.

The One That Looks Most Bearish To Me Is Goldman Sachs…

Goldman Sachs is a major Wall Street investment bank. It consistently generates numbers above and beyond that of its competitors. Its traders report the highest return on equity of any firm on the Street. And it is the investment bank with the closest ties to Washington D.C. The fundamental problem with Goldman Sachs is that the numbers are too good. ("Truly astounding… the word Chutzpah simply does not do it justice…")

How is it that in the midst of a financial meltdown that took out Merrill Lynch, Lehman Brothers, AIG, and all the rest of the financial firms, Goldman emerged unscathed? How is it Goldman reported record earnings? How is it that in the culture of Wall Street, which rewards following the herd, Goldman sidestepped all the land mines? Are its traders so much more brilliant than everyone else? Or is there more to the story?

My bet is on the latter. Goldman's last earnings report is like a Salvador Dali painting. It's an aberration of reality. Goldman has a nasty habit of both reporting short-term gains to juice up its quarterly earnings reports and avoiding the markdowns of long-term losing positions that would have a negative effect. It's like depositing your paycheck in the bank and then paying all of your monthly expenses with a credit card. At the end of one month, you have more money than you did before, and you only report the minimum payment required on your credit card as an expense.

The result looks really good on paper. Eventually, though, the funny accounting no longer works. It happened with MCI Communications. It happened with Enron. And it'll happen with Goldman Sachs. I'm not betting on the long-term demise of Goldman— although, I think that's a good bet.

I'm speculating there may be some fundamental event which causes Goldman to break down in the short term, and that event may have something to do with its accounting policies. What I'm really betting on is the technical pattern of Goldman's stock. It's abhorrently bearish in the short term. Take a look at its chart…

This is a textbook example of a bearish rising-wedge pattern. The pattern is formed as a stock moves higher and the difference between the highs and lows gets narrower. You can also see the negative divergence in the moving average convergence divergence (MACD) indicator. Most of the time, these charts break to the downside in a quick and violent move. (You can see it in action here.)

I expect we'll see the same thing from Goldman Sachs, and I'm willing to bet it happens soon.

Big Inflation Coming 2

Big Inflation Coming 2

By Adam Hamilton | 5 June 2009

At the height of the stock panic in late November, the flagship S&P 500 stock index had plunged 49% year-to-date. Fully 2/3rds of this decline happened in the 9 weeks leading into the panic lows! Naturally the psychological impact of such an epic selloff was utterly massive. Fear exploded to unprecedented extremes.

A stock panic is a bubble in fear, and succumbing to this overwhelming fear leads to irrational selling near lows. But interestingly at the time, investors failed to recognize this truth. They sold aggressively, and they wrongly assumed their selling was rational. Of course the only thing that would warrant a 38% loss in the stock markets in just over 2 months was a new depression. So depression fears mushroomed.

With a depression comes deflation, so deflationary theories became widely accepted in December and January. Yet there was one big problem. Deflation is purely a monetary phenomenon. If prices of anything are falling simply for their own intrinsic supply-and-demand reasons, and not as a consequence of monetary contraction, then it is not deflation. In reality, the money supply was skyrocketing in the panic.

With the Fed ramping the US dollar supply far faster than the pool of goods and services on which to spend it, inflation was inevitable. Relatively more dollars bidding on relatively fewer things means higher general prices, the formula is simple. I wrote an essay on the big inflation coming in January, when deflation fears reigned supreme, using the Fed’s own data to highlight the staggering monetary growth.

Saying it was inflation that was coming, not deflation, was extraordinarily controversial just five months ago. You would not believe the firestorm of flak I weathered for pointing out the threat of inflation. Being contrarian never wins friends. But not surprisingly, today the consensus view on money is shifting to an inflationary bias. With a more receptive audience not blinded by fear, I thought I’d update this analysis.

