Capitalism...Now In HD

Putting Perspective On Today's Money & Money Relation [& The Hoo-Haw About Inflation]

mscullen1@gmail.com (MWS) — Thu, 22 Oct 2009 11:25:00 PDT

There are two things that drive me Mel Gibson insane:

Constantly hearing companies' earnings are "better than expected"
That serious inflation and/or hyper-inflation are destined in our future

Out of sheer annoyance I'll not speak of the first issue. However on the second, yes, one day in our eventual future inflation will be a problem. But just like Prechter was years early on predicting deflation, the loud majority constantly calling for the return of inflation and demise of the dollar are far ahead of reality on their predictions. I attacked (granted, out of great respect) Marc Faber once before when I heard More Calls for Hyper-Inflation. Since then Faber has become more realistic in his prediction; that is he has conceded this could be a decade in the making and I agree.

So now I want to pick up on a concept I started on in Debt, Wealth & Keynesianism. This time let's get more nitty-gritty with definitions of forms of money (media of exchange).

Traditional Money Source:
Commodity Money: This is money in the most traditional sense - gold, silver, copper, etc.
Money Substitutes: Historically certificates used as claims on commodity money, i.e. banknotes
Fiat Money: Federal Reserve notes, Euros i.e. "legal tender" (backed by nothing but faith)
Credit Money: loans, bonds, etc.

Alternative Quasi-Money Source:
Derivative Money: Swaps, CDS, etc.

There will no doubt be controversy surrounding the above categories, but it's critically important to consider all of them in our money system. Many do not consider credit money as calculated in the money supply. Those who don't are only considering it's legal status as a claim to payment for future goods and services or simply just do not understand monetary theory. Indeed, credit money is the dominant form of money in our system. To explain why in more detail, I defer to Steve Keen's Roving Cavalier's Of Credit:

The Data versus the Money Multiplier Model
Two hypotheses about the nature of money can be derived from the money multiplier model:

1. The creation of credit money should happen after the creation of government money. In the model, the banking system can’t create credit until it receives new deposits from the public (that in turn originate from the government) and therefore finds itself with excess reserves that it can lend out. Since the lending, depositing and relending process takes time, there should be a substantial time lag between an injection of new government-created money and the growth of credit money.

2. The amount of money in the economy should exceed the amount of debt, with the difference representing the government’s initial creation of money. In the example above, the total of all bank deposits tapers towards $10,000, the total of loans converges to $9,000, and the difference is $1,000, which is the amount of initial government money injected into the system. Therefore the ratio of Debt to Money should be less than one, and close to (1-Reserve Ratio): in the example above, D/M=0.9, which is 1 minus the reserve ratio of 10% or 0.1.

Both these hypotheses are strongly contradicted by the data.
Testing the first hypothesis takes some sophisticated data analysis, which was done by two leading neoclassical economists in 1990.[3] If the hypothesis were true, changes in M0 should precede changes in M2. The time pattern of the data should look like the graph below: an initial injection of government “fiat” money, followed by a gradual creation of a much larger amount of credit money:

Their empirical conclusion was just the opposite: rather than fiat money being created first and credit money following with a lag, the sequence was reversed: credit money was created first, and fiat money was then created about a year later:

“There is no evidence that either the monetary base or M1 leads the cycle, although some economists still believe this monetary myth. Both the monetary base and M1 series are generally procyclical and, if anything, the monetary base lags the cycle slightly. (p. 11)

The difference in the behavior of M1 and M2 suggests that the difference of these aggregates (M2 minus M1) should be considered… The difference of M2 – M1 leads the cycle by even more than M2, with the lead being about three quarters.” (p. 12)

Thus rather than credit money being created with a lag after government money, the data shows that credit money is created first, up to a year before there are changes in base money. This contradicts the money multiplier model of how credit and debt are created: rather than fiat money being needed to “seed” the credit creation process, credit is created first and then after that, base money changes.

It doesn’t take sophisticated statistics to show that the second prediction is wrong—all you have to do is look at the ratio of private debt to money. The theoretical prediction has never been right—rather than the money stock exceeding debt, debt has always exceeded the money supply—and the degree of divergence has grown over time.(there are attenuating factors that might affect the prediction—the public hoarding cash should make the ratio less than shown here, while non-banks would make it larger—but the gap between prediction and reality is just too large for the theory to be taken seriously).

...
This first major paper on this approach, “The Endogenous Money Stock” by the non-orthodox economist Basil Moore, was published almost thirty years ago.[4] Basil’s essential point was quite simple. The standard money multiplier model’s assumption that banks wait passively for deposits before starting to lend is false. Rather than bankers sitting back passively, waiting for depositors to give them excess reserves that they can then on-lend,

“In the real world, banks extend credit, creating deposits in the process, and look for reserves later”.[5]

Thus loans come first—simultaneously creating deposits—and at a later stage the reserves are found. The main mechanism behind this are the “lines of credit” that major corporations have arranged with banks that enable them to expand their loans from whatever they are now up to a specified limit.
If a firm accesses its line of credit to, for example, buy a new piece of machinery, then its debt to the bank rises by the price of the machine, and the deposit account of the machine’s manufacturer rises by the same amount. If the bank that issued the line of credit was already at its own limit in terms of its reserve requirements, then it will borrow that amount, either from the Federal Reserve or from other sources.

If the entire banking system is at its reserve requirement limit, then the Federal Reserve has three choices:

refuse to issue new reserves and cause a credit crunch;
create new reserves; or
relax the reserve ratio.
Since the main role of the Federal Reserve is to try to ensure the smooth functioning of the credit system, option one is out—so it either adds Base Money to the system, or relaxes the reserve requirements, or both.
Thus causation in money creation runs in the opposite direction to that of the money multiplier model: the credit money dog wags the fiat money tail. Both the actual level of money in the system, and the component of it that is created by the government, are controlled by the commercial system itself, and not by the Federal Reserve.

That should be plenty to form a foundation for my argument, but I encourage all to read Keen's post in its entirety.

Those who are calling for out of control inflation refer to the base money. As Keen points out, the "credit money dog wags the fiat money tail". The chart of debt money to money stock measures doesn't truly capture the essence of how much more credit money exists than fiat money because the M2 & M3 stock measures surely contain deposits from debt money source. To illustrate this more completely one must consider the right inputs.

Total Private Debt (Q2 2009) vs. Base Money (10/21/2009)

From the illustration above it is clear to see How Central Banks Lost Power, reinforcing Keen's findings. Total private debt is many magnitudes greater than base money. True, the financial sector's debt takes a large chunk of that, but even removing that source there is still a large divergence. In fact previously heralded figures like Greenspan cheered their loss of 'control' by advocating the positives of securitization, derivatives and other sophisticated products of financial engineering. Securitization and derivatives add another complicated layer to the money supply. The advent of packaging up loans into a securities frees up lending for banks, allowing them to continue to make loans without posting additional capital.

David Roche defined the leverage derivatives create very process in his book 'New Monetarism'.

Just what form has this new cheap money taken? Why derivatives of course!

It's true, the top 5 banks are levered to the teeth in derivatives. Furthermore, derivatives increase traditional lending capabilities. From the OCC:

Surprise surprise! Our favorite headline commercial banks on the receiving end of generous taxpayer bailouts have enormous amounts of capital at risk tied to derivative contracts, the vast majority of which are tied to interest rates. Why so much risk?

We've seen the 'evil side' of derivatives already. Do you really believe that 'committing' a few trillion to banks when they hold over $200 trillion in derivative exposure alone is really going to solve the crisis?

So what we're deducing from these facts above are:

Traditional credit money is many times the base money in the system and indeed the 'credit money dog wags the fiat money tail'
The process of securitisation amplified leverage by use of bypassing traditional capital requirements in the lending process.
Derivatives are enormous in notional value and exceed all other measures of "money" by unimaginable amounts. Even worse, these holdings are concentrated (in the US at least) in the hands of 5 TBTF commercial banks.

Taking it a step further:

When credit money far exceeds base money the means of supporting payments for the obligations reduces, sometimes severely. This is especially true when credit is supported by asset prices. When asset prices tank, there is no longer support for the debt. The global economy has undergone a great period of ponzi financing that is unraveling and will continue to unravel for many years until a) debt conversions/forgiveness have been agreed upon b) defaults have reduced debt outstanding enough to inspire confidence in lending/borrowing again c) a long agonizing period of repayment is undergone d) a combination of a, b & c.
The advent of securitisation put an already fraudulent credit system on steroids and created greater incentive to take on much higher risk than was warranted in lending. Securitisation is now dead and the source of large new credit creation with it.
What happens when derivative bets go wrong? We've already seen what happens; unprecedented bailouts that are akin to band aids for treatment of deep lacerations. I suppose we have not yet finished this chapter of the crisis so long as such large notional values still loom.

To counter all of my arguments above, inflationists will claim the Fed will keep printing and the government will keep spending in perpetuity or until the system is "cured".

The above graph shows the private debt/federal debt relation. Despite epic increases in federal borrowing there is still a very wide margin. At some point the market will place a cease and desist on the government's madness via higher long rates (sending the economy into another crash). Furthermore, it is the very economy that the government is desperately trying to stimulate that must pay the piper for this excessive federal debt binge, which will choke the priate sector.

As for the Fed and Treasury's valiant effort, all they have to show for it are total adjusted reserves now at $1,017.06! Do tell, if banks are so healthy and have received so much free money, why does this figure continue to rise?

The demand to borrow amongst consumers and ability to lend by banks are inclined to engage in providence. As outlined above, these conditions which manifest such attitudes are likely to continue for a time until credit money/GDP are more in line. The chart below illustrates just that:

I know what's coming next. The inflationists will say, but look! Total debt continues to increase. Two things, GDP was contracting in the first quarter of 2009 and as it is the denominator it will create a higher ratio, and two, government debt increases have increased faster than private credit contraction. But have you read everything I've laid out above! Inflationists are missing the boat because they have misinterpreted the mechanism by which money is extended in our economy. The large portion of government spending (from borrowing) is going to two sources:

To banks via bail outs
Transfer payments to the unfortunate

Is main street benefiting from money barreled down the throats of banks? I think not. Total net lending of -241.1 billion in the second quarter is testament to that z.1 and lending is the main mechanism by which money reaches the economy. Meanwhile JP Morgan and Goldman make record profits trading, a more risky venue for generating revenues. The mechanism is broken and now the only mechanism alive is a never ending game of speculate and steal (from the tax-payer) when it blows up.

On transfer payments, I'd assume the majority would opt to have their jobs back instead of receiving a percentage of their former pay. Indeed, many may have afforded lifestyles that only their former incomes could maintain. This time, the public is not buying the perpetual bubble solution to preceding crises.

Lastly, look back on all of the famous crashes and depressions of the past and see what they have in common; speculative bubbles financed by leverage. [1929 great depression, south sea bubble, tulip mania, Japan's decade (going on two) of deflation and property bust, the "great recession" of 2008/2009] More examples are out there and the extent of the crisis all differ, but the crisis mechanism remains the same triggered by the same ponzi financing.

In summary, why is the relation of credit money to base money and its huge multiple so significant? Because debt can be defaulted on, especially when the means to pay it are in scarce supply in relation and the mechanism to extend new credits is broken. Balance must be restored and a new system must rise to take its place.

Relative Pricing & Risk

mscullen1@gmail.com (MWS) — Mon, 28 Sep 2009 19:16:00 PDT

It seemed every day the bottom was just about to fall out of the S&P 500 over the summer. This never happened. Instead risk taking has returned in the form of egregious multiple expansion. The logic behind the risk taking is actually not so crazy when one puts it in retrospect to interest rates.

The Low Interest Rate Conundrum

The 10 year yield (TBY) = 3.03%

S&P 500 forward earning yield (FEY) = 3.89% (based on S&P earnings (FE) estimates of $41.49, as reported)

Assuming the inverse of the treasury bond yield approximates a good multiple on the market, the S&P 500 fair value on a relative basis of forward earnings would be roughly $1,245. (fair value price/FE = 1/TBY, or FVP/41.49 = 30.3). At 1,066, this actually implies the S&P 500 is undervalued at -0.16 taking the ratio of FVP/Current Price. The model has precedence, Prudential Financial - Topical Study #58, January 6, 2003 (sorry no link):

A spectacular thing occurs when investors expect the earnings yield in stocks to be greater than interest on bonds; they favor the stocks. However, there are conditions that must be met to keep fueling the rally:

Bond interest rates must keep falling, otherwise as the market reaches for the sky, the yield it gives falls with the rise in price. The relative attractiveness will not keep without lower rates.
Earnings must keep up, expectations must rise or at least keep surprising (even if based on grossly deflated estimates).

This picture is painted in relative terms of course. In absolute terms the market is overvalued (fundamentally). An overvalued market price can be corrected by bond rates rising, earnings expectations not being met and/or by prices simply falling.

Psychology plays an important role in this re-risking as well. Bullishness has been growing all summer and investors have all bought their magic beans that they are told will sprout green shoots. So expectations are increasingly becoming optimistic. The higher are you expectations the easier they burst when not met.

The TBY has been on a tear, recently and expectations for the future economy remain bizarrely bullish. On a relative basis, the TBY is so low it is implying the market can go higher to $1,245 keeping the TBY constant. Companies are managing earnings expectations by the lowering the bar so far they almost can't miss.

Any rational person would look at the absolute overvaluation and say, this rally is kaput. However, markets can stay irrational longer than you can stay solvent.