Sadly inflation is woefully misunderstood in popular culture. People tend to think it is simply "rising prices", but this is incorrect. The formal dictionary definition of this word is "a persistent, substantial rise in the general level of prices related to an increase in the volume of money and resulting in the loss of value of currency". The key is the rising prices have to be driven by an increasing money supply.

Consider an example. If the Fed doubles the money supply and hence gasoline prices ultimately double, this is inflation. More dollars are bidding on the same amount of gasoline, driving up its nominal price. But if some calamity takes Saudi Arabia offline, and gasoline prices double, that has nothing to do with inflation. Supply contracted sharply, demand remained constant, and hence prices rose [[until a new supply-demand equilibrium was established: normxxx]]. These are two different scenarios leading to the same outcome, but only one is inflation.

And the reality is that the prices of everything are derived from a complicated mix of the supply and demand of any particular item and the supply and demand of money itself. So usually a given price increase has a commodity supply-and-demand-driven component as well as a separate money-driven component. This is why it is notoriously hard to measure inflation and why average folks have a tough time understanding it.

Since separating out price effects is virtually impossible, it makes far more sense to look at the cause of inflation. That is, money supplies increasing at faster rates than the underlying economy. If you think of price inflation as smoke, an effect, then why not look for the fire that creates it, the cause? This fire is excessive monetary expansion. When a fire initially flares brightly, there might not be smoke right away. But there sure will be if it keeps burning!

Only a central bank can directly affect the base money supply. Yes, commercial banks can expand credit through fractional-reserve banking, but credit is not money. Credit is just access to someone else’s money. If I offered you a $100k check as a gift, you’d be pretty excited. If I offered you this same $100k as a loan, you wouldn’t be. Money and credit are very different beasts, so don’t make the mistake of assuming credit contraction automatically means general deflation. [[Although that difference was conveniently disregarded mere months ago!: normxxx]]

The place to look for coming inflation, the fire that is going to produce the smoke, is in the Fed’s own money-supply data. I’ll start with a broad measure of the US money supply, money of zero maturity. MZM is a liquid monetary measure that includes all currency, checking accounts, savings accounts, and money-market accounts redeemable on demand. It does not include CDs and other time deposits.

This first chart graphs the raw MZM data in yellow along with the absolute annual growth rate of MZM in blue. For reference, the year-over-year growth rate in the Consumer Price Index is also included. While the CPI is horribly flawed for a variety of reasons, it remains the most widely accepted measure of inflation today. But it ignores the cause, monetary growth, and tries to filter out effects, rising prices.

The Fed, or any central bank running a fiat currency not backed by gold, really only has one single power. It can inflate. Inflation, growing the money supply, is the Fed’s response to everything. Sometimes it inflates more, sometimes less, but it is almost always inflating. It is very rare to see money supplies contract, and even in these isolated cases it is only for a trivial amount over a very short period of time.

Back in the mid-2000s, MZM growth was stable near CPI growth. In 2004 and 2005, YoY MZM growth averaged 3.1% while YoY CPI growth averaged 3.0%. Also, note above that prior to mid-2006 the CPI direction generally mirrored that of MZM growth. If MZM growth rates were increasing, so were the CPI’s. And vice versa. But in 2006, a couple major events sowed the seeds for the massive MZM/CPI disconnect we are seeing today.

In early 2006, Ben Bernanke took over the helm of the Fed. An academic, he had a long record of being pro-inflation. He believes the Great Depression happened because there wasn’t enough inflation, so if he was ever thrust into a crisis he would ramp the money supplies rapidly to try and avert it. Late in 2006, the CPI’s calculation methodology was changed. Rising prices would be more aggressively edited out of this index so "inflation" would remain at politically-acceptable levels for Washington.

Bernanke’s mettle was soon tested with the subprime mortgage crisis in early 2007, the general credit crunch in late 2007, and the global stock selloff in early 2008. The Fed’s response was typical, it did the only thing it could do. It rapidly increased the rates of monetary growth. Stable at 4% when Bernanke took office, absolute annual MZM growth soon ballooned to 8%, 12%, even 16% in early 2008! The Fed was flooding the system with new fiat dollars.

Thanks to the CPI’s methodology change, this surge in money was not being reflected in this index. Yet choosing not to measure something properly does not mean it doesn’t exist. The surging MZM growth was readily apparent in commodities prices. The basic raw materials are the first prices to be driven higher by more money bidding on them, it takes time for these prices to flow through to the finished goods the CPI measures. Of course commodities surged mightily in early 2008, partially as a result of this inflation.

Even though the Fed tried to rein in the MZM explosion of late 2007, it was soon confronted with the stock panic. So it responded the only way it knows how to this new crisis, again it flooded the system with more dollars created out of thin air. And as you can see above in the yellow line, even though the stock panic is long over the Fed hasn’t even attempted to withdraw any of this inflation. MZM remains near record highs!

Since the beginning of 2008, absolute annual MZM growth on a weekly basis has averaged 12.9%! This is a staggering expansion rate. Remember the old Rule of 72 from college finance? At this 13% compounded growth rate something will double in 5.6 years or so. Indeed since Bernanke took over, MZM has ballooned by 40%. This incredible deluge of money has to go somewhere.

Theoretically, if money-supply growth didn’t exceed underlying economic growth there wouldn’t be any inflation. This is why the gold standard is such a brilliant solution to money. The natural mining rate of gold almost never exceeds the natural growth rate in the global economy. But of course the US economy hasn’t even come close to growing 40% since early 2006 when Bernanke came to power or at a 13% rate since early 2008.

In fact, per the US government’s own GDP data, since early 2006 the US economy has only grown 11.0%, a far cry from the 40.4% the Fed has grown MZM over this span. And since early 2008, GDP is actually dead flat at 0.4% while MZM money has soared 16.8%. In both cases the excesses are pure inflation, new dollars created out of thin air that are now chasing a relatively smaller pool of things. Higher general prices are the inevitable result.

And boy, if you exist you know this! Over the past several years, have your costs of living risen or fallen? Is your food at grocery stores and restaurants getting cheaper or more expensive? Are your utilities bills and insurance costs rising or falling? Do you feel like you have more disposable income after necessary expenses or less? We all see this relentless and very real inflation no matter what the government statisticians try to tell us. The nominal cost for existence just keeps rising and rising thanks to the Fed.

Now if MZM has averaged 13% annual growth since early 2008, then why has the CPI gone negative? There are a couple reasons. First, the CPI is designed to intentionally lowball inflation. Its custodians filter out rising prices and overweight the rare falling ones, like computers. Washington wants a low CPI read because it reduces non-discretionary government expenditures on welfare programs indexed to the CPI. This gives politicians more money for their pet projects. Wall Street wants a low CPI read because high inflation is bad for the stock markets.

But the primary reason the CPI plummeted was due to the stock panic. If you don’t remember how scared people were in late November and early December, go back and read the big newspapers from then at your local library. Thanks to sensationalist mainstream-media coverage, average Americans really believed a new depression was upon them. I’ve reported tons of hard stats on this in our subscription newsletters since the panic. Americans radically reduced spending, hoarding cash for the worst case.

Remember that the prices of everything are a function of supply and demand. As demand for goods plunged, desperate retailers cut prices to spur sales and clean out inventories. It was this dynamic, a plunge in consumer demand, that drove the falling consumer prices the government emphasized. General prices did not decline because money shrunk. There never was any deflation despite the CPI!

If the raw money-supply data isn’t enough for you, consider the Continuous Commodity Index. The CCI is an equally-weighted geometrically-averaged basket of 17 key commodities. It bottomed in early December as the stock panic ended. Since then, it has surged 31.3% higher. Now there is no way global commodities demand grew by a third in just 6 months. The rise since the panic was driven by a combination of investment demand as well as more dollars bidding on commodities, inflation.