Reforming The Economy

mscullen1@gmail.com (MWS) — Tue, 22 Sep 2009 11:49:00 PDT

Despite a huge stock market rally and some indicators turning up in the economy, many prominent bloggers, economists and investors remain bearish. Some names on that list include Nouriel Roubini, Bill Gross, David Rosenberg, Mike Shedlock, John Mauldin, Paul Tudor Jones, Paul Krugman, Nassim Taleb and Steve Keen to name a few.

Why?

If I was to take a stab at this it would be to say (except for the two Keynesians noted above) that it is because the risks in the economy have not structurally been changed.

Predominant Risks:

excessive leverage
moral hazard
conflicts of interest
complex regulation
complex and misaligned tax code
interventionism
lack of credible transparency

Without addressing these inherent risks even a resemblance of stability will not be obtained. Of course, this is just a starter list. A round table of think tank arm chair economists surely could build a more comprehensive list. Let's address these out of order.

The non-republic, republic:

The past century has seen a growing trend in the overall involvement of our government...interventionism. This needs to be put in check before a currency crisis occurs at some unknown future date from out of control spending. Here are some simple solutions.

Restoring the republic:

Lobbyists have no place in Washington. Their presence distributes unfair subsidies to industries and corporations at tax payer expense, creates " "-opolies which often raise prices and reduce competition. It also represents the wrong constituent. Corporations are not constituents, citizens are. Lobbying brings misrepresentation of interests to Washington, since profits are the interests of corporations while rights and liberties are the interest of citizens. If lobbying is banned then...
The term for house representatives should be increased from 2 years to at least 4 years. It's amazing to me the conflict of interest between terms and agendas are not brought to attention more often. With lobbying erased and terms extended the focus on short term agendas and re-election would be reduced and allow for more strategic, long-term objectives as goals for representatives. More specific and objective research could be sought after in drafting bills where the representative actually writes it! Of course seeking expert advice of non-interested parties would be welcome in research from senators (absent lobbyists this could be done).
As crazy as this may sound, I believe Americans to be truly underrepresented in the house. The number of representatives used to be regularly increased to match population increases and this has not been done in over a century. With more representatives two things will be accomplished. 1) the ease of rushing bills through the floor should be reduced. No doubt the first stimulus may not have passed as quickly as it did with more waffling. 2) more time with constituents, on planning legislation and focus on topics will be afforded for and hopefully better quality bills will result.
The true purpose of the government is to uphold contract law and property rights of the individuals it represents.

The republic; can we keep it? Not if the structure of congress remains as is.

Banking and Monetary System Reform:

We live in a credit based economy that has reached an absolute peak in private sector leverage, largely a result of a fraudulent banking system and an improper role of the central bank. These proposals are based on Steve Keen's assumptions that credit is created by banks before reserves are supplied (by the Fed or depositors).

Fractional-reserve banking is fraudulent, even in name. Steve Keen concludes reserves are a mere mirage and that our current banking system is more like a zero-reserve system. This needs to be addressed immediately. Perpetual credit creation from thin air is inflationary and is the cause of the boom-bust cycle. The bust come when incomes and/or asset prices can no longer support the credit being serviced or when the pool of greater fools runs out and lending slows or stops. Bank runs are inevitable.
Given the fraudulent, destabilizing and inflationary bias of fractional-reserve banking, a system of full-reserve banking should be adopted. Rarely in history has this actually been practiced, but two known successful examples can easily be traced: 1) Bank of Amsterdam 2) GoldMoney.com
Full-reserve banking, in theory needs no lender of last resort. Therefore, the role of the central bank would be altered in a material way. This role creates powerful moral hazards we are all witnesses and victims too. 1) it's lender of last resort powers would be stripped. 2) it's ability to set interest rates would be stripped. Interest rates would be set between investors, borrowers, savers and lenders. 3) it's powers to print money would be stripped. 4) The FRS powers for acting as regulator and overseer of banks and their (now 100%) reserve requirements would remain, but this new reserve level would be permanent. 5) Though demonstrably the FRS has failed in times past as a regulator of lending standards (i.e. fraud), with the conflicts of interests stripped out, the FRS should be able to carry out this task more responsibly.
The FDIC should have no implicit guarantees from the government and should operate as a fully private institution. Of course, with full-reserve banking the institution would most likely fail from lack of a market. Banks and individuals could make their own decisions as to whether they would pay for (seemingly unnecessary) insurance of this nature.
Control of the currency is a much more complicated subject. The powers are vested in congress officially, but to trust congress with this right is suspect almost as much as the FRS. I propose a bi-metal currency backed by gold and silver, authenticated by banks (now with oversight from an non-conflicted FRS).

Debt & Equity Incentives:

Unfortunately not only is our society's monetary system credit based, but every incentive is also given to issue more debt than equity.

Tax deductions are given for interest payments on debt out of pre-tax income.
Dividends paid to equity investors are double-taxed; once to the corporation out of income and once to the investor as dividend income.

Conclusion, tax incentives skew the capital structure of the economy to favor debt investments. An equity based capital structure is much more stable in the long run. Without the incentives for debt based capital a natural balance more heavily weighted towards equity financing would likely emerge.

Remove tax deductions for interest payments.
Lower tax rates on dividends for equity investments.
Lower tax rates paid on interest earned on fixed income investments.

Commercial & Investment Banking:

Those who claim it was a lack of regulation that led to the crisis are misinforming you. The banking and securities industries are two of the most complex and heavily regulated industries in modern society. It was the failure to set intelligent regulation that was, of course, heavily lobbied by the banking sector against, that enabled much of the crisis.

The SEC, the regulatory body responsible for investment bank oversight, severely loosened net capital requirements for the major investment banks in a corrupt showcase of crony-capitalism. The result was highly levered firms invested in high risk assets. Net capital requirements should be strict, as these firms manage other people's money and should have a fiduciary obligation to act in their client's best interest. This should be true for any firm that holds deposits of any kind.
Though controversial even among conservatives, the repeal of the Glass-Steagal act was in my opinion material. The conflicts of interest created when commercial and investment banking activities are conjoined are great and should not be allowed.
Exchanges should not subsidize principals to provide "liquidity". If there is an attractive market with profit potential investors will provide ample liquidity. Also, any trading practice that encourages front-running should be banned (flash trading).
Not exactly a construct of the banking industry, but securities related nonetheless, rating agencies have a government sponsored monopoly (is there any other kind? debatable point) and should be paid by investors, not issuers.
I'm not an expert on commodity markets nor derivative markets, but surely some attention from more qualified individuals could shed light on that. Specifically, the opening of the commodities markets to speculative investors such as oh say pension funds, who have been known to dabble in oil futures in large amounts I'll say. The CFMA would need serious reformation.

Accounting:

The advent of the off-balance sheet item is a monster I'm amazed is still a legitimate practice.
Mark to market, not mark to fantasy
Dubious line items such as "other items" with little disclosure in footnotes would be a welcome reform to added accounting transparency. While at it, more descriptive line item disclosure would be very welcome addition to today's accounting standards.

Tax Code:

Utterly incomprehensible and too complex. Simplification is a must; I am no tax expert. The issue of debt vs. equity incentive was already discussed.

Labor is an economy's most valuable resource. It defines value in all commodities of exchange by its productive capacity. Give back spending/saving power to the economy and dramatically reduce all individual and corporate income taxes. Income taxes should be lower than dividend and capital gain taxes.
If tax burdens must be implemented to support necessary government functions, then labor and capital should not be the primary source of tax revenue for governments. Instead rent, here considered as the price paid for the use of land, should be a major source of tax revenues. The tax code heavily favors landlords and encourages speculation in real estate, we all know the outcome. In theory, taxing rents should not affect land prices in a material way.

Interventionism:

Our government has so many departments I doubt they can even account for them all. Needless to say, services that can be profitably and legally provided through private enterprise should be. Waste in our government is out of control and the size and responsibility must be downsized and restructured. In capitalism...

Institutions are allowed to fail through the courts if necessary.
The welfare state should only be afforded to the (truly) disabled. Citizens believing they have an intrinsic right to government services they are capable of obtaining of their own free will is not a principle of a capitalistic society. The ongoing health care debate is a prime example of that. Is it any wonder obesity in America has become a serious problem given the excessive role of our government in health and insurance industries? Americans have not the proper incentive to care for themselves in this status quo.
Mercantalist policies should be avoided unless to protect from hazard (such as imports that prove fatal from chemicals of manufacture). This includes severely limiting quotas, subsidies and tariffs on trade domestically and internationally.
Competition should be freely embraced. Say, that might be a swell idea for insurance companies that are afforded state monopolies.

Conclusion:

I started with the issue of "the republic" and of course the monetary reforms because they are the most instrumental problems in America today. The future however, predicts these changes will not be addressed until it is too late. Why? because liabilities, both our indebtedness to other sovereigns and our own domestic entitlement liabilities will prove to be too great at some point and some form of default (inflation or otherwise) will occur, most likely not for many years down the road.

Since 2007 when the crisis emerged, all of these factors listed above are still inherent in the system. If nothing has been changed to prevent these complexities from triggering another crisis, why then should one expect them not to occur? Money has been thrown at the problem creating more moral hazard in typical kick the can down the road fashion.

Student Loans: The Non-Issue, Issue

mscullen1@gmail.com (MWS) — Sat, 19 Sep 2009 06:11:00 PDT

It surprises me that so little attention has been given to recent college graduates and student loan performance. First, some background on how students have fared from the National Center for Education Statistics:

Enrollments:

Enrollment in degree-granting institutions increased by 14 percent between 1987 and 1997. Between 1997 and 2007, enrollment increased at a faster rate (26 percent), from 14.5 million to 18.2 million. Much of the growth between 1997 and 2007 was in full-time enrollment; the number of full-time students rose 34 percent, while the number of part-time students rose 15 percent. During the same time period, the number of females rose 29 percent, compared to an increase of 22 percent in the number of males. Enrollment increases can be affected both by population growth and by rising rates of enrollment. Between 1997 and 2007, the number of 18- to 24-year-olds increased from 25.5 million to 29.5 million, an increase of 16 percent, and the percentage of 18- to 24-year-olds enrolled in college remained relatively stable (37 percent in 1997 and 39 percent in 2007).

Average Income:

Cost of Education:

For the 2007–08 academic year, annual prices for undergraduate tuition, room, and board were estimated to be $11,578 at public institutions and $29,915 at private institutions. Between 1997–98 and 2007–08, prices for undergraduate tuition, room, and board at public institutions rose by 30 percent, and prices at private institutions rose by 23 percent, after adjustment for inflation.

All Institutions: from 1980 to 2007-08 the cost of education has risen by a multiple of 5.25. Since 2000 costs have risen by a multiple of 1.42 while men saw their incomes decline by 7.8% over the same time period. Is that value added education?

Indeed, college graduates are finding the wonder jobs they expected after 4 hard and costly years of education are not there, which is quite evident in the latest employment report:

Highlights in orange rectangles are mine. If you are between 20 and 35 this recession is hitting you hard, specifically if you are between 20 - 24.

A severely lagging, but telling sign student loan defaults are set to rise and continue to rise is from the Federal Student Aid:

The cohort default rate is the percentage of borrowers who enter repayment in a fiscal year and default by the end of the next fiscal year.

The Department issues default rates according to the fiscal year that borrowers entered repayment. For example, the fiscal year 2007 default rate is based on students that entered repayment between 10/1/2006 and 9/30/2007. The Department publishes default rates approximately two years after the fiscal year that students enter repayment.

The trend of defaults turned sharply up even before the recession started. This could be confirmed again back in April when defaults soared:

The situation is mirrored in the smaller private student-loan market. In 2008, SLM Corp. also known as Sallie Mae, wrote off 3.4% of its private loans that were already considered troubled, according to its latest annual report -- more than double the figure in 2006. Student Loan Corp., a unit of Citigroup Inc., wrote off 2.3% of those loans in 2008, compared with 1.5% a year earlier.
"The volume of people in trouble is definitely increasing," says Deanne Loonin, a staff attorney at the Boston-based National Consumer Law Center who counsels low-income consumers on student loans and other debt issues.

Lenders say they are hearing more pleas for help as the unemployment rate worsens and debt levels soar among graduates.

Sarah Kostecki, a 24-year-old sales associate in New York, graduated last year from DePaul University with a major in international studies and $87,000 in debt, translating to monthly payments of $685, the vast majority of which are private loans.

The payments represent more than a third of her take-home pay, and to help her make ends meet, her grandparents are giving her $200 a month toward her debt this year. Beginning in January, she'll be on her own, and she worries about falling behind.
"It feels like I'm being punished for having gone to school," Ms. Kostecki says. She has contemplated some of the options offered by private loan companies, such as temporary interest-only payments. But after two years, her payments would jump by almost $200 a month on top of what she's paying now, she says. "I don't want that."

The article goes on to explain various deferment and forbearance schemes that essentially kick the can down the road for most borrowers but exacerbate the problem when it comes due.

Sallie Mae releases quarterly results of their private loan portfolios.

Sallie Mae references the "favorable" trend of forbearance in their presentation. However, what's favorable about this is that it shadowed reality for awhile, avoiding charge-offs of any significance in 2008. In 2009 the story has changed and the trend of delinquencies and charge-offs is accelerating while forbearance decelerating (because eventually the can gets to heavy to kick down any further). There is no indication this trend will slow as more and more college graduates continue to enter the labor force in a bleak economy and as previous graduates run out of options for making ends meet.