If I ended this essay here, investors would have plenty of reasons to deploy capital in investments like commodities that thrive in inflationary times. Our subscribers have already earned big gains in this sector since the panic. But amazingly, this high sustained MZM growth is minor compared to the primary inflation threat. Even though it is going to drive huge gains in my investments, this next chart really frightens me.

The narrowest measure of money supply is known as the monetary base, or M0 (zero). M0 is simply currency (paper dollars and coins) in circulation, currency in bank vaults, and reserves commercial banks have on deposit with the Fed. M0 is critical because it is the base of all money we use for daily transactions. It is also the base from which fractional-reserve banking multiplies. M0 growth has the most direct impact on inflation of all. Its raw numbers are shown in red and its year-over-year growth rates in blue.

For 48 years prior to the stock panic, absolute annual M0 growth averaged 6.0%. And this was within a tight range that seldom exceeded 10%, and even then only for short spells. Why? The Fed, at least before Bernanke, knew that excessive growth in the monetary base would rapidly lead to price inflation. Growing M0 too fast is playing with fire, very dangerous.

The only notable event in M0 in a half century was the pre-Y2k ramp, a brief period of 15.8% growth ahead of the date rollover and all its big unknowns. Yet Greenspan realized how dangerous this was, even for a crisis, so within a year M0 was actually shrinking a bit as he tried to soak up all that excess pre-Y2k liquidity. Interestingly, some economists believe this Y2k M0 ramp helped drive the vertical final few months of the tech-stock bubble and that the subsequent rapid slowing in M0 growth accelerated its bust.

M0 growth was trending lower in 2008, averaging 1.2% in its first half. This is one of the main reasons inflationary expectations were fairly low prior to the stock panic despite the record commodities prices last summer. But then the stock panic erupted and the Fed panicked, getting swept away in the fear. Bernanke decided to inflate far faster than has ever been witnessed in the Fed’s entire history since 1913.

In October, the scariest month of the panic when the S&P 500 plummeted 27% in less than 4 weeks, the Fed suddenly expanded the monetary base by $224b. This was a 25% surge in a single month, just insane. And it led M0 to rocket to its highest YoY growth rate ever by far, up 36.7%! But the Fed was just getting started in its unprecedented inflationary campaign.

In November it grew M0 by another 27% over the prior month, yielding 73.0% YoY growth. In December it again grew M0 by 15% MoM leading to a mind-boggling 98.9% YoY gain. In 4 short months, the Fed had literally doubled the US monetary base! Something like this has never even come close to happening before, so we are deep into uncharted inflation territory here.

By late December this information slowly started to leak out and contrarians who have studied monetary history were appalled. Was the Fed mad? Bernanke responded to these growing criticisms in Congressional testimonies, promising that the Fed would remove its "accommodation" (a euphemism for inflation) as soon as possible. Even though the Fed has never shrunk the money supply noticeably, Wall Street curiously took Bernanke at his word.

So every month since the panic ended in mid-December, when the VXO fear gauge fell back out of panic territory, I’ve been watching M0. In 3 of the 4 months since (May data isn’t out yet), the Fed has actually grown M0 further! In January, February, March, and April, the absolute annual M0 growth rates weighed in at 106.0%, 88.5%, 97.9%, and 111.0%! And in April alone M0 surged to a new all-time record high. And by late April the stock markets had already rallied 29%, yet the Fed was still rapidly growing M0.

Friends, this data is flabbergasting! How can the monetary base double in 4 months, and stay doubled for almost 6 now, and have no impact on real prices? The monetary base is our transactional cash we use to buy everything. Even checking accounts are directly tied to it, although the mechanism is beyond the scope of this essay. The Fed has not only failed to start contracting M0 post-panic, but it is still growing it.

Nothing like this has ever happened before, not even in the 1970s during the last inflation scare. So the inflationary impact of a doubling of narrow money in 4 months will certainly be serious. Exacerbating this effect, as consumer spending recovers and bids on now-depleted inventories of consumer goods, prices will also be rising for pure supply-and-demand reasons. This will be perceived as inflation by most people, so we’re probably facing a perfect storm of inflation.