While I'm no expert on bankruptcy laws I do know student loans are next to impossible to discharge, so these debts will haunt graduates (and in many cases their parents who are also struggling to pay for their students education) for some time into the future. While college graduates do earn significantly more than high school only earners, the net benefit has been declining over the past decade. And now that boomers are now recognizing they are woefully underfunded for retirement, these graduates now have more added competition with more experience.

In conclusion, one has to wonder why this topic receives so little attention? Investors and financial institutions will be slowly bleeding losses on private student loans for some time to come and gen X & Y will have serious constraints on the contribution they can afford to growth in our economy despite their education advantages. Yet another headwind our economy faces in the wake (is it truly the wake yet?) of the most massive credit binge in history.

Gold Bugs Beware!

mscullen1@gmail.com (MWS) — Fri, 18 Sep 2009 15:03:00 PDT

Gold has certainly been in the spotlight as of late. Since July it has rallied approximately 100 points. Gold bugs have proclaimed the long awaited push to 1,500+ has now begun. Maybe so, but I know of some guys who may not like that idea; IMF Approves Sale of 403.3 Metric Tons From It's Gold Stockpile:

The International Monetary Fund’s executive board said it approved gold sales of 403.3 metric tons and pledged to ensure against “disruptions” in the gold market.
The IMF said it would “stand ready to sell gold directly to central banks.” The sales could also be conducted in the open market in a “phased manner” over time, the Washington- based lender said in an e-mailed statement.

"disruptions"? If gold truly is on its way to the moon, this IMF action will only delay the inevitable. Of course in the short term depending on the aggressiveness this could have an impact that would disappoint the dollar collapse believers. The truth is, as outlined here before, gold performs spectacularly in the face of high uncertainty. The fact gold has soared throughout this global stock market rally signals something is amiss. Investors must not be convinced of a great recovery and are hedging accordingly. Global central bank "QE" shenanigans don't hurt either.

Musings Over "Recovery"

mscullen1@gmail.com (MWS) — Sun, 13 Sep 2009 15:48:00 PDT

It's been awhile since I've commented in depth and comprehensively on the state of the economy here. No doubt headlines in the mainstream media have been generous in making the assumption that the economy is returning to growth, albeit on a slow trajectory. The most recent bit of data being the OECD's composite leading indicators that "point to broad economic recovery". While the index is to be respected as it has had a fairly good track record in its predictive ability, there's more than meets the eye. I discussed the Conference Board's Index (here) once before and warned that it should be respected, but again questions still lingered as to the long term sustainability of "green shoots".

Before getting very "HD" (High Definition) into an analysis of why the growing optimism of recovery might be set up for severe disappointment, let's visit a great economic thinker's thoughts on conditions to be expected in a deflationary environment, which I contend we are not out of the woods on yet. From Ludwig Von Mises' "Human Action":

Credit Inflation (pg. 569):

Conditions are different (than money proper inflation) under a credit expansion which by first affects the loan market. In this case the inflationary are multiplied by the consequences of capital malinvestment and overconsumption. Overbidding one another in the struggle for a greater share in the limited supply of capital goods and labor, the entrepreneurs push prices to a height at which they can remain only as long as the credit expansion foes on at an accelerated pace. A sharp drop in the prices of all commodities and services is unavoidable as soon as the further inflow of additional fiduciary media stops.

Now that we know an extended period of credit inflation inevitably leads to deflation once the flow of additional money is shut off and not refueled, we can accept that we have great potential in today's environment for still being in deflation. I would add that popular delusions and the madness of crowds (reference to Charles Mackay) certainly is a necessary condition to set off a credit boom which eventually leads to a deflationary bust.

Mises outlines a few conditions one might expect during a deflationary credit contraction (p566-569):

Banks, frightened by their adverse experience in the crisis brought about by credit expansion, are intent upon increasing the reserves held against their liabilities and therefore restrict the amount of circulation credit.
The crisis has resulted in the bankruptcy of banks which granted circulation credit and that the annihilation of the fiduciary media issued by these banks reduces the supply of credit on the loan market.
Now, it is true that even with no restrictions in the supply of money proper and fiduciary media available, the depression brings about a cash-induced tendency toward an increase in the purchasing power of the monetary unit. Every firm is intent upon increasing its cash holdings, and these endeavors affect the ratio between the supply of money (in the broader sense) and the demand for money (in the broader sense) for cash holdings. This may be properly called deflation.

Keeping these theoretical concepts in mind, let's put them into context of today's economic environment.

Market Watch recently reported the total of 2009 bank failures has now reached 92. As the crisis progresses, experts like Chris Whalen expects hundreds if not 1,000+ bank failures (there are more than 8,000 small banks that hold only about 20% of total bank assets). Failures on this scale are not consistent with economic growth looking forward. The fringe banks are not alone in their troubles. Despite massive government and FRS support and bailouts even the large oligopoly of banks are reluctant to lend. Evidence can most clearly be ascertained of this from two sources:

(1)
Reserve Balances with Federal Reserve Banks:

The most recent value on 09-09-2009 was recorded at $859 billion of reserves, the vast majority of which are excess reserves, that is reserves voluntarily held at Federal Reserve Banks.

(2)
The July Senior Loan Officer Opinion Survey On Bank Lending Practices:

(revealing charts here)

In the July survey, domestic banks indicated that they continued to tighten standards and terms over the past three months on all major types of loans to businesses and households, although the net percentages of banks that tightened declined compared with the April survey.² Demand for loans continued to weaken across all major categories except for prime residential mortgages. The fractions of domestic banks reporting additional weakening in demand in this survey were slightly lower than those in the April survey for C&I loans and home equity lines of credit, approximately the same for commercial real estate (CRE) and nontraditional residential mortgages, and slightly higher for consumer loans.

In response to a special question, domestic banks pointed to decreased loan demand and deteriorating credit quality as the most important reasons for declines in C&I lending this year. In response to a second special question, most banks reported that they expected their lending standards across all loan categories would remain tighter than their average levels over the past decade until at least the second half of 2010; for below-investment-grade firms and nonprime households, the expected timing is later, with many banks reporting that standards for such borrowers will remain tighter than average for the foreseeable future.

I encourage all to click on the link to pdf charts which show lending standards and demand. The demand charts are especially revealing...there little demand and it continues to decline.

Points 1. & 2. have now been satisfied considering the above information. In June the second quarter flow of funds report was released. I will not break it down for you in detail as Martin Weiss has already done an outstanding job of that. For much more Hard Evidence of Continuing Debt Collapse please visit his analysis.

As for point 3. one needs only look to the spike in savings rate, flawed as its calculation may be, the trend is indistinguishable.

Of course, rising savings rates are not deflationary per-say, but they are when wages and incomes are stagnant or declining and spending falling. Consider a recent gallop poll on spending:

Survey Methods:

Results are based on telephone interviews with more than 260,000 national adults, aged 18 and older, conducted January 2008-June 2009, as part of Gallup Daily tracking. For results based on the total sample of national adults, one can say with 95% confidence that the maximum margin of sampling error is ±1 percentage point.

For 2009 data, each generation consists of no fewer than 4,000 interviews. For 2008 data, each generation consists of no fewer than 10,000 interviews. The margin of error for each generation in 2008 and 2009 is ±1 percentage point.

I would assume these polls to be fairly reliable. The bottom line is the consumer is not as thrifty as in times past even in the face of huge government transfer payments, low interest rates for qualified borrowers and lower prices as indicated (by the very flawed) CPI. The poll has some great findings into the demographics issue as well. I would not expect a sudden revival in the consumerism America has enjoyed so recklessly in decades past. Indeed, Record Plunge in U.S. Consumer Credit Signals weakened Spending:

A record $21.6 billion drop in borrowing by Americans added to evidence that consumer spending will be slow to recover as banks and credit-card companies tighten lending standards and households pay down debt.
Consumer credit fell by 10 percent at an annual rate in July to $2.5 trillion, according to a Federal Reserve report released yesterday in Washington. The drop was more than five times larger than economists forecast. Credit fell for a sixth month, the longest series of declines since 1991.

Point 3. looks to be satisfied.

Now let's look to the corporate sector:

Junk Default Rate Rises to 11.5% in August-Moody's:

Moody's Investors Service said the global speculative-grade default rate rose to 11.5 percent in August, the highest level since 1991, as the economic recession took hold.
A total of 15 Moody's-rated corporate debt issuers defaulted last month, 11 of them in North America and four in Europe, taking the year-to-date total to 205 companies, Moody's said in a report on Wednesday.

The ratings agency, meanwhile, cut its forecast for Europe's peak junk default rate, while raising its forecasts for peak U.S. and global rates.

Moody's now expects the European rate to peak at 11.4 percent in the fourth quarter -- the sixth consecutive month that it has reduced its estimate from 12 percent in August, 15 percent in July and as high as 22.5 percent in March.

For the United States, Moody's raised its peak rate forecast to 13.2 percent in the fourth quarter, versus last month's estimate of 12.7 percent, reversing direction after reducing the estimate for at least the previous four months.

Moody's predicted that the global junk default rate would peak at 12.6 percent in the fourth quarter and decline sharply to 4.3 percent by August 2010.

That compares with a 1991 peak of 12.2 percent.

The global forecast is based on an estimated peak in the U.S. unemployment rate at 10 percent in 2010, said Kenneth Emery, director of corporate default research.

"If the U.S. unemployment rate were to increase substantially above 10 percent in the coming year, then default rates would likely be significantly higher," he added.

Surely an economy about to recover to growth would not experience these abnormally high default rates. Hmmm, something is amiss.

Revenue & Earnings:

The S&P Earnings Estimates commentary unfortunately did not come with hard data on sales. So I took an average of the individual issue along with the corresponding operating and as reported figures:

I hid much of the data in the spreadsheet for easy viewing. Unfortunately the font is small. Trusting the average provides a good indication of the overall trend, there is no growth inherent in representative corporate America.

Actual Q2 data:

495 issues (99.51% mkt val) reported: preliminary Operating EPS declined 18.3%, with As Reported up 5.8%.
Again Q3 will be less bad, -9% vs -18% for Q2, -39% for Q1 and the only negative qtr for Q4,'08.

For year 2009 forward earnings estimates (including Q1 & Q2 actuals):

Operating: $54.09 - forward P/E at 1,044 of 19.30

As Reported: $39.35 - forward P/E at 1,044 of 26.53

Are these attractive valuations? Considering all of the data reported above from the beginning of this post is revenue growth in the near future realistic?

For more commentary on the S&P 500 let's visit on some Breakfast's with Dave (Rosenberg) of Gluskin Scheff.

September 9, 2009

With earnings AND revenues down over 20% YoY, it can hardly be said that the fundamentals are very constructive. Current quarter EPS estimates are also down 30% from where they started the year.

Dave must have actual data and confirms revenues are worse than my average taken above.

September 10, 2009

Companies have not really been beating their earnings estimates — only the very final estimates heading into the reporting quarter. For example, the consensus view for 3Q EPS at the start of the year was $21.00, last we saw the estimates were down to just over $14.00. But there is a deeply rooted belief that earnings are coming in better than expected. This is a psychology that is difficult to break. It is completely unknown (for some reason) that corporate revenues are running at a -25% YoY rate, which compares to the -10% we saw at the worst part of the 2001-02 bear market and the -3% trend at the most negative point in 1991.

September 11, 2009

On the incredible multiple expansion of the rally from the March 2009 lows;

In summary, corporate America is not seeing the growth in profits and revenues (more like cliff diving) to support a robust recovery and a soaring stock market.

Dave has some continued thoughts on the labor market:

The problem is not so much with firings any more; it’s more about a complete lack of new hiring. The NFIB index that measures job openings fell again in August — from 9.0 to a 27-year low of 8.0. Challenger hiring plans collapsed 24% in August to a three-month low. Someone obviously forgot to tell the folks at Manpower that the recession was over because its employment plan index for the U.S. just broke below the worst levels of the last three economic downturns. The JOLTS data from the Bureau of Labor Statistics also showed that job openings plunged 121,000 in July and we now officially, for the first time on record, have six unemployed people competing for every possible job opening out there. No wonder organic wages and
salaries are deflating a record YoY rate of nearly 5%.

The U.S. Census Bureau just reported that Americans’ household income last year took the sharpest drop since the government began keeping records in 1947. Median household income sank 3.6% to $50,303, after adjusting for inflation, during the first full year of the recession. At that level, median income is now down to its lowest level since 1997 — a decade’s worth of gains wiped out in just one year. Those that think we are going to see the return of the U.S. consumer into the dealer showrooms and malls on any sustained or meaningful basis for the next several years are dreaming in Technicolor.

That does not bode well for growth outside of any statistical means. And now, a final take from Mises (p. 569):

Prices of the factors of production - both material and human - have reached an excessive height in the boom period. They ust come down before business can become profitable again. The entrepreneurs enlarge their cash holding because they abstain from buying goods and hiring workers as long as the structure of prices and wages is not adjusted to the real state of the market data. Thus any attempt of the government or the labor unions to prevent or to delay this adjustment prolongs stagnation.

This paragraph sets one up to ask, with wages and salaries having deflated 5% yoy and commodity prices as represented by the $CRB Index nearly 50% lower than a year ago; have the structure of prices and wages adjusted to the real state of the economy?

It's tough to say in the face of such severe declines as we've seen that it's not. But with so much government interference one has to ask, why should the process be over now?

Also of great importance are the structural imbalances that remain. Consumers still remain over indebted and unemployment is expected to continue to rise. Bad assets are still on bank balance sheets and how much is any ones guess. What is known is that this economic downturn has created more structural bad assets as delinquencies on mortgages and commercial real estate continue to escalate at a fast pace. Also looming are Alt-A and Option-Arm resets that begin to escalate in Q3 2009. With headwinds such as these, the prospects of recovery seem doubtful despite the positive leading indicators and a tiny uptick in housing permits and sales.

I'll be looking at more concrete evidence in the future. SHOW ME THE MONEY! I want to see broad increases in sales and upticks in temporary workers. I want to see trust and transparency in our financial institutions and diminishing involvement from government. Once data points like these begin to emerge I'll declare the next great bull market. Until then, deflation remains in my view intact. That's not to say markets cannot diverge from fundamentals for much longer than most think; a word of caution.

Not covered in this report are global aspects such as China's massive stimulus efforts (another credit induced boom), global currencies and devaluative monetary policies, and global trade. No definitive conclusion should be made without analysis of these aspects as well. For the sake of not turning this post into a novel, we'll unfortunately dis-include them.

Liberty Analytics Performance Update

mscullen1@gmail.com (MWS) — Tue, 01 Sep 2009 06:22:00 PDT

It's been 11 months since the inception of Liberty Analytics' first strategy:

The Intrinsic Wealth Strategy:

Capital appreciation and income will be the main objective here, and would be suitable for conservative to moderate investors alike. Equities will not be as overweight in this portfolio, but as aforementioned, strict guidelines will be applied as to the margin of safety rule, and financial soundness of the issuers is a core requisite. Options and short strategies will not be employed in this strategy. Bonds and other fixed income securities will also find a regular weighting in this portfolio, including cash. Economic outlook will still bare significance as to the weighting of the portfolio. Value and income defines this strategy.

Since Inception (October 2008) the strategy has returned 3.13%.

Results of Strategy:

The timing of inception for this strategy worked out quite well since the September to November crash resulted in many quality equities at substantial discount. The initial drop off and leveling out was a result of investing in equities that found their bottom in November ahead of the March lows.

March was the start of this now much larger than anticipated correction equity markets are seeing globally. Your humble manager had severely underestimated the power this rally has had. The result was to sell equity exposure in hindsight too early as multiple expansion soared and continues to soar beyond top and bottom line growth. After reducing equity exposure, other investments with negative correlations to the SPX were entered into. The decision was early, but good yield and income has been earned since then and in August as the rally has slowed these investments have started to pay off.

The primary view of Liberty Analytics is that this rally has born no relationship to fundamentals. Indeed with stocks leading the rally such as Citigroup and AIG which are only solvent courtesy of the US taxpayer, our caution is not without warrant. There are still very large headwinds facing the over leveraged consumer and time and saving are the appropriate remedies.

Despite our less than optimistic outlook on the economy, we at Liberty Analytics will concede "the bottom" may be in, but than again it may not. This autumn will be quite telling and from the now current extreme bullish sentiment we'll be looking for a correction. In the face of this there are several investments of interest we are looking to and will start slowly increasing equity exposure with an emphasis on companies that have still shown growth in the face of adversity and are high yielding in earnings and especially dividends. Patience is a virtue.

Conclusion

The past year has been extraordinarily challenging for even the most experienced and successful managers. With rock star funds like Fidelity Magellan down nearly 23% yoy despite successful participation in this rally, Liberty Analytics is proud of its humble 3.13% return yoy with minor volatility in the overall portfolio. We are optimistic despite our overall bearish view that select opportunities will begin to emerge this autumn if a correction takes place.

Money Stock & The Economy

mscullen1@gmail.com (MWS) — Sun, 30 Aug 2009 16:50:00 PDT

Steve Keen is a Australian economist at the University of Western Sydney and author of "Steve Keen's Debt Watch" blog. He was one of the few economists to predict the crisis correctly and continues to be bearish on the economy. What is different about Keen from other economists is his treatment of money and credit in analyzing the economy. He recognizes that the larger the absolute total debt in an economy becomes the larger is its contribution to growth (or contraction). His analysis now determines that there are serious deleveraging headwinds facing many of the world's largest economies.

In other words, there exists large deflationary factors looming that could take years to unwind as credit is adjusted to serviceable levels. What recently caught my brain is his most recent post: Debtwatch 38 - The GFC Pothole or Mountain? He references am empirical study from Kydland and Prescott that proves what Keen has been saying all along; that credit money is created before base money, with a lag of up to a year.

“There is no evidence that either the monetary base or M1 leads the cycle, although some economists still believe this monetary myth. Both the monetary base and M 1 series are generally procyclical and, if anything, the monetary base lags the cycle slightly.

The difference in the behavior of M1 and M2 suggests that the difference of these aggregates (M2 minus M1) should be considered. … The difference of M2-M1 leads the cycle by even more than M2, with the lead being about three quarters.

The fact that the transaction component of real cash balances (M 1) moves contemporaneously with the cycle while the much larger nontransaction component (M2) leads the cycle suggests that credit arrangements could play a significant role in future business cycle theory. Introducing money and credit into growth theory in a way that accounts for the cyclical behavior of monetary as well as real aggregates is an important open problem in economics.”

Taking this idea a bit further into today's world, let's see how the M2 - M1 difference has worked as a leading economic indicator.

First, no one indicator is perfect and can be conclusive on its own. In addition to Fed actions and deposit flows were massive fiscal stimulus packages and taxpayer funded subsidies. Simultaneously, a look at the 1Q09' flow of funds report shows the credit side of things, with all but the financial and public sector in massive delveraging mode. However, looking at this data as if it was in a vacuum one could conclude that with the dramatic changes in M2 - M1 has had quicker than 3 quarter lead time if one were to compare it to the SPX, a good proxy for social mood and possibly monetary stimulus.

Indeed, using a Pearson coefficient equation, a -0.4 is extracted using monthly changes in the SPX over the same period as the M2 - M1 monthly changes. This suggests the M2 - M1 change is more close to real time than three quarters. However, using statistics based from normal distributions has proven anything but reliable. The point here is to consider the possibility of a relationship between these two data points and what has been presented here would only serve as a starting point.

What I've shown is not statistically significant. Glancing at the chart you can see the decrease in the flow of money from 3/08 to 6/08 lead the September massacre in the SPX. After that point the M2 - M1 % changes become volatile, again leading the market in a moderate negative correlation. Extrapolating a specific lead time from this would be difficult and uncertain, but June and July M2 - M1 decreases sure do start looking interesting for September.

FASB Grows Marbles - Pros & Cons

mscullen1@gmail.com (MWS) — Thu, 23 Jul 2009 09:28:00 PDT

The treatment of securities and loans on balance sheets is not a simple matter. Investors wish for transparency and owners reject recording losses, but welcome the upside pro-cyclical features...go figure.

In my own opinion, a middle ground needs to be reached on the fair market value rule. The concept of mark-to-market is investor friendly and transparent so long as you can trust the firm is marking prices honestly. However, FASB is proposing fluctuations in those securities, whether gains/losses are realized or not, flow to the income statement. This is true for securities classified as hedges as well.

While I applaud FASB's new found post-pubescent courage, their treatment leaves me wanting. "Fair value" marks change constantly and often erratically. While these changes should be clearly marked on the books as compared to cost, having in many cases unrealized gains/losses flow to the income statement is erroneous, even when labeled as "comprehensive income". Not only will this add more volatility to earnings, but also less predictability, especially for companies with large securities held on their books. Gains/losses should be recorded when they are realized.On the subject of recording fair market value on the balance sheet and income statement, Bloomberg reports:

The scope of the FASB’s initiative, which has received almost no attention in the press, is massive. All financial assets would have to be recorded at fair value on the balance sheet each quarter, under the board’s tentative plan.

This would mean an end to asset classifications such as held for investment, held to maturity and held for sale, along with their differing balance-sheet treatments. Most loans, for example, probably would be presented on the balance sheet at cost, with a line item below showing accumulated change in fair value, and then a net fair-value figure below that. For lenders, rule changes could mean faster recognition of loan losses, resulting in lower earnings and book values.

The board said financial instruments on the liabilities side of the balance sheet also would have to be recorded at fair-market values, though there could be exceptions for a company’s own debt or a bank’s customer deposits.
...
While balance sheets might be simplified, income statements would acquire new complexities. Some gains and losses would count in net income. These would include changes in the values of all equity securities and almost all derivatives. Interest payments, dividends and credit losses would go in net, too, as would realized gains and losses. So would fluctuations in all debt instruments with derivatives embedded in their structures.

Other items, including fair-value fluctuations on certain loans and debt securities, would get steered to a section called comprehensive income, which would appear for the first time on the face of the income statement, below net income. Comprehensive income now appears on a company’s equity statement.

Another quirk is that the FASB doesn’t intend to require per-share figures for comprehensive income. Only net income would appear on a per-share basis. My guess is that means Wall Street securities analysts would be less likely to publish quarterly earnings estimates using comprehensive income.

Imagining the Impact

Think how the saga at CIT Group Inc. might have unfolded if loans already were being marked at market values. The commercial lender, which is struggling to stay out of bankruptcy, said in a footnote to its last annual report that its loans as of Dec. 31 were worth $8.3 billion less than its balance sheet showed. The difference was greater than CIT’s reported shareholder equity. That tells you the company probably was insolvent months ago, only its book value didn’t show it.

Gold & Deflation

mscullen1@gmail.com (MWS) — Wed, 22 Jul 2009 12:38:00 PDT

While not agreeing with this author's definition of deflation, his arguments and historical references are informative. I understand his logic in using the CPI index to track deflation (CPI flawed as it is), he falsely actually defines deflation as such.

His conclusions about gold are incredible though and I agree completely. That is, high levels of uncertainty, lack of confidence and credit deterioration all contribute to gold demand. This is true for inflation or deflation. The 23 pages are well worth your read, especially for the history lesson.

Written in 96', he noted the bubble like characteristics even then....this credit bubble has not yet finished bursting.

Behavior of Gold Under Inflation

Leading Indicators Turning Up, Bullish?

mscullen1@gmail.com (MWS) — Mon, 20 Jul 2009 18:14:00 PDT

Astute investors are considering the recent data out on The Conference Board Leading Economic Index:

LEADING INDICATORS. Seven of the ten indicators that make up The Conference Board LEI for the U.S. increased in June. The positive contributors – beginning with the largest positive contributor – were interest rate spread, building permits, stock prices, weekly initial claims (inverted), average weekly manufacturing hours, index of supplier deliveries (vendor performance), and manufacturers' new orders for consumer goods and materials*. The negative contributors – beginning with the largest negative contributor – were real money supply*, manufacturers' new orders for nondefense capital goods*, and index of consumer expectations.

The Conference Board Leading Economic Index™ (LEI) for the U.S. increased 0.7 percent.

Based on revised data, this index increased 1.3 percent in May and increased 1.0 percent in April. During the six-month span through June, the leading economic index increased 2.0 percent, with five out of ten components advancing (diffusion index, six-month span equals 50 percent).

A quick look at the chart above begs one large question:

The LEI declined 5 of the first 6 months in 2006, but no recession followed

I'm well aware of the predictive ability, but skeptics do joke that the index has predicted 9 of the last 6 recessions. The index is not perfect, but commands some respect. Let's break down the contributors I highlighted in red:

Interest Rate Spread - This is the largest contributor to the index and no one can doubt the significance of such a steep yield curve (difference between the 10 vs 2 yr treasury yields) in predicting economic upturns. Why?

Expectations of higher growth
Expectations of higher inflation (not a positive)
Banks earn profitable spreads, encourages lending

With regards to the first point, it can happen, but only as a result of a statistical anomaly in calculating GDP. Inflation fears have been growing rapidly since the beginning of 09', so no surprise there. As for the third, well....Bank Fail To Make Adequate Loan Loss Provisions Moody's Says:

July 20 (Bloomberg) -- Banks have failed to make adequate provision for the losses on loans and securities they face before the end of next year, Moody’s Investors Service said.

U.S. banks may incur about $470 billion of losses and writedowns by the end of 2010, which may cause the banks to be unprofitable in the period, the ratings company said in a report published today.

“Large loan losses have yet to be recognized in the banking system,” Moody’s said. “We expect to see rising provisioning needs well into 2010.”

Banks and financial firms worldwide have reported losses and writedowns of $1.5 trillion since the credit crisis began in 2007, according to data compiled by Bloomberg. New York-based Citigroup Inc. has reported $112 billion of writedowns, more than any other firm, the data show.

Any economic recovery is likely to be “weak and bumpy hook-shaped,” Moody’s said. Banks will also be challenged in an environment where government support is replaced by tighter regulation, the report said. Higher credit and funding costs may force a re-pricing of credit, Moody’s added.

“The fundamentals of financial institutions are still traveling on a downward slope,” Moody’s said. “No-one should consider recent improvements as assurance that the current rebound can be sustained.”

It's safe to say banks are constrained to lend and consumers are mostly unwilling to borrow.

Building Permits - In the bust of the biggest housing boom ever, increases in building permits can be viewed of as a negative considering the huge overhang of inventory that needs to be worked off, not to mention CRE's impending bust. For more on this please read 7 Reasons Why Housing Isn't Bottoming Yet.

Stock Prices - The rally in stocks has been impressive and its no wonder they're showing up in the LEI. However, this rally is guilty until proven innocent.

Weekly Initial Unemployment Claims - The contribution to the LEI from this statistic might be explained by emergency unemployment compensation (EUC). Mish had a great post on this, let's revisit:

Around the country, the number of people exhausting their benefits is piling up. By the end of September, more than 500,000 people will exhaust their benefits checks, with the biggest groups in Pennsylvania, California and Texas, according to estimates by the National Employment Law Project, an advocacy group for low-wage workers based in New York City. That number will nearly triple by the end of the year, the group said.