As inflation really takes root in a way everyone can easily see, inflationary expectations will soar and investors will seek assets that thrive in inflationary times. Of course this means commodities, primarily gold and silver. Unfortunately most mainstream investors are still sitting on the sidelines in cash, too wounded from the panic to even think about stocks again. But this ostrich approach will prove disastrous. The kinds of inflation this M0 ramp portends will steamroll cash, rapidly eroding its purchasing power. As mainstreamers realize this, the capital that will flood into commodities and their producers’ stocks should be breathtaking.

The bottom line is the panic money-supply growth in the US has been very excessive, running at multiples of economic growth. And in the case of narrow M0 money, the doubling in 4 months is literally unprecedented. It scares me. With so much new money in the system, and the Fed totally unwilling to undo this terrible inflation over the 6 months since, rapidly rising prices are inevitable.

We’re on the verge of the first inflation scare of the modern era, a time when epic panic buying into hard assets and their producers is increasingly likely. Investors who ignore these dire tidings will probably get crushed by the inflation. But investors who prudently study the dangers and deploy their capital to thrive in them will make fortunes. Mark my words, the money-supply data shows big inflation is coming.

[ Normxxx Here:  And who says we can't have an inflationary depression!?! 1933 through 1939 should answer that question!  ]

ߧ

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.

Place Your Wagers

Place Your Wagers
Click here for a link to ORIGINAL article:

By ContraryInvestor.Com | 2 June 2009

To the point, we want to take a very quick look in this discussion at the complexion and rhythm of US household wages and salaries, and broader personal income circumstances of the moment. The important issue to our forward investment actions and thinking being, in a world where corporations have taken a literal machete to employment costs all in the interests of preserving nominal profits and profit margins, are they essentially destroying the very source from which future aggregate demand will be driven— within the context of a macro household balance sheet deleveraging environment that we believe will also continue for some time to come? [[Not a new question, by any means. It was on the front burner during the Great Depression.: normxxx]]

Moreover, have we entered a bit of a vicious cycle in terms of labor market pressure feeding into wage pressure, feeding into consumption pressure that further constricts corporate profits, ultimately leading to even further pressure on labor costs? We’ll be suggesting to you that current circumstances are very much unlike any prior US economic cycle of the last thirty to forty years at least. We want to try to tie together a number of broader themes we have been discussing for a while now.

Remember that the Employment Cost Index (ECI) that comes to us courtesy of our wonderful friends at the Bureau of Labor Stats (yes, the same folks responsible for the payroll numbers) is made up of two key components— wages and benefits. The current (as of 1Q) year over year change in the ECI is the lowest number in the history of the data. Again, we should not be expecting fireworks, especially in the midst of a deep recession. But in the absence of household credit acceleration, what you see below is the key to future reacceleration of aggregate demand, or otherwise as the case may be.

The history of the two components of the ECI (wages and benefits) is seen below. The year over year change in wages has never been this low in the records of the data. And in terms of growth in benefit costs, we’re pushing historical lows as we speak. What does all of this mean? It tells us labor is under serious total compensation pressure.

And since benefit costs to employers are falling rapidly, this tells us one of two things is correct. Either employees are simply losing employer sponsored benefits (think health insurance) they will need to make up on their own out of wages or total household resources, or their personal participatory costs in employer sponsored benefits are climbing rapidly (think co-pays, etc.). Either way, labor is under serious wage and benefit pressure, really unlike anything seen over the prior three decades at least.

One last chart. This is the history of the year over year change in US wages and salaries from the personal income numbers. We’ve drawn with red bars all of the recessions since 1960 to show you that the year over year change in wages and salaries has actually been quite the tell tale sign of official recession conclusions over this time. Will it be so again? One more time, never over the history of the data (to 1960) have we seen this type of pressure on wages.