As Mish explains in his post, EUC is NOT included in the continuing claims. He also has some interesting commentary from David Rosenberg within the post regarding seasonal adjustments in the claims and slow downs in layoffs related to auto workers affecting the weekly claims, I encourage all to go and read the post. To summarize, Rosenberg postulates that with the auto factories shut down, there's no one to lay off when during normal seasonal patterns there would be.

The LEI may prove to be right down the road in 2009, but considering the above points one has to wonder whether this would lead to a real recovery where jobs, profits and sales increase, or whether this would just be a recovery in a statistical sense bearing no resemblance to reality.

The coincident index has remained negative through all of 2009, but rate of decline is slowing. By far the most important contributor to the LEI is the steep yield curve, but considering banks are far from profitable outside of one time gains and accounting shenanigans, how significant is that?

Developing State Budget Crisis

mscullen1@gmail.com (MWS) — Thu, 16 Jul 2009 08:52:00 PDT

Generally, you may feel all warm and fuzzy inside about the prospects of the economy. After all, Dennis Kneale has officially declared the recession is over and inventory restocking is all the rage (despite still above trend inventory/sales ratios). Banks are reporting large profits again from lucrative proprietary trading desks, churning $100 million trading days. Reflation is indeed on...or is it?

State Budget Crisis

It's truly blasphemous how little attention this is receiving, but let it be known that green shoots are dying in the summer heat. By autumn seasonal change will begin to take hold setting the stage for the deadly winter cold. To expect the effects of state budget adjustments not to have material effects on the economy is naive to put it nicely. Some highlights:

Budget cuts often are more severe in the second year of a state fiscal crisis, after reserves have been largely depleted
Expenditure cuts and tax increases are poison for the economy, especially during a severe recession
In this recession states have already drawn down much of their available reserves; the available reserves of states with deficits are likely to be depleted in the near future
State budget shortfalls of remaining 2009, 2010 and 2011 are estimated to total between $350 - $370 billion

What this looks like:

Bigger picture, commercial real estate is still deteriorating, total public debt is still outrageous and Fed monetary infusions have only been funneled into the wallets of phat cats at brokerage firms resulting in mini booms aka large rallies (and that's all they are). Now use you imagination and ask yourself "has employment bottomed?", "will consumer spending come roaring back?"

State Budget Problems Worsen

More Calls For Hyper-Inflation. Is It Guaranteed?

mscullen1@gmail.com (MWS) — Mon, 01 Jun 2009 07:06:00 PDT

The recent decline in the dollar and spike in rates of treasuries have many worried. Let's investigate that further.

Marc Faber is a bright guy and well respected. However, when it comes to his concerns (guarantee) over hyperinflation his equation is too linear: [A + B = C] Where,

A = Rapidly Increasing Monetary Base
B = Federal Deficit Spending
C = Hyperinflation

Reality is much less linear, in fact non-linear. There are other factors in this equation:

D = Bank Excess Reserve Deposits
E = Rising Savings Rate
F = Falling Home Prices
G = Falling CRE Prices
H = Increasing Loan (option-Arm, Alt-A, Prime, C&I), credit card & Corporate Bond Defaults
I = Rising Unemployment

The catalyst that may have sparked Faber's concern might have been S&P US debt downgrade warnings and spikes in US treasury yields. I take these important signals a bit differently. The bond market is issuing a warning to the Fed and US. What is that warning exactly? If this path continues investors will demand higher rates. Since higher rates are poison both to the economy and the US Governments ability to service its bloated debt, you can throw some wild card non-linearities in there as well:

J = Large across the board tax increases

K = Abandon some of the proposed spending plans

L = Abandon Quantitative Easing

The latter two scenarios (K & L) seem least likely. However tax increases (J) are a certain guarantee. Obama is Hell bent on the central planning model. More recently there have been some tax increase proposals; I mentioned some of the more certain taxes while Sitting On The Fences:

Cap & Trade = higher prices related to energy and transportation (roughly $1,600/yr per household)
Taxing the $250k + income earners
Taxing foreign source income (more double taxation)
Soda pop & alcohol taxes

Then of course come the more biting taxes, namely the VAT; Is A National Sales Tax In Our Future?:

A VAT is a tax on the transfer of goods and services that ultimately is borne by the consumer. Highly visible, it would increase the cost of just about everything, from a carton of eggs to a visit with a lawyer. It is also hugely regressive, falling heavily on the poor. But VAT advocates say those negatives could be offset by using the proceeds to pay for health care for every American — a tangible benefit that would be highly valuable to low-income families.

Example:

Take, for instance, a car with a sticker price of $30,000 and a value-added rate of 10%. Ford might buy its steel and other materials for $8,000 plus $800 in a VAT tax. A dealer then pays $25,000 plus a $2,500 tax for the finished vehicle. Ford takes an $800 credit for the tax it already paid and sends $1,700 to the government. A buyer then pays $30,000 for the SUV and $3,000 in taxes. The dealer collects the $3,000, takes a credit for the $2,500 worth of taxes already paid, and sends $500 to tax authorities. Ultimately, the government pockets $3,000, or 10% of the retail price of the car, in taxes.

These tax increases might occur sooner than most realize. Why? Consider the final trump below.

The final trump is something Faber is disregarding. Dollar Hegemony. The US has a monopoly over the world's currency. Right now there is no serious competition entering the global currency environment to step up and challenge the dollar's standing. In the cases of Weimar and Zimbabwe today, the opposite was true, where more important substitute currencies (i.e. the pound, dollar) were already liquid and available. Granted this could change, and China and Russia are certainly both receptive to the idea of a supranational currency, but don't expect that idea to come to fruition any time soon as the idea would be years in the making.

The massive issuance of treasuries, huge projected deficits and QE promises have raised eyebrows from the global community. As stated earlier, the message sent has just been a warning. Surely Geithner knows this as he was laughed at in China jawboning a strong dollar.

All eyes are now fixed on Washington for a response. If their response is to continue on the path as they are now, then rates will skyrocket higher, the dollar will fall more and the economy will suffer an inflationary depression, but not necessarily hyper-inflation. For hyper-inflation to occur, the major holders of dollars (China, Japan, etc.) would have to simultaneously dump their holdings, tanking the value of the dollar, like in Weimar and Zimbabwe. The result in a massive global depression as all trade is tied to the dollar.

China, the largest US creditor, has shown no signs of that yet. Treasuries, Dollar 'Only Game In Town' As China Buys:

The Federal Reserve’s holdings ofTreasuries on behalf of central banks and institutions from China to Norway rose by $68.8 billion, or 3.3 percent, in May, the third most on record, data compiled by Bloomberg show. The Treasury said bidding from foreigners was above average at its $101 billion of note auctions last week.

China will continue to be a buyer of treasuries until they commit to changing their currency peg to the dollar. A reversal of this sort will not occur overnight, but eventually must happen. This buys the US some time.

The likely result I forecast is higher taxes, slower growth (when it returns) and a long muddle through and transformation of the financial world as we know it. How it turns out is anyone's guess.

Finally, for everyone clamoring about the Fed's balance sheet, please see IMF White Paper On The Fed's Skyrocketing Balance Sheet. There's no conclusion as to the deflation/inflation debate so it's open to interpretation. The data collected there is certainly eye opening, especially the data from the Great Depression, which showed the Fed's balance sheet did in fact explode back then as well. What is so important to note is the asset backdrop. While the recent Fed balance sheet explosion is "unprecedented", put it on a relative basis to derivatives:

We discussed “Eight Bubbles” in play worldwide in November 2008 and their approximate scale, based on latest information in 2009, is as follows:
1. Subprime Mortgage linked Loans & Assets (USD 1.5 trillion) within Mortgage backed Assets (USD 5 trillion);
2. China, India, Eastern Europe and other Emerging Market Loans (USD 5 trillion);
3. Commodities (Commodity Derivatives at about USD 13 trillion);
4. Corporate bonds (USD 18 trillion);
5. Commercial (USD 22 trillion) and Residential property (USD 45 trillion);
6. Credit Cards Outstanding Debt (USD 4.5 trillion);
7. Currencies (Foreign Exchange Derivatives at about USD 62 trillion); and
8. Credit Default Swaps (USD 57 trillion) as a subset of all Derivatives (USD 1,405 Trillion).
The relative scale of the world's financial engine is as follows:
1. The entire GDP of the US is about USD 14 trillion and falling.
2. The entire US money supply is also about USD 14 trillion with rising Quantitative Easing in trillions.
3. The GDP of the entire world is USD 45 trillion and falling. USD 1,405 trillion is 31 times world GDP.
4. The real estate of the entire world is valued at about USD 65 trillion.
5. The world stock and bond markets are valued at about USD 70 trillion.
6. The trans-national universal model financial institutions own about USD 150 trillion in derivatives.
7. The population of the whole planet is 6.8 billion people. So the derivatives market represents about USD 206,000 per person on the planet.

Much of these assets are accounted for off balance sheet or with accounting gimmickry. These figures come directly from the Bank of International Settlements. Still fear inflation as the problem?

It now seems the race is on between faith and credit, meaning will faith be lost before credit?

Relative Value

mscullen1@gmail.com (MWS) — Sat, 30 May 2009 14:22:00 PDT

A quick review of some traditional markets will give us some insight into where the value is hiding.

Stocks

A quick trip to S&P's website will allow you to take a historical look into some price/value relationships of the index.

based from the close of 5/29 of 903.47:

P/E EPS Yield Less Div Yield

EPS TTM 130.75 0.76% -1.62%
EPS 3 yr 18.02 5.55% 3.16%
EPS 5 yr 15.94 6.27% 3.89%
EPS 10 yr 18.56 5.39% 3.00%

P/B = 2 (end Q1)

The dividend yield is currently 2.39%, which means on the ttm basis, the S&P 500 payout is actually over 100%, a clearly unsustainable path. Even the more favorable 5 yr smoothed average is still slightly overvalued.

FINVIZ Screen

I ran a screen out of a possible universe of 6,731 stocks. The criteria were as follows:

Dividend Yield over 2%
P/E under 15
P/B under 2
Current Ratio over 1
Debt to Equity under 1
Sales Growth 5 yrs >0
EPS Growth 5 yrs >0
Return on Equity >10%

The criteria weren't overly conservative but conservative nonetheless. The screen resulted in 97 matches. This is just 1.4% of a large universe, suggesting widespread attractive common stock investments are lacking despite the monumental 40% lower values from the peak in 2007.

Daily Bond Yields and Key Indicators

Data as of 28-MAY-09

Moody's Daily Long-term Corporate Bond Yield Averages

	Utilities	Industrial	Corporate
Aaa	NA	5.75	5.75
Aa	6.41	6.44	6.43
A	6.60	6.94	6.77
Baa	7.83	8.27	8.05
Avg	6.95	6.85	6.90

Moody's Daily Treasury Yield Averages

Short-Term (3-5 yrs)	1.18
Medium-Term (5-10 yrs)	2.78
Long-Term (10+ yrs)	4.31

So called "Aaa" corporates have a fair yield of 5.75% and the highest yielding treasuries are at 4.31%.

The Question Posed

Stocks on a 10 yr smoothed basis offer a "deficit of safety" next to Aaa corporates and long treasuries that looks like this:

S&P EPS Yield 6% deficit of safety to Aaa corporate bonds
S&P EPS Yield 20% margin of safety over long dated treasuries

However, this doesn't take into account dividends. When factoring yields and margin of safety only reinvestible earnings should be considered since that is what determines future earning power. On the adjusted basis

S&P EPS Yield 91% deficit of safety to Aaa corporate bonds
S&P EPS Yield 43% deficit of safety over long dated treasuries

Either case Aaa bonds are clear winners. A word of caution! Rating agencies are an utter failure in model. It is advised that before rushing to buy bonds to study long term earnings records of the companies and to look for adequate earnings to interest coverage (maybe 3x's + at least), conservative capitalization structures, and little indication of "funny" accounting or nonrecurring items. Treasuries still have some attraction vs. stocks, especially if fear returns to markets.

The debate now is whether growth returns. This debate I'l leave to individual investors but my own opinion is there will be little in the department of revenue drivers in the economy for the foreseeable future.

Deflation & Government Bonds

mscullen1@gmail.com (MWS) — Sun, 24 May 2009 20:13:00 PDT

The central concept of this post assumes that the US is and will remain in a deflationary trend for sine time to come, regardless of outspoken calls of hyper-inflation or severe inflation from many. If deflation ends sooner than expected, than the consequences of the investment thesis described here will end in losses.

During times of deflation there are few investments that prove suitable for long-term investment, but among them are government bonds. The two examples illustrated here are the US during the 1920's through 40's and Japan from the late 80's until the present.

If you were a buy and hold investor in the 1930's and your investment happened to be long dated government bonds, you made money:

The spike in yield in 1932 corresponded to the bottom in the stock market, but US government bonds still proved an excellent investment for many years to come. The DJIA on the other hand, tested the emotions of investors with opportunities and tragedies throughout the same time frame.

The yield curve grew steep from 1930 to 1932, signaling the end of the plunge in markets.

What's most interesting is that the action in the yield curve was dominated by changes in the long end of the curve. In other words, the shortest end of the curve never recovered to normalcy, confirming a new bull market had not yet been sparked, but only short cyclical bull markets within a bear.

Notice the shorter term treasuries didn't recover significantly until the late 40's at the onset of a new secular bull market in stocks and bear market in treasuries. What is even more significant is just how long rates remained very low, a deflationary trend.