We’ll make the following quick, but we want to walk through the remaining components of "household financial wherewithal" outside of wages and salaries to get a broader sense of the current circumstances surrounding the character of personal income. …we believe it's the Fed and Treasury that are in good part acting to hold up the US [[and world?: normxxx]] credit markets and US personal income as well in the current environment.

1. Proprietor’s income. Simply, non-wage categorized income of folks who own businesses. A good read on the smaller business community? Indeed. As of now we’re at a rate of change contraction low not seen since the early 1980’s recessions. Not a positive contributor to personal income flexibility for now.

2. Employer supplements to wages and salaries (think 401k contributions, defined benefit pension plans, etc.). Quite negative; but showing some signs of life as employers must now add to defined benefit plans to make up for stock market losses.

3. Income from assets: virtually 100% driven by household interest, dividend and rental income streams. Quite noticeably this has reached a record low in terms of now being a rate of change drag on household personal income circumstances of the moment— a record rate of change contraction for the entire history of the data.

4. Government social benefits. Modestly positive. Increased social benefits need to occur during recessions, as has been exactly the history of the US for five decades now.

5. Personal only income taxes. As you can see in the chart that follows, the year over year decline is pushing toward the lows seen over the entire history of this data.

By now we’re pretty darn sure you get the picture, so we will not belabor the point. As we stated last month in "Of Fingers And Dikes", we believe the Fed/Treasury/Administration has had a huge hand in supporting and anesthetizing the US credit markets (inclusive of LIBOR). Without governmental/Fed/Treasury support, there is no way the headline credit market data would be showing us as much perceptual [[apparent only?: normxxx]] healing as has been the case up to this point. Of course the key question remains, just when can these folks take their collective fingers out of the multiple holes in the credit market dike. For that, we have no answer.

In like manner, at least as per the data above, it sure appears as if the US government is now a major infrastructural support to the personal income circumstances of just about every individual in the US. Again, this is not wrong and this is not bad. The repetition of this pattern has been seen in EVERY recession of the last five decades at least. It’s just that never have we had the annual rate of change in wages and salaries, proprietor’s income, and income from other assets all in negative rate of change territory on a simultaneous basis over the prior five decades. That highlights and reinforces [[and makes more crucial/critical: normxxx]] the role of the US government in supporting personal income.

So as we step back and contemplate the relationship of labor market conditions, consumer confidence, retail sales trends historically and what the equity market is discounting in price in terms of an economic recovery to come, we need to ask once again, just who (or what?) will fund higher household consumption ahead at the margin absent renewed household balance sheet releveraging? (Moreover, households have shown us they have begun to increase their savings rates. How can we have much higher consumption ahead accompanied by higher savings rates when the key core components of personal income are all in year over year contraction mode?)

We continue to believe the financial markets are trying their best to discount a 'typical' consumer and/or corporate demand led economic recovery of the type seen over the past half century. Yet when we look at things like the credit markets, personal income circumstances and the complexion of household balance sheets crying out for deleveraging, current conditions are quite different than any recession of the prior half-century, with the government acting as Atlas holding up the world of "demand", per se, for now.

Yes, we know that old market saws are hokey, but we can’t get this one out of our minds. First price, then optimism… then earnings. There can be no break in the chain in cyclical bull market character, and the first two have already gone a long way in terms of playing out. Absent household balance sheet reacceleration in leverage it sure seems a good bet forward corporate earnings are now as dependent on household wages, salaries and broader personal income as at any time in recent memory. And corporations are continuing to pressure wages and salaries downward to protect margins and nominal profits.

Indeed, our current circumstances are so unlike any period in recent US history that economic signposts and markers of the last three to four decades may be quite misleading in the current cycle. Although it may sound crazy, part of our thinking must at least allow for some possibility that everything we've learned about economic cycles of the last half century will be wrong in this new decade of the millenium.


  M O R E. . .