US Government bonds remained bullish for a long time despite persistent and large deficits and stimulus programs.

Just as now, US public debt was growing at a rapid pace at the same time.

Before presenting how this compares to today, let's consider Japan's deflation as well.

Richard Koo Presentation Richard Koo Presentation pkedrosky Nomura economist Richard Koo talking about balance sheet recessions.

Publish at Scribd or explore others: Fiction art poetry

Fast forward to slide 15 within that document. Japan spent up huge deficits for nearly 20 years and grew its debt to GDP to now almost 200%, yet an investor in 10 yr JGB would have profited nicely.

Recently, Japan's credit ratings were downgraded, but there was no panic sell off as yields on the 10 year were recently quoted at 1.43% and the yield curve remains normal.

Let's fast forward to today. The situation is not exactly the same for the US, but many similarities co-exist. Recently there has been a large sell off in the long bond as equity markets rallied. Also, similar with the other two examples, the yield curve steepened throughout the equity market sell-offs. In this case, the yield curve has remained steep throughout, a bizarre phenomenon that may be sending a false signal.

The main difference between America post 1929 and Japan post 1990 is the public debt starting point and deficit spending starting point. Referring back to Steve Keen's chart above, you can see the US has a much higher starting point now than in the two preceding cases. Also, the US has large amounts of unfunded liabilities and has been deficit spending for some time. The deficits are expected to grow for 10 years +.

The fear is the US is next in line to lose its triple A rating, and soon. All in all, its a non-event that will trigger a knee jerk reaction in probability.

The question is, will the deflationary trend remain intact sparking investors to seek safety in return and capital of US treasuries? The evidence presented above is compelling and suggests the answer is yes regardless of an equity market bottom. Fundamentals of the economy and the equity markets remain impaired and show no signs of improving, just declining at a slower pace.

On a final note, please read Bob Hoye's recent article Great Depressions Are So Methodical. Bob is a market historian of sorts and has interesting parallels of 1929 to 2008. It sort of hints at another year and a half of severe contraction in the economy and equity markets.

Sitting On The Fences

mscullen1@gmail.com (MWS) — Tue, 19 May 2009 07:13:00 PDT

Since the panic melt down of the market in March, investors have seen quite an impressive melt up of the markets since then. This begs the question, Where does the market and where do investors stand?

What Has Changed?

When asking the above question, the most important things to look at in this recession are credit conditions.

The TED Spread has improved dramatically since its severe spike in 08'.

The Yield Curve is Steep and yields on the long end have been steadily climbing as have TIPS, which are now at 2.125% on the 10-year (geez, if investors really feared inflation, wouldn't TIPS be higher?).

Mortgage Rates are steadily dropping, but have ticked up slightly in the past month:
(from Bloomberg)

	CURRENT	1 MONTHPRIOR	3 MONTHPRIOR	6 MONTHPRIOR	1 YEARPRIOR
30-Year Fixed	4.97	4.88	5.27	6.07	5.76
15-Year Fixed	4.63	4.61	4.92	5.73	5.36
5/1-Year ARM	4.54	4.78	5.58	5.9	5.23
1-Year ARM	4.61	4.74	5.36	5.63	5.9
30-Year Fixed Jumbo	6.31	6.35	7.06	7.42	7.12
15-Year Fixed Jumbo	5.92	5.75	6.18	6.68	6.47
5/1-Year ARM Jumbo	5.11	5.19	6.1	6.08	6.04

Corporate bond yields have also improved from their highs in March.

Unfortunately, my access to CDS data is limited, but here is a chart from Bespoke Investment Group:

Spreads have come down from their panic highs, but are still elevated even above the early 08' levels, and CDS speads have been deadly accurate in predictive ability.

The stock market rally has been world-wide, with the Dow Jones World Stock Index having rallied nearly 40% from its lows.

What all of this data is telling us is risk appetite is returning and along with it an appearance of recovery. Is all of this sustainable? Have we embarked on permanent recovery?

A Brief Review Of The Fundamentals:

Stocks - S&P 500 level

With 95% of companies having reported 1st quarter numbers, the results aren't pretty despite "better than expected" earnings releases. Sales are down 13% YoY, with 123 beating last year and 340 falling short. Silly how so few pay little attention to those oh so important top line numbers. The spread between operating earnings and reported is enormous, despite FASB 157 adjustments. Operating earnings are down 64% YoY. S&P estimates Sep 09' as reported 12 mos. EPS will be negative for the first time ever! Let's recap my P/E overview at 919:

2009 forward annual P/E = 32.23
TTM P/E = 61.79
3 yr trailing P/E = 25.16
5 yr trailing P/E = 17.60
10 yr trailing P/E = 19.53

Got value? Now consider if we knock the price down to 500:

2009 forward annual P/E = 17.54
TTM P/E = 33.60
3 yr trailing P/E = 13.69
5 yr trailing P/E = 9.58
10 yr trailing P/E = 10.63

Not pretty.

Unemployment

8.9% at the fudged U-3 level, but 15.8% on the realistic U-6 level, with no sign of easing, especially considering dealership closings will flood the unemployment gates.

Commerical and Residential Real Estate

The Fed released charge-off and delinquency rates today.

Delinquency rates were 7.13% for all residential and commercial loans, get this, an increase of 101% year over year.

Residential stand at 7.91%, Commerical at 6.4%, credit cards at 6.5%. The total delinquency rate reached its peak of 7.47% in 1991 for comparison.

Charge-Off rates decreased from Q4 08' from 1.74% to 1.57% for residential and commercial loans. Ironcially, the decrease was in the commercial arena, in which fundamentals are deteriorating rapidly. Residential charge-offs are still increasing and credit card charge-offs are rapidly increasing, 63% year over year.

Housing

Starts came in today at lower than expected numbers. This is good news, since last I checked there were still huge inventories (not counting shadow inventories and condos) still around 10 or 11 months supply, with 5 being considered normal. US Housing Starts At Record Low:

Compared with the same month last year, housing starts were down 54.2% and permits down 50.2%.
Analysts were surprised by the weak numbers.
"It's just as I said a month ago - I can't imagine that housing starts and permits can get much weaker than they are. And you wait a month and they get weaker," said Hugh Johnson, chief investment officer at Johnson Illington Advisors.

They will continue to be weak for some time, until inventory is worked off, with a few false jumps here and there. Any increase in starts and permits must be viewed as negative.

Government

The rally in not only stocks, but credit instruments, commodities and other asset classes like REIT's and precious metals is truly awe inspiring. Why do I say this in connection to government? Because the Fed has had a big hand in it (I suppose) and the Obama team is planning anti-capitalism measures.

Taxes - Tax Increases Could Kill The Recovery

The Obama budget calls for tax increases of more than $1.1 trillion over the next decade. Official budget calculations disguise the resulting fiscal drag by treating Mr. Obama's proposal to cancel the 2011 income tax increases for taxpayers with incomes below $250,000 as if they are real tax cuts. The plan to modify the Alternative Minimum Tax to avoid increases for some taxpayers is also treated as a tax cut.

But those are false tax cuts in which no one's tax bill actually declines. In contrast, the proposed tax increases are very real. And despite the proposed tax increases, the government's new spending and transfer programs would cause the annual budget deficit in 2019 to exceed $1 trillion, or 5.7% of GDP.

Mr. Obama's biggest proposed tax increase is the cap-and-trade system of requiring businesses to buy carbon dioxide emission permits. The nonpartisan Congressional Budget Office (CBO) estimates that the proposed permit auctions would raise about $80 billion a year and that these extra taxes would be passed along in higher prices to consumers. Anyone who drives a car, uses public transportation, consumes electricity or buys any product that involves creating CO2 in its production would face higher prices.

CBO Director Douglas Elmendorf testified before the Senate Finance Committee on May 7 that the cap-and-trade price increases resulting from a 15% cut in CO2 emissions would cost the average household roughly $1,600 a year, ranging from $700 in the lowest-income quintile to $2,200 in the highest-income quintile. Since the amount of cap-and-trade tax rises with income, the cap-and-trade tax has the same kind of adverse work incentives as the income tax. And since the purpose of the cap-and-trade plan is to discourage the consumption of CO2-intensive products, energy or means of transportation by raising their cost to consumers, the consumer-price increases would be the same for a 15% reduction in C02 even if the government decides to give away some of the CO2 emissions permits.

But while the cap-and-trade tax rises with income, the relative burden is greatest for low-income households. According to the CBO, households in the lowest-income quintile spend more than 20% of their income on energy intensive items (primarily fuels and electricity), while those in the highest-income quintile spend less than 5% on those products.

The CBO warns that the estimate of an $80 billion-a-year tax increase could be significantly higher or lower, depending on how the program is designed. The Waxman-Markey bill currently before Congress calls for reducing greenhouse gasses 20% by 2020 and by an incredible 83% by 2050. As the government reduces the amount of CO2 that is allowed, the price of the CO2 permits would rise and the pass-through to consumer prices would also increase.

The next-largest tax increase -- with a projected rise in revenue of more than $300 billion between 2011 and 2019 -- comes from increasing the tax rates on the very small number of taxpayers with incomes over $250,000. Because this revenue estimate doesn't take into account the extent to which the higher marginal tax rates would cause those taxpayers to reduce their taxable incomes -- by changing the way they are compensated, increasing deductible expenditures, or simply earning less -- it overstates the resulting increase in revenue.

Since the projected revenue from this source is already designated to be used for Mr. Obama's health plan, some other tax increases will be needed. Moreover, Mr. Obama's budget characterizes the projected $634 billion outlay for health-care reform as just a down payment on the program. The budget notes that there would be "additional resources and new benefits to be determined with Congress." Those additional resources would no doubt be even higher taxes.

The third major tax increase is the plan to raise $220 billion over the next nine years by changing the taxation of foreign-source income. While some extra revenue could no doubt come from ending the tax avoidance gimmicks that use dummy corporations in the Caribbean, most of the projected revenue comes from disallowing corporations to pay lower tax rates on their earnings in countries like Germany, Britain and Ireland. The purpose of the tax change is not just to raise revenue but also to shift overseas production by American firms back to the U.S. by reducing the tax advantage of earning profits abroad.

Not mentioned here are the possibilities of capital gain and dividend tax increases, silly soda pop taxes and any other ideas that might be floating out there.

The other most obvious government blunders are going on in the financial sectors now, where rules change daily and lies, deciept and fraud are the name of the game. Most striking here is the moral hazard created and forced industry consolidation, neither of which is good for taxpeyers of the sector in general. Taxpayers can't even count how many dollars they've committed to such fraud because Fed auditors don't know.

Health care costs are set to skyrocket. Don't believe me? America Requires A Dose Of Health Care Reality:

Last week, after meeting groups representing hospitals and insurance companies, Barack Obama announced a breakthrough on reforming US healthcare. It was “a historic day”, he said. The providers had made “an unprecedented commitment” to curb the system’s costs, running at 16 per cent of gross domestic product. They had agreed, he said, to reduce growth in healthcare spending by 1.5 percentage points a year, enough to save $2,000bn (€1,480bn, £1,320bn) over the next decade.
...
Cost control can and should be part of the answer, but not the larger part. Too much is expected of a new emphasis on preventing illness, bringing information technology to bear and reforming the way services are delivered. All these should be done – to improve outcomes and value for money. Experience suggests that they will do little to curb spending.
The deepest of these delusions is believing that subsidies to make health insurance near-universal will pay for themselves, through fewer visits by the uninsured to expensive emergency rooms rather than relatively cheap primary-care doctors and nurses. There will be some savings of that kind, but wider insurance will raise the consumption of health services. That is the idea, after all. No health-policy scholar I am aware of believes this change will come close to paying for itself.
Near-universal healthcare will require higher taxes. The administration said so in its budget, setting aside a “downpayment” of $600bn over 10 years. Most analysts think that comprehensive reform will cost $1,500bn or more. Even without healthcare reform, Mr Obama’s long-term budget does not balance. So count on it: US taxes are going up.

I recommend reading the rest of the article. What is obvious, Obama's administration is set out to do the same capital killing central planning that Hoover and FDR carried out in the depression era, but even grander!

Monetary Stimulus

There have been huge sums of money forced down the throats of banks to keep their pulse at the minimum to be technically among the living. There's a possibility some of this liquidity is finding its way into the capital markets in search that phat yield. Just a theory, and I'm not the first to postulate that. Frank Shostak, a respected Mises scholar, has recently written on the topic, Obama's Stock Market Mini-Bubble:

According to the historical data, the yearly rate of growth of liquidity bottomed at negative 16.6% in May 1929. Yet it took a long time before the S&P 500 responded to this. It took over three years after the bottom in liquidity was reached before the S&P started to recover. The stock-price index bottomed in June 1932 at 4.43.

The time lag between the bottom in liquidity and the bottom in the stock market has been shorter in more recent history. Thus the yearly rate of growth of liquidity had bottomed at negative 5.7% in September 2000. It took twenty-five months before the S&P 500 bottomed at 815.28 by September 2002.

The current bear market that started in October 2007 was preceded by a peak in the liquidity rate of growth in June 2003 — a time lag of over four years. The yearly rate of growth of liquidity stood at 7% in June 2003. The S&P 500 climbed to 1,549.38 by the end of October 2007.

Observe that at the end of February 2009, the S&P 500 closed at 735.1 — a fall of 52.6% from the peak in October 2007. The yearly rate of growth of monetary liquidity hit bottom in January 2008 at negative 6.1%. By the end of April, the yearly rate of growth of liquidity stood at positive figure of 24.9%.

Please go and read the entire piece, there is much more to learn and consider. I will leave you with a part of his conclusion that speaks volumes:

We suggest that, at present, if the pool of real savings is still in trouble, then we are unlikely to have a sustained economic revival. If anything, all the rescue packages and all the massive pumping by the Fed has made things much worse as far as the underlying economic bottom line is concerned.

This in turn means that, despite lofty liquidity, bad economic fundamentals might force investors to direct their money towards other assets, such as Treasuries — and gold. If our assessment regarding economic fundamentals is correct, then the underlying downtrend in long-term Treasuries is likely to stay in force while the price of gold is likely to easily surpass the $1,000 mark.

I share those views as well. Mr. Shostak is keen to note the pool of real savings must increase still. Viewing it graphically can help:

There are years of savings to make up for. If Mr. Shostak's views are correct, then this rally will have limits, and eventually risk appetite will dwindle, instead flowing into "safe" treasuries and gold.

I outlined my own argument for deflation in Debt, Wealth & Keynesianim, however I left out a big piece of the puzzle, derivatives:

The amount of outstanding contracts linked to bonds, currencies, commodities, stocks and interest rates fell 13.4 percent to $592 trillion, the Basel, Switzerland-based bank said yesterday. That’s the first decline in 10 years of compiling the data. The amount of credit-default swaps protecting investors against losses on bonds and loans fell 27 percent to cover a notional $41.9 trillion of debt.
$592 trillion is a staggering figure. To believe only a 13.4% drop in notional value when other assets, including housing have all fallen more in percentage terms will resolve the derivatives issue is a bit optimistic.

In Summary, to answer my initial question - "Where does the market and where do investors stand?" - the jury is still out on how much longer the rally will last, but there is very little reason to believe this rally is anything other than a liquidity/risk driven bear market rally. But with such terrible fundamentals, how can it be sustained? The credit improvements are encouraging, but one has to wonder with so many headwinds how market driven many of the credit readings are.

Important Sentiment Update

mscullen1@gmail.com (MWS) — Fri, 08 May 2009 09:47:00 PDT

This is an Insider Score update, interesting results. Is this rally sustainable or the long haul?

MIT CRE: Moody's Real CPPI Update

mscullen1@gmail.com (MWS) — Thu, 07 May 2009 20:35:00 PDT

It's been awhile since I've updated the MIT CRE: Moody's Real CPPI and with CRE finally catching on in the mainstream let's take a look:

The RCA Database

The commercial property index is based on the RCA database which attempts to collect, on a timely basis, price information for every commercial property transaction in the U.S. over $2,500,000 in value. This represents one of the most extensive and intensively documented national databases of commercial property prices ever developed in the U.S.

Latest Results

April 24, 2009 update: The latest results of the Moodys/REAL CPPI show a return of negative 0.6% in February for the all properties national index.

The results are not pretty through April. Much like residential real estate, supply and demand is all out of whack, creating an inventory overhang that drags prices down further. These data are not representative of the entire CRE market. Strip malls are most likely not included here due to the sheer $ size of properties researched being so large. Also, just wait until the GGP fallout is updated.

Fundamentals Still Negative; Markets - Reaching The Boiling Point

mscullen1@gmail.com (MWS) — Thu, 07 May 2009 12:08:00 PDT

Fundamentals, though slowing in the pace of deterioration, are not improving.

Consumer Credit Falls At Fastest Pace In 18 Years:

WASHINGTON (AP) -- Consumer borrowing plunged in March at the fastest pace in 18 years as Americans put away their credit cards and hoarded cash amid the worst recession in decades.

The Federal Reserve said Thursday that consumer borrowing dropped 5.2 percent in March, the biggest decline since an 8.1 percent fall in December 1990.

In dollar terms, consumer borrowing plunged by $11.1 billion. That's the largest dollar amount on records dating to 1943, and more than three times the $3.5 billion drop that economists expected.

The borrowing category that includes credit cards dropped 6.8 percent in March after a 12.1 percent plunge in February. The category that includes auto loans fell 4.2 percent after rising by 1.2 percent in February.

My sentiment is the pace of consumer credit contraction will continue to stay strong into 2009. Not included above is consumer mortgages, a much larger share of consumer debt.

US Banks Race To Fill $74.6 billion Stress Test Hole:

WASHINGTON (Reuters) - U.S. regulators told top banks on Thursday to raise $74.6 billion to build a capital cushion officials hope will restore faith in financial firms and set a course out of the deepest recession in decades.

...

The relatively modest size of the hole discovered by regulators carrying out the tests, which were based on an "adverse" economic scenario, led to both applause from investors who believe the worst is over and skepticism among those who think the examination wasn't rigorous enough.

Modest??!!!! Fed Sees Up To $599 billion in Bank Losses:

The federal government projected that 19 of the nation's biggest banks could suffer losses of up to $599 billion through the end of next year if the economy does worse than expected and ordered 10 of them to raise a combined $74.6 billion in capital to cushion themselves.

Incredible! Worst case scenario $599 billion more losses...better raise 12.5% of that to cover those losses [wtf?] Does this include off-balance sheet items that FASB is set to bring on to balance sheets near year end? That worst case scenario projects 10.3% unemployment by the end of 2010. Granted, weekly jobless claims have slowed pace slightly, but are still over 600,000. The April unemployment report will be released tomorrow and 8.9% is expected. Is there worst case scenario really worst case?

Commercial real estate will tip the scale further than "worst case" can measure. Consider Rising Special Servicing in CMBS:

The pillaging in Commercial Real Estate has hit a new high. Real Point is reporting that CMBS loans are accelerating their special servicing deterioration yet again. The total amount of CMBS in special servicing has hit $24 billion, after a staggering $3.8 billion increase in April.
April marked the third straight month in which more than $2 billion of loans were transferred to special servicers, in a sign of continued market weakness. Loans get shifted when they become delinquent or are at great risk of becoming delinquent. With lending markets remaining muted, an increasing number of loans are being shifted because they're unable to refinance before they mature.

The number of loans in special servicing has also breached a milestone, hitting 2,062 loans last month, up 237 loans from the previous month.
Not surprisingly, the bulk of weakness continues to be in the 2005-2007 vintage (the very vintage that, to CMSA's chagrin, was excluded from the most recent amendment of TALF - but fear not Bernanke has got a few more aces up his sleeve).

Most frighteningly, the special servicer total excludes the impact from bankrupt GGP, which as Zero Hedge previously noted, put 164 properties in bankruptcy, and according to BofA, $14.8 billion of CMBS loans are backed by GGP properties. Assuming at least half of these loans become "special serviced" the CRE landscape is about to get a much more bloody shade of burgundy.

I encourage all to read the rest of the article. This supports Commercial Mortgage Delinquencies Rising to 11-Year highs:

The percentage of loans 30 days or more behind in payments rose to 2.45 percent, Trepp LLC said in a report. The delinquency rate was more than five times the year-ago number, Trepp said. The New York-based researcher’s records go back to 1998.
...
Commercial property values fell 21.5 percent through February from their October 2007 peak, according to Moody’s Investors Service.

Properties bought in 2006 are now worth on average 11 percent less than their original price, and those bought in 2007 are worth almost 20 percent less, Moody’s said.
...
Mortgages on rental apartment buildings posted the highest delinquency rate of securitized commercial property loans in April, rising to 5.24 percent from 3.86 percent in March, Trepp said.

And what of the market? In the face of green shoots, the market has gone from over-valued to even more over-valued. Consider these P/E scenarios using yesterday's close of 919:

2009 forward annual P/E = 32.23
TTM P/E = 61.79
3 yr trailing P/E = 25.16
5 yr trailing P/E = 17.60
10 yr trailing P/E = 19.53

Got value? Now consider if we knock the price down to 500:

2009 forward annual P/E = 17.54
TTM P/E = 33.60
3 yr trailing P/E = 13.69
5 yr trailing P/E = 9.58
10 yr trailing P/E = 10.63

At 500, assuming those 2009 earnings esimates are reliable [sic], there would be considerable value in the market.

However, as a long term investor you're left wanting; you want yield. As of 4/30/09 the S&P had an indicated yield of 2.49%. There's more value to be had in treasuries with 10 yr yields now back at 3.3%, do I smell the possible fear trade returning soon? Interesting, the $TNX has made a near perfect 61.8% retracement from its October 08' highs and a 50% retracement of the June 08' highs.

Back to the S&P500.

Long term bearish trend lines are still in tact, so a new bull market has not been triggered considering that. Also, we're at a Fibonacci confluence zone. What that means is from the view point of larger retracements, we're reaching a 38.2% retracement from the May 08' highs and a 38.2% retracement of the 2007 September highs. Ironically, the first retracement is also where the 200 day moving average rests. In Elliott terms, I'm still charting one more primary wave 5 down left.

Volume on this last leg up has been impressive, but has it formed a new trend?

Average daily volume on the last leg up has only been 10.8% higher than the last leg down. Impressive, but not significant enough to suggest the new trend is up. If my expectations are correct, then the next leg down will experience significantly less average daily volume, maybe 50% less. Final leg downs, even leg downs that make new lows, nearly always end on lower volume.

No matter which way you look at it, technical, fundamental or relative, this rally just doesn't add up to anything more than a head fake. Unfortunately, there are years of excesses to be removed from the system in terms of both valuations and debt.

Indicators Suggest Rally Is Michael Keaton

mscullen1@gmail.com (MWS) — Wed, 29 Apr 2009 17:30:00 PDT

In Turning Points I outlined my case for the latter part of a leading diagonal forming. Outlined below is the positive correlation between chest hair and performance, but first see immediately below for the previous count:

I predicted a continuation of the diagonal formation until 880. Well well well the S&P 500 peaked today at 882.06:

Many indicators are simultaneously sounding alarms and you're just sitting there in your 4 year old robe with cheap vodka and Virgina Slims instead of catching your neighbor off guard with "the goat" (4 kicks) and going short this overblown rally. Indeed, my chest hair is thick and burly!

Also of note is the length of time the index has been advancing above its 50 day moving average. The fundamentals, always more important longer term are not supporting these green shoots and daily investors get pummeled with and ignore terrible news every day. This cannot go on forever and what I mean by this is Graham's famous saying; "In the short term the market is a voting machine and in the long term a weighing machine". (paraphrased)

Most likely, the market will rip higher by 100 points tomorrow just to smite thee. Oh I'll be waiting though, with 9 iron in hand and the smack your coked up broker forgot to bump earlier today via SDS (Russell Crowe like warriors will gladly consider FAZ as a more manly option, with three times the chest hair, utter conceit and unbareable body odor of your average coked up broker).

My final say is this market rally is Michael Keaton...and for those who know and don't know there you go!

The Four Horseman Of Austrian Economics

mscullen1@gmail.com (MWS) — Tue, 28 Apr 2009 18:07:00 PDT

For this post, relax. Kick back in your favorite easy chair with a fine glass of wine, exotic cheeses and these four enlightening podcasts, courtesy of The Lew Rockwell Show:

Mish Shedlock: It's Fallen & It Can't get Up

Gerald Celente: The Fed Has Wounded You

Ron Paul: Secession, The Fed & Tomorrow

Peter Schiff On Our Economic Future

Debt, Wealth & Keynesianism

mscullen1@gmail.com (MWS) — Sat, 25 Apr 2009 08:25:00 PDT

Fun with data - Quarter 4 Flow of Funds Report -

As far back as this report goes, private sector credit outstanding has been growing. Clearly, nothing can grow forever.

Quarter 4 of 2008 has shown quite a different picture. Consumer credit as a whole has contracted, a first time occurrence as far as this report shows in this 31 year history. The corporate sector has still managed to increase their debt outstanding, albeit at a slower pace, but corporate debt default rates are at record levels right now. Foreign credit has been contracting even more severely, but as a whole foreign credit is much smaller in scale. The government and their keynesian clown economists have blown their credit growth sky high in attempts to revitalize the economy.

It's important to put this in relative terms, please review the following:

Significant credit was created via our government and financial institutions in 2008. Nowadays, there's hardly a distinction since large parts of these government borrowings immediately flowed into the accounts of financial institutions to "spur lending". Of course we all know the money is just being used to cover losses and maintain solvency ratios. Technically insolvent and failed banks are transformed into zombie banks as a result. What is especially striking about financial institutions raising more debt is that as more and more of their assets need to be written down, they are then required to raise more capital as a result of adding to their liabilities. It's a never ending cycle until the LIABILITIES are addressed, namely long and short term debt.

There is more to this story on the consumer side:

The change in wealth in 2008 has been enormous, especially in Q4. For the entire year household net worth declined by $11.2 trillion! In all of 2008 the federal government increased its debt outstanding by $1.24 trillion. This does not include Federal Reserve programs.

Where am I going with this?

Consumers are paying down or defaulting on their debt and at the same time losing enormous amounts of wealth (in many cases their jobs too). The government is borrowing more in an attempt to keep financial institutions solvent so they can lend more to consumers and businesses. What consumer or business is going to borrow in this environment? Essentially this is just a transfer of wealth from the taxpayers to financial institutions and is incredibly ineffective, immoral, unconstitutional and socialist.

The Promise of 2009

With all of the talk of green shoots most analysts sure are ignoring reality. In my opinion the credit contraction that really just began in the 4th quarter of 2008 will spread in 2009. Let's refer back to my previous post Turning Points:

Stress-Tested Banks May Struggle As Bad Assets Triple:

The tests on the 19 largest banks are likely to focus in part on loan quality as a measure of health. The lenders, which may need to raise $1 trillion in capital to cushion losses according to an April 23 KBW Inc. report, may have a hard time persuading investors to give them cash.
...
New York-based JPMorgan’s nonperforming assets grew 185 percent in the past year to $14.7 billion, or 0.7 percent of the firm’s total. Bank of America Corp., based in Charlotte, North Carolina, said bad assets increased 229 percent to $25.7 billion. Problem assets at New York-based Citigroup Inc. rose 128 percent to $27.4 billion, and San Francisco-based Wells Fargo & Co.’s jumped 180 percent to $12.6 billion.

Junk Bond Defaults To Reach Record By March, S&P Says:

Junk-rated companies have about $177.5 billion of debt maturing in 2009 and $179 billion coming due in 2010, including bonds and bank loans, S&P said. So-called junk bonds are rated below Baa3 by Moody’s Investors Service and lower than BBB- by Standard & Poor’s.

Sixty-one companies have defaulted this year as of April 17, three times as many as during the same period a year ago, and affecting $200 billion of debt, S&P said.

The record rate of defaults for high-yield, high-risk, or speculative-grade bonds is 12.5 percent in June 1991, S&P said.

IMF Puts Global Bank Losses From Financial Crisis At $4.1 Trillion:

the I.M.F. estimated that banks and other financial institutions faced aggregate losses of $4.05 trillion in the value of their holdings as a result of the crisis.

Fannie & Freddie Delinquencies Soar (and they are going to get much worse)

All loans 60+ days delinquent increased from 834,831 as of November 30 to 1,229,051 as of January 31, representing an increase of 47 percent over the period. However, prime loans 60+ days delinquent increased by 69.6 percent while nonprime loans increased by 23 percent.

Fed's Losses Dominated By Commercial Real Estate:

The Fed wrote down the value of former Bear Stearns commercial-mortgage holdings by 28 percent to $5.6 billion and residential loans by 38 percent to $937 million as of Dec. 31, the central bank said today. Properties in California and Florida accounted for 45 percent of outstanding principal of the residential mortgages.

Reality is grim indeed. Coming soon are increasing mortgage defaults, commercial real estate loan defaults, credit card loan defaults, corporate debt defaults and not even mentioned here are public pension fiascos soon on their way. Yeah, but aren't the banks profitable now? Please see Bank Profits Are Accounting Shenanigans to see why recent bank profits are misleading.

Can We Count On The Consumer To Borrow Again?

Real unemployment is at 15.6% and rising. Anyone looking for green shoots is simply out of their mind?

What About The Fed?

The Fed, just as the federal government is aiming its arrows in the direction of financial institutions. However, with the consumer in retrench, this will not create inflation since on net, consumer borrowing is contracting and unemployment rising. Again, this is a transfer of wealth from taxpayers to financial institutions.

The Fed is limited in its power. It has already grown its balance sheet to nearly $2 trillion, but just look at these ratios. Credit outstanding is simply many times the current size of the Fed's balance sheet. (note: the above monetary base is in billions of dollars). As a result, their "printing" has been limited in its effectiveness. Why? Because of the simple fact that the Fed is filling holes on the asset side of the balance sheet while encouraging the liability side of financial institutions balance sheets to rise. The path is circular and the only way to stop it is for all parties to grow up and start restructuring. What is not shown here is the even more extraordinary level of derivatives and securitizations outstanding, dwarfing every other $ measure seen here.

Finally, two important points to consider. First, the velocity of money is in free fall:

The likelihood of inflation in the face of velocity cliff diving is low. Indeed deflation is the more likely result. The Fed can make money available to financial institutions, but they are simply going to hoard it for future losses and the pool of qualified borrowers has shrank considerably.

Next, where is most of this federal borrowing and Federal Reserve alphabet soup lending going?

Financial institutions are hoarding the money, that's where all of this money has gone.

In summary, demand for money is extremely high right now; we know this because velocity has fallen sharply and net consumer lending is contracting, personal savings are increasing and all of the Keynesian and monetarist clowns are ignoring what is right in front of their face. Imbalances have existed for far far too long and this is the inevitable consequence. The solution cannot be more of the same imbalances.

The future will be determined partly by social mood and political will in addition to the simple balance sheet debt problems outlined above. Slowly, the public is growing outraged over the course our politicians are taking. Therefore, social mood which governs the level of optimism and pessimism of consumers is more negative. With negative social mood I would say it's safe to assume that a great lending and investment boom is far far away. Political will can play a role, but at great risks. There is the risk that Bernanke will devise a scheme in which the "printing" he is doing will in fact reach more than a bank's excess reserves where it will is only be allocated to future losses. I don't know what that scheme looks like but I know the result...inflation or hyperinflation (currency collapse). The future is undecided, but until the evidence changes my vote is still on the side of deflation and that vortex is still ongoing.

The 2009 Q1 Flow of Funds report is due in June; we'll see if my predictions are in fact correct.

Turning Points

mscullen1@gmail.com (MWS) — Thu, 23 Apr 2009 07:43:00 PDT

Above is my latest Elliott Wave update. Turbulence would be a great descrition of recent market activity. Many may be left, scratching their heads at Mr. Market's stubborn persistence in advancing with cunning and quick head fakes along the way. Along the way reports continue to rock the news, mostly bad, but with pom-pom spirited spins (greenshoots anyone?).

The topics of interest are summarized below with links:

Stress-Tested Banks May Struggle As Bad Assets Triple:

The tests on the 19 largest banks are likely to focus in part on loan quality as a measure of health. The lenders, which may need to raise $1 trillion in capital to cushion losses according to an April 23 KBW Inc. report, may have a hard time persuading investors to give them cash.
...
New York-based JPMorgan’s nonperforming assets grew 185 percent in the past year to $14.7 billion, or 0.7 percent of the firm’s total. Bank of America Corp., based in Charlotte, North Carolina, said bad assets increased 229 percent to $25.7 billion. Problem assets at New York-based Citigroup Inc. rose 128 percent to $27.4 billion, and San Francisco-based Wells Fargo & Co.’s jumped 180 percent to $12.6 billion.

Junk Bond Defaults To Reach Record By March, S&P Says:

Junk-rated companies have about $177.5 billion of debt maturing in 2009 and $179 billion coming due in 2010, including bonds and bank loans, S&P said. So-called junk bonds are rated below Baa3 by Moody’s Investors Service and lower than BBB- by Standard & Poor’s.

Sixty-one companies have defaulted this year as of April 17, three times as many as during the same period a year ago, and affecting $200 billion of debt, S&P said.

The record rate of defaults for high-yield, high-risk, or speculative-grade bonds is 12.5 percent in June 1991, S&P said.

IMF Puts Global Bank Losses From Financial Crisis At $4.1 Trillion:

the I.M.F. estimated that banks and other financial institutions faced aggregate losses of $4.05 trillion in the value of their holdings as a result of the crisis.

Fannie & Freddie Delinquencies Soar (and they are going to get much worse)

All loans 60+ days delinquent increased from 834,831 as of November 30 to 1,229,051 as of January 31, representing an increase of 47 percent over the period. However, prime loans 60+ days delinquent increased by 69.6 percent while nonprime loans increased by 23 percent.

Fed's Losses Dominated By Commercial Real Estate:

The Fed wrote down the value of former Bear Stearns commercial-mortgage holdings by 28 percent to $5.6 billion and residential loans by 38 percent to $937 million as of Dec. 31, the central bank said today. Properties in California and Florida accounted for 45 percent of outstanding principal of the residential mortgages.

Amazing, the news continues to dominate towards the negative side. Even more amazing, analysts speak of "green shoots" because a few government statistics decreased slightly in the speed at which they are deteriorating...utter blasphemy. Furthermore, what really matters are losses. In 2008 we saw losses from bad assets falling in value. In 2009 we are seeing a rapid extension of what was only the beginning of credit losses that started in Q4 08'. (I'll soon post on this, with reference to credit outstanding in the flow of funds report).

What will be the effect?

With credit losses spreading and accelerating the economic reality and deflationary vortex is only going to increase in 2009. I trust not the economic predictions of economists who saw no crisis coming in the first place. The result...lower prices.

Getting back to my Elliott Wave analysis:

Forming is a clear diagonal, seemingly a leading diagonal. When formations like these appear and finally exhaust, look for explosive moves at the termination point, in this case to the downside. Me thinks this may finally exhaust near 880, possibly in tandem with the stress test results, good or bad.

The Coming Gold Rush?

mscullen1@gmail.com (MWS) — Sat, 18 Apr 2009 08:22:00 PDT

Recently gold has been in correction mode and may continue for a good deal of 2009 because of supposed "green shoots" sprouting within the economy.

$GOLD 4 year chart:

I have not been charting $GOLD in terms of Elliott Wave myself, but some charts I've seen from others indicate that we're possibly in a primary wave 4 down correction. This actually corresponds to my $SPX analysis, which could promise to be a long drawn out triangle of some sort, or possibly a combination. Technical divergence measures have not yet indicated a change in the current downtrend in $GOLD. Currently, $GOLD/$SPX is at 1, an interesting phenomenon.

More importantly though are the fundamentals in gold via supply and demand for 2008 from The World Gold Council:

Sustained investor interest in gold over the course of 2008 against a backdrop of the worst year on record for global stock markets and many other asset classes, helped push dollar demand for the safe haven asset to $102bn, a 29% increase on year earlier levels. Identifiable gold demand in tonnage terms rose 4% on previous year levels to 3,659 tonnes.

As shares on stock markets around the world lost an estimated $14 trillion in value, identifiable investment demand for gold, which incorporates exchange traded funds (ETFs) and bars and coins, was 64% higher in 2008 than in 2007, equivalent to an additional inflow of $US15bn. Over the year as a whole, the gold price averaged $872, up 25% from $695 in 2007.

Jewelry consumption is the largest driver in total for gold demand. This has decreased significantly in 2008. However, demand for gold increased over the year by 133 tonnes as a result of retail demand, mainly for bars and coins. 2009 Q1 statistics have not been updated as of yet.

What of the supply side?

Here is a note from Barrick Gold Corp's (ABX) most recent annual filing:

We believe the outlook for mine production from all gold mining companies over the next 5 to 10 years, which currently represents over 60% of total global supply, is one of gradual decline. The primary drivers for the global decline are a trend of lower grade production by many producers; increasing delays and impediments in bringing projects – especially large-scale projects – to the production stage; inflationary pressures on capital costs which have subsequently eased, but have been replaced by global financing conditions that constrain the ability of mining companies to finance projects; a lack of global exploration success in recent years; and a dearth of new, promising regions for gold exploration and production. A decrease in global industry production increases the potential for increases in the sustainable long term gold price.

In terms of production, the outlook is of gradual industry decline. In times of increasing demand, this should put long term upward pressure on price. Those claiming IMF meddling in the gold market should look to their balance sheet year over year. Gold holdings at the IMF have changed very little and compared to the overall gold market are small.

What Does This Mean To Investors?

Unless you have a considerably large pool of savings and income, gold can be difficult to store and acquire because of costs. Gold mining stocks have historically been a cost efficient means of having investment in gold.

Is Now The Time To Invest In Gold Mining Stocks?

It may be a bit premature; to see why consider the following charts and then another reference from the ABX annual filing:

Gold miners typically experience higher margins when gold in relation to other commodities is high, as is occurring now. This chart suggests gold mining operations should be highly profitable. However, in 2008 all time high prices and volatility in commodities prices triggered miners to hedge those prices. In 2009 for many miners this will result in hedging losses:

In 2008, we realized benefits in the form of fuel hedge gains on those contracts totaling $33 million (2007: $29 million; 2006: $16 million), when contract prices were compared to market prices. At a price of $42 per barrel, we expect to realize opportunity losses of approximately $100 million in 2009 from our financial contracts.

Miners also have old commodity inventory to work through:

The trend to lower prices for commodities and other consumables seen in the latter half of 2008 is expected to provide some eventual relief from the extraordinary rate of cost escalation the industry has witnessed over the last few years if prices remain at these lower levels. However, these lower prices will not significantly benefit our operating costs in 2009 due to the impact of existing inventory supplies, committed purchase contracts and commodity hedge contracts.

Therefore I conclude gold miners will disappoint expectations due to these setbacks, instead of realizing record profits from high gold prices. This has been the trend since the beginning of the financial crisis and the $HUI (Gold Bugs Index) has been more in line with the S&P instead of diverging. I expect this trend to change towards the end of 2009 as cost benefits start to realize their way into the operations of gold miners and hence their performance should diverge and outperform the S&P.

I reiterate my long standing position, that demand for gold should remain high maintinaing inflation and/or deflation fears since gold has historically been the most trustworthy and honest form of money.

Green-shoots?

mscullen1@gmail.com (MWS) — Wed, 15 Apr 2009 19:45:00 PDT

There's been plenty of jibba-jabberin lately about so called "green-shoots" in the economy that will lead us into economic recovery. One need only look to the latest capacity utilization numbers, an unfortunately under appreciated piece of data:

Across the board, even utilities, capacity utilization is in percentage terms at record lows. Even the crude level of processing started in acceleration in declines recently.

In the land of economic theory, capacity utilization and inflation are closely tied, with high capacity rates leading inflation. Certainly all time low utilization rates are indicative of deflation. Oh yeah, and the CPI came in today at negative 0.1%, which in reality understates deflation because of owner's equivalent rent malarchy in calculating home prices.

Also worthy of consideration are job losses that do not seem to be losing steam and U-6 unemployment (more close to reality) over 15%. There are in reality, so many green-shoots to refute and so much growing negative news and data.

Green-shoots are for the weak of mind.

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